The Financial State of the Automotive Industry

By all accounts, the U.S. automotive industry is facing unprecedented challenges brought about by a perfect storm of convergent, declining macroeconomic conditions. Restructuring efforts of the Original Equipment Manufacturers (OEMs) and their derivative supply chains and dealer networks are being thwarted by the impact of record high gas prices, deteriorating consumer confidence, a global credit crisis and skyrocketing raw materials costs. Despite all the recent media attention focused on bankruptcy concerns among the domestic three automakers, we do not anticipate any domestic OEM filing for bankruptcy protection. However, we anticipate increased bankruptcy activity within the supplier base in the latter part of 2008 and into 2009.

Background

In response to gasoline prices reaching $4 a gallon, consumers have reacted more rapidly than widely anticipated and are moving away from SUVs and pickup trucks to more fuel-efficient vehicles. As a result of this structural shift, the U.S. automotive industry has scrambled to rationalize capacity and restructure its product offering as fast as it can, a move that severely impacts the entire supply chain. Demand for SUVs and full-size pickup trucks has declined so quickly that OEMs are now sitting on high-inventory levels despite their best efforts to market and move product through rebates and other incentives. Automakers are simultaneously rebalancing car and truck production capacities throughout their supplier networks and, to the extent there are no viable economic alternatives, responding to accommodation requests from financially distressed suppliers in an effort to remain viable and retain market share. For the first time in history, market share of domestic OEMs now accounts for less than 50% of total U.S. vehicle sales, compared with 60% less than five years ago and about 75% as recently as the 1980s.

Trending into 2009

Sales and production volumes have materially declined in recent months, and in our view, this trend will likely continue through 2008 and into 2009. In the first six months of 2008, U.S. total light vehicle sales continued to trend below previously expected levels ' dropping more than 830,000 units ' a 10.1% decline from the same period in 2007. Trucks accounted for 92% of that volume decrease. We now expect “best-case” 2008 U.S. light vehicle top-line sales of 14.2 million to 14.5 million units (down 1.6 million to 1.9 million units from 2007) and key market indicators point to North America light vehicle production ranging from 13.0 million to 13.2 million units. On the cost side, raw material prices, particularly steel ' bolstered by strong demand from emerging markets coupled with a weak U.S. dollar, continue to escalate. In the last three years, the costs of key raw materials have almost tripled. In a softening consumer market with intense competition, consumers are less willing to accept price increases. These factors, combined with rapid changes in product mix, pose a significant threat to the viability of the U.S. automotive industry.

These unforeseen events and their attendant impact on production volumes will undoubtedly give rise to an increase in restructuring activity in the near-term and accelerate the consolidation of a largely distressed supply base. We anticipate a significant increase in M&A and consolidation activity, as well as financial restructurings and acquisitions effectuated through Chapter 11 bankruptcy filings. The automotive supply base can be categorized into three main segments, all with different characteristics, challenges and implications for financial and operational restructurings. The top tier, comprised of a relatively small segment of large public suppliers, is typically more diversified in terms of geographic, platform and customer mix. Many of these suppliers have restructured in and out of bankruptcy over the past few years and have sufficient liquidity to manage through the down cycle, although there remain a handful at this level, we believe are at risk. At the bottom tier are small niche manufacturers, many of which are insulated from bankruptcy due to a specific core competency, be it a value-added process, product or other competitive advantage. The looming risk in the supply base is the mid-tier, generally consisting of private suppliers with revenues in the $200 million to $750 million range. These suppliers are feeling numerous pressures from different angles. They are, in many instances, too small to obtain financing in the capital markets or too concentrated from a geographic, product or customer base. Further, they are less able to withstand the commercial challenges in the negotiations with the large Tier 1s and OEMs. Given OEM initiatives to reduce the numbers of their suppliers, it is at this mid-tier level that consolidation and restructuring activities are expected to accelerate.

Filing for Bankruptcy?

Despite the adverse impact of market conditions on the near-term profitability of U.S. automakers, we affirm our opinion that a bankruptcy filing by the “Detroit 3″ OEMs is highly unlikely. Rick Wagoner, General Motors chairman and CEO, stated the company has “no thoughts whatsoever” of filing for bankruptcy and has “robust” cash reserves with options for raising more money in the future. Chrysler similarly denounced any such rumors, and its vice chairman and president Jim Press stated in a letter to dealers that such reports suggesting Chrysler might file for bankruptcy are “without merit.” With bankruptcy not an option, what other plays do the OEMs turn to in this environment?

