Challenges facing the automotive sector

March 2021  |  TALKINGPOINT  |  SECTOR ANALYSIS

Financier Worldwide Magazine

March 2021 Issue

FW discusses challenges facing the automotive sector with Richard J. Cooper at Cleary Gottlieb Steen & Hamilton LLP, Ryan Blaine Bennett at Kirkland & Ellis LLP, Trevor Borthwick at Mayer Brown, and Thomas Steinberger at PwC.

FW: How would you describe the impact the coronavirus (COVID-19) pandemic has had on the automotive sector over the past 12 months? How has it affected performance and profitability, for example?

Cooper: Coronavirus (COVID-19) has had a multifaceted impact on the automotive sector and has resulted in decreased production and lower inventories, a decline in sales and increased profitability per unit. In 2020, auto sales declined roughly 15 percent from 2019 levels, although there was an uptick in sales in Q3 and Q4 2020. In 2021, the industry expects sales to continue to recover to around 16 million units, a 10 percent increase from 2020 levels. However, although a rebound is under way, rating agencies following the industry estimate it could take 3-5 years, based on previous downturns, for the industry to return to 2019 levels in the US. At the same time, profit margins on new vehicle sales in North America are at record or near record levels. Lower inventories have lifted profits for car manufacturers and dealers due to higher transaction prices and lower inventory holding costs.

Borthwick: The traditional automotive sector already faced significant challenges before COVID-19. Issues such as changes in technology, customer habits and international trade relations have been well documented. Worldwide, the sector has experienced a collapse in demand for new vehicles of something in the order of 30 percent as a result of the crisis. The exact reduction varies by region, with China apparently experiencing a decline of about 23 percent and Europe suffering a decline closer to 40 percent, with variations within regions. However, the overall effect is probably the worst decline in car sales since the Second World War, and this will magnify the impact of pre-existing trends. In December 2019, IHS Markit predicted a 20 million decline in the number of vehicles produced globally. This figure excluded the effect of the latest surge in the pandemic in late 2020 and early 2021, and it is anticipated that the IHS prediction on the decline in vehicle production will be exceeded.

Steinberger: A general observation is the bigger, the better. This holds especially true for the supplier landscape. On average we expect approximately 15 percent less sales of passenger vehicles and approximately 18 percent less production compared to 2019, with Europe affected more heavily than other regions. This will wipe out profits in many cases and end a long streak of profitable years for the automotive industry, especially for suppliers, which were able to outperform original equipment manufacturers (OEMs) in recent years. Nevertheless, suppliers with a real global footprint were able to participate in the rapid recovery of the Chinese market early in Q2 and Q3 2020. We can also see that suppliers with significant aftermarket business saw less impact on their profit and loss and balance sheet than those without this type of business.

Bennett: Pre-pandemic, the automotive sector was going through a bit of a metamorphosis on the technological front. Automation, ride-share and electrical vehicles were all focal points for OEMs and the supply base as they looked to stay ahead or at least keep up with the curve. Then the pandemic hit. OEMs shut down production in the spring. This tested the resolve and liquidity profile of the supply base and forced a realignment of priorities away from development and more to just staying afloat. But the industry weathered most of the storm and, while a correction is in the cards, it is one that was already forecasted pre-pandemic, and we expect it to play out on a similar timeline.

FW: What unique operational challenges have automotive companies faced since the onset of the pandemic?

Borthwick: The problems are those of demand and supply. Not only are customers in lockdown unable to visit showrooms, but lockdowns and social distancing measures have interrupted supply chains, with many production lines shut down in the early lockdowns of 2020. While the easing of lockdowns has allowed some resumption in production, showrooms are still not as active as they were. Some dealerships have been able to create an online offering for their vehicles, but reports indicate that customers continue to prefer to use showrooms when making relatively large capital commitments in vehicles. Constraints on dealerships’ capacity to sell new cars limits, in turn, the extent to which production lines can resume pre-pandemic volumes, with capacity further affected, in the UK and, possibly, Europe by the impact of Brexit.

