Finding opportunities in the auto industry

An industry in transition
The North American automotive industry is in a serious state of flux. Consumer demand for vehicles produced by the Big Three is waning, while Asian manufacturers continue to bring new models and platforms to North America at a faster rate. Spiking commodity prices and foreign currency exposure are leading to increased supplier rationalization and continued cost-down pressure. And too many automotive players have assumed unsustainable leverage as part of their capital structure, making it increasingly difficult for them to negotiate bumps in the road.

Meanwhile, an accelerating trend towards supply chain globalization is threatening traditional labour cost structures and introducing foreign exchange risks. Suppliers interested in expanding internationally must still comply with a host of domestic regulations, ranging from fuel economy and emission guidelines to end-of-life recyclability. Plus, while overcapacity is expected to ease over the next few years, it still exists in some segments.

Taken together, these forces are squeezing automotive players throughout the North American supply chain. As of November 2005, seven of the largest OEM (Original Equipment Manufacturers) suppliers in North America, representing nearly $28 billion in NAFTA sales, were operating under U.S. Chapter 11 bankruptcy protection. In Canada, large manufacturers have begun shutting plants. In light of these trends, Schedule A banks have also begun reviewing their automotive book of business. Yet, despite current circumstances, all is not bleak. North American demand for automobiles is not going away. If anything, this shifting environment is creating long-term opportunities for savvy industry players.

A new framework for success
The current environment presents industry players with an opportunity to enhance their long-term profitability. This is as true for manufacturers and suppliers as it is for capital investors. For instance, manufacturers eager to strengthen their foundation may want to establish a supply chain risk management framework. The components of such a framework could include an advance warning system, a reaction plan to deal with imminent supplier failure, and an insolvency management plan.

In establishing this type of framework, manufacturers should assess not only the magnitude of potential supplier issues, but also the probability of a supplier’s financial distress. Some warning signs that may indicate imminent problems include turnover or succession issues, a weak management structure, pending litigation, environmental issues, labour or union issues, operational confusion, inefficient production or assembly layout, launch constraints, and quality or delivery issues.

If, in reviewing a supplier’s situation, it appears that insolvency is imminent, it is critical for manufacturers to have a response plan in place. Ultimately, this type of plan should include strategies for minimizing the costs associated with supply interruptions, while allocating appropriate resources to creditor negotiations and insolvency management.

Supplier responses
For their part, suppliers may want to consider strategies for customer diversification and growth. After all, since 2000, the top global suppliers have grown by roughly 9 percent  as a group. Similarly, five of the top 10 global suppliers have grown faster than 12 percent annually over the past four years.

Growth channels for suppliers can include an acquisition or merger, organic growth, or a joint venture or alliance. Historically, strong growth has resulted from four primary drivers: OEM outsourcing, new technology or features, material substitution, and selling to more rapidly growing customers. In addition, as NAFTA continues to lose technology leadership in certain areas, a global footprint is becoming increasingly important for suppliers that want to keep pace with key technology developments.

That said, some of North America’s largest suppliers are re-focusing their product portfolios through the sale of non-core product segments and plants, resulting in many assets for sale. It is this final trend that is raising opportunities for capital investors.

Anticipating future trends
As consolidation continues, there is little doubt that advance preparation will pay off for would-be consolidators. Auto industry players may benefit by becoming consolidators — and ultimately emerge as winners.

On the flip side, it seems apparent that some industry players will not survive. As a result, distress M&A activity has begun to escalate. In fact, industry analysts predict that M&A activity is poised for tremendous growth. The reasons are diverse. For instance, slowed M&A activity since 2001 has resulted in a build-up of companies well-positioned to sell. Valuation multiples have also stabilized from their 2001 lows, with deal values reaching an all-time high since the 2000 dot-com boom. This past year, cross-border and transatlantic activity increased with businesses looking for growth overseas. Plus, low interest rates have kept the lending environment strong.

Of particular interest, as well, is the continued rise of uninvested private equity capital, which currently hovers at an estimated US$100 billion. This liquidity has pushed hedge funds into the realm of private equity, reinsurance, lending and other non-traditional investment vehicles. This trend will permit buyers to finance more aggressive acquisition programs and will allow sellers to receive higher valuation multiples.

Preparing for pending shifts
For automotive manufacturers, suppliers or capital investors, the time is ripe for potential transaction activity. While many of the current trends are taking place south of the border, private equity investors will shift more attention to Canadian deals. Auto parts makers that keep abreast of these trends and seek out opportunities will be well placed to make informed decisions amid the current backdrop of uncertainty.