Rating The IPO

Note: "Before IPO" and "After IPO" measure the use of the proceedings to enhance revenue growth. A small difference between the two Xs means funds from the proceedings probably will have little effect on the index.

Rating Scale

Prediction
Delco-Remy is a major player in the manufacture of vehicle starter motors and alternators. It remains closely aligned with General Motors but is internationalizing quickly through several acquisitions and joint ventures. The result is increased revenues over the last two years by $116 million, and there’s no doubt it will repeat this growth in the next two or three as its acquisitions continue. Company gross profit margins are very low, but it’s going after the more lucrative aftermarket, which should help. Also, the Company is revamping its manufacturing facilities in a major way by bringing modern techniques to bear. This will bring down overhead costs and boost margins. However, the products are a commodity business where margins always will be low. Acquisitions will create a bigger and more complex company, but it remains to be seen whether they will increase its percentage of net income. The use of stock to pay debt, buy other companies, and satisfy beneficial stockholders, all of which is likely, will impose a downward pressure on stock price. Still, investors respond to vapid increases in revenue. The stock will open in the upper teens and will move to the low 30s by the end of Year 1.

Material On This Page Taken From Prospectus
"The Company designs, manufactures, remanufactures and distributes electrical, powertrain/drivetrain and related components for automobiles and light trucks, medium and heavy duty trucks and other heavy duty vehicles. The Company's products include starter motors ("starters"), alternators, engines, transmissions, traction control systems and fuel systems. The Company serves the aftermarket and the original equipment manufacturer ("OEM") market, principally in North America as well as in Europe, Latin America and Asia-Pacific.

The Company believes that it is the largest manufacturer and remanufacturer in North America of (i) starters for automobiles and light trucks (including sport-utility vehicles, minivans and pickup trucks) and (ii) starters and alternators for medium and heavy duty vehicles. The Company's products are principally sold or distributed to OEMs for both original equipment manufacture and aftermarket operations, as well as to warehouse distributors and retail automotive parts chains….The Company believes that its participation in both OEM and aftermarket businesses and its diversified customer base reduce its exposure to the cyclicality of the automotive industry. The Company's growth strategy is designed to capitalize on its position as a consolidator in the large and highly fragmented remanufacturing aftermarket."

Summary Of Financial Data
In millions except for Net Income Per Share.

How they wrangled the operation from GM and what the selling price was and how it’s being paid is only partially clear. The Offering will be used to reduce some of the debt. It consists of an amount of equity plus a $130 million Senior Note due in 2007. As of this writing (11/8/97) the precise amount of equity to be offered is unknown but certainly millions of shares. The proceeds from the Offering will be in the neighborhood of $181 million. By way of example, assume 8 million shares are sold into the market at $15 per share for a total of $120 million. This money, generated from the sale of equity, along with the $130 million Senior Note would total $250 million. Since $181 million are the expected net proceeds, it would mean in this example that the difference, $69 million, would slip effortlessly into the pockets of the selling stockholders, namely those deal-makers at the top. And still they would hold complete control over the Company.

An Easy Hundred Million
Here we have yet another example of the forces changing business in the world today, especially in the U.S. where tapping into the funds of willing investors has become a motivation unto itself. The IPO is the country’s most powerful engine capable of pumping money from the bank accounts of the middle class into the bank accounts of the extremely wealthy with baffling ease. The concept is elegant in its simplicity. Find a company that’s already strong, round up the financing in the form of short-term and long-term loans, and buy it. Distribute among yourselves millions of shares of stock and at the same time refinance the debt in the form of a Senior Note due in 10 years and call it the Company’s debt; that way, you reduce, perhaps even eliminate, your personal risk. Now for the good part: Sell your own stock in an initial public offering and overnight accrue riches of dazzling proportion. None of that money goes to help the company, but rely on the fact that it’s a detail about which investors will care little. Nor does the money collected from the Senior Note really reduce the debt. It gets reoriented away from the venture capitalists, who now exit the deal with an enormous smile on their face, and instead becomes owed to a large body of people trying to eke out a few percentage points of interest on their precious savings. In the meantime the IPO has established the company at the public trough without really being a public company, and you can take care of the debt through future offerings. Compared to the amount of stock outstanding, so little has been given to the unwashed masses that you can stay in control indefinitely. All the machinery is now in place where you will continue to sell stock and reap rewards of wonderful magnitude.

