Thursday, 17 July 2008

Industry Structure – China – Parts Makers: The Post Olympic Competitors

The beginning of the 21st century has undoubtedly been a China-centric phenomenon, the country about to enjoy the spotlight of the global arena in the crowning glory of the Olympic Games. But behind the tightly controlled PR machine that projects the futurism of the People's Republic over Beijing, Shenzen & other 'destination cities' there is a paradoxic duality to the very economic fabric of ravenous consumerism

For whilst street-scapes and massive lots are being transformed by modernist glass and steel that reflect an almost 22nd century aura around retail and the consumer process, much of the production nerve centre of the country driving the hub of the economic cycle has machines / plant, management approaches and an endemic culture that are rooted in the past. The 'centrally controlled' embracement of capitalism that has underpinned transformation has been very very gradual, the polar opposite to say Russian & CIS change were Moscow's influence was eroded comparitively 'over-night'. Conversely, the ideology of slowly managed change by the CPC political old-guard is to eak-out as much value extraction “for the country” as possible. Thus today the CPC remains effectively in total control, and offers the notion, indeed is best served, by the notion of bridging managed market exemplified by the smoothing and boosting 'regulation' of capital markets.

Key of course is the decentralisation (in management process if not in decision-making heirachy) of the industrial base, none more important than the automotive industry at VM and Supplier levels. Admittedly deconstructing what was once a singular entity, from raw material extraction to through life service has been a massive exercise, each step slow and critically assessed from the very earliest days (as witnessed from the infamous early days of the Chrysler-Beijing Jeep JV). Twenty-five years on and the initial, painfully slow, pace of change that developed the policy and operational templates for Chinese authorities – especially when dealing with foreign corporations keen to access massive potential consumer demand – ultimately underpinned what has been a very successful phase 1 and 2 for the auto-industry: namely the creation of Sino-foreign JVs that nurtured the core competencies of the 3,500 parts providers and the 100+ raft of state and independent 'start-up' or 'industrial spin-out' vehicle manufacturers.

Given the sector's heavy investment requirement and massive potential and rewards the guiding hand of the CPC has always been more than evident. It recognised the need to absorb process and production technology and multi-faceted IP from external parties to bring the sector to eventually worldclass productivity levels, moving beyond the previous and rapidly declining low-cost base. To improve, in the face of a rising RMB against 'mixed basket currencies', declining US$, rapidly rising input headwinds, rising inflation and the concern of an economic slowdown which has come into fruition over the last 9 months or so since the stock-market peaks of Oct 07.

However, as is the case with general improvement theorem, the greatest gains are made in the early phases – at product, production and sector structure levels - whilst extracting additional improvement as capabilities rise becomes harder and harder. And this seems to be the case today. Adopting engineering procedures and methods has been whilst not easy is a least relatively straight-forward; the problem from here on in exists on many fronts, but increasingly so it is the sticky question of cultural psychology and (lets not be coy) power .

A piece from Yang Jian published in Automotive News Europe (07.07.08) highlights the problem using the example of a Chinese-born, foreign educated VW executive who was parachuted into FAW-VW to assist organizational development and create a base for more dynamic, progressive, fresh thinking that would provide FAW-VW with a heightened competitive attitude and spirit; trying to combine the best traits of American, German and Japanese peer mentalities. His efforts however have gone unrewarded, indeed quietly rebuked by some, thanks to the engrained 'know thy place, follow orders' mentality and social mileau that pervades many state run enterprises as they attempt to evolve into more entrepreneurial (in name if not yet in spirit) entities.

Thus the big players in China-Auto that dominate the market appear to have reached an unfortunate capability plateau. Having been able to adopt best physical & process practice from the 'developed' Triad nations' automakers, the time has now come to adopt similar attitudes and perspectives, and unsurprisingly that looks like a very real stumbling block.

And the timing for addressing this question and that of the whole of the sector's essential structure is critical, since after 10 years of astonishing sales growth (34% in 06, 24% in 07) the domestic auto-market looks to be on the verge of a substantial and possibly sustained slow-down (14% in H108).

[That slowdown exacerbated by economic and social sentiment such as the halved stockmarket, general inflation, rising fuel prices, Sichuan's major earthquake and some social unrest due to the CPC's Olympic infrastructure dictats in certain areas]

Infact the latter good years consisted of price-orientated, incentivised competition artificially buoying the market given the glut of vehicle offerings – old and new. Add to this picture the previously stated rising (value chain) input headwinds and car-makers and their suppliers are increasingly caught between reduced 'price ceilings' and increased 'cost floors', narrowing margins and so individual firm and sector profitability.'

