Monday, 31 March 2008

Industry Structure – Prestige Thru’ Volume – Constructing New Business Models

The New Economy, and now Web2.0, has encouraged new approaches to designing business models. Organisational structures have been dominated by a traditional (and comparitively myopic) perspectives based on asset ownership and vertically integrated structures. The prevalent view was that ownership enhanced control and profit margins. However, more recently flexibility, co-operation and collaboration have become increasingly important for future success; often driven by the investment community.

‘New world’ business ethos (heralded by Dell) has motivated some of the largest corporations in the world towards a business model within which assets are managed rather than owned has led to significant changes not only in structure, but also in attitudes and managerial behaviour. As a result the “new business model” has five common attributes, the firm should: be cash flow driven; focus on return on investment; function with distributed (leveraged) assets or low capital intensity; done so with a single minded view on core assets and distinctive capabilities; and develop competitive advantage by relevant positioning within its industry value chain

investment-auto-motives, has used this criteria to project a new revenue possibilities for a crop of UK and German IPR ‘originator-deployers’, put to use on behalf of themselves and US / global Alliance Clients. Essentially creating a new co-operative business model, derived from the amalgamation of various forefront vehicle construction methods…to deliver a Tier 0.5 function that offers increases vehicle build volumes (efficiency) yet retains the necessary ‘variability’ to nurture a broadened spectrum of prestige marques.

Carmakers were traditionally, ever since the 1920s, ‘volume’ vs ‘niche’. The middle ground manufacturers, once small but grown, slowly gobbled up the big fish adding more names to their portfolios. And as the big fish swam they gobbled not just peer companies but diverse sections of the industry as seen with Ford and the design house Ghia. Thus by the 1970s the industry, from a western perspective, consisted of the very large old-guard (in the guise of Ford, GM, Chrysler, and their European counterparts) versus a numerous but individually very, very small group of ‘survivor’ entities such as Rolls-Royce, Bentley, Aston-Martin, AC, TVR, Morgan, Maserati; aswell as necessary alliances such as Jensen-Healey and Matra-Simca

[The new middle ground could be said to be the by then emergent Japanese whilst the American niche had been a saga of upstart boom and bust]

Thus large multi-nationals with powerful balance sheets were able to pick and choose the products, capabilities and names as they wished, often maintaining brand and trademark rights to many of the targets, and their own list of entitlements. But it was the upturn of the 1990s that saw venerable, independent but under-financed and dishevelled, marques such as Rolls-Royce, Bentley and Bugatti acquired by the impressively strong BMW and VW Groups, whilst Daimler resuscitated Maybach from its own stable. Such parents with funding, technology and resource might re-invented those lustrous marques, the outcomes of which with impressive profitability, is most obvious today.

But perhaps the most successfully evolved re-born brand is Aston-Martin; bought-up by, nurtured and divested in 2007 by Ford. That was perhaps the template that others (ie BMW and VW) sought to mimic.

To make these businesses viable and infact highly profitable, these ventures at Aston, Rolls and Bentley required that the boundaries of vehicle construction knowledge and techniques be expanded to enable the ‘required’ behind business case fundamentals. The ‘required’ is many-fold, but the 3 primary elements being:

a) Business Case fundamental of Cost to Manufacture (BoM and Labour)
b) Distinctive product performance to reflect brand values
c) Variability in the core constructional ‘architecture’ to provide variants and spin-off models.

Each automaker chose alternative, ‘best fit’ technology routes to achieve the aforementioned goals, each derived from specific product needs, relative company technical capabilities (gained from previous experience) and transferable components.
Aston - created its adaptable VH platform to enable various tracks, wheelbases & roof heights to provide a cost-effective model range. BMW created an adaptable all aluminium space frame for Phantom/Drophead/Coupe, much learned from the previous Z8 project; and VW & Daimler chose to stretch conventional BIW methods.

investment-auto-motives conjects that many aspects of the IPR behind these 4 unique and advanced vehicle construction projects, whilst owned individually, has the massive potential to be amalgamated to create a technology base that could serve both the originators (AML, BMW, VW & Daimler) aswell as a plethora of other potential clients; providing an opportunity for the re-invigoration of the niche vehicle segment aswell as a host of worldwide sportscars and limousines.

This concept could underpin a revival of a plethora of names, whether ‘dormant’, ‘under-played’ or ‘lost’…..

1. ‘Dormant’ – Britain’s Daimler, Lagonda,
2. ‘Under-Played’ – Britain’s Bristol and Morgan,
3. ‘Lost’ - France’s Facel Vega, Spain’s Pegaso or America’s Cord, Auburn, Duesenberg & Stutz, Italy’s Cisitalia

The central business idea is to create a new generation of niche, low volume build centres very much in the guise of the 1960s Italian carrozzeria that build highly regarded low volume specials. Latterly names such as Bertone, Pininfarina et al invested in higher-volume infrastructures to serve the build requirements of much higher volume coupe/cabrio mainstream car variants. Good revenue whilst it lasted but left exposed to downturns as we’ve seen with the sector’s divestment, contraction and M&As. This could be said to have left a vacuum for ‘advanced constructors’.

Indeed, the UK-German technology could be licensed to the Italian Carrozzeria names to rejuvenate the Italian sector. But....

....Why not develop an amalgamated ‘spin-off’ engineering and production base for the 4 possible alliance partners. Wouldn’t Ulrich Bez -Dave Richards-Investment DAR, Norbert Reithofer, Ferdinand Piech and Dieter Zetsche rather co-operate to create and spin-off something for themselves? Something that could generate greater revenue with associated client project share-interest and ultimately developing that could be sold off latterly in its own right?

For beyond the resuscitation of ‘Dormant’, ‘Under-Played’ and ‘Lost’ Euro-centric marques it could provide the philosophical and physical business underpinnings for a phoenix-like re-emergence of true US premium sports cars and limousines. Nurturing truly upscale special additions (NB not special editions) of Corvette, Shelby, Lincoln and Cadillac, so creating a new – and much needed - prestige dimension to the US industry.

[The US possibly creating its own ‘Turin’….taking the misappropriated essence of ‘Torino’ off an over bloated 70s Ford Coupe and building a true spiritual home, in Michigan or Down South, for the real All-American Sportscar].

Thus, we believe there is a definite need to properly assess the scientific envelope and synergistic potential of today’s advanced construction techniques, so as to devise advanced specific project and complete new organisational business cases for tomorrow.

Such sector business prospecting and modelling should be prompted by the automotive investment community if it wishes to construct new opportunities.

Thursday, 27 March 2008

Company Focus – TATA J-LR – Pledges, Pressures & Potential

Today, given the recent deal completion, we return to the conjecture of where next for Jaguar and Land-Rover? Ratan Tata and Ravi Kant recognised the need to assuage the concerns of car production unions as a key element in gaining favour throughout the deal pitch, bid-win and recent hammering-out of operational details with Ford and the unions to finalise the $2.3bn price and off-load pension responsibilities to Ford.

Early stages of M&A interest were simply about making the right noises to stay on-side of the critical stakeholder group, and although the detail of big picture has become clearer and clearer, analysts are questioning as to how much of ‘drag’ J-LR could be on TATA Motors in the short and medium term? The markets clearly concerned with shares down 9% since the deal interest announcement in July 07 and recently down 4% at the deal finalisation and close.

Whilst brokerages and research teams are focused on the near-term impact - specifically the heavily increased debt-burden of $3bn in bridge loans and expected additional share creation to capture $1bn - Tata and Kant are obviously keen to demonstrate the broadened automotive scope that TATA now enjoys – fully fledged, globally respected auto-maker.

Beyond the debt servicing headwind, many (including ourselves) are eager to appreciate the detail of the (pre-existing Ford) J-LR business plan that runs up to 2011 and has been essentially ratified by TATA with its pledge to maintain current production and development personnel and facilities commitment affecting Halewood, Solihull, Castle Bromwich and Whitley and Gaydon respectively.

Observers say that TATA will probably provide J-LR with ongoing autonomy to carry on as originally planned, and so echo the Corus Steel take-over that inflicted little disruption. But the Corus vs J-LR contexts were/are undoubtedly experiencing very different market dynamics (tailwinds vs headwinds) and shareholders will want to see TATA setting out plans to turnaround the 2007 $550m loss at Jaguar and have it stand on its own two feet instead of leaning upon (and degrading) its’ siblings positive earnings.

2011 is less than 36 months away and in that time we would hope to see a plan of action outlined by Kant and his management that demonstrates commitment at radically enhancing the profitability of both marques. The next few years will obviously see TATA leverage its lower cost steel procurement via its own UK plants and seek cost-down in low to mid value chassis, engine and electrical parts, nurturing Indian suppliers to raise their quality standards and parts supply range. Asia sourcing and combating increasingly high cost raw materials such as steel, will theoretically put both companies on far surer financial footing and we would expect to see Jaguar’s direct (internal) operational costs greatly reduced by 2011, with an increased revenue from XF, XK, (new) XJ and variants contributing greatly to put the company in ‘the black’ for the first time in over 20 years.

With our focus on LR, the interim should see Kant et al, seek to radically alter the development and production cost-base of the firm looking beyond 2011. Obviously Indian sourced design and development project-work will slash Whitley’s and Gaydon’s relatively high engineering costs, but it will be the future of Jaguar production strategy that should see the greatest change. Drivers for change are the need to develop advanced vehicle platforms that will meet the challenges of tomorrow, including:

1. Reduce vehicle mass for dynamic improvement and to meet European, US and global emissions/CO2 regulations.
2. Reduced dependency on highly capital intensive tooling – moving away from high volume Ford provisioned BIW solutions – to evaluate alternative build types.
3. The integration of alternative powertrain technologies as ‘bolt-ons’ and all new.

Critical to all luxury automakers is the need to seek new architecture solutions and, for those with modest volumes such as Jaguar, seek technology and possibly production partners to share expense and add IPR. FIAT’s Marchionne has mentioned his hopes for a possible Jaguar-Maserati-Alfa Romeo agreement that would plug the weaknesses of UK and Italian companies, critically proving the basis for a new hi-tech generation of advanced platforms for the brands, main focus on a large RWD aluminium hi-content architecture that could be adapted as required.

