Trouble lies ahead for auto parts manufacturers in the European market, and they had better prepare for it. The European Union’s revised regulations for new-car distribution¹ are scheduled to take full effect by 2010. They could drain €10 billion in annual operating profits from the parts industry over the next six years, leaving just €3 billion to €4 billion to be shared annually among the original-equipment suppliers, which furnish parts to the carmakers; the carmakers themselves; and the copy manufacturers, which duplicate highly standardized, large-volume car parts, such as exhausts, filters, and headlights (Exhibit 1). Original-equipment suppliers, which will bear the brunt of the impact, could see their turnover and operating profits fall by as much as 20 and 80 percent, respectively. But though they can’t avoid the sting entirely, they can mitigate the pain.

Spare parts and service account for about half of the European automotive industry’s profits, compared with 26 percent for new-car sales and 18 percent for car manufacturing. In the parts and service after-market, turnover has increased to about €63 billion and operating profits to €13 billion to €16 billion a year. But all that is now threatened.

The first and most important change in the EU regulations involves a broader definition of "original" spare parts—those sold under a carmaker’s brand—to include parts produced and branded by any manufacturer that can match a carmaker’s specifications. This change will attract more suppliers to the aftermarket, because original parts can command a premium and insurance companies often require them for repairs. But original-equipment suppliers, which have traditionally made parts for carmakers and for aftermarket distribution through wholesalers and some retail outlets, will face strong price competition from copy manufacturers. These companies, located primarily in Asia but also in the United States, focus on simpler, high-volume parts, which they have always sold to whole-salers and retail outlets. Thanks to shorter production cycles, lower R&D expenses, cheaper machine tools, and, in Asia, lower labor costs, the copy manufacturers may charge only half of what carmakers and original-equipment suppliers do.

In addition, the reforms not only require carmakers to give all service centers access to the same basic tools and diagnostic equipment but also allow spare-parts suppliers to certify individual repair shops—a move likely to help unaffiliated service centers compete with dealerships and garages franchised or owned by specific carmakers. Last, the new regulations permit carmakers to separate their sales and service functions, both of which have, until now, been situated at dealerships,² and could lead to the consolidation of the carmakers’ distribution networks, with individual salesrooms tied to networks of service centers.

Original-equipment suppliers will face pressure on several fronts. On the supply side, our analysis suggests that copy manufacturers will account for about 22 percent of aftermarket sales once deregulation is completed, compared with 7 percent in 2001. On the demand side, specialty chains such as Kwik-Fit and PitStop Auto Parts will benefit greatly from the copy producers’ cheaper parts and will have more power to negotiate with original-equipment suppliers for lower prices. Under deregulation, these outlets could capture as much as 20 percent of the market, compared with about 15 percent today. Independent garages may also thrive by filling geographical gaps left by carmakers that consolidate their service operations. These shifts may cut the price of auto parts by 15 to 20 percent as of 2010. All players, with the exception of copy manufacturers, will experience a reduction in their overall turnover reduced, and margins and profits will be squeezed throughout the industry (Exhibit 2).

So far, original-equipment suppliers and their core customers—the carmakers—have reacted by trying to preserve the status quo. To lock original-equipment suppliers out of the aftermarket and thereby support franchised garages and dealerships, many carmakers are mulling exclusivity agreements under which the suppliers would furnish them with original parts, which they would then use to supply the aftermarket. But by leaving no room for market segmentation and for a variety of prices, this approach would make it easier for the lower-priced copy manufacturers to sell their products to specialized chains and independent garages.

A more thoughtful approach, involving a transitional strategy adapted to changing conditions, could include a sharper market segmentation. OEMs might, for example, offer not only brands that catered to new-car buyers willing to pay premium prices to safeguard their investment but also lower-priced brands for used-car owners, who are generally more price sensitive.

In addition, original-equipment suppliers should form closer relationships with their customers—for example, by offering certification programs for garages and chains that feature their products prominently or by working with carmakers to develop parts that are harder to copy. Alliances with wholesalers and insurance companies can also preserve a part of the margins endangered by the EU reforms. Ultimately, some suppliers may undertake the risky and asset-intensive strategy of opening branded chains of service garages, as Bosch has done with its Bosch Car Service centers.