Friday, 26 August 2011

Company Focus – BYD – Business Model Cracks Demand More Than 'Green Wash' Rhetoric

This week the WSJ described the concerning events at BYD the Chinese “IT, Auto & New Energy” company formed from its battery manufacturing core, and which heralds itself as an automotive eco-angel.

Its H1 2011 profits dropped by 90% to Y275.36m compared to a year earlier, reportedly to a slump in car sales. Reports suggest that this heavy knock to profitability has sharply deteriorated its green-car ambitions. As the WSJ headline ran: “BYD Sales Darken 'Green' Plans”.

Ever upward market dynamics encouraged BYD to continually add extra spare production capacity, giving a 2011 capacity of 700k units. However, whilst January sales gave 52k units, February, March and April posted a flat-line of 40k units per month which may have presumed a new sales floor. Unfortunately May saw only 32k or so cars sold and June 26k units, so heavily impacting what had been for years an ever expansionary business expectation. Reported 2011 plant capacity of 700k units overwhelms (optimistic)projected sales of 360k units; thus showing a dismal 52% plant utilisation rate and unsustainable commercial basis

Beyond questions surrounding the basic management of the firm and its ability to read the market and equate CapEx & R&D expenditure, this news will undoubtedly also raise questions regards its innate business model, its operational capabilities and its credibility as a truly green vehicle producer.

It is this prescient image by which it differentiates itself both in its home market and by which it seeks to extol abroad for foreign sales traction.

This crisis of confidence also highlights the manner in which eco-tech – or at least the promise of high-return, long-term eco-tech – is both capitalised and managed. It is a question pertinent in both the East and the West. Yet although the past credit-crazed conditions in the West did indeed arguably 'supercharged' eco-style over eco-substance, reduced liquidity means greater awareness and business model critiquing. In contrast though although economic cooling has taken effect in China, and the markets are substantially down over their previous highs, the fact that there is so much liquidity (both RMB & Dollar based) still available in Beijing, Shanghai and Hong Kong indicates that the potential for yet further apparent eco-tech bubbles – or at least overt over-enthusiam – may not have been extinguished.

The immediate BYD lesson demonstrates that it was a mixture of previous stock-price hype and the firm's inability to read market & PESTEL conditions which led it to its recent sell-off. But more so, the obvious chasm that exists between BYD's real-world 'bread and butter' operations of building conventional cars in a conventional manner and without deep acumen versus those investor perceptions – created by the company itself – of an eco-engineering led enterprise that can truly call itself the 'Chinese Toyota'

The past decade has been one of increasing colour and complexity for the varying types of investor with focus on the auto-sector investor. In answer to the regulatory loose yet ethically powerful edicts of the original 1992 Kyoto Protocol vehicle manufacturers old and new have seemingly endeavoured to both develop technical solutions and access funds for doing so.

Since Toyota's original 1996 revolutionary and revelationary Prius prototype vehicle a veritable matrix of enterprise types and solutions emerged. Unsurprisingly that meant established VMs improving conventional ICE emissions whilst 'left of centre' new arrivals such as Tesla, Fisker and a host of others set about offering alternative power-plants, typically EV by nature given the previous 'promises' it comprised. The ability to tap directly into both governmental funding at start-up and development phases and be welcomed by the then buoyant capital markets seeking green investment opportunities only served to boost the apparent green-tech opportunity.

Yet as mentioned in previous essays, the conditions that were created offered a 'feeding trough' for new green-tech enterprises, one which could be abused by knowledgeable participants with marketing hype, absorbing much in the way of funds, providing demonstrator and limited series vehicles, yet whose promise fails to materialise due to a mixture of near empty rhetoric and changed macro conditions. Ultimate ambitions could indeed be that of 'planet saviour', but equally and more realistically for the business-savvy, such 'disruptive technology' can also be sold-off to established market encumbants, in a manner which itself maximises returns.

