China’s Automotive Sector: Strategies for a Changing Industry

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China’s Automotive Sector: Strategies for a Changing Industry

Executive Summary

China’s automotive industry has arrived at an inflection point, following a period

of rapid growth that culminated with a stimulus-driven surge in demand in 2009-

2010. Since then, the industry has sharply decelerated, with total auto sales

growth slipping to 2.5% in 2011. According to the China Association of

Automobile Manufacturers (CAAM), in the ten months through October 2012,

passenger car sales rose 6.7% YoY to 12.6 million vehicles, while total auto

sales rose 3.4% to 15.7 million vehicles. Although overall market growth has

decelerated, there is still sustainable and healthy growth occurring in lower-tier

regions of the country, as well as in certain segments such as premium cars and

compact SUVs. To examine the dynamics of the Chinese auto industry at this

juncture, we recently hosted a presentation by Bill Russo, Senior Advisor at

Booz & Company and Chrysler’s former Vice President for Northeast Asia, who

discussed how automakers are adjusting their strategies to China’s new growth

patterns.

Annual car sales growth is expected to slow to between 5 and 8% over the

next decade as a function of the central government’s desire for slower and

more sustainable economic growth, the phasing out of auto subsidies, and to

a lesser extent the license plate restrictions in cities like Shanghai and

Beijing. Although there are now limitations on passenger vehicle

registrations in 4 major cities, it is important to note that there are over 150

cities in China with populations over 1 million. There is also enormous

growth potential in the lower-tier regions in China, with tier 4 and lower cities

accounting for 80% of the Chinese population.

An industry shakeout is likely in the next 3-5 years, in light of high levels of

overcapacity. By 2015, planned capacity will potentially exceed vehicle

demand by as much as 35%. As a result, competitive dynamics will more

closely resemble developed markets, with larger annual profit swings, strong

purchasing incentives, and an increased emphasis on operational efficiency.

With smaller domestic car companies having given back most of their market

share gains following the expiry of incentives launched in 2009 with the

Automotive Industry Revitalization plan, the notable winners have been VW,

GM, and Nissan. In Mr. Russo’s view, Great Wall Motor and Geely are the

most capable domestic Chinese carmakers, with Great Wall having pursued

an internal organic approach to R&D, while Geely has leveraged external

partnerships and acquisitions to become the only Chinese carmaker with its

own capability in higher speed automatic transmissions.

There is tremendous growth opportunity in the SUV segment, which grew at

a 40% rate in 2011. Premium-branded cars are also bucking the slower

growth trends – while overall sedan growth is in the 5% range, premium

brands are enjoying robust double-digit growth. With an ever-increasing

population of vehicles, significant growth potential exists in the automotive

after-market. However, the sales and service network in China is still very

fragmented, with the top 10 dealership groups representing only 17% of the

HANDS-ON CHINA REPORT

November 12, 2012

Bill Russo

Senior AdvisorBooz & CompanyPresident,

Synergistics Ltd.

Bill Russo is Senior Advisor - employed

by Booz & Company. He is not a member of J.P. Morgan’s Research Department. Unless otherwise

indicated, his views are his own and may differ from the views of the J.P.

Morgan’s Research Department and from the views of others within J.P.

Morgan.

For more information on J.P. Morgan’sHands-On China Series, please contact:

Jing UlrichAC

Managing Director, Chairman,Global Markets, China

+852 2800 [email protected]

Amir Hoosain+852 2800 8641

[email protected]

Mark Stimson+852 2800 [email protected]

Henry Kerins

+852 2800 [email protected]

J.P. Morgan Securities (Asia Pacific) Limited

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HANDS-ON CHINA REPORT – November 12, 2012

total market. In the US, new car sales contribute 60% of a dealer’s revenue and just 20% of their

profit, in sharp contrast to China where new car sales comprise 80% of a dealer’s revenue and

half of their profit. In China, the market leaders will be the dealerships with the right exposure to

diversified growth segments including SUV, mid-market, and premium and the ability to adapt

their portfolio to succeed in delivering after-sales services. Increasingly, they must also anticipate

and position themselves to access the emerging growth opportunity of lower-tier city consumers.

The following is an abridged transcript of Bill Russo’s presentation.

