Is there anything US auto suppliers haven't tried to counteract the enormous purchasing power of the handful of automakers that make up their customer base? As the suppliers' profit margins have been squeezed again and again, they have responded with an array of strategic initiatives, including diversifying their customer base, going global, positioning themselves further upstream in the value chain, and actively helping to design components in hopes of capturing more value than they could by simply bending metal. In the 1990s, the industry also went through an M&A wave that many hoped would deliver the heft needed to push back against the automakers.

Each of these steps helped some suppliers in some ways, but for all their efforts the suppliers have, on average, barely kept up. The industry as a whole has been destroying shareholder value for years; margins have sagged even as revenues have grown. Some suppliers have offset this erosion in part by making their capital work harder, boosting returns on invested capital (ROIC) even as returns on sales have fallen. Yet even this slight improvement evaporates once the goodwill premiums for past acquisitions have been accounted for (Exhibit 1).

A thorough industry restructuring may be required to brighten the suppliers' prospects and bring needed balance to their relations with the automakers. Launching another wave of M&A activity will not suffice. To level the playing field, suppliers must become smarter about how they choose to expand or trim their product and customer mix and adjust their portfolio structure. The way the suppliers rise to the challenge could provide guidance to other industries, such as retailing, where powerful customers also dominate the top of the customer base.

The consolidation that wasn't

Many suppliers believe that their industry consolidated dramatically during the 1990s. In fact, a broad-based consolidation among the leading players never took place, although many mom-and-pop companies were cleared away at the bottom of the pyramid. Thus the annual revenues of the smallest of the top 100 automotive suppliers operating in North America rose to some $400 million, up from around $50 million in the early 1990s. But consolidation within the top 100 itself has actually slowed or gone in reverse, as the 25 largest suppliers command a smaller share of the market today than they did a decade ago. Moreover, the industry's shape has become broader at the base, not more concentrated at the top. From 1992 to 2002, each quartile of the top 100 suppliers had a higher compound annual growth rate (CAGR) in revenues than the quartile above it (Exhibit 2). The era did produce large suppliers, including ArvinMeritor, from Arvin Industries and Meritor Automotive; Dana Corporation, which doubled in size after it bought Echlin; and Lear, which quickly gobbled up more than two dozen smaller companies. Despite such growth, however, industry-wide consolidation has not occurred, and suppliers remain a mere fraction of the size of their largest customers.

Why have such efforts at restructuring failed to strengthen suppliers' positions? As we can see from the ongoing margin decline, unfocused M&A was largely to blame. Suppliers pursued size for size's sake, usually horizontally, adding products in order to provide entire systems or modules to the automakers. A seat maker, for example, might add a carpet product line, or a maker of springs might offer shock absorbers. Yet the automakers are so much larger than the suppliers that moving from $2 billion in revenues in one product line to $4 billion in two product lines did little to improve the suppliers' leverage with their customers. Indeed, the broad horizontal product groupings of the largest suppliers became easy targets for automakers' price-cutting efforts and were easily picked apart by purchasing departments seeking the best price in individual components. Furthermore, very large suppliers became increasingly desperate to win large contracts in order to maintain their growth trajectory. Those holding broad product portfolios found it almost impossible to achieve excellence in their disparate lines.

Effective restructuring

In the next wave of restructuring, companies must think about scale not as the primary way of standing up to the automakers across the board but as a means of finding the portfolio and product leverage they need in specific niches. Of course, they shouldn't abandon efforts to improve their performance through the kinds of specific strategic programs already under way, such as the conversion to lean production, globalization, and customer diversification. Many companies wouldn't have survived the 1990s without such programs. But those initiatives must be part of a broader strategy of improving the industry's standing relative to that of its customers. Individual suppliers must resist the temptation simply to get bigger or to "be a player" and instead focus on dominating their product arenas. Then they must back up product dominance (which influences volume and price) with strong process skills (which drive cost). The scale they achieve should be a result, not an input, of their strategy.¹

The way forward for successful automotive suppliers centers on three strategic decisions.

