The U.S. Auto Industry in 2005 from a Non-Detroiter's Perspective
By Dan Dooley, Principal and COO, MorrisAnderson
This article examines the primary issues currently facing the U.S. Automotive Industry. The perspective is from a senior principal of a national middle-market workout firm where only about 15% of its business is in automotive. The author has worked for Tier One suppliers and has been CEO of Tier Two suppliers. This article warns that automotive suppliers must be very proactive and creative Right Now or they will likely be left behind and see their business die off.
Over-Capacity in basic component manufacturing
This allows the Big 3 and its Tier One to force continual price decreases down the supply chain because some underutilized manufacturer will always take existing sales at low margins to fill up excess capacity. Since it is common practice in the automotive industry for the customer to own the molds and tooling, switching vendors is not as much of a hurdle as it is in other manufacturing industries.
Currently, the U.S. automotive component industry is operating in the mid-60 percent utilization range, a full 15 percentage points to 20 percentage points below the 80 percent threshold that economists generally regard as the midpoint of a healthy industry. This condition almost surely will result in massive production consolidation and the much needed closing of "many" U.S. plants.
Simple math implies approximately a 25% reduction in capacity is needed to "right size" the capacity. I would argue that at least 1 out of 4 U.S. plants needs to be closed as a most conservative estimate. This will be quite a blood letting and we are now at that point in my opinion.
Massive Outsourcing to the Pacific Rim.
The auto component industry avoided the initial wave of outsourcing to the Far East (Japan and Taiwan) in the 80's for several reasons. First, there was tremendous cost that could be squeezed out of the existing supply base as the Big 3 were all basically engineering and marketing companies which had poorly managed operations. Enter Lopez at GM as the purchasing czar and the big squeeze on suppliers began. Second, the new emphasis on operations and the "partial" modeling of the successful Japanese manufacturing system tightened up the supply chain tremendously and resulted in the norm today of two days of inventory on hand at assembly plants and with most suppliers within 8 hours truck travel time (1 shift) of the plant. In this type of environment, it is very difficult to introduce any long lead time suppliers (i.e., Pacific Rim) to the assembly plant mix of suppliers as the logistical risk is too great. Finally, the Big 3 started to spin off major Tier One operations as stand-alone companies (Delphi, Visteon, etc.) and this further reduced costs.
So what's different today? Why will the automotive industry be forced to outsource this time? The cost, productivity and quality penalties of the Big 3 vs. the transplants have not been closed and, in fact, have gotten worse. There is serious concern that both GM and Ford could end up in bankruptcy with both now having their bonds recently downgraded to "junk" status by the major rating agencies. My personal view is that they won't end up in bankruptcy in this economic cycle, but they may the next time the cycle collapses if they don't take drastic action in the near-term.
The point is that with the high, fully loaded labor costs of the UAW plants that are standard at the OEM's and the Tier Ones and the fact that these manufacturers don't have the option to go south to avoid the union, I think you will see a big acceleration in the relocation of major component plants to the Pacific Rim under the "serving the local market" rationale. The bottom line to this is that U.S. component manufacturers had better get a substantial Pacific Rim manufacturing operation up and running or they will be left out in the cold.
Final note is that most other industries (with the notable exceptions of automotive and aerospace) made a major move to the Pacific Rim when China was granted free trade status in 2001. The major type of products moved to China, Korea, India and Vietnam during this aftermath were: commodity products (vs. special order), higher volume products, lighter weight/smaller products where freight cost is less of an issue, and products where there was low risk of engineering change. The general rule was that products in these categories often would result in 30% to 50% lower cost on a landed cost basis than domestically produced components. With savings of that magnitude the industry should come to a point where they are forced to move production overseas.
Raw Material Cost Risk vs. fixed price sales contracts
In addition to the industry standard fixed price sales contracts, vendors are faced with annual price give-backs that were cancelable upon "convenience": convenient only to the customer because only the supplier is bound and the buyer can opt out if someone offers a lower price. This deal is a little like a sports owner's deal with a professional athlete. Both totally put the risk of changing economics on one party – the supplier and the owner.
In the last year we have learned that steel and oil are pure commodities and that market prices can move up and down quickly and by large amounts. Smaller companies have no purchasing leverage with the commodity producers to negotiate long-term agreements or to employ effective commodity hedging strategies. Many component manufacturers have over 50% material content on a sales dollar and larger organizations enjoy an estimated 10% or more lower raw material cost advantage which translates to at least a 5% full cost advantage in businesses that typically have gross margins of 20% maximum and often much less. The bottom line, again, translates to the need to create much bigger consolidated organizations. I think we're talking consolidated component organizations of $1 billion or greater. With many of these companies now in the $20 million to $200 million range, we're talking lots of big time roll-ups that are coming.
Ability to Finance component businesses.
