“It is not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is most adaptable to change.”
--Leon C. Megginson, Professor at Louisiana State on Charles Darwin’s’ Origin of Species.
The lure of the auto industry for many M&A teams has long been the stuff of which dreams are made. The lower middle market presents literally hundreds of new opportunities on a daily basis. If you are venturing into the industry for the first time or are a seasoned participant, you can certainly discover the wealth of opportunity for inorganic growth. The shrewd investor, whether private equity money, a family fund, or debt, should quickly learn that while there are plenty of opportunities, the path to success is often through unanticipated headwinds. At Mid-States, we see failure in achieving company projections as the cause of failure.
Alternatively, we are often viewed as too conservative on the outlook, but often, it is a simple lack of an in-depth understanding of current market trends. More often than not, the ability to recognize the risks comes from experience. At Mid-States, our people have been part of the auto industry for over 50 years. Our team is made up of Detroit natives, born and raised in Motown. Often investors explore the industry for opportunities; we live here; we are part of the industry. We don’t jump at exploring opportunistic ideas, the latest trends, or the ideas that tend to be in vogue.
Our views are developed over a lifetime of experience where a daily discussion on auto sales, the effect of capital markets, labor issues, technology, etc., are as common as the scores of the Red Wings or the Tigers games. From that experience, we suggest a few “lessons learned” in developing projections.
Today’s Disruptive Technology
In mid-2023, we find the auto industry continues to pass through a cataclysmic change, but this is no different than its tumultuous past. We recall previous disruptive changes - the move to front-wheel drive cars, the four-wheel drive, the sport utility vehicle design, catalytic converters and the emissions regulations, and implementation of MPG regulations once thought impossible. If you’ve been here long enough, you’ll remember the change to unleaded gas and seat belts! Many of these were introduced and scoffed at as being a flash in the pan, “never going to happen” technological changes. Yet, here we are, killing it.
Battle-scarred suppliers recall the horror stories of projects begun but canceled midstream by manufacturers for a variety of reasons, either poor sales, recessionary times, or lack of resources. The cancellation occurs despite investments by a tier-one or a tier-two supplier. The supplier wants to ensure their part of a production timetable subsequently gets changed or worse, canceled. How can we reduce the risk of entering a project that eventually misses the expectations of the market and causes financial hardship in the supply base?
Let’s look at today's major disruptive technology, the electrification of the vehicle (EV). This major technological change has moved from could happen to “will happen” or “is happening.” In our opinion, it is all but certain to continue. In the chart published by IHS Global & Goldman Sachs, we see an electric vehicle forecast increase at almost ten times today’s volumes by 2040. That creates new opportunities for existing suppliers as well as new entrants. The internal combustion engine (ICE) and the powertrain begin to fade away, and electrification is the future of the automobile. In our view, it is highly probable this transition will occur.
Globally we think governmental policy will mandate the reduced emissions of the internal combustion engine. China alone, with 25 million vehicles sold per year, will drive this transition. While China’s power sources remain coal-fired facilities, and admittedly this will offset the benefit of vehicle electrification, the net effect remains a reduction of emissions and CO2 into our environment.
The analysis of the environmental effect of Battery powered Electric Vehicles (BEVs)s or Hybrid Electric Vehicles (HEV) (using an ICE for a power source in concert with a battery) is complex. Many studies by credible sources minimize or even eliminate the benefits of electrification. Studies have stated that a battery-powered vehicle driven under a load, hauling a trailer, in an area such as West Virginia, where all power plants are coal-based, is detrimental to the environment. It is possible that generating the electricity to charge the batteries to sufficient levels in certain isolated situations pollutes more than using a traditional ICE in the first place. Still, we believe these are very isolated and unrealistic situations and that as technology continues to drive efficiency, the electric motor is the future.
Effect of Electrification on the Powertrain Supply Base
As one door opens, another closes. A manufacturer of any ICE component will find an estimated doubling of underutilized production capacity in the next ten years. The excess capacity will continue to increase in those twenty years. An exacerbating factor is also that an electric vehicle requires fewer parts. In fact, the electric vehicle requires about 15,000 parts, about half of those required in an ICE-powered vehicle today. Using a far too simplified approach, half of the components will require half of the suppliers.
The idea that the new parts will be skewed toward electronic components further jeopardizes the machining operations, the casting facilities, and the metalworking companies currently in place. Existing manufacturers of ICE powertrain components must look at their capabilities and develop strategies to fit the new market needs. The existing supply base also needs to evaluate the increased competition, given the number of companies in search of a new product.
To further support the coming supply base change, we quote from the November 15, 2022, press release by Ford Motor Company “Ford creates a new EV supply chain that upholds its commitments to sustainability and human rights, the company continues to plan for more than half its global production to be EVs by 2030.”
What about Hydrogen Fuel Cells?
We can’t ignore the additional risks to the supply base without considering the hydrogen fuel cell as a power source. Essentially, the hydrogen fuel cell converts chemical energy to electrical energy. This is achieved by splitting the hydrogen electron from the hydrogen proton and in the process of forming H20. The only by-product of the process is water. The fuel cell requires hydrogen as the input to the process. Oxygen, of course, is abundant in our atmosphere. Hydrogen is the most abundant element on earth, but it seldom exists on its own and the cost of extracting or “manufacturing” hydrogen tends to be expensive. Additionally, there is no current infrastructure to distribute hydrogen, although some States (California) have limited distribution points. The hydrogen fuel cell eliminates the battery in the EV, the electric motor continues to power the car.
