Chain reaction: monitoring and supporting auto suppliers
By: Bob Rajan and Arthur Wicker, Thursday, November 26, 2009, AutomotiveWorld.com
When Henry Ford, the father of the car industry, said, "there are no big problems, there are just a lot of little problems", he could not foresee the unprecedented impact a huge drop in customer demand would have on the automotive world in 2009. It is this 'big problem' that has decimated the car industry in recent months. But it is a series of 'little problems' that should be tackled by car makers and suppliers alike to alleviate the impact of the large.
Bound together in a fight for survival, all elements of the automotive supply chain are making radical changes to their business models in order to weather the crisis and build a sustainable industry for the future. Glimmers of hope are on the horizon, with sales figures up and credit loosening, but we are not out of the woods yet.
Because the failure of one link could have a hugely damaging impact upon the rest of the supply chain, OEMs and the first tier of automotive suppliers have a vested interest in actively intervening to ensure that their suppliers have the necessary liquidity and resources to continue operating.
Effective monitoring
How should OEMs and tier one suppliers monitor the supplier base so that warning signals are noticed and acted upon? Early recognition and intervention is the key to solving liquidity or operational issues at any company in difficulty. Effective use of supplier databases containing risk and financial information, staff training to ensure better identification of problems in the chain, and feedback on operational difficulties are three of the key weapons in the OEMs' and tier one suppliers' armoury.
Typically, OEMs hold a vast amount of information on their suppliers, providing insight into their financial stability, risk profile and whether the supplier should be labelled as 'troubled'. Best practice dictates that this system should pinpoint at-risk suppliers, but due to lack of qualified staff and availability of resources, most OEMs address only the most urgent cases. Already-scarce human and financial resources should be allocated to determine if, when, and how to intervene at distressed suppliers. Monitoring should be focused on tracking liquidity, profitability, solvency, and investment.
Best practice dictates that this system should pinpoint at-risk suppliers, but due to lack of qualified staff and availability of resources, most OEMs address only the most urgent cases.
Such monitoring is not without its challenges. In a changing market, financial and operational data, if available, becomes outdated very quickly. Most automotive suppliers are private companies and are not obliged to make information publicly available. Enlisting the help of staff in regular contact with the supplier base will help to build a more comprehensive and up-to-date picture. It is essential to train them to look for financial and operational signs and equip them to ask (or find the answers to) questions such as:
- Is the supplier starting or increasing the level of receivables factoring?
- Are there complaints that the supplier's payment discipline has slipped?
- Has it requested acceleration of payments?
- Has it become more hesitant or unwilling to finance tooling or development costs?
- Has it increased the number of bank accounts that it uses?
- Does it have to increasingly fight with its own head office to obtain day-to-day working capital?
- How are receivables insurers acting towards the supplier?
- Have delays or errors in shipments increased?
- Has quality declined?
- Have reaction times (i.e. for completing 8D forms) increased?
- Is the supplier experiencing more downtime or staff turnover?
Suppliers should be able to demonstrate to their customers that they have a healthy balance sheet. Too narrow a view of financial performance will be gleaned from a review of just the legal entity with which an OEM has a direct commercial relationship. Due to company-wide cash pooling, a domino effect can be set off across all subsidiaries if one entity enters into some form of distress, let alone insolvency.
In our experience, certain key ratios which should prevent the supplier from being in the red with an OEM are:
- a return on sales greater than 3.0% to 4.0%;
- an equity ratio greater than 15% to 20% of total assets;
- and operating cash flow greater than debt service.
Clearly, a supplier in distress wants to return to profitability quickly and operate as a viable business over the long term. This sometimes jars with the overarching customer agenda, which is about ensuring short-term productive continuity. Of course, this is a generalisation, as both parties have a strong interest in both the short and long term. By and large, however, this distinction in interests prevails.
A financial structure that is simple, easily explainable and has straightforward governance is one that is, in the long run, more likely to generate value and contribute to the success of the enterprise
For the supplier, many of the activities deriving from intervention and on-site monitoring by OEMs and tier one suppliers are likely to consume a great deal of management time. Customers expect and deserve to be informed of relevant developments in the supply chain that could put their own production at risk. Ultimately, though, suppliers should not be burdened to the point that the controls imposed by the customer become a contributory factor towards the supplier's demise.
Taking action
Constructive communication between manufacturers/tier one and suppliers can result in more effective intervention, provision of funding lines and the implementation of a long-term solution. The key concerns to be addressed by both the OEMs and suppliers are liquidity, continuous flow of goods, and communication.
Managing liquidity is a critical skill in any restructuring effort. It is necessary to understand who will provide ongoing funding and in what forms it will come. This may, in fact, emanate from the customer. For the supplier, there are a variety of methods to deploy which will enhance short-term liquidity. These include:
- accelerating receivables payment terms;
- delaying trade payable payments;
- inventory financing;
- implementing consignment stock;
- upward price adjustments;
- negotiations for lump sum payment from customers/lenders;
- infusion from equity sponsor or parent;
- discussions with credit insurers;
- receivables factoring;
- operational support toward inventory reduction;
- and headcount reduction.
It is the supplier's job to implement such liquidity enhancements, but the OEM should be made aware of the measures being put in place to effect change. It is when deliveries do not meet requirements that OEMs will intervene most heavily. This can cause over-reaction on both OEM and supplier side. Demanding (or supplying) more inventory, more people or more containers will create an even deeper liquidity hole. The challenge is to avoid panic and ensure delivery with a measured use of resources.
The long road
After the short-term actions have been implemented, it is also important to keep the 'big picture' in perspective. Although recent evidence indicates that, more often than not, poor band-aid solutions are being used to fix troubled suppliers, defining and implementing the long-term solution for the supplier is absolutely critical. Without it, the supplier's equity holders, future equity holders and creditors have no reason to make the necessary additional sacrifices required of them. Ideally, any restructuring should be focused on the long-term survival of the company, so that it can continue to be a sustainable partner for the OEM. In most cases, this will require stakeholders to strike a deal which involves some risk and some loss.
In many restructuring cases, we have seen a number of (primarily financial) solutions put forward that have simply postponed the arrival of the real problem.
Any restructuring solution must be realistic about the financial and, crucially, the operational viability of the supplier. A financial structure that is simple, easily explainable and has straightforward governance is one that is, in the long run, more likely to generate value and contribute to the success of the enterprise, producing healthy investment returns. In many restructuring cases, we have seen a number of (primarily financial) solutions put forward that have simply postponed the arrival of the real problem.
Simply fixing the right-hand (equity and liabilities)-side of the balance sheet almost always does not make a supplier viable. The left-hand-side of the balance sheet - specifically cash conversion - must be adapted to match the new volumes, while giving greater flexibility to reflect the true future value of the business. Operational restructuring is just as important as financial restructuring in generating long-term value.
While car makers and their suppliers may have conflicting interests, the endgame is the same. Swift action and cooperation will enable all stakeholders to arrive at an optimal solution for long-term viability and growth. Of course, it will be a bumpy ride. As Henry Ford also said, calling upon another form of transportation: "When everything seems to be going against you, remember that the airplane takes off against the wind, not with it."
Bob Rajan is a Senior Director and Arthur Wicker is a Director at global restructuring, turnaround and performance improvement firm, Alvarez & Marsal. For more information go to: www.alvarezandmarsal.com
Published on Thursday, November 26, 2009
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