Supply Chain Risk Is A Rising Tide

By Michael Boudreau CPA, CTP, CFF – November 2019

The auto industry moves the needle in many different geographic markets and it often trickles down to other commercial industries. Stress cracks at the OEM level often create shock waves down the supply chain which increases risk factors at the Tier I, II and III suppliers. Further, it appears that the risk factors today are increasing at a consistent pace. The risk factors can be any event that systematically join together to erode profitability, cash flow and line of credit availability, enterprise value and collateral values. Conversely, these industry risk factors often lead to increased debt and delinquent payment to trade suppliers as well as increase the risk of a supplier defaulting on loan covenants with its secured creditors. Any and all of these risks will often threaten supply interruptions “up the chain” which creates the automotive workout.

In any situation, it’s important to understand the specific risk factor or the root cause of the problems in order to address them. The auto industry continues to evolve and change with electric motors versus combustion engines, autonomous vehicles, crossovers and SUVs versus sedans, etc. However, many of the core issues in the supply chain are constant. A few that we continue to see are as follows:

1) Volumes: It’s easy to discuss this topic at a macro level, but for part suppliers, it’s critical to understand the sales percentages not only by customer, but the vehicles and the platforms the supplier supports. Are those vehicles selling well, or are inventories growing at the dealer level? Are significant dealer incentives needed to move the vehicles off the dealer lot? Answers to these questions will provide great insight into the supplier’s financial forecasts and their realistic assumptions. Fortunately, the General Motors strike only lasted about 45 days, but its impact has negatively impacted auto supplier liquidity.

2) Tooling Collections: Depending on the production tool size and complexity, it may take 3-9 months to build the tool and produce parts. The tools will need to be in the presses to make parts (which may or may not be in the supplier’s plant) and the parts will need to pass PPAP (pre-production parts approval) before the customer will issue payment for the supplier’s already paid for tooling investment. That’s when things can get sticky with delayed payments as the OEMs have been known to delay tooling payments to suppliers to protect their own liquidity.

3) Launch Costs: We can think of these as “Full Production Launch” and “Pre-Production Launch”. By way of example, let’s assume the OEM wants vehicles on dealer lots by September, then Full Production Launch may be in July and Pre-Production Launch may be for the nine months preceding Full Launch. Focusing on Full Launch, this time period is often dominated by poor quality parts that are rejected by the customer. This can and will stress the supply chain when there aren’t enough quality parts to supply the vehicle build schedules. This leads to over-time, scrap, expedited freight and none of which are built into the piece price. The root cause may be due to a poor tool or part design, equipment issues, manufacturing process debugging, poor fit and function, etc. Having said that, determining the root cause and ultimate fault of the problematic parts is often an exercise between customer and supplier that is much like determining who fired the first shot between the Hatfield’s and McCoy’s.

4) Capital Expenditures: Automotive manufacturing in general is comprised of high fixed costs and high volume at compressed margins. This is even before considering the cash or debt required (term notes or capital leases) for equipment. Winning new programs is the lifeblood for any supplier since auto parts have a limited life cycle, but the equipment required to deliver the program will also need to be factored into the quote and overall business case.

5) Commodity Pricing and Tariffs: Commodity pricing fluctuates for many reasons and fluctuations bring risk. Practically speaking, it could take a year between winning the business and full production, during which there could be substantial differences on purchased material and component costs. Depending on whether the supplier is viewed as a strategic partner, they may or may not achieve pricing adjustments for commodity increases. Pricing adjustments can simply be a piece price adjustment, or the OEM may help the supplier by purchasing the raw material for them (aka Steel Resale Program). Under the re-sale program, the supplier will want to track this accounting closely to ensure the amounts due are setoff against the accounts receivable or shown as ineligible for bank reporting purposes to properly reflect the collateral base on the revolver.