And everybody cheers. The extremely wealthy gain prodigious amounts of money, while the others make the incremental advances to which they’re accustomed. It’s a complex matter. In the case of Delco-Remy few can dispute that it will do far better when out from under the oppressive wing of GM, and even GM knows it. The new owners are taking an operation, spread across 3.7 million square feet of manufacturing space, then streamlining it, giving it greater focus, and moving out aggressively to induce consolidation in the industry. Already they’ve made 5 major acquisitions, a bevy of joint ventures, and more are on their way (see figure). The end result is that the rich will get richer, the Company will get bigger, and everybody else will be a little better off. It’s an accommodation that rankles while at the same time being difficult to attack.

In the case of Delco-Remy it’s a near certainty that other secondary offerings will take place, probably as soon as is feasible without causing severe damage to the stock price, and the beneficial stockholders will have their shares mixed in. Such caveats have been given in the prospectus.

The Changing OEM/Supplier Relationship
Still, Delco-Remy is a major manufacturer of starters and alternators and not a company to sneeze at in its ability to design, produce, and distribute products. In fact, it’s a Tier 1 supplier to GM, which means it’s shown itself capable of manufacturing quality components in volume and at a reasonable price. Why then would GM sell such a resource?

The answer to this question relates not so much to GM as it does to the changing nature of all big manufacturing operations in the ‘90s. They’re getting better and smarter and more efficient. They’re becoming less vertically integrated, which means focusing on their core competencies inhouse and outsourcing the tangential work to suppliers who also are becoming better. It’s a good move for GM. By giving the effort over to the supplier, in this case an independent Delco-Remy, GM can reduce its manufacturing space and labor force and consequently its cost. Delco-Remy in turn will become a technology specialist who puts out the effort to maximize the component’s performance and minimize its cost. GM will speed up its design cycles while continuing to exert control over the components it uses. The end result for GM will be a better product made more cheaply and for Delco-Remy the assurance of business and the potential for growth. Both companies are seizing an opportunity which makes sense in terms of thrust and timing.

More Efficient Manufacturing
One of the first orders of business for the Company was to turn a flaccid, bloated, inefficient inhouse operation into one capable of competing in the global marketplace manufacturing what are essentially commodity items. To that end it’s shut down a number of aging facilities, typical of the low-tech approach of the past, and opened 3 new ones called "focus" factories. A focus factory is smaller in size, is adapted for a specific line of products, and has fewer employees. All the current buzz phrases apply—"lean manufacturing techniques," "cell-based manufacturing," and "kaizen methods" to name a few. New agreements have been formed with the United Auto Workers Union to reduce the number of job classifications, which is very important. Instead of filling the factory with a lot of people each of whom performs a small set of functions they now reduce the labor force and give the remaining employees broader classifications. We’re not talking rocket science here. Workers who have more things to do and more say in the process become more productive.

With 5 focus factories operational the Company claims it will be able to reduce its floor space for OEM production from 1.9 million square feet down to 584,000 square feet, a 70% reduction. The savings in overhead costs clearly would be significant.

Changes In Purchasing
They’ve also tackled changes in their approach toward the purchasing of raw materials. Purchasing is one of the more complex endeavors performed by any big manufacturing company. With an operation flung across many different facilities around the world it’s no mean task trying to figure out what’s needed, how to buy at a reasonable price, where it should go, and getting it there neither too early nor too late. Efficient purchasing in today’s competitive environment requires a group of experts at a central location who use a limited number of vendors and who purchase for the needs of the entire company. Only with the rise of computer-networked communications and a great deal of specialized software, which trigger orders and track shipments, has this effort become achievable.

