DEVELOPMENT costs at suppliers still appear to be accelerating. R&D costs, typically amounting to 5-7% of sales, reflect growing demands on suppliers from OEMs for more product development input. As a result, a growing debate has flourished centred on the question of how to finance mushrooming project-related development costs. The OEM stance appears to rest on the tenet that development financing should be indivisible from responsibility for the project itself. The result is closer involvement in the financing process which, taken towards an extreme, involves amortisation of investment costs over actual output volumes and no up-front payments. This process inevitably ups the risk profile of any given development project for a supplier. The smaller the supplier, the higher the risk. SupplierBusiness.com reports.
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Basel II
Some analysts now argue that this squeeze on suppliers is being turned into a pincer movement by banks, which, with one eye on Basel II guidelines, are reconsidering their lending terms. There are already suggestions that some larger banks have capped finance provision for small and medium-sized suppliers, a real blow for companies that have relied heavily on debt financing in the past, most notably those based in Germany. Surveys of external funding structures have shown that the equity financing/banks loans split (as % of total capitalisation) varies considerably between countries, for example, the US (83/17), the UK (88/12) and Germany (31/69). A number of questions immediately arise, most notably how extensive the problem is and what solutions are available?
A uniquely German problem?
According to Richard Markus, a partner at KPMG Corporate Finance, which recently surveyed 76 chairmen and managing directors of German component suppliers, the financing issue is not unique to Germany. However, it is clear that it is in Germany where the perceived threat is most acute, a fact that is acknowledged by the VDA, which has launched a new initiative for SMEs. The VDA has developed a rating tool that “will allow companies to more accurately assess their position in their dealings with the banks and also with customers. The aim of this initiative is to develop a new financing, rating and benchmarking service.”
40% of suppliers in the KPMG study claimed that growing restrictions on available finance were hindering their strategic development. A study by IKB, the German bank, showed that smaller companies were most concerned about their ability to finance future investment. According to Peter Fuss, a consultant with Ernst & Young: “The OEMs are now transferring responsibility for R&D to suppliers, and with it, the risk. The banks perceive auto component development as a ‘soft’ business. Banks lack the necessary resources and know-how to fully evaluate the risk, so they view it as high risk.” This applies principally to overall supplier financing rather than specific projects, although the increasing scale of projects is creating specific difficulties. Fuss notes: “Developing a dashboard for a car could cost €10m; either you are a major supplier that can absorb this cost or you have a huge liquidity gap for 1-2 years. In the case of the latter you need help.”
A broader perspective
Before outlining some suggested solutions to this squeeze, a broader perspective is needed. Financing new product development has been a challenge for suppliers for many years, only some of which has been resourced from customer-provided, direct financing. This burden has been growing for suppliers, especially for the tier 1 integrators, but many have already focused on measures to offset this burden. Improving productivity of R&D expenditure has been a priority for some time, with suppliers screening future product programs at OEMs with increased diligence. Projects with a visible, commercial return, preferably with strong customers and proven models are given priority. ‘Blue sky’ R&D is diminishing in tandem, but even where this continues, customers classed as unwilling to reward innovation with realistic project financing or final piece pricing, risk being by-passed when leading suppliers showcase new technology to potential buyers. Ford has expressed fears in this regard for some time and has modified its purchasing strategy accordingly.
It also has to be acknowledged that the ability of suppliers to finance development spending is to a certain extent cycle-dependent. Although margins at suppliers are probably in long-term decline, there are pronounced cycles within this trend, reflecting general, short-term demand conditions in the auto sector. The financing issue will assume different degrees of significance, depending on this cycle. Strong free cash flow generation at high points in the cycle can probably finance ongoing product development, even if expanding, with some ease. In the down-cycle, the financing issues become more acute. As reviews of recent supplier financial performance in previous issues of SupplierBusiness.com have outlined, many leading suppliers are currently experiencing satisfactory margins and cash flow. A recent comment from Deutsche Bank noted that: “The most striking feature of the auto parts Q3 [2003] results round up was their [the suppliers] ability to generate strong free cash flows, despite a difficult environment”. In other words, suppliers are financing all ongoing development spending and capital expenditure and still generating surplus cash that can be used for a variety of uses, ranging from higher dividends for shareholders, to acquisitions. In such circumstances, problems related to the funding of an increasing product development burden fade well into the background, even for leading integrators.
