A new study by AlixPartners, a consulting firm, forecasts that private equity firms will continue to show greater interest in the auto industry.

At a briefing held in conjunction with a meeting of the Original Equipment Suppliers Assoc. (OESA) AlixPartners’ 2007 Global Vehicle-Industry Analysis noted that while the average transaction multiple (a target company’s enterprise value divided by its EBITDA earnings) in the private equity market throughout the US today is 8.4, the average multiple in the auto industry stands at just 5—and that’s down from a multiple of 6.2 in 2005.

Further highlighting domestic companies’ current woes, the study found also that Ford Motor Co., General Motors Corp. and Chrysler Group together employ 8,200 additional assembly workers in the U.S. than does Toyota Motor Co.’s Toyota USA simply due to more stringent union work rules and job classifications alone.

“Forget the old, three-part ‘perfect storm’ analogy; there are really two big issues to watch in the domestic auto industry this year—private equity and the upcoming labour negotiations this fall,” said John Hoffecker, a managing director of AlixPartners and co-head of the firm’s healthy-company Performance Improvement practice.

“It just stands to reason that the auto industry’s below-average multiples, coupled with its significant cash flows, will make it a magnet for private equity for as long as money for deals remains as free-flowing as it is today. This will put great pressure on all companies, especially suppliers, to perform at higher levels—though it also should present some new opportunities, such as suppliers partnering with private-equity funds for strategic acquisitions or divestitures.

“Meantime,” continued Hoffecker, “our analysis of the cost differential between the domestic automakers and Toyota just due to work rules and job classifications further points up just how important this year’s labour negotiations are to the Detroit Three. At a time when the domestic companies are facing new regulatory pressures that could add literally tens of billions in cost over the next five years, the last thing Detroit needs is that kind of differential. And our analysis was for assembly workers only. We estimate this discrepancy would be 50 to 70 percent wider if stamping, power-train and other manufacturing operations were included, not to mention supplier operations.”

In terms of the opportunities that private equity might present to suppliers, Hoffecker noted that “not all private-equity firms are created equal,” and defined what he called the four types of private-equity firms: “Leverage” (those that look for stable cash-flow companies where only the balance sheet needs restructuring), “Operational” (those looking for companies where strong new management can make the difference), “Distressed” (those looking for companies with a lot of distressed debt, especially the type with covenants that could trigger a change in control, for restructuring and eventual sale) and “Roll-up” (those looking for vertical integration opportunities within an industry segment).

While noting that the number of private-equity deals could decrease dramatically if interest rates rise significantly, Hoffecker emphasized that private equity could indeed be an all-new M&A (mergers and acquisition) source for suppliers. “The example from the aerospace industry last year of the private equity firm Onex helping Spirit AeroSystems expand its business with the acquisition of the aerostructures unit of BAE Systems is a good one of where private equity was open to risk-sharing as well as deal-making,” he said.

In terms of the multiple challenges facing domestic automakers, Hoffecker cited what he called their “profit indifference curve.” It shows that as market and regulatory pressures move the product-line mixes for US automakers away from SUVs and other light trucks to passenger cars, every 5 percent shift in mix would have to be accompanied by a 3 to 4 percent increase in total company vehicle sales just to maintain the same operating profit levels—a tall task. “With the domestics currently having more than 60 percent of their mix in light trucks, they’re going to have to run incredibly fast just to stay in the same place,” he said.

Considered one of the most comprehensive studies of its kind, the AlixPartners analysis looked worldwide at 51 automakers, 25 heavy-vehicle producers and 297 auto suppliers (up from 104 last year), and measured and compared them across a wide range of operating as well as financial metrics.

Among other findings in the study:

  • North American suppliers are being consistently outperformed financially by their European (as well as Asian) counterparts; and, even with the avalanche of supplier bankruptcies already, 27 percent of North American suppliers face “fiscal danger” (possible insolvency) within 24 months;
  • India is on track to become a bigger auto market than Brazil, France and South Korea within the next six years, and Indian suppliers, flush with cash, could be poised to go on an acquisition binge of their own, following the lead of companies such as Bharat Forge Ltd., now the second-largest forging company in the world;
  • China, whose auto-components exports to the U.S. were up a whopping 38 percent in 2006, is this year on track to permanently pass Germany in that department (as it did in the first quarter of this year), while the market capitalization (stock price times shares outstanding) of Chinese and Indian automakers together is now larger than that of General Motors and Ford combined, even though the latter’s revenues are ten times greater;
  • Within just five years, North America, Europe and Japan will together make up only about half of the global auto market, down from controlling about three-quarters of the world’s market five years ago;
  • Sourcing from India, China and other low-cost countries (LCCs) is critical to the success of most Western automakers and suppliers; however, much of LLC sourcing to date has been woefully ineffective (mirroring another recent AlixPartners study in which 38 percent of CFOs and other senior financial executives from three industries, including autos, said their outsourcing of SG&A functions was “not fully effective”);
  • Despite the woes in the domestic supply industry today, the returns of top-performing suppliers have been consistently growing since 2002, with returns much higher than those in other industries;
  • Suppliers with strong balance sheets, as opposed to just the lowest costs, are now in the best position to achieve sales growth globally, given the level to which the risk to automakers of failing suppliers has risen.

Said Hoffecker: “The auto industry can still be a growth industry, no matter what a company’s geographical location happens to be or even its product segment. But, as this study confirms, the companies that are in fact achieving growth today are moving at warp speed to shore up their balance sheets and to achieve a cost or innovation advantage in their markets.”

See also: FEATURE: ‘Barbarians at the gate’ enter the auto industry