As a practical matter, a bankruptcy filing by any domestic OEM would likely bring the industrialized world to a grinding halt, putting tens of thousands of people out of work, bankrupting national pension accounts, devastating the interdependent supply base and pushing the U.S. into a prolonged economic recession. The domino effect of a filing by General Motors, Ford or Chrysler would be far-reaching and could trigger a rash of bankruptcy filings. Consumers would be hesitant to purchase automobiles from a bankrupt company and that, in and of itself, would have a direct and material impact on the success of either a stand-alone restructuring plan or a contemplated sale transaction. Far in advance of even contemplating a bankruptcy, the OEMs will look to sell unencumbered assets and business units (Hummer, Volvo, etc.), seek government intervention, reduce or eliminate dividends, defer VEBA payments and court foreign investment. Operationally, they will continue to focus on closing plants, reengineering manufacturing footprints, reducing head count, consolidating the supply chain, adjusting production schedules and rationalizing product portfolios.

Strategy

The immediate strategy for General Motors, Ford and Chrysler is a focus on preserving and raising incremental liquidity and a restructuring of operations to meet product demand in response to changes in consumer preferences. The goal is to make it through 2010, when labor, plant and cost basis adjustment benefits kick in. General Motors has announced several initiatives to improve its liquidity position by the end of 2009, including operational measures, asset sales and approaching the debt capital markets to raise upwards of $10 billion. Ford's liquidity profile is much stronger
than that of General Motors and should provide an adequate cushion during this economic downturn, but successful execution of its restructuring plans are critical. Cerberus-owned Chrysler is a private company and financial reporting is limited, so a complete assessment of its liquidity profile is more challenging.

Bankruptcy activity looms heavily on the horizon for the many companies comprising the U.S. automotive supply base, particularly if a long and drawn-out recession occurs, and if sales and liquidity continue to decline. A sales decline of more than 1.6 million units in 2008 compared to 2007 will have a massive economic impact at all levels of the supply chain. Suppliers most at risk include those with a high dependence on large SUV and truck volumes with large concentrations on domestic OEMs. At American Axle & Manufacturing, for example, the GMT900 platform generates in excess of 50% of total revenues. After a long battle with its unions and a strike that took a real toll on the industry, further plant closures may be necessary as a result of recent volume declines. The interdependency of the global supply chain puts all suppliers with significant exposure to domestic OEMs at risk of financial distress. We expect the near term industry outlook to pose significant financial risk to the supply base with as many as one-third of automotive suppliers at risk of filing for bankruptcy.

Actual Filings

To date, bankruptcy filings in the automotive industry have been low in light of restructuring initiatives being implemented by OEMs and the resulting retrenching in production forecasts. The significant drop in truck volumes began to garner headlines only in May 2008, and the absolute percentage declines per month since May have surprised the market. Yet, suppliers are only now adjusting to the volume declines. It could take another three to six months for distress to work its way through the supply base in terms of cash flow shortages, defaults, liquidity issues and ultimately filings. Suppliers are now in the process of doing everything they can to conserve cash to weather the economic storm. It is more likely that bankruptcy activity will significantly increase in the latter part of 2008 and into 2009, with the market not fully showing signs of stabilizing until 2010 when many OEM restructuring initiatives would take full effect.

In 2008, there have been 18 automotive industry bankruptcy filings, compared with 15 in the same period in 2007. Between 2006 and 2008, 90 automotive industry companies filed for bankruptcy. As a percentage of total bankruptcies filed in the U.S. and Canada in 2008, the automotive sector represents 7.9%, compared with an average of 4.3% in 2006 and 2007, indicating an increase in activity in the sector. Furthermore, a closer review of the ultimate fate of 38 of the 90 filings, companies that are more pure-play automotive suppliers, shows that a bankruptcy filing in the automotive industry is not a reprieve to right-size the company and emerge as a stronger independent entity with a clean balance sheet ready to compete once again. In fact, nearly 50% of these suppliers (18 companies) have liquidated. Six of the companies were sold to competitors, eight have reemerged and six are still in bankruptcy. At most, 14 of the 38, a little more than one-third of the group, may re-emerge as restructured companies. Numerous issues affect these outcomes, including the longer average stay in bankruptcy, more challenging capital markets to finance an exit, numerous competing parties-in-interest making plans of reorganization more complicated and cautious investors concerned about business fundamentals.