China’s automotive industry has arrived at an inflection point and in the future, market competition will

be more intense. There will still be demand growth, but year-on-year growth will continue to slow.

Companies – both MNCs and domestic brands – will need to develop new strategies to maintain

relevance and profitability. There will inevitably be a period of consolidation because the market is

geared towards a higher level of capacity than what the market demand is likely to be.

Asia Pacific passenger vehicle sales in 2010 accounted for 22.2 million units, while in 2015 we expect

30 million units. India will be the second largest market in the region by 2020, but will still lag

significantly behind China. As the largest automotive production and sales region, Asia Pacific has

become the battle ground for dominance of the automotive industry in the 21st century. Automotive

leaders going forward must have very Asia-centric businesses if they want to compete in the global

auto industry. Over the last 5 years, China has represented 33% of the total global growth in light

vehicle sales, while developing countries account for 75% of global sales growth.

China’s overall car sales totaled 18.5 million units in 2011, including commercial and passenger

vehicles. Overall automotive market growth was 2.5% last year, with commercial vehicle sales

declining over the last year while passenger vehicle (PV) sales grew more than 5%. Infrastructure

spending and investments in urbanization have largely driven the commercial vehicle segment.

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Meanwhile passenger vehicle sales were boosted in 2009 and 2010 by government incentives and

subsidies. This yielded 46% YoY growth in vehicle sales in 2009, and 32% YoY in 2010. This

contrasts rather sharply with the 2.5% growth achieved in 2011. This happened because many of the

incentives that China implemented in 2009 were phased out over that two-year period. When

incentives are removed from a market, you will typically see a decline in sales - which did not happen

in China in 2011. In fact there are segments within the automotive sector that are growing quite

robustly, even without the subsidies in place. This is an indication of the fundamental strength of the

China auto market. With continued growth of an increasingly urbanized population of middle-class

and higher consumers, China has been able to sustain growth in 2011, albeit at a slower pace.

Annual car sales are expected to slow from a rate of 25% over the last 10 years, to between 5 and 8%

over the next decade. The slower growth rate is a function of several inter-related drivers that include

the central government’s desire for slower economic growth, the phasing out of auto subsidies, and a

third but less influential factor is the implementation of restrictions on passenger vehicle registration in

cities like Shanghai and Beijing. Although there are now restrictions on PV purchases in 4 major cities,

there are still more than 150 cities in China with populations over 1 million, which in the grand scheme

of things limits the negative impact of this policy on auto sales. In short, here are many places to go

to tap new growth opportunities. However, the process of industry growth is beginning to shift to a

different pattern. Automotive manufacturers, suppliers and dealers that adjust their strategies to the

new growth pattern will prosper.

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China’s commercial vehicle industry will recover gradually but at a relatively slow pace. The key

drivers are China’s urbanization, expected increases in FAI, and the shorter life cycle of Chinese

trucks due to poor maintenance, low quality fuel, and poor road conditions. China is now 50%

urbanized, and we expect this ratio to grow to over 65% in 2020.

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We may see high levels of overcapacity and significant margin pressure within the next 3 - 5 years,

and an industry shakeout is inevitable. On the supply side, there are some very big challenges in

terms of overcapacity since 2010. With a deceleration in growth in 2011, overall capacity growth in

China outstripped demand growth. This will become even more magnified by 2015. Chinese

automotive companies have limited experience in managing a market slowdown, and are now facing

the potential for a significant overhang if they continue to add new capacity. To some extent, the

attitude is that if you have the authorization to build additional capacity, you build it quickly – or you

may not get a chance to do it later. The consequence of overcapacity in the automotive industry is

larger inventories in the channel, higher discounts and thinner margins. Forecasted overcapacity

levels may be the catalyst for the long-anticipated phase of industry consolidation, and competitive

dynamics may start to more closely resemble those of developed markets with larger annual profit

swings, strong purchasing incentives, and increased emphasis on operational efficiency. Car

companies which lack a diversified product portfolio with clear brand value propositions will be more

susceptible to large up and down swings in profits due to this development.

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In China, the top 10 automotive enterprises now account for 87% of total sales. All foreign brands

manufactured in China are produced through joint ventures with Chinese partners. To ensure a stable

and sustainable development of the domestic industry, the National Development and Reform

Commission (NDRC) has set a target for the top ten automotive enterprises to achieve 90% share of

the overall market.

