How European Automakers Aim to Keep Winning in China Despite Market's Slowdown

Was the chief executive of the world’s largest premium manufacturer actually implying the industry’s engine of growth might be running out of gas, a reporter wanted to know. “You heard me right,” answered Reithofer, pausing to let the words sink in. “We were really spoiled the last few years by the growth rates … but we saw in 2014 that they were increasingly on the decline and above all, it was no longer possible to achieve the kind of contribution margins we had three or four years ago.”

Weeks later Audi, China’s premium market leader, said its March sales rose by just 1.5%. Volkswagen brand, meanwhile, failed to increase volumes in China for the fifth month out of the past six. There is no more denying it: The days are over when China’s remarkable growth was like a tide that lifted all boats.

Experts argue China’s auto market will never be the same due in part to a paradigm shift in the country’s economic model that will see an end to the era of effortless double-digit volume gains and fat profit margins. Industry demand slowed to a relatively tepid 9.9% increase to 19.7 million passenger cars last year, when the country recorded its slowest pace of economic expansion in almost a quarter century. Moreover, much of the rise was due to a surge in cheap SUVs and minivans primarily sold by Chinese brands.

The China Association of Automobile Manufacturers expects passenger vehicle sales to rise 8% to 21.3 million vehicles in 2015. Volvo CEO Hakan Samuelsson is less optimistic. He said at last month’s Shanghai auto show that he expects overall passenger car growth to slow by as much as 7%, while he sees the premium sector staying reasonably strong with a rise of between 5% and 10%.

Growing pains?

Automakers often say that these changes are the typical growing pains experienced in a maturing market. They point out that lower percentage gains from a very high base still translate into large overall increases in car sales.

But China’s role is far more crucial than executives admit as the market accounted for a quarter of all global car sales by European automakers last year, according to IHS Automotive. And, more importantly, China accounted for 40% of all automakers’ global profits last year -- roughly as much as Europe and North America combined -- a recent McKinsey study showed.

“BMW management’s comments on China need to be heeded,” Bernstein analyst Max Warburton wrote. The analyst added in a separate note in late April that while BMW was, at that point, the only automaker to warn about China, others will follow, which is why the firm is “growing more pessimistic” about profitability in China. “Demand is easing, consumers are pickier, [they] buy smaller engines and demand discounts. This is going to catch up with everyone,” Warburton wrote. He also noted that VW and Ford had cut prices by 5% to 10% and that “the pattern of sales over the course of each month is becoming unhealthy.”

The slowdown comes at the most inopportune time for Europe’s carmakers, whose margins are already being squeezed by the billions in costs they are forced to swallow for developing low-emissions technology to satisfy tougher regulations at home. Automakers desperately need a robust China to help offset a collapse of sales in Russia as well as disappointing results in Brazil and India. “Of the motors driving the global economy – the BRICs – basically only “C” for China is left standing,” Volkswagen CEO Martin Winterkorn said in mid-March.

Pollution & inflation

China is turning its back on the debt-financed property and infrastructure bonanza that fueled its growth. While it did lift overall wealth and income standards, it unintentionally lead to dangerous levels of pollution and bouts of speculative inflation in real estate markets. Jochen Siebert, founder of Shanghai-based consultancy JSC Automotive, warns mismanaging this complex transition could let the air out of what he believes is a massive credit bubble. “When you talk about real estate, which accounts for roughly a third of the economy, we are already well into crisis mode here. Most developers are now on the verge of going bankrupt,” he said.

McKinsey’s economic think tank, MGI, found that the country’s public and private sector debt has nearly quadrupled since the pre-crisis year of 2007, rising from $7.4 trillion to $28.2 trillion. China is now more indebted than the U.S. relative to the size of its own economy. “China is coming to an end in many ways. If the status quo is maintained and there is no reform, the country could suffer a hard-landing -- I can even imagine a recession,” he added.

Not only do carmakers face a cyclical downturn, they also have to contend with structural declines in key parts of China resulting from attempts to rein in pollution and manage congestion. Porsche finance chief Lutz Meschke fears authorities might be pressured into eventually banning all cars running on gasoline from cities such as Beijing and Shanghai, especially now that the Chinese documentary “Under the Dome” has created a growing awareness of the environmental problems. “At playgrounds you will always find a red flag, which goes up to tell parents when it’s not safe for kids to play outside,” he said. “It is no longer the exception [in Beijing], it has become the rule.” To guarantee it won’t be shut out of the Chinese market Porsche is developing an electric car that Meschke calls a “life insurance policy.”

The government is trying to subsidize a fledgling market for New Energy Vehicles, electric cars and plug-in hybrids that can go at least 50km on electricity, targeting a half million sales this year. Chinese brands are making progress since only locally built NEVs benefit from government subsidies. Scientists warn, however, that pushing NEVs could backfire, causing CO2 to rise in the short term as the country’s power grid relies on burning coal containing heavy amounts of ash, sulfur and other impurities.

