Auto industry experts see obstacles, hope in the supply chain

By Stephanie N. Rotondo

Portland, Ore., Oct. 29 - At a webinar held by Turnaround Management Associates this week, several auto industry experts attempted to shed light on the present and future of the sector.

The experts opined that restructuring actions taken on the part of automotive parts suppliers - and the industry as a whole - had poised the sector to emerge from the market turmoil stronger than before. However, there are still some obstacles in their path.

The automotive industry took a massive hit as the economy turned downward, but it was not the only one affected by the crisis. Automotive parts suppliers were also hurt as their largest customers scaled back production and made other cost cuts.

As a result, the market has seen several bankruptcies and alternative restructurings coming out of the automotive supply chain. Delphi Corp. and Lear Corp., for example, ended up filing for Chapter 11 protections, while others, such as Sonic Automotive Inc., managed to undertake an internal restructuring without the aid of a bankruptcy court.

With the economy returning to some semblance of normalcy, there are still questions surrounding suppliers and their new role in the supply chain, as well as the global economy.

"We are certainly more hopeful here at Ford [Motor Co.] as we come out of that trough," said William Strong, a staff member of Ford's corporate finance department, as well as the manager of its supplier analysis group.

Parts suppliers "are more resilient than we had anticipated," he added.

John DiDonato of Huron Consulting Group agreed that the sector has shown resiliency throughout the economic dark days, even as some had to liquidate certain parts of their business "to stay alive."

"I thought there were going to be a lot more distressed situations," added Justin Mirro of Moelis & Co., but companies "weathered the storm by pulling cash for working capital."

Added Heather Lennox, Esq., of Jones Day LLP: Auto parts suppliers are "finding a way to survive, but they are still overleveraged."

Staying afloat

With the credit markets on near lockdown - especially for the auto industry - parts suppliers have had to be creative in finding ways to survive.

One of the most important ways suppliers have fought off their demise was to cut costs and capacity.

"There has been a lot of operational work taking capacity out," said Mirro.

"Suppliers that can clean up their operations [...] they are going to be the ones" investors look at.

"From an inside the company point of view, we have management teams that were able to cut costs from their operations," added DiDonato. And it is that reduction of cost structure that will enable a company to emerge from the economic nightmare stronger and better poised for the future.

"When volumes are stabilized, cash flows will improve" based on the cuts made, DiDonato noted.

"What we are seeing now, we look at a company like Lear, which has gone through a balance sheet restructuring," Mirro added. In that instance, the company - with the help of a bankruptcy court - was able to trim debt by over $2 billion and the remaining debt was converted to equity, which in turn saw "a new investor base coming with that."

"This is a model supported by the OEMs," Mirro said.

Another way companies have weathered the storm is to liquidate certain non-core assets, resulting in leaner, more efficient companies with better bottom lines.

"Either way, we get a much stronger supplier as volume starts to come back," Mirro said.

Investors, where art thou?

Still, there is no denying that there are still some concerns surrounding the industry and investors and banks alike are hesitant to jump into that space.

Mirro believes that if a company is "able to come through a restructuring" with a cleaner balance sheet and is, therefore, able to access the tight credit markets, the hedge fund investors that had previously taken their money and ran will comeback.

"Banks are still hesitant to lend into a working capital base," Mirro said. "But we are seeing the high-yield space [open back up] and the private placement market [opening as well]."

The auto industry, Mirro explained, is set up for debt products, "which fits very nicely with debt investors." Companies need the money now, but based on supply agreements - which tend to be at least three years in length - they have the ability to fund long-term maturities, as revenues come in.

"There are investors out there," Mirro said. He again cited Lear as an example. Before Lear filed for bankruptcy, its bonds had been trading in the teens. Now, those same bonds are in the 70s.

"I think people are thinking this company will come out of the box a stronger company," he said. Investors will take interest in similar strong performers.

Still, Mirro was uncomfortable generalizing about hedge funds and what their reaction might be to the new and possibly improved sector.

"I hate to generalize about hedge funds because they seem to change as often as I change my socks," he said. That being said, he believes that new hedge funds - perhaps funds that had never before played in the auto space - will be coming in to take advantage of the investment opportunities.

