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Auto-parts makers prepare nuts and bolts reform as cars go digital, electric

When auto-parts maker Continental AG in September announced a wide-scale restructuring that would see multiple plant closures and affect up to 20,000 jobs, a reference in the same news release of "a huge growth opportunity" in the industry looked at odds with its message.

The juxtaposition shows the unnerving crossroads the automotive-parts industry has reached as it contemplates a decline in internal combustion engines, or ICEs. In their place, it is gearing up to make components and software for the sector's electric-powered, connected and increasingly autonomous future that will be fewer in number but, crucially, higher in added value. Parts-makers could increase revenues by 30% in the next decade through the high-tech sensors, processors and software, alongside their mainstay mechanical and electronic wares, according to Deloitte.

Therein lies the reason why these companies, or the larger ones among them at least, expect to flourish despite the painful decisions this transformation will force them to make.

"We believe that manufacturers, through more and more stringent regulations, will be forced by 2030 to equip more than 40% of their vehicle fleet with electric powertrains," Elmar Degenhart, CEO of Continental, said at the Frankfurt Motor Show in September.

"Together with the necessity of connecting, integrating the systems, the cars to the cloud, this will be a dynamic process over the next 10 years. Those will be the growth drivers of the industry and this will change cars dramatically."

Getting there, however, means hefty investments at a time of slowing new car sales. U.K.-based consultancy LMC Automotive forecasts a 3.7% global decline in vehicle sales to 77.2 million in 2019. It could be a long wait for meaningful financial returns on some new technologies as the deployment of autonomous driving systems is widely thought to be at least a decade away.

From alternators to algorithms

This sector's behind-the-scenes research and development is also of great importance to its carmaker clients, accounting for more than a third of the total annual auto industry R&D spend of €54 billion in Europe alone. Their labs were the birthplace of advances including anti-lock brakes, electronic stability assistance, and tubeless and treaded tires.

Auto-parts makers' focus on innovation is already intensifying as they face increasing competition from technology companies. These companies, enticed by an increasingly electric and autonomous future, are rapidly entering the automotive space. Data from the European Patent Office shows that technology and telecoms companies jointly filed about 50% more patents related to self-driving cars than the automotive sector from 2010 to 2017. Meanwhile, the collective research investment by the likes of General Motors Co.'s Cruise, Alphabet Inc.'s Waymo and Uber Technologies Inc. was more than $80 billion by 2017, according to research by policy organization the Brookings Institution.

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While dipping into a shrinking pool of increasingly coveted talent from the IT sphere, both Continental and Bosch are cultivating skills in artificial intelligence and cybersecurity in-house through online learning platforms. Between them, their automotive divisions rely on global teams of almost 400,000 people.

"Our understanding is that most of the auto-parts suppliers are investing substantially into software engineers and developing their own products for the auto industry," Matthias Heck, a Moody's auto-parts sector analyst, said in an interview.

"Companies have to be fit for the future and address the trends in the automotive industry — electrification, autonomous driving and improving environmental standards. There are a lot of trends in the industry that require a lot of innovation. Parts suppliers are quite well positioned to benefit from these trends," Heck said.

A survey of more than 300 senior automotive industry executives published in October by injection-moulding specialist Protolabs found that 7 in 10 respondents said pressures to innovate were more intense now than ever. Roughly half of the respondents also believed that within the next three years, a new entrant to the automotive field will disrupt the market with a new kind of vehicle and that at least one established car manufacturer was likely to go out of business.

Research & Divestment

This fundamental shift comes at a time of great strain for the auto-parts industry. The median EBIT margin for the largest suppliers fell from 7.3% in 2016 to 6.1% in 2018, according to S&P Global Market Intelligence data, a stark reflection of the increasingly challenging operating environment.

Schaeffler AG is a case in point. The German company has seen its profit margin sink from 12.3% at 2016-end to a forecast 7% to 8% for 2019. In response, the company in March announced 900 job cuts as part of a two-year strategy dubbed RACE, or Regroup Automotive for higher margin and Capital Efficiency. Matthias Zink, CEO of Schaeffler's automotive OEM division, described the plan on a call with analysts as "way more than a pure restructuring program." It will see the company reduce the number of low-margin products in its portfolio in favor of higher-margin goods, consolidate five European factories, and prioritize R&D spend on e-mobility and autonomous driving.

"We want to further reduce the large extent to which we rely on the internal combustion engine while being an innovative technology partner to our customers utilizing the opportunities offered by the fields of hybridization and electrification much more extensively," Zink said in a release.

Evidence of this shift can also be seen in the company's M&A strategy. In November 2018, it agreed to acquire Elmotec Statomat Holding, a manufacturer of machinery for the production of electric motors. This followed a deal announced in August 2018 for Paravan, a chassis mechatronics business that aims to develop road-safe vehicles for those with physical disabilities that operate with electric controls rather than steering wheels.

"We said we want to strive as well for a reasonable value-add on the e-mobility side. And this is why we acquired this Elmotec thing," Zink told analysts.

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For the many thousands of small, independent parts-makers that constitute the rump of the industry, its rapid transformation could prove more lethal than lucrative. Small-parts companies are typically highly specialized, rely on a small number of larger suppliers and carmakers, have narrower profit margins, and lack the financial firepower to evolve away from products that electrified and autonomous cars will doom to obsolescence.

Consultancies predict a wave of consolidation among producers of engine-related parts as this market enters a "harvesting" phase that sustains returns in a declining market by tapering investment on innovation and merging with others to maintain scale.

"The economics of these kinds of components are quite fragile," said Christoph Sturmer, a Germany-based global lead analyst at PwC Autofacts. "All of their production is highly automated. They need 90% to 95% utilization of factories; otherwise, they start to burn money."

The internal combustion engine is still far from breathing its last gasp, however. While some nations have scheduled outright bans on sales of new engine-powered cars within the next 20 years, developing countries lacking power grid infrastructure look set to rely on the technology for several more decades, analysts say. By 2025, Deloitte forecasts the market for ICEs at $234 billion, down 6% from $250 billion in 2018. It is significant, but not quite a body blow to the century-and-a-half-old technology.

Some large component makers have taken the step of carving out their powertrain manufacturing operations. Aptiv PLC's 2017 spinout of Delphi Technologies PLC is among the most notable, while Continental has separated and rebranded its powertrain division, now known as Vitesco Technologies, with a view to a potential IPO. The companies say these separated units will also take the lead with their electrification-related products giving them a forward-looking role.

"Up until now, the industry has considered itself a hardware supplier. Now we are talking about transformation and not just technology substitutes of ICE to EV, but we are looking at transformation and different business models," said Sturmer. "R&D is a lot more profitable than stamping parts and shipping them. ... They are trying to go where the money is and that is in new technologies."