Sunday, December 19, 2004

The Rebuilder's Dilemma

This past week I’ve been pulled away by some personal issues. But these are issues that have political and economic dimensions. I am an owner in a small manufacturing operation in the automotive parts rebuilding aftermarket. The industry we are in has experienced, over the past decade or so, a dramatic and often painful restructuring and contraction. Tough decisions have needed to be made over the past ten years and over the past week. I do not intend to discuss too much the specifics of my own situation. But this is a story of the fate of smaller US manufacturers in the face of globalization and consolidation.

The need to repair parts for autos is as old as autos themselves. In the forties, this coalesced into an industry, with its own distribution system and supply chain. The idea of parts rebuilding is simple. When a part fails, it usually is only one component of that part that has failed. Repairing or replacing that component, along with other components prone to wear or early failure, produces a rebuilt part that functions like new, but for less cost. The parts rebuilding industry is a recycling industry. And, over the years, untold tons of steel, copper, aluminum and other metals have been saved from being scrapped; while unrebuildable components have met exactly that fate, being sorted and sent to scrapyards for recycling by other means. There is a significant problem in the US as how to handle the waste produced by complete cars that are no longer practical to repair. But our landfills are not clogged with used and discarded transmissions, engines, starters and alternators.

Early signs of trouble for automotive parts rebuilders began to surface in the late 80s. A handful of businesses, including some larger operations, began to go under. But business was still relatively good for most companies and it was easy to view the cause of failure in these cases as specific to the individual companies. By the mid 90s, however, industry-wide changes began to be harder to deny. The Automotive Parts Rebuilder Association (APRA), the industry’s leading trade organization, commissioned a private study of these changes. For reasons of institutional interest, the APRA never released the results to their members, though inevitably copies leaked out. The study was, in retrospect, fairly prescient. It saw fundamental shifts in the distribution chain and was relatively pessimistic about the possibility of returning to the way things had been for decades.

Businesses, large and small, began to fail. The remaining businesses began to suffer from declining margins and increased competition over the remaining orders. After a large enterprise shut it doors, there would widespread expectation that the remaining players would be able to split up the orders that that company had remaining. Yet these expectations were always dashed. The industry wasn’t just contracting, it was vanishing. Payment problems began to become endemic, and companies that once could reliably pay their vendors in 30 days now struggle to meet commitments to pay at 120 days.

In an effort to stay afloat, desperate companies tried various strategies. Once sacrosanct supply chain rules fell by the wayside and companies, at first surreptitiously and then openly, began to pursue their customers’ customers. Cutting overheads could only go so far. The industry demands people with a fairly specific skill set and reducing wages, in the US, was not a viable option for the most part. Some firms sought to expand their way out of the problem and take advantage of economies of scale. This has proved to be a largely unsuccessful strategy. It involved fairly significant financing, often using receivables as collateral. As sales continued to decline, firms were unable to replace paid or out-of-formula receivables with new ones and started to starve for cash flow. Perhaps most portentous, some firms began to explore or expand foreign operations, notably in Mexico, and importation from overseas producers, notably from China.

Today, the rebuilding industry is a shadow of its former self. There are many fewer companies. And few of these are healthy. In the sub-industry I am in, one firm has emerged as a kind of Walmart equivalent. (We’ll call it Company X. They like to sue people, so I’d rather not name it.) It has gobbled up or put under most its competitors. It has created alliances with OE manufacturers to become the sole distributor of certain types of product. It imports large amounts of goods from China, India and other countries, offering 100% new parts for less than or near to the cost of US made rebuilt. Recently the next largest competitor has closed it doors. Company X bought the assets, though not the liabilities, of its competitor in a lengthy negotiation with the primary secured creditor. And now, finally, many people in this generally conservative industry are waking up to the fact that, when it comes to certain products, they no longer have a choice of supplier. They resent it. But it’s largely too late.

The root causes of this contraction are rather complicated. A lot of the generalizing rhetoric of the critics of globalization and industry consolidation seem too simple when you’re on the inside of the problem. Increased reliability of automobiles and their components – a good thing for most people – is a significant factor. Parts simply don’t fail like they used to. And people have been less likely to keep vehicles past the warranty period.

The automotive aftermarket depends on either do-it-yourselfers or independent repair shops as the ultimate consumers. So part of the problem too has been the increased complexity of automobiles and the corresponding decrease in the DIY market. Automotive parts retailers have seen their revenue base shift to accessories – the things people buy for their cars but don’t really need. Tires and brakes are last two remaining really healthy bits of the automotive aftermarket – but there are safety issues involved here and people are less likely to wait for actual failure before replacing these. Additionally, the publicly traded auto parts retailers have, in an effort to boost stock prices, sought increasingly inventive ways to squeeze their suppliers for profit. One common practice is to only accept suppliers who are willing to put product in on consignment, that is the retailer doesn’t create a payable to the vendor until point of sale to the consumer, and then insist on 120 day terms. It takes a sizable investment for a manufacturer to ramp up to supply a major retailer. Walking away due to these sorts of terms can mean financial collapse.

