The German supplier sector has found itself under increasing pressure to evolve and compete as the rapidly shifting structural sands of the global supply network encompasses 'bottom-up' consolidation and retirement for North American firms to 'top-down' quality learning and expansion for Asian firms.
Caught in the middle-ground is Europe, none perhaps more exposed than Germany, a country that has built its second-half 20th century economic success on the back of superior, world-class engineering and technology. But the end of the 20th and beginning of 21st centuries have seen the quality chasm shrink as industrial education, development technology are adopted to nurture global-wide regional skills-bases.
As the supply-base at large treads a production path to the Near and Far East, chasing lower production costs and growing local markets - as we've seen with VM's - the centre of gravity moves East and the raison d'etre to create localised R&D and new product development centres grows. Renault, GM, Hyundai et al have been the arbiters of change and are persuading their suppliers to locally support. Most recently with the announced PSA-Mitsubishi green-field production plant venture in Russia's Kaluga area. (Since the noted success of Daimler's groundbreaking supplier-vested Smart build hub all VM's have lobbied for close-proximity supply to reduce logistics complexity and costs and maintain the production quality dialogue).
This trend comes at a time when the very fundamentals of supply-sector economics is being challenged as Eastern suppliers, with or without Western JV assistance, are able to design and deliver a plethora of 'low-value' components, primarily with metals casting & machining, metal fabrication and rubber products. That has fragmented the production bases of 'low', 'mid' and 'high-value' components engineering and production.
The problem for Germany is that the post-WW2 industrial policy that melded a socialist-market-economy mentality with the ambition of self-sufficiency – most notably evident at VW's Wolfsburg - which underpinned German industrial strength started to become its undoing when set against the modern globalised context that emerged in the 1990s. The German consensus between labour corporations and government – the sozialmarktwerkshaft – had for decades given high salaries to induce high productivity, backed by large public investments in education & training and governed by powerful legislation and regulation, especially so in labour contracts so as to create and spread wealth. Along with a monetary policy that maintained low inflation and a strong D-mark.
However, as Japan rose as an economic powerhouse, and the rest of Asia threatened – ultimately delayed by the 1998 Asian Crash - the Bundersbank, politicians such as Gerhard Schroder and think-tanks such as the Friedrich Ebert Foundation realised that Germany was becoming increasingly isolated from not just its more flexible, low cost European neighbours, but seriously disjointed from the rest of the world; and so perhaps at greatest risk of future economic shock.
The 'Wirtschaftswunder' (economic miracle from the 1950s-90s) was recognised to be redundant.
As a consequence German industry instigated what were seen to be radical reactionary reforms as European Integration and the beginning of Globalisation took hold, the competition gap in traditional industries such as coal, steel and engineering grew as a result and German unemployment swelled. Companies like Bayer, Hoescht and VolksWagen had to make their voices more loudly heard both on the public stage and within the halls of power, and did so.
A major driving force of that period was the auto-sector, underpinning the major export pillar that had started with the trickle of VW Beetles in the early years and led to conquering the world in the premium sector by the 90s; not forgetting the importance of trucks and of course auto-parts.
The breadth of automotive technology has grown immensely over the last 2 decades, the Germans and Japanese the major proponents and purveyers of that trend. As part of its long-held self-sufficiency ethos the German supplier-base expanded to maintain 'whole vehicle' capability; spanning from Basic Bearings (as we shall see with Schaeffler) to Bluetooth Telematics (Continental). But of course the sector consisted of many many privately-owned and publicly owned enterprises and it has been the progressive, forward thinking firms like Robert Bosch that actively encouraged the technical stretch, recognising that its USP lay in tomorrow's world (as large German tech traditionally had, from Braun to Siemans etc) and as a large international entity could see the world changing at first hand.
