Auto Woes Contagious for Metals Suppliers

The following was excerpted from Forging Ahead: PricewaterhouseCoopers’ quarterly analysis of mergers and acquisitions in the global metals industry. In its first-quarter 2009 analysis, the consulting firm reports that the auto industry slowdown continues to weigh heavily on the metals sector and may spur new deal making aimed at diversification.

The automobile industry is one sector that has had a dramatic upstream impact on the metals industry during the economic downturn. What is unique about automotive’s effect is the uncertainty of the industry’s structure following a global economic recovery, particularly in North America.

Companies that are major direct or indirect suppliers to certain distressed automobile manufacturers may find their market positions fundamentally changed going forward. The impact on each metals company will be very different, depending on which makes and models they supply.

Although all automakers have realized significant reductions in volumes, as year-to-date U.S. sales are down 38 percent compared with 2008, General Motors and Chrysler are the only companies that have accepted federal loans. These two companies are under considerable pressure to make changes that position them to succeed and most certainly will be more aggressive in their efforts to restructure than other automakers.

Many of PricewaterhouseCoopers’ metals sector clients are saying their exposure to the automobile industry has proved greater than they realized and that the structural changes within the industry are imposing corresponding structural changes upstream in the supply chain that endanger a large swath of the industry. And that process could accelerate.

For example, consider the impact that a so-called surgical bankruptcy of GM, would have on the metals sector. [Editor’s note: GM filed for Chapter 11 on June 1, after publication of PWC’s report.] It could split the company into a good GM and bad GM by rapidly shedding troubled or less profitable brands and reduce its dealership network by nearly 3,000 retail stores over the next two years. GM [had] already announced it [would] shed Hummer, Pontiac and Saturn, with or without a bankruptcy. A metals company tied closely to a supplier for discontinued brands will likely find its revenue slashed significantly in a relatively short period.

Chrysler has long planned to forge a deal with Fiat, an Italian automaker, as a means to become a viable company when it emerges from Chapter 11 bankruptcy. As a result, companies with ties to Chrysler will likely contend with additional competition from established suppliers of Fiat.

Problems are hardly limited to U.S. companies. Successful Japanese brands Honda and Toyota are cutting production at their U.S. plants because of the depressed market. But they enjoy generally healthier financial and labor situations than their Detroit counterparts. Yet, even if foreign-based original equipment manufacturers take over market share shed by U.S. OEMs and ramp up U.S. production, U.S. metals companies may find themselves frozen out because vehicles manufactured by non-U.S. OEMs contain far less North American material, even when manufactured in the United States.

In addition to the $17 billion to date in government loans to GM and Chrysler, the stimulus bill approved by Congress in February could provide some mitigation to the recessionary forces facing the industrial sector through current and future funding of infrastructure projects. But that stimulus money is likely not a determining factor for large portions of the industrial sector, such as metals. The stimulus plan has limited direct impact on the automotive sector, which is largely driven by consumers’ wealth, income and credit availability. Any benefit will be derived from the psychological effect on consumer confidence and the corresponding increase in consumer spending in automotive and other durable goods. The future of consumer spending may well decide which companies survive and which sectors undergo reorganizations that could spur mergers and acquisitions.

Although the automotive industry’s troubles are well known, its dismal statistics are even more telling. The PwC AUTOFACTS global light vehicle production forecast for 2009 is 54.9 million units, down 17 percent from 66.2 million units in 2008. The 10.1 million-unit U.S. sales predicted for 2009 translates into North American light vehicle output of 8.7 million, the lowest since 1982, according to the AUTOFACTS second-quarter forecast. An industry that suffered from chronic overcapacity before the economic crisis now faces a painful unwinding of that capacity. Much of the global manufacturing and industrial base is following.

The exceptions to this automotive gloom are the BRIC countries (Brazil, Russia, India and China), particularly China and Brazil, where aggressive government tax-incentive programs targeting burgeoning domestic markets have propped up sales and production. Those nations account for 25 percent of the 2009 global auto production forecast, compared with 9 percent in 2001.

For developed markets, government-backed programs and incentives seem to be the only viable near-term path to mitigating the collapse in demand and production. For instance, some European countries have adopted modernization programs that provide incentives for junking older, less fuel-efficient vehicles, which can be applied to the purchase of newer, greener cars. The standard setter for this type of program appears to be Germany, which has seen a 20 percent improvement in sales for the first quarter of 2009 vs. the first quarter of 2008 since adopting the program in early 2009, including a 40 percent increase in March 2009 vs. March 2008.

