Perspective

If the automakers are the dog, then the auto parts and components supply industry is the tail, and from 2008 to 2011, the dog that saw GM and Chrysler enter bankruptcy wagged the tail so hard it lost an estimated 57 parts makers and 20 percent of its work force, or 100,000 people.

Perhaps it was inevitable that the economy would eventually recover and return to demanding new autos at historical averages of roughly 15 million new cars or more per year. According to a report in the Detroit Free Press, "U.S. auto sales sunk to a 30-year low of 10.4 million in 2009 but are on the rebound. Last year, they grew to 12.8 million, and analysts are predicting 14.5 million or more this year."

There were worries earlier this year that parts suppliers would not be able to retool and restart idled plants fast enough to meet the rising demand, but our view of the industry is that suppliers have met the first wave of the ramp-up, primarily because the rise has been steady rather than spiked. Another concern has risen, however: How will suppliers meet the demands of the wave of new auto models expected to be introduced within the next four years?

In the 2012 widely quoted "Car Wars" report by Bank of America/Merrill Lynch analyst John Murphy, he says that manufacturers are planning an "assault" of 105 new models by 2014-2015. Now depending on the latest economist you listen to, the economy will either double dip or continue to recover during the next four to seven years, a period of time that is critical to lenders as most term debt is set with maturities of five to seven years. Since term lenders, unlike asset-based lenders, look primarily to cash flows for repayment of loans, the anticipation of general economic conditions is critical.

Bank of America Business Capital is active in the auto supplier industry and from every source we talk to on the manufacturing and supplier side, the sunnier forecast is more accepted. The rationale is that things went down too far and too fast. Nobody was buying cars two years ago. Just the replacement of autos being scrapped is above the production level of 2010. The current projections of recovery in the industry are still not equal to the peak before the recession. The projections merely get the industry back to normal, sustainable levels.

If all that is true, the good news for suppliers is that they are back to work; the bad news is that they have to fund tooling and capital expenditures, or CAPEX, on trailing profitability numbers that have been historically depressed.

The Supplier Dilemma

In any market upturn, a firm has the opportunity to grab market share and profits if inventory can be built fast enough. The dilemma for automotive part suppliers is that while they usually have enough accounts receivable and inventory to finance working capital, such as labor and operational overhead and trade payables, ABL alone won't meet the needs of companies that need to reopen or build new plants and retool for new models.

For example, a supplier that showed 2006 EBITDA of $75 million, a key metric for lenders, may have dropped to $30 million by 2010. The EBITDA run rate projects to be as high as $70 million this year, but bankers typically consider historical numbers when determining ability to repay loans in addition to projections. An ABL lender may provide a $50 million revolving working capital loan, but term lenders may be reluctant to provide the $30 million needed to retool, rehire, refit and engineer parts for new models. So how auto suppliers will fund their CAPEX is the multi-million-dollar question. The answers depend on the unusual nature of the auto industry.

For some borrowers, the bifurcated loan package referenced in the last issue of CapitalEyes can provide the answer. In the bifurcated loan, a term lender, hedge fund or institutional investor will take the cash flow part of the loan. It will be expensive money, however, often priced in the low teens and will take senior liens on any assets to which the ABL lender does not attach, such as real estate, machinery and equipment, patents, trademarks and other intangible assets. There may be convertible features to the debt as well.

For others, the answer may come from subordinated lenders, who offer high interest loans often with equity like features thrown in as well. Others may look to their private equity owners, many of whom invested in the industry during the distressed years, to provide equity capital to bridge them until banks are more comfortable with the credits.

Auto supplier challenges

The nature of the auto supply industry is unusual in several ways, many of which affect a lenders ability to finance these companies. The first is that an auto supplier only does as well as the models it is supporting. The second is that even though the supplier is responsible for having new lines built, they will ultimately be owned by the auto manufacturer. Another challenge is offshoring issues in places such as Mexico, where financing can be much harder to obtain. And finally, many lenders who were scarred by making loans to suppliers have left the business, narrowing the field of both term and ABL lenders in the industry.

An auto parts supplier is only as good as the car he is making parts for. That means that the supplier is dependent on the manufacturer's ability to design, build and market its ultimate product. Disruptions can happen, such as last year's Japanese tsunami and the explosion in the German resin factory that upset the supply chain earlier this year. Perhaps the largest risk is if cars are marketed poorly by the manufacturer or face drastic recalls that affect ongoing sales. That is why lenders keep close watch on monthly and yearly sales for all vehicle models in validating the financial projections of a supplier. They also depend on third-party forecasts.

When a supplier tools up a production line, there are no guarantees the manufacturer will give its guarantee to purchase parts until the part undergoes a production part approval process, or PPAP. At the end of the process – worked on jointly by the supplier and manufacturer – the manufacturer actually owns what is called a "work cell" because it can't risk not having parts to its best-selling cars and trucks. But until it's signed off, the supplier takes the risk of investing in plant, equipment and tooling. Lenders typically don't lend on AR/inventory until the PPAP is complete. However, lenders will advance in percentages based on how far the PPAP has progressed. We should point out that both supplier and manufacturer are heavily involved in the tooling process and it's rare for a supplier to be rejected. However, a supplier may book an accounts receivable but not see actual cash for six months, which causes other problems.

Suppliers based in the U.S. and Canada have better access to asset-based financing than those in Mexico because the laws are more favorable to senior debt holders. Lenders are wary of lending in Mexico because if it comes down to collecting assets that are backing a loan, the court system is slow and can be unresponsive to lien holders. By the time a case works itself through the courts, the inventory may have disappeared. In many cases the suppliers who will obtain financing will have contracts with the largest manufacturers in the U.S. The other way a Mexican company can obtain financing is if it is funded by a subsidiary of a U.S. company.

Finally, when banks lose money in an industry – it was hardly a novelty during the recession and financial crisis – they tend to shy away from that industry for a period of time. This is especially true with term or cash flow lenders in the automobile business. It is indeed a tricky space.

Eventually cash flow lenders will return, but for now whether or not a supplier gains CAPEX financing is situational. Good things are happening. Ford's debt was upgraded to investment status. The industry was selling 17 million units before the crash and wasn't making money. As a result it has right-sized and is poised to enter a healthy environment for – hopefully – years to come.