What to own

Conventional wisdom may suggest otherwise, but suppliers that focused vertically on owning more of the value chain within a product line have outperformed those that expanded horizontally across a broader range of products. Why? Purchasing departments are skilled at picking apart portfolios of products, but evidence shows that they are much less skilled at disaggregating the sources of value within the many steps that move a single product from raw material to finished good. As a result, control of more of the links in a product's value chain should generate larger profits.

Suppliers must therefore define a target product range, ignoring industry chatter about "systems" and "modules" and "cross-selling" in favor of a more sophisticated view of how their customers really buy. If an automaker buys brake systems through two departments—one for basic mechanical-brake devices and another for antilock-brake electronics, for example—a sales pitch for a combined brake system will face an uphill struggle. If an automaker relies on its tier-one automotive-interior supplier to specify a particular console producer, then owning the console production process may be more valuable than adding interior product lines, such as package shelves and pedal assemblies.

It will be important for suppliers to be aggressive about divesting assets and businesses outside their chosen product segments, thus freeing up cash for the kind of targeted growth—organic or acquired—that will build real leverage. This kind of supplier-level realignment will also improve the industry's performance over time by encouraging smarter consolidation than has been evident in the past. Most important, a focus on products, value-chain links, and processes will lead to optimal scale; starting with an arbitrary volume target unrelated to product economics leads nowhere.

What skills to develop

Very often, the most profitable links in a product's value chain are tied to specific processes. Such skills give focused suppliers another defense against powerful customers, which can't reverse-engineer products whose processes are patented, highly unusual, or based on years of specialized expertise. Our research shows that suppliers focusing on excellence in manufacturing or engineering processes, such as hydroforming (a type of metal-forming process that relies on hydraulic pressure rather than mechanical strikes to create complex shapes without as many expensive dies), have outperformed those focusing on innovative products, such as remote keyless entry. The reason is that processes are much harder for OEMs to reverse-engineer than products are. A big automotive-steel company, for instance, may grab attention for its more visible product innovations, but the maker of a special grade of steel that solves an SUV's crash-test problem will capture more value. It is simply harder for automakers to shop around for a set of processes than for a group of products.

What role to play

Broadly speaking, second-tier suppliers—those focused on selling as much to other suppliers as to automakers—are, on average, more profitable than their tier-one counterparts that deal exclusively with carmakers (Exhibit 3). They enjoy higher profits partly because they are less exposed to some of the world's most aggressive purchasing departments and partly because they typically manufacture a key component of a larger system rather than assembling the system itself.

Indeed, in most large automotive systems a few core components, often produced by tier-two companies, create much of the value. The smaller companies that control these "choke points"—key parts that may be small in dollar value but immense in their impact on the performance of the system as a whole—all tend to generate higher economic value and shareholder returns than do the much larger enterprises that ship the final system or module. Such smaller companies make parts such as the yaw-rate sensor, which provides the most crucial data for the brain of an electronic stability system; the washer nozzles that make it possible for larger windshield-wiper systems to help drivers see roads; and the special balance shaft that prevents some expensive engines from shaking themselves to pieces.

Of course, to identify these choke points, companies must develop a deeper understanding of each link's profitability and its balance sheet and then make a hard economic analysis of which links are most valuable to control. This kind of focus on value choke points is one reason the private equity investment community, with its more objective analysis of value creation, has greater interest in second-tier suppliers than in first-tier ones. Unfortunately, most suppliers typically fixate on sales volumes rather than profitability as the measure of success.

The winning auto suppliers of the future won't try to fight size with size to gain an advantage against their big customers' purchasing power. Only a restructuring that focuses on excellent processes as well as excellent products will provide the precision-targeted leverage suppliers need to fight back effectively and to preserve the long-term health of their industry.