Special Report
Multinational car executives' eyes must flash dollar signs when they look at the burgseoning auto markets of India and China. In these two countries, with populations of more than a billion each, fewer than 20 in 1,000 driving-age inhabitants owned a car in 2006. Compare this with 900 car owners per 1,000 inhabitants in the U.S. With purchasing power forecast to grow above 10 percent per year in China and by more than 7 percent per year in India over the next five years, car sales will grow enormously.
But as well as promising high returns, these two emerging markets also carry high credit risks for the established automakers--not least because of intense competition, quality issues of manufacturing domestically, uncertain intellectual property protection, and the inherent volatility of developing markets. The Chinese market, already at an advanced stage in its development, has become less volatile and more predictable than in the past. Yet it arguably poses a higher risk at this point, owing to the significantly higher investments foreign original equipment manufacturers (OEMs) have already poured into this market. Indeed, China already represents a major factor in foreign OEMs' investment decisions, production strategies, and profitability expectations, particularly for those with the largest presence, Volkswagen AG and General Motors Corp.
The Indian auto industry, on the other hand, is at an earlier development phase, and it will take longer for new entrants to be able to reap rewards from the market, as they are still at the initial stages of the investment cycle.
Hot growth in China And India will fuel demand
According to a report on the global economic outlook published by Standard & Poor's Ratings Services in March 2007, global economic growth is disproportionately riding on India and, to an even larger degree, China--both of which have seen energy demand rise sharply, as befits industrializing economies. India's economy makes up just 6 percent of global GDP (on a purchasing power parity basis as defined by the IMF) but is likely to account for 10 percent of global GDP growth. China's contribution is yet more startling: It accounts for about 15 percent of global GDP, yet it provides 31 percent of global economic expansion. The U.S. economy, by contrast, makes up 21 percent of global GDP and just 15 percent of GDP growth.
Real GDP in China is likely to grow by about 9.5 percent this year compared with 7.4 percent in India (see chart 2). We expect domestic consumption and spending in China to accelerate amid some employment gains and quickening wage growth. In India, the recent consumption-led growth is shifting towards an investment-led expansion and has seen nearly 8 percent growth for a fourth straight year. At the same time, the robust global economy has bolstered external demand for Indian goods and services, despite a rising rupee.
An increasing reliance on oil means the Indian economy is vulnerable to spikes in international crude prices. And while the economy would also suffer from a slowdown in global expansion, a more immediate risk is domestic inflation. The Reserve Bank of India has raised lending rates to curb inflationary pressures caused by high credit growth and excess liquidity. Using monetary policy to curb demand-side inflation will naturally come at some cost to growth, however moderate.
Chinese car sales accelerate, and India is right behind
China's relative advantage over India is also echoed in its auto sales, which show no signs of running out of gas. We expect sales to grow by at least 10 percent-15 percent per year on average over the medium term, and forecasts by J.D. Power and Associates (which, like Standard & Poor's, is a unit of The McGraw-Hill Companies) suggest that China could overtake Japan to become the world's second-largest automotive market as soon as 2007 (see chart 3). After rapid sales growth of 60 percent-70 percent per year between 2001 and 2004, industry observers feared a dent in performance that could hit manufacturers' profits. But the market cooled off early in 2005 when the government increased interest rates to control demand, and now there are strong signs that the market is maturing and stabilizing.
In India, the second fastest-growing auto market, passenger cars sales grew by 16 percent in 2006 compared with just 8 percent a year earlier, fueled mainly by increases in the small-car segment boosted by tax benefits, new model launches, and greater access to consumer financing. Nevertheless, the international OEMs' chances of gaining from this are being dampened by the predominance of cheaper, locally manufactured motorized three-wheelers, which still hold nearly 80 percent of India's total vehicle market (see chart 4).
Competition in chinese market eats at automakers' profits owing to this world-leading market growth and a fragmented industry, competition in the Chinese auto industry is more intense than in India, which is still dominated by a few large players - a situation that's bound to change as a result of the current attempts of all international OEMs to gain a greater foothold in this market. In the more developed Chinese market, every major international manufacturer is present through imports and, increasingly, with local assembly and production plants, which are generally owned in conjunction with local joint-venture partners. In this way, the foreign players have captured about 70 percent of the market (see chart 5). Although the country has more than 100 auto manufacturers, only a few companies--including the market leader First Automotive Works Group (FAW- produce more than 500,000 units per year, including commercial vehicles.
