GM and Ford's falling market share, unprofitability and massive layoffs paint a grim picture for America's automakers. However, prospects for Japan's auto leader – Toyota – are at an all-time high with huge market capitalization and output volume poised to surpass GM in 2006.
In China, Japanese automakers, most notably Toyota, seemed to get off to a late start. Deceleration in Chinese auto demand, along with overcapacity and inventory accumulation has led to fierce price competition in China. Significant pressure on margins will continue and only those companies with efficient channel management, high quality and appealing products will survive. It is in these areas where Japanese auto producers look likely to succeed and ultimately come to dominate China's auto market.
Japanese automakers' strength lies in their focus on continually reducing costs, producing high-quality cars and innovating new technologies such as the popular Prius hybrid sedan. While many of the Japanese methods of auto-making have been recognized and emulated by European and US companies, Japanese companies have managed to retain their productivity edge.
One area where Japanese and western automakers have significantly diverged is in their strategy towards auto parts suppliers. Japanese companies produce almost all key components in-house or through an affiliated enterprise, where each partner has mutual equity interests. Along with promoting and cooperating in R&D, the companies work effectively with their suppliers to eliminate waste and lower costs.
European and American companies have generally chosen to outsource or divest investments in suppliers, thereby externalizing direct costs and minimizing market risk. By encouraging specialization and competition among individual suppliers, they are able to source parts at lower prices. However, many of the components sourced by European and US automakers can actually be pricier than those sourced by the Japanese. One reason for this is that much of the R&D costs of innovating and improving components are borne by Japanese OEMs. Western companies leave more R&D costs to the parts suppliers, who inevitably pass these costs back to automakers.
Superior supply chain management plays a major role in ensuring companies like Toyota can make their system of supplying auto parts work so efficiently. Japanese companies have a stable supplier base that minimizes transportation costs, can optimize just-in-time delivery needs and is flexible to meet engineering and scheduling demands. European and American automakers have to deal with the high cost of managing distribution for each supplier. These costs can be especially cumbersome in China, where distributors may be unreliable and logistics are difficult to manage.
While Volkswagen entered China 21 years ago, Toyota signed a sedan joint venture deal with China's First Auto Works (FAW) only three years ago. Late entry into China can present obstacles in terms of creating JV partnerships, establishing brand recognition and gaining market share. However, Japanese automakers can and will benefit from a "second-mover advantage."
Japanese OEMs will not suffer from the detrimental legacy effects that companies who experienced the "easy days" of China's auto market face today. The earliest entrants operated in an environment characterized by low competition and high gross margins. Consequently, company culture became complacent and did not focus on continually improving efficiency.
As a second mover, Japanese automakers' partnership with Guangzhou Auto will prove to be a key ingredient to their future success. Western automakers, who partnered with Shanghai Automotive Industry Corp and FAW may run into misaligned incentives as these larger Chinese companies would rather build themselves into powerful global brands.
Strategically, Japanese firms have also taken a different tack towards investing and expanding operations in China. Compared to western automakers, Japanese firms have taken a more cautious and market-based approach, investing in manufacturing facilities and expanding production capacity as dictated by demand forecasts. This strategy will help avoid costly and inefficient low utilization rates. As they have done in the US, Toyota is confident that their late entry will not be a long term setback in China. Toyota and its parts suppliers are developing quickly in China and by 2010, the company aims to have raised its current 3% market share to 10%.
What are some of the factors that could be potential obstacles to Japanese automakers' success in China? First, vertical integration has inherent risks. Cross shareholdings and close-knit integration, could precipitate a domino effect if one supplier falls. Second, new innovation and/or significant improvements made by GM, Ford and Korean automakers could present a challenge. Finally, if Sino-Japanese relations deteriorate in the political arena, Beijing may rein in the growth of an unfriendly nation's investments in China or Chinese consumers may boycott Japanese products.
While the success of Japanese automakers in China is not guaranteed, the formula for success – cutting costs, maintaining quality and improving design appeal – is the same in China as it is in the developed markets. The difference will be in the speed that the China market plays out, as proven concepts for successful automaking already exist. Despite a late start, the likes of Toyota have a solid history of making good decisions and turning in healthy returns on investments. There is no reason to expect much difference in China.
Based in Shanghai, Sean Leow is an Associate and Derek Shi is a Senior Sourcing Engineer at Alaris, an Allied Capital portfolio company that provides operational and strategic support to private equity firms and middle market companies.