Headroom for most North American auto original equipment manufacturer (OEM) suppliers is tight as companies grapple with a combination of low volume growth, less-than-full recovery from inflation, and--for companies with powertrain, electronics, and software exposure--increased spending on research and development (R&D) and capital expenditures (capex). Suppliers are counting on additional client compensation to offset inflation but OEMs expect suppliers to share their cost-reduction efforts. Disruption from Chinese OEMs within China will make the Chinese market difficult for suppliers as market shares shift rapidly. The slowdown of vehicle electrification introduces new challenges in terms of balancing electric vehicle (EV) investment against volatile volumes, and renegotiation on pricing and volumes. It also presents opportunities in the form of a longer ICE tail to fund the transition as well as expanded hybrid EV (HEV) business.

Here we answer questions about current trends and risks we see in the North American auto supply industry.

Frequently Asked Questions

How has the credit quality of auto suppliers trended the past couple years?

Suppliers to auto OEMs' credit quality has generally improved.   Suppliers faced a difficult environment from the end of 2021 through the first part of 2023 when inflation and supply chain shortages eroded margins and cash flows. Suppliers suffered from not only lower volumes, increasing input costs, and rising labor rates, but also massive customer volatility. Throughout 2023, the supply chain issues improved, production volumes increased, OEM production volatility subsided, and suppliers were able to realize large recoveries from their customers. For the suppliers we rate, this translated into higher margins and free cash flows in 2023, with an expectation for additional improvement in the coming years (see chart 1).

Chart 1

The result was an improvement in credit quality for many issuers and, given the higher cost of debt, some increased focus on deleveraging. As a result, we upgraded a number of companies (see graphic) including TI Fluid Systems PLC, Lear Corp., Adient PLC, Visteon Corp., Clarios Global L.P., and IXS Holdings Inc..

Graphic

Is there much ratings upside expected within the next couple years?

We don't expect another spate of upgrades in 2024 and 2025.   While certain suppliers could improve margins and credit metrics within the 12-24 months, we think ratings upside may be limited due to financial policies, particularly for larger issuers, which may use their strong balance sheets to prioritize mergers and acquisitions and share buybacks.

Beyond financial policies, upside for all OEM supplier ratings maybe more limited due to three key risks:

• Persistent labor inflation;
• Risk of disruption from China; and
• Product transition risk from ICE vehicles to EVs

We explore each of these risks in more detail below.

What has been happening with labor inflation and what are suppliers doing to address the inflation?

Higher inflation for longer has been a persistent trend all over the world.   Labor markets remain quite tight and labor inflation has remained high in key geographic regions for suppliers, most notably Mexico and Eastern Europe. In Mexico, the stronger peso (until very recently) has exacerbated wage increases from a tight labor market. Overall wage increases in Mexico have been averaging around 5% per year the past three years and minimum wage rates have increased 20% per year over the past two years. In Eastern Europe, suppliers have indicated markets like Poland and other eastern countries have had tighter labor.

While inflation was mostly passed on to OEMs in 2023, we think it will be harder for suppliers to pass on inflation-related price increases, particularly labor inflation, over the next few years. OEMs have indicated they plan to focus more on costs as car prices come down from the peaks that resulted from supply chain shortage and low vehicle inventories. Inventories remain below pre-pandemic levels but we still expect a 10% price correction on U.S. new vehicle prices during 2024 and 2025. Pressure on prices for OEMs and a focus to reduce costs on EVs will likely make the pass-through of inflationary costs outside of indexed raw materials much harder for suppliers.

Larger, global OEM suppliers will likely be better positioned to offset these higher costs by moving labor to lower-cost countries and increasing automation. In their first quarter call, both Lear and Aptiv noted they are shifting some of their footprint from Eastern Europe to North Africa, and Aptiv is also moving some of its footprint from Mexico to Central America. In addition, both companies are working to increase automation in their plants. Last quarter, Aptiv announced its plan to increase automation of standard labor hours from roughly 15% today to 30% by 2026 and 50% by 2030. Lear acquired WIP Industrial Automation in the first quarter to increase the use of robotics and automation software in its plants.

What risks do China's auto market pose to North American auto suppliers?