Restricted sales

For now at least, cities are simply restricting by decree the license plate registration of new cars to tackle pollution. Shenzhen became the eighth major city to do so, imposing limits virtually overnight with registrations expected to be only a fifth of last years. Said BMW brand sales chief Ian Robertson: “Since that regulation came into force, there have been far fewer new-car sales. Of course there are other cities that are still expanding and thanks to them, we will see growth continue in China, albeit at a more normal level than in recent years.”

Profits under pressure

Boston Consulting Group’s Marco Gerrits, head of the automotive practice in Greater China, warns the market is becoming hyper competitive due to this combination of cyclical and structural problems, especially as segments become increasingly crowded with new products. “Overall profits are coming under significant stress in the Chinese market,” he said. “Are carmakers prepared? I don’t think so. They won’t be able to offset this with cost reductions and productivity gains.”

VW is expanding production to build 5 million cars in China by 2019, an annual increase of more than 7% that matches forecasted economic growth, but it is already starting to become cautious. “Under no circumstances will we risk building up overcapacity,” VW Group China boss Jochem Heizmann told Automotive News Europe. VW is heavily dependent on China to maintain sales and profit growth. Last year group volumes in China for the first time outstripped those in Western Europe and the U.S. combined. Bernstein estimates that more than half of VW’s 10.8 billion euro net profit in 2014 came from China, either in the form of shared JV profits, the sale of parts to its two JVs, or royalties received.

While Heizmann attributed part of its recent weak performance in China to lost production from retooling plants, two other factors played a key role as well. Incentive spending had risen to levels VW would not match while growth was primarily found in segments where the brand was not present: low-cost SUVs and minivans. At the Shanghai show last month Heizmann said VW is exploring the possibility of developing products in these two segments to keep up with the market shift.

Surging SUVs

Chinese brands are gaining share with SUVs such as Great Wall’s Haval H6 or the Changan CS35. “The flourishing SUV segment has helped Chinese brands stave off pressure,” LMC Automotive wrote, adding that seven of the top 10 best-selling SUV models in the first two months of this year were domestic nameplates. “Chinese automakers now have a renewed strategic opportunity to excel.”

To remain competitive amid the new pricing pressure, foreign automakers are forced to shift production of more models to China and increase local content. This squeezes their lucrative business of selling components to their joint ventures, and also means that they will begin splitting profits with their Chinese partner rather than booking them entirely on their own P&L sheets, which they can do for imported vehicles.

At the same time, foreign automakers walk a tightrope between losing market share on the one hand and gaining it at the expense of domestic brands. This can quickly attract attention from Chinese state TV channel CCTV, famous for its annual state-sanctioned attacks in mid-March on foreign companies, which have repeatedly targeted VW.

Analysts say the government is unhappy with the lack of knowledge transfer between JV partners and feel the foreign carmakers that benefit disproportionately have not been sufficiently motivated to help their Chinese partners, many of which are state-owned enterprises, improve. This is stymying VW’s efforts to raise its 40% stake in its joint venture with FAW, they say.

Over the past three years, the government has been urging foreign carmakers to join with their local partners in marketing new indigenous brands in exchange for green lighting capacity expansions.

General Motors, Nissan and their JV partners have already enjoyed some success with the Baojun and Venucia brands, respectively, while late last year Daimler launched its Denza line of electric cars developed with China’s BYD. Others have dragged their feet, however, including Volkswagen, which has yet to show a car sporting either the Kaili or Tantus brand.

Three European companies with capital ties to their JV partners might have a competitive edge in this sense. Daimler owns a 10%t stake in BAIC Motor and two senior German executives sit on the board, where they advise their Beijing partner on how best to expand its business. Daimler’s Mercedes-Benz brand started production last month at its new compact car factory in Beijing with output of the GLA crossover. “The benefit is it’s easier to tell my people that we are partners looking for win-win [scenarios],” Daimler CEO Dieter Zetsche said. “And, this is certainly a better premise for success than looking at the partner as the best enemy you have.”

PSA/Peugeot-Citroen counts one of its JV partners, Dongfeng, as a major shareholder with a 14% stake in the French automaker. China eclipsed France last year as PSA’s largest market.

‘Growth to be had’

Sweden’s Volvo meanwhile is fully owned by China’s Zhejiang Geely and claims this helps align their common interests. “What’s unique about our situation is that while everyone else has arm’s-length partnerships, with our owner we have no reason to hold back certain technology,” Volvo CEO Samuelsson told Automotive News Europe. “We’ll use China for product development to a larger extent than other companies.”

He added in late April that he expects Volvo to grow faster than China’s premium market this year. “It is going to be tougher,” he said in a statement. “But there is still solid growth to be had, especially in the premium sector.”