Delphi has exhibited many of the aforementioned issues. Dura Automotive Systems is another example. The company filed for bankruptcy protection in October 2006 and filed a plan of reorganization in August 2007. The plan was approved by creditors and the court, but the company was unable to obtain required exit financing and was forced to remain in bankruptcy until March 2008, when it filed a revised plan of reorganization that included a reduction in exit financing of $85 million and a conversion of $225 million of second lien debt into preferred equity. Although Dura managed to exit from bankruptcy before financing windows all but closed, the state of the capital markets today does not bode well for companies seeking traditional exit financing. Alternative sources of capital may fill this void at a heavy price.

Conclusion

This perfect storm of colliding macroeconomic factors will very likely force the accelerated consolidation and rationalization of the global automotive supply chain, and liquidity is critical to survival. Although it is unlikely that a U.S. OEM would seek bankruptcy protection, structural changes brought about by the foreseeable rationalization of the supply chain will require more effective supply chain risk management systems that include advance warning systems, contingency planning, and insolvency management. To weather the storm, the OEMs must be proactive, anticipate imminent problems and plan accordingly. U.S. automakers must focus on building long-term viability and a sustainable business model in an intensely competitive industry. There's a rough road ahead, but in the final analysis, the U.S. automotive industry is at a true inflection point. Gone are the days of high-volume, high-market share brands. Numerous challenges remain, and those OEMS that produce segment-leading, award-winning products will make it through the current structural changes. The ripple effect to the supply base, in terms of the number of suppliers left to support these OEMs, will cause necessary and dramatic consolidation, necessitating significant restructuring expertise.

Ben Gonzalez is a principal with Grant Thornton Corporate Advisory and Restructuring Services. He specializes in advising financially distressed companies and their stakeholders. Gonzalez has experience in all aspects of Chapter 11 bankruptcy proceedings, including buying and selling distressed companies through the 363 sales processes, pre-bankruptcy planning, assessing short-term liquidity requirements, evaluating alternative capital structures, and developing plans of reorganization. He may be reached at [email protected]

By all accounts, the U.S. automotive industry is facing unprecedented challenges brought about by a perfect storm of convergent, declining macroeconomic conditions. Restructuring efforts of the Original Equipment Manufacturers (OEMs) and their derivative supply chains and dealer networks are being thwarted by the impact of record high gas prices, deteriorating consumer confidence, a global credit crisis and skyrocketing raw materials costs. Despite all the recent media attention focused on bankruptcy concerns among the domestic three automakers, we do not anticipate any domestic OEM filing for bankruptcy protection. However, we anticipate increased bankruptcy activity within the supplier base in the latter part of 2008 and into 2009.

Background

In response to gasoline prices reaching $4 a gallon, consumers have reacted more rapidly than widely anticipated and are moving away from SUVs and pickup trucks to more fuel-efficient vehicles. As a result of this structural shift, the U.S. automotive industry has scrambled to rationalize capacity and restructure its product offering as fast as it can, a move that severely impacts the entire supply chain. Demand for SUVs and full-size pickup trucks has declined so quickly that OEMs are now sitting on high-inventory levels despite their best efforts to market and move product through rebates and other incentives. Automakers are simultaneously rebalancing car and truck production capacities throughout their supplier networks and, to the extent there are no viable economic alternatives, responding to accommodation requests from financially distressed suppliers in an effort to remain viable and retain market share. For the first time in history, market share of domestic OEMs now accounts for less than 50% of total U.S. vehicle sales, compared with 60% less than five years ago and about 75% as recently as the 1980s.

Trending into 2009

Sales and production volumes have materially declined in recent months, and in our view, this trend will likely continue through 2008 and into 2009. In the first six months of 2008, U.S. total light vehicle sales continued to trend below previously expected levels ' dropping more than 830,000 units ' a 10.1% decline from the same period in 2007. Trucks accounted for 92% of that volume decrease. We now expect “best-case” 2008 U.S. light vehicle top-line sales of 14.2 million to 14.5 million units (down 1.6 million to 1.9 million units from 2007) and key market indicators point to North America light vehicle production ranging from 13.0 million to 13.2 million units. On the cost side, raw material prices, particularly steel ' bolstered by strong demand from emerging markets coupled with a weak U.S. dollar, continue to escalate. In the last three years, the costs of key raw materials have almost tripled. In a softening consumer market with intense competition, consumers are less willing to accept price increases. These factors, combined with rapid changes in product mix, pose a significant threat to the viability of the U.S. automotive industry.

