Restructuring and bankruptcy challenges in the automotive sector
January 2020 | TALKINGPOINT | BANKRUPTCY & RESTRUCTURING
Financier Worldwide Magazine
January 2020 Issue
FW discusses restructuring and bankruptcy challenges in the automotive sector with David Bryan at BM&T, Fred L. Hubacker at Conway MacKenzie, Inc, and Thomas Steinberger at PwC.
FW: Reflecting on the last 12-18 months, how would you describe the general state of the automotive sector? What pressures are being exerted on the industry, and how are companies faring?
Bryan: The automotive sector has enjoyed steady global growth. Since the turn of the century, global car production has grown from 41.2 million to over 70 million and commercial vehicles from 17.2 million to over 21 million. Financial distress and insolvency filings have been low. There was a spike in the mid-2000s and with the financial crisis in 2008 and 2009 when GM and Chrysler went through bankruptcy. Since then it has been a benign environment with few businesses in distress and formal bankruptcy processes. But the sector remains highly competitive with low margins, high fixed costs and increasing investment requirements. The global market topped out in 2016 and is now falling, particularly in China and Europe. A recent report by the German Centre for Automotive Research expects the global market to dive by over 4 million units. Add to this the diesel issues, new emissions requirements, electrification and longer-term challenges around sharing and autonomous vehicles, and it is no surprise that signs of distress are starting to appear.
Hubacker: In general, the automotive sector remains relatively strong in the US, because overall volumes have remained near the 17 million light vehicle sales level for an extended period. Many large supplier balance sheets are reasonably strong but there are numerous uncertainties, including trade policies, commodity prices, interest rates, the capital expenditure (capex) required for new technologies, and the sales success of many new vehicles launched in the past 12 months.
Steinberger: It is all about uncertainty. Uncertainty about future market and technology trends, uncertainty about the impact of the market cooldown and future developments in China, uncertainty about Brexit, trade wars and future regulations on emissions. So, managing in uncertainty will be key in order to become or remain a successful player in this industry. I see pressure from multiple directions. There is, especially in Europe, immense pressure from regulations and the upcoming penalties for CO2 emissions. Car manufacturers will have to manage demand and supply very tightly in order to achieve these emission targets. In parallel, the slowdown of demand in many major markets, such as China, the UK and Southern Europe, creates pressure from the topline of the business. Even if original equipment manufacturers (OEMs) have become more flexible in recent years, this may not hold true for suppliers. We have seen numerous suppliers struggling from lower orders and the resulting effects on revenue, profits and cash.
“It is a thin line between losing huge sums of money by being the early mover or by arriving too late in a new market.”
FW: In your opinion, have any developments in recent years laid the groundwork for troubles ahead?
Hubacker: Trade policies and tariffs have had an unsettling and costly impact on the industry, and government regulations with respect to emissions and fuel economy continue to drive costs up. Record amounts of capex are being spent to support internal combustion engine and drivetrain fuel efficiency improvements and for development of affordable hybrid and fully electric vehicles.
Steinberger: Hindsight is always perfect, so I will not judge the fundamental decisions of the OEMs in general. It is a thin line between losing huge sums of money by being the early mover or by arriving too late in a new market. What I can say is that there seems to be a connection between the volatility in demand created by the change in regulation last year and the rise of distressed supplier cases, at least in Germany. On the supplier side, I would also mention that the aggressive globalisation of the supply chain, with medium-sized suppliers having plants on at least three continents, often overstretches management capacity. This creates problems with loss-making plants and subsidiaries, as well as major ramp-up problems in new projects.
Bryan: It is difficult to predict exactly what will happen and, more importantly, when. Complacency is perhaps the biggest problem faced by the industry. After a long period of steady growth, it is easy to get settled into business as usual. Indeed, many younger managers coming up into senior positions may never have experienced falling markets, volatile production schedules and the existential threats of changing vehicle technologies. As with many industries that face disruption, it often happens quicker than anybody expects, and those who are slow to respond will fall by the wayside.
FW: What are some of the operational and financial restructuring strategies that automotive companies need to utilise to address current and future challenges?
Bryan: At the top level, we are seeing an unprecedented level of cooperation among OEMs to share the huge research and development (R&D) costs of electrification. That, in turn, is leading to mergers and consolidation in the industry. How that may impact further down the supply chain remains to be seen, but businesses need to look at their position in the chain and conduct scenario analyses on the impact of what might happen. This should involve a detailed look at customers and suppliers and their viability. Two studies in the UK in the last few years found that approximately 30 percent of all insolvencies were caused by the insolvency of a customer. Businesses need to take a long hard look at their operations with a view to both efficiency and flexibility. A deep dive into cash flow is also essential to really understanding how it is working and where it can be improved. Many suppliers have a good handle on their costs but little understanding of cash flow. A hard look at the cash requirements of capex and tooling is also necessary. Alongside cash flow there should also be a review of financing.
