Episode Transcript
[00:00:06] Speaker A: The world's focus on the EV revolution has new automotive plants and gigafactories popping up all across North America and beyond. And this opens up new opportunities in various sectors, including construction and the automotive supply chain. But there are always risks with new opportunities. So in this trade security podcast, we'll dig into the role that trademark insurance can play to protect service providers and suppliers on the road to the energy transition. I'm Janet Eastman, and today my guest is Mike Brownhill. He is a former underwriter who is now the commercial account director, advanced manufacturing at EDC. Mike, nice to have you here.
[00:00:48] Speaker B: Thanks for having me.
[00:00:49] Speaker A: Oh, you're very welcome. So the scenario that we're going to look at in this conversation, and you walked me through this before because this, this is a huge industry. So we're going to take it through the lifecycle of a new automotive plant. So it's construction with its initial capex requirements, getting it operational, sourcing the vehicle specific tooling, procurement of components for assembly of the vehicles right through to the aftermarket parts, and the opportunities along that path for trade credit insurance for both the domestic and export markets. So it's a big topic we're going to cover in like 20 minutes. So starting with the construction of a new plant, Mike companies will be providing services and supplies for the construction of these new plants. So where do you see a strong case for trade credit insurance within the construction trades at this stage? So paint a picture of how and why you see that trade credit insurance opportunity.
[00:01:51] Speaker B: Oh, great. First, what I'll do to preface all my comments today, I'm going to talk in the context of an OEM plant. So a Honda, a GM. But a lot of the same things will hold true for companies in the parts supply chain as well, if they have to build a new plant. So when you look at credit insurance as applies to building any kind of a new building, you have a lot of sub traits involved. So you have a lot of service providers, you have input providers selling into some form of a construction consortium. So in that kind of a scenario, there's a lot of risk for commercial disputes which aren't covered by insurance, but also for problems to arise through the financing of various projects. It's very common in construction for companies to create special purpose vehicles, spvs to limit their liability around a given construction project. So great opportunity for companies to explore credit insurance when they're selling to random building company number three, LLP. They don't know who's behind it. They don't know the bench strength, the capacity to pay of that company. So if you work with a credit insurer to support those, those sales, then you have some assurances of what's going to be your result in the day that you will be paid by somebody for the work you're doing. Okay.
What also can come up as you're working in new construction is the potential ability to be included on a labor and payment. Sorry, labor and materials bond. And these are financial instruments that can avail some subcontractors to some financial protection remediation through a surety mechanism that can be seen as a risk enhancer in credit insurance, or potentially something that displaces the need for insurance. But not all suppliers can access them. So it's really up to the supplier to inform themselves, their risk management.
With all that happening, the other thing that can come up in this industry, in automotive, that can make it risky to be engaged in the construction, is the risk of the program being delayed. We've seen lately some investments have been delayed as a result of changes in consumer demand.
So if a contractor is working on building a new facility and the vehicle that would ultimately be manufactured is delayed for whatever reason, be it natural consequences, be it an OEM production decision, they're potentially waiting on receivables. So having some insurance provides a great backstop to knowing that they aren't going to be out that money for too long.
[00:04:20] Speaker A: Okay, fair.
[00:04:21] Speaker B: And lastly, through all of this, as it applies here and at other points in our Q and A, there's always the benefit of progress payments. So, to the extent that you can, as a supplier, negotiate progress payments, you're obviously de risking your contract.
[00:04:37] Speaker A: Okay, so an initial equipment installs, like the factory capex items. What's the risk there for the supplier and the installer? And then you talked about progress payments. I guess those are milestone payments. What are the risks there?
[00:04:54] Speaker B: So it's a fine line when you're talking about the initial capex going into a plant, when compared to the construction of the plant itself. You go in one of these big factories. Some parts of the capex, functionally are part of the building. So an overhead crane system. Other parts are more specific to the production of the car parts, like a massive stamping press. So it's important for suppliers to know who they're selling to. You might think, hey, I'm selling this overhead crane system to GM. That's great. But actually, you're selling it to the construction company because it's bolted into the concrete. But if you're selling the press, you might be selling to GM. So you have to understand, whose payment risk, again, are you taking? You can be back to the SPV comment that I made earlier, or you'd be looking at a normal, accredited automotive supplier. So there's some risk in knowing and being comfortable with your counterparties.