The U.S. Congress is considering a handful of bills that could establish similar plans, including a potential $4,500 cash-for-clunkers program. The impact of these programs may be uneven across producers in the metals sector. For instance, fiscal stimuli that target the infrastructure and automotive sectors create demand for pipe, rebar, tubing, and flat-rolled products, but not so much for plate and other highly specialized products. These policy measures cannot do more than partially offset declines in construction (residential and commercial), machinery, aerospace and energy sectors, whose orders are rapidly faltering.

Yet, even if stimulus plans succeed, global automotive sales are not expected to return to their previous highs for several years. The industry and its supply base will shrink. We expect the global OEM supply network to rationalize and consolidate significantly. This process may prove even more severe for North American suppliers, with their heavy reliance on U.S.-based OEMs that have seen their 2008 combined market share fall below 50 percent for the first time in history.

The bottom line is that the metals sector, particularly in the United States, faces a near-term and possibly longer-term future in which the global automotive industry is both much smaller and more concerned with environmental efficiency. The sector should reasonably expect to earn less of its revenue from the automotive industry.

Diversifying away from auto
Many companies have realized this and are making efforts to diversify into sectors with larger growth potential—namely healthcare, energy, and public sector infrastructure spending. To adapt to these new realities, many companies likely will retool some of their processes and product lines to produce goods catered to the new growth engines.

This process might well spur M&A activity as automotive-dependent sectors look for strategic purchases or mergers that match skills and capabilities that can function in an energy- or healthcare-driven economy. In the short term, though, with deal financing still difficult to find, metals companies are seeking to fill the void the automotive industry has left in their income statements.

For now, metals companies are focused on repaying debt and rolling over short-term maturities. Many are raising capital to sustain operations. Alcoa, Rio Tinto, BHP Billiton and Century Aluminum have all raised capital in the bond or stock markets in recent months. Alcoa even bought itself a one-year liquidity insurance policy hoping that the markets will recover in that span.

In the first quarter of 2009, the pace of deal announcements declined significantly, particularly as measured by deal value. We attribute this to the difficult operating environment for metals companies caused by falling end-market demand and attendant weak commodity prices. Despite the anemic level of deal activity, several quarterly trends in the metals M&A environment are of interest.

First, minority stake investments increased significantly during the first quarter. Acquisitions of minority interests grew from roughly one-third of deals during the previous two years to more than half of deals announced during the most recent quarter. We attribute this to the continued difficulty in raising the capital necessary to engage in large deals, as well as metals companies growing risk aversion and focus on capacity rationalization and cost reduction.

Second, Aluminum Corporation of China (Chinalco) has entered into two deals with Rio Tinto and its subsidiary Hamersley Iron, for almost $8 billion plus the promise of additional direct investment. The investment will provide a vehicle for Chinalco and Rio Tinto to enter into a number of joint ventures to develop aluminum, iron ore, copper and coal projects. This positions Chinalco as a major raw materials player and secures Rio Tinto’s strategy for the next decade.

Though we acknowledge an increase in global debt issuance during this most recent quarter compared with the first quarter of 2008, volatile capital markets, as well as a weak operating environment and poor sentiment, are likely to remain impediments to any rebound in metals deal activity.

It is also likely that the need to reduce debt and increase liquidity will drive most new deals, coming as distressed sales of assets or divestitures of noncore assets by targets to survive an extended downturn. Purchases out of bankruptcy are attractive because they are relatively quick and allow acquirers to cherry-pick the assets they want. We also expect to see broader termination provisions, given recent high-profile break-ups of announced deals across all industries.

Overall, metals M&A activity is likely to remain muted; however, expect well-capitalized buyers to continue to use this downturn as an opportunity to invest in attractive metals and mining assets. If the 2009 contract price for iron ore follows the recent drop in the spot price, though, a balancing act will occur between the lower value of iron ore companies and the steelmakers’ need to conserve cash.

PricewaterhouseCooper’s Metals practice provides industry-focused assurance, tax and advisory services. For more information, visit or call Metals Leader Robert McCutcheon at 412-355-2935.

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