China is the largest auto market in the world and over the past few years has become one of the most complicated and dynamic markets worldwide.   EV sales have grown quickly in China and domestic Chinese OEMs have been able to gain significant market share, particularly for EVs. According to data from the China Passenger Car Assn., within the past three years, the share of domestic Chinese brands has moved from 40% to 55%-60%. Much of the share increase has come from increasing penetration of EVs because most of the EVs sold in China were produced by Chinese domestic OEMs. EV share has increased from around 5% in 2020 to more than 30% in 2023 and closer to 40% in the first half of 2024. The loss in share by global OEMs to Chinese automakers has generally meant a loss of share by our rated North American global auto suppliers.

Which rated suppliers have the greatest exposure to China? Of these exposed suppliers, what is their mix of domestic versus international OEM revenue and what do we expect to happen going forward?

The following suppliers generate at least 10% of revenues from China (see table).

Table

Not all suppliers have publicly disclosed their mix of revenue exposure to Chinese domestic versus international OEMs. However, several suppliers have given rough estimates of their revenue mix. BorgWarner Inc. has a more favorable exposure in China with 75% of sales to domestic OEMs and 95% within e-products. We expect BorgWarner to continue maintaining this strong share particularly as it works with some of the leading Chinese OEMs such as BYD Co. Ltd., Great Wall Motor Co. Ltd., and Li Auto Inc., none of which we rate. Magna International Inc. has roughly an even split at 50% domestic/50% international OEMs. Other companies like Adient PLC and Aptiv PLC have revealed that only 40% of revenues are generated by domestic Chinese OEMs. For TI Fluid Systems PLC, only roughly one-third of sales are to Chinese OEMs and Lear has indicated only 30% of China sales this year will be to Chinese OEMs. Sensata Technologies B.V. has lost market share in China due to lower exposure to domestic OEMs.

While most suppliers lost share alongside the international OEMs they sell to, the future looks more promising based on backlogs.   Aptiv and Adient have indicated their backlogs are roughly the inverse of current sales with 60% of backlog in China to Chinese car companies. Lear has indicated roughly two-thirds of backlog is to domestic OEMs. Lear also has a strong position with BYD and it expects to produce 30% of its seats over the next few years. TI Fluid has been winning business on brake lines for BYD and the company expects by 2028 more than 50% of sales will be to local Chinese OEMs. Sensata has shifted its strategy by developing country-specific contractors to increase domestic share. Some suppliers who currently have minimal sales to China (less than 10%) could benefit from the growing Chinese EV market as supply chains get reset. For instance, American Axle & Manufacturing Inc., which generated 4.5% of 2023 revenue in China, recently won electric drive units with Guangzhou Xiaopeng Motors Technology Co. Ltd. (Xpeng; not rated).

We believe suppliers will likely continue to experience volatility in China as they see if their bets play out as to which Chinese OEMs will be successful.   We think it's a much more challenging task for suppliers to confidently book business in China given how many car companies there are and how market share has moved so quickly and become less concentrated (see chart 2). In addition, many of the companies making electric vehicles are new and making profits. Outside of Tesla Inc., BYD, and Li auto, few Chinese EV companies are profitable (for more details, see China EV Startups Struggling To Stay Afloat, published May 28, 2024). We think suppliers will have to stay flexible and nimble to adapt to the rapid changes in fortunes of Chinese domestic companies. Still, there could be opportunities for suppliers who partner with the right Chinese OEMs both within China and outside the country. Exports of cars from China have increased significantly and an increase in exports may increase sales for suppliers who are partnered with Chinese OEMs that are increasing their exports. Additionally, some leading Chinese OEMs are looking to set up manufacturing abroad, particularly in regions like Hungary and Mexico. We believe suppliers who have strong relationships and content currently with these Chinese OEMs, such as BorgWarner, could potentially pick up some of this business.

Chart 2

What risk does the growth of Chinese exported vehicles and the growth of Chinese OEMs globally pose to global suppliers and their ratings?

We think it's too early to declare if the increase in Chinese vehicles exported globally will be significantly harmful to suppliers within North America and Europe.   However, one risk would be that Chinese OEMs directly export full vehicles to North America or Europe, primarily relying on local Chinese suppliers for many of the parts. However, exports could be limited by tariffs, particularly in the U.S. and less so in Europe. For this reason, some leading Chinese OEMs are looking to set up manufacturing abroad, particularly in regions like Hungary and Mexico. It's possible that Chinese OEMs bring their own suppliers with them as they relocate production of vehicles to Mexico and eastern Europe to serve the U.S. and Europe. Finally, some EV makers like BYD and Tesla have benefitted from being more vertically integrated, which could decrease dependence on suppliers longer term.