The ability to bring real-world EVs and LEVs to market is indeed onerous, and really only within the capabilities and desires of major VMs. Yet whilst PSA has sold 2500 or so of such vehicles in car and small van form, Renault-Nissan promotes its overtly ambitious (ie untenable) 2016 EV plans for 1.5m vehicles and BMW showcases the i3, the pragmatic reality looks very different. That reality has taken the shape of Hybrid power-train technology JVs between BMW & PSA and Daimler & Renault. In the meantime GM and Ford roll-out US hybrids at low volumes periodically. And as well known Toyota leads by far (across brands and models) with Honda seeking to replicate. Yes you may well see a prominantly placed Nissan Leaf if you live in a large conurbation, but such trialled cars are more about public exposure and brand halos than as true income streams.

But by the greatest impact has arguably been the creation of stepped phase ICE based product improvements in standard vehicles, aswell as the introduction of green credential sub-brands: VW's 'bluemotion', Skoda's 'green-line', SEAT's eco-motive', Ford's 'econetic', Opel/Vauxhall's 'ecoflex', Volvo's 'e-drive' and Mercedes' blue-efficiency', whilst BMW has engineered-in its 'efficient dynamics' ethos.

This then depicts the scene from the western perspective, where old and new manufacturers came to market from the opposing angles of evolutionary vs revolutionary, and where investment-auto-motives predicts both will eventually arrive at the pragmatic hybrid powertrain solution; an end-point well understood by most of Japan's engineers and execs well over a decade ago.

This then the experience of Triad region manufacturers, capital markets and car-buyers.

The commencement of the 21st century 'green decade' also had a perceptional effect in China, but perhaps more so in the minds of green-entrepreneurs, banking executives, and capital markets than arguably the case with the average new car buyer.

The burgeoning new middle class took to the roads thanks to the policy-led intended 'perfect storm' which leveraged JV knowledge between domestic & foreign producers, induced massive FDI, recycled export earnings into new credit forms for internal consumptive growth and created a plethora of domestic companies and brands now still being concentrically absorbed by planned auto-sector consolidation. The game-play was typical from both state company and new private company angles: appropriate foreign vehicle platforms via JV or licensing, compel state funding, refine the business model and access capital markets funding and grow the business with consumer-centric strategies regionally and nationally.

However, the inclusion of green-tech as a customer-led business differentiator was largely an anathema given market demands for as affordable yet as prestigious cars as possible. Yet that was precisely the apparent business platform and product differentiator that was seized upon by the Shenzen company BYD Auto Co, led by Founder & Chairman,Wang Chuan-fu.

Unlike the masses of similarly styled competitors - who had re-played the west's early 20th century auto-sector development model creating car companies from other commercial engineering entities – the battery producer BYD approached the matter in a far more calculating manner. It presented itself as looking further down the road to the emergent 'eco-horizon'. Where, in time, it could position itself into the similar unique position held by Toyota's sub-brand Prius.

Hence in 2002 BYD bought up the small auto-manufacturer Tsinchuan Automobile Co Ltd, creating BYD Auto in 2003, and set about the task of creating China's first eco-sensitive auto-maker. Its primary commercial remit: to appear more advanced than its competitors and on par with leading Japanese and European auto-makers.

For the last 6 years or so its approach of near 'copy-cat' designs (to Toyota & Honda's global models) along with supportive financing has made BYD the poster-child of Sino industry.

Whilst its foreign role-models have been critical of its methods, within its protected domestic industry walls, the company has delivered 2 very popular cars since its original 'Flyer' model, and has grown an expanded model range. Those popular cars are the small F0 (formerly F1) and compact F3 as the primary production focus; supported by the mid-size F6 and G3. These 4 models combined have been the cash-cows, seemingly maintaining a balance between lower margins on high volume small & compact cars and larger margins on lower volume mid-size cars. More recent models are the F8, S8 & M6.