Steinberger: The name of the game is managing uncertainty. Fluctuations in demand and the seamless continuation of the supply chain during the ramp-down and re-ramp-up phase were certainly the biggest challenges for the industry. These are in many cases supply chains stretching over multiple continents, with weeks or months of lead-time for certain components with typically very low inventory levels. Apart from purely operational challenges, it was key to align operational necessities with the available financial measures, such as short work compensation, deferral of tax payments and state aid, among other things, in multiple jurisdictions in order to soften the impact of close to zero revenues in March and April 2019. Certainly, the shift from a largely earnings before interest, taxes, depreciation and amortisation (EBITDA)-driven industry to a purely short-term-cash driven operating model was a key hurdle to overcome for most companies in the sector.

Bennett: When OEMs resumed production after the shutdowns in 2020, a number of Tier 1 and Tier 2 suppliers were concerned about the ramp-up costs, both operating and capital expenditure. While automotive suppliers are used to regular summer shutdowns, the COVID-19 production stops were not anticipated and suppliers with thinner liquidity or covenant issues were exposed if the ramp-up costs were too much to bear. Interestingly though, and unlike prior cycles, OEMs were very accommodating to their supply base this time. We saw a number of measures, including shortening payment terms, advancing capital for tooling and just a general willingness to support and help the supply base get back online. This, of course, resulted in very few suppliers faltering as a result of the start and stop of automotive production.

Cooper: The COVID-19 pandemic has created a variety of operational challenges for automotive companies, including industry-wide factory shutdowns in the spring of 2020, an inability to procure certain key supplies such as semiconductors, employee absenteeism, and the need to ensure safety and social distancing in factories. Recently, both Volkswagen and Ford announced plans to cut back production at certain factories in China, Mexico and the US due to semiconductor chip shortages. Given the existing shortages from suppliers, automakers will likely seek to fortify their supply chains by bringing key suppliers closer to their assembly lines and seek to have multiple suppliers for various components. Additionally, many expect that the safety and social distancing measures the industry adopted in factories will remain in place – these measures will continue to increase operating costs and be a drag on efficiency.

FW: How would you characterise the current level of financing available to automotive companies? What funding sources are being tapped in the current market?

Steinberger: From a high level we see a significantly more resilient industry compared to what was expected and feared at the start of the COVID-19 pandemic in Q1 2020. Our research also shows that at the start of the crisis the availability of cash and credit lines in the industry was almost twice the level – in percentage of revenue – compared to the Lehman crisis in 2009/10. Even with a critical view, especially on the powertrain sector, from the financing world most suppliers were able to keep their financing situation stable or even could tap into new credit lines. Apart from traditional bank financing, state aid was certainly a very relevant factor, especially for medium sized and privately-owned players in the market for which access to the capital market was already limited before the COVID-19 crisis.

Cooper: Overall, the balance sheets of automotive companies are much stronger compared to the last crisis they faced in 2008/09. Ford and General Motors each have around $30bn of liquidity and Fiat Chrysler has about $20bn. Tier 1 suppliers are also in a better position than they were in 2008/09. As the pandemic spread in the spring of 2020, the ‘big three’ and their critical suppliers sought to boost liquidity by drawing down on existing credit lines, entering into new credit facilitates and issuing new bonds. Ford drew down $15.4bn, General Motors drew down about $16bn and Fiat Chrysler drew approximately $6.8bn from their existing credit facilities. General Motors entered into a 364-day $1.95bn revolving credit agreement for use by General Motors Financial and priced $4bn of new senior unsecured notes. Ford sold about $8bn in bonds and Fiat Chrysler finalised a $3.8bn emergency credit facility.

Bennett: Financing sources still remain generally open to companies in the automotive sector in light of the market’s overall cash-heavy dynamic, coupled with low interest rates and a strong desire from investors to ‘put capital to work’. However, if and when the capital markets dry up, that is likely to trigger a significant level of distress as companies become increasingly unable to refinance their maturing debt or otherwise raise new capital to fund their technological transformations – something that was in play well before COVID-19.

Borthwick: Bank, bond and equity markets all remain available. For example, Jaguar LandRover, which some commentators have highlighted as potentially stressed, was able to launch two successful bond issues in the autumn and winter of 2020. Geely and Aston Martin were both able to raise equity in the early summer of 2020 and banks have remained supportive of the sector for the time being. However, it is uncertain how long these conditions will continue, particularly as and when governments begin to withdraw financial support for business.