There are some factors offsetting this risk, including U.S. and Europe standards, which are more rigorous, and Chinese OEMs seeking to benefit from partnering with existing western suppliers that can build to these standards. In addition, legacy suppliers have an existing and, especially in Europe, an underutilized production base that could ramp up quickly for Chinese OEMs. Finally, we believe suppliers that currently have strong relationships and content with Chinese OEMs, such as BorgWarner, could potentially acquire some of this business.

For now, it's too early to determine and quantify how significant an impact the rise of Chinese car sales in Europe and North America will have on suppliers.

What risks do additional tariffs on Chinese-produced goods mean for North American and European suppliers?

We don't believe any such tariffs will significantly impact suppliers.   Suppliers generally produce in low-cost geographic regions close to their end markets. For example, in North America, production largely takes place in Mexico, and in Europe, Eastern Europe is responsible for much of the production. North Africa also has a number of producers. While suppliers may be getting simple stamped parts from China (nuts and bolts for example), we don't think suppliers are importing high-cost inputs for vehicles--with the exception of batteries that are made by large Chinese companies like CATL. Therefore, like the 25% tariffs placed on many Chinese products in 2018 under former President Trump, we don't expect additional tariffs to significantly impede OEM suppliers. However, these tariffs on batteries and critical minerals will likely push up input costs for U.S. automakers, delaying automaker profit targets and translating to higher EV prices for end customers until alternative supply options are identified. In turn, this could disincentivize purchases at a time when U.S. EV sales have become sluggish. For example pure battery EV (BEV; excluding plug-ins) share fell from 7.5% in 2023 to 6.9% in the first half of 2024. In the same way slower adoption of EVs will elongate the time for automakers to achieve profitability, some suppliers will have the same issues over the next couple years as profitability is pushed out in the EV business. Still, longer-term tariffs on completed vehicles coming out of China and into North America and Europe will likely protect suppliers in the same way local OEM partners are protected.

What are our updated expectations for EV penetration and how does that broadly affect the suppliers we rate?

Despite the deceleration of EV adoption, our longer-term forecast remains mostly the same. We expect global EV penetration (including BEVs, plug-in hybrid EVs [PHEVs], and HEVs) to hit 19%-21% by 2025 from 16.5% in 2023. Regionally, penetration will be highest in 2025 in China at 35%-40%, followed by Europe at 25%-30%, and the U.S. at 14%-16%. This still presents a substantial opportunity and transition challenge for North American-based auto suppliers, particularly in their international operations. We've seen an increase in investment in capex and R&D to support transition to EV efforts, while EBITDA margins have also been constrained by EV products, which require greater volumes to ramp to achieve margin parity with ICE products. However, due to the slowdown in EV adoption, we believe suppliers will benefit from positive product mix due to the longer ICE tail, which will also help fund their transition needs.

Major challenges that have slowed North American EV adoption include tougher consumer affordability and lack of sufficient charging infrastructure. The average EV transaction price in June 2024 was $56,731 compared to the average ICE price of $48,644 according to Cox Automotive (before incentives). Higher interest rates and inflationary pressures are further exacerbating affordability problems. To partially tackle this, consumers have been leasing EVs, which enables many buyers to qualify for the $7,500 IRA tax incentive. The sales slowdown has also been seen at the large national dealers. According to Penske Corp., 87% of its BEVs sold in first quarter 2024 required significant discounting. Additionally, lack of charging infrastructure and upgrades needed to the power grid remain challenging hurdles. Despite these challenges, North American auto suppliers are continuing to invest into the transition particularly as longer-term, EV penetration will likely increase. Furthermore, many of North American suppliers are expanding their EV offerings internationally as well, where EV penetration is stronger.

To what extent are our the suppliers we rate exposed to this EV transition risk and how does this affect their credit profiles?

We can largely bucket our issuers among four different categories:

• Suppliers that are significantly exposed to ICE products without a longer-term transition strategy,
• Suppliers with a significant exposure to ICE products that are investing heavily to transition,
• Suppliers that are somewhat agnostic and are investing moderately to transition, and
• Suppliers that are largely agnostic.

