Tuesday, 26 May 2009

Industry Structure - GM - Playing Value Chain 'Connect 4' with GME

GM's European division (GME) has understandably come under a lot of scrutiny over the last few months since Detroit's announcement that it would divest a major (60+%) portion of the entity. [investment-auto-motives welcomed this move given its previous impartial recommendation via this portal to do so].

Since then Sergio Marchionne was obviously the first to enter into negotiations, whilst later enquiries of interest directed to GME's lead "NomAd" (Commerzbank Dresdner Kleinwort) came from Magna International (with Plan B of GAZ alliance partner) and various 'fall-away' PE companies with only the most seriously positioned PE firm neing RHJ International. (RHJI a portfolio investment company understood to be one of Ripplewood's funds, with Timothy C Collins & the Rothschild family as key members). Post the deadline date was reported contact from a potential Chinese bidder, noted as Beijing Auto, whilst recent broad-brush employment/union concerns led FIAT SpA to mildly revise its offer in an attempt to alleviate German government concerns regards post-merger staff cuts.

Frederick Henderson et al at GM's HQ will be seeking the best buyer proposal which offers both short-term incentive (ie a cash offer to assist its woeful balance sheet) and longer-term attraction. This would be by way of a synergistic business relationship, that strategically aids GMNA operationally and regards cashflow, thus across: R&D, advanced components, outsourced production etc and secondly provide a demonstrably useful future share-capital increase & dividend yield. In short a welcome income stream from GM's retained shareholding in the new company.

For GM and the investment community at large, the inferance is that the rationality of value creation in whatever guise must prevail over any political pressures arising from preferences or bias from either Washington or Berlin quarters.... or indeed any short-termist attitudes regards size of the 'cases of immediate cash on the table' from more liquid bidders, no matter how enticing.

Thus given the number of apparent interested buyers, Henderson and his executive team will be busily evaluating/'playing' an industrial version of that children's logic-game 'Connect 4'; each of the bidders representing a play on the automotive value chain.

Case by case they reflect the 3 fundamental integration routes of the M&A game:

1. Horizontal Integration - FIAT Auto / [Beijing Auto]
2. Vertical Integration - Magna (Tier 0.5 "Short Vertical" ), RHJI (Tier 2+ "Long Vertical")
3. Diagonal Integration - Magna-GAZ ("Short Vertical" + "Horizontal")

With regard to FIAT Auto, Marchionne obviously sees the massive economies of scale (and future profits) to be had as he attempts to intertwine 3 companies hamstrung by individual overcapacity in presently saturated regional marketplaces. The appeal to create a leaner, more competitive 'super-group' industrial entity is undoubted. One that offers improved product pricing flexibility (due to reduced competition) and so unit margin improvement leverage plus inter-divisional distribution opportunities possibly boosted by the rebound of, primary EM markets if GMLA is also secured.
His marriage of efficiency and volume is of course CEO strategy 101, but GM's concern about passing on what are prime assets to a powerful foe - domestically & internationally - was always a prime issue regards FIAT Auto, all the more so if the divested package was forced by Washington to included GMLA.
Moreover, whilst Henderson recognises the US as GM's prime defensive home territory he also well understands the critical role GME has to play to assist the NA market rebound given its core competencies in compact and mid-size Delta, Gamma and Epsilon 2 platforms; the smallest of those ideally re-directed in future for comprehensive or heavily shared low-cost engineering in South America.

The second "Horizontal" play comes very tentatively from Beijing Auto Industry Corp (BAIC). Already a successful proponent of JVs with the likes of Hyundai, Mercedes and Chrysler it has become the No 5 Chinese automaker critically from alliance learning and technology transfer.
As to how real the enquiry is, is open to debate, since although Chinese automakers have indeed been successful at home, the domestic sector is undergoing a period of restructuring and consolidation so the big fish (like BAIC) chasing the smaller fish to grow market share, improve efficiencies and broaden product lines.
With so much important M&A action on its doorstep would BAIC really endeavour to stretch itself so so far with Opel? Probably not, even with what domestically appear large cash hoards. GME is of a very different scale and complexity and since that cash was hard earned it is unlikely that BAIC management would risk it in such a venture, even with nominal German Aid backing.
And more so than with the FIAT bid, German union voices would be aghast at (even the remote) possibility of a 'lift and shift' to China. Beyond that Chinese financial analysts have stated that BAIC is simply not in the position to seriously bid as it should recognise its own budgetary and management limitations.

