Disclaimer: The views expressed here are mine and may change without notice. Past performance is not indicative of future results. All investments carry risk, including financial loss. This analysis is for educational purposes only and does not constitute investment advice or recommendations of any kind. Conduct your own research and seek professional advice before investing. Please see important disclaimers here and here.
Often macroeconomic factors such as low car demand are quoted as reasons for auto parts suppliers' bankruptcies. However, it is ironic to observe suppliers go bankrupt when car companies and dealerships are making record profits. What led to this outcome? Let's look into the potential reasons.
The primary reason is bad economics. Typically, parts suppliers have long-term fixed-price contracts with car companies. On the other hand, supplier expenses are subject to increases every year because of heavy labor and material components. In effect, your costs are increasing but revenue is fixed, resulting in profit margin compression. Things get worse during an inflationary period similar to the current one we are living in.
Second, the industry structure puts parts suppliers in a precarious position. Their customers (Car companies) are consolidated while the parts suppliers are a highly fragmented industry. This gives car companies an upper hand in negotiating better economics for them. Car companies seem to ask for price cuts regularly, putting pressure on supplier revenues. This dynamic has played in various parts supplier bankruptcies such as APC and Car component technologies.
Third, heavy debt load. Typically, car companies promise high volume for suppliers in return for better terms for themselves. This likely leads to suppliers borrowing to purchase equipment and material to support the extra volume. Consequently, suppliers' interest expense load increases.
In effect, you have a business with a compressed margin and a deteriorating balance sheet. Thus, we see auto part suppliers going bankrupt (declining employment) whenever the car industry goes under a bit of stress such as in the 2008 financial crisis and the 2020 covid induced economic crisis.
As I mentioned in an earlier post, for business success, taking care of your suppliers is one of the legs. Car is an important industry in the economy. Every party in the value chain needs to be in a reasonably strong financial condition for a healthy ecosystem. While easing production volume can temporarily help, only with good economics can auto parts suppliers have a sustainable business. Here are important lessons for investors. When evaluating the strength of the business model, be sure to understand the economics of the company and the industry structure in which it operates.
