The recent UAW contract with the Detroit Three could also exacerbate the impact of an economic downturn on suppliers by giving manufacturers greater flexibility to reduce production when faced with declining demand. This could result in greater cyclicality than has been seen recently, where inflexible cost structures resulted in higher incentives to prop up demand. Event risk has been reduced, given the new UAW contract, but more severe industry cycles could rapidly undo some of the progress toward stabilization within the sector that was made in 2007.
INDUSTRY STRUCTURE
Despite industry-wide pressures, operating and financial performance among the suppliers diverged in 2007. Companies with strong balance sheets, a diversified operating profile, or technology-driven products (Johnson Controls, Borg Warner) continue to perform well. A number of companies that suffered operating losses and impaired balance sheets over the past several years have shown clear benefits from restructuring activities (American Axle, Lear), with stabilized cash flows and the opportunity to modestly improve balance sheets in 2008. Other portions of the industry (Visteon, ArvinMeritor) have yet to reverse negative cash flows and risk further balance sheet erosion and more severe restructuring actions.
On an even lower rung, the industry is likely to see the emergence from bankruptcy of a material portion of the U.S. supply base (Delphi, Dana, Dura, Federal Mogul) assuming that operating and financial profiles are palatable to debt investors under current capital market conditions. New private equity capital is playing a major role in recapitalizing several of these companies, although little new capital is being committed to the industry without the benefits of restructuring through the bankruptcy process. In addition to companies emerging from bankruptcy, private equity will maintain an active role in the restructuring of the domestic industry (Tower/Cerberus, Lear/Icahn, Visteon/Pardus).
The industry continues to suffer from overcapacity and an uncompetitive cost structure in the U.S., resulting in a further migration of its manufacturing footprint to low- cost locations in Asia and Eastern Europe. It is noteworthy that despite a large number of assets on the market by highly motivated sellers, major transactions from strategic buyers have been relatively few. The Detroit Three and their former captive suppliers, Delphi and Visteon, still have a number of properties in the market that will either be shut down, or sold at highly distressed prices (or with financial support from sellers). Even European suppliers with strong currency advantages and a stated desire to grow within the U.S. through acquisition have been relatively inactive.
Expanding suppliers, transplant and domestic, have chosen to pursue supply contracts directly from OEMs rather than purchasing assets from other suppliers that may have uncompetitive wage and benefit structures, or excess capacity. The wholesale closure of production facilities by companies that have the added flexibility provided by the bankruptcy process is a clear indication of the cost gap that remains to be addressed in the industry. Weakness in the U.S. supply base has led to an acceleration of the expansion of European and Asian suppliers, which will put further stress on competing U.S.-based suppliers. This expansion is often at the request of the OEMs which remain concerned with granting long-term contracts for new platforms to financially vulnerable suppliers.
OPERATING PERFORMANCE
First and foremost, margin performance will continue to be driven by proprietary technologies and diversification - global geographic diversity, product diversity, and diversity of end customers among global vehicle manufacturers. In 2008, margin expansion will again be the challenge for the suppliers, as well as the yardstick for measuring progress on restructuring programs. Restructuring will continue to be an ongoing process for most of the industry, and cost structures will continue to evolve. Given this evolution, the uncertain profitability of recent contract wins that are now entering production will have an impact on margins. Pricedowns remain the rule for major parts of the industry, which the suppliers are forced to offset by continued productivity improvements. However, an increasing portion of the supply base, based on technology, quality or proprietary processes, has been able to better hold pricing - allowing restructuring efforts to show up in improved margin performance. Commodity prices, although still high, have come off recent peaks, and are expected to be less of a headwind going forward, potentially providing some margin relief. The consolidation of the steel industry, however, may limit the potential price declines seen by other commodities in an economic downturn.
Risks to free cash flow include higher capital expenditures and working capital requirements, both related, in part, to expansion of contracts with non-U.S. manufacturers, as well as further migration of manufacturing operations to low-cost locations. As a result of weak operating results and capital constraints, capital expenditures have been declining over the past several years on an absolute level and as a percentage of revenues. (See the Fitch report Auto Supplier Liquidity, available on the Fitch web site at 'www.fitchratings.com'.) Given the required investments and start-up costs associated with new product launches, and an accelerating pace of launches by OEMs, increasing capital expenditures could extract a greater claim on operating cash flows. As suppliers have expanded international sales and international manufacturing operations, suppliers have also experienced increases in working capital requirements. The weakening of the U.S. dollar could also affect the competitiveness of low cost countries.
Given further production declines in 2008, less visible second-tier and third-tier suppliers will continue to experience a significant degree of operating and financial stress. With less technology-driven value-added products, higher exposure to Detroit Three unit volumes, and less access to external capital even under the best of capital market conditions, these suppliers will be further hit by weakening economic conditions and the potential increase in cyclicality. For first-tier suppliers, this situation poses the risk of supply interruption, or of having to step in and provide varying forms of financial support that could absorb precious capital.
Despite severe damage to industry balance sheets over the last several years, industry liquidity remains fairly healthy. Non-investment-grade suppliers capitalized on the very attractive conditions prevailing in the leveraged loan market to boost liquidity and extend maturities, typically with loan structures and pricing that are certainly not available today. Debt maturities in the sector are very limited, reducing refinancing risk. Financing risks in the sector remain focused on those companies attempting to raise exit financing, where terms have clearly tightened. Chrysler's inability to place its bank financing in the market and Delphi's restructuring of its original reorganization financing plan demonstrate clearly that the capital markets are wary of auto and auto supplier prospects entering 2008. With industry unit volume declines, balance sheet improvement is likely to be limited, and refinancing risk will become more of a factor post-2008.
