Wednesday, 10 September 2008

Industry Structure – China – From the Running Red Hot to Post Bubble Blues to the Opportunities Therein.

Whilst China captivated the world in the run-up to, and during, the Olympics, there have been many observers – from the Beijing Street-Hawker to Wall Street Trader – who have wondered how the economy would fare once the massive public expenditure programme ended. That programme preserved a level of social and fiscal confidence within the country since the domestic stock-market highs this time last year (with P/Es at 25-35) turned to massive down-turn capitulations in sector after sector..

For all the talk of normative corrections, setting stocks back on more conservative and realistic ratings, the once ravenous appetite that underpinned Chinese growth as state assets became privatised appears to have largely diminished. Many planned IPOs have been shelved or post-poned, only the very secure (such as railways and infrastructure) now welcomed by overtly conservative private investors recognising the importance of central government's essentially guaranteed funding plans.

Thus it seems that China is reflecting the dynamic of western markets of the last few years, now looking at low-yield, long-holds as the safest of bets in what's become a risky and volatile capital market, drastically eroded by formidable inflation a 12 year high. Inflation that in turn is adversely affecting operational profitability across the board, especially so for those industries with heavy CapEx, overhead, raw material and staffing costs.

Unsurprisingly so, from the consumer's perspective, that jittery socio-economic climate has been most recently evident and most forcefully felt in the auto-sector; as sales figures for August revert to the levels of 3 years ago. Locally based consultants state that the August figures are the result of the public's Olympic focus, and that 'normal service will resume' as new models and incentive packages arrived at end Q3 & through Q4.

However, there may reason to argue that after what has been a long period of over-incentivised sales, applied not only to older models but also to new, that the new car market (in qualitative sentiment terms, if not in quantitative statistics) has effectively been saturated. Also note that the voracious Chinese consumers have been quick to re-purchase newer vehicles at the 2 & 3 year mark, recognising the value of the deals on offer, but also inadvertently swelling nearly-new used car ranks and so in turn promoting the vicious spiral of undermining new car prices. Since there has been little bounce from the stock-market downturn consumer confidence has been slowly diminishing, no matter how highly anticipated the grand Olympic event.

Reviewing the year to date, CAAM stated average sales by mid year rose by 'only' 14.3% compared to a previous forecast of 20%. By August that figure was a rise of 13 percent [4.55m units]. Of course mid-teen figures would be magical in western markets. But in what has been a 'wonderland' of 25%+ growth in recent years, the expected slowdown to 20% (resulted as the volume ripple spreads wider but with less intensity) was unfortunately demonstrably over-optimistic. The law of diminishing returns hit harder than expected.

So in effect the Olympics, as a massive public works programme, only really served to try and delay and massage the downward rate of consumer confidence, having little real effect to re-invigourate the economy; even with the accompanying supportive use of fiscal policy directives that sought to revive faltered capital markets. Indeed, some of London's Chinese community saw the Olympics as a timely “smoke and mirrors” exercise to the world. And though a possibly overtly cynical view, it would make sense that the Communist Party might try and re-configure the prime elements & sectors of its industrial base whilst the world's attention is focused on the results of Chinese commercialism, and not the management of machinery behind the scenes.

So what does this mean for the Chinese auto-industry?

The critical element is of course the profitability of the general sector and the players therein, whether state transformed, JVs with foreign manufacturers (as the large producers are), spin-offs from other sectors (such as motorcycles & defence) or indeed privately backed newcomers.
In May 2004 the State Development & Reform Commission set out a new policy that would alter the face of the industry by an intended date of 2010. That ambition was the enlargement of domestic companies (through organic growth and via consolidation best exemplified by the SAIC-Nanjing merger) aswell as the forming of commercial relationships between domestic and foreign enterprises – a key aspect that stretches from the 1978 agreement between Beijing Jeep and Chrysler to the more recent one with Chery Auto.

