Bankruptcy raider moves in on auto-parts

(Fortune Magazine) -- Like detectives Briscoe and Green tracking down a murder suspect, the dogged investigators from W.L. Ross & Co. were in hot pursuit. And just as with the TV gumshoes from "Law & Order," serendipity - or plain luck - was playing a starring role.

Sifting through the European assets of a bankrupt American auto-parts company a year ago, they uncovered an ownership interest in three plants in Brazil. Even though Brazil was a long distance from Europe and way off their radar screen, the plants looked like potential turnaround prospects.

Ready to roll: Ross studied the parts business for two years before starting to buy.

More from Fortune Will Mmmhops be a hit? NBA confirms L.A. Clippers sale to ex-Microsoft CEO Steve Ballmer FBI and SEC probe into Carl Icahn and golfer Phil Mickelson FORTUNE 500 Current Issue Subscribe to Fortune

WHAT ROSS LOOKS FOR Barriers to global competition Ross picked plastic parts because they can't be shipped long distances. Good operations, weak balance sheets Cleaning up debt is easier than rebuilding a business. Stable markets Ross shopped in Europe first because market shares are less volatile. Diversity of customer base Companies tied to GM and Ford have suffered as production has dropped. Specialized knowledge Look for products that require technical sophistication. Hidden surprises Ross found a factory where he couldn't get control of the lease, so he bought the real estate.

When the Ross team flew to South America to take a look, they found three debt-laden but well-run plants making plastic parts like instrument panels for such customers as Fiat, Volkswagen and Ford (Charts).

Ross has a special fondness for plastic parts because they scratch easily and thus aren't suited for shipping long distances - a fragility that protects them from global competitors. Within six months he acquired control of the plants. Another link in the New York financier's growing International Auto Components Group (IAC) had been forged.

Ross, 68, has made a fortune for investors and for himself by buying broken-down companies in distressed industries like steel and textiles, slimming them down, trimming them up and putting them back on sale.

"My wife accuses me of trying to reinvent the 19th century," Ross says. The payoff from his bottom-fishing strategy smacks of the 19th century too -Rockefeller and Carnegie. Ross's first fund has returned an average of 40 percent annually since it was started in 1997, and his next one, started in 2002, has doubled in value every year.

Ross has earned a reputation for farsightedness, smarts and diligence. Says Delphi CEO Steve Miller, who sold bankrupt Bethlehem Steel to Ross in 2003: "In negotiations, it was clear he knew all the details. He knew more about my company than I did." Ross later packaged Bethlehem with some other steel companies and sold them for a $2.5 billion profit.

Ross's earlier ventures look elementary compared with the complexities of the auto-parts business, though. There is a huge imbalance between suppliers - 10,000 in North America alone - and their customers - a couple of dozen giant automakers. Guess who holds the upper hand?

Automakers can and do demand annual price reductions for the life of a contract. Combine that with burdensome debt, soaring commodity prices and fragile production schedules, and you have the potential for a major catastrophe.

The timing of that catastrophe is still in doubt. Ross expected an "approaching storm" to engulf the U.S. parts industry in 2006 and prepared to make a move on companies that got into trouble. Consumers were tapped out, unit volume was down, the product mix was changing and suppliers were too dependent on individual companies. As he predicted, several suppliers went bankrupt. But auto sales remained relatively strong at around 17 million units. "We may have been a year too early," Ross says now.

Just screening the troubled companies would be a full-time job. Ross figures that half of the 50 largest suppliers in North America lost money in 2005, and very few earned more than 3 percent on revenues. But Ross operates worldwide. How does he find the candidates for investment that will produce the returns that his investors expect?

Ross has molded his firm along the lines of a SWAT team - small (just 50 people, based in New York), flexible and fast-moving. He leads the auto-parts effort himself, backed by a deputy and up to eight associates.

Although he recently sold part of his company to Amvescap (Charts), a global investment company based in London, for $375 million, Ross stays closely involved in deals. Tall and bespectacled, he has the manner of an opinionated finance professor. "Our interest is to be a provocateur of change," he likes to say.

Ross analyzed the auto-parts business for two solid years before making his first investment. "We really study it, and then try to beat it to death," he says. Two wall charts are created, one enumerating the industry's problems, the second listing solutions. "Once we get to where the second list corresponds to the first one, then we start buying things."

Ross picked segments within auto parts that were the most fragmented and had the strongest potential for high return. After identifying safety products and metal stampings, he decided to start with plastics. Resin prices were rising steeply, yet the parts makers not only had failed to get cost protection written into their contracts, but had also agreed to cut prices on finished goods 2 or 3 percent a year.

