March 1, 2008
Roundtable - The Auto Sector Shifts Gears
Mergers & Acquisitions: The Dealmakers Journal
March 1, 2008
The New Year didn't exactly change the tide in the auto sector. General Motors was the lone auto giant to see sales climb in January, while the likes of Ford, Chrysler, Toyota Motor Sales USA, and American Honda all registered declines over last year, according to a recent story in the Chicago Tribune. And it doesn't appear that things are going to get much better in 2008, as both Ford and GM have trimmed their production plans for the first quarter by between 7% and 11%, while Chrysler, according to industry forecasts, is seen cutting its first-quarter production by as much as 15% over last year.
This is on top of continued softness in a sector that for years has been struggling to find a bottom. But out of the weakness has emerged opportunity. The trophy deal in the space was Cerberus Capital Management's takeover of Chrysler last year. The hedge fund paid $7.4 billion for an 80% stake, a relative bargain compared to the $36 billion Daimler paid less than ten years earlier, and as part of the disposal Daimler actually invested another $700 million into Chrysler as further inducement for Cerberus. Meanwhile, the same struggles can be seen in the companies that service the OEMs, which only make life more difficult by passing on their woes directly to their suppliers. That too has created opportunity for distressed investors and turnaround shops whose mandate it is to help these companies survive and flourish.
Mergers & Acquisitions, as part of a roundtable, corralled a number of top pros in the field who've taken on this charge. Participants included John Weykamp, the head of the restructuring and advisory services practice at accounting firm Crowe Chizek and Co.; Justin Hillenbrand, a partner at distressed buyout shop Monomoy Capital Partners; Jim Gillette, a director of financial services at automotive forecasting firm CSM Worldwide, Garrett Kanehann, a founding partner of distressed PE shop BlackEagle Partners; Clifton Roesler, a managing director of investment bank W.Y. Campbell & Co.; and Danielle Fugazy, a contributing editor at M&A, who moderated. The following is an abridged version of the conversation.
Mergers & Acquisitions: What role is private equity playing in the automotive sector today?
Hillenbrand: We consider it playing an important role these days given that strategics have their own issues in the auto industry. About 75% of the auto industry is in distress, so that limits a company's ability to acquire their peers or suppliers, for that matter.
Generally we see ourselves as providing two real roles: One is liquidity. We, as an industry arguably have too much capital. There's certainly a lot of capital to spend. And, two, we provide focus. We've uncovered that being owned by either an entrepreneur, a division of a larger company, or even a stand-alone company that has the same management for a very long period of time, tends to make a company lose focus about what's important. For private equity firms it's all about cash generation.
Kanehann: Private equity can facilitate the resuscitation of the auto sector. There's also an interesting thing that we find today, where certain companies owned by entrepreneurs are actually run pretty well and are growing as a result of the dislocation occurring around them. We found some of these entrepreneurs are really struggling with that growth. So while they are not troubled, they are beginning to choke on the growth they're seeing, while the distress occurs around them.
Roesler: The word "discipline" is important. A disciplined approach to demanding a financial return is what the private equity funds are known for and what is needed. What's occurring is that private equity is very disciplined when it comes to pricing. Regular companies are not. For example, the guy who runs the factory is saying it's going to cost us $6 to make this part and the salespeople are selling it for $4 thinking they're going to make it up on volume or the next big win. That doesn't happen under private equity ownership.
Hillenbrand: I'm always surprised when you come across an owner, CEO or manager of a company because many think: I'm a $1 billion company today, but we can be $4 billion. When you analyze the economics behind it, though, it doesn't make sense. If you were a $1 billion company and manufacturing 100 different parts or components, and you shrink it to $800 million or $600 million and focus on 30 parts, all of a sudden you make money. And it's just a foreign concept to a lot of people.
I really think you're going to start seeing that shrinking happen with Chrysler now that Cerberus [Capital Management] owns it. I'm almost certain that three years from today Chrysler will be a smaller organization than it is right now.
