Monday, 21 January 2008

Macro-Economic Trends – Europe - Capital Funding & Expenditure in Turbulent Times

Top of mind for Boards and CFOs are undoubtedly the prominent economic issues of: Credit Squeeze and Cost-Push Inflation. These dramatically affect Capital Expenditure and Operational Cash Flow plans. Central Banks recognise this and have sought to alleviate the pressure on industry and the possibility of a downward (fear induced) fiscal spiral through injected liquidity. Additionally, working with government(s) to seek inflation restraint policies to avoid the very real possibility of a hard-landing, lengthier recession.

The expanding effects of what was originally considered a localised US credit-crunch are making themselves more apparent globally, as the complexity and international reach of structured investment vehicles (such as collateralised debt obligations) have become apparent; whether from Australian municipal investments to broader Asian commercial paper and at every debt tranche, from Grade A, to Second Lien, to Mezzanine to their original roots in High Yield.

Rapid transparency has been encouraged to maintain market confidence, after the shocks of the US’s Fannie May and UK’s Northern Rock and the major write-downs for the likes of Citi and Merrill Lynch. Banking and market commentators are keen to ratify that much of the discount process has been undertaken, 'proven' by the recent stake-buying of foreign Sovereign Wealth Funds and other private equity interests. So seen to be trading at below historic P/E, the western banks, now going through rapid organisational contraction, are often cited as general value stocks, growth dependent on short vs long term Bond Yield curves/margins and of course sound new lending policies.

That means that once operational efficiencies are implemented there will be room to generate improved margins. Given present stock-market fragility, such margins are seen to derive from general retail banking (as an ever cautious public decides to save) and fixed income (as debt providers and corporate bond brokers); the auto-makers obvious clients.

Both the publicly listed and privately held automotive sector companies have experienced general investor caution given the ramifications of business model credit reliance and consumer's employment confidence. This lack of business traction witnessed by the 20% and 5-9% drop in US and European automotive share prices (respectively) have led to tremors in the sector, some analysts commenting that there's been an over-reaction providing new investment opportunities. We think there are such opportunities given dilligent research.

Having secured long-term funding throughout 2006/7 the US Big 3 have undoubtedly escaped the worst of the credit-crunch consequences. Although much of their funding was secured with (for them) the unusual need of asset backed securitization, the structured deals made then (rates & clauses) will no doubt look ‘ameniable’ relative to the undoubted likelihood of higher cost borrowing if the banking sector is to rise again. Those costs may well be born by the many US tier1, 2 & 3 suppliers that have yet to formalise re-structuring; putting ever greater strain on their already surpressed business models given automaker cost-down pressures and materials/currency headwinds.

So it seems that the US Big 3 have escaped the worst by securing their CapEx and Ops Funding early, what does this mean for their European peers?

European news of late has been mixed given initial thoughts that it might escape the downturn. But injected ECB liquidity to prop-up the markets, given a strong Euro and increasing European banking exposure to SIVs/CDOs, did little to quell worries, instead small but persistant stock sell-offs further threatening the outlook, which in turn have prompted calls for an ECB rate cut.

As far as specific lenders are concerned, ultimately a contrasting set of mortgage debt-default winners and losers will become apparent and we’ll see accordant lending policies & rates emerge; dependent on individual level of write-downs and level of reliance on flagging US, UK and Eurozone economies. Those banks with stronger balance sheets may look to either maintain a conservative lending policy or seek to out-compete their wounded rivals, but given the major slow-down in corporate borrowing (largely due to far reduced M&A activity) the banking sector will be hunting for new fixed-income sales, Automakers will be waiting to see what may be on offer, but we suspect that of the future deals done we’ll see many more ‘debt for equity swap’ made between those stronger (on par valued) banks and any weakened (undervalued) auto-makers. The weakened banks may well seek-out those VMs with higher FCF to directly service any higher return deals, perhaps attracting VMs who don't wish to see their own share-holding dilution. Watch this space.

Now to basically preview the positions of the European automakers:

French auto-producers, although theoretically well placed as low CO2 car-makers, have come under pressure to rationalise. A falling French domestic demand and relatively strong Euro have hurt profits, also tempered by the inflation rises in what were previously attractive lower cost EU production regions such as Spain and E.Europe. The strong voice of Sarkozy’s and his cabinet have subtly been questioning the benefits of French industrial unification. Part of that, whether a Renault-PSA agreement of sorts could both drive component purchase efficiencies, assist French suppliers in scaling-up volume (eg PSA’s Faurecia & Gefco), and help assist in reaching 'equilibrium' with labour costs (As seen with the new pay agreement signed on 18.01.08). As for the funding climate, both Streiff at PSA and Ghosn at Renault have set out their plans to reach 5.5-6% and 9% margins by 2010. Given that much of that expansion will continue to come from emerging markets, and the expected higher cost of long-term Euro-sourced financing at 4% - 5% if the ECB turns from monetary dove to hawk), we would not be surprised if such projects are funded locally through JV partners to access lower cost funds. Or more likely utlise dual currency agreements. This would allow an offset of current Euro strength (though declining) vs probable local currency relative weaknesses. As with the possible PSA-Mitsubishi deal for a new Russian factory, access to Mitsubishi sourced Yen funding would seem credible depending on Yen-Rubel Futures figures.