Notably, the European Union, as recently as their report in March of this year the building of the European Hydrogen Bank is planned to hold 20 million tons of hydrogen with a distribution network across the EU. The EU has stated that hydrogen is a key technology toward decarbonizing the EU by 2050, and to meet specific goals already agreed upon by 2030.
As the supply base moves toward EVs, and investments in new technology ramps up the supply base needs to be aware of the real possibility that the hydrogen fuel cell could replace the battery in the EV. We realize that there is already massive investment being made into battery manufacturing. Just last week the Department of Energy estimated that by 2030 battery production capacity in the U.S. will be sufficient for 10 to 13 million vehicles a year.
We note the potential impact of the hydrogen fuel cell not to opine on the merits of the technology but to advise caution to the supply base. The lower middle market supplier, in the search for new products, may be considering significant investment in battery production without the consideration for the downside.
Middle/Lower Middle Market Supply Base Actions Required NOW
Let’s assume that you are a supplier of ICE components that appears certain to be unnecessary with the advent of the EV. Going back to Mr. Darwin – the survivor is the one that is most adaptable to change. It’s not the strongest nor the smartest but the one that can adapt to the changing conditions. So, how do you adapt?
Be painfully realistic - Start by forecasting revenue over the next five to ten years in a “do nothing scenario”. Use a good database source as the basis for the projections. The resulting revenue forecast is how long you have to live.
Stop investing in capital equipment specific to the current product unless the payback is very quick. Milk the equipment and the technology you have in place.
Expand your horizons to new markets/products: (A) Form a core sales/marketing/engineering team tasked with investigating a new market/product direction. This should be at least 50% of individuals from outside the company. Select the team carefully, it’s not just the “best” engineer you got, it’s the most creative thinker, the person that doesn’t always follow the rules but gets things done. The team reports only to the top decision maker, there can be no filter of ideas through a hierarchy of management. Creativity is a key attribute of these team members. Quality market research is important for determining opportunities. No accountants please on this team, not yet. (B) Pick the top 5 best fits for new products or markets and thrash it through with the entire management team. The focus should be positive and “how to make it work” vs. “that’ll never work” approach. The transformation to a new market/product is risky for certain but you have no choice. Doing nothing is fatal. (C) Develop detailed plans to further investigate the five alternatives. Now bring in the accountants. Some preliminary ROI calculations are required to compare alternatives. None of the ROI’s will look very good, there’s way too much risk vs certainty of results, but not doing anything is fatal.
M&A Strategy follows the same process, but an acquisition/divest approach might be the best path to success. Divest the businesses or product lines with dim futures in the EV transition. The sooner the better as value will continue to decline as the EV market grows. Acquire companies that have a positive outlook whether automotive or another field. These don’t need to be EV related, other industries or products that your knowledge and skill set can transfer is best.
Higher Risk Approach
Importantly, lower middle market supply base companies have got to develop a higher risk mindset. Often the company is not particularly resource heavy and often risky projects are avoided. We knew one CEO that was convinced that the right approach on new capital was never to take on a project that if it goes wrong, you die. Unfortunately, that approach won’t work here. The transformation to EV will kill many suppliers but those that can adapt will be very successful.
Actions which are Probably the Wrong Approach
As you ponder your company’s direction, the urgency of action in the long term becomes smothered under the need for short term action. Some actions you should probably not take:
Short-term actions to increase revenue of current ICE components, particularly if capital investment is required, seem unwise unless very short-term returns can be realized.
Consider an alternative, lower volume footprint, that reduces costs and allows competitive pricing. Trying to get in front of the transformation by chasing volume decreases is just not going to work.
Expand your potential customer base by visiting other OEMs or tier one suppliers to competitive quote new business for existing product, even if a contribution margin pricing is required. We continue to believe that contribution pricing is a fool’s game. There are limited short term scenarios where it may be prudent but ultimately you have to cover your fixed costs.
Develop a volume-based pricing model to vary prices as ICE components’ volumes decline. This approach suggests as volume drops price increases are built in. This is a great idea if your customer agrees.
Summary
The key takeaway is that the automotive market is changing again. It does not have to be detrimental to your business, but it does require advance planning and serious strategy decisions. The “clean piece of paper” approach remains the best method. Your decision to adapt is likely a higher risk strategy than you would like, but ultimately you have no choice.
Those that adapt survive. Most important – DO IT NOW.
We welcome discussion and comment on this or any of our Newsletter articles. If you would like to discuss our services in more detail or to discuss the content in today's newsletter, please contact us to learn more about how we can assist your company or client.
Below are the direct phone numbers and emails for a Mid-States team member who can answer your questions (yes, we answer our own phones):
Joseph P. Alam III
Managing Director
(313) 670-5713
Joe Alam Sr.
Senior Advisor
(313) 215-1700
Jim Connor
Managing Director
(248) 935-4037