FW: What initial steps have automotive sector companies taken to navigate the crisis and adapt to recent changes in the market? Is there a greater focus on core activities, rather than expansion into new areas?

Bennett: Initially, when shutdowns went into effect, there was a heightened focus on liquidity and reducing capital expenditure to preserve it. Once the supply base began to recognise the positive level of support from the customer base, companies shifted back to more normalised capital expenditure and R&D spending. Most are still catching up to their pre-pandemic projections and plans, but the stronger, more customer-supported suppliers are appropriately focused again on the recalibration strategies that were being implemented pre-pandemic.

Borthwick: Consolidation is a clear feature of the market. Although there were only 55 automotive M&A deals announced in the first eight months of 2020, according to PwC, deal sizes remained significant, with the total value of deals in the period exceeding $20bn. PwC expects more than 250 M&A deals in the sector globally in 2021 as consolidation gathers pace. Dealerships have sought to switch to online sales, with ‘click and collect’ offerings being favoured. However, the Society of Motoring Manufacturers and Traders still estimates that the industry in the UK alone lost £1.3bn in sales in 2020. The one area of relatively good news was an upturn in sales of electric vehicles, and it is likely that there will be renewed focus on digitally connected, automated and electric vehicles through the remainder of 2020. It seems that the pre-pandemic trend toward various forms of shared ownership was reversed, at least in the UK, during the pandemic.

Cooper: The automotive industry is adapting due to the pandemic – factories have adopted social distancing to keep assembly lines running and automakers are seeking to accelerate the move to more regional parts suppliers to increase reliability. Before COVID-19, the industry was seeking to adapt to major changes, such as the development of fully electric vehicles (EVs), driverless cars and digital factories. Investment in these areas has continued – Volkswagen and General Motors recently announced they are investing $86bn and $25bn, respectively, in these areas through 2025. The onset of the Biden administration and the Democratic victories in the January Senate runoff elections should only hasten the industry’s move to shifting production to EVs. Over the long term, it will be interesting to see if remote working and consumer concerns regarding the use of mass transit – each of which may linger well beyond the culmination of the pandemic – will result in a shift in product offerings, favouring SUVs over compact cars, or overall demand.

Steinberger: After Lehman, automotive OEMs were clearly focusing on cost flexibility and the ability to deal successfully with demand fluctuation. For OEMS and large multinational Tier 1 suppliers, this paid off during the crisis. Medium-sized and smaller suppliers were less able to cope and were hit harder by the demand reduction. Before the crisis, we already saw a trend where larger suppliers sold or at least separated non-core activities. This is a trend which we expect to continue and accelerate, since the need to free up cash and resources has increased either to overcome COVID-19-related losses and cash-burn and create the necessary resources for R&D and ongoing transformation.

FW: To what extent do you anticipate a wave of restructuring and insolvency activity in the automotive industry over the coming months? What are likely to be the key issues to address in such cases?

Borthwick: Given the severe decline in new car sales in 2020 and resulting high levels of debt incurred, and with sales levels not forecast to regain 2019 levels until 2022 at the earliest, restructuring, distressed M&A and insolvencies in 2021 and 2022 seem inevitable. We expect many corporates to require restructuring of some degree. Excess debt on the balance sheet will be a key issue to address, unless equity investors are prepared to provide support in the form of material new equity. But the main challenge will be identifying a clear and sustainable path to make the business proposition attractive to current stakeholders and future investors. It will no doubt take quite some time to obtain reliable data on what post-COVID-19 customer behaviours will be. Until that becomes clear, the question is whether investors will be prepared to provide the necessary capital to address the operational and financial challenges.

Cooper: While automotive OEMs and many of their Tier 1 suppliers have built significant liquidity such that we do not expect to see significant restructuring or insolvency activity, we may see restructuring and insolvency activity among non-Tier 1 suppliers – particularly among small-to-medium-sized suppliers or foreign suppliers that have not received financial support from their governments or have been negatively impacted by supply chain issues. Unlike OEMs that amassed cash on their balance sheets, many auto suppliers did not prepare their balance sheets for the COVID-19-induced downturn in the economy. For instance, Techniplas, a producer of plastic components for the auto industry, commenced Chapter 11 bankruptcy proceedings in Delaware in May 2020 citing the coronavirus, among other issues, as the reason for the filing. While certain suppliers were able to seek relief under the US government’s Paycheck Protection Program, certain medium-sized suppliers were too large to qualify. Whether additional near-term filings will follow will depend largely on production through 2021 and whether the industry trend to EVs and more localised supply chains disrupts certain suppliers.