Thus the case for an inevitable sector shake out has been on the cards for some time, the VM's price reduction demands of their Suppliers being the catalyst of change amongst the supply chain in line with change at VM level. investment-auto-motives highlighted the probability last year and soon after we witnessed the acquisition of Nanjing Auto by SAIC. We believe that was the first of naturally aligned M&As where similar products and platforms drive the impetus for industrial coalescence amongst automakers. As also stated, beyond technically based production-orientated stimulation there are also marketing (product range extension), regionally political probabilities and importantly the evolutional development of the supply-base itself, which will precurse and determine much of the VM re-structuring.

At the beginning of the year AlixPartners undertook an executive survey that questioned the future of the Chinese Parts Sector, and unsurprisingly given the 3,500+ suppliers operating. The industry has historically performed better than even the automakers, riding their growth wave, with a compound annual revenue growth rate (CAGR) of approximately 31% (2004 to 2007), also averaging a net profit margin of 7% in 07, versus a net margin of 4.5% for client vehicle makers.

But to maintain sector profitability in a slowed growth consumer market (estimated at a CAGR of 15% 2008-11, supplier industry investors will be demanding operational efficiency improvements Of course off-setting the domestic sales order book and pipeline are export potential, presently only accounting for 14% of annual turnover and perversely facing reduced VAT rebates instead of incentives – hitting the 'lower value' glass (screen), steel/alloy (wheels) and rubber (tyre) exporters particularly hard. (We suspect is one of the CPC's levers to force internalised sector change and to incentivise the sector to move up the value curve...China is itself trying to move away from its reputation in commodity parts production). (Even so CAAM forecasts that exports are expected to reach $40bn by 2010). So given the reduced likelihood of short-term export traction all eyes will be upon sector rationalisation to create the winners and losers into phases 3 & 4 of the Chinese automotive revolution.

Thus there is an imminent 'tipping-point' to come, especially for the wholly owned 100% Chinese companies that tend to operate at the lower-end, vs mid and high-end JVs with globalised multinational partners. Thus the present-day sector's level of high fragmentation, and the inherent inefficiency now being exposed by reduced growth, means consolidation is inevitable for the more forward thinking entities to survive. Counter to matured western markets with typically a top 10 corporations taking 50% marketshare, in China it is the top 100 suppliers that command the same slice of the industry's total market share. An additional problem, that rides against China's ambition to move up the value curve, appears to be an acute lessening of access to technology, the era of good-will backed international JVs and licensing deals is virtually over, many of those commercial agreements are now majority-controlled by foreign companies whose boards are effectively blocking technology transfer to their local competitors.

In short the parts' sectors earnings have peaked and only a major overhaul will put the supply-base back on a firmer footing.

It was back in May 2004 that the CPC published its new forward plan to create this recognised need for reform. To quote:

“The Policies call for an overhaul of the Chinese automobile industry by the year 2010 in order to create large companies that can compete on the international market. As part of this overhaul, car and motorcycle manufacturing enterprises are encouraged to develop international cooperation and large enterprise groups are encouraged to associate or merge with international automobile groups”.

“The establishment of new sino-foreign joint ventures in automobile manufacturing requires approval by the SDRC. The Chinese party in a sino-foreign joint venture to manufacture complete cars, special purpose vehicles, agricultural transport vehicles and motorcycles is required to hold a majority share. If such manufacturer is a company limited by shares, one of the Chinese parties is required to hold a controlling stake that is bigger than the aggregate of the equity held by all foreign investors. Foreign investors in enterprises located inside export processing zones which manufacture cars and car engines for export may be permitted to have a majority share upon approval by the State Council. The Policies permit foreign investors to create two or more joint ventures in China to produce the same categories of vehicles, if they join forces with their existing Chinese partners to associate or merge with other companies in China”.
As stated, the march towards this aim has been ongoing, but it will be the international ambitions that are key. And its here that the parts sector will naturally be ahead of the VMs.