This thesis offers great potential, essentially creating a mid-volume niche vehicle production capability that could service: Jaguar, Maserati and Alfa, but also provide the potential to create feasible business cases to release Daimler as a luxury limousine brand unto itself. With Gaydon based Aston Martin looking forward to possible IPR and technology contracts for others, the basis of Jaguar aluminium structure know-how, plus Aston’s advanced composites could provide the technology basis for a new mid-volume (50-150K units pa) hi-tech facility that could be utilised by Jaguar, Daimler, Maserati, Alfa (large car)/Lancia (large car), Aston-Martin and a resurrected Lagonda.

This could provide an alliance basis for these brands to cost-efficiently build very distinct vehicles in the £50-£100-£120 price ranges, essentially competing more ably against the Germans and providing a set of eclectic ‘re-born’ and unique mid-size limousines that sit under new Baby Rolls-Royce and Baby Bentley Saloon…seen as ’off the peg’ offerings from Bespoke Tailors if you will?

If Jaguar could create such an entity, it would provide a sound footing for itself as an advanced performance and luxury semi-niche auto-maker, but also have developed the ability to act as a 0.5 tier complete car provider for others. That opens the doors to licensing and royalty possibilities, taking Jaguar well beyond the limitations it experiences today.

Tuesday, 25 March 2008

Company Focus – Toyota – Expanding the Cult of ‘Scion-tology’

Toyota has rightly been put on a pedestal as the example of what a late 20th / early 21st century volume automobile maker should be.

Its rise in contemporary times has been meteoric, globally recognised and respected, from the African taxi-bus driver in a 20 year old Hiace van to captains of industry who glide through New York’s Upper East Side in the new LS600h L hybrid.

The Toyota brands burgeoning domination of the mainstream segments (LM, M, L, then S) was in 1989 joined by Lexus to tap into the growing premium segment. The Lexus story - from inception to delivery and onto today -has become the veritable case-study of automotive industry success; now enjoying the highest volume sales of any premium car-maker.

Hence the Toyota and Lexus lineage of doing things right gave immediate confidence to the financial markets and industry observers when the corporation announced its youth orientated ‘Scion’ brand in 2003. The “Son of” Toyota was created to appeal to the distinct Generation Y-ers who were rejecting Gen-X and previous demographic populous’ values and traits. Scion was to be a targeted, tribal-driven, community-minded option straight out of ‘left-field’ for the a reactionary rejecting youth that wanted anything but mainstream and common…something far more personal and ideally co-created, it’s origins in California the trend heartland of the US, and from their to ideally go global.

Of course that ideal of ‘co-creation’ is not peculiar to Scion, it’s been part of the philosophy (step by step growing in fundamental engagement) behind 1997 New Beetle, 2001 New Mini and 2007/8 New Cinquecento. But unlike VW, BMW and Fiat, Toyota and Scion have – without iconic product history – tried to develop something that does not lean on past glories and halcyon yesteryears. Instead the brief was to create for a new consumer from a blank canvas, not just focusing on product design but also on utilising the potential of the web to create platforms for tribal interfacing, discussion and bonding, so building the cultural web. (In this regard it’s an evolved version of GM Saturn’s face-to-face ‘Saturn Family’ efforts in the early 90s)

The start was impressive, the radically boxy and space efficient bbX concept was very original to American eyes but was in fact a re-modelled near production ready version of the Japanese bB. So here was Toyota bringing something original to the table, unlike the US Big 3, VW, other Japanese and Koreans. Whilst initial interest was very positive attracting much attention and sales, the developing product range was far more conservative since they were (like the xB but not as original) adaptations of Japanese and European models; hence much of the initial Scion flavour was being, not distilled and improved, but watered down. The current car range consists of (‘angular’ small) Gen2 xB, (‘soft’ compact) xD and (‘soft’ compact coupe) tC – in our opinion the latter 2 of the 3 nigh on aesthetically conventional….the (soft small) xA discontinued

But for all the effort in trying to maintain that original marketing punch, it has decidedly gone off the boil as sales have markedly dropped over the last 16 months (on a YoY basis). What was supposed to herald a new era of Toyota-Consumer connection has had to be heavily critiqued in California and Tokyo if the sub-brand is to remain true to is ideology and roots as linking with urban trend-setters and being an “experimental social and product laboratory”. From today’s standpoint, given the influx of less than original altered and re-badged cars, and possible pressure to ‘move metal’, Scion could be accused of having become a cynical sales exercise. Especially so in these latter days of stagnant markets. But given that the compact segment is so important, Scion needs maintain and improve its stance to compete against an ever crowded marketplace with influx of smaller cars.

investment-auto-motives believes that a main failing point of Scion is the ‘reality gap’ between how the marque presents itself and its products as highly graphic and ‘cool’ and the business reality off offering base cars that look anything but highly graphic’d and cool. Much needs to be done to customise a car (obviously at a cost) to reach the Scion image nirvana. Thus many customers buy a base car and slowly, given the funding restrictions of youth users, build-up an eventually part or fully customised car. But that time lag and the real world issue of caution in spending on a depreciating asset does undermine the Scion image. This essentially means that many of the Scions seen by Gen-Yers out on the street don’t reflect the advertising.

Undoubtedly, car-specified options & accessories and after-market items direct from Scion add relative handsome margins to non-core revenues but the limited range of exterior, interior and (in reality pseudo) performance parts don’t really visually or performance-wise add much value. The real differentiator is the complete body kit, which necessitates relatively major body-shop work to spray, fit, (possibly fill), and spray-match to the receiving vehicle. Thus this key element of the Scion strategy to ‘provide the look’ is a relative rarity amongst buyers.

Equally, whilst Scion claims to be at the forefront of leading trends and apparently seeks out trend-setters, the normality is that there can’t be 130,000 pa trendsetters. By far the majority of Scion’s clients are seeking that image difference to add a style dimension to their regular lives, so they in themselves don’t reflect the ideology of the brand, and so there is a case that true trend-setters see Scion’s users as ‘vanilla wannabee’s’ from suburbia.

Hence managing this ‘reality gap’ should be at the top of Toyota North America’s Scion re-generation drive. Reducing inventories to reduce inter-dealer competition and raise unit margins has been undeniably a good move, but as reports suggest the 130,000 pa volume at today’s record US$ FX lows against the Yen, means that profitability will be tight

Toyota North America needs to:

1. Re-evaluate the basic profitability levers of the current business model
2. Properly identify the trends that can be incorporated into Scion product and lifestyle design
3. Find the magic that allows Scion to be both “niche” and “volume” to provide the high margins associated with niche and high unit turnover of volume. (The BMW 3 series, BMW Mini and Fiat 500 USPs)

Point 1 will hopefully see a detailed deconstruction and measure of the full Scion value chain from vehicle assembly to dealer methods & accessories fit to the fundamentals of the (real world and virtual world) ‘communities’ (such as 2nd Life and club-classifieds).

Regards point 2, apparently marketing executives are scanning London, Paris, Barcelona and Tokyo underground trends to pick-up on how to best evolve the stylistic element of the offering. The new concept car Scion Hako, displayed at the New York auto-show, melds the original xB boxy formula with an American-esque street rod flavour, and looks like “the son” of xB and a Chrysler PT Cruiser. From a design-strategy angle, this we hope, looks to be a quick interim show-case effort to demonstrate that Scion is indeed moving forward. (The xB + PT formula is a very obvious solution)

As for Point 3, the brand sits in a massively potentially profitable white-space between:

A. General Social Trends (fashion, web, tribes)
B. DIY Car Personalisation
C. High cost dedicated custom designers (eg West Coast Customs),

The trick is to find the key from each and integrate this into the business proposition.

With this in mind, there needs to be short, medium and long-term plans established and implemented across the board, a Product & Service Strategy that makes meaningful expansions of the brand character and infills the ‘reality gap’.

investment-auto-motives has looked at this issue and has identified critical areas for rapid, mid-term and long-stay product and service enhancement potential

In summary, Scion executives need to desperately re-assess their market position, competitor context and create stronger client links.

The competition is approaching fast with perhaps Hyundai’s Kia indicating a tailored vehicle approach, if not totally Scion-esque, to its next crop of small cars with the 3 variations of its Scion xB like ‘Soul’ car in ‘Burner’, ‘Diva’ and ‘Searcher’ guises. Beyond this near term threat is Nissan’s US only Electric powered Cube ‘box-car’ and of course the style icons of an expanding Mini range (Clubman and SAV beyond Coupe and Convertible) and Fiat 500 in various guises including Abarth.

Toyota did indeed make a market splash with Scion, and the ripples were expected to be more prosaic and long-lasting than has proven. It must now more than ever prove its present and future potential worth by radically moving the personal small vehicle game forward. Doing so before less complex & ambitious, but better directed, others smother the “son of” Toyota before he has had time to mature, both in the US and possibly internationally.

Scion was intended to eventually be the third leg of the mighty Toyota Corp in years to come, so Toyota’s financial backers, especially the heavily exposed Japanese, American, Asian and European pensions and insurance institutions must hold Tokyo and Californian management to task over exactly how a faltering prodigal son can be brought back from the edge through in-depth considerations of cost-efficiency and brand-creativity.

Friday, 21 March 2008

Industry Structure – East Meets West – Extending the TATA-FIAT Alliance

The Financial Times has reported that TATA Motors has successfully secured the desired full $3bn sum in what are obviously turbulent lending times. This spans beyond what many saw as an expected immediate credit agreement of $2bn to cover the J-LR sale. The $3bn comes from a myriad of underwriters led by Citi and JP Morgan and reports state that TATA will be seeking a further $1bn in due course, the details of which are at present sketchy.

Given the present squeezed credit conditions, there is liquidity but only for the most compelling of investment arguements, so could that extra $1bn be used as part of an extended alliance rationale between specifically well matched TATA & FIAT groups, to possibly including Ford when advantageous on a project by project basis?

Such a TATA-FIAT-(Ford) agreement could effectively 'bolt-on' any FIAT-Ford JV projects - such as the small 500/ Ka cars and Iveco-Ford trucks - into a broad strategic picture between the Indian and Italian conglomerates. The very fact that Ratan Tata sits on the FIAT Board and has now forged a relationship with Ford seniors means that the Duo are seriously looking at extending their nascent relationship and possibly including the US company when agreeable.

However, although a potential tri-regional, 3-party alliance looks good on paper the realities of consistantly operating as such a fully integrated 3 headed beast are far more complex than a paper exercise would suggest. Hence the 2 + 1 arrangement suggested, based on solid 2 party alliance grounds.

