Disruption is Afoot in the Auto Space (Short Syncreon)

Rod Lache, Managing Director of Wolfe Research and Institutional Investor’s #1 ranked auto analyst every year since 2012 puts it bluntly: “The automotive landscape will change dramatically over the next five or 10 years.” Recode’s Kara Swisher asks, will owning a car “[b]e as quaint as owning a horse” one day?

We’ve been talking about a coming wave of auto disruption and distress since our inception. Here we discussed the cascading effects of EVs (“Removing the engine and transmission destabilizes the car industry and its suppliers” h/t Benedict Evans); here, using the case of GST AutoLeather Inc., we declared, “Disruption, illustrated”; and here, in October 2017, we asked “Is Another Wave of Auto-Related Bankruptcy Around the Corner?” Ok, fine, “around the corner” is open to interpretation. ……

One company that garnered our attention provides services on both sides of the border: Auburn Hills-based Syncreon Group BV is a specialized contract logistics company focused specifically on tech and auto supply chains with locations scattered throughout the US and Canada, including Detroit and just over the border in Windsor. Major clients include FCAU, Ford Motor Company ($F), General Motors Inc. ($GM), Volkswagen Group ($VWAGY), and many others (e.g., Harley Davidson Inc. ($HOG), Audi AG ($AUDVF), BMW ($BMWYY), etc.). The company is at risk.

Exemplifying this risk are some recent events:

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🚗Where’s the Auto Distress? Part II (#MAGA!!)🚗

In “🚗Where's the Auto Distress?🚗,” we poked fun at ourselves and our earlier piece entitled “Is Another Wave of Auto-Related Bankruptcy Around the Corner?” because the answer to the latter has, for the most part, been “no.” But both pieces are worth revisiting. In the latter we wrote,

Production levels, generally, are projected to decline through 2021. Obviously, reduced production levels and idled plants portend poorly for a lot of players in the auto supply chain. 

And in the former we noted,

So, sure. Distressed activity thus far in 2018 has been light in the automotive space. But dark clouds are forming. Act accordingly.

And by dark clouds, we didn’t exactly mean this but:

With a seeming snap-of-the-finger, Harley Davidson ($HOG) announced that it would move some production out of the US to Europe, where HOG generates 16% of its sales, to avoid EU tariffs on imported product. Per the Economist:

It puts the cost of absorbing the EU’s tariffs up to the end of this year at $30m-45m. It has facilities in countries unaffected by European tariffs that can ramp up relatively quickly.

Trump was predictably nonplussed, saying “don’t get cute with us” and this:

AND this:

More from the Economist:

AMERICAN companies “will react and they will put pressure on the American administration to say, ‘Hey, hold on a minute. This is not good for the American economy.’” So said Cecilia Malmström, the European Union’s trade commissioner, on news that Harley-Davidson plans to move some production out of America to avoid tariffs imposed by the EU on motorcycles imported from America.

Will react? Harley Davidson has reacted. Likewise, motorcycle-maker Polaris Industries Inc. ($PII) indicated Friday that it, too, is considering moving production of some motorcycles to Poland from Iowa on account of the tariffs. Per the USAToday:

In its first quarter earnings released in April, Polaris projected around $15 million in additional costs in 2018. Rogers said the latest tariffs would raise costs further, declining to estimate by how much. "But we're definitely seeing an increase in costs," she said.

General Motors Co. ($GM) also weighed in. Per Reuters:

The largest U.S. automaker said in comments filed on Friday with the U.S. Commerce Department that overly broad tariffs could "lead to a smaller GM, a reduced presence at home and abroad for this iconic American company, and risk less — not more — U.S. jobs."

Zerohedge noted:

The Auto Alliance industry group seized on the figure, arguing that auto tariffs could increase the average car price by nearly $6,000, costing the American people an additional $45 billion in aggregate.

Moody’s weighed in as well:

US auto tariff would be broadly credit negative for global auto industry. Potential US tariffs on imported cars, parts are broadly credit negative for the auto industry. The Commerce Department is conducting a review of whether auto imports harm national security. A similar probe resulted in 25% tariffs on imported steel and 10% on aluminum being implemented 1 June. A 25% tariff on imported vehicles and parts would be negative for most every auto sector group – carmakers, parts suppliers, dealers, retailers and transportation companies.

Relating specifically to Ford Motor Company ($F) and GM, it continued further:

US automakers would be negatively affected. Tariffs would be a negative for both Ford and GM. The burden would be greater for GM because it depends more on imports from Mexico and Canada to support US operations – 30% of its US unit sales versus 20% of US sales for Ford. In addition, a significant portion of GM's high-margin trucks and SUVs are sourced from Mexico and Canada. In contrast, Ford's imports to the US are almost exclusively cars — a franchise it is winding down. Both manufacturers would need to absorb the cost of scaling back Mexican and Canadian production and moving some back to the US. They would also probably need to subsidize sales to offset the tariffs for a time, with higher costs eventually passed on to consumers.

