A young man in a slick blue sports car zooms down an open road: “Anytime,anywhere: I’m a star,” reads the slogan. The advertisement, which hangs inside a BMW car showroom in downtown Shanghai, is not terribly realistic – car buyers here would have to drive a long way to find a road remotely like the one in the ad. But the ad isn’t about reality, it’s about aspiration. Smart, sporty and foreign, it epitomizes everything BMW is branding itself as in China, to astonishingly good effect.
“There’s been quite a rise in demand, even in just the 13 months I’ve been here,” said Zhou Weide, a salesman at the dealership. He reckons sales at the showroom are up by around 40-50% from this time last year.
Thanks to high import taxes, prices here are steep. A 2012 BMW X1 xDrive28i retails for US$85,000, compared to a US$33,000 starting price tag in the US. Why are Chinese consumers willing to stomach such a hefty price? “It’s the high quality – made in Germany,” said Zhou.
China’s auto market is bifurcating. The lower end of the industry is struggling, but the country’s premium auto market – dominated by the German brands Audi, BMW and Mercedes-Benz – is experiencing vertiginous growth, because newly rich Chinese are willing to pay top dollar for top brands, import duties be damned. But while inelastic demand will propel German car companies in China for some time yet, maintaining profitability is getting harder.
The overall Chinese passenger vehicle market is feeling decidedly queasy these days. Sales grew by 6.2% year-on-year in the first half of 2011, according to data from the China Association of Automobile Manufacturers. That might not seem bad compared to the still-sickly markets of the US and Europe, but it is underperforming China’s broader economy, and is well below the 33% growth the auto industry experienced last year.
The most important reason for the decline is the removal of government incentives to buy cars, introduced as part of the 2009 stimulus measures. Also contributing to slackening demand are higher fuel costs and tighter traffic restrictions in big cities.
Feeling the pinch
The pain has not been distributed equally throughout the industry. Headwinds have disproportionately hurt automakers at the lower end of the market, and Chinese automakers in particular. BYD, the car firm in which Warren Buffett’s investment company Berkshire Hathaway holds a sizeable stake, announced in early July that its first-half profits plunged 85-95%.
Such figures make the performance of the three big German premium automakers all the more striking. Audi (a unit of Volkswagen) posted a 28% year-on-year increase in sales in the first half of 2011; sales of Mercedes-Benz (part of Daimler) were up nearly 50% in the same period, and BMW’s sales rose 61%.
Even more astounding has been the profit growth. The companies in question are reticent about their China profits, but the numbers speak for themselves: Daimler’s second-quarter 2011 net profit rose by 30% year-on-year. BMW’s profits more than doubled in the same period, and VW’s almost tripled.
The most obvious reason for these stellar figures is that the German carmakers are riding the wave of China’s premium car market, which grew 48% in 2010 and moderated only slightly to 31% in the first half of this year.
They are not alone. Luxury car companies have flocked to China since import restrictions were eased somewhat in 2004, and have been amply rewarded. German carmaker Porsche has a strong presence in sports cars, Ferrari and Lamborghini in race cars, Land Rover in cross-over vehicles and SUVs, and Bentley and Rolls-Royce in luxury sedans. All have recorded growth rates comparable to the
But these companies are still niche players in the premium market. “There are really only three automakers that cover the whole premium market; we call them the ‘ABB’ brands,” said Mei Songlin, Asia Pacific general manager at JD Power and Associates, an auto research company. “A is for Audi, B is for BMW, and another B is for Mercedes-Benz – which in we usually just call Benz in Chinese. These three are dominating the high-end market.”
Brand, baby, brand
The key to the German automakers’ financial success has been maintaining broad appeal while preserving a top-shelf image. “The ‘premium’ element of any car segment is really just the brand appeal,” said Arndt Ellinghorst, London-based head of automotive research at Credit Suisse, an investment bank. “The brand triggers a 30-40% pricing premium.”
This brand strength is a substantial advantage when it comes to defending market share. Would-be luxury car companies need a long time to build up the image needed to break into the market – particularly if they want to avoid being confined to a niche segment.
“It’s reasonably safe to say that you don’t create luxury brands any more – they’re just too historic,” said Philippe Houchois, head of European auto research at UBS.
He pointed out that the last time a brand was created in the premium car segment was the emergence of Lexus in the 1980s. But even that isn’t a perfect example – Lexus has so far been unable to gain much market share outside North America.
The future exception in China may be Volvo. Geeley’s purchase of the Swedish brand could allow Volvo to tap Geely’s existing distribution network in China, potentially delivering products with the brand equity to challenge the three German automakers.
The power of price
A more immediate threat is internecine price competition. “I could see a brand with weaker product momentum offering more discounts,” said Ellinghorst of Credit Suisse. “But it’s a very, very dangerous drug to use. Because once you introduce discounts, you never get rid of them.”
He noted the appearance of steep price cuts in some recent Mercedes niche limo products, and said such “structural discounts” could spread to other premium models. This would earn market share but eat away at the net brand equity German automakers have built up.
Calum Macrae, UK-based head of Autofacts, an automotive forecasting service owned by consulting firm PwC, says that the price competition has so far been limited, similar to other markets. However, he cautions that it only takes one manufacturer with excess capacity to trigger a price war.
“Generally, premium manufacturers tend to respond to the ‘pull’ of customer demand, rather than trying to ‘push’ a product onto the market,” he said. “But in China we are in new territory, and it will be interesting to see pricing responses.”
At least the carmakers themselves seem aware of the danger. “We believe price stability is part of being premium,” said Ivy Ji, a spokesperson for BMW China, in an emailed response to questions. “At the moment, demand for many of our models is far over supply. We may have some temporary incentive policies for a few models based on product life cycle, but generally we don’t offer much of a discount.”