On this basis TATA and FIAT well recognise the opportunity and challenges in expanding their current inter-relationship.

Relationships are created as much through human contact, credibility and belief as through commercial rationale, so a TATA-FIAT expansion and integration of interests could be effectively sealed through the ‘marriage’ of 2 of the contemporary ‘industrial royal families’: the Tata’s and the Agnelli’s - represented by Sergio Marchionne. However, it should be noted that there is a very important 3rd personality dimension to this seemingly dual-family equation, and that is the (oft hidden) presence of the Indian businessman Pallonji Mistry and his 18.35% stake in Tata Sons – compared to Ratan’s <1% share. He has historically been reportedly a sleeping partner, happy with TATA's international alliances, but he obviously wields influence, so must not be conveniently discounted.

Very basic analysis recognises that the two conglomerates share distinctly similar characteristics regards respective portfolios of industrial interest, with both direct mirror-images in specific sectors and segments (ripe for consolidation) as well as the ability to plug each other’s areas of operational weaknesses (beckoning mutual assistance). Thus such a 'marriage' has definite merit.

From the perspective of TATA Motors - a singular division within a 7 sector, 98 company-wide Group - the breadth of activities spanned and depth of the value chain covered has been key to self-reliance and internally supported growth, an ethos of the TATA Group's domestic rise. Activities include:

a) Materials – Steel and Composites (advanced materials)
b) Chemicals – Agro-Chem, Food Additives, Soda Ash, Pigment, Pharma-Drug
c) Engineering – Automotive [Motors, Auto-Components], Eng Services, Eng Products
[inc TAL Manufacturing Eng & Construction Equipment]
d) Energy – Solar, Power Generation/Distribution, Oil & Gas
e) Information Systems – inc TCS [Consulting (Auto)], Technologies [Eng & Design],
Elxsi [Product Design Dev]
f) Consumer Products – Personal Accessories, Retail, Tea, Ceramics, Publishing
g) Services – Hotels, Residential Construction, Reality & Infrastructure, Financial Services, Quality Mgmt, Central TATA Services [GA etc]

Looking at the TATA immediate coverage alone (even without FIAT) highlights the amount of internal industrial collaboration, technology transfer and value-adding integration that could emerge. The very fact that the Group previously targeted Close Bros Merchant Bank for take-over demonstrates the corporate will to expand financial services, become closer to The City and utilise such an internal investment banking function to maximise individual company and group value extraction.

Against this multi-divisional powerhouse, even Fiat Group looks more constrained with fewer and less complex divisions, yet it has greater market penetration and influence on relative markets. To summarise FIAT Group includes:

1) Automobiles – FIAT, Abarth, Alfa Romeo, Lancia, Maserati, Ferrari & Fiat Professional MCVs and LCVs.
2) Trucks, Commercials & Buses– Iveco, Iveco-Magirus, Astra, Irisbus
3) Agriculture & Construction – Case New Holland
4) Components & Production Systems – FPT, Magneti Morelli, Teksid, Comau
5) Publishing and Communications – La Stampa, Publikcompass

With such a comparitive context as the thesis, the following very basically reviews the potential for cross-company integration &/or alliance throughout the value chain.

1. Mineral Extraction & Commodities
TATA Petrodyne Oil & Gas exploration and production provides a stable, first-phase foothold for industrial conglomerate fundamentals in terms of securing an integrated lowered-cost base for conventional fossil fuel energy generation and the use of the ‘black-gold’ as a base for petro-chemical activities.

2. Power Generation
Although seen as ‘dirty’ by green lobbyists, the truth is that conventional power generation methods using gas, oil and coal/coal extraction is the cornerstone of the Asian growth scheme. Although alternative energies are being evaluated, for the foreseeable future, little is expected to change. The reason that low cost (technologically and profitability) known methods take economic precedence as part of massively powerful and relatively inert industrial frameworks; yet to be politically committed to the notion and workings of carbon capping & trading.

3. Metals - Steel and Aluminium
From 1907 the Indian group has developed an array of steel products including, for automotive, conventional offerings such as the standard hot & cold rolls/sheets for BIW and various rings and bearings, aswell as more advanced ferro alloys and assessing ferro-chrome and titanium opportunities. In what has historically been a slim sector, TATA’s prime goal is to be the lowest cost steel producer in the world achieved through foreign firm M&As (eg Corus, Millenium Steel, NatSteel ) and JVs, providing economies of scale in product lines and ‘localised’ global plants. Another aim is to develop steel business away from its commodities perspective with new product developments to better segment the sector and brand titles to differentiate. Thus TATA Steel seeks to gain competitive advantage and increase its order book from the global auto-industry.

Under Italian state development policy through the 20th century, FIAT never built-up capability so far ‘upstream’, and so has always bought-in its flat and section steel. The decline of the (small) domestic Italian steel industry demanded sourcing from elsewhere, initially primarily within the EU and latterly BRIC regions, especially so Brazil given FIAT’s #1 automotive market standing and domestic procurement volumes. Relative to Latin America, and specifically Brazil’s ambition to increase production by 135% by 2018 through “irreversible investment”, we see the ongoing ‘Steel Wars’ unceasing between Brazil, India & China. With this in mind FIAT may be able to decrease its historical ‘over-payment’ for its steel by leveraging the TATA relationship and requesting that Brazilian steel producers keep competitively on par.

Given the massive price hikes of 51-69% demanded by iron ore miners that were largely unchallenged and the likelihood of consolidation in the mining sector giving greater price fixing power, TATA and FIAT and in a good position to redress the balance of power and ‘buy-in’ pricing mechanisms if they can raise steel production capacity and so gain further leverage over supply from TATA Steel’s suppliers.

Lastly, beyond the similar flat hot/cold sheet steel requirement, FIAT’s Teksid division, specialising in steel and aluminium engine castings, could be matched against TATA’s casting capabilities to evaluate the possibility of IPR, technology and projects transfer between both parties to individually ‘raise their game’. Just a singular example of the “seeking to plug mutual weaknesses” ethos of an enlarged relationship.

4. Plastic/Composites Production
Here TATA, not surprisingly given its heavy industry origins and diversity of corporate interests, has holds the ‘centre of gravity’ between the 2 multi-national corporations under the banner of ‘Automotive Composite Systems International’. This division specialises in vehicle skin panels (to class A surface quality) aswell as NVH parts and structural parts, and much of the learning has been evolved through business links with Germany’s respected Menzolit-Fibron, seeking to create a similar capability in SMC, BMC and ‘long thread’ at greatly reduced expense.

Given the global ‘Green Squeeze’, especially prevalent in Europe, demanding that European automakers reduce vehicle weigh and so corresponding CO2 output, the use of recyclable plastic fenders, door skins, vanity panels etc is expected to increase. Since FIAT sits alongside PSA as Europe’s ‘greener’ VMs, there could be much to exploit by integrating ACCI’s applications knowledge. The learning from this stretching of design-development parameters in Europe could then be latterly introduced within TATA’s own mass market vehicles to in turn raise their environmental credentials. However, in the meantime, Jaguar and Land-Rover would benefit greatly with increased use of high quality composites to reduce vehicle masses in aim of their respective brand and vehicle performance ideals.

TATA’s ‘Advanced Composites’ division also operates in designing and manufacturing for specialist hi-performance requirement fields such as the defence sector (bullet proof clothing and vehicle armouring* of relate to Land Rover’s SVO and Military functions), aerospace and medical electronics. A FIAT relationship would see this division develop materials for Ferrari, Maserati and Alfa Romeo at probably reduced cost, and serve to expand the division’s capabilities into the performance car sector spanning much from specialist bespoke for say Ferrari F1 to volume runs for sportier Alfa variants This would promote ‘Advanced Composites’ as the leading light in the Asian automotive composites market.

5. Low-Value Parts
The fundamentals of the mutuality between FIAT and TATA in this realm have been proven by their JV already underway in India - focused on the slightly less sophisticated but robust Palio and Sienna cars. Given India’s previous long-lasting technology gap, it has relied upon what are comparatively basic engineering solutions and so ‘low-end’ parts that have changed little in 50 years. These suppliers have long been under pressure to drive up economies and down prices, so India and TATA is seen as a global Mecca for low-value parts such as wheel and engine bearings, hub and engine block/head castings, differential cases, transmission gear-sets, U & box section channel etc etc.

VMs have for years been assessing Indian manufactured items for cost/quality and been pushing the western-supply chain to form JVs and M&As of their Indian peers. TATA recognised this and so intervened by building up its own Auto-Components division (Auto-Comp) which includes JVs with the likes of Johnson Controls and Visteon, so it could offer foreign VMs aswell as itself a lower-cost (though probably not lowest-cost) ‘one stop shop’ effectively developing into a whole vehicle-capable Tier1 and Tier 0.5 supplier.
To negate too much detrimental cross-pollination of IPR and technology, it is understood that the likes of Johnson Controls and Visteon have not divulged advanced systems and parts, instead keeping them as their USPs back in the US.

So in reality, TATA ‘Auto-Comp’ could be said to have developed beyond simply yesteryear low-end items. That capability exists in abundance elsewhere in India, but TATA were cogniscent in not getting trapped completely at the low-end of the parts value chain. To date FIAT have been major beneficiaries of the Auto-Comp business model in making Palio and Sienna happen, and will undoubtedly seek to expand it’s use in the increased localised production of other vehicles for India

6. High-Value Parts
In contrast to low-end and mid-value parts, high-value offerings are proffered by FIAT and its Components and Production Systems. Done so through its dedicated 4 company network of FIAT powertrain (3.1m engines/2.5m transmissions annually), Magneti Morelli (powertrain, electrical, chassis, exhaust etc), Teksid (castings of steel blocks & aluminium cylinder heads) and Comau (automated/robotic production systems). The 4 company divisional Sub-Group states that it is committed to consolidating and investing in emerging markets.

There’s scope for more FIAT-TATA collaboration beyond the obvious powertrain initiative, Teksid probably able to deliver much to TATA Steel’s castings section and the previously mentioned expansive ‘AutoComp’ division. Indeed, given the level of synergistic potential, the compelling argument for an IPR and technology trickle-down from FIAT Components & Prod Systems to TATA is undeniable.

