Wednesday, 6 February 2008

Industry Structure – China – 2008+ Prognosis

Given the massive BRIC+ growth story of the last 5 years, and China’s leading role within that context, the obvious question facing investment analysts is to what degree the new year financial markets fall-out will impede future growth; if at all. We are of the opinion that whilst a de-coupling of direct macro-economic interest between Asia and the US has undoubtedly occurred, the recent stock-market tremors felt throughout the east demonstrate the underlying inter-dependence, and highlight the important role, of financial markets. Markets which to date have been the driving force behind continued Asian, specifically Chinese, expansion.

Even before recent tremors there was an understanding that the multitude of Chinese auto-makers could not be sustained given the voracity of competition that has seen an erosion of vehicle prices and subsequently margins. Governmental policy reaction was to push for overseas expansion to help ‘de-pressurise’ the local market.

As ever, there are mixed opinions regards the size and pace of consolidation amongst Chinese VMs – especially so the politically prompted state-sanctioned organisations that have “socially” vested interests in maintaining their primary positions – ie FAW, Nanjing, Shanghai, Beijing, Dongfeng & Guangshou. Hence, we have recently witnessed SAIC’s take-over of Nanjing MG set to produce an enlarged heavyweight; something that was very much “on the cards” given the previous respective Rover & MG acquisitional synergies of the two parties.

To what degree their state controlled counterparts, the previous auto & defense spin-out corporations (eg Brilliance, BYD, Chery, Changfeng, Chang’an, Changhe &Hafei), aswell as private others (eg Geely & Great Wall) may be prompted to similarly act is open to debate, but much of the raison d’etre for M&A will of course depend on market dynamics and maintained profitability levels,

2007 saw the market grow by 22% and 2008 growth forecast is at 20%, so ironically such circumstances (on paper) would expect to see an even greater number of new entrants appear, especially so as a result of as spin-off enterprises from present incumbents to dissuade truly new entrants from trying to take a (segment/regional) slice of the enlarged pie. But forecasts and projections are rarely perfectly correct, companies cannot rely on ‘a rising tide lifting all boats’ so will continue strategic risk management. Thus the Chinese domestics, ever the realists, will be looking to defend their positions by:

1. Continued major financial support from highly liquid state & private funds, within a protected market
2. Governmental influence of R&D strategies (eg EVs, Hybrids) under the “Harmonious Development” policy that underpins CNH3&4 etc.
3. Further extracting technical knowledge from European, American and Japanese JV partners…trying to leap the ‘fit & finish’ gap.
4. Amalgamating Chinese operations and continue cross interests (as in sharing technical expertise gained from said JVs)
5. Demonstrate to domestic buyers that Chinese can equal Japanese & German quality
6. Recognising the fact that scale equals leverage across all fronts; from R&D ventures to dealer network
7. Continuation of export plans, focused on cost sensitive emerging regions, specifically Chery, Geely, FAW & Yutong
8. Continuation of foreign plant plans, focused on BRIC & North America
9. Developing allied platforms, modules & component strategies with ambitious Chinese suppliers (eg Wanxiag, Xinyi Glass, Norstar, Minth, Tong Yang etc.)
[NB 2005 was first year parts exports exceeded imports]
10. Learning from previous Chinese overseas expansion eg:
a) Haier – conservative approach building local US business – success story
b) TCL – European M&A failing due to cultural management differences
c) Lenovo – successful dualistic approach leveraging best of IBM & Legend

Although Chinese companies have benefited from foreign JVs, learning a great deal about component and vehicle quality, the truth is that to date they have, because of limited production technology access and little market elasticity, biased cost over appeal. This previously suited a bourgeoning unsophisticated, cost-conscious domestic market, but times have changed. Personal aspiration, rising disposable income and VM inter-rivalry, have raised marketplace expectations, evident from the move out of small hatchbacks into compact sedans, even though smaller cars benefit greatly from taxation state tax-breaks.

Chinese buyers have long recognised the quality differential between advanced ‘foreign’ cars (from JVs) and pure domestic product – the proof is in residual values. Since Eric Thun’s 1996 observation of the previous massive ‘quality gap’ (see ‘Changing Lanes in China, Cambridge University Press 2006) for over a decade the situation has remained the same. Although the gap has decreased measurably, it is still top of mind for new and 2nd hand a car-buyers alike. Domestic VMs will continue their improvement march, knowing it is key to gaining product credibility, consumer confidence, improved profitability and ultimately independence from JV partners.

As result many domestic VMs, like the Japanese & Koreans beforehand who had to start without an auto-history, have undertaken a copy+ product design approach, mimicking where possible the styles of Japanese, Korean and German cars. Hence, as we saw at the over 60% of the aesthetic of Chinese own brand cars are essentially copied, the rate even higher at 80% for SUVs. This partially a result of the origins of the donor platform (esp SUVs where Isuzu was so prevalent), but primarily driven by the need to keep development costs as low as possible yet also retain a stylistic familiarity with one or more more prestigious ‘foreign’ cars. Hence we see:

Large Cars –
FAW Redflag HQ3 (direct) relativity to Toyota Crown Majesta

Medium Cars –
Chery Eastar to Daewoo Magnus
Brilliance Splendour to BMW 3 series

Compact Cars –
BYD F3 to FAW-Toyota Corolla (front & side)
BYD F3 to Honda Fit sedan (rear)
Maple Hysoul 305 to Audi A4 (front grill treatment – misguided effort)
Maple Marindo MB to Cadillac CTS (rear treatment – misguided effort)
Jiangnan Chaunqi to Buick Excelle

Small Cars -
Chery QQ to Deawoo Matiz (renowned example)
Tongtian Glow to VW Polo
GWM Florid to Toyota Yaris
GWM Perey to Nissan Note
GWM Cool Bear to Toyota Scion xB

