COMMENT: Where does the Chinese car industry really stand?

Investment banker Meyrick Cox describes the development of the Chinese auto industry, its structure and offers a view on the challenges it faces in the future.

Given the astonishing growth in the Chinese car market and the staggering displays of new models, hybrids and electric cars at the last Auto Shows in both Beijing and Shanghai, not to mention the other smaller Chinese shows as well as the record-breaking volume statistics, it would be easy to form a view that the Chinese car industry is going gangbusters.  Well, it is – and it isn’t. 

The global OEMs and their Chinese JVs are selling pretty much everything that they can build or ship in. For example, Porsche is seeing strong growth primarily as a result of removing a supply constraint for the Cayenne. But some of the domestic Chinese OEMs are seeing absolute volume falls and their share of the market has declined materially over the past decade. What has gone, or is going, wrong? How can this have happened in a control economy that is so regulated?

It is instructive to look back at how the Chinese car market has developed and how it has influenced the global OEMs. It’s very much a case of a number of highly distinct phases, although in this review I will be deliberately vague about the timing of each phase, since the line is blurred by different companies developing at different speeds. 

The lost years
It wasn’t so very long ago, up to the mid-80s, that the Chinese car market was less than 10,000 units and unless you were a very senior government official or a foreigner, the chances of securing a car were very thin indeed.  China had, to all intents and purposes, lost touch with the skills of mass manufacture, never mind how to develop modern cars. The demand simply wasn’t there – or, more pertinently, wasn’t allowed. The products were stuck in the 50s. The market was at least consolidated with FAW making the Hongqi, Shanghai Auto the eponymous Shanghai and then a few truck makers such as Dongfeng, Chang’An, Chongqing etc.

The early years
In 1986, the auto industry was chosen as a pillar industry and accorded special status. Multi-year plans were published, known as the 5-year plans (although they were rather longer-term in fact). Foreign OEMs were allowed, and encouraged, to form 50-50 joint ventures with domestic OEMs; although they were slow to get going. Initially, the only significant ones were Jeep, Fiat and VW.  At the same time, globally, the dominant trend was offshoring. While entire vehicle manufacture didn’t move to China, many of the component makers started offshoring to China, India, Thailand etc to take advantage of materially lower labour rates and this in turn led to globalisation of components, platforms etc. In one of those wonderful unplanned consequences, it made the international OEMs more competitive and kicked off an era of cost downs.

Early growth
As the Chinese market took off, in the early 90s, so did the JVs. Capacity expansion was promoted and domestic brand development encouraged. Everybody, both Chinese and global OEMs, wanted to join in: GM, Nissan, Ford, Audi, BMW, Toyota, Honda etc all came to China and formed JVs.  This drove further consolidation in the West to an extent, although more within OEMs than between them. In the meantime, a plethora of private manufacturers had appeared and, without wishing to be indelicate, some of them simply copied foreign cars.

The WTO years
At the end of the decade, China applied to join the WTO, introduced a range of more liberal policies and growth exploded. As the next 5-year plan came out, regulations tightened a little bit, the pressure to share technology grew, China moved towards owning intellectual property (“IP”) and the extent of the JVs deepened. The million-car platform became the order of the day and if you didn’t have significant Chinese volume, life was tough. Towards the end of this phase, there were Chinese OEMs that were very significant in scale; extremely competent at making cars but, and it’s a big but, making other OEMs products. In this phase, we saw the first overseas acquisitions of foreign OEMs by Chinese OEMs:  Shanghai/Rover MG; BAIC / Saab assets; and Geely’s astonishing acquisition of Volvo from Ford. 

Premiumisation
Revolting word, but it captures the theme. All of a sudden, China was a 10m unit market and went from wanting mobility to wanting brands. BMW, Mercedes, Audi, Jaguar Land Rover simply took off in China. Premium sales today are 30 times what they were in 2000. The Chinese consumer ‘got’ premium and wanted it now. China became a material profits driver for some: for the German premium OEMs perhaps as much as 50% of profits and for GM, China has probably exceeded 100% of its profits and before its insolvency was probably the only profitable part of the business. We are even seeing the beginnings of an IP legislation that has some teeth and so in a 600-word version of a much more complex tale, we have arrived at the current day.

