Divergent Roads: Fitch North American Auto Suppliers Credit Outlook

CHICAGO--Dec. 1, 20045, 2004--Fitch Ratings expects the overall credit quality of the automotive supply industry to remain mixed in 2005. North American-based suppliers operate in a global, overcapacitized industry. However, good credit quality suppliers have been able to maintain traction from solid liquidity and cash flow generation despite the vagaries of the industry, while many others spin their wheels in the mud as strong cost and pricing headwinds offset structural cost and productivity efforts. Fitch believes supplier credit quality in 2005 could deteriorate further due to lower industry production and significant cost pressures. While an improving economy could be a plus for demand, increased incentive spending has produced disappointing sales results leading to higher inventories and production cuts. In addition, higher gasoline prices have whittled demand in some vehicle segments. With a higher level of incentive spending, automakers are likely to increase their efforts to reduce material costs, meaning higher potential for greater year-over-year supplier price reductions. Other significant trends having a material impact on supplier margins and credit metrics in 2005 include commodity price pressures, as well as pension and health care costs.

On Divergent Roads - A Mixed 2005 Credit Outlook

In 2005, the higher rated credits in the sector are likely to maintain their credit profile, as strengths in technology, cost structure, competitive strengths, and balance sheet position them to withstand numerous industry pressures. At the lower end of the rating scale, particularly at those companies with high fixed cost structures and high labor costs, these factors will be much more difficult to absorb, with margins likely to deteriorate and potentially leading to further downgrades as cash flow and balance sheets are affected.

Why do some suppliers have good traction while others spin their wheels if both are operating under the same driving conditions? Successful suppliers are those that have been able to capitalize on managerial and operating strengths to produce top-line growth, margin retention, and working capital efficiency. Factors affecting a supplier's ability to grow revenue in a global, overcapacitized (capacity for roughly 77 million vehicles with only about 57 million annually produced) industry include: high technology offerings and product innovation, which enable the creation of and/or adaptation to changes in industry trends, as well as the ability to quickly capitalize on changing vehicle legislation regarding safety, fuel economy and emissions, possession of full service capabilities (research, design/engineer, and manufacture). These enable supplier involvement in the early stages of new vehicle development and concentration or diversity of business mix (geographic footprint, customer base, and product segmentation).

Factors that affect a supplier's ability to maintain margin and cash flow given the industry environment include: the ability to develop new or alter existing processes with wisely chosen but frugal capital investment to quickly adapt to industry changes; cost containment to manage pressures from rising commodity prices (steel) and labor costs (pension and health care); manufacturing discipline where product variances and work-in-process are minimized, bottle-necks are infrequent to non-existent, proactive maintenance schedules are kept, and on-time delivery is maximized; second-tier supplier issues are successfully managed; and a focus on working capital management to maintain liquidity while controlling accounts receivable, inventory, and accounts payable turns. Other factors affecting credit quality under current industry conditions include strategic acquisitions and divestures of noncore assets.

Industry Volume - Caution, Speed-Bump Ahead

While the potential for a slight increase in domestic auto sales exists, given modest improvement in economic conditions, Fitch expects flattish 2005 light vehicle sales, in the mid to high 16 million unit range. Consumers have become somewhat desensitized to the ever-escalating incentive packages offered by manufacturers. With improved economic conditions but no incentive spending traction, original equipment manufacturers (OEMs) may be more disinclined to spur sales along by increasing incentives later in 2005 as they have attempted to do throughout 2004. In addition, higher gasoline prices have had a modest negative impact on the sales of truck-based, fuel-thirsty sport utility vehicles (SUVs) which in recent years have been a source of increasing volume in the industry.

In 2004, second half production cuts have had only a minimal impact on reducing high inventory levels. Due to high inventories and including already announced first quarter 2005 production schedules, Fitch believes a negative year-over-year comparison for first half 2005 industry production volume is likely, with the decline being from 5%-10%. Assuming economic improvement continues and first half 2005 inventory adjustments are successful, Fitch believes second half 2005 production could improve by 2%-5%, versus a weak comparison from the second half of 2004. Combining both front and back-half forecasts together, for the full year, Fitch expects 2005 production volume to be in a range of flat to negative 3%.

Revenue - Some Moving Parts Create Offset to Negative Case

Generally speaking, suppliers can incur anywhere from 2% to 5% annual price reductions from their automaker customers. To varying degrees, suppliers have been threatened with the removal of future business if greater price concessions were not given on current contracts. Since the general level of incentives escalated throughout 2004, Fitch believes that North American automotive suppliers are potentially at greater risk of these types of customer strong-arm tactics in 2005.

Having laid-out the possible downside to 2005 revenue, it would be remiss to not mention potential offsets to the negatives. New business backlog represents revenue from the production launch of a new vehicle program and can lessen the impact of annual supplier price give-backs. A corporate culture that fosters innovation enables suppliers to maintain a steady stream in their new product pipelines. With several new products to offer, the supplier has greater potential for annually garnering contract wins on new vehicle programs. This steady stream of new product increases the likelihood that new business backlog can outpace the rate of decline from annual price give-backs, stabilizing or enhancing margins. In cases where the backlog is significant, some suppliers could show year-over-year increases in revenue. Suppliers involved in early stage vehicle development have contracted well in advance of the actual production launch. Vehicle development cycles can run as short as 24 months but as long as 48 months.

Given long lead-times, automotive suppliers typically have some revenue visibility two to four years out.

