Industry trends: A Top-to-Bottom Consolidation

Sweeping change that has been reshaping many sectors of the automotive market in the past few years continues to pressure both vehicle and parts manufacturers, or suppliers, to strengthen core competencies, operate more efficiently, and cut costs. The movement, paced to a large degree by mergers and acquisitions, is steadily transforming the industry through massive consolidation in all areas of the automotive supply chain. Vehicle manufacturer consolidation, which is decreasing the number of global vehicle makers to just a handful, has heavily impacted change in the automotive parts manufacturing industry: the number of automotive parts purchasers is declining as the number of vehicle manufacturers shrinks. Fewer vehicle manufacturers means fewer parts suppliers. On top of that, increasing competition, pressures to establish a global presence, overcapacity, and tighter production cycles are pushing vehicle manufacturers to achieve cost reductions by rethinking car design, assembly, and production methods. No longer wanting to deal with hundreds of suppliers, vehicle manufacturers increasingly expect suppliers to deliver modular components or entire automotive systems, which themselves may be made up of hundreds of parts. Gone are the days of just supplying brake pads or a steering wheel. Parts manufacturers increasingly are furnishing entire vehicle systems, and, consequently, their numbers are shrinking as vehicle manufacturers choose to form closer relationships with a small number of dominant suppliers. As more pressure is placed on Tier 1 suppliers (parts manufacturers who supply product directly to vehicle manufacturers) to provide complete automotive systems and modules and to become systems integrators that can assemble modules, those suppliers will be required to invest even more heavily in product design, development, and testing in order to secure lucrative contracts. Also, recognizing that vehicle manufacturers are expanding into new, global markets, Tier 1s should have the ability to follow their customers into new markets. All are pressuring suppliers to get bigger and more diversified via m&a. New technological capabilities in car design and production add yet another pressure on suppliers to keep pace with the times. Jeff Sands, head of North American Automotive Investment Banking Services at PricewaterhouseCoopers Securities, says that m&a activity in the automotive electronics market, for example, has been driven by the increase in the electronic content of vehicles, which has been going up about 25% to 30% per year in sophistication level, with the introduction of navigation systems, global positioning systems, sensors, and night vision features. In addition, current wiring technology, which uses separate wires for separate functions, is giving way to multiplexing, he says, which will operate all of a vehicle’s wiring functions, from door locks to brake lights to navigational systems. M&A Activity Is Largely Driven By Shareholder Value Concerns “Air bags are another example of technology-driven m&a in the industry,” he says. “Steering wheel technology changed dramatically when airbags were introduced, and then airbag technology started overriding steering wheels. When that happened, airbag companies started acquiring steering wheel manufacturers.” In addition, Michael Burwell, Automotive Transaction Services Partner at PricewaterhouseCoopers, sees automotive consolidation as largely shareholder-driven. “When you look at overall shareholder value, you see the differing P/E multiples of vehicle manufacturers and of Tier 1 suppliers, where the differential is about two to three points. Vehicle manufacturers look at that and are wondering whether they are getting their fair share,” he says. He adds that vehicle manufacturers, when looking at increasing shareholder value, are trying to come up with ways to raise prices, increase market penetration in emerging markets, and cut costs. “Hopefully, through this consolidation process, they will end up dealing with fewer suppliers and getting higher-quality components, which helps take costs off the top. At the end of the day, that strikes a change in shareholder value,” he notes. Besides diversity of customer base, historical performance, and a track record of earnings performance, acquirers are looking for targets that have advanced technological capabilities, says Burwell. “Buyers aren’t just looking for a consolidation play, they are looking for technology, because technology is driving this market.” Vehicle Makers Call the Shots In Setting Industry Strategies Automotive technology has a huge impact on what companies’ m&a strategies will be, Sands remarks. “The OEMs are dictating what the strategies will be, and the suppliers are dictating which way they are going to implement them. OEMs have played marriage-broker to some extent in core areas to make sure that certain companies and technologies mesh together to develop better products. Beyond that, the Tier 1 suppliers are asking, How can I develop a more value-added system and change the way the OEMs think about buying?'” According to the 1998 PricewaterhouseCoopers Global Automotive Deal Survey, vehicle manufacturers no longer have the resources to handle all the R&D and testing needs for their growing product lines. For example, Audi now outsources more than half of its engineering work on new models, compared with less than one-third five years ago. Manufacturers today want “component system partners” that