Chinese and foreign Private Equity will be seeking out short, medium and long term opportunities, the likes of Blackstone, Merrill Lynch, Temsek, HSBC, Allianz & Goldman Sachs wanting to desperately leverage the relationships and liquidity build-up in the region over the last 3 years, both as stock holders in powerful domestic banks eager to lend to promising sectors and firms, and through the highly prized, latterly approved, foreign funds that have been given authority to operate in China's slow but increasingly open capital markets.

The chance to reduce the highly disperate and unco-ordinated Auto-Parts sector looks to be a strong promise. Making use of the greatly developed new cross-country transport network to aid plant location & logistics overheads and making use of possible new US, European and Japanese foreign partnering agreements - themselves benefiting from turnaround & Chapter 11 re-organisation – will develop routemaps for value creation from 'down the road' M&A opportunities and ultimate exit strategies.

For the moment Bloomberg reports of the high interest in fund managers buying into the 12 listed Chinese auto-parts firms through the HKSE, given that even at a p/e of 30 the stocks are good value compared to their mainland listings at 139 p/e and a worldwide of 41 p/e. Sell and buy side analysts recognising the major potential for the sector both via domestic sales increasingly shifting to major VMs such as Ford, GM, VW etc giving proven quality product that can be deployed and effectively substituted for other OEM components worldwide.
That will push up listed stock prices of recognised names like Xinyi Glass, Norstar and Weichai Power, which in turn will improve MarketCaps and allow for additional financing to intensify M&A competition by allowing these trade buyers into the game.

2008-10 will definitely see the cogs of industry and finance whirring continuously in Shanghai, Shenzen, aswell as within each of the municipalities

Tuesday, 8 July 2008

Macro Trends – USA – The New "Mobility + Habitat" Opportunity to Create Social Panacea

The second decade of the 20th century saw Henry Ford ride the US wave of economic expansion (including his own $5 day initiative) to provide “Mobility for the Masses” via the Model T.
The second decade of the 21st century could well be the converse, if ongoing economic decline persists longer than anticipated.

investment-auto-motives believes that such a scenario should be critically considered by Ford, GM and Chrysler, and that they need to look beyond their strategic and operational norms to create possible new business models that serve themselves and those American's that may have lost sight of the American Dream.

That business model is the provision of singular solutions for “affordable mobility + habitat”.
Today, commentators such as Soros and Forstmann believe that “[market] correction has only just begun” eventually leading a resultant major economic systemic shock; possibly most prevalent in the USA. With the advent of the August 2007 credit crunch, we have and will continue to witness a partial breakdown of the private home ownership model – the very backbone of a modern market economy. Some believe that house price 'normalisation' will wipe a further 20%-25% off the value of property (it already having dropped 10-15%) pushing more and more people into negative equity and carrying on the trend for home-buyers to simply leave the keys and walk-away. Equally, such price instability means that first time buyers will be reticent for years to buy back into the home-ownership model, whilst they wait for stabilization and endeavour to accrue savings to help put them eventually back on the housing ladder.

Although Congress has been presented with The Housing Rescue Package, formulated by government and industry, purporting to assist and slow-down the avalanche of re-possessions, its effect won't be measurable for years, and in reality there is little consensus that the avalanche is containable, only market forces able to find the natural equilibrium; which could take up to a decade. In the meantime, (possibly) 'displaced' millions will find themselves requiring 'alternative' housing circumstances, whether that be through family, renting (at reduced but still relatively high prices) or finding new options.

investment-auto-motives forwards the proposition that it, along with the investment community and Detroit's Big 3, start to sketch-out and formulate potential new business models that offer 'mobility+habitat' solutions for singles and couples.

Something that places a POD orientated Mini-Van type vehicle at the heart of the offering, which has an affiliated 'docking station' plot within the grounds of a dedicated leisure-orientated community, itself part of an inter-connected regional infrastructure that exists within the temperate-warmer US Southern states spanning: Southern California, Arizona, New Mexico, Texas, Louisiana, Alabama, Georgia & Florida. Primarily aimed at the 20s- mid 30s, it would, in effect, be the re-invention and combination of the SoCal/Florida Condo Complex and Leisure/Trailer Park.

As Hedge Funds and Private Equity well appreciate as the credit crunch takes hold the public will seek-out low-cost regional vacations and so these said funds have invested monies into Leisure Parks and Recreational Vehicle & Caravan/ Mobile Home manufacturers.
Looking at the broader social and housing trends, Detroit could look to 'take charge' of the situation and create new vehicle-centric solutions for new this new era. That may mean looking at alliance, JV or M&A relationships with associated renowned leisure vehicle manufacturers such as AIRSTREAM and WINNEBAGO et al.