The Company appears to be implementing these approaches. For some materials, copper wire and steel specifically, they’ve managed to align themselves with the purchasing of GM to get even greater economies of scale. It’s a subtle advantage that few of their competitors would have.

The Market
The industry segments into two broad categories, one for the OEM market, that is, for those companies like GM which make vehicles, and the other for the aftermarket.

The OEM market is far and away the larger in volume. Any company who is a supplier to the auto OEMs will necessarily have size and maturity and be able to produce high-quality parts consistently. They must meet demanding standards imposed on them by the OEM. It’s always the dream of those attempting to enter an industry to become a supplier in the OEM segment because of the level of business they would be assured and the stability it would bring to their operation. The downside is that the margins are razor thin. Gross profit margins for the Company ranged from 17.1% in ’95 to 21.7% in ’97. With margins like these it’s surprising if they can scratch out any net income at all. Their earnings before interest, taxes, depreciation, and amortization (EBITDA) for the same period was 9.8% to 12.7%, which is extremely low even for Chinese standards.

The aftermarket consists of the production and sale primarily of used parts which are refurbished or, as they say, remanufactured, to perform like new. Aftermarket components are not factory installed by the OEMs. Instead, they are used in the maintenance and repair of vehicles. The cost to remanufacture an old part is considerably less than that required to manufacture a new part; the result is a higher profit margin. Consequently, the aftermarket becomes very important given the slender margins of the OEM segment.

A number of factors are propelling high growth in the aftermarket. First, in the U.S. the average age for cars and light trucks in ’96 was 8.5 years as compared with an average care age of 7.9 years in ’86. That is, people are keeping their vehicles longer, thus an increase in the rate of repair. Second, the lengthening warranty that OEMs offer on their vehicles motivates them to reduce their costs when service is required. To do that they use remanufactured parts. And third, worldwide distribution for auto parts is rapidly maturing with the emergence of mass merchandisers and the automotive parts chains. Along with all the dealerships and wholesale distributors they represent the channels through which the aftermarket products are sold.

The Company has a strategy to advance its presence in the aftermarket as much and as rapidly as possible. Its rate of growth increased from 19.2% in ’95 to 45.2% in ’97. By ’97 the aftermarket accounted for 45% of the Company’s net sales and 63% of EBITDA, a clear indication of its better margins.

In implementing its strategy for growth in the aftermarket segment the Company can bring to bear two very significant advantages, the first being that it’s an OEM supplier and the second, that it’s a supplier to GM.

Advantages Of The OEM Supplier
As an OEM supplier it will have the chance to sell into the dealership channel for those vehicles using its parts. Equally important, it will have its manufacturing already in place—from the production line to the engineering staff, labor force, and management—making the creation of products for the aftermarket a relatively easy step. Without the leverage gained from supplying the OEMs, the cost of entry and risk involved is substantial. At the very least those who supply only to the aftermarket will be constrained in their size and their penetration of the market. It explains why this segment of the industry is so fragmented.

Despite being the largest manufacturer of starters and alternators in North America the Company has only a 12% market share. Since those who serve only the aftermarket are smaller an opportunity is opened for the Company to grow through consolidation. It’s now beginning to do this with a vengeance.

Being a Tier 1 supplier to GM, one of the greatest vehicle manufacturers ever formed, also carries with it a few sizable advantages. Having been part and parcel of GM, Delco-Remy of course will be able to use its relationship to extreme advantage as it increases its international presence. GM has agreed to continue buying from the Company all its automotive starters for the North American market and all its heavy-duty starters and alternators for the U.S. and Canadian market. Further, GM has agreed to distribute the Company’s aftermarket products through GM SPO, its distribution system, which is worldwide and deep.

The Company is acquiring competitors and establishing joint ventures abroad to gain a physical presence in those areas. It will become useful because of the movement underway for international standardization of the automotive and heavy-duty vehicle platforms. With standards, a vehicle, which is acceptable to one country, will be acceptable to all and not have to go through modification to conform to any unique national requirements. It means the Company will be able to apply uniform manufacturing methods among the various operations and potentially to shift products between the various geographical markets of the world more easily.