7. Engineering Design & Development
Similarly, given the cost-down drives of western VMs, FIAT would look to evaluate in which exact areas TATA Technologies (its automotive Design & Engineering Consulting division) could assist. This Indian ‘D&E’ service, based in Pune, was specifically created to provide a dramatically reduced low-cost out-sourcing service to western VMs and its supplier base. As such it has carved a new niche of value-orientated, price specific basic engineering service, that sits below the increasingly whole car project based likes of MSX and the top tier advanced engineering consultancies that specialise in specific vehicle systems.

Although the D&E’s business model was created from a need for lowest cost ‘bums on seats’ engineering, it is well recognised that it must walk-up the value-chain, so has focused on developing knowledge-based services (inc CATIA V5, UGS NX, and it’s own internally developed KNEXT systems) through collaboration with renowned European and US Eng IT business partners. However, there could be said to be a level of marketing spin in describing some of these systems as truly value-added given their accordance to basic industry standard software. However we are unfamiliar with KNEXT, this may provide truly unique engineering insights and IT capabilities. But essentially D&E is about creating the basis for whole-car development facilities and slowly eating into MSX’s market territory, possibly seeking a down the road alliance.

8. Information Technology
In a similar vein, given India’s prevalence with IT, it’s not surprising to see much multi-company presence within TATA’s IT/IS division. TCS has grown in stature and global recognition, more internationally renowned than other sibling companies that
Serve the IT needs of domestic banks, airlines and corporate bodies. Relative to automotive, we mentioned TATA Technologies that sit under the IT umbrella, but another is TATA Elxsi, strongly geared toward IT-based product design, especially for car, truck and bus with the largest styling team in India.

IT has obviously become a sin quo none of industry, and as such today underpins TATA Group developments in the knowledge sphere as perhaps the first listed oil and gas operations in the physical dimension. It is here that TATA could once again assist in plugging FIAT’s future IT requirement as it possibly seeks to best understand the Italian company’s core and out-sourceable future IT needs and best fulfil them.

9. Vehicle Production Plants
Fiat’s wholly owned and JV assembly plants are dotted around the world including: Italy, Poland, France, Turkey, Egypt, Brazil, Argentina, South Africa, China, possibly Mexico soon) and India. Its Indian connection goes back to a 1951 licensing agreement with Premier Motors, the relationship developed as a 1997 JV (51% FIAT) and a full buy-out by FIAT in 2001. Fiat India produces ‘clones’ of Brazilian models using 90% local content, and importantly in 2006 agreed that TATA would manufacture the Sienna & Palio cars and Sell them through its large distribution network

In contrast TATA seems very India-centric, which given its own history is surprising.
Plants are located in: Jamshedpure, Pune, Lucknow, Pantnagar and Ranjangaon (the FIAT JV home), and plans for Dharwad and Singur producing the new Nano small car. Abroad, M&As and JV such as: Land-Rover & Jaguar in the UK, MarcoPolo Bus/Coach in Brazil, Thonburi Pick-Up in Thailand and FIAT Commercial Vehicles in Argentina assist TATA greatly in gaining an expanding foreign footprint. Plus of course the acquisition of Daewoo CVs in S.Korea, an important step in re-balancing the truck businesses exposure to local sector cyclicity.

Thus, TATA-FIAT have already undertaken shared interests in engine & car production in India, and truck manufacture in Argentina…so what more to come?

10a. Passenger Cars
The degree of mutual advantage gained with the car initiative is obvious; TATA gains a collaborator in advancing its own car quality and plant capacity expansion, whilst FIAT gains a powerful entry-point into a rapidly growing regional market. Given TATA’s #2 domestic status, behind Maruti-Suzuki, it looks to be an ambitious growth plan to eat-away at Maruti’s dominance, and in due course, via FIAT’s global presence, allow TATA to introduce its cars into global markets. The synergies are apparent and already being speculated upon, from within the two Group’s boardrooms (remember Ratan Tata is on FIAT’s Board) and externally throughout the grapevine.

Given the current focus on acquisition of J-LR, minds are on Sergio Marchionne’s previous conjecture regards the potential for a Maserati-Jaguar tie-up. FIAT’s CEO’s speculation dampened down in recent months as TATA and Ford finalised the deal’s details and pricing. Suspect Ratan has a quiet word with Sergio so as not give cause to have Ford argue for a higher value deal at the last minute.

Beyond premium divisional synergies, which are all very real and deserve focus another time, the mainstream divisions economies of scale are perhaps the more immediate ‘big wins’ at top of mind in Turin and Mumbai. Talks about this issue will have undoubtedly been periodically re-visited, but quite understandably each company will look to maximise its own non-partner based strategic options first, squeezing efficiencies where necessary, to maintain relative independence in core operations, yet also seek meshing only where and when appropriate – in effect given ever changing conditions, consistently re-defining JV appropriateness.

Importantly, the new Abarth division could be used by TATA as a case-study template for its own endeavours in creating an Indian performance sub-brand, possibly even adopting the Abarth brand through a co-licensing deal or having Abarth ‘breath’ upon its own cars, so applying the re-born moniker, as Carl Abarth did originally for FIAT and other clients. Indeed it could eventually be the basis to introduce far sportier coupe variants into the TATA range as the customer-base so demand.

10b. SUVs/4x4s
FIAT has historically produced 4WD versions of its utility cars and as SUVs became popular obtained its small SUVs from Mitsubishi (Pajero Pinin) and Suzuki (Sidici); so targeting smaller car-derived vehicles. Whilst it produces the Iveco badged old fashioned utility vehicle (that looks very Defender-esque) and has previously displayed a Hummer-esque concept called the Oltre, based in the Iveco light truck platform,

FIAT’s role in true off-roaders (in the Land-Rover/LandCruiser sense) has been limited. TATA however has focused in that arena, albeit with dated designs and technology. Thus, there may well be good opportunity for TATA-Land Rover-Iveco to identify alliance ventures, very probably starting with defence vehicles which, if contractually won can provide handsome income.

And further down the road is the ability to cross-share powertrains to enable each marque to possibly have a full compliment of ‘soft’ to ‘hard’ CUVs and SUVs.

10c. LCVs & Pick-Ups
The previously mentioned “criteria that defines JV appropriateness” is presently the stumbling block behind the hiatus on the jointly designed Pick-Up medium sized project for Latin America. This may be a test case that helps both parties better understand each other’s JV and business model boundaries.

However, there may be another reason. Perhaps the hiatus has occurred to integrate Land-Rover into the study so as to gain better results.

10d. MCVs/Light Trucks & 10e. Medium & Heavy Trucks & Buses
Tata is presently the world’s #5 in medium & heavy trucks, and #2 in medium and heavy buses, whilst Iveco stands known but not as renowned as the likes of Volvo. To this end it seeks to move from being an “international actor” to “global player”, primarily through expansion in Latin America and China.

As with cars, there are on the surface great synergies to be had, but a full and proper marketing and engineering analysis is required to properly identify best routes forward, whether via plant and distribution JVs as seen in cars, technical alliance for next generation vehicles, or simply leverage of each other’s supplier-base to obtain cost and technology advances.

11. Construction
The substantial TATA interests of Pollonji Mistry play a significant role here since his wealth was built via construction and property development projects and runs a very sizeable firm. This very well may have focused TATA development in this sector, spanning excavators (esp recently mini-excavators), back-hoes and tall crawler-cranes and asphalters, dominating the local market for such equipment. Once again collaboration has played a key role in getting TATA into these segments with Hitachi, John Deere, Libiro & CESAN.

FIAT’s New Holland, Case & Kobelco products, at first glance, seems to sit well as yet another contributor to the licensed/re-badged TATA equipment range, offering larger excavation plant than Hitachi derived machines and larger back-hoes. However, so do the the source suppliers, so TATA may, as is business practice, be using the FIAT link to best negotiate with the Japanese and US firms for expanded licensing agreement terms.

12. Agriculture
Although TATA involves itself in Agro-chemicals it doesn’t operate within the agricultural machinery sector, but given it’s Construction Sector interests and rapidly changing governmental agricultural policies for larger farming in India and across the world, it would seem only a matter of time before TATA looks seriously at this arena, if not doing so already. Of course FIAT’s Case, New Holland & Steyr agricultural machinery ranges would be a ready made sharing solution offering a myriad of specific tools (from tractors to combines) in varying sizes. Primary focus would probably be on Case given that it offers products better suited to large scale arable needs as opposed to the more specific and premium offerings from New Holland and Steyr.

13. Communications & Publishing
Given today’s media-centric, information rich world, it’s not surprising that both TATA and FIAT operate in these fields to both gain revenue streams and have an opportunity to have a voice for socio-political influence, as the Italian newspaper La Stampa undoubtedly does in current affairs and the Indian subsidiary of McGraw-Hill Publishig does in terms of educational books to help educate the mass of future workers.


When FIAT announced the TATA Motors agreement back in 2006, Milanese financial analysts from forms such as Rasbank SpA stated that they hoped the agreement would be wider in scope than just basic vehicle assembly. In that time local component supply to the Indian made products has increased and so reduced variable production costs for FIAT.

Additional alliance projects have been sought, and are being discussed, whilst further more are in the pipeline for in-depth analysis.

The fact is that, at this juncture of globalisation, with jittery consumer and financial markets, both ‘royal industrial families’ - the Tata’s and the Agnelli’s – recognise the need to best understand how to serve each other’s purposes without stepping on each other’s toes. The 2 MNCs are complimentary in many many areas and could undoubtedly plug each other’s deficiencies and so raise respective capabilities.

But of course, on a project by project basis, there are always other alternatives with perhaps other collaborators that may serve more immediate business plans or improve project or profit-centre revenues when viewed singularly.

The job of Rata Tata and Sergio Marchionne is to see past the small-fry (though it may not be anything such to local company management) and create, if feasible, new worlds of opportunities on the global stage. That is why Tata sits of FIAT’s board and why Marchionne has such an interest in TATA’s development plans.

Successful examples of “East meets West” business interlinks are easy to see, especially prevalent in China today but perhaps subtler in India given the far longer Indo-European industrial relationships that formed post WW2.

Institutional investors in both Group’s will be pushing the respective executives to seek out those opportunities for collaboration and so sector and market leverage, and it is of course the respective CEO’s duties to pay full and proper regard to such demands. But equally they should not be coerced into making specific possibly doubtful deals happen for investor sentiment, even if it means momentary rise in stock demand and share-price, when acumen states that there is doubt.