Private equity players could also be looking for a piece of the pie.

"I am seeing traditional private equity investors that made money in technology now looking at automotive," Mirro said. "There are a lot of strategic groups out there that see this as a perfect opportunity top pick up assets and rationalize" balance sheets.

Mirro calls it a "win-win," as suppliers get the funds they need to make their product, while costs are being monitored and controlled as necessary.

"We're going to see more deals like that," he said. "That's the type of deal Ford and every other purchasing department like to see."

"Once some more M&A activity occurs over the next 18 to 24 months, there is going to be a need for debt products and opportunities for equity raising," he added. And that is when the investors will pounce.

And, "debt investors have very short memories compared to equity investors," he said.

Also, there is another arena of investors that have already begun to take up some of the distressed automotive assets: the Chinese.

"One would think that would be the perfect investment thesis," Mirro said, and in instances such as Delhi and Lear, that has occurred. He also speculated that the market will see more Chinese involvement.

"I think it is just a matter of the Chinese getting more comfortable with these opportunities," he said.

The role of the Big Three and banks

During this time of tight credit markets, some auto suppliers have turned to their biggest customers: the Big Three.

Both Ford and GM have given aid to their respective suppliers, but Strong cautions that that is only as a last resort.

"At Ford, we are certainly not a bank" - a sentiment he repeated several times throughout the conference - "as much as certain suppliers think we are," Strong said. "We are only a lender of last resort."

Given such, Strong says that suppliers must be open and honest with their OEMs and that if they are honest, automakers are more likely to try to help. That could come in the form of some financial aid, or simply a matter of renegotiating contracts.

Strong also indicated that companies might even be willing to go to bat for their suppliers when lenders won't free up cash.

"Say we get a large supplier who isn't able to get financing to launch our new models or even for working capital," Strong said. Then the question becomes, "Are those credits markets going to open up?"

"That's what keeps us up at night," he said.

"If they don't have the capital, that can be a challenging time for the OEM," DiDonato added.

But Ford, for one, has helped its vendors get that financing, Strong said.

"A lot of lenders got gun-shy," Mirro added, noting that some secured lenders at Chrsyler LLC were particularly so.

"It takes commercial bankers a log time to react to the macros" of the economy, DiDonato said, "especially when their balance sheets have been taken out by certain sectors."

"We're seeing people get a little more creative with term sheets," Mirro noted. That creative financing, in his opinion, will replace traditional bank funding.

Government as investor: Yea or Nay?

"I think the general view is that we understand why it happened for the same reasons it happened in the financial community," Lennox said of the government's financial bailouts of the auto industry. However, she cautioned that investors and companies should be skeptical of such involvement.

Though right now the government seems to be content as a "passive investor," Lennox conceded that that could change at any time.

"It could be dangerous for the country if somebody" decides on a whim to take a more aggressive role in the industry.

"[Still,] that was what it was," she said. "But I think it's a dangerous trend and I, for one, hope it stops."

Costs, capacity are all that matter

In the end, those in the supply chain that are able to reduce costs and capacity should be able to stay alive and in some cases even thrive once the economy turns around.

But there are still concerns that some will not be able to do that.

"Costs need to come down," Lennox said, especially on the labor front.

"There needs to be some realization on the labor front that costs need to come down in relation to the realities of the 21st century," she said.

And, capacity needs to be kept in check.

"It comes down to profitability," said DiDonato. "And there isn't a better time in terms of capacity being taken out to see improved profitability.

"Without taking out that capacity, there is no assurance that margins will improve," he added.

But as companies shut down plants in their efforts to reduce capacity, another problem has popped up.

According to Mirro, "I am getting calls daily from investors looking to buy these old facilities."

Investors can pick up these fully stocked facilities for cheap and then open up their own company to produce this or that product.

But, "that is exactly what we don't want to happen," he said. That would only once gain increase industry capacity that could then have a "ripple effect," causing more distress later on.

"I wish the government would have thought about that a little more and provided more oversight," he said.

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