An increased global presence for the Company will help reduce its reliance on GM, which currently is very high. GM accounts for 97% of its automotive OEM sales, and GM SPO for 24% of its aftermarket sales. Together these revenues constituted 39% of the Company’s total ’97 net sales. Their acquisitions and joint ventures will help to give them a broader customer base. Already they’ve picked up business throughout Europe as well as in Brazil, India, and Mexico.

The Technology
Starters and alternators are technically well-understood devices. On the whole they’re considered commodity components and require little in the way of sophisticated manufacturing techniques. However, as with all areas they’re amenable to improvement through the normal advances made in technology and material science.

Over the last number of years the Company has introduced a line of so-called gear-reduction starters, which is considerably improved over the older straight-drive starters. These are now used on 44% of GM’s North American automotive platforms with the exception of Saturn and Geo. The importance of the new starter is in its weight reduction. It produces the same power at 7.7 pounds that the earlier type produces at 13.6 pounds, a 43% improvement. Weight is of vital interest to the automotive industry. The weight of the vehicle is directly related to its mileage efficiency, and the U.S. Federal Government has incentivized, if not mandated, the industry to meet targets for its improvement known as the Corporate Average Fuel Economy (CAFE) standards. To do so the industry has sought to reduce vehicle weight by shaving off weight from every component. Often this amounts to ounces. Thus, a 6 pound reduction on a small component is significant and will be of interest other OEMs.

The Company has come out with several other new products including a heavy duty brushless alternator for high vibration applications and a large-frame alternator for heavy duty vehicles. Like all major manufacturers it’s in league with those strong R&D companies around the country capable of advanced research on new applications. Their alliances include SatCon Technology Corp, EcoAir Corp, and Arthur D. Little. Recently, Arthur D. Little made the news with an announcement by the Department Of Energy about a technology breakthrough for electric cars.

R&D, though, doesn’t seem to be very high on their list. The Company will grow not because of any single improved product but because of their high rate of acquisitions.

The Financials
It’s not correct to say the Company is new, because Delco-Remy has been manufacturing parts for decades. And the important relationship it has with GM is not one to be terminated soon by either side. On the other hand, the management is new, its strategies are new, and its appeal to the public for funding is new. The Company’s track record can be said to have begun in ’94, so there’s been little time to assess results. On the surface their actions appear good. The acquisitions, mainly of starter and alternator companies, are in focus with its core business. It divested itself of a large-bore diesel remanufacturing operation, which it didn’t need. It’s developing a global presence along many fronts—through joint ventures, through a concerted effort to get international business, and through GM’s aftermarket distribution channel, GM SPO.

Since ’95 revenue has increased $116 million, a good percentage of it being growth by acquisition. What positive effect all this will have on the bottom line remains to be seen. Gross margins have increased slightly to 21.7%, but it still seems very low. That will necessarily translate into low net income when or if the Company gets out of its deficit phase. They’re very close to the edge on their ability to show a profit. If management acts on its inclination toward the use of equity for future acquisitions, the dilution could well ripple through share earnings and stock price.

In ’97 the Company took a $34.5 million restructuring charge, which clobbered its performance for the year producing a $14.3 million loss. As of July 31, 1997 total debt stood at $341.3 million. Interest expense on the debt has crept up to $38.7 million or 5.6% of revenue, still reasonable. Chances are good they’ll leverage themselves even higher over the coming years and then pull it back through a secondary offering. The investor can forget about a dividend for the next several years at least; the banks to whom the Company owes money have dibs.

The Management
Although Mr. Sperlich is Chairman of the Board and Mr. Snyder is COO, it doesn’t appear that a CEO has yet been selected.

Compensation for management has not been listed for the current version of the S1 document.

The Underwriters

• Morgan Stanley Dean Witter
• Credit Suisse First Boston
• Salomon Brothers, Inc.