Again, Capex is very big, very expensive, as I said, progress payments, milestone payments, one in the same.
Figuring out what makes sense for you as a supplier, what you can ask for, and what you have the leverage to get.
In some cases, some equipment is more on the commodity end of capex, and some of it is very niche and specific. If you're supplying an extremely high capacity overhead crane system, there may be only a couple suppliers that can do that. There isn't an ability to rapidly swap you out. If you're looking at something like a conveyor belt, well, that's more common, and you are at threat of replacement if you. If you demand progress payments.
Okay. And the last thing that comes up, and this is gonna be the first time I talk about it, but I'll talk about it more shortly, is the need for conditional. Well, it's not the need for conditional payment, but the need for commissioning. As you're installing this equipment, it has to work. It's not a question of just selling a widget, and it sits in inventory. You're talking about complex pieces of equipment and machinery that has to be calibrated, installed, validated. So there's often a commissioning process to make sure that it can do what it's intended to do.
As a result of that, often the contracts have conditional payment terms. So for any company looking at a credit insurance option, you have to find a solution that can ensure the conditionality of those payments that you have to perform, and only by you successfully performing, does a payment obligation be triggered.
Wow. Okay. Okay.
[00:07:27] Speaker A: What about vehicle specific tooling? So, for the layperson, which is kind of like me, this relates to things like the dyes and the molds made to manufacture specific parts. So let's talk about the risks for the tooling company, because I guess, you know, you look at the average car, how many parts are in that thing, right? So let's talk about that.
[00:07:52] Speaker B: Certainly.
So, like I said, the average car, how many parts are there? Ten to 15,000 different parts. You got to think every screw, every bracket, everything is custom made for that vehicle. So to make each one of those parts, you need tooling. So you said the comment about what the layperson knows about the tool and dissector. It's a very complex industry, but the long and short of it is every single part in a car is made by dedicated stamping dies, injection molds, some other type of mold, and they are all made specifically for that part. And they have to work properly on their own and properly in unison to make parts that will bolt together and ultimately form a car.
So in that respect, it is a very complex industry. Also, at the other end, it's actually quite simple in isolation. It's only as it aggregates together, it becomes really complex.
What's interesting in this space is credit. Insurance is often used as a financing tool in the tooling sector, more so than a risk management tool.
The reason here, there's a couple of reasons, but chief amongst them is tooling is exceptionally capital intensive.
In the case of making larger molds or die sets, it can take anywhere from twelve to 18 months to make that piece of metal, to cut that metal. So that ties up a lot of capital. As you're buying that initial hunk of metal, as you're paying your labor, you're paying for the amortization of your machine time, electricity. So you're starting off, let's say, with a million dollar hunk of steel, investing a million dollars variable cost in it over the span of a year, all the time when potentially not getting down payments or progress payments. So, leveraging credit insurance on the risk of contract cancellation, which brings in coverage for work in progress inventory provides a lot of support to banks. So banks will increase how much they will margin on work in process inventory, finished goods or unbilled contracts receivable because of the insurance that can be attached to it.
And it's important because this is a really long duration period, like I said, which is after it's done being built, it's followed by another type of acceptance. So, as I said earlier, all the parts have to work together for a car to work. The oems have determined or created a process that's referred to as PPAP, the production part approval process, which is a validation process where the supply chain, the parts companies and the oems make sure that the tooling works. It makes parts to the specifications and at the right production rate. And all of the pieces that fit together have to be ppapped simultaneously, because you don't want to have a door panel where, for example, the window switch doesn't fit, you have to integrate all that. So that causes further delays as rework might be required. So always there's risk of nonpayment of cancellation through this entire period. Then finally you hit PPAP, which is great. You might have triggered your conditional payment term. There's a second conditional payment term, sometimes called start of production, which is the OEM saying, hey, it all looks great, it works beautifully, but I don't want to pay you until after the car is being manufactured. So it could be another three, four month delay. So all of this creates massive capital, draws on the tool and die sector, which is why the banking is so important. The other side, banking dominates over risk, is the toolers have experience in managing the risk in this sector in the great Recession, 0809, it's the only time we've really seen en masse, the oems be severely challenged. You think about it. Think about all the brands GM used to have. You have Pontiac, Saturn, Oldsmobile. They're gone. Hummer's back. But at that time, what the tool shops learned is the leverage they have by having physical possession of the product. So what happened then is a tool shop would be working on molds that would be making very similar parts for a Saturn and a Chevy. GM cancels Saturn, and the mold company effectively was able to hold the Chevy molds hostage, saying, I know this car, the Saturn is not going to be built, but the Chevy is. And if you want this tool, you got to pay me for both.