Suppliers that have a strategic market position in a growing segment could see increases in 2005 revenue. Vendors providing products and services to vehicle makers that are adding new or increasing production of more popular vehicles would stand to benefit from the added volume, i.e. manufacturers have been increasing their line-up of cross-over vehicles. These vehicles have the underpinnings of a car but the cabin and outer-skin of a sport-utility-vehicle (SUV), giving the consumer the desired functionality with better ride, handling, and fuel economy. Another opportunity for suppliers arises from the intertwined issues of fuel economy and vehicle emissions legislation. While the legislation on fuel economy and emissions is separate, these issues are interrelated from manufacturers' perspectives because a more fuel efficient vehicle produces fewer exhaust emissions. In addition, with the higher price of gasoline in the U.S., manufacturers have an added incentive to focus on further improving fuel economy ratings. Suppliers that provide products and services in engine management, aspiration, and exhaust, as well as products that enable reduced vehicle weight, stand to benefit.

The Stop and Go of Margin and Cash Flow

In 2005, suppliers' margins and cash flow could be constrained by their customers' efforts to potentially demand greater year-over-year price reductions. Other factors affecting Fitch's 2005 margin and cash flow outlook include commodity price pressure from steel- and petroleum-based raw materials, pension and health care, the relative level of new product launches, and currency. Due to annual price give-backs and the need to be globally competitive, suppliers with good credit metrics have been able to improve manufacturing efficiency. Many have adopted methods such as Kaizen, Kan-ban, and Six-sigma, which enable margin and cash flow to be maintained despite lower per unit revenue. Kaizen programs seek to find ways to improve through-put in a manufacturing process, but to be truly effective, management must embrace it as part of the corporate culture, engraining it upon the psyche of the shop floor. Kan-ban programs like Kaizen are only effective if engrained in the culture, but the focus is on removing bottlenecks to reduce work-in-process inventory. Six-sigma is a statistical tool box that enables greater repeatability, reduces variance, and improves quality but is relevant to the functional areas of the organization, as well as operations.

Fitch expects commodity price pressures to remain in 2005, especially steel costs and to some degree the cost of petroleum-based raw materials like plastic resins. However, it appears that with the price of a barrel of oil now in the low $40s down from highs in the $50s earlier this year, some relief may be on the way in 2005. Due to higher steel costs and supply shortages, some suppliers were vulnerable to margin pressure and work stoppages in 2004. There has been some discussion in the supplier community about recovering incremental steel costs from customers either as an out-right price increase or in the form of a steel surcharge. However, Fitch finds it highly unlikely that any supplier would achieve anywhere near 100% recovery of the incremental cost given the degree of global overcapacity in their customers' facilities. Long-term contracts that were in-place prior to early 2004 and run into 2005, as well as supplier pooling purchases through their customers' steel-buying programs may also defray some of the incremental cost. Another way suppliers might try to seek relief could be through global resourcing. However, logistics and the cost of transportation may be prohibitive relative to the cost of the commodity.

Pension and health care expenditures continue to be constraints on 2005 margins and cash flow. Recent economic growth and increases in the discount rate have not moved the long end of the yield curve, which could result in even lower discount rates at year-end 2004. Modest asset returns and higher contributions will offset some of the increase in the liability but overall underfunded positions are likely to show little improvement. This will extend the timeframe needed to close the gap, extending the claim on operating cash flows, which are already under pressure from operating fundamentals.

In the coming year, suppliers may incur higher launch costs as their OEM customers have recently been increasing the number of new or significantly redesigned models offered each year. OEMs are more frequently rejuvenating their vehicle line-ups since incentives for new models tend to be relatively low compared with models in the advanced product life-cycle stage. Suppliers with good credit metrics have learned how to successfully manage new vehicle program launches. However, to the degree that a supplier has higher launches relative to its existing product base, margin pressure builds due to higher fixed costs but low revenue and volume during production ramp-up. In addition, earlier supplier involvement in the new vehicle design process should be reducing the cost of launching a new vehicle as the practice should be resulting in fewer late design changes. However, it is Fitch's observation that while the domestic automotive industry has made some progress with this practice, it may be more akin to only lip service at this point. Long term, suppliers that annually incur new vehicle program launches, assuming the launch curve and late design changes are managed well, should experience a positive influence on margins from these factors.

Currency issues for automotive suppliers are likely to persist in 2005, albeit having a mixed impact on suppliers. For example, European automotive operations tend to have higher labor costs, especially in Germany. A weaker dollar would make the profit margins of the higher cost operations a greater piece of the whole, reducing overall corporate margins. However, for some suppliers, the reverse is true as Euro-denominated operations produce slightly better margins, having an accretive effect on the overall corporate margin. The degree to which the impact occurs on cash flows depends on the degree to which each company repatriates the cash generated by foreign operations or exports cash to invest in weaker operations abroad.

Other Important Cash Flow Items

With improving economic conditions, Fitch expects that cash interest paid on adjustable-rate debt and on any new issuance of debt could increase as we progress through 2005. Since vehicle development cycles usually have multiyear time horizons and since OEM efforts to more rapidly rejuvenate product lines had a greater overall impact on suppliers beginning in 2003, the year-over-year incremental capital investment by suppliers for new product launches should be stable in 2005. Working capital could be affected if there are further changes in OEMs' accounts payable policies as was a concern in 2004. If OEM policies are to decrease payable turns to conserve more cash, in some cases, suppliers would be at the mercy of the whims of their larger OEM customers. If this were to be the case, then suppliers might rely more heavily on accounts receivable securitization facilities for short-term funding. Higher steel costs and supply shortages have also had an affect on working capital by affecting suppliers' inventories and payables, as well as causing minor temporary line shutdowns. In 2005, strategic bolt-on acquisitions and divestitures of noncore assets should continue at a moderate pace.