Steinberger: On the operational side product portfolio, capacity management and operational excellence, especially with regards to ramp-ups of new products, are the key drivers for restructurings. Many large Tier 1 companies are actively selling parts of their ‘legacy’ portfolios in order to free up funds and resources for the transformation. The second main driver is capacity consolidation. With lower demand and higher volatility in demand, a company’s production footprint must come under scrutiny. We see many cases in which plants with historically low performance now become candidates for closure, with a resulting headcount reduction. Flexible concepts for capacity usage are key to deal with volatility.
Hubacker: Capacity rationalisation and capacity usage are extremely critical, control of new product launch processes and costs are very important. Tight controls on capex spending are needed to ensure facilitation is aligned with demand. Aggressive procurement strategies are required to secure and keep best total system costs suppliers for raw materials, components and tooling. In addition, selling, general and administrative (SG&A) costs must be constantly monitored for elimination of waste and for substantial reductions. Creative combinations and joint venture (JV) partnerships will continue to proliferate as OEMs and major Tier 1s attempt to share the burden of investments in new technology, which may or may not result in positive returns. The sharing of risk for these investments is as important as the sharing of cost.
“While there have not been many notable US filings since the great recession, turmoil in Europe has resulted in an uptick in European proceedings.”
FW: How would you characterise the current level of financing available to automotive companies? What funding sources are supporting the sector?
Steinberger: The automotive supply chain in Europe, except for OEMs and some large global Tier 1 suppliers, is still a segment with many medium-sized companies in Tier 1 and Tier 2 roles, many of them still family owned. For these businesses, and most of them are still financed via classic loan structures from commercial banks, it becomes more challenging to get financing. Most banks have a critical view of the automotive sector in general and even more so of the classic powertrain segment. The combination of an asset-heavy industry sector with large funding needs for future projects, as well as criticism of the sector, creates a challenging future environment. Apart from the classic financing structures with bank loans, factoring and leasing, we so far do not foresee a widespread usage of alternative financing instruments or investors.
Hubacker: In general, financing has and continues to mostly be available from a variety of traditional banking, mezzanine lenders, venture capitalists and private equity (PE) sources. Clearly, the enthusiasm of various lenders is nowhere near what it was several years ago for several reasons, most notably the expectation that volumes near term will turn downward as the economy softens and the autocycle ends. Opportunistic lenders are still participating, however, with many on the sidelines expecting multiples and valuations to come down. Commodity suppliers in the space have gotten significantly less expensive while high tech companies, electronics, electric, autonomous and connectivity are maintaining their values and attractiveness for financing.
Bryan: Availability and types of financing will vary with both the size and nature of the business. Larger businesses have more financing options available, as do public companies and private equity-owned businesses. Funding has been relatively easy, with plentiful credit and low interest rates, but will likely prove more difficult going forward. Lenders are well aware of the headwinds facing the automotive sector and the credit cycle is tightening. Asset-based lending (ABL) has largely replaced traditional overdraft lending for smaller businesses in the UK and is increasingly common around Europe. It works well in the automotive space with large creditworthy customers. There has also been a big increase in the number of alternative lenders which can sometimes be more flexible and innovative than traditional lenders. Most importantly, any refinancing needs to be supported by a good business case and be planned rather than sought in an emergency.
FW: Have any recent, notable bankruptcy cases in the sector caught your eye? What lessons can we draw from their outcome?
Hubacker: While there have not been many notable US filings since the great recession, turmoil in Europe has resulted in an uptick in European proceedings. As US companies assess restructuring strategies, those with European subsidiaries and operations overseas should be focusing on pragmatic approaches to constituent alignment with their European counterparts.
Bryan: So far there have been relatively few large or notable bankruptcies. Perhaps the biggest surprise has been several mid-sized German Tier 1 and 2 suppliers entering insolvency proceedings. This is a warning sign and the insolvency profession is touting automotive as the next big area for corporate distress. In some recent cases, senior management seemed to have been taken by surprise. Frequent large changes in schedules, an unexpected re-sourcing by a customer and an inability to flex the cost base fast enough caught them out. Turnaround activity was too little, too late and they went almost straight to insolvency. This highlights the need to take a deep, hard look at business operations and financing to prepare for a difficult future. Customers are already assessing their supply chains and will not hesitate to re-source work if they think they are at risk. There is an urgent need to get businesses ready for the battles ahead.
Steinberger: In general, we have seen an increased number of insolvencies in the sector, starting around a year ago among smaller businesses, but increasing in size over time. Currently, we see more cases in the area around the classic combustion powertrain, with asset-heavy business models. In many cases, the outcome is still open, which, in and of itself, is also a message. It will become increasingly difficult to find new investors for businesses with a pressing need for transformation or even those with a business model which will be obsolete 10 year from now. In addition, larger strategic and financial investors have mostly shifted their M&A activities to digital activities around e-mobility and autonomous driving.
“Survival of the fittest will determine whether a business will still be around to play a part in the disrupted industry of the future.”