So they exerted supplier leverage, which is very fascinating to watch take place.
And the other thing that the tool shops have learned on top of that is that they also have ongoing leverage if they're doing repeat business for the same company. So if they finish one die set, it's shipped out. They started working on another one for the same customer. Any payment problems in the first one, they're holding the second one hostage.
Then beyond all that, they even have the ability to get either consensual or not, or statutory liens, depending on what state they're selling to, that can let them get a secured right over the tool, so that if the company doesn't pay, they have a valid demand to take to court to get payment. So there's a lot of inherent protection in there, but the value of insurance in the tool and die sector really drives around the ability to get better financing leverage and the secondary benefit of protecting the AR if you can get coverage that supports the, the PPAP and the start of production payment terms.
Okay.
[00:13:38] Speaker A: Okay. Wow.
That. There's a lot of information in there that's. So there is that I would like to dig into later, but we can't right now. So let's outline the risks in the area of the production of parts and services where the trade credit insurance plays a really important role. Like, share some real life stories here.
[00:13:58] Speaker B: Sure. So you think after what I just laid out, the horror story of the tooling sector, that the parts sector is going to be even worse. And what's fascinating there is it's actually better. It's easier, because when you're selling the parts, you're selling repeat orders. So most automotive production is done on a just in time basis. So if you look at a major assembly facility, most of their tier one suppliers, which is the people who supply line directly. So this applied right to the production line. They are delivering multiple truckloads a day. And as a result of that, it's frequent shipments, frequent invoices, and it turns really quickly. So in that kind of environment, what you end up seeing is typically relatively short payment terms. The amount of product flowing is ridiculous, but the terms are really tight. The traditional north american oems used to have a terms that were called mns two. I don't know why they chose those letters, but it stood for second day, second month. It worked out on average to 45 day payment terms, which is comparably good in this economy when most people now are seeing 60 to 90. And that's generally where parts have shifted to the more 60 to 90 day terms. But again, a lot better than looking at two years potentially for tooling.
What you have here, from a credit insurance point of view, is really having to have comfort in the next layer of the supply chain. I haven't really delved into it, but we are dealing with one of the world's most complex supply chains in automotive, fundamentally, you start with raw materials, which I kind of group in this example into parts. So you have steel. So steel is going to be sold to the first guy in the supply chain. He might make a bracket just choosing a random part. So that person then sells this bracket to somebody who's making a sub assembly that subassembly, then gets sold to a tier two who's making. I'll just choose a seat base. That seat base is now fully assembled and now is sold to a magna as an example, who is assembling the whole seat. And then Magna is that tier one I mentioned earlier. So each one of those separate rungs is going to be selling on some version of second day, second month, net 60, net 90 days to the person ahead of them. So there's a lot of billing done on between each of these rungs on a continual basis.
All of these billings are governed under typically master contracts. So the, the production cycle of a car is typically five to seven years, which is why, for example, if you drive a Dodge grand caravan like me, they made them basically the same for five years. So the parts all look the same. The contract was basically, you will supply x number of parts over this horizon and we will send you individual releases. So there's a master contract, but what's being insured is the individual releases at each time. So the credit insurer won't sign on to protect the five year part supply because you haven't made the part. They're shipping in year five. They're insured based on when they're shipped.
So that's the most common thing you see in the parts sector. It's complicated.
