Over the past 10 years, automotive original equipment manufacturers (OEMs) and suppliers have experienced a period of growth and innovation. While innovation and investments are necessary in order to be prepared and relevant for the automotive megatrend revolution, this has brought about new complexities within the automotive industry, particularly for the supply chain. This is creating new challenges for supplier risk professionals.
The economic crisis of 2008 brought about a focus on financial risk, and the period of growth since 2009 has led to an increased focus on operational and manufacturing risk. However, in the current environment, new factors such as cyber risk and integrity risk can cause production interruptions just as easily as a financial or operational concern. These issues, which were an afterthought 10 years ago, have created additional complexity for supplier risk professionals today and highlight the need for a comprehensive supplier risk strategy.
Signs that supplier health is deteriorating
While suppliers' financial health has been relatively stable over the last several years, we are seeing recent margin erosion, worsening debt metrics, and constrained liquidity across the supply base. Furthermore, in many of our recent distressed supplier engagements we've noticed trends toward more complex, severely distressed situations that involve deeper customer involvement and higher cost/risk.
In 2019, U.S. light vehicle sales reached 17.0 million units, which was the fifth straight year of sales over 17 million units reflecting the steady climb from 2009 when car sales were at just 10.4 million units. However, recent forecasts predict weakening of volumes to 16.8 million in 2020 and 16.5 million in 20211, which may have a negative impact on suppliers' financial health. Furthermore, while there is no shortage of volume forecasts, most agree that we have reached a plateau.
In addition to financial challenges, we have noticed increasing operational/manufacturing risk within the supply base. We believe manufacturing concerns are one of the leading indicators of overall supplier distress, and it is often a harbinger of financial distress. In today's environment, the increased launch cadence, decreased focus on quality, and skill gaps in the plant floor talent pool are causes for concern. For example, a new product launch is often the time in which the initial stages of supplier distress may be noticed; however, without a comprehensive, proactive approach to identify and correct the situation, performance may deteriorate.
It is common for supplier risk professionals to focus on trailing metrics such as quality and delivery, but these occur too late in the process. Best practices focus on a shift to more upstream metrics and an understanding of metrics related to plant turnover and machine downtime. This helps to identify the problems that are causing the quality and delivery issue. Using more predictive metrics and holding firm on milestones can help to identify challenges earlier in the process and focus more on a fix rather than taking a monitoring approach.
The suppler risk program for 2020
A proactive, comprehensive supplier risk program is critical for avoiding costly situations where production is threatened and/or reputational risk could damage the brand. Supplier risk programs have historically waited for an obvious sign such as a bankruptcy or a launch failure before recognizing that there is a challenge within the supplier base. While a reactive strategy can be a conscious approach to addressing supplier risk, we believe that a more proactive and predictive methodology is an achievable and realistic goal. This strategy can also provide your organization with a competitive advantage.
Ownership issues in the supply base
Some leading companies are incorporating ownership structure metrics into their supplier risk programs. Two areas of focus include private equity and familyowned suppliers.
It's important to track private equity firms because they might prioritize maximizing economic returns on their investments over the interests of the customers. Private equity owners also understand how to use leverage in order to compel customers to provide significant concessions when they seek to exit their investments. With private equity investment holding periods continuing to rise among automotive suppliers, we are seeing an increased demand in requested concessions to help provide the private equity-owned with the required rates of return as they look to divest investments prior to a potential economic downturn. Knowing which suppliers are private equity-owned and having a diverse supply base can help mitigate this risk. As an example, a private equity-owned supplier in its sixth year of ownership with a poor financial health rating is probably more risky than one that is in its first year with a green financial rating.
On the other end of the spectrum, while family-owned businesses do not typically intend to unexpectedly close their doors or leverage their customer base, generational transitions can be problematic for the long-term stability of their business. As such, it is important to know which of your suppliers could fall into this category and understand if they have a robust succession plan and business plan. In the last few years, we have seen increased risk for generational suppliers with revenue of less than $250 million, often because they lack the financial and operational expertise and resources to proactively navigate declining performance and/or the impact of the changing automotive ecosystem.
Changes in the automotive ecosystem
As consumer demand shifts, there is a growing demand for trucks, SUVs, hybrids, and electric vehicles. Other trends involve the evolution of powertrain and mobility.
As consumer sentiment and the overall automotive industry continue to innovate and shift in regard to mobility, connectivity, and ride sharing, more commodity-based products may face further price pressure, consolidation, and irrelevancy in future years. Suppliers who cannot respond to the shift in demand and do not have a diverse client, product, and platform base are at risk of profitability erosion and liquidity constraints over the next several years.