Magna International represents the first case of possible "Vertical Integration". It above all others has become the modern-day examplar of a burgeoning new automaker; starting from its parts-maker roots to create a Contract-Builder business for some of the most hallowed names in the industry - Mercedes, BMW, Jeep, Chrysler etc. Buying up the assets of flailing operators like Steyr-Puch to provide outsourced assembly capacity for high margin niche products and simultaneously enlarging its 4WD engineering and production capabilities.
Thus its interest in GME is to effectively create a fully fledged Tier 0.5 business. The full exploitation of this business model has been on the minds of industry execs for 20 years, the ideal to allow today's typical car company to instead become effectively a Brand Broker between outsourced manufacturer and distributors/dealers.
Magna has been the major proponent to fit the jigsaw pieces of such an ideology together, recognising the size of the opportunity to become the No1 large scale contract assembler.
Thus if successful, the company's end-game could be to collate the best physical assets (plants, tooling, human resource etc), divest of the lesser productive items - possibly to China - and sell off the Opel Brand to a trade or PE buyer as part of a long-term supply agreement.
Its own ability to essentially re-invent the rules of automotive assembly, without the headwind of intrinsic legacy costs and the tailwind of more flexible labour, would regenerate the profitability of auto-manufacturing when given such freedom.
[NB Latest reports indicate that Stronach et al at Magna have convinced Russian Sberbank Rossi of its business model to finance a Magna-Sberbank JV for 55% of GME].

RHJ International represents a deeper level of "Vertical Integration" stretching to Tier 1 & 2, and so reflecting typical long-reach value-chain consolidation. RHJI is a holding company with interests stretching across Auto Parts, Electronics, Audio-Visual & Leisure Resorts.
Its Auto Parts companies include Asahi Tec Corp (60.18%), Honsel Int Tech (51%) and Niles Co [electrical switches] (77.3%). Beyond immediate auto-related companies the collection of audio/visual company & brands held could be said to offer indirect synergies given the level that media and entertainment has infiltrated the driving & passenger experience over the last decade of so.
But its prime capabilities are Asahi & Honsel which produce 'higher-end' lightweight core components such as aluminium, magnesium (and iron) extrusions, castings, machined and fabricated items for chassis (esp wheels), driveline & NVH (Noise, Vibration, Harshness) applications.
Moreover they have expertise in electrical and environmental engineering which has snowballed from Japanese government contracts. Thus RHJI seems to be promising the ability to re-engineer the typical car (and perhaps new vehicles) for a new era. (VW the proclaimer of 'das Auto' will be watching avidly). Reports indicate that it has been courting influential German Economics and Industrial Ministers to demonstrate the value-added it can bring to Deutsche Auto GmbH.

Lastly there is the "Diagonal Integration" of Magna-GAZ, which seems to offer the combined strengths of Magna's advantageous manufacturing position with opportunity for operational symbiosis with GAZ. This undoubtedly incentivised for Magna and the German government given the Russian government's agreement to fund strategically important stricken enterprises - aligning Berlin and Moscovite empathies.
Furthermore Oleg Deripaska's mighty influence is still apparent given his retained empire's financial restructuring, and so the leverage advantages of his Russian Machines enterprise and the massive commodity orientated conglomerate Basic Element which specialises in aluminium production via UC Rusal. Add together the sum of the parts of the empire and it could provide cost-effective (chaebol-like) internal purchasing agreements, to assist Magna-GAZ profitability. Basic intelligence suggests that (like FIAT) it is a 'no cash' offer instead offering the industrial leverage of Russian materials, labour, logistics, parts, production and distribution.