Focus on lower tiers
The supplier financing issue is, therefore complex. Major tier 1 suppliers generating satisfactory cash flow probably have the necessary resources to fund more outsourced development work and shorter model/component cycles. Nevertheless, for this to be sustainable, OEMs must be willing to provide realistic rewards for innovation. Insolvencies among the tier 1 supplier base are infrequent but do happen, even if the causes of these are invariably complex and seldom traceable to one specific trend such as a growing R&D burden. The focus of the ‘financing crisis’ should, therefore be on the lower supplier tiers, especially those that traditionally rely heavily on debt financing. These companies are vulnerable to increasing R&D burdens being pushed down through the supply chain by OEMs and the tier 1s.
Financial institutions willing to fill the void left by unwilling banks are increasingly mooting solutions to these challenges, although many believe further consolidation of the supplier base is inevitable and desirable. In the KPMG survey, 70% of respondents believed that within the next four years there would be a further wave of consolidation because of financing difficulties, high risk and lack of innovation resources. Ernst&Young also concluded that the most likely scenario would be more M&A activity in the German supplier industry.
Creative solutions
Other solutions provide company-specific answers and begin to embrace the full creative powers of bankers and financiers. Some believe private equity can provide a solution but in reality providers of such finance have little to gain from funding day-to-day product development projects, preferring outright company acquisitions that offer a profitable exit route at some future date. A high proportion of respondents in the KPMG study indicate a willingness to consider private equity to improve their position but subsequently backtrack when the full implications of this become clear (loss of control, corporate governance etc).
Despite many banks becoming more risk averse and looking to reduce exposure to weak investments, a handful appear willing to tailor products for smaller suppliers, most notably IKB, Landesbank Baden-Württemberg and HVB (Hypo Vereinsbank) in Germany and the Bank of Austria. These are traditional finance providers for Mittelstand suppliers in Germany. Asset-backed securities and factoring of accounts receivable are some of the short-term packages being considered.
ING is pioneering a project finance approach to the issues, which seeks to find a way of financing most of the investment related to product development on a stand-alone base. Although applied in other industrial sectors, this approach has yet to find favour in the automotive industry. Project financing would be undertaken through the creation of a new dedicated company that carries all investments made by key suppliers for a specific OEM project. Members of the so-called Special Purpose Company would be selected after being awarded a contract and having been considered a strategic partner for the OEM. Despite some obvious attractions (reduction of investment borne directly by participants, reduced risk etc), this approach appears more suitable for tier 1 suppliers that, as noted above, have less pressing funding problems than those in the lower tiers.
Outlook
It is clear that a financing problem has emerged for certain suppliers in recent years and that this is hindering strategic development. Availability of traditional debt financing from banks has diminished in some areas, simultaneously with increasing R&D costs that have been pushed down the supply chain from OEMs. Many believe this will herald a further wave of consolidation in supplier ranks, especially if the more creative financing products emerging from financial institutions prove unattractive and/or too costly. But it would be unwise to over-emphasise these challenges and to ignore the complexities involved. Suppliers are facing up to rising R&D burdens by enhanced screening of customers and projects in order to maximise commercial returns from development spending. Currently, strong cash flow generation is also evident at many major suppliers, a testament to recent internal cost-cutting programs and other margin-enhancing measures. This is providing adequate funds for growing product development needs without recourse to external funding. Challenges faced by the German Mittelstand suppliers show few signs of becoming universal.
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