Restructuring Brazil's Automotive Supplier Industry

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The following article originally appeared in the GAPConnection, a quarterly publication of A.T. Kearney's Global Automotive Practice. The GAPConnection, which is written by A.T. Kearney consultants, explains, explores and analyzes key issues affecting the automotive industry, including supply chain management, manufacturing techniques and efficiency, changes in the retail and distribution system, financial and economic matters, globalization of the industry and other topics. 

IIf you would like additional information on this article or to receive the GAPConnection, contact Jay Houghton at 248-204-9067, or Sara Hogan at 248-204-9068. 

By Doug Harvey (Southfield), Markus Stricker (Stuttgart) and Marcelo Baptista (S‹o Paolo)

After stagnating for most of the 1980s, Brazil's automotive industry is on the mend. Much of its healing brought on by major changes in the country's economy. A big part of the recovery is due to the country's Real Economic Plan, which brought an end to high inflation rates. It is also the result of establishing South America as a free-trade zone through the Mercosur agreement, which at the time was with Argentina, Uruguay and Paraguay. Furthermore, the Brazilian government has improved its economic competitiveness by removing import restrictions and lowering import tariffs. These efforts have proved successful, for by 1996, despite increasing competition from imports, Brazilian vehicle production doubled to more than 1.8 million, a significant increase when compared to the 915,000 vehicles produced just six years earlier. 

Today, optimistic about Brazil's economic reforms and anticipating high levels of growth, automotive original equipment manufacturers (OEMs) have pledged to invest more than US$14 billion in the country's automotive industry by the year 2000. By then, analysts predict, annual vehicle production will be 2.5 million to 3 million, potentially making Brazil the fourth largest automotive producer in the world - an accomplishment that will have a profound impact on the structure of the industry and its supply base. This article examines the restructuring of Brazil's automotive industry. We discuss the impact of the changes on OEMs and on automotive parts suppliers as well as the implications for system integrators, foreign investors, the major players in the supply market - Brazilian firms or multinationals - and finally, the risks of investing in Brazil. 

Brazil's Automotive Parts Suppliers

Changes in Brazil's automotive industry will have an enormous impact on the local supplier industry that primarily supports four multinational companies - Volkswagen, GM, Ford and Fiat. Most local suppliers have supported these companies since the 1950s and have flourished in the country's closed, noncompetitive environment. Beginning in the 1990s, however, with vehicle production booming, suppliers in Brazil felt the sting of competition. OEMs engaging in global sourcing programs challenged local suppliers to lower costs and improve quality. Some suppliers have already dropped out of sight as OEMs consolidated their supply bases. 

Investments By Local Suppliers

Local Brazilian suppliers will probably not be able to fully support the surge in the automotive sector. They will be hampered by the high cost of capital in Brazil, their lack of technological know-how and insufficient quality levels. Many of these suppliers are still reeling from the early 1990s when competition led to lower prices and thus severe drops in margins that undermined their investment capabilities. 

Although many of the 450 member companies of SindipeÁas, the Brazilian Automotive Supplier Associ-ation, say they plan to collectively invest US$9 billion in Brazil from 1996 to 2000, it is highly unlikely considering the current profile of suppliers (i.e., lack of capital and technological know-how). Brazil's major suppliers such as Cofap, Freio Varga and Metal Leve, which have large domestic market shares, operated with losses until 1995, resulting in investment levels substantially below world levels as a percentage of revenue. 

Setting the Stage For Investments In Brazil

Multinational automotive components suppliers attracted by the promise of strong market growth will fill the void left by local suppliers unable to compete in the new industry. Joint ventures and acquisitions will prove attractive to the multinationals now importing parts into Brazil, given the high cost of transportation and tariff protections. By 2001, Brazilian OEMs with 60 percent local content will be able to import cars at only 18 percent duty. OEMs not meeting the local content threshold must pay 70 percent duty on imported cars and up to 70 percent on material. This incentive has led to growth both in production capacity and foreign investment. Production is expected to reach 2 million vehicles in 1997. Foreign investments will reach more than US$14 billion by 2000, at which time Brazil will likely have at least 10 OEMs, up from the current Big Four. For the next few years, foreign investment is expected to drive an average annual auto industry growth rate of 8 percent. 

Industry Consolidation and Foreign Suppliers

Supplier industry restructuring in Brazil is similar to restructuring in the worldwide auto parts industry in recent years. Three characteristics are important to understand the Brazilian situation: 
  • Just-in-time production processes and the high cost of transportation have led OEMs to demand that suppliers locate parts plants close to OEM assembly operations 
  • The auto parts sector is consolidating into a smaller number of tier one suppliers, which will operate as system integrators 
  • A wave of joint-ventures and acquisitions by major U.S. and European suppliers is sweeping across Brazil

Close proximity to OEM assembly operations

In Brazil, local suppliers enjoy two major competitive advantages over imports. First, deficiencies in the infrastructure of developing countries (i.e., high costs of shipping merchandise due to obsolete and inefficient port installations, and poor road conditions) favor suppliers located near customers. Second, the import tariff system and restrictions on the minimum share of local components under the Mercosur agreement benefit suppliers that have plants in the region and export part of their production. 