When evaluating a supplier's risk profile it is more critical than ever before to take a closer look at the overall supplier profile and gain a deeper understanding of the supplier's customers, products, regions, business plan, and strategy in order to provide a more robust risk assessment. Gone are the days when you could just use the seasonally adjusted annual rate (SAAR) as the guiding light for supplier distress. The preferred approach is to perform a proactive strategic supply base analysis to determine risk points and have a long-term plan versus waiting until you are the last customer at your supplier incurring the cost of a wind-down.
There are many external forces that place increased pressure on the automotive supply chain. Two of these factors relate to tariff/trade and recall exposure.
Tariff and trade regulation can result in significant costs to certain suppliers and the need to find new tiered suppliers or cancel supply contracts as absorbing the duty can be unsustainable. While the added cost of tariffs must ultimately be absorbed at some point in the supply chain, there is no defined standard as to who absorbs the cost. Given the complexity of trade and tariff regulations, not everyone has a full understanding of their implications, and maybe even more important, the strategies to mitigate their impact. However, working closely with your supply base to ensure they are being proactive, and understanding the actions they are taking to mitigate risk and cost, can be beneficial to all parties.
Another regulatory element that can strain the automotive supply chain is a recall. There has been an increase in the volume of manufacturer-initiated recalls, which likely is due in part to the increasing scrutiny of regulators and also a desire by OEMs to be more proactive in naming a recall for issues that might have been addressed in the past through a Technical Service Bulletin. Supplier consolidation, the increase in technology in a vehicle, and more vehicles using similar software/systems has created a ripple effect where a recall can have a larger impact compared to the past where there was a fragmented supply base and differentiated products. While the financial and reputational impacts of a recall can be costly, recalls also cause disruption due to the need to ultimately replace the recall parts, which can create a sudden strain on the supply chain. While recalls can never be fully eliminated, we have observed companies getting more creative with the use of data and analytical tools to try and identify risk within the supply base and address problems earlier in the recall life cycle.
Supplier commercial ask strategy
When suppliers need assistance from their customers, that assistance often comes with unwanted ramifications such as being put on a "do not source list" and/or triggering the customer's supplier risk management group.
As a result, we are seeing a recent trend of suppliers making requests directly to the purchasing department of their customer, often bypassing the traditional supplier risk triggers and supplier risk specialists within their customer organizations. By deploying this tactic, suppliers may avoid getting flagged by the risk group and still receive their desired concession. In some cases, this even occurs as several small asks spaced out over a period of time.
It is critical to establish a process to ensure these types of supplier requests are flagged within the organization and there is further holistic analysis of the commercial asks so you understand the "big picture" substance of the request and potential associated supplier risk profile before providing any concessions.
Summary and key takeaways
As we experience a down cycle within the automotive industry, supplier risk professionals should focus on adjusting and tailoring their approach to proactively identifying distress and minimizing the risk and cost of distressed supplier situations.
- While financial health has been relatively stable over the last several years, we are beginning to notice margin erosion, worsening debt metrics, and constrained liquidity across the supply base.
- There is a need for a stronger focus on proactive and predictive supplier risk financial management.
- With the increased launch cadence, quality concerns, and lack of talent, we have been witnessing manufacturing concerns as one of the leading indicators of supplier production risk and is often a harbinger of financial distress.
- The changing environment necessitates a revised approach to dealing with supplier manufacturing risk-a proactive fix approach rather than a reactive monitor.
- Private equity ownership holding periods continue to rise beyond the median as the market cools, causing concern of aggressive action for customer concessions to support required rates of return on the private equity (PE) firms' investments.
- We are seeing an increase in risk in family-owned generational suppliers with revenue of $250 million and below. They often lack the financial and operational expertise and resources to enable a proactive approach to correcting declining performance and navigating auto megatrends.
- Understanding where these suppliers exist in your supply base and proactively addressing potential challenges can help minimize potential distressed financial and "hostage" situations
- The auto supply base is facing several complex interconnected issues such as:
- Sedan/truck mix
- Customer/product mix
- Powertrain changes
- Regional strategies
- New technology and mobility considerations related to their impact and investment
- Dig deeper to gain a better understanding of your supplier's profile, strategy, and associated risk areas as you look to the future.
- For suppliers who are struggling with a tariff strategy, recommend subject matter experts who can provide strategies to mitigate the risk and the impact of tariffs.
- A continuous focus on safety and quality, and the use of data and analytical tools can help to mitigate product recall risk.
- Suppliers have recently been focusing efforts on making requests directly to the purchasing department of their customer.
- These requests may bypass the supplier risk "triggers" and supplier risk specialists within the organizations.
- Establish a process to ensure there is further holistic analysis to understand the "big picture" substance of commercial asks and potential associated supplier risk. This analysis should include resources familiar with supplier distress/risk.
- LMC Automotive, Global Automotive Sales Forecast, Quarter 4, 2019