Steinberger: Even before COVID-19, the industry was already in restructuring mode, with slightly eroding sales and a massive transformation of the powertrain and the trend for autonomous driving. These issues will not go away and will now have to be solved with less resources in a shorter period of time. Apart from the ongoing fight for operational excellence and cost reduction in the industry, product portfolio and especially global footprint management will shift into focus, with ongoing demand uncertainty and lower sales levels going forward. In addition, the future will bring increased levels of debt, lower equity rations and the need to repay state aid in many cases. The combination of these COVID-19-caused issues with suffering margins from restructuring and transformation could create the need for additional financial restructuring, with the gap between EBITDA-levels and net debt levels widening.

Bennett: Our overall view of the sector is generally negative. If and when the market downturn begins and capital markets tighten, there will be a significant uptick in automotive restructurings and Chapter 11 cases. Several automotive companies are already facing substantial EBITDA declines, are beginning to push against leverage covenants in their debt documents and have impending maturities that they will be struggling to refinance. All of that while undertaking operational restructurings in an effort to rationalise their business in light of overall industry trends.

FW: What advice would you offer to automotive sector companies on reimagining their business strategy to meet future demands?

Bennett: Be flexible. We have seen significant investment in new technology as consumers’ interest in electric and autonomous vehicles grows internationally. Many traditional automotive companies have also begun partnering with companies that have not traditionally played in the automotive space. And others have spun off or wound down increasingly obsolete product lines to proactively adjust their product portfolio in light of customer and OEM industry trends.

Steinberger: It sounds easy and could be oversimplified but the advice is to focus and prioritise. The industry needs to do the following. Shift from long-term capacity increase to short- and mid-term capacity management. Shift from a planned and long-term financing of the transformation to cash-containment with shrinking revenues. Shift from parallel investments in computer-aided software engineering technologies to prioritising e-mobility and digital investments. Finally, recognise the disruption which will come from changing customer needs and customer structures. Recent months have shown that the crisis did not lead to a softening of emission standards or widespread stimulus for traditional cars. Even more, the shift to hybrid and full-electric powertrains has accelerated, and the push for net-zero carbon emissions will reach the industry and the supply chain. The cost-effective management of R&D will also differentiate future winners, since R&D spending will certainly have to increase. The industry has only been moderately successful so far in transferring that into better margins, especially in the supplier segment.

Cooper: Consumer demands and regulatory requirements regarding automotive production were shifting on a global basis long before the pandemic. Governments in Europe, Asia and the US have demonstrated a willingness to hasten the auto sector’s transition away from gas-powered engines. For instance, the European Union has included stricter emissions regulations as part of its climate plan. The incoming Biden administration has said it plans to make significant investments in the electric vehicle industry, such as through creating 500,000 new electric vehicle charging stations and by increasing federal incentives with respect to electric vehicle manufacturing. Japan plans to ban gas-powered cars by 2035. A successful business strategy, whether for an OEM, supplier or dealer, will take these shifts into consideration. Additionally, successful automotive sector companies can benefit from lessons learned during the pandemic, including improving the reliability of supply chains focusing on online ordering and services to consumers.

Borthwick: The era of the internal combustion engine seems over. Being connected, automated and electric are clearly important at present, and shared ownership may remain a trend. Also, it seems that the underlying concern among customers driving many of these trends is concern for the environment. Reduced or zero emissions and minimised carbon footprints seem likely to be the keys to success in the 2020s and beyond. However, the COVID-19 crisis can also offer opportunities. Tools to implement a restructuring, which might not otherwise be available, can also be used to expedite reorganisation of a business model that might otherwise take many years to achieve.

FW: In the wake of COVID-19, how confident are you that the sector will rebound to pre-crisis levels? What factors will separate those automotive companies that survive from those that fall behind?