will assume responsibility for developing and testing larger and more complex automotive systems. Increasingly, vehicle manufacturers require Tier 1 suppliers to manage relationships with Tier 2 suppliers, which supply sub-components to Tier 1s, and Tier 3 suppliers, which furnish materials such as fiberglass, foam cushions, textiles, and other commodities. Smaller Suppliers Will Have To Rethink Their Futures What this means for automotive parts manufacturers is that if they cannot internally develop the new skills that vehicle manufacturers demand they may be forced to partner with other suppliers or give up their Tier 1 status. Sands points out that Tier 1 suppliers must now be prepared to make heavy investments to develop and/or acquire these new capabilities, which raises the costs and risks of being a Tier 1 player but also presents opportunities for growth and profit increases for players with strong cash flow, honed capabilities, and technological know-how. “The size of these suppliers today has gotten so big,” says Sands. “We used to say just two years ago that a company would have to be a half-billion-dollar player to be a long-term supplier in the industry. That has doubled now. If you’re not a billion-dollar supplier now, you need to think about whether you want to stay in the business, because you will not have the critical mass to sustain the R&D efforts it’s going to take to develop the new technology that will drive the kinds of margins you’ll want.” Facing the costly investments required to stay competitive, suppliers may rethink their long-term commitment to the automotive industry. Some big suppliers, such as ITT Industries Inc. and United Technologies Corp., have chosen to get out of the business. Some smaller suppliers have chosen to link up with other suppliers to broaden their skills and expand their resource base. Still, other suppliers, the Automotive Deal Survey notes, are choosing to sell operations – gaining “growth through shrinkage.” Sands notes that retaining Tier 1 status is not a requirement for competitiveness in the automotive parts manufacturing industry. When Tier 1s are freed from the systems integration responsibilities they are being pushed to assume, Tier 2 companies, which often are smaller private and family owned firms, can focus on competing on price and quality in niche markets and serve as reliable suppliers to Tier 1 companies. Moving Risk Further Down The Automotive Supply Chain But whether players opt to expand their capabilities through acquisitions or joint ventures, sell non-core assets to other players, or exit the industry altogether, the impact of all the m&a activity on the supply chain is quite significant, says Burwell. He expects that the current 1,500 Tier 1 suppliers and 1,000 Tier 2s will consolidate, over the next four or five years, into approximately 150 systems integrators and 450 direct, or Tier 2 suppliers, and about 1,000 indirect, or Tier 3, suppliers of commodities used in the manufacturing of automotive parts. The changes occurring within the supplier ranks create many strategic alternatives for automotive parts manufacturers, from expansion, to scaling back of operations, to exit from the industry, he adds. Whether automotive parts suppliers like it or not, change is upon them. But even though suppliers that move into systems integration and assembly functions assume risks and responsibilities that previously had been borne by vehicle manufacturers, there are definite advantages of consolidation to suppliers, Sands adds. Suppliers are offered the opportunity of extra volume and security in long-term contracts. The changes in the industry will help them control margins, manage costs, and diversify risk, since they will be put the squeeze on Tier 2 suppliers to provide superior parts at a low cost; in other words, under the new industry dynamics, Tier 1 suppliers move risk and responsibility further down the supply chain. Reaping the Benefits of Supplying Larger Components “Suppliers are trading at between 20% and 30% P/Es where the OEMs are down to eight to nine times P/E ratio. That is because suppliers are adding a lot more value to the systems overall. They now have a more diversified customer base, a more diversified platform base, and their earnings are much more stable. If they supply parts on a global basis for several platforms, if one doesn’t sell well in one country but does well in other countries, they’ll still have a good year,” Sands says. “If a parts manufacturer will now supply an entire vehicle interior, that supplier can contract for that entire interior for a fixed price, so now it has much more latitude to work on cost reductions because it now supplies a bigger package. Companies like Johnson Controls, Lear, and Magna have really taken that interior concept and made it work for them,” says Sands. As the level of technological sophistication has been raised throughout the automotive supply chain, companies like Magna Seating Systems of America, Lear Corp., and Dana Corp. are now calling themselves Tier 0.5 (point five) suppliers, he explains. They have actually become such skilled systems suppliers that they are almost involved in the assembly of vehicles, because the systems that they supply are so complex and so important to the vehicle. In some cases, their work is being done directly on the assembly line, he says. “Now you have 0.5 suppliers like Magna that are talking about manufacturing niche vehicles. And Magna has the ability to do that. It can do stamping and complete interiors