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The pressures resulting from this overcapacity development may be the catalyst for the long-

anticipated industry consolidation phase. The existence of many weak sub-scale manufacturers is

understood, and the Chinese government had articulated a plan in 2009 to consolidate the industry

into 2 distinct “tiers”: the Tier 1 group consisting of companies with an annual capacity of 2 million

units that are encouraged to acquire smaller automotive companies throughout China, whereas Tier 2

consists of companies with an annual capacity of 1 million units that are encouraged to drive regional

consolidation.

Presently they have reached the Tier 1 target, with Chang’An, Dongfeng, FAW and SAIC. The goal of

having at least 4 other companies with sales above 1 million units has not been reached, with BAIC

currently the only company above that level. In order to achieve the NDRC targets, some structural

realignment in the market will likely occur over the next several years.

However, progress toward implementing this restructuring plan has been slow during a booming

growth period where all companies were expanding. As the market slows, it is now time to accelerate

industry consolidation. This will not be easy, as many companies will resist a top-down push to

restructure. Ultimately, market forces must determine the companies that have earned their right to

survive this consolidation phase.

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In 2009 and 2010, local vehicle manufacturers have benefited from tax incentives and other subsidies,

but they have lost momentum recently. Over the period where there were subsidies and incentives in

the market, the local OEMs saw their PV market share increase. The incentives were directed at cars

with engine sizes of 1.6 liters and below, which are generally manufactured by the local OEM brands.

Larger cars tend to be produced by the international car companies, although some international

companies that produce cars with low engine displacement benefited as well. The increase in market

share from 25% to 29% shows how local car companies were in fact propped up by these incentives.

However, these share gains have largely been erased when the incentives were phased out.

The very notable winners have been VW, GM, and Nissan, especially in 2011. With the local

companies, there are a few which are particularly strong including Geely and Great Wall, two

companies which I fundamentally think are the best run Chinese car companies. Geely has been

especially interesting with their ability to create a full-range product and brand portfolio. In particular,

they are the only Chinese car company that has in-house automatic transmission capability, which

helps them to achieve a more upscale positioning with their Emgrand brand. Geely acquired this

capability then they purchased the Australian gearbox maker Drive Train Systems International in

2009. Great Wall Motors has also become a full-range manufacturer of sedans and SUVs. They have

a very strong set of capabilities built around their manufacturing and body engineering skills, and have

relied on a more organic approach to their R&D.

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Early movers had the advantage in the early-2000s when China joined the WTO. Shanghai VW, FAW

– VW and SGM were particularly well positioned due to their early relationships with the larger state-

owned companies. In 2002, VW had a combined share of over 50%, but of a much smaller market,

while Shanghai GM was third with 12%. Shanghai GM now has market share of 8%, but this does not

include GM Wuling, which would bring the total closer to 13%. The clear winners have been VW, GM

and Nissan, which is a result of having the right combination of products, localized capabilities, and

strong JV partner relationships.

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The Chinese auto market is reaching an inflection point, thus requiring new strategies. With slower

growth prospects and a fragmented landscape of manufacturers, we may be tempted to become

pessimistic about China’s automotive future. However, we must remember this is still the largest and

fastest growing auto market in the world, and companies that adjust their strategies to the new growth

pattern will prosper.

There is enormous opportunity in the lower-tier cities and provinces in China. China’s tier 1-3 cities

have seen incredible growth in auto sales, but tier 4 and lower cities account for 80% of the Chinese

population, and some companies are better positioned than others to succeed in these markets.

Compared to the higher tier cities that are confronted with the problem of market saturation as noted

before, the lower tier cities have greater potential for growing demand, and consumption of

automobiles in the future. Moreover, this process will be further promoted, as the Chinese

government places a focus on boosting the economic development of these regions.

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Demand will become more binary as lower tier cities cross the mobility threshold and OEMs may have

to adopt dual strategies. The domestic Chinese automakers tend to focus their sales in lower-tier

cities. In Beijing, for example, local brands have a much smaller share of the market and there are

fewer local brand dealerships. Some companies have started to seize the opportunity. For example,

GM’s mini-vehicle China JV (SAIC-GM-Wuling) introduced the first own-brand car (Baojun, meaning

treasured horse) to target the fast-growing lower tier consumer, aiming to combine world-class quality

& low ownership costs. By becoming a pioneer in moving down to compete in the low end market,

GM-SAIC-Wuling aim to capture the shift in the growth pattern toward lower-tier cities and provinces.