Weykamp: And more profitable. We're looking at a smaller company right now that has great sales growth. They started out with $60 million in sales. In three or four years they've doubled their sales - they're a $120 million company today. Three or four years ago they were making $3 million in profits and this year they're going to book a $1 million loss. And it's been a steady, linear relationship in both the sales and the loss every year. That's essentially a reflection of private ownership versus private equity ownership. That wouldn't be tolerated in the private equity world.
Gillette: There are a lot of suppliers that are doing the right thing, and there are a number of suppliers that are making their cost of capital at this point in time, and they fully adopted this role of saying, "We don't want to be huge. We just want to be valuable and profitable."
When I first came into this business, forecasters said you had to be a $100 million company in order to survive. And then it was $500 million. And then it was $1 billion. I'm just saying, you have to be the best that you are within that particular segment to survive. And what we're seeing now in the industry relative to these firms that are spinning off some of their operations is that they're deciding, "It's really not for us, but it could be somebody else's gem."
When you look at the top 50 to 150 companies, most of them have gone through what they need to do in order to survive through this downturn we're seeing in 2008.
Where we're really seeing the brutal activity going on are the companies below $200 million. The smaller outfits that you guys are talking about - the entrepreneurial businesses, the family-owned companies. The major role that private equity is playing is that they're getting these businesses back on track saying, "You've got to create value. You've got to have cashflow." And a lot of them are still trying to support their large yachts and homes in Florida when it just isn't that kind of world anymore.
Kanehann: Another important thing that the private equity industry does is it instills in its companies a sense of urgency. Every day I'm waking up and my pants are on fire to do more to create value. Because the customer base is on a relentless march toward better products, more efficiency, and if you don't have the sense of urgency, you are going to fall by the wayside.
Hillenbrand: I agree with that. We have bought probably four or five family-owned businesses, and I find that the mentality is completely different. They run the business for a comfortable lifestyle rather than to maximize profitability - and sometimes in doing that, they make questionable decisions.
Weykamp: Everybody is focusing on private equity, which clearly is one of the primary ways to take the small entrepreneurial private company and refocus it professionally. And in the restructuring world that I live in, we're always looking for an exit strategy. Clearly private equity coming in and buying out families is one. And quite often when I see that, some of these companies have been enlightened enough to bring in professional management but they're still controlling it at the family level, whether that's at the board level or just the patriarch of the company.
Mergers & Acquisitions: I think a lot of our readers know the macro story, but looking at some of the micro factors, why is there so much distress around smaller automotive components companies and suppliers?
Hillenbrand: The automotive space is structurally an interesting industry. You have the OEMs that have created this really long supply chain, and back 10 years ago, you might have had 20 other companies in the same industry - mom-and-pop shops that set up alongside the next tier up. And these family businesses don't necessarily have huge amounts of capital behind them. So when you're tied to one OEM and that OEM moves south, or stops growing, they don't necessarily know how to manage it. That's one small microcosm of a huge answer.
Gillette: The number one reason for distress has been a concentration of customer portfolios insufficiently diversified. If you look at the vehicle build in North America, we've seen about a roughly 4.6 million annual unit decline between 2000 and 2008 for the Big Three in Detroit. So when you take a look at Michigan and you look at these entrepreneurial firms we're talking about, many of which were formed after World War II, gramps put the thing together at that point in time, and the family has been running it ever since. They knew somebody at General Motors or Ford, and it's not unusual to find 60% to 80% of their business is with a single company.
Most of those companies are going through restructuring right now. For example, Lear is a very large business that was doing somewhat okay from a cash flow standpoint up until a couple of years ago. But 68% percent of their business was still with the Detroit Three. Compare them to Johnson Controls, which has taken the strategy of customer diversification over time.
The triggering event that has occurred is that the standard commercial banks in North America have pretty much disowned a number of the suppliers because the risk level was viewed as being too high.
Hillenbrand: You also had - at least over the last two years - people borrowing their way out of problems without fixing the underlying operational issues. In 2002, 2003 and 2004, capital was cheap and everyone was lending at four, five or six times Ebitda. When it comes to refinancing now, you're not only faced with a market that's not lending at those terms, but your Ebitda went from X to half of X, so you're definitely in deep trouble.