So what does the Chinese auto industry look like today? There are many counts, but 77 domestic OEMs is the best estimate I’ve seen with revenue of US$287bn spread over 13.9m units, 682 models and about 500 platforms. The average Chinese OEM offers nine models and produces 20,000 units per model. Critically, this all includes JV output. Take that away and it looks even worse. Chinese OEM revenue per platform is around US$0.5bn; compared with, say, VW around US$12bn.  Chinese policy is worsening this situation by forcing JVs to add a JV-owned brand product to the line up.  Just what China needs:  more models and more brands! 

The overall market, by value, is 25% Chinese OEMs; 70% JV OEMs and 5% imports. The domestic share has shrunk from 40% a decade ago.  The majority of the Chinese OEM vehicles are in the A & B segments, and they compete almost entirely on price. Meanwhile premium has grown to 17% of the market.

What are the trends in today’s Chinese auto market?

• Owner drivers.  I was struck, at a friend’s wedding in Shanghai recently, to see a young married couple arrive in a Panamera.  Very glossy and so far, so Shanghai, but there was no one in the back – they drove themselves. Labour costs have driven up the cost of chauffeurs; and car ownership is spreading further down the wealth spectrum, so China today is no longer a purely-chauffeur market. This raises all sorts of interesting questions around the touch and feel, handling and infotainment preferences of a Chinese owner-driver compared with a Western driver. We don’t know the answers yet, but they will have views, and those views will start to drive car design globally.
• What happened to China being a sedan market? When I was last in Hangzhou, I would say one-third of the cars not only are driven by the presumed owner, but are small hatchbacks.
• Regulatory pressure on fuel consumption. Note, not CO2 as in the West, which a cynic like me might note as purely tax-driven.  China will have to import any incremental gasoline that it uses; and that’s a strategic security risk which China doesn’t want to take on, so this not a cynical tax game; it’s a real issue.  We ain’t seen nothing yet on fuel consumption regulations in China.
• Further premiumisation (sorry, that word again). Already 17% of the market, and is expected to grow to 25% by the end of the decade and its all foreign OEMs; none of it is Chinese-branded.  . There has been some very interesting work done recently on the price discount that domestic brands suffer over imported brands. It’s at least 30% on a like-for-like basis never mind about adding “premium” on top of that. That’s crippling!
• Exports: struggling domestic OEMs trying to drive volume through exports.  To places like Iran.  I’m not aware of any country / industry becoming competitive through exports: successful exporters have been strong at home; and have taken those successful products abroad.  Exporting based on price needs a sustainable cost advantage…
• Costs:  China is no longer a cheap place to make cars. 

So where does this leave the domestic OEMs that we started with? The simple answer – in trouble.

• Costs are spiralling – I can remember when advising on the Shanghai / Rover MG deal that skilled labour was at risk of getting to US$1 a day.  It’s eight times that now, which challenges the whole labour-driven model. VW has stated that its Slovakian factory is cheaper than its Shanghai ones;
• Quality is great, really it is.  I like nice, tight shut lines, but they come with a cost. To achieve the relentless consistency that modern car manufacturing demands, you need machines. That means that the factories look much like Western ones, cost the same and labour falls to less than 10% of the cost, although you need more checking in China, so that offsets the slim cost advantage that you thought you had in China;
• R&D.  I’ve heard various estimates of the number of Chinese OEMs, but lets stick with the 77.  BMW spends more on R&D than the top 10 Chinese OEMs combined spend outside their JVs. So does Daimler, VW, GM, Ford, Toyota, Honda, Hyundai etc etc.  Even Porsche spends more than the top ten Chinese OEMs in absolute terms. The Chinese OEMs aren’t catching up either. They are falling further and further behind. Making a 2-litre gasoline engine produce 200 bhp isn’t so hard; but making it do that and 140g CO2 with acceptable noise, vibration and harshness (NVH) characteristics, bulletproof reliability and 100,000-mile plus durability is really, really tough. Their engines are mostly designed by AVL and Ricardo. They are stuck at the assembler stage and are a long way from being effective integrators let alone developers. The Chinese OEMs spend a smaller percentage of a much lower sales value on R&D, leading to pitiful results.
• Brands.  This, frankly, is the biggest issue.  There are two global auto brands owned by China:  Volvo and MG.  That’s it.  It has taken Toyota 20 years to establish a second-rate US premium brand (Lexus). The reality is that there are four global premium brands (plus the super premiums like Ferrari etc):  Audi, BMW, Jaguar Land Rover and Mercedes.  That’s what consumers want to own.
• Component suppliers. Not one of the global auto component leaders is Chinese, whichever segment you look in.  There are large ones, such as SAIC’s component business, but no scale leaders. There are none with class-leading technology.  Increasingly, they are losing their cost advantage.