In 2011, Shanghai GM Wuling sold 1.21 million units, and this will grow significantly with the

introduction of the Baojun passenger vehicles. Baojun has already demonstrated how well GM

understands the local Chinese market, with monthly sales recently exceeding 10,000 units for the first

time.

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In the future, the main growth opportunities will be further inland. In order to capitalize on this,

companies must have products that are appropriate for these consumers, but also need service and

dealership networks. Hyundai is a very good example of a company that has taken a very balanced

approach to the market, by establishing R&D centers and dealer networks, which has assured

Hyundai’s local adaptation and sales success. Hyundai outgrew the market in all 31 provinces in

China in 2009 because of their attractive price/value proposition and well-balanced approach to

dealership network development.

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Reflecting the expiry of government tax incentives and the shift in product preferences, 2011 has seen

mixed results in terms of segment growth. In a market that grew at 2%, SUVs saw 20% growth, while

there was over 40% growth in the compact SUV segment. In a market that is slowing overall, it is

important to identify the segments that are outperforming. Vehicles with engine sizes that are 1.6 liters

and below still account for 69% of total passenger cars sold. Volkswagen has capitalized on this by

adapting smaller engines in new vehicles as a way to increase interest in the product, such as the

new generation VW 1.4TSI Polo GTI and Golf 6 that dropped the 1.6L and 1.8T engines used by the

last generation platform.

On the flip side, pickups and minibuses have seen a decline of 8.9% in the last year.

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Premium vehicles are the sweet spot, and this segment represents 9.8% of the total automotive

market in China. Premium-branded cars are also bucking the slower growth trends. While overall

passenger vehicle growth is in the 5% range, we are still seeing strong double-digit growth rates for

premium-branded cars.

China is on a trajectory to be somewhere between Taiwan and the US in terms of premium car sales

as a percentage of total sales. China is already Audi’s largest market, it was BMW’s largest market in

the first quarter of this year, and it is Mercedes’ third largest market after Germany and the US.

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It is no coincidence that companies with the most localized capabilities in China have also been the

most successful in China. Japanese companies have relied on “transplanting” capabilities from Japan

as opposed to tapping into localized capabilities, and this has not proven to be the ideal approach.

The recent consumer shift away from Japanese brands today due to the islands territorial dispute is a

deep emotional issue which is unlike the supply chain disruptions that occurred last year, and has the

potential for having a much longer-term impact on the sales of Japanese-branded products in China.

There is a clear correlation between localized R&D and Product Development capability and market

performance, where localization is defined as the ability to develop, source components and

manufacture a vehicle in China. Examples of highly localized products include the Audi A4L. It has a

61mm larger wheel base than the European Audi, and a wider rear seat space. The customized

designed chassis with a 13 mm larger road clearance is also more appropriate to China’s roads. The

Chinese A4L also has automatic fuel quality sensing to adjust engine performance based on gasoline

quality. These are localized innovations that fit the typical Audi consumer, who normally has a

chauffeur, and is usually sitting in the back seat. These configurations are exclusive to China.

Another example is GM’s multi-tiered product strategy, where their products also have more focus on

rear seat entertainment as well as a turbo charged 1.6-liter car.

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The sales channel in China is still very fragmented, despite the massive size and rapid growth of auto

sales in China. The market share of the top 10 dealerships in China represents 17% of the total

market, which shows a lot of room for consolidation. One of the large problems in building out

capabilities in lower-tier cities in China is the challenge of finding dealer groups with the ambition of

becoming “national consolidators”. For automotive sales, the “go west” campaign will largely be

played out by leading dealer groups from the profitable east coast, expanding into the central and

western markets. Investors should look to the leaders in these developed coastal markets, with the

right exposure to diversified growth segments including SUV, mass market, and premium products

The main challenge is that some of these dealer groups will have a difficult time adapting their

business portfolios to cater to preferences in the lower-tier cities. A lot of the larger companies are

private, and will probably list their shares to obtain the capital needed to build out their lower-tier city

capabilities. Due diligence is very important for investors, to ensure that a dealership’s income is from

the automotive sales and services business. Many dealer groups in China have made their money by

buying prime real estate, as opposed to having a solid core automotive business.