Kanehann: One thing that we didn't talk about is this absolutely relentless march toward higher quality and more sophisticated products. The Big Three are in a knife fight for their life to stop the market-share erosion, and as part of that fight they're continuing to drive for better quality and a more sophisticated product line. And what that does, is it makes it harder on the suppliers. Where four microns of tolerance was okay three years ago, today a micron is what they need. And if they don't get a micron of tolerance from us, they're going to approach a Japanese competitor who can provide that.
Roesler: Another problem is the negotiation of what do you do when your customer won't pay a price that covers the cost of the product you're selling. You can keep shipping until you go out of business or you can have the fight. You'll defer death by continuing to ship for a period of time at which point you'll just run out of cash and lose the business.
Depending on whether you're the shareholder or you have public shareholders, I think there's some question about the fiduciary responsibility of going into bankruptcy. You just cost all your shareholders their worth, or stop shipping right now to survive another day. Your customer may never award you another piece of business, but at least you survived to see another day.
Hillenbrand: We just did that two weeks ago. We had a Big Three customer that said, "We're going to change the price on you," and we said, "No." And then they threatened to shut us down, we told them "fine." Then we announced the plant shutdown two weeks ago and moved the business to some of our other facilities.
It comes down to the fact that you know you can't live with that price, and you realize that they're going to keep taking advantage of you going forward. And so we made that decision.
Mergers & Acquisitions: In general, what does it take to get distressed automotive part companies financed?
Hillenbrand: It all depends what type of company you're going to buy. In the last year that we've been in the market for these types of assets, we've found that senior debt is around two and a half times Ebitda. However, the big caveat is that most of the financing available for automotive deals is asset-based, because a lot of companies don't necessarily have Ebitda. We've bought automotive companies for as little as three times and as much as five.
I'm not saying that that's where the market is by any means, but in the distressed field, when you're talking about sub-$500 million-revenue businesses, you're not going to see huge multiples. If you do, they are suppliers of Toyota, Honda and Nissan.
Kanehann: The whole notion of multiples in our world is sometimes misleading. We paid an infinite multiple for the company we bought in November because it's losing money. But on the first day we bought it, we made a number of substantial changes, which - on a run rate basis - makes that go positive.
In the troubled automotive space we've been seeing companies that we can purchase for four and a half times, and when we finance the deal, we tend to go more conservative. Part of that is because of the market, since no one is going to give you a lot of money.
It is primarily asset-based, but also - when you're walking into a burning building - you have to be sure that you have all of the necessary gear. You want more liquidity versus less, so we're going to finance and capitalize our business appropriately. So that means that there is probably more equity than your "garden variety" buyout, but that's fine, because stuff comes up that you really can't plan for.
Hillenbrand: And that's actually a technical term. "Stuff" actually does come up. I completely agree with that. We over-equitize a lot of our companies knowing full well that a year from now, when we get the business back on its feet, we can always recapitalize the company, but there is no point in going into a troubled situation thinly capitalized in this business. It just adds an extra layer of stress on an already stressful situation.
Mergers & Acquisitions: How hard is it to perform due diligence on these companies?
Kanehann: We invest in underperforming companies, so a key element of the diligence effort is the operations and how can we fix them. And as a finance person, an investor, a former investment banker, that's not necessarily part of my skill set.
What we do is we use our sister consulting firm Caledonia Group, which is a lean-manufacturing consulting firm that has operations people on staff - not finance people, not former accountants or former investment bankers, but people who have actually run factories before. They help us get at the key issues of what is causing the trouble in a particular manufacturing environment.
Hillenbrand: We ask two extremely simple questions. The first one is: Does it have a reason to exist? You'd be surprised at the answer to that. If you are the No. 8, No. 10, or No. 15 player in a particular industry, then there isn't really a compelling reason to exist unless you provide an unbelievably niche product that is a subcategory. It weeds out a lot of companies really quick. If I built a plant around the [Pontiac] Aztec, I'm not sure how excited I'd be about its reason to exist.
