Suppliers face more cost pressure as industry shifts to EVs, self-driving cars

Europe’s largest automotive suppliers are likely to see a stable market in 2019, but many are looking farther ahead to prepare for a vastly more complicated future. Taken together, those two considerations are likely to complicate their profit picture, analysts said.

Most market watchers are predicting that auto sales in Europe will be flat this year, although SUVs and crossovers -- which typically contain higher margin content from suppliers -- will continue to gain market share.

However, a continuation of slower growth following a post-recession peak in 2017 will make it harder for automakers to meet profit targets, and that pressure, in turn, could be passed down the supply chain. At the same time, automakers are spending billions to shift to making electrified and self-driving cars.

“With automakers facing slower growth, regulatory demands to fit fuel efficient/EV technology and other pressures on margins, we believe they will need to find offsets,” Max Warburton of Bernstein wrote in a note to investors in December. “A likely reaction is to start scrutinizing purchasing costs more closely.”

Noting that purchasing makes up about 60 percent of automakers’ costs, “the focus quickly turns to outside suppliers,” Warburton said. “We are now seeing the early signs of automakers targeting big headline savings.”

Other issues weighing on suppliers’ minds in 2019 will be the threat of additional tariffs on cars exported to the U.S., Britain’s exit from the European Union and the lingering effects of production disruptions from the new Worldwide harmonized Light vehicle Test Procedure (WLTP). Moody’s, in a November note, said the outlook for European suppliers in 2019 was “stable,” adding that revenue growth could exceed projections for auto sales growth -- a forecast that takes into account “increasing uncertainties, especially in Europe and China, with opportunities to further increase content per vehicle, even in a more difficult industry environment.”

One of the biggest trends in recent years has been suppliers selling off or spinning off divisions seen as less vital to midterm or long-term strategic plans. That has led to the creation of new players such as Veoneer (Autoliv’s former electronics division), Delphi Technologies (Delphi Automotive’s former powertrain division) and Adient (Johnson Controls’ former seating division). More such moves will happen in 2019, including perhaps the largest of them all, as Continental prepares to spin off its powertrain division, with an IPO possible in the first half of the year. “We are going to see more companies splitting or divesting divisions to focus capital,” said Neal Ganguli of Deloitte. “Capital is scarce and you can’t invest everywhere.”

It will also mean that more suppliers will enter into alliances or ecosystems with automakers, other suppliers and even players from outside the industry, especially in highly technical areas such as autonomous driving. “For example, in a cooperation between a supplier, an automaker and a semiconductor company, there is a benefit because you will have much better vertical integration,” said Andreas Tschiesner of McKinsey. Such collaborations will mean the appearance of more and more “Tier 0.5” suppliers, who are integrating products from other suppliers, a job that was once the domain of automakers, he said.

One trade uncertainty -- the status of NAFTA -- was resolved in 2018, but two significant worries remain: 1) the possibility of higher tariffs on vehicles exported to the U.S. from Europe, and 2) the effect of Brexit. Tariffs imposed by President Donald Trump on steel and aluminum have already had an effect on the global supply chain, but the president's threat to impose tariffs of up to 25 percent on imported cars would be felt even more sharply in Europe, where Germany’s premium automakers are the largest exporters to the U.S. Holger Engelmann, the chairman of Webasto, told Automotive News Europe that an escalated trade war between Europe and the U.S. would "have a negative impact on the whole economy," adding that it would put the auto industry's gains since the 2008-09 recession at risk.

Similarly, if a "hard Brexit" or "no-deal Brexit" is the reality, then European suppliers might face duties on parts shipped to or from the UK. Schaeffler has already cited Brexit as one of the reasons it is closing two small factories in Britain. "We don’t know yet if it will be a hard landing or a soft landing. That that will influence the forecast for the European market," Valeo CEO Jacques Aschenbroich said. "The European market so far, except for WLTP issues, is on a positive trend. Now, will that trend be broken by political decisions? I hope not."

A Sept. 1 deadline to certify all car models and variants under the WLTP tests left some automakers flat-footed, as they scrambled to adjust powertrains to meet emissions standards under the test, which more closely mimic real-world conditions than the previous regime, the NEDC.

Production of uncertified models was halted, especially at Volkswagen Group, Europe’s largest automaker. Analysts expect the disruptions to continue through the first quarter of 2019.

Valeo issued two profit warnings in 2018, citing the WLTP as a reason. But some suppliers say the worst is over.

“A lot of our customers have turned the corner with regard to getting production back up,” said Ray Scott, the CEO of seating and electrical supplier Lear, which does about 40 percent of its business in Europe. “I see Europe turning around in the early part of the first quarter.”

Like automakers, suppliers are trying to juggle current profit goals with the need to spend heavily to develop future technologies through research and development or acquisitions. ZF, for example, has just announced a 3 billion euro investment in its transmissions operations -- the heart of its business -- to prepare for electrification. Continental cut sales and profit guidance last August, citing higher costs for developing hybrid and electric car technologies, among other reasons. Schaeffler has issued similar statements, noting the cost of prototyping many more components.

“There was a strong underestimation of the production methods needed to produce hybrid electric vehicles and 48-volt systems,” Continental Chief Financial Officer Wolfgang Schaefer said. ZF CEO Wolf-Henning Scheider said his company could not afford to skimp on r&d, even as spending increases on it outpaced expected sales growth. “The increase comes across the business sectors,” he said. “We have to be prepared for all the things that the transformation of our industry will bring us.”