But of course, this is where the human element of bigger picture give and take comes into play between the Tata’s and Agnelli’s (via Marchionne) in the form of understanding, mutual respect and keeping an eye on the ideal of more “jam tomorrow” for both. So, even with the possible loss of the Mercosaur Pick-Up vehicle JV, there is a far greater picture to be, where amenable, co-operatively created that strengthens both Eastern and Western camps.

Tuesday, 18 March 2008

Industry Practice – Vehicle Leasing – Upturn and Evolution of the Model

With the repercussions of dented economic confidence being experienced in business and consumer circles, most companies are fighting to stay on top of profitability. The auto-industry a prime example of buyer malaise and corporate brain-tapping. But, for investors and astute management, such times offer the opportunity to seek-out alternative and additional revenue streams, re-structuring entities to better fit the future.

Heading into the troughs of any economic cycle – whether regional or possibly global – offer, indeed necessitate, such strategic reviews. So as part of this ongoing auto-motive sector re-jig, there are emerging new and evolved business model propositions.

Under greatly changing political-economic and socio-economic skies, ever changing, fragmented and hectic operational and lifestyle demands are impinging upon business vehicle users and private purchasers alike. Never before have a myriad of vehicle based requirements been needed, especially felt given today’s fiscal pressures for enterprise and individual’s alike.

Set against this tumultuous backdrop, western auto-makers especially are having a tough time, with GM & Ford equities presently hitting a 52 week low. At such a time, VMs will be looking to raise revenues via and extended their customer-base beyond a squeezed dealer-base; itself not keen to overstock. Hence automakers will probably start looking once again at secondary client groups such as fleet and hire-car companies to provide immediate sales lift, But it is perhaps the short and long-term opportunities that exist within the Leasing Sector that might prove tactically and strategically more advantageous - to take on quantities of production to assist through this lean economic and build alternative user-orientated, higher margin automotive revenues streams.

Lease-Cars have historically been the preserve of business users. However personal financing trends have altered so much in recent years that the fallible credit strictures and decreased realisable profits (from ever lengthening purchase contracts of up to 84 months) have driven automakers and dealers to start finding new sales arrangements. As a result Leasing is back on the table in both pure Finance Lease (vehicle only) terms and Operating Lease (expanded running costs) terms, which are usually allotted to private and business buyers respectfully, but the convenience factor of Op Leases means they will be increasingly offered to individuals as a form of more hassle-free motoring.

To very briefly summarise the pro’s for both parties…

Leasing from the Leaser’s viewpoint gives:
- Maintained vehicle ownership
- Greater legal title to the immediate return of the vehicle if payment default(s)
- Stable income stream
- Likelihood of repeat purchase if leasee has been satisfied
- Ability to re-lease or sell vehicle at end of agreement term (depending on market conditions)

Leasing from the Leasee’s perspective provides:
- Lower monthly charges
- Lower credit stricture/qualification
- Finite lease plan term able to fit personal near-term financial circumstances
- Ownership Ease……Possibly as far as an all costs inclusive “One Stop Shop”.... insurance, servicing, road tax, depreciation

This re-emergence of re-defined Leasing for the private user arena opens up a world of possibilities for vehicle use methods which could evolve into any of the following:

A. Mobile Phone type service contracts that would extend the Lease plan to include possibly (discounted) fuel purchase and drive-charges as with London Congestion Charge – these extended charges simply ‘factored’ into the service charge formula

B. Car-Club type service contracts that allow for the user to swap on short & long notice periods the type of car they use. Hence it could be swapped for weekends away, extended family needs increasing passenger numbers, a car-less period such as whilst abroad etc etc, essentially matching the car to the functional or emotional need of the user.
Combine of A & B

Key is the ability to alternate between vehicle types so as to better fit with personal lifestyle and ‘buying power’ requirements, whether as a single, couple, family or for leisure pursuits, work needs etc.

Given the exploration of the topic in industry circles, it is today that the question arises as to whether an automaker would try and develop such a sophisticated service for itself, thereby stretching its own value chain downstream into consumer culture and maximising the turnover and profit margins.

To get to that point, undoubtedly a VM would purchase a car-lease or car-hire company to acquire the basics of business competencies, thereafter re-mouldng that bolt-on acquisition to form the type of advanced Lease Company service offering demanded.

This would also provide the holding group VM with greater inventory and value of automobiles and allow greater control of residual values, through supply constraint, in the used car market-place – a major headache for VMs at the present both in terms of maintaining brand value and in terms of having to reduce new car values relative to plummeted near-new used car values.

Along with the dealer-buy-out initiatives some VMs are considering and undertaking, a full evaluation of such a new business regime must be undertaken, combining creativity and old fashioned ‘devil in the detail’ acumen.

Conversely, Automotive Lease Companies should see the opportunities arising for extended commercial links with VMs and Dealer Groups, and so begin to further court them with ever more imaginative schemes. No doubt some leasing companies will remain traditional, others seriously undertake possible alliance-based relationships with VMs, whist some possibly face friendly or hostile take-overs by peer trade buyers in their own sector (identifying the trend) or by predatory VMs seeking to enlarge their grasp on consumer’s automotive demands and indeed lead them.

Critically, with this ability to stake greater hold in that middle ground (between ‘pumping production’ and ‘enticing buyer’) will allow far greater influence in the costly arena of product complexity, reducing and streamlining vehicle feature and so in turn gaining component supply and manufacturing efficiencies.

At this juncture investment-auto-motives believes opportunities are abound in the Lease-Car world. Thus investors in all related commercial fields should seriously demand that respective corporate managements - individually and possibly collusively – creatively construct new strategically important higher-margin value-adding route-ways forward. Lease Companies, VMs, Dealer-bases and of course Finance Houses should re-visit "what could be" scenarios.

With such a catalyst for change, there are undoubtedly specific companies across all sectors for investors to watch and mark, perhaps first and foremost within the Lease sector itself, with great potential for sector consolidation and improved inter-relations with independent and VM linked Finance providers. Investment banks, private equity and hedge funds are looking for stable investments in today's choppy waters (ie infrastructure funds, commodities funds, precious metals/stones funds) so devising maximum value Leasing models will be welcomed as the auto-sector being proactive.

Thursday, 13 March 2008

Industry Practice – Accounting Fundamentals – Growing Pressures to Massage the Books?

For some time (years infact) the automotive sector within ‘old world’ markets has gone through efficiency drive after efficiency drive so as to maintain control over escalating fixed and variable costs.

Whilst certain headwinds such as labour pricing and legacy costs have been battled and won, the never-ending pressure of energy fixed costs and raw-material variable costs constantly mount, the local US and European region ‘margins squeeze’ countered with on-going supplier re-negotiation and sales re-alignment away from fleet and rental. But in truth, private sale vehicle discounting still carries on to ‘shift metal’ and so improve turnover volume – especially in C & C/D segments - ultimately undermining the hard-fought wins achieved by the procurement negotiators. The pressure set to grow more intense as recession hits the US and Europeans take a firmer grip on their wallets, the only upside (if it could be called one) a consumer shift into small B sized cars. Some fortunates, like GME have claimed ‘success’ of their small and more affordable offerings as with the Chevrolet brand, which have admittedly kept European divisions in the black, but that’s only really relative to far poorer performing US cousins.

Though this is a general trend in the west, thankfully lacklustre sales have been offset by rapidly growing BRIC+ markets, even as Eastern Europe starts to slow. So whilst the likes of VW appears to shine – as with its latest record results – others like PSA and even BMW highlight cause for concern in a dropping, or at best flat, 2008 market.

This means that the HQs of European-centric automakers and foreign MNC’s European arms will once again look to see what fat can be cut out of their operations, but after what has been severe operational cost-cutting – also buoying local results – many like ourselves are concerned that there is little to extract from what are ostensibly lean profit centres. Indeed it has been a prior willingness to ‘right-size’ and ‘cost-down’ that has provided the positive margins to date.

Under such commercial conditions it is natural to ask the question “just how will the European arms keep constricting?”

As we’ve seen with GME many will seek to continue to out-source, not just standard back-office GA work, but also what were deemed as core activities such as portions of R&D and platform development work to both their supplier-base (offloading responsibility), to development project out-source specialists such as MSX International and of course ‘in-source’ to cheaper corporate engineering centres, primarily in Asia.

This takes care of the trimming of what were previously core ops, but once that has been done – possibly close to that point now – it may be a case that pressure is so high of legitimately (or otherwise) massaging the accounting methods and figures. As ever, creative accounting that can blur pure operational clarity tends to focus on:

1. Costs – ‘Capitalising’ and ‘Reserves’
2. Stocks – ‘Work in Progress’, ‘Inflationary Effect’ via FIFO to LIFO, ‘Altered Timing’, ‘Playing with Discounts’ & ‘Double Counting’
3. Off Balance Sheet Financing – the use of ‘Associate Company’ status
4. Depreciation – Loopholes closing

1. Costs -
Given that costs are such a large predetermination of margins, they will always be the arena that is open to a change in definitional interpretation and figure-work juggling across the Balance Sheet and of course impact upon the Profit and Loss Statement.

Even with the aforementioned out/in-sourcing of development work, the ‘capitalising’ of retained project costs – added to the Balance Sheet as an effective ‘Asset’ - may still be open to legitimate application and so removed from the P&L. The past saw abuses by the likes of British Leyland and Rolls-Royce Aero-Engines in the 1970s, so strictures were set and have been ever since through GAAP and IFRS, but being a legal process, it’s still open to plausible use.

A proper instrument open to management use for valid use, but can be abused in the allocation of costs. It spans aspects such as:

A. Loss-making contract(s) - often for specialist clients demanding greatly altered specification vehicles such as the military, where engineering development and final vehicle pricing don’t reflect actual costs
B. Bad debt provision - where a client may have gone bankrupt, into Chapter 11 or simply argue and refuse to accept and pay for work undertaken
C. FX losses - essentially hedges against foreign exchange currency movements.

2. Stocks –
‘Work in Progress’
Given that stock(s) are a prime indicator of profits, and are the singular direct inter-relate between the Balance Sheet and P&L, this area is open to re-interpretation of accounting methods, which inevitably allows it to be used as a reservoir against which additional costs can be drawn-off or pumped back.
As ever stocks of parts or complete cars can be counted not as pure stock items, but with a little re-invention, counted as work in progress and so discounted from stock quantities. Typically the auto-industry will create 2 separate, dedicated areas for ‘Work in Progress’ which stores:

1. Part-built assemblies - therefore extracting from parts stock
2. Unfinished Vehicles – therefore inhibiting from being included in vehicle inventory.

