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From Recovery to Victory: Time is now for the auto value cha...

From Recovery to Victory: Time is now for the auto value chain

Admin February 23, 2022 0

The automotive industry has reached a fork in the road: one path leads to reinvention and success, while the other maintains the current status quo. Business leaders will only have a brief window of opportunity to reimagine their core operations. To ensure their survival and success now and in the future, it’s time for automotive industry players to act.

While the speed and route to a future automotive value chain will vary, we believe the ultimate destination is common. To prepare for any radical change, an organisation will need to take decisive actions around what the future strategy and operational configuration has to look like.

As part of these considerations, companies (including dealers, OEMs, suppliers and service providers) will likely need to identify within their organisation a technology, product line and/or division that needs to be reviewed and potentially given a new direction. This is because continuing with the same strategy that benefitted from the strong automotive market of the past is unlikely to optimise returns in this evolving market. Particular attention needs to be paid towards areas that will not be part of core strategy over the next decade and beyond.

Assets identified as ‘non-core’ will differ in scale. For some companies such assets are a small part of the overall business. For others, a desire to leverage previous investments will mean they constitute a larger portion. Some companies (particularly suppliers and dealers) may face stark decisions – their whole business may fall into the non-core category and require strategic review.

In dealing with distressed assets, cost optimisation projects are often more useful than narrow-focused cost-out programmes. But delivering a cost optimisation project in the current climate is a challenge. COVID-19 has already driven businesses to cut costs with examples in the automotive industry including, but not limited to, reduction of inventory levels, renegotiation of key contracts, review or delay of capex investments, stopping or reducing performance rewards and a temporary freeze on new hires. However, cost optimisation will be needed to provide businesses with the flexibility and agility they need to capitalise on any potential market recovery.

While short-term cost-reduction initiatives have been necessary, a more structured and strategic reflection on the cost base will be required to boost recovery and prepare businesses to thrive during uncertain times. At a minimum, this will include assessing the financial impact of cost reduction and optimisation measures from both a functional and end-to-end process perspective (that is, order to cash, procure to pay, etc.) to understand the cost and the potential value created.

Linked to this is an increasing trend towards executing non-core asset disposals by joint venture (JV) formation or separate listing/ring-fencing. While this does not deal fully (or at all) with the vendors’ exposure to the current and future performance of the asset, it does have benefits. The upfront carve-out required to get the business on a stand-alone basis makes future disposal easier and enables the remaining business to focus on core strategy execution. If structured correctly, it can also isolate financial liabilities.

Meanwhile, it is also anticipated that the sector could also see a new consolidation dynamic: vertical consolidation. This would be a reversal of well-developed procurement strategies at OEMs and large tier-1 suppliers. For more than a decade, the trend has been for OEMs to outsource complex and invaluable modules (from instrument panels and powertrain modules to HVAC systems and door modules) to tier-1 suppliers. The OEM manufacturing process has increasingly become an assembly operation, with the manufacture of modules and parts handled by suppliers. Accordingly, tier-1 suppliers have outsourced detailed parts manufacturing to sub-tier suppliers located across a complex, integrated global supply chain.

Two emerging pressures have led to this changing dynamic: First, COVID-19 was a shock to the hyper-efficient ‘just in time’ supply chains refined to be as close to real time as possible. As the pandemic impacted automotive factories, production halted as parts could not be manufactured or delivered in sufficient time or quantity.

This has brought in to question the resiliency of automotive supply chains and whether the pursuit of ever-increasing efficiency has gone too far. OEMs and tier-1 suppliers are considering bringing production of critical parts/components back in-house to secure supply and avoid significant disruption in the future. Vertical consolidation around specific geographies is also a solution being considered to enable increased resilience. This means creating larger supply bases with enhanced capabilities through mergers and that reduce logistics risks by being closer to the OEM factory gates.

Second, vertical consolidation is being viewed as a tool to help stabilise profit levels in the face of lower volumes. Companies are trying to make more income from each vehicle to make up for the gap left by lower volumes. The focus has been on complementing product sales with service sales, particularly around digitally enabled mobility solutions. However, capturing additional margin from each vehicle by expanding the level of value-add content ‘owned’ on each one, whether at the OEM or supplier level, is a feature of vertical consolidation being explored by industry executives. The current market environment presents a unique opportunity to change the direction of a business, and sell-side M&A can be an effective tool for companies looking to reinvent themselves. However, creating maximum value through divestiture can be challenging. During the industry consolidation expected to emerge – whether by acquisition of non-core divisions, or consolidation of whole businesses horizontally or vertically – it will likely be a buyer’s market in the near future.

The cost of executing a value-creation strategy through buying, combining and rationalising automotive companies is currently low due to the disruption impacting the market, which is depressing deal prices and creating opportunities around stressed and distressed assets. Simultaneously, the potential for profitability improvement is high, due to these same issues. This means that the potential for creating value is there for buyers up for a challenge. Private equity investors (PEIs) are well-placed to capitalise on this opportunity.

According to cross-industry research by Deloitte, changes in the market environment and corporate strategy aside, the largest hurdles to divestitures anticipated this year include changes in operating performance (36%), inability to negotiate acceptable deal terms (35%) and inability to obtain acceptable value for assets (33%). In the automotive sector, there are additional factors, such as uncertainty around market volumes, the transition to EVs and a rapidly changing regulatory environment, that all make the creation of an investment hypothesis that stands up to scrutiny increasingly difficult, but completely necessary.

Sellers must now expend significantly more effort helping potential buyers build the hypothesis, making it easy for them to see the value that can be created and to have confidence that uncertainty can be mitigated (or even leveraged).

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