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Automotive OEM and Tier 1 Consolidation – Tip of the Iceberg
Consolidation activity in the domestic automotive industry will continue altering the competitive landscape for companies across the entire automotive universe, specifically at the Tier Two or middle-market level where consolidation pressure is the greatest. The current business climate for automotive suppliers is characterized by consolidation-driving factors including an increasingly global marketplace, industry-wide overcapacity, and fluctuations in the pricing and availability of raw materials. These industry-specific factors combine with a resurgent merger-and-acquisition (M & A) market.
Over the past three years, strategic buyers have been relatively inactive in the automotive sector due to a sluggish economy and the heavy debt burdens of many companies. However, the recent economic recovery has allowed many of these companies to improve financial health. Current market conditions make M & A alternatives viable solutions for the strategic challenges facing many companies. The competitive dynamics continue to change as the industry heads toward a supply base of fewer larger and globally positioned suppliers able to serve customers worldwide. Many factors contribute to supply-base consolidation, the most prevalent starting at the original-equipment-manufacturer (OEM) level.
Major structural changes are sweeping through the domestic automotive industry, affecting not only the colossal OEMs, but small, family-owned suppliers of components as well.
Foreign Competition Makes an Impact
Market-share erosion due to the continued success of foreign brands has stunted unit volumes for the domestic Big Three, resulting in limited revenue growth. Year-to-date light-vehicle market share (cars, light trucks and SUVs) produced by the Big Three is 60.1 percent as of September 2004, significantly lower than the 70+ percent market share of the early 1990s, and the 85-percent market share of the 1970s. For the first time in history, the Big Three’s percentage of total cars sold in the United States fell below 50 percent.
The economic downturn that began in late 2001 and the softening of unit volumes exacerbated the Big Three’s market-share struggles. Going forward, industry experts forecast North American light-vehicle production to be 16.1 million units in 2004, slightly off last-year’s 16.3-million unit pace, and down significantly from the record high of 17.7-million units of 2000.
From the perspectives of revenue and cost per vehicle, the Big Three compete against companies with dramatically lower cost structures. The Big Three’s labor costs are essentially fixed as a result of a union contract that secures 95 percent of the members’ base pay, even if they are laid off.
Additionally, legacy costs remain an increasingly significant portion of the cost structure. For example, each hourly General Motors employee supports roughly three retirees. With the average age of the hourly worker at 50 years, with 24 years of experience on the job, this ratio should increase to 5 to 1 within 10 years. Overall, employee-related legacy costs to the Big Three translate into a cost disadvantage of approximately $1300 per vehicle when compared to foreign competition.
A company with a lower degree of operating leverage (higher fixed costs) will exhibit more dramatic swings in profit. This factor has negatively impacted earnings for the Big Three and created an environment where it is advantageous for the domestic OEMs to produce at a level greater than the equilibrium of supply and demand. They then must use rebates and favorable financing to entice consumers to purchase new automobiles at low margins and, occasionally, at a loss.
Another factor contributing to the Big Three’s uncompetitive cost structure is excess capacity. DaimlerChrysler utilizes its current capacity the most efficiently among the Big Three, at a rate of 89 percent. GM and Ford are slightly less efficient, utilizing 73 percent and 78 percent of their capacity, respectively.
What to Do? Reduce Component Costs
Given their burdensome legacy costs and underutilization of capacity, one of the last remaining cost levers within the domestic OEMs’ control is the component cost of the vehicles. The positive news for the automakers is that component costs make up approximately 70 percent of a vehicle’s total cost. As a result, every automotive OEM, not just the Big Three, is aggressively moving to reduce component cost. These reductions ultimately are achieved by driving the entire supply base toward greater efficiency and lower prices.
