Why the Detroit Three should merge their engine operations

Tue, Dec 22 2015

GM and FCA should consider a smaller merger that could still save them billions of dollars, and maybe lure Ford into the deal.

Fiat-Chrysler CEO Sergio Marchionne would love to see his company merge with General Motors. But GM's board of directors essentially told him to go pound sand. So now what?

The boardroom battle started when Mr. Marchionne published a study called Confessions of a Capital Junkie. In it, Sergio detailed the amount of capital the auto industry wastes every year with duplicate investments. And he documented how other industries provide superior returns. He's right, of course. Other industries earn much better returns on their invested capital. And there's a danger that one day the investors will turn their backs on the auto industry and look to other business sectors where they can make more money.

But even with powerful arguments Marchionne couldn't convince GM to take over FCA. And while that fight may now be over, GM and FCA should consider a smaller merger that could still save them billions of dollars, and maybe lure Ford into the deal. No doubt this suggestion will send purists into convulsions, but so be it.

The Detroit Three should seriously consider merging their powertrain operations, even though that's a sacrilege in an industry that still considers the engine the "heart" of the car. These automakers have built up considerable brand equity in some of their engines. But the vast majority of American car buyers could not tell you what kind of engine they have under the hood.

More importantly, most car buyers really don't care what kind of engine or transmission they have as long as it's reliable, durable, and efficient.

Combining that production would give the Detroit Three the kind of scale that no one else could match.

There are exceptions, of course. Hardcore enthusiasts care deeply about the powertrains in their cars. So do most diesel, plug-in, and hybrid owners. But all of them account for maybe 15 percent of the car-buying public.

So that means about 85 percent of car buyers don't care where their engine and transmission came from, just as they don't know or care who supplied the steel, who made the headlamps, or who delivered the seats on a just-in-time basis. It's immaterial to them. And that presents the automakers with an opportunity to achieve a staggering level of manufacturing scale.

In the NAFTA market alone, GM, Ford, and FCA will build nearly nine million engines and nine million transmissions this year. Globally they will build over 20 million of each. FCA estimates that nearly 90 percent of that production overlaps, meaning they're all building very similar engines and transmissions. Combining that production would give the Detroit Three the kind of scale that no one else could match. And that would give them the lowest powertrain costs in the industry by a wide margin.

Engines and transmissions are expensive. They take years to design and develop and require a huge capital outlay to tool up. A common rule of thumb is that it costs half a billion dollars to develop a new engine, and another half billion for a factory to build it. The same rule of thumb applies to transmissions. By merging those powertrain operations together the Detroit Three could eliminate a lot of duplication and cut costs considerably.

Merging those powertrain operations now would provide a smoother transition to right-sizing and downsizing.

They could also keep some of that work in-house, to develop variations that already enjoy solid brand equity, like GM's LT4, FCA's Hemi, and Ford's EcoBoost. As long as they kept it to bolt-on technology, they could afford to develop unique variations that gearheads would pay extra to buy.

But how would you merge this all together? The best way would be to form a separate company, or turn it over to a supplier. I don't think it could be done on a collaborative basis because each automaker would argue that its designs should be adopted by the other two. And those arguments would go on for years. You need an impartial arbitrator to make those hard-nosed decisions, and that calls for a separate, stand-alone company.

There's another reason why a merger like this makes sense. As car sharing and mobility services become ever more popular, car ownership is likely to decline. Automakers will need fewer factories in the next couple of decades. So merging those powertrain operations now would provide a smoother transition to right-sizing and downsizing. A kinder, gentler chop of the axe, if you will.

The BRICS have collapsed or stalled out, Europe will take years to recover, NAFTA is near its peak -- there is little opportunity for growth anywhere in the global industry. Automakers and suppliers are already coming under more pressure from the investment community, and activist investors are demanding that more cash be given to shareholders. So yes, details aside, the D3 need to take bold action that will result in significant financial improvement and free up billions of capital.

A new powertrain company would have so much scale that it could more easily afford to add new technology to engines and transmissions than any of its competitors. This would include hybrids, plug-ins and fuel cells. So in this case a monopoly would give the D3 a competitive advantage. Just as Apple relies on Foxconn for almost all of its manufacturing, there are advantages to this kind of relationship.

Besides, the character of an engine today is primarily set by the software and calibration. That can always be kept in-house. Writing software does not involve big capital outlays.

Automakers need to take bold action to convince Wall Street they're making progress to boost their margins. Merging powertrain operations would not deliver the kind of savings that a full-blown combination of GM and FCA would provide. But it would be far more manageable, far quicker to implement, and would drop billions to the bottom line.

John McElroy is host of the TV program Autoline This Week and an automotive industry expert. He also hosts the web series Autoline Daily and Autoline After Hours.

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By John McElroy