But if it's got a diversified customer base, you're going to have Big Three exposure. And it's not like the Big Three are going away tomorrow. They will continue to produce cars. But you have to figure out what the right mix is.
The next question we ask is: Does it have problems we can fix? We're operations guys. We have ex-Toyota people in our fund who help our portfolio companies identify ways to streamline their business and implement the manufacturing. If the company has an R&D issue, that's not our cup of tea. If it's got 60 days of inventory, if it takes eight hours to change a die, these are all things that you can fix and address.
Weykamp: Due diligence is also tough because most of the guys have no idea where they're making their money or, more appropriately in a lot of cases, where they're losing money. So, is it an activity-based issue? Is there any type of accounting? Do they have any bill of materials that you can follow? It's amazing. A lot of these companies are already weeded out, but there are still a lot of them out there.
The other thing that's often missed in the standard cost basis is what they are expected to produce. And maybe that's based on what the OEM told them. We all know that that never happens, so they usually are short of the projected volumes.
Roesler: When is mezzanine available? And how far do you have to get up before a "true, LBO-type financing" is available for an automotive supplier?
Hillenbrand: Although no lender will ever admit it to me, I think there are some magic hurdles out there where things become a lot easier in financing. For example, a $15 million Ebitda company all of a sudden opens you up to a half a turn of additional leverage. Multiples seem to expand at $15 million of Ebitda as well.
The lending market for the sub-$250 million revenue company, and the sub-$15 million Ebitda company, is either two-and-a-quarter or two-and-three-quarters senior leverage, and I would be very surprised if you found someone willing to take more than a turn below that whether it's mezzanine or Term B or whatever you want to call it these days. So you're looking at total leverage of around three and a quarter or three and a half.
Mezzanine or Term B in our world is almost a scary word, because they don't necessarily understand the restructuring market, especially if you go to these hedge funds.
Mergers & Acquisitions: How big of a role does outsourcing play in the industry?
Kanehann: One example that we're dealing with right now involves a business we bought in November. Federal Mogul is a large customer and they want us close by. So we have set up operations in China and Mexico. At the end of the day, the customer drives that. We don't want to be there unless they want us to be there. It's not a question of cutting labor costs by $2 per hour in that country, but rather that the customer wants us there.
Hillenbrand: It goes back to the first question we ask, which is, does it have a reason to exist? And an extension of that is to ask, does it have a reason to exist in North America?
Kanehann: A customer said to me the other day that they would much rather fly into O'Hare to talk to us than spend a week to fly into China, find a translator, and conduct business that way. It's a real cost to them, so there can be some value in being located here in the U.S.
Gillette: There's extreme irony in the fact that the companies that are pushing the offshore sourcing movement more than anybody else have been the Detroit Three. And now it's those guys who are living and dying on the basis of "buy American."
Engine manufacturers have actually increased in the United States over the last 10 years, because you see companies like Toyota become more active here. They are building engines in the United States rather then shipping them in from Japan. If you look at the government statistics, you'll find that the dollar value of the actual components built here in the U.S. has been relatively stable. And the reason for that is because the non-American names are building more and more here, whereas the Detroit Three are building offshore.
Hillenbrand: Toyota is a fascinating case study. Seventy five percent of their supplier base is within 100 miles of them. That's the complete opposite to the Big Three. In Toyota's facility in Georgetown, Kentucky they have eight hours of inventory in that plant. So, you stop delivering coiled steel; eight hours later there will be nothing in that plant - absolutely not a single thing. And it's unbelievable how they've managed logistics. You do that by having people close by.
Weykamp: The thing that always surprised me is that we haven't read more in the press about the domestic OEMs shutting down the plants because of the supply chain problems in China.
Hillenbrand: And it will be interesting to see what happens over the next five years once shipping becomes more expensive. The shippers aren't idiots. They're going to figure out that all this is coming from China and it's necessary, so they'll jack up rates. Prices are increasing over there because wages are going up and they're capitalists, or at least trying to become capitalists.