The company obviously has its product supporters and detractors, the video web-share site has been used to promote positive and negative lights. BYD's Vietnam distributor depicting coverage of a sexy female advertising photo-shoot, whilst another filmed the supposed poor vehicle quality at a motorshow demonstrating the 'poor door-shut'; yet this ostensibly looks like a staged effect given the repetition of the same force applied to achieve a 'bounce-back' off the door jam/lock. Notionally independent videos from the 'ChinaCarsForum' depicts the crash-tests undertaken by C-NCAP, set-up by the Chinese authorities as a counterpart to the Euro NCAP crash and assessment process.

However, the good, bad or indifferent BYD product quality is not the focus of this posting; it is the solidity of the 'green credentials' that BYD proffers, the strength of the implicit vs explicit achievement, the boost-effect such a stance has had to investor interest and the manner in which the business appears to have been managed.

From this perspective, BYD has indeed produced the much vaulted eco-cars in the manner of F3DM and F6DM plug-in hybrids and the E6 MPV with full-electric drive, hence an EV. Yet the production figures for these cars is astonishingly small compared to their conventionally powered counterparts. The F3DM & F6DM were showcased in 2008 as a pre-cursor to the Beijing Olympic games and the F3DM used in the event's fleet of eco-cars along with those 50 or so cars similarly engineered by competitor Chery. Since then, the F6DM has never been build whilst the F3DM sold 48 units to government agencies in 2009 and 417 units to government and public in 2010. In 2010 the E6 MPV was showcased, with 40 units used as taxis in Shenzen for 'field-tests'. And in mid 2011 the S6DM SUV appeared.

For comparison purposes, 520,000 or so BYD cars were sold in 2010, thus the eco-variants represent about 0.08% of production volumes. At that level accusations of corporate 'green-washing' look substantiated, since if the company were wholly serious and dedicated to the cause, it would have not only produced far more eco-variants but would have also had those variants tested in batches 'in house' by both professional technician-testing teams and by allowing its management and staff to use and critique the vehicles much as any regular auto-producer does in its normal operations. Indeed since the eco-cars themselves were not all-new models need necessary protection from industry spies and press photographers the impetus would have been to deploy as many cars as feasible to run as development 'test-beds'.

This should have been part and parcel of operations from the very beginning and could have been ramped-up in size and learning in parallel to the scaled-up production and so income contribution from its conventional ICE powered cars sold.

The following from company sources shows the annual production totals to date, and breakdown of 2010 sales by model:

2010: 519,800 units
2009: 448,000 units
2008: 170,000 units
2007: 85,942 units
2006: 55,038 units
2005: 16,000 units

2010 domestic sales by models:
F0: 148,457 units
F3: 264,364 units (including 417 units of F3DM)
G3: 50,416 units
F6: 51,651 units
E6: 33 units
S8: 7 units

Notionally approximately 1% of the production total could have been devoted to eco-variant testing, thus providing 160 cars in 2005, 550 in 2006, 860 in 2007, 1700 in 2008, 4500 in 2009 and 5200 in 2010.

Given interest in foreign export markets (see end-note), and particularly the US market for eventual mass-entry, the F3DM in limited numbers is also currently being 'field-tested' by HACLA (the Housing Authority for the City of Los Angeles). This is supposedly a precursor to 2012 market entry along with the E6 model, The PHEV compact car to be priced at $28,500 and the EV MPV at $35,000.

The recommended 1% eco-production level would have exceeded BYD's in house testing capabilities, but could have then been deployed in a far more even 'field-test' manner both in China and elsewhere. The present method appears very much to be under 'controlled conditions', given the Shenzen taxi service's home-town links to BYD and the apparent 'routed drive circuit' at HACLA which looks to mimic the closed-loop operations of delivery e-vehicles. Thus both test-beds do not reflect real-world conditions.

It appears that the field-tests created have been done so so as not to stretch the capabilities of the embedded technology whilst also not of a scale that would demand much heavier R&D cost absorption.