To give an example, I have a client who is a major line direct supplier to an OEM. Out of being responsible, I'm not breaking confidentiality, I'm going to be a bit cautious in the example, but I've been through their facility and seen how much they make on a given day. And if you can imagine seeing three hockey arenas, good canadian reference, full of parts from floor to ceiling, getting filled and emptied on a daily basis.
That's how much you can see parts moving and how much the importance of being paid matters because the amount of money gets tied up in that inventory on a daily basis. If there's a hiccup in payment, then that can cause working capital crunches.
And it really is important for the entire supply chain that everything keeps moving, because once a production line is shut down, it costs millions of dollars an hour in lost revenue, lost production. And that's hard to make up because there are only so many hours in a day and so much ability for the supply chain to react.
The other thing I haven't touched on in the parts supply chain, which is an interesting dynamic, ties back to the capex we mentioned earlier, parts suppliers own their own capex, so the tooling is bought and sold and is owned by the OEM, a parts company. So again, I'll choose Magna. They own the press. The die is sitting in every part they sell. They amortize out a few cents of that capex to the OEM or other part suppliers to the person ahead of them in the supply chain.
A risk that is hard to ensure is a kind of a reconciliation risk, because sometimes, most of the time, vehicles don't hit their projected sales volumes. All the oems will say this new vehicle will sell 200,000 units a year. The part suppliers typically don't budget based on that. They take a dose of reality and they adjust the budget down to maybe 120,000 units. So if they have $120,000 of capex and they have to amortize it over a year, they're going to add a buck to each part they make. But if they come up short, there may or may not be a true up with the OEM offering to make them whole on their capex. So that comes down to the type of contract the part supplier negotiates, whether or not they have that provision. But then it comes down to what that invoice looks like. If they can get that insured. So that can be a really significant delta at the end of the year, if production is really off, that all make sense as best as possible.
[00:20:06] Speaker A: I might have to listen back to this and go, okay, I'm following along, right?
Okay, I don't even want to go. And I was thinking it as you were talking, but like you said, it costs millions of dollars when you have to stop production for a day. And I just thought of the whole Covid scenario and I went, oh, my goodness. Like, oh, my goodness. But we won't go there.
So let's now talk about the aftermarket parts business, because when you and I initially talked about this, I found this part really interesting because the consumer might not need a part for their vehicle for many, many years, like a gas tank for their car or whatever, but when they need it, like, even if their car is nine years old, they can still get that gas tank. So how long has the guy who's holding the gas tank been waiting to get paid for that part? And how does that all work?
[00:20:59] Speaker B: Yeah, and it's not a part of the industry that's often thought about. And it's really fascinating in that regard. There's two streams of the aftermarket. The one is pretty simple. It's kind of a dealer direct service. So you buy your car, you get an offender bender. Normally, if it's a couple years old, you're going back to the dealer and they will have ready access to the same parts that were made when it was built.
And those are normally made by the same part supplier through the same supply chain. They're just, they're over producing. So in my example, if you're making 120,000 units, maybe they're actually making 130,010 thousand spare parts are going to a parts depot.
What you're giving as an example, Janet, and the reality most of us live is you keep a car for ten years because they're expensive, and you go to your local garage because something broke your suspension broke. Your gas tank is falling out.
What they do then is they reach out to a parts retailer in the US. The big ones are your Napa's, your O'Reilly's pep boys.
And they always have a part ready, like I said. Well, they always have a part ready because they make the supply chain finance it.
Most cases, the parts will churn at some regularish frequency. But car parts, like, they're not fresh food, right? They aren't going to go bad.
They will sit in inventory. And you can sometimes hear people talk about new old stock parts, parts for 40 year old cars that have been sitting in inventory for 40 years. They've never been used. But more often than not, what you're dealing with is traditional aftermarket, again, a gas tank where they will be made by a dedicated aftermarket supplier who will sell it directly to a Napa, who I'll use for this example. And the terms on Napa's purchase order will be one year, typically, at best, six month payment terms, normally one year. So that aftermarket part supplier has a few choices, the better. Credits like a Napa often have a financing arrangement with some local bank or some major bank in the states where that bank will purchase the receivables and discount them. They'll pay you 95, $0.97 on the dollar. But you get your cash now, or you can hold it and have a very long dated, one year long receivable, tying up your working capital, tying up your cash.