FW: What do you believe are the essential elements of a viable restructuring effort to create long-term value in the automotive industry? What advice can you offer to companies that are considering this process?
Steinberger: Strategy matters. The automotive industry is known for its tight cost control and continuous improvement processes in general, but without a clear strategy these efforts will be futile. Strategy needs to address the individual capabilities of a company and its future ‘right to win’ in a fast-changing technology and regulatory environment. The top priorities we currently see on the operational side are ramp-up, with many suppliers having suffered tremendous losses on bad ramp-ups in the last two years, capacity management, including global footprint strategies and greater flexibility for fluctuating demand, and end-to-end cost control on a product level, with full transparency on margins and product changes from nomination and concept to the start of production.
Bryan: Simple balance sheet restructurings will not be enough. There must be a viable business that can be competitive in a changing industry. In the long term, there must be a deep understanding of how and when the industry will change and a good plan to be able to continue to be relevant and able to add value for customers. This may be challenging for those companies whose business relies primarily on the internal combustion engine (ICE), and it will require an analysis of all the options. For those with a strong presence in the electrification of vehicles it could be more a question of how to ensure they capitalise on that and can grow fast. M&A activity could be a key part of strategy and we will see an increase in such activity throughout the supply chain. Some may even choose to simply exit with a sale or managed winddown of the business while there is still value left. In the shorter term, survival of the fittest will determine whether a business will still be around to play a part in the disrupted industry of the future.
Hubacker: The essential elements of a restructuring include the following. First, credibility. A company’s ability to articulate and demonstrate its capability to deliver on its commitments to its constituents. Second, customer support. Products or services that are both valued by customers and can be delivered profitably. Third, product portfolio. A balanced product mix, including meeting the demands of today’s customers and the customers of the future throughout the launch and balance out cycle. Fourth, constituent alignment. Ensuring that the restructuring plan properly aligns all constituent objectives within the framework of the long-term plan. Finally, flexibility. A successful restructuring must always require compromise and the ability to quickly adapt to changing circumstances. Those considering a restructuring should begin the process as soon as possible to preserve optionality. There is an inverse correlation in the time it takes for a company to recognise and address its challenges to the paths available to effectuate a turnaround. Those looking to develop a strategy should look to subject matter experts and develop a thorough and robust roadmap to long-term viability.
FW: What is the outlook for the automotive sector? Do you expect to see an increase in restructuring and bankruptcy cases over the coming months and years?
Bryan: Things are likely to get worse before they get better. Those focused on certain aspects of future vehicles, such as electrification, may see huge growth. That could lead to problems, however, and companies will need to be well capitalised. Others will see increased volatility and, in some cases, severe decline. There will be a big shake-out throughout the supply chain and at the retail end of the market where dealerships will come under pressure. This will lead to a big increase in turnarounds, restructurings and bankruptcies in the coming years. In some cases, there may be nothing left to turnaround or restructure and quite possibly little left for sale out of an insolvency process. Those that can plot a way through the disruption and act early to weather the storm will ultimately benefit. Those that do not face a bleak future.
Hubacker: The outlook for the sector is definitely mixed. The strength of the economy and the availability of credit in the future months are significant uncertain factors that underline the health of the industry. We definitely foresee an increase in restructurings and financial difficulties in the upcoming months, particularly in the Tier 2 and 3 levels of the automotive sector.
Steinberger: From a purely market perspective, we do not foresee a severe downturn of the industry. Latest indications show a flat development for the rest of 2019 and no major recovery in the next year. There will be no significant tailwind on the demand side, which would help the industry. We have certainly seen an increase in restructurings and bankruptcies over the last 6-12 months and expect to see even more of these in the near future. The mixture of slowed demand, high expenditures for R&D and future technologies, combined with a very critical view on the industry from major players on the financing side, will create more distressed situations in the future. Medium-sized businesses, often with only a single product or technology, an urgent need for transformation, such as in the combustion powertrain sector, and with historically mediocre margins, will suffer from these changes in the industry.
David Bryan is a qualified accountant with a long career in the automotive sector. After qualifying he joined United Technologies before spending 15 years in Tier 1 automotive supplier Mayflower, including several years in the US. Following the collapse of Mayflower, he joined a leading US turnaround consultancy before co-founding European turnaround and restructuring boutique, BM&T. He has worked on large cases such as Collins & Aikman and Dura and with many mid-size auto suppliers. He can be contacted on +44 (0)7801 034764 or by email: dbryan@bmandt.eu.
Fred Hubacker has over 40 years of significant experience providing senior leadership, advisory and business development services for companies in the automotive industry. He has served in numerous executive roles throughout his tenure with Venture Companies Worldwide, New Venture Gear Inc, Textron Inc, Acustar Inc, the Chrysler components manufacturing subsidiary, and Chrysler Corporation. He can be contacted on +1 (248) 433 3100 or by email: fhubacker@conwaymackenzie.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 +49 089 5790 6443 or by email: thomas.steinberger@pwc.com.
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