CWI Automotive Newletter May 2017 - German versiond332c5czpwjztv.cloudfront.net/wp-content/uploads/2017/05/CWI... · CLEARWATER INTERNATIONAL 2 THE AUTOMOTIVE COMPONENT SECTOR IN

CLEARWATER INTERNATIONAL1

CHINASPECIAL EDITION Automotive

THE AUTOMOTIVE COMPONENT SECTOR IN CHINA: LESSONS TO BE LEARNED

Foreign Invested Enterprises (FIEs) vs. Domestic Suppliers –Shares of the Automotive Component Market in China

Continued Growth

Summary

Source: CAAM, Clearwater International China interviews and analysis

Around the start of 2017,Clearwater International’s Chinaoffice interviewed close to 20APAC and China CEOs of largeautomotive component companies(global sales between $2bn and$20bn) in order to understand theirviews on the current situation andthe future of their companies inChina. The automotive componentsector presents a bright spotamidst the China gloom projectedin the international press. For mostautomotive component companies,China represents one of theirlargest, fastest-growing and mostprofitable markets. The future willbe one of further growth, althoughthere are important challenges todeal with, such as increasingcosts, local competition andpossible disruption from newtechnologies. The automotivesector in general, and theautomotive component sector inparticular, is in our view one of themost ‘advanced’ sectors in Chinain terms of foreign presence. Howforeign automotive componentcompanies have achieved theircurrent position, and how they dealwith the new challenges ahead,brings valuable lessons for foreigncompanies in other sectors.

The automotive component sector in China is currently dominated byinternational suppliers, and this dominance is expected to continue.The automotive component sector not only benefits from the growth of itsclients – OEM car producers – but also from a general shift to ‘quality’,which is particularly beneficial to international producers.Growth in the passenger car market is expected to hit 6-7%, which willmirror GDP in the next few years. The growth will be driven by thecontinued rise of the middle class, lower costs for better quality vehiclesand further government consumption and tax subsidies.

“The car market will follow the GDP evolution, so we expect the ‘new normal economy’ to mean slower growth rates than in the past. However, the Chinese car

industry still has a lot of room to grow, so we do not expect as big an impact as there may be in other markets - growth will continue for a long time.”

“We are reflecting growth between 6-8% in our 3 year plan… the only short-term risk we see is a drop in government incentives, especially if incentives for cars

with <1.6 litre engines ends in 2017.”

The coinciding shift to ‘quality’ favours international component suppliers.As consumers increasingly value quality, OEM producers, includingChinese ones, will expect higher quality components produced at scale.Considering these two factors, component producer CEOs are optimisticabout their businesses and are budgeting higher growth than OEMs are -5 to 15% - for the coming 5 years. While organic growth may hit 6-8%,many companies are implementing inorganic growth strategies to allow foran extra 4-6% YoY growth. This implies a continuation of the double-digitgrowth pattern until at least 2020.

“Our 5-year plan forecasts 12-13% YoY growth. Compared to the past, this goal can now only be achieved through a combination of organic and inorganic growth… without inorganic initiatives, we are planning for only 7% growth.”



Changes in Client Structure – the Surge of Local OEMs

Disruptive Technologies

Margin and Cost Pressure

Source: CAAM, InterChina interviews and analysis

Generally speaking, component producers in Chinaare profitable and, for many companies, moreprofitable than in other large global markets. The endof the ‘good margins’ era in China has been predictedfor many years, but that prediction has been onlypartially realised. Yes, costs have increasedsubstantially over the last 5 years, and prices areunder some pressure, but this has been largelycompensated by scale and efficiency improvements.However, future price pressure is expected toincrease considerably, while costs may still increaseto some degree.

“China today represents 8% of total company sales and contributes a slightly lower percentage of profit. In 4-5

years, we should exceed 10% in both.”

“China represents 10% of global sales and 15% of global profits… we see clear growth potential, but profits will gradually fall in line with those in Western countries.”

“China is 20% of our sales and 30% of our global profits. We expect this to continue for a number of years given the competitiveness of our product segment, but in the longer

run, pricing pressure will increase.”

There will be increasing pressure on OEM car prices(20-30% decreases in the mid-term), which will bepassed onto Tier 1 and 2 suppliers. Some suppliersare clearly seeing this trend already in several keycomponents, such as dies, where OEMs are puttingadded pressure on manufacturers to absorbinvestments and costs.In terms of costs, labour and other expenses shouldbe more stable than in the past. However, some keycosts, such as raw materials, energy/utilities and land,will bring added pressure. Specifically, we expect thefollowing increases in these cost drivers:

§ Inflation at +2%.§ Salary increases between 4-6% (except direct

labour, which is a fixed number based on regionalminimum wages set by the local governments).

