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By Richard Hilgert

The automotive supply business is a cutthroat, no-holds-barred, highly capital-intensive, and sometimes labor-intensive, industry. So what, if anything, enables an automotive supply company to generate returns that exceed its cost of capital?

Generally, suppliers that consistently produce economic profits that translate into solid returns for investors have a substantial global manufacturing presence, have a well-diversified customer base, have highly integrated and long-term customer ties, enjoy steep customer-switching costs, and have moderate pricing power. Morningstar covered companies that exemplify some or all of these traits and have positive moat trends or that already rate as narrow-moat stocks include Autoliv (NYSE:ALV), BorgWarner (NYSE:BWA), Gentex (NASDAQ:GNTX), Johnson Controls (NYSE:JCI), and Tenneco (NYSE:TEN).

Global Presence

Automotive original-equipment manufacturers, or OEMs, want vendors that can supply their requirements globally. To reduce cost, the underlying structure of a particular vehicle sold in the United States may be the same as another vehicle that might be sold in Europe, South America, or Asia. Also, some countries have local content laws that require a certain percentage of components be sourced from within that country. Winning a contract to supply a major component or system for a global vehicle program requires a supplier with a substantial global manufacturing presence. Developing a sizable manufacturing footprint requires an enormous capital investment, which provides a substantial barrier to entry for potential competitors, particularly given auto suppliers' uncertain prospects of economic profit.

Customer Diversity

Not all OEMs are created equal. Barring a global economic meltdown, suppliers that have a diversified customer base have a better probability of more consistent revenue streams than companies that rely heavily on any one manufacturer. A diversified customer base enables suppliers to reap the benefit of differences in the level of demand in varying global regions. Additionally, customer diversity reduces the risk to the supplier that any one particular vehicle program may turn out to be a dog by increasing the chances for supplying a bona fide, home run model.

Japanese OEMs had been most preferred by suppliers because of their long-term approach to doing business with vendors and their willingness to share profitability. However, the Japanese manufacturers are extremely slow to initiate a new vendor relationship. OEMs in developing markets are also attractive due to the growth prospects of the respective regions. Domestic OEMs setup operations in developing markets and, due to local content laws plus the desire to do business with already trusted suppliers, request that domestic suppliers set up shop with them. One of the reasons suppliers willingly agreed was the potential for business with other OEMs in developing markets, especially China.

Up until the bankruptcies of General Motors (NYSE:GM) and Chrysler, the domestic OEMs were notorious for poor relations, regularly hitting suppliers over the head with a price reduction hammer. Annual contractual price reductions are the industry norm as OEMs expect suppliers to implement lean manufacturing practices to incessantly extract costs through continuous process improvement. Given their own financial problems, domestic OEMs relentlessly pursued supplier price reductions to the point of nearly destroying their own supply base. Having substantially restructured in 2009, relations between domestic OEMs and suppliers have improved, but the jury is still out as to whether U.S. automakers have permanently changed the way they do business. The true test will come once demand in the U.S. and Europe fully recovers to pre-crisis levels and the OEMs once again feel pressured to use incentives to maintain or even grab market share.

Highly Integrated, Long-Term Customer Relationships

Close ties with OEM customers are critical to success in the automotive industry supply base and create another significant barrier to entry. New vehicle lead times can be up to 36 months in duration. For complex, integral vehicle systems, engineers are involved early in the new vehicle development process. For example, an exhaust system plays a key role not only in vehicle emission reduction, which is legislated, but also in engine development and even the end user's perception of the vehicle. The exhaust system must be engineered in such a way that minimizes back pressure and maximizes airflow for optimum fuel efficiency and engine performance. Exhaust systems are also acoustically tuned with the engine to generate the "right" kind of sound that the OEM wants its customers to hear while driving the vehicle. Limited engine and exhaust noise from a Chevrolet Camaro SS, a Ford Mustang Cobra, or a Dodge Challenger SRT8 would be inconsistent with these vehicles' personalities and the target customer base.

Once launched, most vehicle programs have a 5-10 year life cycle (the current Chevrolet Impala has had the same underpinnings since 1995, and the Ford Ranger small pickup had the same underpinnings for nearly 20 years), assuring some suppliers long-term contractual streams of revenue, albeit subject to volume changes dependent on consumer demand. When a vehicle nameplate has a complete redesign and a particular supplier that provided a specific component or system was on the predecessor program, that company typically becomes the incumbent supplier for the redesigned, successor vehicle program. In total, suppliers generally have a 6-13 year tie-up with each customer's vehicle program.

Prohibitive Switching Costs for Customers

The customers of certain suppliers would incur prohibitively high switching costs should they decide to withdraw business in the middle of a vehicle program, especially when a supply agreement is in place for a complex, highly engineered, critical vehicular system. Costs for switching to another supplier would include the substantial lead time and investment to develop and validate a new system, the potential for production disruptions during transition, as well as the cost of moving large, expensive heavy equipment and tooling. The whole process of changing a critical supplier might cost an OEM as little as a few million dollars to as much as $1 billion, depending on the size and scope of the components or systems being replaced.

A Stream of Competitive Advantages from Innovation

Consistent product and/or process technology innovation enables more favorable pricing relative to many automotive industry suppliers overall. Suppliers cannot simply cost-cut their way to prosperity and must support measures to grow the top line. Even so, a single innovation in a highly competitive industry represents a temporary advantage at best, by no means creating an economic moat, as competition can quickly adapt to or even outright copy the technology. However, the frequent, consistent development of innovative products and processes enables a pipeline filled with individual competitive advantages, generating a steady stream of economic profits, potentially flowing into a narrow economic moat. Automakers are willing to pay for components and systems that provide substantial product differentiation, weight reduction, enhanced safety, reduced cost, and/or provide a unique cost effective solution to meeting any regulatory requirements.

Automotive Suppliers Can Consistently Generate Economic Profits

In conclusion, and contrary to popular belief, some automotive suppliers possess the ability to generate returns on invested capital that are in excess of their weighted average cost of capital, creating potentially attractive opportunities for investors. Substantial barriers to entry exist due to sizable investment, already established global manufacturing presence, and very close, longstanding customer relationships. Suppliers that have invested heavily in developing their global presence are in a competitively better position if they are able to substantially diversify their customer base. Customers' switching costs can be prohibitively high, in combination with the integral nature of the supplier/customer relationship, making the market shares of some suppliers very sticky. Lean manufacturing practices and technological innovation are the mere price of entry into the automotive supplier industry. However, there are only a few that have engrained lean manufacturing into their culture and even fewer that successfully generate product and/or process innovations that translate into a consistent stream of competitive advantages.

Companies we cover that possess these traits and that have positive moat trends or are already rated as narrow-moat stocks include Autoliv, BorgWarner, Gentex, Johnson Controls, and Tenneco. Since early December 2010, valuations for the entire auto parts sector have risen substantially, and we believe the stocks on our coverage list are fairly valued. However, sector valuations have been driven by overly optimistic Wall Street forecasts for U.S. light-vehicle demand. As the year wears on and volumes disappoint the Street, we think these stocks will correct, providing investors with an opportunity to buy at more attractive valuations later this fall.

Source: What Drives Auto Supplier Stocks?