[Infact we believe that Ford's AIRSTEAM mini-van concept is a part exploration into this possibility along with links with other American travel Legends such as the Sante Fe 'Super Chief' train as re-born on the F-250 Super Chief concept].
Indeed Detroit would need to work with other recognised and renowned enterprises with the leisure, hospitality & leisure parks industries, such as Disney Corp or perhaps Las Vegas greats, so as to wholly re-invent the idiom and remove it from the less than respectable connotations it has had I the past.

As for the Wall Street 'catalytic agents' that could wish to pull such an venture together, Kirk Kerkorian & Tracinda obviously comes to mind with sizable stake in Ford and the MGM Grand providing plausible management capabilities for new business models from sector cross-pollination.

Much would obviously need to be worked out and calculated, but given Detroit's aim to maximise platform utilisation, to move upstream as Brand Enterprises, better inter-connect with the public and Wall Street's desire to sweat automakers assets, create new business models and take advantage of low-cost assets (such as today's/tomorrow's depressed land values), there is certainly be much mileage in the Mobility + Habitat opportunity, derived from merging Automotive, Leisure, Home & Finance/Mortgage sectors.

Get the formula right and the initial model serves as a stepping stone into latter day full-blown home-ownership. And as the land prices of the infrastructure parks rises so it can be transformed into apartments or housing, assisting America by providing that all important, local stepping-stone, and of course giving the commercial stake-holders a high value long term vested interest, that could develop a dual-value meshing of Autos and Home loan.

So just as Henry Ford gave the American worker to buy into mobility, so today there is the opportunity to re-create an enjoyable journey into the 21st century American Dream.

Tuesday, 1 July 2008

Company Focus – CarMax Inc – The Not So Recession-Proof Business Model

Since the age of the Model T the Used Car marketplace was always one of buoyancy. Come economic boom or recession, the demand for used cars by respectively new 'come-of-age' drivers, 2nd/3rd car households or regular thrifty down-scalers. So, even if periodically dealers had to reduce margins and push volume, there was always an essential demand-supply equilibrium.

Through the 1990s the environment tightened as an ever increasing array of new models came to market by old and new VMs, which along with deflationary 'real' pricing and lenient credit terms, meant that the dream for many of owning a new car became a plausible reality.

At this point in the mid-90s the Used Car Trade fought-back. Yes there had been market contraction but a round of retail consolidation bringing forth larger, more professional dealerships helped to rid the trade of the infamous 'back-street' operators. More than ever the influx of new cars eventually fed into 2nd hand showrooms providing the used car customer with a plethora of choice, and dealer groups were able to offer in-house finance deals which also boosted per unit margins.

CarMax rode much of this wave, its expansion based upon the regionalised contraction of used cars, but able to 'stay and play' taking an increasingly larger slice of the diminishing pie thanks to a nationwide network that provided vehicle access (esp used fleet), volume buying power, general efficiencies of scale and via IT systems, professionalism (vs the archetype local used car merchant), and a high proportion of return business with speedy return/turnover rates.

However the first decade of the 21st century has witnessed gradual erosion of the used car trade as the volume manufacturers have waged price and incentive wars to satiate the over-capacity that spewed from high-cost western plants. The vicious circle of forced production to cover high overheads that in turn over-populated the marketplace with vehicles could end in no other manner than ongoing margin erosion and value destruction. In turn the used dealer groups consolidated again, with the added pressure of the internet now allowing a potential buyer to view national availability of a certain vehicle with a certain specification – driving a new Dutch Auction climate.

And with the amazing credit deals made available, new cars became within reach of every socio-economic group...why buy used when new was available? Thus the long-running adage that: “a car dealer doesn't lose, good or bad times, single malt booze” has apparently come to an end.

Perhaps the most visible example is Richmond, Virginia based CarMax Inc, a year after year roll-on success story that appears to finally run our of steam given the ever mounting market and operational headwinds. With Q108 profit of $29.6m vs $65.4m (down by 55%), the senior management team isn't providing a specific revised FY earnings guidance, instead leaving analysts to draw their own conclusions rather than overtly disappoint once again later on.