On the supply side, Moody’s continued:

Tariffs would also hurt major auto-parts manufacturers. The largest parts suppliers match automakers' production and vehicles and may struggle to adapt following any tariffs. Suppliers' efforts to keep cost down often result in multiple cross-border trips for goods and could incur multiple tariff charges. Avoiding those costs may disrupt the supply chain. Some parts makers have US capacity they could restart at a price. Companies with broad product portfolios, large market share, or that are sole suppliers of key parts will fare better.

And what about dealers and parts retailers? More from Moody’s:

Significant negative for US auto dealers, little change for parts retailers. Dealers heavily weighted toward imports (most of those we rate) will suffer. Penske Auto and Lithia would fare best. Many brands viewed as imports, such as BMW and Toyota, are assembled in the US, so there could be model shifting. Tariffs would be fairly benign for part retailers insulated by demand from the 260 million vehicles now on the road.

Upshot: perhaps its too early to give up on our predictions. Thanks to President Trump’s trade policy, there may, indeed, be auto distress right around the corner as big players adjust their supply chain and manufacturing models. Revenue streams are about to be disrupted.

💩Will KKR Pay Toys R Us' Severance?💩

Optimism Remains in Toys R Us Situation

Surprisingly.

You’d think that every person on the planet would be sufficiently jaded by anything Toys R Us at this point. Apparently not everyone. And, oddly, the optimism seems to come from someone typically critical/skeptical of private equity…

Yesterday Axios’ Dan Primack’s lead piece asked, “Should the former private equity owners of Toys "R" Us pay around $70 million in severance to the company's 33,000 laid-off employees?” The question seems to stem from reports that limited partners (i.e., pension funds) are questioning what took place with the Toys investment. We noted this on Sunday:

🔥Elsewhere in private equity, maybe there’ll be backlash emanating out of Toys R Us?? The Minnesota State Board of Investment voted to halt investments in KKR pending a review of the bigbox toy retailer. 🔥

With this as background, Primack wrote:

This is not an academic question. It's become the subject of some public pension investment committee meetings, prompted by a lobbying campaign by left-leaning nonprofit advocacy groups, and has gotten the private equity industry's attention.

• The basic argument: Bain Capital, KKR and Vornado killed Toys "R" Us by saddling it with too much debt, while taking out fees along the way. It's only fair that they help folks who are without work because of private equity's mismanagement, particularly when PE firms are so rich and many of the employees were living paycheck-to-paycheck.

• The legal argument: There is none. The private equity firms no longer own Toys "R" Us, and a bankruptcy court judge threw out the severance package because employees weren't high enough in the creditor stack.

We’re old enough to remember when mass shootings got private equity’s attention too. They promised to divest. They didn’t. And then Vegas happened. And then Florida happened. And then Bank of America ($BAC) swore off lending to gun companies only to, uh, lend to Remington Outdoor Company.

We’re old enough to remember people like Warren Buffett say that they should pay more in taxes. That his secretary has a higher effective tax rate than he does. But, to our knowledge, he didn’t exactly voluntarily write a billion dollar check to the U.S. Treasury.

Likewise, neither will KKR write a severance check to employees. No frikken way in hell. Why? Because there is no compulsion to do so. The legal argument? He’s right, “[t]here is none.” So, yeah, good luck with that.

And so the above is really where the piece should stop. A nice little moral high ground piece about how employees and vendors got effed, it is what is, now on to tariffs, Petsmart’s asset stripping “mystery,” Harley Davidson’s ($HOG) war with President Trump or Moviepass owner Helios & Matheson’s ($HMNY) stock hitting a record low.

But Primack also points out,

Finally, the pro-severance folks are a bit liberal (no pun intended) with their math. They argue the PE firms took out $464 million, by adding up advisory fees ($185m), expenses ($8m), transaction fees ($128m) and interest on debt held by the sponsors ($143m). Yes, we were first to point out how the general partners may have gotten back more than they put in. But some of those fees were shared with LPs — including the now-aghast public pensions — while the interest was held in CLOs that had their own investors. In other words, PE "profit" was much smaller than claimed (although, on the flip side, you could argue the firms collected management fees on Toys-related capital that ended up being set on fire... again, it's complicated). (emphasis added)

Right. We’re sure the Minnesota State Board of Investment is cutting a check as we speak.

Sadly Primack didn’t stop there; he continued,

PE firms do have moral obligations to portfolio company employees. You break it, you own it (even if you technically broke it while owning it, which caused someone else to own it).

Um, ok, sure.

He continues,

Bottom line: The PE firms should pay at least some of the severance, or figure out some other form of compensation. And I have a sense that they might. Not because of preening public pension staffers or legal obligations, but because it's the right thing to do. Sometimes it's just that simple.

LOL. Riiiiiiight. In the absence of Mr. Primack having an inside track at KKR, it’s just that fantastic (def = “imaginative or fanciful; remote from reality.”).