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There are other important trends to note as well. Today, there are over 100 million cars in use in

China, and we will see this grow significantly each year as the market produces 20 million new cars

per annum.

In the US, new car sales contribute 60% of a dealer’s revenue and just 20% of their profit, in sharp

contrast to China where new car sales comprise 80% of a dealer’s revenue and half of their profit. In

China, the market leaders will be the dealerships with the right exposure to diversified growth

segments including SUV, mid-market, and premium and the ability to adapt their portfolio to succeed

in delivering after-sales services.

With the growth of the auto market in recent years, the demand for after-sales service, maintenance,

and used car sales is growing as well. In response to the slowdown, manufacturers and dealers must

recapture growth by building capability across a variety of after sales services, including

establishment of a sub-dealership network and heavier involvement into service delivery and

innovation.

Questions and Answers

With Japanese automakers experiencing headwinds from the islands territorial dispute

situation, which brands do you see benefitting? Do you think Sino-Japanese tension will

ultimately hurt the image of Japanese car products and their brand value?

Many analysts compare the recent disruptions to the supply shortages that Japanese automakers

faced after the earthquake and tsunami in Fukushima last year and the flooding in Thailand. This is a

totally different situation, and consumers now are dealing with a much more emotional issue, with

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protests targeting anything Japanese and images of cars being burned. Moreover, dealers are more

reticent to invest in Japanese brands. A recovery in China can occur, but it is not a 3-6 month

proposition, it is more like 2-3 years, because a car being projects your aspirations and image of your

success and “face” is very important in the Chinese culture. Chinese consumers are now taking a

second look at other brands, and so the immediate beneficiaries are the Korean carmakers including

Hyundai, and then the American and Europeans car makers as well.

It will take a long time to establish the consumer belief that Japanese cars are once again fashionable.

Chinese consumers have always had a very high esteem for Japanese products especially because

of quality perception. I don’t think this is a permanent issue, the issue is whether or not the

relationship between China and Japan will be restored with the political rhetoric in the leadership

change in China this year and the national election in Japan next year. Though the anti-Japanese

protests have stopped, the purchasing of Japanese branded cars has not come back and the interest

of dealerships to invest in Japanese brands has not rebounded.

Do you think future policy will continue to favor electric cars?

Policy will continue to favor fuel economy and lower displacement. China will continue to invest in

newer technologies, but I don’t think the market is there for electric cars. I think we have already seen

very large investments made, with very little payback. The electric vehicles will be most prominent in

commercial applications including buses and taxis. You will see more future products coming from

OEMs emphasizing good fuel economy. For example, delivering good performance with smaller

internal combustion engines using turbo-charging is also something that is working well for several

manufacturers.

What are the key focus areas in investment for automotive R&D?

Chinese companies started their development as copy-cat companies, and their transformation from a

“reverse-engineering” to a “forward engineering” company, where they can do their own development

of core technologies, has been a struggle. Geely is much further along than their counterparts with

regard to their ability to develop their own technologies like power train systems. Although this

required an initial large investment, it is paying dividends now. Chinese car companies lack

capabilities to develop the more complex powertrain and safety technology typically available in

Japanese and other Western brands. This is where they need to focus and invest.

More cities are trying to regulate car purchases by restricting the number of license plates

issued. Do you think this is a threat to the automotive industry?

It does restrict sales, but there are many other cities that can absorb the lost sales in the near-term. It

is, however, a pattern for dealing with traffic congestion that will be repeated in other cities as well.

The interesting thing about restrictions in cities like Beijing and Shanghai, is that it typically results in a

richer mix of products being sold in these cities. This clearly indicates that people in China prefer to

buy as much car as they have the opportunity to buy, and that premium cars have a very bright future

in this market. The pattern of restrictions on license plates may take on different forms, but I think it

will continue to be a policy that China’s city governments pursue. I don’t agree that it addresses the

root cause of the problem of traffic congestion. The government would do better by providing

adequate public transportation, increasing parking capacity, enforcement of traffic laws, and better

urban planning to attack this issue. Densely populated cities like New York and Tokyo have far more

cars per capita, yet Beijing has the worst traffic congestion in the world.

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