Item 2, often sees a build up of vehicles kept in Quality Assurance quarantine bays that are identified as requiring re-work. The quarantine bay has been known to reach the sizeable proportions relative to the automaker type (VM vs niche).

‘FIFO to LIFO’ -
In times of inflationary effect – as is definitely happening today [esp raw materials and parts] – the need to re-valuate stock worth (and so WiP costs and product price) is of course vital. So at such times there is often an accounting methodology switch-over from FIFO (First In First Out) to LIFO (Last In First Out), so that real (inflated) costs can be calculated and ideally passed-on to maintain margin. Under such conditions it greatly assists if a company can be a ‘Price Maker’ and not a ‘Price Taker’. Unfortunately for Tier 1 & 2s, they have historically been the latter, and may well continue to be as we see VMs such as GM assist the likes of Delphi in re-structuring.

‘Altered Timing’ –
Pushing costs forward into next year’s/quarter’s P&L can be done by taking the costs attributable to part-completed goods out of the P&L, and instead regard them as part of the value of stocks, not ordinary WiP. This obviously puts a greater pressure on next year’s (or quarter’s results).

‘Playing with Discounts’ -
As the name states, it is the ability to raise ‘sales’ by abusing high stock conditions through use of exceptional discounting. This can deplete stocks quickly and give the impression of impressive turnover, but does leave the inherent danger of saturating market demand for a set forward period and, if un-coordinated, see a massive cash-flow burn via rapid and unnecessary re-stocking, which will see liquidity effectively trapped and sat idle in the form of unmoving stock.

‘Double Counting’ –
Once again, as the name suggests, an unintended (though sometimes unquestionably intended) double-count of stock. In autos it relates more to finished vehicles sat in a manufacturer’s lot awaiting distribution and where company owned cars/trucks are not properly differentiated from customer paid/ordered vehicles awaiting delivery. This then leaves the door open to abuses of double counting and there have been stories where auditing accountants have been shown (with rapid reshuffling) the same vehicles time and time again!

3. Off Balance Sheet Financing –
Less of a problem for conventional automakers that simply assemble, and more open to abuse by high technology firms/makers who are able to take minority shares in ‘green-shoots’ R&D ventures that are yet to prove themselves. There have been cases of funds being transferred into such start-ups and incubatory small companies, whilst there is no legal requirement for them to be listed as a Group’s subsidiary, the minority stake giving them ‘associate’ standing. They may become only visible if/when they start providing dividends to the shareholding ‘parent’.

4. Depreciation –
Whilst people are under the impression that ‘Depreciation Charges’ can be abused carte-blanche, ever since the tightening up of regulatory loopholes through the 1980s and 90s Depreciation abuse (for want of a better term) has been limited, especially so in listed European companies that are far more closely watched and evaluated by “sell-side” and “buy-side” analysts.

Thus we see that the Costs and Stock aspects of the Balance Sheet and P&L are, as ever with legal regard, instruments by which analysts and investors can be proportionately misled.

We don’t of course state that western automakers will deploy illicit tactics, the likes of which we’ve seen in the past; but simply that come Q1,Q2,Q3,Q4 and EoY results, that equities and fixed income analysts may well be probing deeper into how the figures were legitimately calculated. As times get tougher, so historically we’ve seen, automotive companies have needed to be slightly more complex in their accounting methods. And as the € : $ FX rate maintains record levels and possibly widens, raw material costs rocket and inventories of cars look to swell, each and every automaker will be ‘sweating’ their accounting resource assets.

Wednesday, 12 March 2008

Company Focus – TATA Motors – Leaning on a Hybrid Leverage?

Ratan TATA and Ravi Kant have impressed both the investment community and auto-industry in the successful 3 phase turnaround of the company, the last step of which revealed the ambitious plans set out that have led Indian conglomerate to relieve Ford of 2 of its once ‘jewels in the crown’ of a bygone PAG.

Pitched against a number of PE firms throughout 2007, the TATA win was announced late in the year, the recent months concerned with hammering-out details of the deal, most important of which, beyond price and payment structure, the agreed technical, production and administration support agreements so critical to a smooth transition in this typically complex ‘carve-out’ deal.

Timing however has been less than auspicious relative to capital markets sentiment. The continued fall out the credit crunch demonstrates that worries go beyond the boundaries of sub-prime, near-prime becomes more shaky and the accompanying CDOs are continuing to hit blue-chip investment bank balance sheets, so reigning in lending and raising credit stipulations. Whilst obviously felt greatest by the US institutions (including cornerstones like Freddie Mac and Fannie May) the global credit-risk shockwave – even in arguably decoupled Asian regions – has raised the ratings sensitivities from the big 3 credit agencies. As the TATA – JLR deal was progressing we saw Moodys start to twitch about the expected TATA leverage needed to not only pay the $2bn price-tag, but also the, as then, unknown costs of integrating the 2 western automakers into the industrial fold.

Since January TATA has announced its additional funding ambition, to the tune of $3bn. That obviously well supersedes the $2bn Ford agreement, and is far higher than any basic amalgamation costs to be incurred. So the markets are asking “how exactly will the extra $1bn be used”, whilst Tata and Kant will be asking “how can we best structure the leverage and who will be most amenable?” Acting as the all-important intermediaries in finance structuring and financial instrument buyers will be Citigroup and JP Morgan. Newswire reports mention that much of the borrowed amount will be in the form of short-term bridging loans, which if is the case, is theoretically obviously expensive to TATA, especially so under present liquidity conditions, and may reflect lender’s present cautiousness in staking a greater claim in TATA here and now, though that’s not to say that longer term arrangements won’t be made as and when TATA proves its case (ie giving greater transparency) or when market nerves settle. In reality all exposed lending parties will want to:

a) spread their risk
b) maximise short term rewards and
c) create a longer-term fixed income revenue-stream
d) seek to probably use transferable & hybrid loan instruments (ie convertible bonds and income securities)

The importance and use of such dual-character hybrid securities will probably play an ever important role in what are still considered jittery equities markets and relatively illiquid money markets. Given the value extraction TATA Motors sees in Jaguar-Land Rover in addition to normative car and truck operations, it will seek to maintain as much in the way of preference shares and ordinary shares as possible, but given the present financing climate that will be hard. Hence the undoubted employment of convertible bonds; providing satisfactory fixed income (reportedly at 2pp over LIBOR in the short-term) and the requirement for a debt swap when TATA shares look set for an upturn.

Now, if we take a look at who the Citgroup and JP Morgan Book Runners are targeting as debt underwriters we can see a definite pattern emerging as the $3bn loan is split evenly in terms of the number of US & Japanese companies (if not in direct loan value terms), the remainder going to a French and (expectantly) an Indian bank:

1. Citigroup
2. JP Morgan
Additional Underwriters
3. Standard Chartered
4. Mitsubishi UFJ
5. Bank of Tokyo
6. Mizuho Financial Group
7. Calyon
8. State Bank of India

The numbers in the consortium aren’t surprising, but perhaps what is interesting, is the number of Japanese concerns that have taken the opportunity to back TATA. Given a lack of opportunity to invest into China – due to political and commercial issues - India has for many years been seen as a natural home for Japanese investment, especially so the motor-cycle and auto-industries, in which the Japanese managed to use their inherent industrial strengths in these sectors ‘re-play’ their own economic histories via the likes of Kenetic-Honda, Hero-Honda, Suzuki India, Maruti-Suzuki etc.

Beyond the historical aspect, it’s clear that within the effectively stagnant Japanese economy that Japanese institutions are keen to gain exposure to external economic stimuli, none more so than India at present. Beyond the direct financial benefits of under-pinning TATA, investment-auto-motives’ believes that there may also be a diplomatic angle that could serve to align TATA and Japanese VMs and Tier 1s & 2s, so complementing the gains made by Suzuki in its JV with Maruti and assisting the Japanese supply-base to create transplants in India for local production and export back to homeland assembly plants in Nagasaki, Prefecture 1 etc.

But what of TATA’s use of that additional $1bn?

The TATA Motor’s group spans many vehicle divisions, which themselves are broadened more so by the Jaguar-Land Rover acquisition. Without repeat the outlook provided with the pre-Christmas posting that evaluated TATA’s J-LR intentions (18.12.08), senior management has a broad remit indeed in building-up a Motors Group that operates (now) in every vehicle segment.

Integration of J-LR was never going to be as immediate as some industry commentators first thought, Ratan Tata’s recent Geneva Show comments ratifying the fact. However there will be 2 main foci for the Indian management team interfacing with J-LR and they will be:

1. Re-sourcing of low-value J-LR components from the lower cost TATA supply chain
2. Re-allocation of transferable engineering development work to TATA Technologies Ltd to exploit lower cost ‘bums on seats’ in India
3* Complete vehicle line transfer of Defender 4x4 to India

This last initiative will not have been aired for politically sensitive reasons, but the reasons to do so are powerful and alluring:

A. To act as the Iconic corner-stone in competing against Mahindra for light 4x4 Military commissions, in India and beyond
B. To provide an intermediary product between the lower-duty TL 4x4 and medium truck range, gaining parts sharing efficiencies where possible
C. To reduce Defender Bill of Material and Production Costs dramatically.
D. Free-up production space and capacity at Solihull for other vehicles.

Point C will be one of the first ‘quick wins’ for TATA, since the vehicle is essentially a 50 year old simple design that constitutes basic engineered and fabricated parts (esp BIW with high aluminium content) and possibly the most intensive hand-built labour production process in the developed motor industry. Defender in reality would have been outsourced to a low-labour cost region years ago had it not been for the military significance of the product and threat of disruption.

Beyond J-LR, the TATA cars division will need re-capitalisation as a new generation of small & medium vehicles start their R&D and engineering development process. With the Fiat marketing JV underway, it would be feasible that both companies are seriously assessing the possibility of further sharing powertrain, other high-cost modules, and very probably evaluating complete sub-structures. Such synergies could assist the development of eventually a shared Indian production base for TATA-Fiat. And given the Fiat-Ford small car connection, and the recent TATA-Ford relationship, that alliance network could grow larger still. Lastly of course the new Nano ultra-small car will require ongoing production launch and additional plant capitalisation.