§ RMB depreciation of 3-4% YoY.

New Energy Vehicles and high-tech, connectedvehicles will reshape the industry at the China andglobal levels in the years to come.

“In the car market, the main trends worldwide (and even more so in China) are electric vehicles and connectivity.

China is heavily subsidising R&D in these areas in hopes of becoming a technological leader. For the Chinese

government, it is not just the incentive of reducing pollution and having more control over energy efficiency, but also that

Chinese companies can take a strong position in this new market.”

“Geely aims to expand its capacity from 400k units/year to 2-3 times that by 2020, and to have 80% of its production

focused on electric vehicles by 2018.”

“The development of electric vehicles and the connectivity market will have big impacts on the automotive market, since

it means incorporating, at the same time, both new technologies and new players. However, the pace of growth in the China market remains unclear (current sales size is

insignificant).”

The client landscape is changing dramatically. LocalOEMs will continue to grow and quickly win marketshare.

§ In 2016, local brands’ market volume was over 34%.By 2018/2019, this could reach 40%. Key playerswill be Geely, followed by BYD and Great Wall.Some of the SOEs (SAIC, Dongfeng, BAIC andFAW) may also become more important.

§ Overcapacity may become a problem in the mid-term, but not now. OEMs have grown their capacitytoo quickly (today’s CAPEX investments assumedouble-digit growth, which will not be met in reality).

§ At the same time, there will be further consolidationamong the OEMs. The merger of Dong Feng andFAW may happen, although opinions here diverge. Ifit goes through, it may trigger other SOEconsolidations. Consolidation of private companiesis unlikely in the mid-term.



Local Competition

Action


The impact of these new technologies in China islikely to be biggest on the OEM side, where China willmake efforts to skew the car industry more towardslocal brands. However, for component producers, newtechnologies are also an important long-termchallenge, both because of the potential impact ontheir business in China and globally and because ofthe uncertainty of the outcome. This uncertainty ismuch bigger than in other major markets, where it ismore an issue of competitive development andchanges in client structure. In China, however, there isthe additional factor of government interference.

For China, these new technologies are actuallyconsidered potential game changers, which mightallow the country to not only decrease its dependenceon international component suppliers and OEMs, butalso to achieve industrial leadership in the sectorlocally and globally. The government commitment tothe new technologies (as stated in the China 2025policy and several related documents) clearly showsthe strategic importance China attaches to the EV andconnectivity trends. We can expect a continued pushby both the government and Chinese players toachieve the maximum level of control over thisindustry within China, while at the same time creatingthe global standards for products.

This balancing act between market access andtechnology transfer – with its unclear and uncertainoutcome – will determine the structure of the industryin the mid to long term in China, and possibly globally,too. In any case, at this moment there seems to stillbe considerable room for international componentsuppliers as China brings state of the art technologyinto the country. Acquisitions of smaller technologyplayers in the space is one of the options beingconsidered.

Asia is one of the global priorities for most Tier 1automotive component producers, and China is the topmarket in Asia. The key to success in the China marketis local decision making, speed and flexibility. Whileglobal supply chains are important, Chinese clients area big part of this chain, as even ‘international OEMs’are 50% Chinese, given the legal requirement for a50% or more Chinese share in any car or truck OEM.Therefore, much attention is being given to China, andmany companies are starting to see the benefits ofgranting more decision making flexibility to China-based leadership.

“China is a hot topic for our global board. Along with the USA, we are one of the top two countries in terms of new

investment plans; our board has finally decided to go for inorganic growth in China, which represents a big change

from their traditional approach.”

“After a restructuring brought about more flexibility, I report directly to the global CEO, who always listens to ideas that

allow us to adapt to the changes in China… we are becoming more and more of a ‘local’ player in terms of speed and risk

assessment.”

Foreign players are dominant in the car componentsector, and in the short and medium term, thisdominance seems endangered only at the margins,with some specific Chinese companies (e.g. Wanxiang,Huaxiang, Minth) threatening global suppliers in Chinaand – through international acquisitions – abroad. Otherlocal producers in the market are clearly overinvesting,as they follow their OEM customers without critical /professional planning.

“One of our local competitors has already doubled our capacity, but we know most of these lines are not yet

running….they make the CAPEX first, then offer the capacity to their customers, taking on all the risks without closing

contracts in advance… this cannot be sustained.”