The experience of Germany's Volkswagen in China illustrates the country's growing significance in foreign OEMs' investment decisions, production strategies, and profitability expectations, as well as the risks involved. As the first foreign carmaker to enter the Chinese market nearly 20 years ago, it gained a nearly 60 percent market share in the mid-1990s. Since then, this has fallen to 18 percent, although this still represents the leading position. Nevertheless, sales in absolute numbers are growing steadily, and the 711,000 units sold by Volkswagen Group in China in 2006 represent 12.4 percent of the group's global sales volume. China was once the most profitable market for the Volkswagen group, but in line with its falling market share, it made losses there in 2005. It recovered to a modest profit of 108 million in 2006, showing the initial success of a cost-reduction program and new model initiative. Volkswagen aims for a production cost reduction of 40 percent by 2008 and 10 new models to be introduced by 2009, one-half of which will be developed in China. Despite its established production base, investments in China remain high for the group: Between 2007 and 2009, Volkswagen will invest €1.9 billion in China, which, however, will be financed from internal funds of its local joint ventures. These investments are not targeted at further capacity expansion, with the exception of powertrain, but at restructuring activities and improvement of local development expertise.
Number two in the Chinese market is the U.S.'s General Motors Corp. Through its six joint ventures, it is well positioned to capitalize on rapid market growth in the Chinese market, and the company is in the process of significantly increasing its production capacity in China. The book value of GM's investments in its Chinese affiliates amounted to about $2.8 billion over the past three years, which has allowed it to launch new models. For example, GM's Regal and Excelle models have managed to take sales from Volkswagen's Santana, Bora, and Audi. Profitability, as measured by GM's share of its Chinese affiliates' net income, amounted to a constant $300 million per year over the past two years. This represents a meaningful contribution to GM's net income of $1.2 billion in the Asia-Pacific region in 2006, and stands in sharp contrast to its huge net loss of $4.6 billion in North America during the same period.
Other large foreign manufacturers in China include Honda Motor Co. Ltd. Hyundai Motor, Toyota Motor Corp., Peugeot S.A., and Nissan Motor Co. Ltd. However, the progress made by the largest indigenous Chinese players, Chery Automobile and Geely Automotive Ltd., is particularly remarkable: As well as market shares of 7 percent and 6 percent, respectively, in mainland China in 2006, they already have meaningful export activities. And their sights are now set on making serious inroads into the US and European markets in the medium term.
The fledgling Indian car market is significantly more concentrated than China's, although foreign players are increasingly making inroads. They are currently working at setting up or expanding their existing production bases in India, but progress is slow and they must avoid the overcapacity already prevailing in China to preserve overall satisfactory profitability in the long run. Indian automaker Maruti Udyog Ltd. MUL, which is 54 percent owned by Suzuki Motor Corp. dominates with a market share of about 49 percent (see chart 6). At present, it specializes in the small-car segment, but it has strong plans to penetrate the medium- and large-vehicle segment in the near future. The next-largest players are Hyundai Motor India Ltd., a subsidiary of Korean Hyundai Motor Co., and India's own Tata Motors Ltd.
In the year-to-date November 2006, Tata Motors held third position in midsize entry-level sedans (Indigo) and in the compact-car segment. Finally, Honda Siel Cars India Ltd., a joint venture between Japanese Honda Motor Co. Ltd. and Siel Ltd., is the fourth-largest player in the Indian market.
Major manufacturing investments shifting to India
While China has been the key focus of OEMs' capital expenditures in recent years, the bulk of the production capacity build-up is meanwhile completed. That does not mean, however, that the investment in China is over for foreign OEMs--as demonstrated by Volkswagen's plans to invest €1.9 billion over the next three years. Nevertheless, we believe the investments in China will be more add-on as far as capacity expansions are concerned, and will increasingly target efficiency gains and cost-saving measures. Capacity build-ups in India, on the other hand, will require higher overall investments by foreign OEMs if they want to seriously participate in growth. Furthermore, high import tariffs make local production a prerequisite to reach a meaningful market share in India.