Additionally, the commercial vehicle and truck ranges – spanning LCVs, MCVs and HGVs - will need updating to meet market competition, fleet operators demands and ever-pressured CO2 demands from a growing contingent of domestic lobbyists.
And as with cars, there will probably be an ongoing programme of transference of the TATA Daewoo Commercial Vehicles engineering and low-value production work into Indian facilities, lead by (and the expansion of HV Transmissions and Axles divisions)

And fittingly, given mention of voracious lobbyists, the Alternative Propulsions division has promised to deliver 2,500 AP vehicles through 2008/9. Various options are being developed and reviewed, and we suspect the 2,500 vehicles will be essentially test-bed products used by Green government and private sector fleet, many of which will be adaptions of the Ace Mini-Truck and Nano Car, whether air-propelled, ULEV forms or complete EVs using ‘compromised’ but stable battery technology (ie Ni-Hy not L-ion).

So, given the expansive ambitions of TATA Motors, the additional $1bn that markets are querying will be directed toward a plethora of evolutionary product, project and organisational needs.

Though Ratan Tata and Ravi Kant have historically provided only ‘teasers’ of their intentions, preferring big block-buster announcements as seen with J-LR and Nano, it may now be time for them to discretely metaphorically ‘open the books’, so as to demonstrate in detail the mid-long term intentions of the Group. For at the moment as far as the outside world is concerned they are sky-high aspirations, and at that level they are rather cloudy.

Provide more detail and the probability of gaining less expensive borrowing in the short term and a greater influence on the underwriting conditions of convertible bonds or such swap-based instruments could assist in putting the Group on a better financial footing. Of course that puts greater pressure on TATA to deliver, but that hasn’t been a problem over the last 5 years. “More of the same” investors will be calling, even if credit ratings agencies are perhaps being over zealous in there risk of default reporting. As ever, the role of the Chairman and CEO is to maximise the investor enthusiasm and reduce their retractable coverage to gain the best cost of borrowing, but relative to other auto-firms TATA's WACC should be lower than many.

Monday, 10 March 2008

Macro Level Trends – Political Affirmation – Countering the Counterfeiters

The counterfeiting of products has long been a prevalent and growing trend. Its origins are lost in the past, primarily associated with important documentation and fiat currency for obvious reasons. But in today’s world, and with lesser stakes than direct fraudulent intent, it’s a trend that has gained a degree of social acceptance, which is why today originators and brand owners have lobbied for greater protection from government.

That social acceptance has come within the last 40 years as aspirant consumers sought the halo effect of designer couture and accessories at without premium pricing. Initially comprising of ‘midnight production runs’ of the real item, the growth of Eastern capabilities across clothes manufacture, handbag production, watch-making etc etc, provided cultural and geographic seclusion and with that protection.

Such success of basic copy-cat consumer goods like clothes, coupled with the advancement of Eastern capabilities across many different manufacturing sectors has seen the value rise to an estimated $500bn annually. The main problem is that counterfeits are now far more widespread and even unrecognised, not just by the odd gullible market-stall buyer, but for business to business procurers or aftermarket retailers of safety-critical products and components.

Thus, corporate lobbying has managed to raise the issue as high as the European Commission, the president of which, Jose Manuel Barroso, is about to open the Counterfeiting Summit to highlight the problem and provide informational exchange across sectors as to how to combat the issue. Whilst governments such as the UK have made tackling counterfeiting a priority within new empowered divisions such as SOCA (the Serious Organised Crime Agency) under the belief that such profiteering is often co-ordinated by much larger criminal gangs.

An example given of the ingenuity and coverage of counterfeiting was citing unauthorised copies of the iconic 1967 Ferrari P4. This serendipitous illustration highlights that the issue has been within automakers and parts suppliers’ scope for some time. Whilst design and production licenses are agreed to third parties for anything from a complete car through to proprietary component as industrialisation has advanced in less regulated and more corrupt regions so the problem has grown and grown.

Moulds and other tooling, once removed from proprietary OEM’s control can be exploited, indeed such is the advancement of ‘replication’, only the original CAD drawings are needed to make a copy-cat mould or such. And without those, an original component can be reverse-engineered, possibly using 3-D scanning, to get a very good dimensional and visual – though often not performance rated – copy.

The quality of packaging used by counterfeiters is also improving, making it difficult for both consumers and enforcement personnel to distinguish between real and fake goods. Importantly, counterfeiters are increasingly shipping their products around the world for final assembly and distribution, thereby minimising the risk of seizures in the countries where components are produced. Trademark owners are increasingly finding counterfeit production and distribution operations in Russia and the former Soviet Republics, China, India, the Philippines, the Middle East and Africa and some Latin American countries.

As Barroso recognises, for Europe, this problem gives particular cause for concern as the enlargement of the EU and subsequent reduction in the numbers of customs officers, coupled with the extension of the border of the EU towards the east can only make the task of preventing these illegal imports far harder.

The first global congress on the issue, held in May 2004 highlighted that counterfeiting:

1. Damages investment and innovation
2. Has potentially disastrous economic consequences for small businesses
3. Escapes taxation - smuggled into countries or with forged or invalid documents
4. Puts a severe strain on law enforcement agencies
5. Diverts government resources from other priorities

The headline topic and associated IPR & Profitability concerns are those that automakers primarily seek to fight, and thankfully since that inaugural congress the reality of counterfeit products has become more availed as the topic gains attention.

Besides the now estimated 1 in 8 copy-cat auto-parts that are in existence, the real aghast came when certain Chinese car producers blatantly copied full vehicles such as the Chery QQ (based on Daewoo Matiz) and BYD infamous for its creations such as the CEO (based on BMW X5) & F8 (based on Merc CL) and Nobel Minicar (based on Smart ForTwo). In September ’07 BMW set-out a law-suit against the European importers and distributors of the CEO, which (like BYD) claims that no wrong has been done given that it did not contravene any Chinese statute laws. Daimler also plans legal action against the Noble Minicar, hence the importance in timing of the EU Commission’s President’s words.

BMW and Daimler legal teams are hoping the precedent has been made by Continental, who managed to defeat the importation and sale of counterfeit Chinese tyres by German aftermarket sellers.

The World Retail Congress, to be held next month in Barcelona, will look at the ‘future-proofing’ of marketing, distribution and retailing efforts of many companies from a myriad of sectors, and of course the hot-topic of counterfeiting will be deeply discussed

Broadly, whilst we see incremental improvement amongst the political thinkers in understanding the scale of the problem in Europe, and seemingly prompting to do something in what are flat-demand and necessarily protected markets, the bigger issue for multi-national corporations is the extent to which the counterfeiting problem is entrenched in fast growing and far less ‘protectable’ BRIC+ markets.

For it will be in these regions that consumers will seek-out affordable fake symbolistic yet also performance dependent products like Continental tyres on performance cars. and beyond this worrying prospect come the concern for revenue. Reputation and revenue…nothing could be higher on companies’ agendas.

Friday, 7 March 2008

Micro-Level Trends – Industry Re-Integration – GM : Delphi : Goldman's?

Carrying on the PE vs Trade debate, perhaps the best example of the tussle for under par value is Delphi; both in its own right as a corporate entity and relative to the M&A opportunities that are emerging from, possibly forced, asset sales as the US supplier-base sector remains structurally and financially weak.

Having been under Chapter 11 protection for two and a half years, providing the breathing space to set a re-organised growth path, a US bankruptcy court has recently permitted a $50m payment to Delphi’s lawyers and financial advisors and supported a divisional divestment strategy that sees its steering mechanisms unit sold to Platinum Equity LLC, whilst the wheel bearings unit is bought by Kyklos Inc.

Quite obviously the company and its advisors seek to maximise divisional sale income from what are effectively low-value but high cost functions that specialise in what are in reality basic components that are readily available either off the shelf or as specified from BRIC+ regions at greatly reduced costs.

Delphi’s valuation and future funding quandary was ever present throughout 2007, required taking time to assess by potential lenders as the complexity of deconstructing, detangling and valuing America’s biggest Chapter 11 ‘case-study’ became ever more apparent. Latest calculations of capital injection requirements present a case for $6.1bn. Whilst the process of crunching the numbers has gone on, waiting and visibly acting has been a co-operative PE alliance, eager to see what potential the financially dissected enterprise actually offered. Led by Appaloosa Asset Management, the consortium identified value in Delphi and has bought-in throughout 2006/7.

The PE group consists of:

Appaloosa Asset Management (Lead Role)
Goldman Sachs Group Inc
Harbinger Capital Partners Master Fund 1 Inc
Merrill Lynch and Co Inc
UBS Securities LLC
Pardus Capital Management LP
Pierce, Fenner and Smith Inc

These PE investors together have stated that they are prepared to submit a $2.55bn injection package that will obviously intrinsically provide board-room voting rights and allow major influence on Delphi’s corporate strategy. Thus far, the influence desired is that Delphi continues to grow its customer-base well beyond the historically prevalent GM, critically gaining independence from what it sees as a politically franchised prime client that has always had undue influence over Delphi, able to often dictate component pricing and contract agreements, a situation that brought Delphi to its knees and if not dealt with now, at this crucial juncture, will always leave the company subservient to ‘The General’.

Obviously GM has recognised the subtle threat coming from the PE sector, so has obvious concerns that what it sees as its own, ‘friendly’ supply base could be threatened, which in turn of course poses worries about GM’s own re-bound, having come this far after positive UAW negotiations and FY07 financial results demonstrating that the company is near the tipping point of getting back into the black after so long. GM’s strategy and future turn-a-round projections undoubtedly rely upon the ‘efficiencies’ it has gained from its suppliers, Delphi being the priority. So understandably sees Appaloosa’s strategic plans for Delphi as an undoubted threat to future stability and traction. It ideally seeks the benefits of the close association it had prior to 1999 as it’s then parent, without the financial and legal responsibility; even though it does have to take on accounting ‘charges’ on its own books.

Thus as a counter-bid - as seen via an SEC filing late on 5th March and subsequent to an ‘assistance’ statement of 12th Feb. - GM has ‘affably’ stated that it will forgo a payment worth approximately $2bn from Delphi (of a $2.25bn debt) that was due from the $6.1bn leverage total, on-top of which it may lend another $0.83bn+ to assist. This would consist of:

a) $2bn first lien note
b) $825m second lien note
c) $175 cash loan

Unsurprisingly, its understandable agenda is to reduce, parts pricing. Given the ‘fixed’ UAW rates, this was always the next issue to be addressed to reduce its variable (manufacturing) cost-base, and the estimated $1.5bn reduction (based on 1999 contract agreement terms) would aid substantially.