Ultimately beyond the bidders, GM, the German government and possible latterday large-scale institutional and private individual investors will question the philosophical focus of such restructuring. Crucially, whether the new GME should, from a value-chain perspective, be restructured 'laterally' (FIAT-GME-Chrysler) or 'vertically' (Magna or RHJI) or 'diagonally' (Magna-GAZ).

FIAT, Magna, RHJI & GAZ will have weighed up as best they can the innate detail and broad ROI of these 3 options. Done so to gain both the vendor's perspective and German governmental perspective; to get into the heads of these 2 co-dependent divestment arbiters, so as to create their own strategic arguments that places them in the best possible light.

Day by day press reports discuss the pros and cons of each bidder and the leading contender for the moment. Thus it was said that RHJI was increasingly in favour by Klaus Franz of Opel's works council, catching the leading Magna bid; thereby prompting Marchionne to revise his FIAT offer.

In the meantime the ever increasing likelihood of GM's soon entering Chapter 11 means that Opel will require governmental bridging financing which itself could induce the creation of an intermediate Trustee body as advised by the Economics Minister Karl-Theodor zu Guttenberg. To do so would provide much needed breathing space that would enable far better consideration of GME's future, and allow each bidder to round-out their own due diligence intelligence and strategy presentations.

This array of disperate bidders will either be seen to create a plethora complex issues, or judged against key criteria - ideally explicit, but in all probably more so implicit. If the former it suggests that the ongoing talks will stretch into June and possibly beyond given the added dimension of GMHQ's own Chapter 11 administration dealings. It will seek as large a slice of the new entity as possible as part of a contributive effort toward its own re-birth. If the latter, as seems to have been the case given the 28th deadline date, the present murky picture for the future of GME will clear.

Historically. the auto-industry has of course witnessed national industry re-alignment as regional economics have contracteda and what were once buoyant companies whither. GM's own US birth was from such a case of amalgamation, as was Germany's own 'pre-modern' Audi (born from the Auto Union conglomeration of Wanderer, Horsche, DKW and Audi) which itself was merged into VW.

And for GME/Opel, depending upon outcome, after 80 years of GM 'stewardship', it may now be given the kind of operational independence not seen since its automotive inception in 1899. That was 36 years after the company's own founding which produced sewing machines and bicycles, obtaining the license for French Darracq chassis technology on which it bolted Opel custom bodies.

It's logo is of course the electrical 'lightening bolt' and in our new age of burgeoning hybrid and electric vehicles, might the new stewards of Opel re-assess the viability of new licensing arrangement in order to add a strategic 'leap-frog' to its product line and business model? Inspired by Darracq, could a new Opel once again turn to France and Renault-Nissan to assist in the supply EV technology and architectures?

investment-auto-motives has pointedly highlighted Europe's less than favourable FX and trade positions compared to its global competitors, and so the need for impetus regards EU industrial policy. Germany is seen as a technical tour de force with revered 'eco' engineering. So the opportunity to showcase much needed EU vision and renewed integration through GME/Opel's re-orientation could be very compelling - politically and financially.

[NB. See previous investment-auto-motives' conjecture regards the EU to potentially plan an geographically prescient 'Eco-Rainbow' for automotive technology: an arc spanning (right to left)Germany, Scandinavia & the UK - using the notion of scaled-size and value-chain driven eco-tech collaboration].

Today, we hope that a 'lightening bolt' of directed creative reasoning has struck within the Ivory Towers of Berlin, Detroit and Washington, so that a grand-plan context can be set for Opel/GME in its own right and to act as the catalyst of change in EU autos.

In which case, if so, today's deductive 'game' of "Connect 4' rationality may act as a precurser to a far more powerful, holistic international EU exercise of 'Join the Dots' to form that persuasive collaborative Rainbow.