While suppliers spending on R&D to sales, and capex to sales, as a whole hasn't deviated too much from pre-pandemic levels (see chart 3), on average supplier margins are lower than they were before the pandemic began.

Chart 3

This is due to repercussions from inflation, lower auto production volumes, and lower profit contributions from e-products. Furthermore, suppliers such as BorgWarner, Dana, and American Axle have deviated from the group and increased capex and R&D investment relative to pre-pandemic levels given their product portfolio ICE exposure. Nemak S.A.B. de C.V. and Magna International Inc. also both manufacture battery enclosures, which is a capital-intensive business.

• Suppliers we deem to be significantly exposed to transition risk: PHINIIA and Tenneco don't currently have EV products despite their portfolios being materially exposed to ICE. Phinia has chosen to broaden its aftermarket and commercial vehicle portfolios to target the remaining ICE car parc. Tenneco is focused on increasing efficiency and margins in its operations across its portfolio. These companies may look to pick up conquest wins and further consolidate the ICE supply chain as other suppliers shift their focus away from ICE to EVs. So far, PHINIA has done a good job of managing down its capacity while also gaining conquest wins. In the near term, the slowdown in EV adoption in North America and Europe is a tailwind for these companies; however, upside to ratings could be limited due to the overhanging risks to their ICE portfolio without a strategy to transition to EV products.
• Suppliers that are exposed to ICE but are investing heavily to transition include Magna, BorgWarner, Dana, American Axle, and Nemak. These suppliers have higher capex/sales and R&D/sales ratios than others given the heavy reinvestment to support transition. Despite the slowdown in EV adoption, it may be difficult for these companies to reduce their investments, which could burden margins and free cash flow over the next few years and potentially lead to negative rating actions. Issuers with greater scale and stronger financial metrics--such as Borgwarner and Magna--will likely be better positioned to fund transition costs and capital investments, therefore maintaining stronger credit profiles.
• Suppliers that have some exposure to ICE and are investing moderately to transition include TI Fluid, Cooper-Standard Automotive Inc., and Metalsa S.A. de C.V.. For these suppliers, a smaller portion of these portfolios will become obsolete for EVs such as fuel tanks,certain fluid delivery systems, and subframes for ICE engines. However, other products such as brake fluid systems, sealants, and general frames won't be affected and the companies have a pipeline of new products to gain content on electric vehicles and replace lost ICE content. This includes thermodynamic products to manage the battery temperatures, fluid systems to cool the battery, and frame packs that integrate the battery into the frame. There is some degree of tooling and investment into new product development for EV products, but this degree of reinvestment isn't substantial enough to diminish credit metrics. In case of Metalsa, EV adoption on the light trucks segment have shown lower growth rates, which has hindered the company's transition given its concentration on this business line, yet they remain in line with customers' needs.
• Suppliers that are largely agnostic or will benefit from increased EV penetration include Aptiv, Adient, Lear, Goodyear, Sensata, Visteon, Autokiniton US Holdings Inc., Harman International Industries Inc., and Clarios. These suppliers make products such as seats, tires, electronics, or structural components that are largely agnostic to the powertrain. While the EV transition risk to credit metrics is much lower, the slowdown in EV adoption could lead to some topline and margin pressure as EV launches are delayed and lower EV platform sales temporarily weigh on results. Aptiv stands to benefit from more rapid EV adoption due to its strong position in high-voltage wiring and greater technology implementation for advanced safety and user experience in EVs. The recent slowdown in EV penetration has hindered Aptiv's market share growth but we still see it as better positioned longer- term. As well, Visteon's battery management systems or Lear's battery disconnect systems will grow faster with more EV content.

While we haven't taken ratings actions directly linked to EV transitions within the North American autos suppliers industry, the impact of transitioning to EVs has played a partial role in some actions.   Many suppliers operate with margins lower than pre-pandemic levels due to inflationary pressures, foreign currency headwinds, and softer industry volumes. These problems are further exacerbated by costly transition costs and capital investments, as well as unprofitable or low EV product margins--in part, leading to negative rating actions (see e.g., "Dana Inc. Downgraded To 'BB-' From 'BB' On Weakening Credit Metrics; Outlook Stable," published March 10, 2023, and "Mexican Auto Supplier Nemak S.A.B. de C.V. Outlook Revised To Negative On Delayed Deleveraging; 'BB+' Ratings Affirmed," published April 1, 2024). Suppliers that have maintained higher margins have been more capable of absorbing the transition impact. Also, there have been companies that benefitted from the EV transition such as Clarios (see "Clarios Global L.P. Upgraded To 'BB-' From 'B+' On Improved Credit Metrics; Outlook Stable," published June 4, 2024.