These unforeseen events and their attendant impact on production volumes will undoubtedly give rise to an increase in restructuring activity in the near-term and accelerate the consolidation of a largely distressed supply base. We anticipate a significant increase in M&A and consolidation activity, as well as financial restructurings and acquisitions effectuated through Chapter 11 bankruptcy filings. The automotive supply base can be categorized into three main segments, all with different characteristics, challenges and implications for financial and operational restructurings. The top tier, comprised of a relatively small segment of large public suppliers, is typically more diversified in terms of geographic, platform and customer mix. Many of these suppliers have restructured in and out of bankruptcy over the past few years and have sufficient liquidity to manage through the down cycle, although there remain a handful at this level, we believe are at risk. At the bottom tier are small niche manufacturers, many of which are insulated from bankruptcy due to a specific core competency, be it a value-added process, product or other competitive advantage. The looming risk in the supply base is the mid-tier, generally consisting of private suppliers with revenues in the $200 million to $750 million range. These suppliers are feeling numerous pressures from different angles. They are, in many instances, too small to obtain financing in the capital markets or too concentrated from a geographic, product or customer base. Further, they are less able to withstand the commercial challenges in the negotiations with the large Tier 1s and OEMs. Given OEM initiatives to reduce the numbers of their suppliers, it is at this mid-tier level that consolidation and restructuring activities are expected to accelerate.

Filing for Bankruptcy?

Despite the adverse impact of market conditions on the near-term profitability of U.S. automakers, we affirm our opinion that a bankruptcy filing by the “Detroit 3″ OEMs is highly unlikely. Rick Wagoner, General Motors chairman and CEO, stated the company has “no thoughts whatsoever” of filing for bankruptcy and has “robust” cash reserves with options for raising more money in the future. Chrysler similarly denounced any such rumors, and its vice chairman and president Jim Press stated in a letter to dealers that such reports suggesting Chrysler might file for bankruptcy are “without merit.” With bankruptcy not an option, what other plays do the OEMs turn to in this environment?

As a practical matter, a bankruptcy filing by any domestic OEM would likely bring the industrialized world to a grinding halt, putting tens of thousands of people out of work, bankrupting national pension accounts, devastating the interdependent supply base and pushing the U.S. into a prolonged economic recession. The domino effect of a filing by General Motors, Ford or Chrysler would be far-reaching and could trigger a rash of bankruptcy filings. Consumers would be hesitant to purchase automobiles from a bankrupt company and that, in and of itself, would have a direct and material impact on the success of either a stand-alone restructuring plan or a contemplated sale transaction. Far in advance of even contemplating a bankruptcy, the OEMs will look to sell unencumbered assets and business units (Hummer, Volvo, etc.), seek government intervention, reduce or eliminate dividends, defer VEBA payments and court foreign investment. Operationally, they will continue to focus on closing plants, reengineering manufacturing footprints, reducing head count, consolidating the supply chain, adjusting production schedules and rationalizing product portfolios.

Strategy

The immediate strategy for General Motors, Ford and Chrysler is a focus on preserving and raising incremental liquidity and a restructuring of operations to meet product demand in response to changes in consumer preferences. The goal is to make it through 2010, when labor, plant and cost basis adjustment benefits kick in. General Motors has announced several initiatives to improve its liquidity position by the end of 2009, including operational measures, asset sales and approaching the debt capital markets to raise upwards of $10 billion. Ford's liquidity profile is much stronger
than that of General Motors and should provide an adequate cushion during this economic downturn, but successful execution of its restructuring plans are critical. Cerberus-owned Chrysler is a private company and financial reporting is limited, so a complete assessment of its liquidity profile is more challenging.