Related to these trends is the entry of the OE manufacturers – Ford, Delco-Remy – into the rebuilding market. Within the last decade Ford deauthorized its network of Ford Authorized Rebuilders and went into the market big-time with its Visteon division. The Delco-Remy story (now split between Delco and Remy Intl) is too complicated to discuss here. Let it suffice to say that the entry into the rebuilding industry of the OE’s is a large part of the industry consolidation. And, needless to say, no move by any large manufacturer, no merger or acquisition within the automotive aftermarket has caused even the slightest hint of anti-trust problems. In a world in which Time Warner and AOL can merge, the automotive aftermarket is small potatoes.

In a closely interrelated industry where bankruptcies are increasingly common, bankruptcy law which greatly favors secured creditors (banks) over unsecured trade creditors has been a factor, particularly for mid to small sized businesses. Following a bankruptcy, many a trade creditor has been strong-armed into paying to the secured creditor everything it collected from the bankrupt firm in the 90 days prior to the bankruptcy or face an expensive court battle to prove that it hadn’t received preferential treatment. The current rules put the burden of proof on the unsecured creditor.

Yet, co-equal to all of the above, has been the increased importation of goods, particularly from China. In truth, as with the Walmart phenomenon, part of this problem is self-inflicted. A friend of mine who is a US component remanufacturer tells me the story of an open forum of rebuilders he attended a few years back. At one point he stood up and asked the attendees if they would be willing to pay a bit more for US reman over Chinese new. About 90% of the hands went up. Yet at that moment of purchase decision, considerations, such as where did this come from, what are the longer-term ramifications for the sum total of these purchase decisions for my industry, fall away. Maybe it’s because these decisions happen in isolation. One Chinese component isn’t going to destroy the whole automotive aftermarket. Maybe it’s because those colorful flyers with all the low, low prices don’t have the words “Made in China” or “Made in India” printed all over the place. So people are not really confronted with the choice. Maybe it’s because, well, it’s cheaper.

It’s a version of the Prisoner’s Dilemma. We’d all be better off if we supported one another. But each fearing that the other one won’t, we chose our own selfish interests and, in doing so, diminish our own well being.

But this is not the whole story. The success of this industry has depended in large part on the fact that, until quite recently, the rebuilt parts were substantially cheaper than their 100% new counterparts. This is less true today, largely due to Chinese imports.

Even so, there are costs associated with importing goods from China. Lead times tend to be lengthy, relative to domestic production, so the importing firm needs to take something of gamble on the future demand for the product. Most Chinese firms still demand payment by letter of credit executable upon presentation of an ocean bill of lading – that is to say once the goods hit the water. So there are finance costs. Other costs such as customs clearing and duties need to be paid up front. Ocean freight is still the only viable means of shipment. This adds to lead times, but it also means that it is only practical to buy product in container loads, and ocean freight costs are still largely the responsibility of the importer. Importation is out of the question for smaller firms. Mid size firms that do not specialize in importation have often floundered on the rocks of one of these issues. It falls to specialized importers and large companies (like our Company X) to really make a go at this, further decreasing the competitiveness within the industry.

Quality has been an issue too. There is no good means of dealing with defective product. Small quantities of defective goods wind up being “eaten” by someone in the US supply chain. It isn’t so easy to return the stuff, especially if it’s been prepaid. And quality from Chinese manufacturers has been spotty, though steadily improving, an improvement that has come partly through the cooperation of US firms providing the Chinese firms with the technical know-how.

Massive subsidization of the Chinese automotive parts industry by the Chinese government has helped them to leapfrog their US counterparts in acquiring equipment and QS and ISO certifications.

Yet for all of this, within the remaining US market, the Chinese goods are not that much cheaper. The change in one single variable would dramatically change the fortunes of the US manufacturers. The hard peg of Chinese currency to the US dollar, which causes the cost of the Chinese product to drop for the US (and world) market even as the dollar drops, ensures that prices of Chinese goods will steadily undercut their US counterparts, owing to the huge advantage in labor costs in China. Experts disagree as where the value of the yuan would be if set by the market. But the consensus it that it is undervalued by approximately 40 per cent. This effectively reduces the cost of Chinese goods by forty per cent in the US market. Speaking, for the moment, solely for the US automotive parts aftermarket, an increase of 40% in the cost of Chinese goods would price them out of the market.

This hard peg comes at a cost to the people of China too, whose buying power, and thereby the value of their labor, is undervalued.

Powerful interests stand to gain from this arrangement. Companies far larger than Company X, for example Walmart, would be in deep trouble if the Chinese currency was set by the market.

Even if it were so inclined, the US government is in no position to pressure the Chinese government to allow its currency to be set by the market. While Japan remains, far and away, the number one foreign holder of US debt, China has bought 175 billion in US debt as of the end of October 2004.

And so the little company I am a part of and another one have decided to merge. And between us, we will offer product with a significant amount of Chinese components. There really is no other viable option at this point.

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