Steinberger: We expect a slow rebound to pre-crisis levels for 2023 or, in a more optimistic scenario, for 2022. But even in a positive scenario, the industry has only a little chance to overcome this crisis through growth. The adaption of the production network to the ‘new normal’ of little to no growth, combined with fluctuation demand, until at least the end of 2021, will be a key differentiator in the industry. With the pre-crisis focus on new plants and new standard operating procedures, we have seen several cases in which the traditional ‘homework’ has shifted out of the strategic focus. Even if it sounds boring, operational excellence and best-in-class cost management will become increasingly important, since an environment with little growth and slow demand will create further cost pressure down in the Tier 1 to Tier 3 segment of the supply chain.

Cooper: The industry is fairly confident of a rebound to pre-crisis levels. However, rating agencies have noted that it may take a couple of years for the industry to reach those levels. In Q3 and Q4 2020, we saw the beginning of a recovery in the US, however certain manufacturers and suppliers have been harder hit than others. The ability to rebound is bounded by supply chains, and the continued shortage of semiconductor chips has caused Volkswagen, Ford and Honda to announce production reductions and temporary factory shutdowns in China, Mexico and the US. In the end, OEMs and suppliers that have amassed sufficient liquidity to avoid near-term financial stresses, have business plans that reflect the changing dynamics of the marketplace and have protected themselves against supply chain disruptions are going to be more successful than those that have not taken those measures.

Borthwick: If the end of lockdowns produces a surge in spending of cash saved during the pandemic period, heralding a new ‘roaring twenties’ as some have predicted, then there is potential for recovery. In the UK, the pandemic has seen an increased preference for commuting by car rather than public transport, and if this trend proves to be sustained it will also fuel a rebound. The marked contrast between the fall in sales of diesel and petrol cars in the lockdowns and the increase in sales of electric vehicles suggests that those OEMs with the most developed hybrid, as well as electric vehicle offerings, will benefit most from the rebound. Hydrogen fuel cell offerings may also prove to give an advantage. Conversely, OEMs that have underinvested in alternatives to petrol and diesel may well find themselves falling behind.

Bennett: OEM customers have spared most of their supply base by shouldering much of the near-term burden associated with the pandemic. But the same factors that would have been at play before the pandemic will be relevant going forward, namely to what extent a supplier is relevant in terms of its product offerings, innovation and reliability. The industry is ripe for consolidation given the various macro-influenced technological factors at play and, ultimately, OEMs’ willingness to support a particular supplier through pricing and new sourcing will be tied to whether that supplier has kept up with the curve or fallen behind.

Richard J. Cooper is one of the preeminent cross-border bankruptcy and restructuring lawyers in the US and is the recognised leader in cross-border and sovereign restructurings involving companies and countries in Latin America and other emerging markets. His practice focuses on domestic and international corporate, municipal and sovereign restructurings, and he has advised clients involved in some of the most prominent and noteworthy restructurings in the US and Latin America over the last 20 years. He can be contacted on +1 (212) 225 2276 or by email: rcooper@cgsh.com.

Ryan Blaine Bennett is a partner in Kirkland & Ellis’ restructuring group. He focuses his practice on protecting and advancing the financial interests of corporate debtors and secured and unsecured creditors in the various transactional and litigation-related aspects of the debtor-creditor relationship. He can be contacted on +1 (312) 862 2074 or by email: ryan.bennett@kirkland.com.

Trevor Borthwick is a partner in the banking and finance practice of Mayer Brown’s London office. He represents banks and borrowers on large and complex financing arrangements, debt special situations and restructurings across a wide variety of sectors. He can be contacted on +44 (0)20 3130 3556 or by email: tborthwick@mayerbrown.com.

Thomas Steinberger has worked in the business recovery services team at PwC since 2005 and currently leads PwC Europe’s automotive transactions and restructuring practice in its Munich office. He has more than 20 years of experience in industry and advisory. Additionally, he has broad experience in the execution of complex restructuring projects in medium-sized and listed enterprises. He holds degrees in electrical engineering and business administration. He can be contacted on +49 89 5790 6443 or by email: thomas.steinberger@pwc.com.

© Financier Worldwide

THE PANELLISTS

Richard J. Cooper

Cleary Gottlieb Steen & Hamilton LLP

Ryan Blaine Bennett

Kirkland & Ellis LLP

Trevor Borthwick

Mayer Brown

Thomas Steinberger

PwC