These reforms were recognised as being necessary since the early part of this decade when it was understood that the economic miracle of rapid growth could not be sustained, especially since China relied so much on low-cost exports, and that other countries such as Vietnam, Kasakhstan, other ex Soviet regions and perhaps even North Korea, were placed as natural future low cost successors that could both generate internal growth and importantly attract foreign capital. Thus, to sustain Chinese growth in the long run, would need insightful economic management that both fiscally cooled and fiscally re-energised the nation as appropriate, increasingly relative to the global economy – even if the de-coupling theory was theoretically proven.

Thus the natural evolution of the auto-sector would witness its rapid rise / expansion, induce competitive forces which, in turn, would degrade margins. This along with the desire to plan the sectors direction for both vehicle and parts-makers (set on a world-stage) would effectively demand sector re-structuring before / by / soon after 2010.

investment-auto-motives posits that over the last year since the severe Beijing & Shenzen stock-market downturns that China, masked by the hype of the Olympics, is a watershed period for Chinese industry, across many sectors from mining to steel to autos to the ultimate ambition of high-value specialisms.

As publicly listed corporate prices remain low, with the potential to drop further in the short-term under operating pressures, well see an eventual swath of auto-sector M&As, very possibly reflecting recent events in Europe. The Schaeffler acquisition of Continental and Porsche's buy-into VW could be models by which private entities (whether trade, family or PE) procure very tempting targets that can either be: a) synergistically absorbed into the holding company, b) bought as undervalued concerns awaiting the upturn or c) bought with divestment or spin-off potential.

Beyond potentially undervalued listed companies more easily available to foreign interests, there is also potential for progressive smaller local firms to seize the opportunities of mergers, or at the very least, alliance relationships. As we've stated previously, that could be formed from many different strategic perspectives, specific to: volume efficiencies of same car models / architectures, vehicle portfolio expansion using eachother as OEM suppliers to 'fill-in' respective ranges, to simply looking at operational functional advantages utilising eachothers differing core competancies.

Of course the possibilities are not simply restricted to more the obvious horizontal dimension of the sector, but also vertically, where upstream suppliers or even downstream distributor-retailers seek to maximise value-chain efficiencies via logically justified acquisitions. As with Japanese and Korean forebears it is often the stronger but invisible parts-suppliers that have the financial muscle to catalyse the lower orders of the more visible weaker car-makers in the industry.

And from the financial philosophical viewpoint, between the high profile listed corporations and myriad of smaller local firms are the likes of Chery and its peers, itself well placed and ambitious with plans for 42 new models between Q208 & 2015. These able and growing firms that appear to have attained the best of both worlds from 100% Chinese ownership (and its attendant political connections) to the technology sharing being accrued from production agreements with the likes of FIAT and Chrysler on mid and small cars.

Rationalisation spreads beyond strategic and capital expenditure concerns. There is a major need to address general productivity costs in this high inflation era, so just as commodities and raw material prices are slowly being tamed, so the thorny issue of wage cost inflation will need to be dealt with, very probably done so with corporations' judicious use of 2 arguments: I) reduced profits demanding input cost adjustment across the board, II) the natural effects of wage deflation as new transport infrastructure provides work access and opportunity to what were previously agricultural workers (as occurred previously). [We concur with a recent UBS/Economist report that counters talk of emerging restrictions on Chinese labour supply. Demographics and Land Reform policy and mechanisation will ensure supply well past 2025]

To this macro-economic end, domestic and foreign investors will be keen to assess the opportunities that both emerge and those that must be investigated and generated. Therefore, bankers in the China, Europe, the Middle East and US will be 'mentally plotting' each type of company relative to their prime referance points, or core strengths, that envisage a re-positioning in the shuffling sector. Re-positions that prove themselves to be aligned to the 2004 Reform Ideal...that being...

Under the Policies, the examination and approval system for domestic and foreign investment in car manufacturers is to be reformed into a dual system whereby certain projects require approval and others solely need to be filed for the record. 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.

A broad remit that has much scope for investment returns as the industry itself rationalises and thereafter takes advantage of a re-energised US & European opportunities as those economies pull out of their slump. Meanwhile, maximising the Emerging Market export & CKD possibilities that will be a strengthening thread before advanced market incursion.