That ongoing learning duly permeated the German government, and whilst there has historically been a very close 'socialist' knit between government and industry (as seen by the existence of Supervisory Boards with nigh-on 50 year worker representation), the rate and impact of global change, compounded by demanding capital markets and massive inter-regional investment flows, meant that Germany needed to adapt and reform industrial outlook and policy. (That was 'assisted' by the influx of cheaper labour made available in 1989 with the fall of the Berlin Wall, that assisted in reducing part of the input cost equation). For the big German conglomerates like Bosch and Continental, already international in scale and operations, the changing governmental stance has been part of day to day business, indeed they helped drive it, but for the smaller concerns with domestic-centric operations the change has been daunting.
We stipulate 'daunting' because a higher proportion of German firms have been historically, and still are, family owned. (95% of Germany's 3m businesses are family controlled). Fortunately within industrial engineering they have enjoyed little strategic disruption on the back of an ever growing German automotive and engineered products demand. General business acumen and inter-family association has witnessed collaborations and takeovers in each industrial products segment; especially during economic downturns or hiatuses. But in essence, the smaller and mid-size firms (like Schaeffler) were essentially living in a protected, stable, insular eco-system that did not encourage the evolutional development experienced by more exposed firms in say the US, UK or Japan – the voracity of competition exposure was simply not as high.
But the last few years have seen the results of 'reformation trickle-down' from big corps back in the 1990s. Ten years on industrial re-alignment has start to take shape as the mid-large size enterprises within Deutschland GmbH. Companies that lived off of yesteryear glory days and often held back by traditionalist family power, have been forced to understand their individual industrial positions, thus broader national appreciation and latterly international management thinking have emerged.
This well exemplified by Schaeffler's acquisitions of LUK, INA & FAG in attempt to become a major concentrated national player with international reach across all continents. Broadening its product portfolio, increasing individual (Auto, Ind, Aero) sector & sub-segment market shares, generating economies of scale greatly needed to combat energy & materials input costs and reducing general sales & administration overhead. But critically, as Geissinger knew, the move was to avoid being trapped in the highly competitive, low-barrier entry, arena of precision bearings. In summary,the M&As have broadened the portfolio to include:
a) Schaeffler's,INA's, FAG's overlapping & complimentary bearings range (P/T & wheel hubs)
b)LUK's clutch & gearbox components
c) Schaeffler's & INA's engine (timing & drive) systems components
But as the growing company's dynamic CEO Jurgen Geissinger well knows Schaeffler Group is still an industrial minnow when it comes to vying on the world-stage, and he's recognised that heavy reliance in a few pockets is untenable, made all the more evident this month with European car sales down 8% this month, and US premium car sales heavily contracted, hitting the German premium brands hard, who in turn will be adding additional efforts in major procurement cost savings on low-value parts; in turn squeezing Schaeffler.
Hence his unsurprising strategy to strengthen the core bearings business via M&A of German peers and then to look at Schaeffler re-positioning itself as an industrial powerhouse far further up the value chain into sustainable, higher margin electrical and electronic systems territories. The latest of which are technologies like Lithium-Ion battery development & production and Intelligent Network Telematics for motoring's 'tomorrow's world' - disciplines Continental through its own efforts and previous purchase of Siemens VDO are industry leaders within.
[Although it has technical leadership in the R&D laboratory, it still needs to promote such innovation for industry and public acceptance, hence with its recent positive - we think overtly flattering - 'Consumer Acceptance of Electric Vehicle's' survey].