City (A segment) Cars -
Shaunghuan S6 to Daimler Smart

MPVs -
Fengxing Jingyi to Mitsubishi Grandis

Sports & Convertible Cars -
BYD F8 to Mercedes Benz CLK (frontal styling)
BYD F8 to Renault Megan CC (rear styling)

Cross-Overs -
Shaunghaun SCEO to BMW X5 (renowned)
Feidi UFO to Toyota RAV4 3dr
Chery Tiggo to Toyota RAV4 5dr

SUVs -
GWM Hover to Suzuki Axiom
Huanghai Qisheng to Hyundai Santa Fe
Huanghai Aolong to Ssangyong Rexton
Shaunghaun Laibao S-RV to Honda CR-V
Tianman Hero to Kia Sorento
Zotye 2008 to FAW-Toyota (Daihatsu) Terios

Specialist 4x4 -
Dongfeng Hanma to Hummer H1

Concept Cars -
Changfeng Liebao CS7 to Hyundai HCD9 Talus (‘broadly’)

The copy+ avenue has been chosen (by primarily independents) because it has been proven to work. Instead of trying, probably unsuccessfully, to start from scratch with absolutely no brand or product equity, the copy+ formula allows for basic connotation, if not absolute replication. In short it endeavours to mark a new brand’s position and provide credibility. [NB. Nissan and BMW started with re-badged Austin 7s build under licence].

And don’t think this is always done without the original foreign automaker’s consent, often agreements are made to replicate cars under a local brand where the foreign manufacturer has no intention (or been prohibited) from competing in the segment (eg FAW Redflag & Toyota Crown Majesta). Infact investment-auto-motives believe that for some time there have been tacit agreements in place between western and copy+ eastern makers to ascertain the exact 'west-east' price differential of a multitude of components, building up to complete vehicles. Re-manufactured original components spread across a singular or various copy+ car(s) allows for a direct comparison of quality-matching and cost-down – much needed by western VMs if they are to source parts from Chinese Tier 1s and 2s so as to revive their profitability. Every VM performs cost-assessment exercises on competitor cars, this is simply an extension of the same.

Whilst the copy+ game is an optimum strategic direction for ‘new’ automakers, success of course depends upon perfected execution, and in this regard, there is a broad spectrum of ‘winners’ and ‘losers’. Much obviously depends upon the basic platform being used, whether:

A. derived from the original VM to match the original perfectly
B. similar in engineering ‘hardpoints’ to approximate the original well
C. very dissimilar in ‘hardpoints’ so making for fundamentally poor match

Each Chinese VM has started from very different places, depending upon the vehicle sourcing agreements made, both at initial start-up and again in terms of re-negotiating newer platforms or the ability to produce their own. And the abovementioned list of vehicle results clearly demonstrate the levels of success achieved, some like the Zotye 2008 a very close interpretation to the Terios, whilst others like the Shaunghaun Laibao S-RV are, because of basic oversized dimensions, is a remote approximation to the Honda CR-V. Now whilst western eyes can criticise, the truth is that what looks like a ridiculous re-interpretation may well work if the segment has very little differentiation – as has been the case to date with the SUV segment heavily biased to Isuzu Trooper platform Thus an ‘oversized CR-V’ is at least seen to be more contemporary, if to our eyes aesthetically awkward.

Having looked closely at product trends, what about the structure of the industry itself?

As stated in a previous Chinese Industry post (09.01.08), the primary question is how the industry will need to consolidate; even with the continued growth levels that to date haven’t stopped the trend of discounting.

To our minds, there are 5 basic rationales:

1. Specific product-relative consolidation
2. Segment-relative consolidation
3. Vehicle portfolio expansion consolidation
4. Regional-orientated producer consolidation
5. Big Fish-Little Fish consolidation

#1 is the most obvious, directly encompassing commercial ventures with exactly the same, or very closely related, product types. We saw this with (SAIC) Roewe-MG, and could viably see a similar in the 4x4/SUV sector, many players long reliant upon old generation Toyota Landcruiser, Isuzu Trooper/Rodeo & Mitsubishi Pajero base vehicles. These include Beijing, Changfeng Liebao, Changfeng Yangzi, Dadi, Dadi Chengdu, Fudi, Fuqi, Jiangling/Windwind, Qinling Isuzu, Shaunghuan, Shuguang, Tianma,Yema and ,Zhongxing.

Given that fact that some of these brands also have extensive assembly operations in emerging regions such as Russia, Turkey, Egypt, Ukraine etc, we firmly believe that there is major potential to seek economies of scale by amalgamating what are mostly disparate 4x4 operators with aging product and an endangered future.

There are other ‘similar product’ arguments that are too detailed to relay here.

#2 offers the same scaling sentiment as #1 but from a specific segment perspective, specifically: utility pick-ups, utility 4x4s, small minivans, small ‘older’ platform cars, etc etc.

#3 relates to the ambitions of those VMs who wish to plug the gaps in their vehicle ranges as soon as possibly, ideally gaining additional technology knowledge in the process – using the M&A of such target companies to do so.

#4 pertains to either state-influenced or private network wish to forge a stronger local industrial base through amalgamation, perhaps in the attempt to take a structural lead within China.

#5 is simply the scenario of the bigger players (FAW, Dongfeng, SAIC, Beijing, Changan etc) seeking, trough acquisition, dispense with regional/sector small fry competition, absorbing their smaller volumes and critically gaining what is potentially untapped extra plant capacity.

In truth, all these factors will play a role in the evolution of the Chinese auto-industry, thus investment-auto-motives continues to monitor the scene closely and is in the process of drawing up probable best-fit, optimal M&A deal scenarios.