The established automakers' manufacturing build-up in China has made it the world's fourth-largest manufacturer of automobiles after North America, Western Europe, and Japan, and the third-largest producer of commercial vehicles behind the U.S. and Japan. In 2006, total passenger-car production amounted to 4.25 million vehicles, which means that passenger cars now outnumber commercial vehicles built. Massive capacity build-ups in the Chinese market could result in a total installed production capacity in excess of 10 million units by the end of the decade. On a positive note, it appears that the capacity utilization rate has finally bottomed out, and is unlikely to deteriorate further, as capacity expansion will largely be absorbed by the growth in unit sales.
In India, foreign automakers, as well as their domestic competitors, have strong capacity expansion plans. Forecasts suggest that production capacity will increase by more than 80 percent over the next three years. This means that the capacity utilization rate, which was a robust 75 percent in India in 2005, is likely to deteriorate significantly until the end of the decade to levels similar to China, currently with capacity utilization rates somewhat below 60 percent.
Uniform profit margins
In terms of manufacturing competitiveness, China has the edge over India due to the low cost of labor given that productivity for the two countries is similar (see table 1).
Profitability in China has suffered from pressures of overcapacity and the fragmented market. Vehicle prices, which used to be significantly higher than those in most other markets, have been falling rapidly since China's accession to the World Trade Organization (WTO) in 2001. Since then, operating profit margins for cars have dropped to the 4 percent-6 percent levels that are in line with the world market, as a result of the nation's tariff cuts and rapidly growing competitive pressure. High material costs and lower-albeit improving--quality and availability of components, as well as higher production costs than the world average have contributed to these
declining levels of profitability. Labor costs, however, remain favorable, amounting to only 20 percent to 25 percent of the world average. Meanwhile, we believe that profitability in China has bottomed out and that mid single-digit margins should be sustainable in the medium term, to some extent supported by the gradual increase of local content, which is promoted by the Chinese government. In India, however, profitability is stronger among Indian automakers, aided by good production efficiency as a result of higher plant utilization rates, higher percentage of local content, and sales financing profits.
The industry-average profit margin before depreciation, interest, and taxes has grown to about 12 percent in 2006 from below 10 percent over the past six years. Industry-wide profitability over the past two years have been relatively stable, highlighting the efficiency gains attained by the manufacturers, which have offset significant steel price increases.
Risk of copycats in China
A further risk factor associated with investing in China is the potential for uncertain protection offered to intellectual property. There have been many reports in the financial press of alleged violations in China of trademarks, patents, or copyright. Toyota and Honda have each been involved in intellectual property lawsuits China. Nevertheless, the government now seems to be making a more serious effort to address these issues. For example, the State Administration for Industry and Commerce decided in October 2006 that the Honda logo was a "well-known trademark, which would be unlawful for a third party to use." What's more, domestic manufacturers are now establishing internal intellectual property departments and trademarking, copyrighting and patenting their intellectual property. Time will tell whether this combination of state and private involvement will bear fruit. The regulatory environment in India is more accommodating to foreign entrants, and copyright protection-- based on the British legal system--is stronger. There are no restrictions to setting up a car manufacturing plant, as 100 percent foreign ownership is permitted. India's new Auto Policy of 2002 led to a reduction of import duties on components and CKDs (completely-knocked down units) to 15 percent in 2005 from 30 percent in 2003, stimulating domestic production. Furthermore, foreign direct investment was encouraged by the provision of tax incentives. In line with WTO regulations (of which India has been a member since 1995), import duties
and excise duties on import vehicles - while remaining high in absolute terms--are being reduced gradually. Nevertheless, tariffs on second-hand cars remain particularly high at a combined more than 120 percent, to protect the country's domestic auto industry.
Setting sights on the West
As the Chinese auto market consolidates, the strongest domestic players are already beginning to pose a competitive threat to the established automakers. Already in 2006, export volumes of Chinese-made vehicles (including CKD) reached 340,000 units--although in dollar terms the value of exports still lags behind the value of imports. The Chinese government has outlined an ambitious plan to increase the export value of vehicles and auto components from $11 billion to $120 billion within the next decade. It may not be too long before U.S. and European automakers have to defend their home markets from profit-hungry Chinese auto executives.
Source : automonitor.co.in
(5/6/2007)
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