In this "Jnet" series, we introduce current topics in the field of corporate M&A, revitalization and restructuring that are relevant to Japanese companies operating in the United States. In this issue, we explore the implications of increased M&A activity in the automotive industry.
While the last several years have been challenging for many industries, the automotive industry was particularly hard hit. In 2009, General Motors Co. (GM), Chrysler Group LLC (Chrysler), and 27 major automotive suppliers filed for bankruptcy court protection. Last year, U.S. automotive sales reached a 30-year low. This year, the automotive industry looks surprisingly different. Benefitting from a rebounding economy, U.S. auto sales jumped 20 percent in April. Chrysler, Ford Motor Co. (Ford), and Toyota Motor Company all reported increases of about 25 percent, and GM saw a 20 percent increase in the brands it will retain. In April, GM repaid $6.7 billion to the federal government, ahead of schedule, and in May the company announced its first quarterly profit in three years. Certain foreign automotive companies are also seeing increasing profitability. Volkswagen AG (Volkswagen), Europe’s largest automaker, said first-quarter profits almost doubled from a year ago.
In addition to improving local economies, the car makers are also benefitting from robust sales in emerging markets, especially China. Last year, China’s auto sales increased by 50 percent and overtook the United States to become the world’s largest auto consumer. China also overtook Germany as Volkswagen’s largest market.
The economic slump meant that automotive companies focused on radically slashing costs in every way possible, including layoffs, factory closings, asset dispositions, and even seeking bankruptcy court protection. However, now that the market appears to be improving, numerous automotive companies have stated that they are beginning to consider acquisitions. For example, GM was at one point this spring contemplating buying back its old financing arm, GMAC LLC, according to The Wall Street Journal. Johnson Controls, the automotive and building systems company, said it is looking at potential acquisitions across all of its business lines in a January earnings call.
A few deals have been recently announced. In April, the U.S.-based turbocharger maker, Borg Warner Inc., acquired Dytech ENSA SL, a Spanish manufacturer of exhaust re-circulation coolers that help reduce emissions in diesel and gasoline-direct injection engines. Also in April, Germany’s Daimler AG entered into a partnership with Renault and Nissan Motor Company to develop a new generation of small cars, share engines, and cooperate in small commercial vans. According to a press release, the deal was motivated by a desire to cut the R&D costs required to develop new technologies to make more environmentally friendly vehicles.
In some cases, continued government ownership or residual restructuring issues may complicate M&A. However, as revenues improve, it is likely that acquisitions will also increase. Corporate and private equity (PE) funds that are pursuing deals should be aware that because of the distressed nature of the industry, added due diligence may be required. As it enters what is hoped to be a recovery phase, participants in the automotive industry still must be careful in order to avoid unprofitable deals and unhealthy debt levels.
Although it appears that the industry has recovered from its lowest point, it is still unclear what a normalized market will look like for the U.S. or the international market. Based on sales totals through April, United States volume could reach 11.5 million this year, compared to last year’s sales of 10.4 million vehicles. However, that number is far below the 17 million in volume recorded in 2005. Acquirers must develop robust forecasting models that consider general economic trends, including unemployment rates, gas prices, and increasing interest rates. They should also consider how potential profitability may be affected by price incentives and a shift towards smaller, less-profitable cars. The automotive industry is still in flux, and buyers will require a comprehensive understanding of many factors to create more accurate projections.
Technology in the automotive industry will likely evolve rapidly in the next five years in response to government regulation and consumer concerns about both the environment and gas prices. Therefore, acquirers should carefully examine the state of the technology of their targets and include future R&D costs in their valuation models. In addition, many distressed automotive companies slashed R&D investments in the last two years. Acquirers should examine whether a target was able to maintain sufficient investment in the key parts of its business to retain its critical advantage. Similarly, some targets may have also limited their capital costs and as the business cycle improves, buyers may need to spend a larger than anticipated amount to maintain or upgrade equipment and facilities.
The cost structures of companies that have emerged from bankruptcy or that have recently undergone major financial or operational restructurings may be misleading. Instead of focusing on what the company currently looks like, the acquirer needs to know what will be needed to achieve its proposed financial performance. For example, a company that has recently emerged from bankruptcy may appear to have several advantages, such as largely forgiven debt or lower employee costs. However, it is not clear how long into the future those advantages may last. As the industry improves, unions representing the automotive industry may be able to negotiate for significantly higher wages and benefits or additional employees may be added. Companies that received discounted government funding or had their loans forgiven must be able to function in a more “normal” financial setting. Buyers should examine what costs may look like at least five years into the future and anticipate the possibility that current cost structures are likely to increase or at least change.
Corporate or PE funds that are looking at targets that have recently emerged from bankruptcy face additional due diligence challenges. They should have some understanding of the bankruptcy process and be aware that the forecasts developed as part of the plan of reorganization may be overly optimistic, potentially driven more by recoveries to stakeholders than to economic realities. Baselining these projections against historical financials is often challenging as well since the company may have changed dramatically during the bankruptcy process by shedding assets and revamping its cost or capital structure. In addition, the financials maintained during the bankruptcy process must conform to Bankruptcy Court rules, but do not usually meet GAAP requirements. In other words, recently available financial information may not give the quality and type of information needed to provide comfort concerning recent financial performance. Lastly, acquirers should be aware of the nuances of fresh start accounting.
Human resources issues always need to be considered, since a target’s team of professionals and their intellectual capital may be a large component of that company’s value. Consequently, acquisitions involving distressed, restructured, or companies that have emerged from bankruptcy should include added scrutiny around human resources. Acquirers should be aware that many of a target’s most valuable employees and executives may have previously left the company. In addition, some who stayed through a restructuring or bankruptcy may have done so as the result of a retention package. If they choose to leave once their package expires, a potential acquirer may be left with the shell of the business they thought they were buying.
It appears that the automotive industry is quickly showing signs of improved performance. Automotive sales are increasing both in the United States and globally. It is likely that this improving environment will create an increase in M&A activity. An environment where costs have been radically cut and many companies have undertaken significant restructurings should provide attractive investment opportunities for both corporate and PE funds. However, the distressed nature of many of these targets raises numerous commercial due diligence issues that should be carefully analyzed. Doing so will help to make valuation models more accurate and deals more successful.
This text was reprinted, with permission, from "M&A Spotlight: Increased Automotive Mergers Require Tailored Due Diligence".
For more information regarding this article or KPMG's services in the area of mergers and acquisitions, please contact a member of your KPMG engagement team or Tomoya Miyahara at firstname.lastname@example.org or 212-954-6351.