Two major changes have occurred that directly affect component manufacturers right now. First, GE had a financing ("Fast Pay" Program) deal with the Big 3 and Tier One that was killed by a recent Accounting Board ruling. Up until July 2004, GE was essentially factoring Tier One receivables with the Big 3 and paying the Tier Ones within 10 days despite being paid in say 60 days by the Big 3. The Big 3 got a discount for participating and GE made a margin on the deal. However, the receivables were guaranteed by the Big 3. The accounting ruling would have forced the Big 3 to establish debt on their balance sheet equal to the amount they guaranteed. This killed the tactic and the Big 3 weaned the Tier Ones off this financing during late 2004. Although many Tier Ones replaced the Fast Pay deal with ABL facilities, it was too little cash too late.
The second thing that changed was that many metal suppliers were essentially forced by market circumstances to participate in the OEM's Steel Resale Programs as a way to at least partially mitigate the doubling of steel costs during 2004. Essentially, the Steel Resale Program is a long-term deal that the Big 3 has with the major steel mills for a fixed price long-term supply of steel. Historically, this price is like insurance in that the price is perhaps 10% higher than spot prices, but it is fixed. As you can imagine, many metal manufacturers bought steel on their own to save money. Of course, this was a great move until steel prices rose significantly. The bottom line is that most steel component manufacturers now buy steel under the Steel Resale Program which means the legal buy-sell transaction is with the Big 3 customer. This was the only way to get partial pricing relief.
The change moved suppliers from vendor financing with 30-60 days accounts payable to customer financing of accounts payable where the customer accounts receivable has a direct "contra" effect on its borrowing base for the customer accounts payable. Given that most suppliers have asset-based lending facilities, this reduced "net" receivables and essentially forced suppliers to pay cash for steel. This is now a huge capital structure issue with almost all metal component manufacturers on a steel resale program.
Value Added Services
To fight the pricing pressure there is a drastic need for automotive component manufacturers to do more than basic fabrication processes which are the most easy to replicate and thus allow easier movement of products from one manufacturer to another. This means that the manufacturer's relatively safe harbor is a higher labor content doing more value added operations (welding, assembly, etc.). Manufacturers are constantly proposing redesign of existing processes integrating their components and their customer's upstream processes as a cost reduction play for their customers. Again, this moves labor farther away from the Big 3 where the highest labor costs are and also cuts the total suppliers involved in the game. However, the ability to provide value added services is at the cost of additional engineering and support staff. Smaller organizations will struggle to provide the necessary support and be forced to compete on price. This provides another piece of evidence for the coming supplier consolidation.
Continuing Loss of Market Share
Trucks and SUV's have propped up domestic auto performance for the last five years. The higher-end Chrysler 300 and new Cadillac models are the only passenger cars made by the Big 3 making significant strides in new sales. The aging customer base of the Big 3 consumption has been strong throughout the recent recession due to heavy marketing incentives and the SUV craze. The demand has started to drop this year. The Big 3 will have to look to consolidate its lines and look to vendors to help with costs. Again, consolidation is coming.
So, what do I do if I'm a domestic automotive component manufacturer?
Shut all but your strongest plants. Jam plants together and get to fully utilized capacity. Ignore growth capacity for now.
Move a significant portion of your production to the Pacific Rim – 25% to 75%. You must be on the front end of this movement.
Invest some time and money trying to pitch upstream integration of labor and value added to your customers especially if you think you are selling to a plant that's likely to be closed in this downturn. Given the cost structures of the Big 3 and Tier One, you will see more outsourcing down to Tier Two.
Manage accounts receivable tight. Don't be afraid to stop shipping when you're not paid on time or you have a payment dispute. The customers don't have the inventory to withstand credit holds for more than a week, so you have leverage.
Diversify some portion of your business out of automotive. Many suppliers are 100% or near so automotive dedicated. Few really are committed to chasing other industries. You need to pay an outsider to have any chance of doing this successfully. Do not use automotive sales people or you will fail.
The next three years will be a battlefield in automotive with lots of casualties. There will be a big consolidation of Tier Two and Tier Three suppliers. Personally, I don't see any of the Big 3 filing bankruptcy in this downturn, but I expect at least one to do so in the next industry down cycle as the legacy and labor costs simply create too large a cost disadvantage. This future potential bankruptcy of either GM or Ford would likely be in 2010 or later, in my view.
Let me close with a prediction that all of the Big 3 will establish sizable manufacturing capabilities in China over the next five years to serve the "local" market. Of course, these plants will be setup with lots of over-capacity to grow. At some point, one of the Big 3 will announce a "trial" program to "temporarily" import Chinese made vehicles into the U.S. The UAW backlash will be severe which will accelerate the Big 3 move to shift even more production to China.
In essence, this will be a "union breaking" strategy and the UAW will react with a vengeance. I think it's likely we'll have, again, labor violence like this country saw in the 1920's and 1930's as the UAW fights for its very life.
Think of the irony that will have then developed. The Far East manufacturers (heavily Japanese) will be successfully making vehicles in the U.S. for the U.S. market; however, the U.S. Big 3 will be making vehicles in China for import into the United States.
View the updated 2008 Article.
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