I wouldn't be surprised to see more in-sourcing over the next five years on parts that went over there and realized that either they've become too expensive or they're not finding the savings that originally sparked the move.
Mergers & Acquisitions: What do you think the industry looks like in five or ten years, and where is private equity at that point?
Hillenbrand: I think you'll see the trend is to not put all of your eggs in one basket. And that's obviously not a new statement. But, you'll have suppliers supplying eight to ten different OEMs versus three or four, like we've seen historically.
You'll also see Ford, GM and Chrysler become smaller than they are today and become more profitable. I think Chrysler will be at the front of that considering what they're going through.
Kanehann: If you look at the top ten auto companies in the world, the vehicle manufacturers, they are still going to be around. But I agree there's going to be some erosion with the U.S. Big Three.
Roesler: Everyone has been waiting for the bottom, and every year everyone has wondered whether it represented a bottom. I think 2008 has a fairly decent prospect of finally being the bottom. Wilbur Ross said in 2006 that when we reach a year in which only 15 million units are sold then the sky will fall. Well, we're going to see that this year. So, if Wilbur Ross was right, the sky might fall, but that's going to cause a huge, additional shakeout.
Gillette: Here's a positive note on General Motors. If you take at look at the Detroit Three, the one company that is pretty well positioned to take advantage of the growth in those emerging markets is General Motors. If it reached the point 20 years from now where GM says, "We're not going to sell in North America anymore," it may not make a difference at that point, because they are doing such a good job in some of the emerging markets.
Now, Chrysler is kind of sitting back and seeing a dramatic decline. They're taking something in the neighborhood of 600,000 units out of their normal production for 2008 because they're trying to rationalize and figure out what it is they produce that's going to be most profitable. They're asking, "How can we focus our business?" This is the right thing for them to do.
Weykamp: That's clearly a change in behavior.
Gillette: Before there was this proliferation, where we had to have a vehicle that fits in these buckets. We had to have an SUV, we had to have a 4-door sedan, we had to have all of this. But in the past, Ford would have been just as happy if they turned out pickup trucks. And they would have done a great job with the pickup trucks.
Hillenbrand: Probably more profitable, too.
Gillette: I did a study back in the late 90s, and all of the profit at Ford was coming out of the F-Series pickup truck.
There're a lot of issues at Ford relative to products down the line, and I think that if you're looking at five to ten years out, you may find that the Ford family ends up not having a role in that company anymore.
Hillenbrand: There's a mentality against shrinking your business. It's almost like you admit to defeat. But from our standpoint, a lot of times it just makes total economic sense, and when a private equity firm does bring in a new mentality, at some level it gives companies permission to go try things that haven't been attempted before.
If you're manufacturing on the same types of automobiles you're going to have a burst of new ideas. And if Ford was just a pickup truck company, I bet it would be unbelievably profitable.
Gillette: There isn't a Porsche for everybody. There isn't a BMW for everybody. There isn't even a Honda for everybody. The only company I mentioned that was really on top in terms of equity creation that basically has something for everybody is Toyota, but that's kind of a case all by itself.
I get this question once in a while, where people ask, "Do you think private equity is a flash in the pan?"
And, especially relative to the auto industry, I think that the public markets are done for the auto industry as a whole. What we're going to see going forward, because of the tangible advantages of the governance issues, is that privately held auto companies will be able stay focused. Being able to take a longer term perspective on these things is really going to drive private equity investment for the long term.
If it does get fixed here in North America, which I think is going to take a long time, private equity is going to be a significant factor in fixing the industry, whatever that means.
Jim Gillette, CSM Worldwide
Justin Hillenbrand, Monomoy Capital Partners
Garrett Kanehann, BlackEagle Partners
Clifton Roesler, W.Y. Campbell & Company
John Weykamp, Crowe Chizek and Company
Danielle Fugazy, Mergers & Acquisitions
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