Private Equity’s Footprint in the Auto Industry Is Likely to Grow, Says New AlixPartners Study

Private-equity firms know a good deal when they see it and, right now, some of the best deals going are in the auto industry. That’s according to a new study released today by AlixPartners LLP, the global business-consulting firm, at a special briefing held in conjunction with a meeting of the Original Equipment Manufacturers Assoc. (OESA).

The 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 white-hot private-equity market throughout the U.S. 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 labor 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 labor 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 wherein 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 U.S. 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 major 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.”