How has the EV adoption slowdown affected the suppliers we rate and how do we expect them to adapt to these challenges?

To address the challenge of slowing BEV adoption resulting in lower EV product volumes, suppliers are seeking multiple recovery avenues from their OEM customers. We expect suppliers to seek to reprice contracts with their customers due to much lower-than-promised volumes on some platforms. Suppliers could also be awarded additional volumes on ICE and hybrid platforms to make up for BEV production volume declines. However, we recognize there will be challenges for suppliers in getting recoveries. Firstly, OEMs are looking to improve affordability of EVs partially through cost reductions, as such the supplier base will likely have to bear some of this burden. Secondly, suppliers will need to carefully balance recoveries against winning new business. Being too aggressive on recovery negotiations could mean losing out on potential future business wins, particularly given OEMs' focus on cost reduction. At this moment, it's difficult to gauge the success of the suppliers we rate in renegotiating pricing and volumes and the ultimate impact on ratings. Overall, we believe that larger suppliers with mission-critical parts will likely be better positioned to reprice contracts and renegotiate volumes.

The volatility of EV adoption has also increased difficulty in aligning fixed costs with volumes to achieve proper economies of scale. BorgWarner had initially anticipated achieving $5 billion of e-product revenues by 2025, which will no longer be the case given the slowdown. American Axle and Dana's growth in EV backlog has also slowed as issuers delay new EV program launches. American Axle increased its 2024-2026 electrification backlog slightly to $300 million, up minimally from its previous 2023-2025 electrification backlog of $290 million. Dana's backlog grew slightly more to $703 million through 2024-2026 from $585 million from 2023-2025. Given these volume setbacks, suppliers have to balance R&D and capex spending to maintain an innovative edge while also adapting to a lower-volume environment. BorgWarner expects to achieve breakeven EBITDA on EV products by 2024 and Dana by 2025, but we anticipate it could take much longer before EV portfolio margins achieve parity with ICE portfolio margins.

To offset these risks, suppliers can leverage their more profitable ICE product portfolios for longer to fund their EV transition needs particularly if more OEMs consider extending ICE product lifecycles. Suppliers, will have to make crucial strategic choices on the timing for wind-down of ICE production capacity in conjunction with their OEM customers to cater to evolving consumer demand around alternate propulsion systems. Hybrids also present a strong opportunity for suppliers to win new or better contracts. Content per vehicle for many of suppliers tends to be higher on hybrid vehicles versus BEVs or ICE vehicles due to support the dual propulsion systems. For instance, TI Fluid has stated that PHEVs require longer fluid handling lines and more connectors than both ICE and BEV vehicles.

What are the insourcing risks that suppliers face and what does that mean for more supplier consolidation?

To gain stronger economies of scale on EVs and improve profitability, we believe OEMs could choose to insource certain high-volume components. For instance, Ford Motor Co. and General Motors Co. have insourced some of their battery production and electric drivetrains on new EV models. Tesla insources their own electric drive units and low-voltage batteries. BYD is also heavily vertically integrated and it has been difficult for many North American suppliers to win content on BYD models. Other OEMs could look to follow Tesla and BYD's vertical integration approach to gain economies of scale on their EV platforms. While it is still too early to tell to what degree OEMs could choose to insource, we believe certain suppliers may be at greater risk due to insourcing. Most notably, American Axle and Dana face risk from insourcing on their light vehicle e-axles. Historically, roughly 50% of axles have been produced by OEMs internally and 50% have been outsourced; however, vertical integration on EVs could change this for e-axles. While we think that both Axle and Dana have a compelling product pipeline to address OEM needs, it's a longer-term existential risk to their large light vehicle axle businesses, particularly for American Axle. However, because we believe it could take longer for trucks and SUVs to electrify in North America, this will be more of an issue later in the decade. In addition, despite these risks, we believe suppliers will remain critical to OEMs and have the benefit of scaling technology across multiple OEM customers. Maintaining leading innovation and a cost-advantageous production footprint will be critical for suppliers.