While the U.S. economy overall is strong, there are risks that will likely affect the automotive supply chain in the coming year. These include tariffs on products such as steel and aluminum, and continuing trade disputes with China.
In addition to the upheaval in global markets, the shift in the automotive industry away from passenger cars and toward trucks and sport utility vehicles has caused automakers to realign their product offerings, lay off workers, and end the production of a number of car models.
For suppliers who have been dependent on contracts to provide parts for these vehicles, this realignment could be very problematic—and if those suppliers are in your supply chain, their trouble could cause ripple effects for your business.
Global Trade Uncertainties
The Trump administration’s trade policies are having a significant impact on the automotive industry, as well as other manufacturing industries. Commodity costs are rising due to the increased tariffs and the retaliatory tariffs other countries have imposed. Ford and General Motors have each reported that they expect steel and aluminum costs are likely to be $1 billion higher in 2019 than they were in 2018. Suppliers’ profitability will likely suffer from these increasing commodity costs. Smaller suppliers using fixed price-contracts are already dealing with pressure from higher raw materials costs and an inability to pass those costs onto consumers.
There is little doubt that these higher tariffs are already causing stress in the industry. Some manufacturers were able to obtain relief from the tariffs on certain items; however, the deadline to apply for such exemptions has now passed, and the government has only approved about 10% of the requests that were submitted.
But perhaps even more alarming is the uncertainty of what the future holds. For example, the United States and China recently agreed to a 90-day “cease fire” in the escalating trade war, which will (at the time of this writing) end on March 1. At this time, no one can know whether the negotiations will be successful, or what would be deemed a success by both countries. Suppliers are in a difficult position because they may be subject to new tariffs or other restrictions on their products with little notice, and almost no ability to anticipate and prepare for these changes before they occur.
Reduced Volumes and Changes in Consumer Taste
In addition to trade uncertainty, there has been a significant shift in customer demand for vehicles in the United States. In the past few years, the demand for passenger cars has decreased and the demand for SUVs and light trucks has increased. However, the increase in demand for SUV and truck products is unlikely to offset the reduced car demand, leading to lower volumes overall.
Manufacturers are already responding by changing their product lines and eliminating some car models altogether. Recently, GM announced that it would stop production of several passenger cars, idling five plants in North America and implementing layoffs of more than 10% of its workforce. In early February, GM laid off 1,300 salaried workers at its Warren Technical Center in Michigan. Ford has also announced that the only passenger car it will make in the future will be the Mustang.
The dramatic reduction in passenger cars and softening volume may push some suppliers into distress. According to Laura Marcero, the industrial practice leader at Huron Consulting Group, suppliers are likely to see lower volumes in the next 18 months due to these changes. These changes in demand will affect suppliers who focus on products for passenger cars. They will also impact those who have already been experiencing some financial difficulty. This is likely to exacerbate the effect of increasing commodity costs and trade woes facing suppliers and the industry as a whole.
Identifying and Protecting Against Troubled Suppliers
These market conditions are likely to cause some suppliers to have difficulty fulfilling orders, and they may seek price increases from their customers, including other, higher-tier suppliers in the supply chain. In addition, the shift from passenger cars may cause individual suppliers who are dependent on those products or who are operating on thin margins to falter.
A troubled supplier can cause significant harm to the upstream suppliers and ultimate customers. Customers should routinely evaluate the companies in their supply chain for warning signs of distress:
- Requested price increases, accelerated payment terms, or customer financing support, or use of factoring (a company selling its accounts receivable at a discount to raise cash)
- Late deliveries or changes in product quality
- Requests for technical or other support from customers
- Delayed collection of accounts receivable and delayed payments of accounts payable
- Employment of consultants, including restructuring consultants, and financial advisors
- Deteriorating market position, including lawsuits or warranty demands
- Delayed or restated audited financial statements
- Removal and replacement of key management roles
- Changes in debt structure, such as new loans, extensions, and modifications of existing loans.
Action Plans for Customers of Troubled Suppliers
Understanding your options is key to resolving these issues in the most advantageous manner. Customers should routinely analyze their contracts to maximize their position in dealing with potentially troubled suppliers. A customer’s existing contracts with a given supplier have a substantial effect on the customer’s rights and remedies, both pre-bankruptcy and post-bankruptcy. For example, terms of the contracts govern critical issues such as:
- Ability to terminate the contracts
- Supplier’s stop shipment rights
- Customer’s re-sourcing rights
Ability to demand adequate assurance of future performance pursuant to section 2-609 of the Uniform Commercial Code or consider the contracts repudiated by the supplier
- Bankruptcy considerations, including assumption and rejection rights
- Recovery of tooling
- Lien and setoff rights
To preserve supply, manufacturers also may participate in pre-bankruptcy workouts. These transactions often include multi-party agreements among the troubled supplier, its most significant customers, and its secured lenders to solidify the commitments of each party to keep the supplier operating while the workout progresses. These agreements commonly include access and accommodation agreements, and subordinated participation agreements.
An access agreement permits the customer, under certain circumstances threatening production and only as a last resort, to access the supplier’s plant to produce parts using the supplier’s own equipment and employees, pending transfer of the contract or facility to a healthier supplier.
Through an accommodation agreement, the customers may provide accommodations that protect the lenders’ collateral base through protections on inventory and receivables, commitments to continue sourcing parts to the troubled supplier and limitations on setoffs, (or demands in bankruptcy settlements). In return, the lender agrees to provide working capital financing and not to foreclose or otherwise impact the supplier’s business.
Faced with unknown foreign trade risks, increasing commodity costs, and the realignment of vehicle lines to account for shifting consumer demand, all suppliers and customers need to be aware of any potential disruption in the supply chain. By actively monitoring vendors and taking the proactive steps outlined above, automotive suppliers can protect the supply of critical parts and continue to fulfill their contracts with their own customers.
Ann Marie Uetz and John A. Simon are partners with Foley & Lardner LLP. Tamara N. Dolcourt is a bankruptcy and restructuring attorney with the firm.
