Auto Focus: The Lousy Economics of the Automotive Component Industry
Shoreline Business Monthly • June 1998
by Jim Gillette
As the renowned investor Warren Buffett has frequently pointed out, some industries have lousy economics.
Given the current state of the global auto component industry, we suspect it may fall into that category. In spite of strong sales of light vehicles in North America, net profit margins of many suppliers are beginning to look more like razor-thin grocery store returns.
During the most recently reported twelve-month period, after-tax income as a percent of sales for a sample group of publicly held suppliers has averaged only 1.6 percent compared to 6.4 percent for all the companies in the S&P 500. Some companies are beginning to exit the business rather than continue to fight the dismal profit outlook.
Heading for the exit
ITT Industries, for example, recently announced that it was exploring options that will likely lead to the sale of its automotive component operations. The Anti-Lock Brake/Traction Control business is a good example of a product line requiring large expenditures for R&D, having a short lifecycle due to rapid technological innovation, and intense competition from a few global players. We estimate that the price to the OEM of an ABS system has fallen by a factor of seven over just the last ten years.
General Motors, which got into the ABS business during the late 1980s, is also heading for the exit by attempting to sell its Dayton, Ohio brake manufacturing operations. When its system was introduced, it was targeted to cost less than $500, significantly lower than the competition at the time, but well above the market price today.
We wrote in this column last year that the current merger and acquisition frenzy could be divided into three stages (that are occurring to some extent simultaneously): 1) Consolidation To Achieve Critical Mass, 2) Growth To Build Competencies, 3) Selective Divestiture To Achieve Focus And Build Shareholder Value. The parts divisions of the automakers have been in the third stage for about 10 years. Competitive intensity and the resulting profit squeeze are encouraging the large Tier One/system integrators to follow suit.
Here are some other examples:
Following the sale of its brake business to Bosch in 1996 and its seatbelt and airbag business to Breed Technologies in October last year, AlliedSignal is now considering getting out of the auto parts business altogether. In spite of cost cutting efforts, AlliedSignal is still not able to generate acceptable returns from the remaining parts business, which is mainly comprised of the aftermarket targeted Fram oil filters and Prestone antifreeze. The other product lines at AlliedSignal appear to be doing well.
TRW president Peter Hellman recently advised that the company is considering selling some its auto parts units in view of price pressures. Auto parts make up 66 percent of TRW’s annual revenues and slightly over 60 percent of the company’s worldwide workforce. While Hellman says that TRW is committed to staying in the auto parts business (airbags in particular), divisions not meeting profit targets will be considered for divestiture.
What’s behind the profit squeeze?
Large Tier One/System Integrator suppliers are especially hard hit by the following:
- The oligopoly/oligopsony trap. You may remember from Economics 101 that the worst strategy a firm operating in an oligopoly (few suppliers) can employ is to compete on price. During a price war, firms will continue to cut prices until prices equal costs and all economic profits are drained. Only the buyer benefits. Industry consolidation has rapidly forced the Tier Ones into an oligopoly structure where several of the participants have cut prices deeply to gain market share. The situation is made worse in that suppliers are also operating in an oligopsony industry structure. That is, there are few potential buyers who are usually careful not to buy too many components from a single, large supplier lest the supplier gain too much control. Most firms have a considerable portion of their business with a small number of customers. Telling a customer like General Motors that you will no longer sell to them could have disastrous consequences.
- Intensified global competition to land business on “world platforms” has also led to giving huge price concessions in order to capture high volume orders. Lear is a good example of a supplier who has been employing this tactic.
- The requirement to make global investments in order to “follow the customer” is resulting in some high-risk assets being added to supplier balance sheets. In most cases, considerable profit-draining excess capacity is being created because of the need to deliver components in highly cyclical emerging markets where demand peaks can be short-lived.
- Design and engineering expenditures continue to soar as technological changes accelerate, products enjoy shorter life cycles, and innovations are being replicated or replaced more frequently.
- High-margin product differentiation is more difficult to achieve as fast followers drive down prices with “me too” products.
Harvard economist Michael Porter has shown that the five requisites for a profitable industry are: low supplier power (i.e. component suppliers have the ability to negotiate low prices from their lower tier suppliers), low buyer power, little threat of substitutes (i.e. alternative technologies, processes, or materials), and weak competitive rivalry among industry participants. Four of the five (supplier power being the possible exception) are clearly working against a strong profit outlook for the automotive component supply industry.
There is hard evidence that suppliers adopting focused positions below the system integrator level (those we have previously defined as strategic component and process dominant suppliers) have less exposure to the profit-retarding forces and, therefore, can still potentially enjoy higher margins.