and it owns an assembly line and is currently assembling vehicles for DaimlerChrysler in Europe. Also, Volkswagen has assembly facilities in Argentina, where it has chosen six Tier 1 suppliers to control the assembly plant — and share in the profits of assembly,” he adds. So, with some Tier 1s integrating up the supply chain, where does that leave vehicle manufacturers? Sands thinks that car manufacturers could very well become marketing, brand management, and customer-oriented companies. He expects that their strategies could change in order to garner post-vehicle-sale dollars. “Many may want to own repair shops, paint shops, insurance companies — all the dollars associated with vehicles once they leave the showroom floor,” he notes. OEMS Could Evolve Into Marketing-Oriented Companies “In fact, they may want to manage that consumer from the time he decides to buy a vehicle until he turns it in to be resold.” He explains that if companies like Ford Motor Co. and General Motors Corp. become more customer-focused, there will be more room for Tier 1 suppliers to take over assembly operations, which is already starting to happen. What about car design? “All the Tier 1s have some design capability, but the true design, imaging, brand awareness, consumer focus, and marketing functions will be done by the vehicle manufacturers. I don’t see them relinquishing those functions,” he remarks. What about integration down the supply chain? Skip Potter, a Vice President at the Automotive Aftermarket Industry Association, notes that there has been only a handful of companies that have been able to successfully integrate automotive manufacturing operations with distribution or service operations. “Pep Boys is one of the few. It has done a good job at integrating multiple functions. But unless you narrow down a service or a product line, it’s difficult to merge manufacturing, distribution, and service.” He adds, “Pennzoil has done it with it’s oil change operations. There’s a case where you have total vertical integration in a single product line, but it’s very hard to do.” Automotive M&A Activity in 1998 Almost Doubled 1997’s Levels Burwell and Sands expect m&a of both vehicle and parts manufacturers to continue well into the beginning of the next century. Acquisitions throughout the supply chain have been steadily rising in number and dollar value over the past few years. According to the Automotive Deal Survey, the 320 announced or completed parts manufacturing deals in 1998 were almost twice the number surveyed in 1997. The disclosed value of the deals in 1998 — $30.3 billion — was nearly double 1997’s value of $16.7 billion. The huge increase in the average disclosed deal size, the Survey explains, points up the scale of consolidation. Dana’s acquisition of Echlin Inc. for $4.1 billion, SPX Corp.’s $2.3 billion acquisition of General Signal Corp., and Federal Mogul Corp.’s $2.2 billion acquisition of T&N PLC were some of the major supplier deals of 1998. Activity in the first three quarters of 1999 suggests that this could be another record year of consolidation among automotive parts manufacturers, with increased deal values, as shown in the accompanying table. TRW Inc. acquired LucasVarity in a $6.8 billion deal, Lear acquired the United Technologies Automotive Inc. unit of United Technologies Corp. for $2.3 billion, DuPont Co. completed its acquisition of Herberts, the coatings subsidiary of Hoechst AG, for $1.9 billion, and Eaton Corp. bought Aeroquip-Vickers Inc. for $1.6 billion. In addition, the world’s largest automotive supplier, Delphi Automotive Systems, completed its IPO in February, with General Motors spinning off its remaining 82% interest in May. Several of 1997’s most active acquirers were also at the forefront of deal activity in 1998. Lear and Textron Inc. each acquired six companies in 1998, while Magna and TRW each acquired five. U.S. suppliers again were the most acquisitive in 1998 deals, completing 180 transactions with a value of $20 billion. That’s up from 59 deals with a value of $6.4 billion in 1997. According to the Automotive Deal Survey, 1998 was a record year for global m&a activity in many automotive sectors, with more than 620 announced or completed deals with a disclosed value of more than $80.5 billion. Vehicle manufacturers completed 45 deals valued at $44.5 billion a value that was dominated by the $40.5 billion merger of Chrysler Corp. and Daimler-Benz AG. In other automotive segments, 104 deals valued at $1.2 billion were done in the retail and distribution sector, down from 189 deals with a value of $5.6 billion in 1997. The automotive aftermarket, in which AutoZone was an active acquirer, saw 109 deals valued at $2.3 billion. Car rental and leasing services, backed by the $698.7 million acquisition of Ryder TRS Inc. by Budget Group Inc., posted 40 deals with a value of $2.1 billion. However, the brisk m&a activity in the sector is shrinking the pool of acquisition targets and raising price tags on remaining targets. Burwell notes that contrary to what happens in many industry consolidations, where the best targets are picked off early, there are desirable targets left, and he has seen multiples increase as consolidation progresses. Experts in the field say that six to seven times EBIT-DA is about average in deals in the sector. However, Burwell notes, it is important for management teams to calculate the right price for their companies’ acquisitions, so as to avoid overpaying and creating a “value gap” that cannot be offset by deal synergies.