The European and US auto-sectors enjoyed the temporary reprieve given by the various national scrappage schemes, but now reality hits and possibly much harder than previously expected. The profitability crunch now heightened by the fact that the mining industry has re-tabled the notion of sector consolidation – long on the cards – to improve its own performance; especially now that China has been identified as a net importer of coal, this demonstrating its economic hunger and continued demand for base commodities.
As expected, the Rio Tinto - BHP Billiton concept of up-stream production integration is obviously growing increasingly real, the companies managing expectations over the last few months, with today, a letter in the FT from the legal and external affairs executive indicatively not only defending the position, but highlighting the fight it is willing to take on to achieve the ambition.
Understandably, the global industrial base is holding its breath given the possible consequential outcome, and so presents its case to relative sector bodies - in the automotive case, the voice of Europe's ACEA now being heard vying against this “duopolistic” intend. However, even it must know that to state that such a move was unexpected would be disingenuous.
The growing gap between iron ore's long-term contract price and its near-term spot price has been growing over the last year, ever since the equities rebound and miner's angst that they had ultimately locked-in their contract prices too early, but had little choice given the fragility of sentiment at the time. The 2009 commodities surge led to a historic watershed in the negotiational stance between iron ore miners and steelmakers when on 30th March the usual benchmark setting, first-round Japanese talks effectively changed the game for all. The previous annually set price agreements (based on average mid-term trend pricing) were abandoned, instead becoming a quarterly event with direct relevance to spot prices.
Having been a victim of the price/inflation turnaround the miners were keen to make-up ground, and it seems to ensure supply for its rapidly re-aligning industrial base Japan was happy to oblige as was a similarly keen China, itself experiencing a lesser re-alignment. That sets a new price of between US$110-120 per tonne for the Q2 2010, hence up 100% over the 2009 contract settlement price. 'Wet finger in the air' predictions from sector analysts indicate that the biggest 3 miners: Rio-Tinto, BHP-Billiton & Vale would enjoy a $5bn boost to bottom-line performance.
In what appears a tactic to essentially get ahead of the future demand curve, attract investment capital and so increase capacity, efficiencies and further improve profits, Rio & BHP are fighting hard to demonstrate the advantages of its proposition. It says Chinese Walls will create split between the combined upstream and still separate downstream components of their operations, so gaining the best of both worlds: creating scale-efficiency at source (primarily W. Australian mines) and encouraging sales and marketing competitiveness at the retail level to its customers.
For the large capacity steelmakers primarily operating in hungry markets, the price increase can be ammortised over the capacity and steel type, with of course probable scale-ordering discounts made quietly available. This silent but expected reality would best serve India's ArcelorMittal; No1 by a tonnage processing factor of x3. And so in effect ArcelorMittal can afford to let Japan's Nippon and China's Boasteel and their 'brethren' set a global price that it very probably won't have to pay. Equally S.Korea's POSCO with similar processing tonnage to the Japanese and a lesser structural cost to endure should theoretically have the ability to swallow the revised prices; indeed this action possibly expected by the relevant national governments as part of their ongoing export drives and cross-sector, cross-economy profitability hopes to maintain economic balance; assisted by the Won's recent international deflation as a consequence of the Renminbi's maintained FX stance.
But it will be the comparatively smaller others like TATA, US Steel, NucorCorp, Severstal, Corus etc with less of a bargaining stance that will be forced to pass-on the 12 month price increase (of $380 to $550 to $725 by Q2 end for high-quality hot-rolled) to try maintain their own margins.
[NB investment-auto-motives expects that the steel-sector's smaller players will in due course need to consolidate further, primarily via allegiances with a few M&As to maintain negotiating strength, whether the Rio-BHP consolidation is enacted or not].
Thus, for the vehicle industry, whilst China and Japan very probably intends to swallow the iron-ore price via absorption at the steel-processing level and as part of operations overhead at the manufacturing level (possibly with relative in-place tax relief), others vehicle producers elsewhere will be forced to pass-on much if not all of the input price hike.
That is bad news for the US, Europe & Russia. In India TATA may have the ability to re-jig its transfer-cost arrangements so as to reduce the on-shock to its burgeoning customer base (especially obviously on Nano). Whilst in Brazil, the local big 4 – VW, GM, FIAT & Ford – will probably be able to gain government assistance in compelling the local supply-chain to partially suppress local consumption pricing – probably adding any lost component 'invisibly' into iron-ore and steel export pricing.
So, at first glance, the big losers appear to be GM, Ford, FIAT-Chrysler, VW, PSA, Renault, BMW , and Daimler. Thus yet again, for the nth time, the western region structural cost bases of these manufacturers will come under pressure, especially so now that the expected volume decline appears now the green consumer incentives have disappeared and governments cannot afford to replay them.
Obviously investors will be keen to see just how prepared these companies are to react to the input price hike, the advantage of scale, platform / systems / parts commonality being key, whilst also recognising the importance of CEO's and CFO's proven performance in previously locking-in long-term contracts with steel-suppliers. In relation to the last issue, any that did will be sure to convey that to the investment community.
The ramifications present the all too familiar juxtaposition of 'winners & losers'. For the near-mid term.
The former camp consisting of VW Group leveraging purchasing scale and commonality, Ford on the same basis and Renault-Nissan absorbing into previously cost-amortised 'old' platforms. Although both BMW & Daimler are a long way from leveraging the production scale increases from next generation small cars, basic business-model economics indicates that they can better absorb the on-cost given their premium position, internal ability to create a pricing elasticity, and the ability to adopt alternative materials (aluminium or composites) where brand/model relative.
[NB the aluminium price slowly falling as large national inventories are being run-down].
In the latter camp, PSA may well have leveraged Varin's steel-supply know-how but it still faces ongoing structural and model portfolio headwinds,, whilst FIAT-Chrysler – even though working rapidly towards - have yet to realise the volume efficiencies Marchionne envisaged, which in itself it is suspected will take longer than envisaged unless Chrysler effectively buys its US market share.
Critically this will be a harsh test for GM-Opel having been assisted through its restructuring, and it will need to re-demonstrate its EU production sites' commercial viability.
Thus, for the European view, the bet is that the relative positions of EU 8 are little changed – the sun will still shine for some, cloud for others. What is of consequence is the level of 'hit' each takes given individually maintained vs individually weakened sales volumes the endemic relative structural costs by unit, platform and marginal productivity site measures, and critically the methods announced by executive teams to combat this newly emerged massive headwind.
Pressure then once again builds, this time though with little apparent reprieve, and so the western industrial base for all steel-linked consumer goods – from cars to fridges - is put under the micro-scope to see if cracks appear, so in turn presenting re-structuring and/or alliance opportunities.
Some will crack....but the best of the crop – strategically attuned & operationally fit – have far from any intention in doing so. As the impinging price war rages at the input level, so no doubt the default position for the wavering mass manufacturers will be to create a price war at the dealer level, so as to try and create a virtuous cycle of spiraling volume and reduced per unit costs. That internally generated sales-focus pressure may be their all too typical undoing.
Yet more rounds of the same to come no doubt, whilst the intelligent producers look to balance-sheet strength and diminished-cost asset acquisitions across both the US & Euro regions. The ramifications of the commodities pricing wave throughout the sector are yet to be seen. A case of 'watch this space' as the automotive intelligensia leverage the resultant circumstances.