[NB Hybrid Development - It should be noted that Toyota's initial phase of hybrid development between 1990-2000 on a conventionally engineered small sedan car cost well over US$1bn and was underpinned by average annual vehicle production of 4.5m units per year. Infact that production waivered between 4m in 1990 to 3.1m in 1995 to 6m in 2000, yet all the way through the hybrid project was protected and funded by the BoD.

NB EV Development - investment-auto-motives has stated time and again that present EV systems (battery set, controller & ancilleries and motor) are not suitable for a conventionally engineered steel monocoque vehicles, whatever battery chemistry option is used type, hence German manufacturer's preference to develop carbon-fibre and aluminium structure vehicles for all important weight reduction and range extension].

The WSJ highlights company sourced figures for R&D spending as increasing YoY from 2007-10,from RMB 0.65bn (US$97.5m) to RMB 1.4bn (US$210m), with H1 2011 numbers showing a pro-rata annual decline. Whilst the figures are not broken down into the separate divisions, if we presume the Autos arm took half the R&D budget it would have provided a steady state rise from approximately US$50m to US$105m. This is meagre by global standards, but the Chinese cost base should have allowed sizeable green-tech achievements, more so than the number of 'field-test' cars publicly announced.

The purported 'grand vision' – if indeed ever truly present - has been at best misdirected; the those eco-cars created simply used as showcase vehicles to promote the BYD brand whilst simultaneously providing a halo-effect over their standard model counterparts. That conveying the idea to customers that they, through the apparent kudos of their cars, are part of a green-revolution. Thus in reality well orchestrated PR to boost the brand profile and so production car demand.

But the lamentable number of PHEV and EV 'field-test' cars created relative to the number of conventional production in comparison to conventional ICE cars indicate a level of cynical 'green-wash' by which sales could be maximised and R&D costs minimised in an effort to create an investment and profitability 'snowball'.

Last year's announcement of a JV with Daimler titled 'Shenzen BYD Daimler New Technology Co' created to give BYD access hybrid and electric drive-train technologies (and Daimler to lower cost production) only serves to demonstrate that BYD in effect had/has very little in its 'R&D cupboard'. As described, R&D did have the significance portrayed, production and short-term profitability took precedence.

However, whilst BYD's management seemingly well understood the competitiveness of the market-place - hence its key differentiator of 'eco' - it seemingly failed to recognise the degree of consumer demand elasticity directly tied to government incentive schemes (providing a pricing incentive) and to the expanding economy (providing a feel-good-factor incentive). As incentives were retracted, and indeed dis-incentives to car ownership introduced in some areas, and the economy cooled so did market demand markedly.

The argument now set forth by the company that this sales decline has ruptured the green development plans looks spurious given the basic but powerful evidence previously presented.

Instead BYD as a parent company and BYD Auto Co itself sit at mutual watersheds.

BYD Co Ltd must:

A. Decide if it does indeed have the executive and management capability to operate its three arms effectively: IT, Autos and New Energy.
B. If not, then consider divestment of the Autos arm, retaining partial share-holder interests.

BYD Auto Co must:

1. massively re-shape structurally to befit the new era in reduced domestic vehicle demand.
2. seek-out ways to either divest of fill the 'idle' 48% plant utilisation gap, by way of:
3a. secure additional export arrangements beyond Bahrain, Russia & Caribbean
3b. secure contract manufacture arrangements with other Chinese VMs
3c. secure deeper alliance relationship(s) with foreign partner(s).

From the London perspective BYD looks like a prime full or partial take-over target for either a flourishing domestic auto-player, or as likely, by a western manufacturer with large cash reserves, in situ Sino JV enterprise encompassing a strategic intent for greater access into the Chinese market.

Doing so would immediately access both BYD Auto's 360k 2011 production volume and critically allow access to the spare capacity of 240k+ units annually. Importantly it provides a Chinese domestic sub-brand that sits (in price point terms) below its in situ own brand that typically holds a foreign brand premium over rivals.

