There are approximately two million vehicles produced annually in Canada by five Original Equipment Manufacturers (“OEM’s”) - Ford, Fiat-Chrysler, General Motors, Toyota and Honda. In addition, there are approximately 1,000 parts manufacturers that supply the OEMs. Some are Tier 1 suppliers such as Magna, Linamar, Martinrea and ABC, while most are Tier 2s or 3s. The industry generates approximately $107 billion in annual revenue.
There are eight assembly plants left in Canada versus 14 in 1997. The industry employs approximately 45,000 people versus 62,000 in 1998. All passenger vehicles made in Canada are assembled in Ontario. 85% of vehicles manufactured in Canada are exported, mostly to the US. The industry is capital intensive, cyclical, highly regulated and competitive.
Due to higher prices of vehicles, increased number of off-lease vehicles and consumer debt levels, new vehicle sales, both in Canada and the US, are expected to decline in 2019. US new car sales are expected to decline by 2.4% in 2019 to 16.8 million vehicles, versus 17.2 million in 2018, while Canadian car sales are expected to decline by 2.8% to 1.93 million vehicles, versus 1.99 million during that period.
Source: The Wall Street Journal
Source: DeRosiers Automotive Consultants Inc., Scotiabank Economics
Like many sectors, the automotive industry is being transformed by technology-driven disruptors. Four important disruptors are set out below.
- Electric Vehicles—OEMs and parts manufacturers need to adapt to changes in components, away from fossil fuel vehicles to electric technology. This means enhanced expertise and capital investment;
- Autonomous Driving Vehicles—This requires a major investment by OEMs and software companies. Legal liability associated with autonomous vehicles remains an unknown;
- Ride Sharing and Urbanization—Ride sharing is commonplace, as illustrated by Uber, Lyft and Zipcar.Also, millennials increasingly want to live closer to work and are using alternative modes of transportation; and
- Manufacturing Innovation—With improving manufacturing technology, parts manufacturers need to innovate their production processes. For example, light-weighting parts contributes to a more fuel-efficient vehicle.
Partly as a result of fuel efficiency and lower fuel prices, since 2014, the size of vehicles has become less critical. Fuel efficiency increased by 3% for light trucks and 2% for sedans from 2017 to 2018. Consumers are prepared to buy bigger vehicles and consumer tastes have shifted away from sedans to light trucks and SUVs. In 2018, only 29% of new vehicle sales in Canada were sedans, while the balance was light trucks and SUVs. As an example, Ford indicated it would no longer make sedans after 2018. GM is cancelling production of multiple sedans, including the Chevy Volt, Chevy Impala, Cadillac CT6 and XTS and Buick LaCrosse.
The Move South
The trend among North American OEMs has been to locate new production in Mexico. This is driven by low wages, generous Mexican government incentives and trade agreements (NAFTA/USMCA).
Mexico has turned into an auto industry powerhouse. In 2019, Mexico is projected to produce 4.3 million vehicles as compared to approximately 645,000 in 2013, an increase of over 500%. Canada is projected to produce 1.95 million vehicles in 2019 compared to approximately 2.3 million in 2013, a decrease of 15%. This trend is expected to continue as evidenced by GM’s recent closing or downsizing of seven plants in the US and Canada, including Oshawa.
OEMs expect parts suppliers to supply on a “just in time” basis, which generally requires them to be within short travel distance of the OEM plant. This applies wherever the OEM has a plant. Shipping parts long distances is not economic and exposes the manufacturers and OEMs to risks, including tariffs, currency fluctuations and transportation issues (such as potential delays crossing the border (particularly in the age of Trump)).
Stresses on Parts Manufacturers
Due to the competitive nature of the parts industry, OEMs have increasing leverage over parts suppliers. OEMs are seeking long-term supply agreements with price reduction clauses. There is growing pressure on the parts supplier to absorb the costs related to new product designs.
As OEMs expand their manufacturing presence around the world, parts suppliers follow in order to obtain or retain supply agreements. This can lead to a number of challenges for parts manufacturers, including:
- for the smaller ones (Tiers 2 and 3) they may not have the capital or engineering expertise to open a plant in a foreign country, thousands of kilometers from head office. However, if they don’t, they risk losing the relationship; and
- if the parts manufacturer makes the capital investment and opens close to the OEM, the OEM has significant leverage over the manufacturer due to its dependence on that OEM.
Key Takeaways for Parts Manufacturers
For suppliers to be successful, they will need to:
- have access to capital in order to invest in innovation and to meet OEMs’ logistics requirements;
- be able to adapt by investing in new technologies and business models;
- specialize versus commoditize; and
- reduce costs so they can accommodate pricing demands from OEMs.
Considerations for Lenders to Parts Manufacturers
It is important for lenders to auto suppliers to identify the risk factors in the suppliers’ business. Risk factors include:
- OEM concentration and dependence;
- producing commoditized products and/or products that may become obsolete; for instance, parts not suitable for electric vehicles;
- proximity to major OEM customer’s production facilities and capability (and capital) to open new production facilities;
- demand for programs that the borrower is currently supplying, program lifecycle and the borrower’s pipeline of future programs;
- ability/leverage of borrower to negotiate contractual terms with OEMs;
- exposure to exchange rate fluctuations;
- relationship with its labour force, particularly if unionized; and
- legacy pension obligations.
What are the Most Important Steps to Consider in the Event of Distress of an Auto Parts Manufacturer?
Based on our experience dealing with distressed automotive suppliers, it is critical that suppliers and their stakeholders work cooperatively to try to achieve their respective goals. When working in a just-in-time environment in the sector, the risk of a shutdown is catastrophic for the OEM and its stakeholders – from supplier to vendors to creditors to employees.
Some important considerations in the event of distress of a manufacturer are noted below:
- The lender, manufacturer and OEM need one another to achieve their respective goals. In general, the goal of the lender is to collect outstanding accounts receivable and realize on parts inventory, while the OEM needs the manufacturer’s product to continue to operate without supply disruption. The supplier and its employees want the business to continue to operate with the hope of completing a going-concern transaction or a successful restructuring.
- Tensions in the restructuring process drive multi-party negotiations. Typically, the distressed manufacturer (usually through its receiver/monitor), its lender and OEM will enter into an “Accommodation Agreement”.
- An Accommodation Agreement provides, amongst other things, a framework in which the OEM, lender and manufacturer work cooperatively to maintain a supply of parts for the OEM while the OEM agrees to pay all of its existing obligations, except for permitted setoffs, and may even supply working capital for a limited period to facilitate the restructuring process. Among other things, the OEM also agrees to buy any remaining inventory and certain OEM-specific fixed assets at the end of the term of the Accommodation Agreement.
- While wind-downs under an Accommodation Agreement can take several months, the process is orderly and the outcomes are normally beneficial for all stakeholders.Recoveries are maximized, OEMs are supplied without disruption and an opportunity is provided to achieve a successful restructuring or sale, which is critical to gaining the support of the workforce during the restructuring period.
It’s been close to a generation since the end of the last restructuring of the automotive industry. There are a limited number of restructuring professionals that remember the ins and outs of automotive restructurings. Experienced professionals understand the dynamics of negotiating an Accommodation Agreement and the significant benefits they bring to all stakeholders in an automotive context, particularly when compared to the catastrophic outcome if one is not in place.