Challenges And Opportunities In The North American Manufacturing Sector
Pauline Renaud, May 2009
In recent months, demand for manufactured products has significantly declined. Rising prices for raw materials, combined with tight credit conditions, volatile markets and a lack of financing options have put North American manufacturing companies under tremendous pressure as they scramble to survive. According to government data, US industrial production fell by 1.5 percent in March, not only the fifth consecutive monthly fall, but also the lowest overall level seen in a decade. The downturn is particularly severe in the automotive industry, with year-on-year sales down by almost 50 percent. Figures are no better in Canada, where one in seven manufacturing sector jobs has been lost between 2004 and 2008. “The last 12 months have been challenging not just because there is a downturn, but because of the perception that the depth and length of the downturn may be different than past cycles,” explains Chris Besant, a partner at Baker & McKenzie. “That makes forward planning, both to survive the downturn and for profiting from the eventual upturn, much more difficult than in past recessions.” Therefore, most companies now have no other solution but to implement drastic cost-cutting programs, in the face of looming bankruptcies. The less fortunate have simply been forced to liquidate.
Manufacturing in survival mode
Although some industries fare better than others in bad times – including food, cosmetics, staples and pharmacy – most segments of the manufacturing sector have been affected by the global economic downturn. According to the US Federal Reserve, the decline in production was led by decreases in consumer goods, including furniture and electronic goods, and by business equipment, such as computers and communications gear. Mining production also fell by 3.2 percent in March when compared with February, and by 6.9 percent when compared with production in March 2008. Furthermore, thousands of job cuts have been announced in recent months, including those made by Goodyear Tire & Rubber Co., flash memory maker Spansion Inc. and Deere & Co, the world’s largest maker of farming equipment. However, the sector’s plight has not gone unnoticed. In March, President Barack Obama signed a $787bn stimulus package of spending and tax cuts, which he says have started to “generate signs of economic progress”, while warning of “pitfalls” ahead. According to a recent study by the Institute for Supply Management, 36 percent of the manufacturers surveyed indicated that their industry will benefit from the stimulus package, while 34 percent said it would directly benefit their companies. But for most experts, recovery is still far in the future.
In the meantime, solutions are limited and usually consist of aligning manufacturing capacity and cost structures with reduced demand. This means lowering operational costs, closing plants, outsourcing operations and instituting lay-offs, as well as negotiating revised pay and benefit packages with employees and unions. The transformation facing American manufacturing has indeed encouraged the union movement in pushing its agenda, making the environment even more challenging. In addition to those cost-cutting measures, eliminating non-profitable assets is another widely used solution. “Strategies being utilised include refocusing all activities and resources on the profitable, core business segments that represent the remaining competitive advantage for the company,” confirms James Loughlin, a principal and managing director at Loughlin Meghji + Company. “This allows the company to reduce costs and harvest cash from segments now deemed to be non-core and no longer strategic.” This approach is reportedly being considered by General Motors (GM), which may split the company into a ‘good GM’ and a ‘bad GM’.
Experts also recommend that companies should focus on communication to manage stakeholder expectations, but also evaluate tools to reshape the company, such as out of court workouts, in court solvent reorganisations, and in court formal bankruptcy restructurings. Mr Besant also advises companies to make “a list of what obligations, businesses, assets, liabilities and personnel need to be shed to achieve that vision, and what assets businesses and capabilities need to be acquired to get there. That is the critical step for success,” he insists, adding that incremental change is a mistake. “Downturns are opportunities for radical revitalisation, and the ultimate winners are those who change deeply and quickly.” But given the extent of the current turmoil and the subsequent rapidity of the drop in demand, many are finding it difficult to reduce their fixed cost footprint in order to clean their balance sheets and rid themselves of excess debt.
This is particularly relevant to the automotive industry, which has been hit head-on by the downturn. Rapidly rising oil prices in 2008, pricing pressure from raw material costs, competition from the public transport sector and changes in consumer buying habits are putting most automakers and their suppliers at risk. In the US, bad business practices at the Big Three automakers have also been blamed for their financial difficulties. After being bailed out by the US government a few months ago, both GM and Chrysler were recently given tight deadlines to come up with aggressive restructuring plans. A failure to do so will mean bankruptcy for one or both of the giants, and will consequently impact the whole sector, explains James H.M. Sprayregen, a partner at Kirkland & Ellis LLP. “The US domestic automobile industry is dependent on the status of the Big Three, and the potential effects of a Big Three bankruptcy, or bankruptcies. Some suppliers may benefit from a government supplier support program that went into effect in early April, which gives suppliers access to cash. Very significant unknowns still exist and the above conclusions may change substantially, based upon an increased or decreased level of US government involvement in the US auto industry,” he warns.
