Booming sales, but looming questions

08:24, June 28, 2010      

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After surpassing the United States in 2009 to become the world's largest auto market, China set a new sales record of 5.8 million units in the first four months of 2010 - a stunning 60 percent increase over the 3.6 million units sold during the same period in 2009.

This extraordinary sales momentum has understandably created a sense of euphoria among automakers, leading to many to announce plans to invest in additional production capacity in China.

In recent weeks, Volkswagen announced plans for a new plant in Foshan with capacity to build 300,000 vehicles annually; BMW will build its new 3 Series and 1 Series at a new plant - with a capacity of 100,000 units - in Shenyang; Toyota plans to build a new facility in Changchun that will have an annual capacity of 100,000 vehicles; and Nissan said it intends to increase its China production capacity by 70 percent in the coming years.

While these initiatives are a welcome sign of confidence, there are some reasons to take a more cautious view when considering China's future potential.

Reasons for caution

First, much of China's recent automotive sales growth can be attributed to significant liberal bank lending practices during the past 12 to 15 months.

It should be noted that growth in auto sales were essentially nonexistent in early 2009, and sales did not start to rise until stimulus measures began to take hold in the second quarter of last year.

Without those measures, China's market would likely be growing at a much more humble pace. And while some of the incentives remain in place, there have been movements to scale back on some of them.

Second, plant capacity utilization rates are the key metric of profitability for most automakers. Vehicle production plants are capital-intensive businesses, and the general industry rule of thumb is that a typical high-volume plant needs to achieve 80 percent capacity utilization to reach financial break-even. Every vehicle built and sold after that is profit for the automaker.

But JD Power estimates that China's total industry capacity utilization reached 70 percent in 2009. Given the increased production capacity that many automakers have installed or are planning to add, we estimate that passenger vehicle capacity utilization will decline to around 67 percent in 2010, and will continue to decrease marginally during the next five years.

When capacity utilization declines, the natural tendency of most automakers is to lower vehicle prices to make them more attractive and affordable to consumers. While this is good news for automotive buyers, it translates into lower margins and profits for automakers. Price cuts by one automaker beget cuts by competitors. The result is deflationary price wars, which weaken all competitors.

Other options

What is an automaker to do in this situation? Investment in production capacity is basically sunk cost - there is no way to get that money back. But there are things that an automaker can do to drive sales and reduce costs in other areas:

Build the highest quality vehicles possible, even if this requires an increase in cost to achieve this goal. Delivering quality vehicles - even at higher cost - delivers many benefits.

We see in markets throughout the world that vehicle models ranking among the highest in quality typically enjoy the highest sales volumes, are sold at higher premiums, and have higher margins. Consumers generally are happy to pay a premium for quality. Quality vehicles also enjoy higher repeat purchases from consumers, and provide higher rates of positive word-of-mouth referrals to potential customers.

Focus on building and selling a limited number of models. Focusing on a limited number of models - especially for start-up Chinese domestic automakers - allows an automaker's best design and engineering resources to be dedicated to a limited number of products. This reduces overall development costs, raises quality, and increases the likelihood of achieving manufacturing efficiency and scale.

Focus on marketing a limited number of brands, rather than multiple brands. Positive brand reputations are expensive to create and maintain - there are enormous advertising, marketing, logistical and other associated costs associated with supporting a brand.

China has more automotive brands from which to choose than any market in the world, so standing out from the crowd is imperative. Channeling a company's financial and human resources to support one or two brands can achieve tremendous economies of scale and reductions in costs.

Deliver a superior customer retail experience. While superior vehicle quality and brand reputation frequently trump the customer retail experience in terms of influencing what vehicle a customer will buy, the importance of customer satisfaction cannot to be underestimated.

With the number of new car dealerships in China growing at a rate of more than 1,000 new stores annually, customers have more choices than ever before about where to buy their vehicle. If they do not receive superior service at one dealership, there is little to prevent them from moving on to another dealer - even of the same brand - in the same or nearby vicinity.

China's anticipated economic growth is a given which means rising sales in China's automotive market are assured. But this does not assure a profitable future for all automakers, as competition is fierce, and getting tougher. Focusing on these fundamentals, simplifying one's business, and understanding the expectations of customers, are a proven path to long-term viability.

Source: China Daily


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