In the early years of the automotive industry, automakers strived for vertical integration, producing virtually everything from wheels to windshields. As the maturing market offered slimmer margins, the benefits of efficiency through specialization became apparent. As a result of the array of market factors currently in place, the domestic automakers now concentrate on value-added, less capital-intensive operations such as marketing, designing, and if necessary, assembling the final vehicle. The responsibility of system production, assembly and design now falls to a select group of globally positioned Tier One suppliers. Compelled by the pressures of competitive bidding, Tier One companies and their suppliers have become increasingly efficient in their production of component parts.
The necessity for greater mass-production capabilities drives the current supply-base consolidation trend. Currently, there are very few global companies able to take on the daunting task of supplying a complete system directly to an OEM on one or more platforms. The Tier One’s global approach to filling this void in the supplier marketplace may involve one or more of the following four major action items:
- The company must attain the critical mass, global presence and ability to deliver the complete system to the OEM customer. Depending on the situation, the company may already be in this position. If not, a significant merger or acquisition may be necessary.
- The company may need to pursue select smaller acquisitions to supplement its technological or operational abilities. These acquisitions would allow the design and supply of a complete system, and could possibly provide a supplier a competitive advantage. Now more than ever, technological advances are of critical importance to automotive OEMs, as a proprietary innovation or unique product offering has become increasingly necessary to maintain strong product demand in the crowded marketplace.
- After a supplier has determined its area of expertise and focus, it may choose to divest non-core or non-value-added commodity operations--basic machining operations for example, on the premise that another company specializing in machining could supply the components more cost effectively. The overall goal is to focus on value-added core competencies, presumably less capital intensive, while strengthening financial position.
- To keep pace with pricing pressure applied by the OEMs, Tier One suppliers will need to transfer this pressure to their component suppliers, stressing improved efficiency and effectiveness and ultimately resulting in lower component costs. The Original Equipment Suppliers Association estimates that in 1990, 30,000 suppliers formed the automotive supply chain; that number decreased to approximately 10,000 in 2000; and that by 2010 only 4000 to 5000 automotive suppliers will remain.
The primary driver of the oncoming consolidation wave will be the Tier Ones’ desire to purchase components from large companies that can meet the following criteria:
- Provide research and design capabilities that will reduce component costs and increase performance;
- Assist in the engineering and design of components relative to the entire system;
- Globally produce and deliver a wide range of components within the select commodity type (for example, various types of highly engineered machined components utilizing a wide range of capabilities);
- Deliver components for the lowest price on a global basis.
Suppliers generating revenue between $200 million and $1 billion will be in the best position as a result of industry consolidation. This consolidation likely will require component suppliers to specialize within a specific commodity such as stampings or machined components. Component suppliers also will need to leverage economies of scale to reduce costs and meet the diverse needs of their customers. To reach this point, the commodity specialist likely will make acquisitions to increase size and capabilities, and to gain access to new customers. These integrators or mega-sized commodity specialists will be able to meet the needs of the Tier Ones on a global basis.
For suppliers with revenues under $200 million that offer commodity-type components, viable long-term options seem relatively limited, and such suppliers may become attractive targets for the integrators. Options for smaller suppliers include:
- Establish themselves as the leading supplier of a highly specialized niche product that falls below the radar screen of larger diversified suppliers;
- Quickly make the acquisitions necessary to become a mega-sized commodity specialist;
- Maintain the current book of business and customer base as long as possible;
- Merge with a company intent on surviving the oncoming wave of change in the automotive supply base.
Expanded Role and Clout
The emerging Tier Ones, and to a lesser extent the mega-sized commodity specialists, will be rewarded with more responsibility and clout with the OEMs as they assume an increasingly important partnership role. Understanding the motivations behind this upcoming trend is the first step in the strategic-planning process. The next step, which for many companies has already begun, entails enacting the necessary strategic alternatives to be best positioned for a future role in the evolving automotive industry.
By Michael D. Benson, managing director, head of investment banking, automotive group, and Gene P. Bitonti, associate, at the Detroit, MI, office of Stout Risius, Ross Advisors, LLC, 248/208-8800; www.gosrr.com