Selling pressure burdens auto debt as fossil fuel phase-out looms
Structural change within industry and high debt burdens are combining to create selling pressure that may lead to large-scale debt restructuring
By Jonathan Rogers
01 August 2019
Auto debt is being sold off, as structural change within an industry that is facing the challenge of a long-term switch from fossil fuel to electricity presents a challenging credit proposition.
Debt issued by car makers and ancillary entities – such as the manufacturers of drive shafts – referred to in industry speak as OEMs and OESs respectively, is being hit as structural change combines with a high debt burden to create a selling pressure which is arguably just beginning and which may yet play out in the form of a large-scale debt restructuring across the auto complex.
“Overcapacity plagues the automotive industry globally and the combination of slumping demand for vehicles together with the need to invest in the necessary manufacturing capability for electric vehicles (EV) and the attendant technology presents a less than salubrious medium to long-term credit landscape,”says David Beckett, head of Europe at global banking group SC Lowy.
Jaguar Land Rover (JLR), a subsidiary of India’s Tata Group, exemplifies this dynamic, albeit in JLR’s case intensified by the idiosyncratic effects of Brexit, which has seen investment in the British auto industry effectively stall in the first half of 2019 with just £90 million (US$110 million) invested in the January-June period versus an average of £2.7 billion annually over the past seven years. At the same time British auto manufacturing collapsed 20.1% over the same period.
Against an inauspicious backdrop, JLR has suffered three consecutive quarters of losses, thanks not only to fears of Britain crashing out of the EU without a negotiated deal, but also in large part to the shift away from internal combustion engine (ICE) vehicles powered by fossil fuel.
Senior unsecured JLR paper (rated B+/Ba3 by S&P/Moody’s) denominated in US dollars, British pounds and euros has declined by an average of 9.5% at maturities from three-five years over the past year as the sector has entered into toxic territory among investors.
Last June 21, Moody’s downgraded the corporate family rating of JLR to B1 from Ba3 citing high leverage and cashflow constraints.
And in relation to the shadow of the industry’s necessary transformation from ICE vehicles to EV, Moody’s tellingly observed that JLR’s adjusted Ebitda margin has declined in recent years due to R&D expenses linked to electrification with fiscal 2019 notable for a high 14 times leverage, negative 3.4% margin and negative £1.4 billion free cash flow.
Meanwhile the pile of debt issued by the OES industry has followed the downward path of OEM paper as rising research and development costs associated with the production of electronic vehicles strains that segment of the supply chain.
“The transition from fossil fuels to alternative energy sources in the auto sector needs to keep moving forward,” said Fiona Reynolds, managing director of the Principles for Responsible Investment, the London-based NGO which aims to foster environmental, social and corporate governance practice amongst investors.
“The switch to electric cars will require a significant investment by carmakers, including investments in research and development but will also create opportunities in the form of new products and services. Policymakers worldwide need to take deeper actions to encourage consumers to switch over to electric cars and hybrids,” says Reynolds.
Although the internal combustion engine (ICE) will not rapidly disappear from the automotive industry and is likely to continue to play a major role over the next few decades, it is estimated that sales of ICE-powered vehicles peaked in 2018, with new car deliveries in the US, China and Europe – the most significant markets in terms of sales volume – slumping last year and failing to recover in 2019.
Meanwhile the structural change in the industry and the pressure on the credit quality of traditional OEMs and OESs operating in the ICE-powered space is being driven by ever stricter emissions regulations globally – with adherence to the Paris climate accord underlying that dynamic – the price of batteries, the growing penetration of charging networks and government subsidies designed to boost the EV sector.
Asia is expected to experience the fastest penetration of EV, followed by Europe and the US, and as soon as 2025 around 10% of all vehicle sales are expected to be EV.
Germany presents the clearest case of regulatory input, as all of the country’s 16 federal states have voted to ban petrol and diesel vehicles by 2030 to leave just zero-emissions vehicles on the road.
“Market trends are easily observable within the liquid public bond arena, but it is also apparent that there is also concern within the loan space from the banks,”said SC Lowy’s Beckett.
“We are not yet seeing active and wholesale selling from the banks but their workout teams are telling us they have a growing number of auto suppliers on their watch-list, with the concern most prevalent in Germany. As the stress builds over the coming months, we expect banks will start to seek out liquidity options to exit problem loans as they actively manage their risk to the sector.”