Bankruptcy activity looms heavily on the horizon for the many companies comprising the U.S. automotive supply base, particularly if a long and drawn-out recession occurs, and if sales and liquidity continue to decline. A sales decline of more than 1.6 million units in 2008 compared to 2007 will have a massive economic impact at all levels of the supply chain. Suppliers most at risk include those with a high dependence on large SUV and truck volumes with large concentrations on domestic OEMs. At American Axle & Manufacturing, for example, the GMT900 platform generates in excess of 50% of total revenues. After a long battle with its unions and a strike that took a real toll on the industry, further plant closures may be necessary as a result of recent volume declines. The interdependency of the global supply chain puts all suppliers with significant exposure to domestic OEMs at risk of financial distress. We expect the near term industry outlook to pose significant financial risk to the supply base with as many as one-third of automotive suppliers at risk of filing for bankruptcy.

Actual Filings

To date, bankruptcy filings in the automotive industry have been low in light of restructuring initiatives being implemented by OEMs and the resulting retrenching in production forecasts. The significant drop in truck volumes began to garner headlines only in May 2008, and the absolute percentage declines per month since May have surprised the market. Yet, suppliers are only now adjusting to the volume declines. It could take another three to six months for distress to work its way through the supply base in terms of cash flow shortages, defaults, liquidity issues and ultimately filings. Suppliers are now in the process of doing everything they can to conserve cash to weather the economic storm. It is more likely that bankruptcy activity will significantly increase in the latter part of 2008 and into 2009, with the market not fully showing signs of stabilizing until 2010 when many OEM restructuring initiatives would take full effect.

In 2008, there have been 18 automotive industry bankruptcy filings, compared with 15 in the same period in 2007. Between 2006 and 2008, 90 automotive industry companies filed for bankruptcy. As a percentage of total bankruptcies filed in the U.S. and Canada in 2008, the automotive sector represents 7.9%, compared with an average of 4.3% in 2006 and 2007, indicating an increase in activity in the sector. Furthermore, a closer review of the ultimate fate of 38 of the 90 filings, companies that are more pure-play automotive suppliers, shows that a bankruptcy filing in the automotive industry is not a reprieve to right-size the company and emerge as a stronger independent entity with a clean balance sheet ready to compete once again. In fact, nearly 50% of these suppliers (18 companies) have liquidated. Six of the companies were sold to competitors, eight have reemerged and six are still in bankruptcy. At most, 14 of the 38, a little more than one-third of the group, may re-emerge as restructured companies. Numerous issues affect these outcomes, including the longer average stay in bankruptcy, more challenging capital markets to finance an exit, numerous competing parties-in-interest making plans of reorganization more complicated and cautious investors concerned about business fundamentals.

Delphi has exhibited many of the aforementioned issues. Dura Automotive Systems is another example. The company filed for bankruptcy protection in October 2006 and filed a plan of reorganization in August 2007. The plan was approved by creditors and the court, but the company was unable to obtain required exit financing and was forced to remain in bankruptcy until March 2008, when it filed a revised plan of reorganization that included a reduction in exit financing of $85 million and a conversion of $225 million of second lien debt into preferred equity. Although Dura managed to exit from bankruptcy before financing windows all but closed, the state of the capital markets today does not bode well for companies seeking traditional exit financing. Alternative sources of capital may fill this void at a heavy price.

Conclusion

This perfect storm of colliding macroeconomic factors will very likely force the accelerated consolidation and rationalization of the global automotive supply chain, and liquidity is critical to survival. Although it is unlikely that a U.S. OEM would seek bankruptcy protection, structural changes brought about by the foreseeable rationalization of the supply chain will require more effective supply chain risk management systems that include advance warning systems, contingency planning, and insolvency management. To weather the storm, the OEMs must be proactive, anticipate imminent problems and plan accordingly. U.S. automakers must focus on building long-term viability and a sustainable business model in an intensely competitive industry. There's a rough road ahead, but in the final analysis, the U.S. automotive industry is at a true inflection point. Gone are the days of high-volume, high-market share brands. Numerous challenges remain, and those OEMS that produce segment-leading, award-winning products will make it through the current structural changes. The ripple effect to the supply base, in terms of the number of suppliers left to support these OEMs, will cause necessary and dramatic consolidation, necessitating significant restructuring expertise.

Ben Gonzalez is a principal with Grant Thornton Corporate Advisory and Restructuring Services. He specializes in advising financially distressed companies and their stakeholders. Gonzalez has experience in all aspects of Chapter 11 bankruptcy proceedings, including buying and selling distressed companies through the 363 sales processes, pre-bankruptcy planning, assessing short-term liquidity requirements, evaluating alternative capital structures, and developing plans of reorganization. He may be reached at [email protected]