Rather than competing on price, the automakers have been keen to emphasize their brand differences under the broader rubric of Brand Germany. This is fine for Mercedes-Benz and BMW; if an automaker breaks ranks with this compact, it will be Audi.
Audi, the leader of the pack in China, is in something of a sticky situation. It received a tremendous head start in the China market thanks to government fleet purchases. But this has proved a mixed blessing: Audi’s government fleet sales were so successful that the brand is now closely associated with China’s official panjandrums – and by extension, corruption and indifferen
ce. Extravagant automobile purchases by government bureaucracies are a source of ongoing social tension here, and the state auditing bureau has repeatedly tried and failed to get government bureaucracies to publicly reveal how much they spend on cars. Audi has struggled to shake off this association, which sometimes doesn’t go down well with private buyers.
“There’s an inherent target conflict for Audi,” said Ellinghorst of Credit Suisse. “How much more premium luxury do you want to get? At what point is it a threat to your government purchases?”
Regardless, the apparatchik market is shrinking. Yale Zhang, Shanghai-based general manager of research outfit Auto Foresight, reckons government fleet purchases now account for only 5-10% of total sales.
However, Zhang argues that Audi may still be best placed among the German automakers because of its strong distribution network within China and stable brand image. Moreover, its parent company, Volkswagen, has diversified to serve nearly every segment of Chinese demand.
The same cannot be said of Mercedes-Benz, which has staked out a position firmly on the higher end of the premium car totem pole. BMW has stayed closer to Audi in pricing, but Ellinghorst of Credit Suisse argues that the firm may have the smartest consumer branding: Its younger, sportier image goes down well with China’s rich, who tend to be a decade (or more) younger than their peers in the US and Europe.
More profit, less profitability
How these three brands differentiate themselves is critical, because most analysts agree that the profitability of all three is bound to decline in the Chinese market eventually.
German premium automakers derive their profits from three revenue streams here. The first and most profitable is direct exports of fully-made cars from Germany to China. The second stream is exporting car parts from Germany – or other high value-added markets like the US – for assembly and sale here. The third is making and selling the cars in China with a joint venture (JV) partner company.
The third option is the least profitable, because JV revenues are accounted for “at equity,” meaning that the German companies get a 50% slice of the JV’s net profits. In other words, the German parent gets only half the profit on a car made and sold in China through the JV, but it gets to keep all the profits from the same car made in Germany and exported to China. Macrae of PwC notes that losing the “made in Germany” label might dim the brand luster.
Sounds unattractive, but the JV option is likely to increase its share of revenue streams nevertheless. Ellinghorst of Credit Suisse reckons that only about 5% of profits of the German automakers come from their JVs today – though figures vary considerably between the three. But in the near future, as manufacturing moves into China, that proportion will rise to 20-25%.
Even though moving manufacturing processes into China is likely to cut into profit margins, the Germans may not have a choice: Analysts say production capacity in Germany has maxed out, and it’s better to increase production capacity in China rather than adding more facilities back home.
On the positive side, this will lower production costs and allow for lower pricing. Producing in China can also allow automakers to more easily tweak their products to fit local preferences. Either way, while absolute profits will increase, the profitability of German car firms is bound to fall in coming years.
Eggs in one basket
This raises questions of whether the German carmakers are too exposed to the China market. Houchois of UBS reckons that the three companies earn an average of 10-12% of their revenues in China and make 30% of profits here. China is already Audi’s biggest market, and both Mercedes-Benz and BMW say the country will soon top their list as well.
Much of the concern about over-exposure is focused on the chance that Beijing will change the rules of the game again. The fortunes of the auto industry are more sensitive to government regulation than other sectors as it is.
“The main risk on those premium brands in China right now is exogenous factors like regulations and restrictions,” said Houchois. “In a way we’ve had a situation where markets have been heavily distorted by public policy on the way up. It could just as easily hit them on the way down.”
Regulations are a threat, but traffic restrictions and stricter emissions rules tend to hit the lower end of the market much harder. In fact, as Mei of JD Power points out, regulation that hampers the lower end of the market could actually boost premiums: Faced with regulations limiting each household to one car, buyers who might otherwise opt for two mid-range vehicles often choose to splurge on one premium car instead.
Moreover, strong demand seems like a sure bet for the foreseeable future. Premium car sales make up just 6% of China’s overall auto market, compared to 15% in the US and Europe. “The gap is the growth potential,” he said. As China develops, growth in the premium segment should outstrip the overall car market by about 50-100%.
“Growth on the premium end will slow somewhat, and I think it’s going to be more – I want to say a more ‘normal’ level of demand but there’s nothing normal about the year-on-year growth you see in China,” said Macrae of PwC. “And if you extrapolate the share of premium brands in China to a future position in 2030-2040, you could have a premium market in China that’s as big as the global [premium] market is now in total.”
Present value of future revenue
All those stats clearly have equities investors excited. A bit too excited, perhaps: Analysts say markets have clearly priced a substantial degree of future growth into the stock prices of BMW, Volkswagen and Daimler. But if profit margins dip, the enthusiasm could fade quickly. “Extreme optimism from investors cannot go on forever,” said Houchois of UBS. “There are different views [on stock prices] in the sector, but certainly we are starting to be a bit concerned about the excessive enthusiasm we see in the market.”
But this is a problem for retail investors – the car companies themselves probably aren’t losing sleep over inflated share prices. The biggest problem for them now is calculating exactly how much new production capacity to build. They will have to push the investment button sooner rather than later – high demand from China is causing global supply shortages.
And of course the challenges facing German premium cars are all problems their Chinese competitors would love to have.
“They’ve played their cards very well,” said Ellinghorst. “I think it’s just that after decades of investing in quality and brands, German car companies with brand equity are having a great time in China, full stop.”