Lower Tier Supply Firms Approach the Tipping Point

One might wonder why is the financial health of lower tier suppliers even worth discussing given the monumental problems facing their behemoth Tier 1 customers, not to mention the OEMs. The answer to this question relates to two key supply chain conditions – the fragility of the overall Tier 2-5 automotive supply chain because of weak overall financial condition, compounded by the situation that over 50 percent of the value of an automobile is provided by these small mostly privately held suppliers.

The automotive industry is rapidly approaching (or has already passed) a point that without a widespread transformational restructuring of the lower tier supply chain, the Big 3 faces a near-term train wreck. This calamity will be characterized by substantial production interruptions as OEMs, integrators and parts makers’ struggle to manage multiple chaos events caused by a rash of concurrent bankruptcies and supplier liquidations.

I characterized the required changes as transformational because of the substantial magnitude of complex and interrelated issues facing these suppliers. Diagram 1 presents these issues including:

• A looming capacity shortfall by high performing suppliers as demand for their services outstrip their facility, equipment and people resources.


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• Difficulty by many lower tier suppliers (including many high performance enterprises) in rapidly scaling up their business systems and capacity by a magnitude of 2-3 times by the end of the decade.


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• Suppliers have excessively focused their talent and resources on the management of commercial issues versus innovation and/or other customer value-creating activities.


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• Launch shortcuts generating quality spill and warranty risks for suppliers and customers alike.


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• Under-capitalized suppliers inability to finance expansion, relocation, fund losses or even afford a large tooling program.


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• A broad transition from private capital being relatively patient to being extremely impatient as entrepreneurial wealth withers at an astounding rate within the supply chain.


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• Precipitous actions that will be taken by many banks as they attempt to manage credit risks resulting from large losses incurred for the ’04 calendar year by hundred of lower tier suppliers.

 Supplier margins were ravaged during CY 2004 propelling many suppliers into net losses at both an income and cash flow level. Contributing factors included the crushing impact of huge raw material increases, punitive quality related costs imposed by customers for even the most trivial quality defects, and energy and health care insurance costs escalating at double digit rates. For the average supplier with a debt to equity ratio exceeding 3:1 (the industry average), this financial performance becomes problematic for even the most sympathetic commercial banker attempting to get updated loan facilities through bank credit committees.

These conditions will usher in a year with a rapidly growing number of supplier liquidations and bankruptcies. Not only will suppliers with substantial debts loads face turbulent times, but so too will some high performing suppliers enjoying strong business models, solid profitability and comparatively low overall debt loads.

The dynamics work this way. Healthy Supplier A is a $20 million niche product specialist earning a strong $1.5 million net income (7.5 percent of sales). The company has a small credit line with a regional bank and manages trade payables at a comfortable 45 days. Healthy Supplier A has a nicely diversified customer based with approximately 80 percent of revenues earned evenly from four large customers.

Integrator Customer A experiences financial difficulty and declares chapter 11 bankruptcy. Its $1.7 million payable owed to Healthy Supplier A becomes uncollectible, at least in the short-term. This results in a $1.7 million write-off of the receivable, a reduction in owner’s equity of the same amount, and a corresponding decline in line of credit available since the credit line is collateralized by accounts receivable. Over night Healthy Supplier A has a weaker equity position and less borrowing power.