"In most auto parts, 50 to 60 percent of the total cost is raw materials," Ross says. "A lot of the problems the industry had were self-inflicted because they weren't thinking it through."

The next step was to identify individual targets. "Our screen initially includes everybody," says Ross. "Not everybody is for sale, not everybody is in trouble, so it sifts down."

Rather than going after North America first, Ross decided to start in Europe. More companies were available, potential buyers were fewer, the market was less volatile and Asian automakers were less of a threat.

Ross describes himself as a big-picture guy who doesn't get wrapped up in operational details. Yet the clash and clangor of the plant floor hold little fear for him when it comes to analysis. "A lot of it is simple: material wastage, reject rate, cleanliness, safety. I never saw an efficiently run factory with a bad safety record."

All this work is done with one result in mind - reducing the potential downside by becoming the low-cost, high-quality producer. Ross wants to win by being smarter than the other guy, not braver. "We hate risk - we really do," he says.

"That saying that return is somehow proportionate to risk was invented by a Wall Street guy with a very risky deal. It means there is some God up there who says, 'You know, Mr. Ross, you took a very big risk, so here is your reward.' As far as we can figure out, that mechanism doesn't exist." Ross would prefer to worry about things that he can control: the problem that didn't get put up on his chart, the question that didn't get asked in due diligence.

Most of the feet-on-the-ground work falls to Ross's point man on autos, Stephen Toy, 33, a graduate of the State University of New York at Albany, who has worked with Ross for ten years. Toy has walked through dozens of auto plants. He scrutinizes the condition of the tools and machinery, analyzes the use of floor space and talks to plant managers to see if they focus strongly enough on improving efficiency.

He also talks with customers, vendors and, of all things, landlords. In attempting to buy an operation in the Czech Republic a few years ago, he was unable to get a plant's lease assigned to his company. So he bought the building too.

The pursuit of Collins & Aikman, a struggling U.S. maker of plastic auto parts, illuminates the Ross method.

An earlier private-equity buyout of C&A led by David Stockman, budget director under President Reagan, was going up in flames. Rising commodity prices, overhanging debt and production cutbacks by the Big Three had ravaged the business, forcing Stockman to resign in May 2005. Five days later the company filed for bankruptcy.

Ross likes bankruptcies, but he ignored C&A's U.S. business while Toy flew to Europe to see what he could salvage from its overseas operations. While there, Toy discovered C&A's interest in the three Brazilian plants and arranged to visit them in September 2005.

"We had no real expectations," Toy recalls. "But we found an impressive management, well-run operations with good market share - they were the leader in their segment - and modern technology."

Toy went back to New York and reviewed the situation with Ross. They had uncovered what Toy calls "a good company with a bad balance sheet'' - too much debt to work its way back to solvency. They reported to the bankruptcy administrator in Britain that they wanted to bid on the South American assets in addition to the European ones, and a separate auction was held.

Unlike the other bidders, Ross didn't condition his offer on a complicated package of debt and securities - he just wrote a check. The deal closed in mid-April.

Many financial operators would have been tempted to start cutting costs so they could put the plants up for sale. Ross went in the opposite direction. With the proceeds from a $65 million rights offering, he paid down the debt on the three plants - and decided to open a fourth one.

He'd learned that Toyota (Charts) needed a reliable supplier of painted bumpers for its facility in neighboring Argentina. Toy arranged a videoconference with Toyota between New York and Brazil, and Ross flew to Japan for a face-to-face meeting. With a contract in hand and the proceeds from the stock offering, he is starting to build a plant near Buenos Aires.

Ross's diligence paid off. Shares in the South American plants, traded on the Brazilian stock exchange, have risen ninefold since the deal was announced.

That kind of return has drawn a crowd. With giant auto suppliers like Delphi in bankruptcy, other investors are circling. Toy says he now gets two or three new deals across his desk each week.

After Ross scooped up nine European plants owned by Lear Corp. (Charts) making - what else? - plastic parts, financier Carl Icahn invested $200 million in Lear, and he now owns 13 percent of the company.

Ross seems unruffled by the competition. Because of the complexity of auto parts, he believes all the study he put in upfront will pay off. His auto-parts company, IAC, now consists of 27 facilities in Europe, Japan and South America, generating more than $1.5 billion in annual revenue.

He's still waiting to make his first investment in North America, but he's considering a number of them and expects to announce the first before year's end.

_________________

Private equity's barbarians are on top - for now