Many previous new car buyers bought into higher-priced large SUVs, which now have residual values that are now, in the real market, far under their expected, notional re-sale valuations since gas prices hit $4 per gallon on the back of $140 per barrel oil. Those who could avoid being lumbered with their fuel-guzzling follies would have traded them against far more fuel efficient cross-over and passenger cars, thus meaning that CarMax will have in theory and on-paper been making decent margins on smaller vehicle sales, especially through finance, but we suspect that CarMax will have already had a large inventory of large SUVs that were previously selling before the crunch and have had to have been taking on more of these unloved giants to move their smaller vehicle stock.

Thus as we've seen cashflow has been drying-up as unfashionable stock levels increase, a situation that eventually leads to business crunch. In the meantime CarMax may be able to massage its accounts somewhat. The first is specific to valuation of its stock; especially the full-size SUVs and Pick-Ups. If it can convince auditors and authorities that those unwanted vehicles are worth their 'book' then CarMax can at least swell its inventory value and add a cushion of comfort to its Balance Sheet and P&L. And at such economically strained times, the US authorities may well let such legal accounting methods pass without scrutiny to maintain the health of the nation's largest used car dealer group and the inherent employment fall-out ramifications.

[Indeed, if dealer principles have been savvy, they may well have bought those SUVs at well below book and so legitimately shown paper profit per vehicle]

However, this paper based 'inflated' valuation of an out-of-favour stock inventory can't last long, even with compliant external assistance, and as the turnover of sales continues to diminish and stock value falls – and probably quickly - so does the corporation's intrinsic valuation.

Given Warren Buffet's investment in CarMax in November 2007, Berkshire Hathaway obviously saw a brighter long-term outlook for the group as the credit-crunch took hold. But what were his fundamental perspectives? Belief in the used car market's buoyancy? A major turnaround including substantial divestment? Or via full break-up of the company?

Turnaround Advisors, M&A Specialists and Bankers will be keenly eye-ing-up CarMax at the moment, eager to identify how best to move onward from today's down-beat results.

A 'Re-Growth' Turnaround would obviously require massive overhead efficiency, variable cost drives and stock balancing including:

- Staff reduction at each location, scaled back to dealer principle, star sales-people and core administrators.
- Scale-back of low-value operating & maintainance costs eg vehicle valeting occasions & charges
- Reduction of network size via leasehold sites expirations. hard leasehold site contract renewel negotiations and possibly only limited sale of freehold properties given present-day low plot valuations.
- Seriously look at the wholesale export of full-size vehicle stock to Latin America and Middle Eastern destinations where booming economies and low gas prices have created a consumer demand for status 4x4s from Suburbans to Navigators to Blackwoods.
- The purchase of Toyota, Honda, Mitsubishi, Hyundai, Mini, VW, Ford, GM & Chrysler used vehicles en mass from each VM owned dealerships and large regional groups to provide a healthy new portfolio. Also helping to clear their own inventories (esp GM & Ford)

This would dramatically change the 'shape' of the company, reducing its overhead, savings of which could be transferred into vehicle price reductions, or ideally concentrating and improving the purchase experience so that more potential customers are converted into direct sales. And such a mass shipment of vehicles would clear the decks for inventory renewal.

A Break-Up might see investors push for an immediate sell-off of the unfavoured SUV stock, done so at 'fire-sale' prices. But this would once again undermine the nation's used car values, so putting pressure upon Detroit's Big 3 own new car prices – a less than ideal scenario. Instead perhaps better to seek better pricing from foreign shipment ads described above. Of prime worth and concern is the network's dealership spots. Each is typically a sizable plot that may outweigh the immediate needs of today's VMs and independent new car dealer groups.

But looking forward it is far from inconceivable that a VM may wish to own large flagship sites for the expected 2010 economic upturn, ready with new portfolios of consumer friendly fuel efficient vehicles and a more confident, self-rewarding consumer-base – especially so if employment and inflation/interest figures are kept low and stable. By controlling CarMax as a VM's central new & used outlet it may be able to far better control its brand's used residual values and so, in turn, assist its own new car prices.

We believe Buffet has evaluated each possible eventuality, and although the stock, now appreciably down on his November buy price, appears to have tractive potential which ever path the business eventually takes. But the central elements are stock removal/replenishment and network divestment. If Buffett can urge the Board to see beyond simply operational tampering, with the possible sale/sub-leasing to American, Japanese, European or even Chinese majors CarMax could pull back and prosper once again.