The strategy of bringing suppliers closer to the production plant started in Brazil in the early 1990s at Fiat's Betim plant. Dubbed ³the integrated factory,² Fiat had 230 local suppliers of which 41 were near the plant. With production of Fiat's new Palio model in 1996, the strategy broadened as 65 of the model's 70 suppliers were located near Betim. The tactic has worked so well that Fiat now strongly encourages its overseas suppliers to establish operations in Brazil. Many have done so. For instance, Standard, a body trim supplier, built a US$50 million plant in nearby Varginha, and BTR, a sealant and gasket maker, built a US$25 million plant in Betim, right next to Fiat's production site. 

Toyota's and Honda's plans to build assembly plants in Brazil have attracted attention from several mid-size suppliers. According to Toyota, more than 30 Japanese suppliers have already made contacts to analyze Brazil market potential. Honda says two suppliers - Kikuchi Company and Tokyo Seat Company - are planning to build plants in Brazil. 

Suppliers operating as system integrators

System integration is a process in which suppliers take on additional responsibilities and supply OEMs with an integrated system rather than a single component. Gradually, many suppliers have become system integrators, thus shrinking Brazil's supplier ranks. In the 1980s, for instance, there were 2,000 supplier companies in Brazil; by 1992 there were 1,500. This number dropped again in 1995 to 1,300. 

System integration is best illustrated at Volkswagen's industrial condominium concept plant in Resende. There the OEMs responsibilities have been reduced to a minimum. The automaker is responsible for a small number of tasks, including engineering, manufacturing, logistics and quality control, while the vast majority of operations are performed by suppliers - an approach that has reduced the number of direct suppliers to just 10. In fact, suppliers have taken on so much responsibility that they employ more people than the assembler. Suppliers employ 1,800 people while Volkswagen Rensende employs only 200 people. 

A wave of foreign investments

International companies are increasingly establishing local operations to supply Brazilian OEMs. Foreign investments can take the form of new OEMs attracting new suppliers - for instance, Chrysler is building its Dakota truck in Brazil and its Cherokee in Argentina and has urged Detroit Diesel Corporation to install a diesel engine plant in Brazil to supply both operations. Also, foreign investment is taking the form of acquisitions or joint ventures by American or European companies and Brazilian suppliers. For example, Mahle's takeover of Metal Leve and BTR's acquisition of OSA. Of the 60 largest suppliers worldwide, more than 30 are already in Brazil. These include Arvin, Bosch, BTR, Eaton, Dana, Lucas, Mahle, Pilkington, Rockwell, Saint-Gobain and ZF. 

The speed of these investments is impressive. Paulo Butori, president of SindipeÁas, says a recent query of the association's members reveals that auto parts supplier companies with Brazilian capital, which had a market share of 75 percent in 1995, may account for only about 20 percent of the revenues in this sector within two years. 

A fundamental factor for such investments is the tariff structure under the Mercosur trade system. Mercosur gives an implicit advantage to large-scale supply companies well established in the Mercosur market, because the 60 percent nationalization requirement considers production from any Mercosur country as local. This explains the significant increase in auto parts trade in these countries in the past three years. It also points to another trend in the industry - integration of the supply chain across the Mercosur region. 

Supplier integration takes place through trade and investment by OEMs and by the suppliers themselves. For example, three years ago the Weg group, an electrical motors supplier seeking to be one of the five largest producers worldwide, built a plant in Argentina. The company is now the market leader in the Mercosur region. 

Figure 3 illustrates the overall increase in imports and exports in Brazil with most of the growth being generated by increased trade with Mercosur members. 

Risks For Automotive Suppliers Doing Business In Brazil

The strategy for growth of the automotive and supplier sectors face challenges, principally the reaction of several countries and international institutions against the protection given by the Mercosur trade system. Recently, Mercosur tariff rules have been under fire from the World Bank, the IMF and Japan, which has brought this issue to the World Trade Organization (WTO). 

One of the main controversies is the incentive given to OEMs to invest in Mercosur countries. Local auto manufacturers can import cars they produce elsewhere under an import tariff of about 31 percent, whereas imports from OEMs not located in Mercosur countries are subject to a quota and a 63 percent to 70 percent import tax. Recently, the U.S. government threatened to take this case to the WTO. Both GM and Ford have tried to defend their interests in Brazil by defending the Brazilian automotive regime. Mitsubishi has put a hold on building a plant in Brazil until the issue with the WTO is resolved. 

Another major concern comes from labor unions. The unions argue that even though production has doubled in the past six years, employment has been reduced as a result of more automated production techniques and substantial productivity improvements, both necessary to compete internationally. A recent study indicates that jobs in the automotive industry will be reduced by 30 percent by the year 2000. 

Pressure may also come from local components suppliers requiring protection against the competition from multinationals and imports. Whether that protection takes place or not, the degree to which Brazilian suppliers will invest in expanding capacity and quality, while reducing cost, is still not certain. Recently, OEMs have found it difficult to get high quality components supplied by the local industry because some suppliers prefer to supply the replacement market - where margins are higher and quality and logistics requirements are lower. 

Also questionable is the continuing level of investment by OEMs. In a few years Brazil will have 12 to 15 OEMs producing. Whether the Mercosur market, which is expected to buy three million vehicles by 2000, is able to absorb this number of producers, and whether they will be able to export competitively will greatly influence the ultimate investment total. 

Conclusion

With the recent surge in production and investment by OEMs in Brazil, experts wonder if local auto suppliers have the capabilities to keep up with the increasing challenge of being globally competitive. We believe only new investments by foreign auto components suppliers can guarantee the future growth of the auto industry in the Mercosur. And, despite the risks, we predict this critical success factor will play out as multinationals move into the Brazilian market despite the risks. 
 
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