Things are already quite shaky. In spite of the US government’s efforts to seek a comprehensive financial solution, a recent study by CIBC World Markets predicted that half of the nation’s 51 light vehicle plants are expected to permanently close in the coming years, leading to the loss of another 200,000 jobs in the sector, on top of the 560,000 already lost this decade.
As result, carmakers are left with a few options to try to restructure their businesses. In the short term, they can shut facilities, wok out interim support systems for the supply chains and dealer networks stressed by the uncertainty in the sector and negotiate government participation. But automakers also need to implement operational and administrative restructurings. They are, for example, advised to retool and rationalise the damaged brands in the case of North American companies, reconfigure the product offering and production capabilities to match consumer demand and preferences and prepare for the coming technological transformation in the nature of personal transport, among other solutions.
Besides the difficulties associated with the implementation of cost-cutting measures, several other challenges have arisen for troubled companies in the manufacturing sector. Firms that depended on continued sales growth and profitability to service high levels of debt will need to restructure these debt obligations, says Mr Loughlin. Some companies that are still viable, but over-leveraged, may still be able to reorganise and therefore survive. But for many other businesses, “refinancing debt is very challenging, if not impossible in the current credit environment,” notes Mr Loughlin. “Therefore, a substantial percentage will find it very difficult to avoid formal insolvency. Key challenges will include raising the required financing to allow the company to operate, while going through a formal insolvency or Chapter 11 proceeding. Raising financing for debtor-in-possession (DIP) facilities in the current US credit environment is very difficult.”
Indeed, DIP financing has become increasingly expensive and is only offered on shorter terms, while being accompanied by higher rates and fees. “There will be a rise in formal insolvencies, but not until the valuation valley is reached, since DIP funding has contracted, and formal filings need credit in the system in order to exit by sale or a funded financial plan,” explains Mr Besant. “Hitting the valley floor in asset deflation will allow for a more reliable short-term liquidation and long-term valuation analysis, which provides a floor for the easing of credit for DIP, exit finance, and distressed M&A.” But some experts suggest that there are likely to be more DIPs that force quick sales or are used as ‘loan to own’ strategies. Under such a strategy, a private equity firm extends credit, or acquires the debt of a borrower, with a view to converting its debt position into a controlling stake, often through bankruptcy.
Opportunities on the horizon
On the bright side, the current economic downturn and lack of liquidity will provide some investors with excellent M&A opportunities, when the financial and credit crisis eases. Sophisticated acquirers, such as private equity firms and hedge funds, are increasingly making investments in distressed companies, due to the low indicative trading value of debt. And this is likely to increase, as the price of deals will get more attractive. “Private equity firms appear to be entering the distressed debt-investing arena in a meaningful way, using loan to own strategies,” confirms Mr Loughlin. “Private equity firms have billions of dollars to invest in the right situation. They can also protect their own instruments by making ‘bolt on’ acquisitions at good values to drive profits and avoid covenant defaults.” In bolt on acquisitions, the acquisition will fit naturally within the buyer’s existing business lines or strategy. But PE funds are not resistant to the financial crisis and some of them are running into difficulties, particularly regarding their access to financing and issues with their existing portfolio companies. Therefore, the impact of PE firms within the sector in the long term remains to be seen.
Private equity aside, healthy trade buyers can also benefit from the opportunities in the distressed manufacturing sector. One company’s problem can become another’s chance to buy at bargain prices while adding revenue streams, developing new product lines or expanding its geographic coverage. “Those companies with strong balance sheets and cash flows can take advantage of what is likely to be a buyers’ market,” says Mr Sprayregen. Indeed, consolidation across the manufacturing sector is somewhat inevitable. However, Mr Sprayregen points out that, “necessary consolidation may be delayed by the enormous uncertainty in the industry and by the ordinarily large up-front cash costs of achieving synergies in consolidations, as those may be challenging to fund up-front in the current environment.” He adds that such transactions will be “dependent on the strength of the acquirer – specifically, their access to cash – due to the scarcity of credit and financing options in today’s markets. These types of plays will be longer term plays, as buyers will need significant staying power in such situations, to get to the time of economic recovery – whenever that happens.”
Nevertheless, the outlook is grim in the short to medium term regardless of the angle. According to a recent study by PricewaterhouseCoopers, US-based industrial manufacturers are expecting an average negative revenue growth over the next 12 months. Demand is the overwhelming concern, as oil and energy prices have plunged and are therefore no longer a major drag on growth. But for cash-rich companies and investors, there are golden opportunities. This has been highlighted in the study, which reveals that the number of manufacturers planning M&A activity remained constant at 32 percent in the last quarter of 2008, compared with the previous quarter. An increase in cross-border transactions is also expected, as regional consolidation may be reaching its limits in a number of industries. Ultimately though, there is still hope, with many believing that the manufacturing sector will pick up in the next two years, returning M&A levels back to normal.