This exactly what GM China did when buying a portion of the small passenger-van maker Wuling Motor. However, that was enabled through GM's own JV with SAIC, something which no doubt was critical to the ruling party at the time. That may have reflected a long-held explicit/implicit precedent that any access to a smaller domestic company may only be done via an already established Chinese JV; and as the home economy inevitably shrinks slightly in the near-term such a viewpoint may hold as strong today.

Theoretically, the accessing of BYD could be undertaken by a host of western manufacturers including VW, BMW, Daimler, Renault-Nissan, PSA, Ford, GM & FIAT-Chrysler, each with Sino JV partners and any of which could feasibly argue the case for acquisition.

But given that BYD already recently formed a 50:50 JV company with Daimler in late May to enable 'Chinese electric car' technology share, it stands as obvious candidate for full or partial acquisition interest, then giving it direct access to BYD Auto for low-cost (properly managed) R&D and platform co-development, and allowing it access to BYD's own 'technology core' of consumer-electronics batteries and consumables.

But critically it allows Daimler the option to either:

A. Persuade BYD shareholders of the advantages in selling off the Auto division.
B. Reverse integrate the listed BYD into the private 50:50 JV, so as to create a newly formed parallel German-Sino battery company which has strong German links and various exit-strategy options.

These are still very early days, and this is but unprompted conjecture, yet Daimler's Dr Zetsche must be musing such possibilities now that BYD's own share-price is at near record lows.

Undeniably BYD in its first incantation (2003-2011) has for some been an investment bonanza for some, its original HK listed shares announced at HK$10.50 having recorded took a steady trajectory to high levels of HK$85 (US$10.90) resulting from a combine of the 10% interest taken by Berkshire Hathaway owned Mid-America, the exuberance of the Beijing-Shanghai-HK capital markets and the unlimited potential for 'converting' the American motorist toward a 'plugged-in' automotive future.

But today BYD stock hovers at HK$16.20 (US$2.08)

And even that needs to be deconstructed to ascertain exactly which corporate divisions are offering what levels of potential value creation or value destruction.

Some long-term BYD investors who bought in during the stock's acceleration – themselves absorbed by the notional potential for the marriage of old and new technologies to transform the car market - will undoubtedly feel let-down. Indeed taken for a ride, albeit notionally in an eco-friendly investment vehicle.

Furthermore, the resignation of the Vice Chairman Mr Xia Zhi-bing prior to the results announcement (on 5th August) albeit as stated on “personal grounds”, will have prompted external parties that some kind of disagreement at board level did emerge, that Mr Xia wished to sensitively seperate himself and by simple virtue of the announcement casts a partial shadow over the company; with special attention drawn to its accounting and profits distribution methods.

BYD must now prove itself as not simply a promoter of eco-tech through PR, advertising and 'green light' graphic annual reports, but as the entity it conveyed itself to be. The BYD Auto story thus far only serves to highlight the dangers inherent in long-term investment in China via its public markets, it highlights a story of a firm that partially succeeded in conquering the small car market through a mix of external consumer and public 'green-washing' and internal ramp-up of YoY scale efficiencies so as to try and buy market share when time became apparent.

To continue to leverage the brand perception BYD Auto has built-up over recent years it will now need to re-invent itself: fulfilling its eco-rhetoric with advanced engineering actions, and able to demonstrate itself as a knowledgeable and efficient manufacturer of conventional cars. These 2 individual strategic threads will be hastened by the inclusion of a foreign partner, so BYD's next challenge is to truly entwine both strands to truly set itself apart.

It must re-present itself not as the naïve automotive 'Green Horn' nor as the peddler of 'Green Wash' but as nothing less than the the 'Green Hornet'; a comic book character who sought a better world assisted by his own advanced technology vehicle.

However, from the prime perspective of investment purposes, the investment community will now need to critically examine the organisational and monetary fundamentals of the company, and to assist its own future growth BYD Autos must become a more independent and transparent entity in its own right.