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 capitalism...as 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