It is possible to ensure these extended payment terms. Obviously, it's easier on a good credit than a bad credit when you're talking about long duration terms, but it doesn't give you as much support ensuring it than with a bank as factoring it does. So in my experience, we actually see greater prevalence of companies in the aftermarket leveraging these factoring facilities and only ensuring those accounts where there is not that option provided to them.
Okay.
It is a very challenging sector in that regard, and it's relatively concentrated. So happily, from a part supplier point of view, most of the business is with those big companies and very little is with small regional players.
Okay.
[00:24:14] Speaker A: Okay. So now that we've looked at the whole picture here. Yeah, tell me, and I'm assuming that it is the same, but are the risks the same in the auto industry for both the gas and the electric vehicle? And it's my understanding that an electric vehicle has fewer parts, but I don't know. So, so what do you, what, what do you say to that question?
[00:24:36] Speaker B: Well, I'll give you the worst answer out there, it's a kind of. It depends and a yes and no.
So I think functionally, you hit the nail on the head.
The type of risks don't change. Yeah. The number of parts, the type of parts, those vary.
At the end of the day, you still need sheet metal and tires to get down the road. So a parts apart where a change is not the type of risk, but the degree.
You might remember a couple years ago, there was a lot of noise in Wall street about spacs. Special purpose acquisition companies. This is, they also called blank check companies, where somebody would go out, incorporate a company just to pile a bunch of money in. It would incorporate basically an empty shell that would get funded with $500 million, and then that company would go out and merge with a new EV startup and you'd have an inventor with this new EV technology, new vehicle, and they'd get functionally married with a SPAc and poof, you have a publicly traded company that has an idea and has some capital.
So that was great to get the initial engineering underway. Like 500 million sounds like a beautiful number for starting a new vehicle. It costs over a billion dollars to build a car. And in that respect, 500 million kind of got you moving. But unless you got traction, you got a strategic investor, then you come down to fundamental credit risk. You have zero revenue coming in, a bunch of money going out, and no assurances of success.
So in the EV space, there was a lot of companies who didn't make it, or they got some cars made, but couldn't develop a dealer network, distribution, and find a way of getting traction to get more success down the road. The ones who succeeded focused on managing liquidity, being conscious of their debt maturities and working around it, raising more equity, and in some cases, having strategic investors. So, of the newest crop of EV companies, I'll single out Rivian and Lucid, both of whom have fascinating product and who went and took advantage of the market. But they also have strategic investors. When Rivian launched, their two biggest investors were Ford and Amazon.
Lucid is largely owned by, I think it's a saudi sovereign wealth fund. So they have deep pockets behind them to support what they're trying to achieve, which makes it a lot easier to get down the road of success.
Those are not challenges faced in the gas market, because the parts suppliers, the technology is well established and proven, so you can relieve more on your traditional supply chain, because in the internal combustion ecosystem, the oems design the vehicles, but it's kind of a set group of suppliers who do the heavy lifting of making the parts, they will collaborate work more together. There's less whiteboard innovation, which means it's cheaper to do so. That's your original question. The risks are the same, but you can see why they're dramatically different in scope.
[00:28:05] Speaker A: Right? Okay, Mike, there's so much here to think about and dig into. And if I like for people in the automotive sector, I think this is a really good thing to listen to so they can get. I mean, they might know a lot of this, but there might be some of it they just don't at all understand. Fascinating. Thank you very much for your insights. I really appreciate it.
[00:28:25] Speaker B: It's been my pleasure.
[00:28:26] Speaker A: Mike Brownhill is the commercial account director, advanced manufacturing at EDC. I think we'll probably have to talk to him again sometime about some other things, but thank you again.
The Trade Securely podcast is brought to you by the Receivables Insurance association of Canada. We are a member supported organization of Canadians helping canadian businesses grow, and EDC is one of our members. You can follow us on LinkedIn and on axiom for industry and business news and always visit tradesecurely cA for news in the insurance industry related to trade credit. I'm Janet Eastman. Thanks for listening to our podcast. And remember, cover your assets.