The above five issues are not an exhaustive list, but they are the typical problems that need to be addressed and corrected. The executive leadership team at each auto supplier is obligated to work with their customers to ensure the above issues, which often lead to profit leak, net losses or worse, are addressed quickly and profitably. Having said that, the customers are often slow to react to help solve these problems, especially if they are being supplied quality parts on a timely basis. Often times, Middle Market suppliers themselves either:
a.) fail to address the issues in a timely manner with customers
b.) are not skilled at preparing the appropriate financial forecasts necessary to quantify the customer ask and
c.) are very slow to push their customers for the economic adjustments necessary to maintain viability.

The above operating issues gone untreated will eventually erode EBITDA and liquidity. The obvious short- term answer is to extend trade and tooling payables, but this strategy is a short- term reaction and sooner or later, vendors will react by tightening payment terms to COD and / or require large payments to reduce their exposure. Either way, the companies accounts payable function is now “robbing Peter to pay Paul”. This process can go on for as long the supply base will tolerate it, but without a paradigm shift, the supplier is now in a downward spiral.

As the company approaches its tipping point, a Chapter 11 bankruptcy filing may be on the horizon, however the following two other issues may happen first:
a) Loan default
b) Supply interruptions to customers

Next steps by the company are critical to its viability. Both the lender and the customers will be re-thinking their long- term relationship with the company. It’s imperative to engage restructuring-insolvency counsel and a Financial Advisor who are both experienced in dealing with distressed auto suppliers as industry experience is very important for this type of specialized work. Both moves will help re-establish credibility with both the customer and the lender and help the supplier craft realistic end game solutions.

Loan Defaults
A loan default is a game changer and not a welcomed one. The loan documents typically permit a lender to accelerate the debt and require immediate payment in full in the event of default. They also typically grant the lender the right to paydown the loan by sweeping funds from the borrower’s bank account and to notify the borrowers customers to pay the bank directly for outstanding invoices. The loan documents also typically provide to have a Receiver appointed. As a result of these typical contractual rights, the borrower will want to be proactive and schedule a meeting with the bank to discuss the root causes of the problem and to present a turnaround plan within a reasonable time frame. The turnaround plan should include supporting financial forecasts so the bank can better understand the financial roadmap moving forward and measure interim progress against the plan financials.

Supply Interruptions to Customers
Customers have an economic interest in knowing that their supplier is viable and can supply quality parts on a timely basis. Deviations in the supply chain and significant supply interruptions can cause disastrous economic results. As a result, customers will want to understand the financial picture going forward as well. Further, it’s very likely the supplier will or should have several requests from their customer. The financial forecasts are critical to laying the foundation for a path forward. The supplier and customer will often enter into an Accommodation Agreement, which will identify various actions to be performed by the parties within a specific time frame. These agreements can be voluminous, but they often deal with issues related to: a.) liquidity and pricing b.) tooling payments c.) AR payment terms d.) resourcing parts & associated winddown costs e.) new business awards f.) inventory buy-back provisions (bullet proofing the collateral) g.) inventory bank builds h.) non set-off agreement. These are typical examples and aren’t meant to be an all- inclusive list of all the issues for every situation. Finally, customers will certainly want to know that the supplier has a viable long- term banking agreement in place.

Summary
Numerous macro and micro factors are negatively moving the needle to erode EBITDA, liquidity and viability. Middle Market companies need to act faster and implement strategies to mitigate the risk factors to improve their outlook and control their destiny. Too often however, managements hope for an easier solution that never materializes and by doing so, puts their company in a downward spiral. Best practices suggest seeking outside help experienced in the auto industry early in the process to achieve best results.

Michael Boudreau CPA, CTP, CFF is a Director with MorrisAnderson, a financial consulting firm focused on restructuring and workouts, debt refinancing, performance improvement, CRO and interim management, transaction advisory and other fiduciary services. He has 25+ years’ experience in the automotive supply chain as Financial Advisor, CFO and Treasurer. Boudreau has also been a Court-Appointed Receiver for both Commercial & Industrial (C&I) as well as real estate matters.