So what next in the Delphi saga?

Undoubtedly, given the dynamics of the global supply-base network, an ever weakening $US dollar, acquisitive European, Asia (tho' less so Japanese) trade buyers and an expected US economic rebound in 2009/10 that should buoy the car-market substantially, Delphi continues to be a prime interest to Private Equity, General Motors, possibly other VMs seeking a major US supply chain (eg VW, Hyundai?) and of course other foreign Tier 1 and 2 components companies, especially Europeans such as Bosche or Continental. The latter examples perhaps prominant given the record € vs $ differential that makes Euro-US M&A so tempting at present and into the mid-term; especially so as Delphi divests of its low-end product portfolio and so begins to equate with the more hi-tech competencies of German peers.

Given VW’s interest in massively growing its share of the US car market, and recognising BMW’s present troubles in obtaining high quality parts supplies from the current US network, it could (given Piech’s high influence with German industrial circles & a unification sentiment within political spheres) endeavour to work with its European suppliers to grow a capability base with NAFTA (not necessarily only the US). This would underpin a localised product quality push that targets the Toyota quality benchmark that has been key to the Japanese company's US success.

Of course such a scenario may be the hidden agenda of the PE firms who recognise Delphi as being of great worth to foreign buyers, whether as a lean, singular core entity (the evolution of which we see today) or as functionally split amongst specifically aligned and identified European, Japanese, Korean and (highly likely) Chinese trade buyers.

At present, given the on-going re-organisational debates and “re-al politick” that engenders yet another request for Chapter 11 protection, the abovementioned idealised PE exit strategies, look a long way off. The PE consortium appears to be running out of patience with a threat to withdraw their support by the end of March if the $6.1bn hasn’t been obtained. That would seriously damage Delphi’s stock price and so Market Capitalisation and so credit-worthiness. Of course the possibility is that such a move could be used to by the PE group to buy-back in at a reduced price and upping the present hold to gain greater control over company direction. And of course the PE firm recognise that it has more than a modicum of power since its own investment is based on a template that dictates that Delphi can only take on additional debt if creditors are willing to take only a small risk premium, which of course puts-off potential other creditors, leaving the parts-maker open to hostile bids without GM support.

Hence the Delphi saga continues with a PE vs GM tussle.

There are of-course a number of possible outcomes in terms of the future ownership, shape and profitability model Delphi may take. But at this present time we wouldn’t be surprised if Rick Wagoner is engaging with Ferdinand Piech to discuss what may seem like an amenable dual interest in Delphi. Add the possibility of a GM-VW tie-up regards a refurbished leased or sold plant for VW to give VW US production entry and perhaps Wagoner could out-fox the PE boys. Then again they are undoubtedly doing the same thing amongst the foreign Tier 1 & 2s in Germany and beyond.

Quite obviously, for some time Delphi management has found itself caught between the proverbial "rock and a hard place" - a possibly invisible PE agenda versus the 'strings attached' help of GM. At present it seems that Delphi prefers the intentions of the devil it knows, apparently siding with its primary customer with subtely aired concerns about the possibility of the PE brigade's real intention of 'shorting' Delphi stock to make a quick buck. No one can say whether that's a geniune reaction to the news of a PE pull-out, or a machination to tarnish the PE offering.

Interestingly Goldman Sachs' has distanced itself somewhat from the remaining PE ideology that Delphi should de-couple from GM. Perhaps it's thinking of jumping ship, siding with the GM link and possibly raising the required funds from its own coffers or raising a new consortium?

With a $6.1bn requirement, $3bn offered by GM and 'only' $2.55 current PE offer, it leaves an effective shortfall of $0.55bn. Could Goldman's raise a new $3.1bn fund by April 15th? In 5 weeks we'll know!

Wednesday, 5 March 2008

Micro-Level Trends – Mergers & Acquisitions – PE vs Trade? And why Complexity Matters Most.

As is often the case in unsure times, generalist opinion differs whether the state of western capital markets and the auto-industry itself means that the balance of M&A ability and power is held by private equity funds or in-sector trade buyers.
The same question posed relative to the charging bull markets of BRIC+ regions.

Of course idealised answers are sought to assist opinion-forming regards one camp vs the other, to notionally assist advisory firms, deal-brokers and under-writers, but in reality although general assumptions can be ratified or dismissed by the quantitative analysis of automotive M&A trend surveys, it is the specific circumstances of individual M&A cases that matter. And of course each case will be different, with specific financial and strategic pros and cons, depending upon purchaser’s own strategic intentions.

Typically For PE they will be…

i) to turn-a-round target company performance via growth strategy and cost-savings
ii) to release potential via synergies with other portfolio companies (inc i )
iii) to divest the asset-base to ‘over-paying’ secondary buyers
iv) to sell-on a re-organised, efficient and part-proven ‘new’ company.
v) to leverage the balance sheet to improve ROE and re-build.

For a Sector Buyer they will be:
horizontal or vertical integration and value chain improvement
i) improved geographic or segment access to new customers
ii) improved geographic or segment access to new suppliers
iii) improved access to R&D
iv) synergistic product & service advantages (ie scale efficiencies)

Whilst the PE vs Trade question is an over-simplification, undoubtedly consensus forms behind well structured arguments for M&A theory relative to market conditions and respective business needs; so although both seeking ‘added value’ from an acquisition and may deploy similar tactics, the background business and financing contexts of PE vs Trade will invariably be different.

The results of such a difference were seen throughout ’05, ’06 and ’07. For western industry the heavily increased operational pressures on auto-suppliers, especially so in input costs, altered the PE stance on upstream buy-outs, preferring to seek downstream aftermarket and niche acquisitions that appeared to have greater B2B and B2C order-book and margin possibilities and enabling quicker pay-back periods. That left trade buyers less ‘harassed’ by competing outside firms to seek specialist ‘bolt-on’ buys to bolster and extend their own operations. However, remember that the growing band of restructuring specialists, such as distressed debt funds (eg Alchemy) are able to bridge that apparent PE vs Trade gap, and may yet prove a headache for the trade fraternity.

Set against the variability of a possible 3 pronged attack of Generic PE, Trade and (PE backed) Restructuring Specialists, it has been noted that the very nature of corporate complexity has had an enormous impact in on divestment issues. Complex deals that demand a level of continued co-operation after formal separation have become known as ‘Carve-Outs’, the deal transaction time required for full completion sometimes into over a year or possibly more. In the past divested units or complete businesses were far less inter-related with parent or sister businesses, hence providing simple M&A valuations and procedures, but as organisations have become more complex in their working natures (from cross-shareholdings to singular protected sourcing to shared contracts) so has the job of negotiating and extracting the core enterprise and associated peripheral functions.

Understandably, as advisors recognised the complexity growing. so they grabbed the opportunity to service the strategy implementation needs, the likes of Delloite and others have evolved their own services to specialise in this fruitful arena known as ‘Transition Services’. Generally assisting as an intermediatory in creating what are essentially outsourcing supply contracts of (typically): engineering services, testing services, procurement services etc, to maintain seller-to-buyer support integrity.

Detail, and the quid pro quo politics that accompany it, obviously takes what can seem an eon, so much depends upon the logical and emotional intent of the 2 parties. Ideally, if negotiations take place set against a bigger picture of additional down-the-road mutual interests, this can aid the ‘bon ami‘ and actually help form a greater working business partnership for the greater good. But of course that is not always possible. Two present-day examples demonstrate well: the reportedly distinctly different M&As of a amenable Jaguar/Land Rover-TATA deal vs the problematic Porsche-VW deal.

So we have seen how complexity and politics play major roles in implementing a ‘horizontally integrated’ M&A typical of auto-makers’ strategies, but what of the complimenting supplier-base?

Here we’ve seen 2 distinct plays:
A) extension up the value chain to improve margins and avoid ‘dog-fight’ lower cost competition
B) aiming to co-create a ‘cost-balanced’ high-value/low cost global enterprise.

Demonstrating play A, Germany’s Continental embrace Motorola and Siemens VDO in an attempt to extend beyond tyres and immediate technology into higher value business realms that surround complete vehicle dynamics focused electrical architectures. (see post dated 30.01.08)
And demonstrating play B, Canada’s Magna buy-out of the American firm Allied Transportation Technology and the Chinese firm Zhangjiagang Suxing Electronics demonstrates the opportunity, or perhaps defensive action, to amalgamate the best of western technology capable and eastern production capable synergies.

Such speedy integration of often 2 or more targets underpins conjecture that automotive supply base will continue to shrink through the balance of the decade, estimates of the reduction vary from as little as 50 percent to as much as 80 percent and more from 2000 levels. Whatever the exact figure, this consolidation is changing the auto supplier landscape significantly, especially so for commodity items.

Whilst the PE vs Trade M&A rate debate continues, we believe that industry observers should not discount the role and power of provate equity. The fall-out effects of the credit-crunch are indeed visible, and banks themselves have tended to retain cash to defend themselves against further fall-out, so restricting the conventionally available liquidity for specifically LBOs. But whilst that may be the case within the US and partially in Europe, liquidity is of course global, the US$ especiall so, and there’s a great deal of it on the balance sheets of Asian firms, the budget suplus accounts of national governments, the acruals of typically petro-dollar based Sovereign Wealth Funds and within Asian central banks themselves accessable by local capital markets looking at US based opportunities. Hence PE has learned to look beyond its conventional backers and onto new clients.

Beyond the liquidity question, is that of does PE have innate expertise to transform the supplier-base opportunities? (Especially as VM deals look rare in the face of a preferance for trade alliances) Although PE has had focus in other sectors, the fingers-burnt syndrome of 1990s venture capital firms taught the industry much. It perceived the supplier industry as ripe for consolidation 15 years ago and observed highly fragmented market segments (such as die casting, machining, injection molding, stamping, outside processors). Successful outcomes were varied, but it taught PE a great deal about how to change its approach for the next round of deal-making, consolidation and profit-taking…which may well be here for them.

Lastly, the PE vs Trade debate will continue, but ultimately it will hopefully be stringent strategic assessment, in thorough due dilligence and conservative expectations, that lead to plausible approaches, offers and acceptances, and not a rush to beat the sector competition or the 'other side'. Present times are not those in which to be rash, and investors will undoubtedly punish those that are.