For Renault, perhaps a similar story, seeking independent or dual funding deals between it’s historic lenders (BNP-Paribas/Credit Agricole/Calyon & Societe Generale/) and Chinese, Russian, Indian, Mexican etc banks.[Given the similar knock-down to hit French banking we suspect that government will expect some national banking involvement in foreign investment projects given the national/regional economy’s direct interest].

But, if dovish, the ECB’s muted rate cut should be good news for domestic investment impetus, the recent labour agreements helping to secure a new platform of confidence in French industry after so much labour concern in recent times. We expect that domestic investment to come in the form of expanded high-value R&D activities and possibly lower CapEx/ higher variable cost manual intensive niche car build lines to endeavour to buoy French VM brand credibility in the face of ever intensive German, Japanese and Korean competition.

In Germany, real worries concern the export dent from the beginnings of the generally agreed US recession. BMW, Mercedes and VW/Audi are rightly worried about not only unit volume drop, but a maintained weak $ policy which obviously erodes margins with the forex pressure. Although the muted ECB rate reduction (to possibly 3.5%) would deflate the Euro, the luxury makers specifically must now seek alternatives. Given US market importance, the obvious ideal is the expansion of localised lower cost, $ paid parts sourcing and production. VW’s decision to join BMW & Daimler with a US plant of its own expected in April; though we suspect given its US market aspirations the decision simply needs rubber-stamping at that time. Without the plant ambitions “to take on Toyota” and reach 1m US sales by 2018 looks empty indeed..

As cut-backs are made at home to reign in costs (such as BMW’s 8,000 redundancy package) and the possibility of further VW cuts given present Porsche AG power, the German VMs are unsurprisingly looking to protect their US share and expand BRIC+ share, believing that any European market shrinkage can be off-set. Thus once again the strong Euro is the prime factor in seeking funding paths for US & BRIC+ projects; especially given political pressure to extend the use of the Euro as a globally acceptable currency on par with the $ (very unlikely at present, but that will probably not stop political efforts).

For VW it may once again soon caught between the intentions of Porsche and Government, given a recently announced draft legislation designed to overcome the abolished ‘VW Law’ (protecting regional labour interests) that gave Porsche far more commercial flexibility but diminished local government rights. If the white paper looks to be gaining favour, VW-Porsche management will have only a finite timeframe in which to act if it wishes further rationalisation before an eventual Bill is passed. Many think that the airing of the draft is simply to curry voter favour, the reality of conversion small given the European Court ruling – VW-Porsche must certainly hope so, but if it does appear to carry weight (via an economically disenfranchised electorate) then management will seek to maximise change as soon as possible, and that would have funding ramifications (eg extended voluntary redundancy payments) under a shrinkage of Wolfsburg activities and possible translocation of plant to foreign shores.

For Italy, the revived FIAT shows the way forward for automaker reform, much on the back of past GM involvement & recent Ford collaboration and its focus on "Neo-Liberal" emerging economies. Investors are happy with progress, but seek continued value-extraction given the Chery engine & vehicle production alliance, the all important future re-entry into the US, aswell as the benefits accrued from the Ergom acquisition and Severstal links. Given FIAT’s organic and geographic growth position and small to luxury brand stable we imagine FIAT will continue to be a favourably viewed for the underwriting of fixed income, debt-equity swaps, additional stock floats and continued M&A.

Although ahead of the auto-crowd, CEO Marchionne recognises and makes public the need to speed up the re-construction of Alfa Romeo if it is to fulfil its global potential and contribute proficiently to the bottom line. Given the undoubted heavy expenditure on this initiative (inter-related to the re-born Abarth brand) we would hope to see detailed plans and updates on Alfa’s ongoing CapEx long-term demands (such as corporate-owned US dealerships) and more immediate evident a ramp-up of US market-entry ‘re-launch’ needs (as illustrated by the 8C supercar release).

All in all, these are undoubtedly tougher times for many European automakers to demonstrate their future earnings potential, much of which is expected to come from expansion beyond the Euro-zone, primarily in US & BRIC+ markets.

The funding of what are often ambitiously touted expansion plans will in this 'cold funding climate' may demand conservative re-appraisal, requiring far more business plan and risk management details. The historic reality of such (smaller scale) initiatives have often been driven by over-optimistic ideas regards speed of implementation and captured growth, Fiat’s previous efforts are prime case studies, by which they will have learned.

The major difference today of course is the stabilisation of what were once highly promising but ultimately economically volatile markets Globalisation seems to have come, the theory ironically proven by Eastern growth and Western Contraction.

Within that environment, liquidity for a time, may be scarce for all but the best credit-rated organisations and even for them with more stringent conditions. Whilst many US and European banks re-build their ‘written-down’ balance sheets and Eastern SWFs come to their aid, it looks ever more certain that the European VMs will need to dip further into their own current asset / cash reserves for immediate expenditure, until banks settle once again. Not necessarily a bad thing given the related boost of confidence such action theoretically show and of course this method far reduces the cost of borrowing, notionally developing a stronger mid-term balance sheet.

Important will be the maintained US$ & Euro valuation differential, given that much of the overseas expansion will be paid for in US Dollars, possibly more advantageous now than ever, even with the US revenue headwinds, depending on the size of the CapEx 'bet'.

And there-in is the age-old dilemma and rub - the paradoxical need to conservatively present bigger pay-off bets to automakers themselves and their current and future investors.