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INVESTING
June 24, 2022

Auto Industry Thoughts—Dusting Off the Recession Playbook

By Mike Borowske

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Historical Overview

The automotive industry has been, historically, a large source of defaults and restructurings, particularly during recessionary periods. This is due to the industry’s high degree of embedded cyclicality, volatile margins, significant debt burden, sizable contingent liabilities, and labor-relation challenges. During the global financial crisis (GFC) of 2008-2009, several Original Equipment Manufacturers (OEMs) and a large number of Suppliers successfully restructured their balance sheets, legacy obligations, and fixed-cost structures to improve their durability across a wide variety of macroeconomic environments. In the five to seven years following the GFC, the sector experienced an impressive run of improving sales and production volumes, which resulted in record profitability, solid free cash flow generation, and more sustainable capital structures.

The industry was again put to the test during the COVID-19 pandemic beginning in 2020, as automotive executives were forced to revisit their recession playbooks. They needed to shore up their respective liquidity profiles and adapt to a number of headwinds, including: (1) A wide-ranging shortage of semiconductor chips; (2) Dramatically higher raw material input costs; (3) Significant just-in-time supply-chain difficulties; and (4) A prodigious advancement in the adoption rate of electric vehicles (EVs).

Current Industry Landscape

As we look out to the second half of FYE 2022 and into FYE 2023, Western Asset believes investors in the high-grade and high-yield automotive space should be prepared to address a mix of cyclical, secular, and technical risks. With this in mind, our industry framework has identified a list of key considerations we believe will be drivers of future performance.

    Industry Negatives
  • Production challenges related to the ongoing semiconductor shortage
  • Volatile raw material input costs that will pressure margins
  • Heightened geopolitical tensions in Europe (Ukraine/Russia conflict) and China
  • Substantially higher fuel prices that will likely impact price/mix (i.e., cars vs. trucks/SUVs sold)
  • Migration toward EVs—can they be manufactured profitably?
  • Structural risks from new entrants and technological disintermediation
  • Negative supply technicals—''always a new auto deal to buy''

    Industry Positives
  • Strong consumer demand
  • Modest leverage profiles for most OEMs and suppliers
  • Robust liquidity positions across the industry, to weather macroeconomic uncertainty
  • Reduced breakeven points and more flexible fixed-cost structures
  • Lean dealer inventory levels
  • Near all-time highs in used car prices, resulting in strong equity positions for most owners

    Items to Monitor
  • Increasing auto loan interest rates and the potential for more restrictive lending practices
  • Likelihood of higher delinquencies and/or repossessions, particularly in lower-credit tiers
  • Upcoming labor negotiations with the United Auto Workers in mid-2023
  • If Tesla continues to take market share, which manufacturers will be the biggest donors?
  • How far off are we from an Apple vehicle launch?

Our Positioning Going Forward

Western Asset’s investment approach in the automotive sector is predicated on the following cornerstones: (1) Detailed fundamental credit research process that seeks to identify companies with highly resilient business models and balanced capital structures that are run by experienced management teams; (2) A specific focus on issuers with significant size, scale and geographic/customer diversification, above-average margins, robust free cash flow generation throughout the business cycle, and technologically sophisticated product offerings; (3) Uncovering select idiosyncratic opportunities that we believe are rising star candidates with positive rating agency migration potential; (4) Avoiding companies that do not generate positive adjusted EBITDA, are hemorrhaging cash and require access to the capital market to fund their operations; and (5) Not participating in new-issue offerings from issuers with aggressively levered balance sheets that contain limited covenant protection for creditors or those that are poorly structured.

While we have identified a number of near- and intermediate-term risks, we believe recent market volatility has unearthed select attractive relative value opportunities across different segments of the industry value chain. More specifically, two segments of the market that should not be overlooked, in our view, are senior secured tranches of certain aftermarket and tire manufacturers, as well as short-duration paper from high-quality BB rated issuers. Both of these are currently yielding 6.50% to 7.00%, which can provide an attractive risk/reward proposition for investors with longer-term time horizons.

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