Put all this together and I simply don’t see how with fragmented R&D, smaller volumes, lower price points, and an uncompetitive parts supply chain that this industry can compete on a global scale without fundamental restructuring (and, given that M&A is my day job, a bit of that as well).

What’s wrong? The JV concept is flawed. Western OEMs are not going to share their technology if they can possibly avoid it. Not now, not ever. Sharing means creating a competitor – why would you do that? I know that GM has been forced to do so as a result of its insolvency, but waiting for your JV partner’s insolvency isn’t a strategy you can plan an industry around.

There are far too many OEMs in China.  The National Development and Reform Commission (NDRC) has recognised this and published its list of consolidators, but nothing that I have noticed has happened.  China will never, ever catch up on R&D, let alone pull ahead until there are, say, three Chinese OEMs, each of which is spending more than the major Western OEMs on its own R&D. Modern cars are very complex and while it’s relatively cheap to catch up, copy, call it what you will, it’s really, really expensive to develop original new technology that meets all the varieties of legislation around the globe. Mahindra did a great job developing the Scorpio for US$150m; it was highly fit for purpose and quite correctly based on simple tried-and-tested technology. The market loved it, but I doubt Land Rover lost a wink of sleep; and I can’t see Mahindra being able to develop a new Range Rover competitor for anything but a factor of that.

Exports? Forget about it. If you aren’t competitive at home, you won’t succeed abroad, and I don’t count places like Iran.  Price is not a long-term strategy unless you have a sustained cost advantage.  China doesn’t.

Bluntly, I think China needs to control more premium brands. That’s a wonderfully vague statement but you only have to compare, say, BMW’s margins with any of the mass-market manufacturers and it’s very hard to argue with. Of course, the Chinese state could go on subsidising the industry for the 40-50 years it takes to develop a premium brand but I can’t see that happening somehow.

If this sounds critical of the planning behind the Chinese car industry, it’s not meant to.  I’m awestruck at the progress that’s been made in the last decade even, never mind about the turnaround in a remarkably short period from what I dubbed the “early days” of the mid-80s. It has never been done in such a short time period anywhere else in the world. Amazing. It’s just that the industry is at a turning point where the structure which has served it well to date isn’t right looking forward. So China needs the boldness and the vision to implement some of the changes that it has already presaged and, in some areas, go further still.

I can’t wait and I only hope to be able to play a small part in it, as I have to date.

Meyrick Cox is a Managing Director at Moelis & Company, an independent global investment bank that provides financial advisory, capital raising and asset management services to a broad client base including corporations, institutions and governments. Mr Cox has more than 25 years of investment banking experience representing the world’s largest automotive and industrial companies across a broad geography including Europe, Middle East, Africa, India and China; in particular he has been involved in the creation of six of the Chinese Auto Joint Ventures (JV) and almost all outbound Chinese Auto Original Equipment Manufacturers (OEM) acquisitions. Automotive PR, a global service provider, facilitated Mr. Cox’s appearance at the Global Automotive Forum in Chengdu China in October 2011. This article is in part based on his presentation.