However, from Schaeffler's family owned, cash rich, perspective the timing of its interest in the far larger peer is near perfect. Frozen liquidity conditions in the credit-crunch fall-out have contracted, indeed battered, the stock-market. The upside for acquisition hungry hunters that many bourses are showcasing well below par prices for a host of sectors and companies, perhaps none more so undervalued as the listed, auto-related enterprises. Unsurprisingly the best deals to be seen are where the value-gap is greatest – and that means companies of major size with with high-value products and capabilities. As such Geissinger well knows Continental represents an attractive, value for money, prospect. Its divisions spanning a myriad of high-end, valuable technologies in:
a) Chassis & Safety
And, per the norm, we have witnessed the usual negotiational 'courting dance' over the last few months as Schaeffler endeavours to courteously, yet forcefully, chase Continental taking increasing percentage of swap stakes via Merrill Lynch, openly highlighting its desire to take 30% of Conti but not be legally pressed into having to take and finance a latterday 50% controlling action – that German law presently demands. (NB Geissinger is hoping to ride the present day consensus for commercial legal reform and have the restrictive 'ownership onus' diluted to gain a powerful position within Conti but not be obliged to take on the weight of its legal requirements). This has all played out as his hostile initial bid of 70.12 Euros per Conti share has been improved to 75 Euros per share, and a thawing climate between the parties demonstrated by Conti's statement that “we will continue talks with the goal of reaching a solution to the benefit of the company as soon as possible”...”even as we evaluate other possibilities”. As to what degree Conti is really 'open' is debatable as reports indicate that it has been seeking 'White Knight' saviors from the Large Cap PE arena that could ensure a continuance of stability.
However, market conditions aren't great for PE and those large funds that have liquidity are spending much of their time reviewing the potential of investing in the diverse classes of asset and non-asset backed mortgage instruments banks recently had to put back on their balance sheets but are keen to offload at a discount (yet still ironically underwrite) to PE.
So the market understandably sees Continental as probably having to fight its own corner, and much of that will come down to the demands of its own institutional and large-holding investors. At the time of writing the share price just nudged over 74 Euros, not far off the 75 Euros offered. That we feel is the result of Conti's management 'persuading' (by whichever legal means possible) the price up to force Schaeffler in turn to re-offer at a higher level. Continental's management knows its value is well under-represented and is essentially pushing for time to 'run-up & run-out' Geissinger's bid.
At the opposite end of the spectrum, those customers which buy from both Schaeffler and Conti would rather see a friendly, magnanimous outcome rather than one which causes little operational disruption. And ideally see smooth possible absorption into an enlarged cost-saving entity which could pass-on a portion of those savings to customers. Theoretically possible, but pragmatically harder to obtain, especially if the Schaeffler family wish to see immediate returns on their M&A investment.
But whilst the individual players undertake their 'pitch and swing' bid tactics, there may be external government and industry observers who'll want to push to maintain a kind of unified front to German Auto. They recognise (as do the Schaeffler family) that Schaeffler's current position is untenable in the long-term and that has major ramifications for the economic livelihood of Herzogenaurach, its home town in Bavaria.
So ultimately, this episode in German industrial power-broking could be effected by the subtle influence of regional and national politics in seeking a fair result for all. One that avoids leaving Schaeffler in its long-term untenable position, and one that allows Conti to make use of the smaller companies good standing in precision, high quality mass components.
Exactly how the other primary stakeholders will react if this episode becomes a dilution of what should be an increasingly deregulated free, open market system is obvious, with much reaction resultant from their own expected growth forecasts. The likes of Capital Group (with its 2 Funds) ,Axa Group, Barclays Global Investors, Marsisco Capital, Societe General, Morgan Stanley-Wilmington and UBS will rightly have high expectations of Continental's longer term performance given the global growth of vehicle production and of course well recognise the traditional cycle of the auto-sector and the trough-point it now resides within.
So Schaeffler will have to pull something quite compelling out of the bag, or use its political might to help push through its bid. German industry has historically always been about a politically meshed group of powerful families, and as we see Porsche AG's inceasing hold over VW (both firms with major Porsche and Piech family interests) and the ever present Quandts at BMW, maybe Maria-Elisabeth Schaeffler & Georg Schaeffler and their sizable network will be plying invisible political moves to accompany her recent public PR appearances. This would accompany her 'Bavarian Order of Merit' as presented by Governor Stoiber and ex-German President Herzog.
This is indeed a testing time for Deutschland Auto GmbH, and appreciating the direction and nuances will be key for Continental's core investors as they in turn seek to see their preferred outcomes.
But too much political intervention raising the spectre of dilution to short or long term value-creation will not be welcomed.