At the same time, supplier consolidation is nowoccurring, driven by MNC acquisitions of local players,domestic-to-domestic acquisitions and natural attrition– elimination of smaller low-quality Chinese players dueto their lack of scale, quality or technology.




“Our China entity has always been, and will always be, more independent than our American or European offices

because we operate many business through Joint Ventures where we must respect our Chinese partners’ ways of doing

business. However, we can say that our Chinese organisation is moving towards more standardised

procedures, which is in the core interest of an industrial company.”

“Our China entity has full decision making power, as the global CEO is frequently in China. Decision making speed

is increasingly important because of the increased importance of Chinese clients, and because of more and

more foreign JV OEMs behaving like Chinese companies. Decision making speed has become a key competitive

advantage for us, and this cannot be achieved without local decision making authority.”

In terms of the management priorities for the shortand medium term, the focus is on continued growth(both organic and inorganic) and efficiency.

Since pricing pressures are bound to increase,efficiency is taking on a more prominent role:

§ Plant efficiency via CAPEX and automation. MostMNCs’ China plants still have technological gapscompared to their EU and USA counterparts.Closing these gaps should increase efficienciesand protect profits over the next 2-4 years.

§ Further localisation, including fewer expats infactories and more local production equipment.

§ Localise raw material procurement and decreaseimports.

§ Consider rentals in lieu of purchases (for instance,for new factories).

On the growth side, both organic and inorganic pathsare being followed. In terms of organic growth, it is allabout growing market share, in particular to theChinese client segment through the strengthening ofrelations with local OEMs. This is done via M&A or JVand building ad hoc factories for each OEM. Inaddition, some companies are considering introducingadjacent product categories that have not beenpresent in China. This is driven by new areas likeaftersales and services and greater qualityrequirements.

Along with organic growth in the traditional segments,there is a need for inorganic growth projects focused onChinese OEMs. This is a very different market, wheremany FIEs lack the right product / price / relationshippositioning.

“Around 32% of the market is made up of local OEMs, which FIEs have a difficult time accessing due to prices. Other JV OEMs such as DPCA, SVW, FAW-VW are also very price sensitive and not open to innovative or high-tech solutions.

For 75% of the market, the customer still remains highly price sensitive and not entirely ready to pay for added value

solutions.”

The outcome is that many companies consider M&Aand JVs as key to their growth paths. In terms of M&A,the typical target company has 0.5 to 1 billion RMB inrevenue, is privately owned or part of an SOE that isconsidering a carve-out. These companies should havestrong relationships with Chinese OEMs (even caseswhere a single OEM represents more than 50% ofrevenue would be considered). In addition, the targetsshould own local technologies that have priceadvantages, be profitable and well managed in a localChinese way. A key success factor is to assesswhether or not the commercial and sales practices thatmade the company successful can be retained afterintegration. Lastly, EBITDA multiples should not exceed10, depending on growth and synergies.

A second inorganic growth trend is to develop JVsOEM-by-OEM. This has been quite normal in the pastwith the large SOEs, like FAW, SAIC, etc., but nowthere are new opportunities with POEs. Greenfield orbrownfield JVs are the best model, preferably with alocal player that both knows the OEM well and ismotivated by constraints in terms of scale, efficiency ortechnology (as Chinese OEMs are increasing theirefficiency and technological requirements).

Some companies are also looking at investing in start-ups or early stage companies in the EV andconnectivity fields. Although the rules of the game aredifferent here – with different valuation expectations, forinstance – there seem to be many opportunities forinternational component suppliers who bring thetechnological experience and OEM access.



Conclusion


The car component sector is typical of other sectors in China, where global companies have established anentrenched leadership position, which is now further enhanced by the increasing quality requirements of clients,higher costs and stricter compliance enforcement. However, as China upgrades the industry, this position isunder threat, first from market changes and stronger local competition, and secondly from government policiesfavouring local companies in the long run. Further localisation, with a stronger and more empowered localmanagement team, closer relationships with clients and fast decision making are key to maintaining andstrengthening China market positions. In terms of strategy, it is about efficiency (lowering costs and improvingprocesses) and organic and inorganic growth. For inorganic growth, acquisitions and JVs with suppliers to theChinese segment of the market and with companies active in the emerging EV and connectivity segments is key.


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CWI Automotive Newletter May 2017 - German versiond332c5czpwjztv.cloudfront.net/wp-content/uploads/2017/05/CWI... · CLEARWATER INTERNATIONAL 2 THE AUTOMOTIVE COMPONENT SECTOR IN