China Autos: A Major Part of the Global Scene

March 22, 2013 Market Insight ING PERSPECTIVES MARKET SERIES China Autos: A Major Part of the Global Scene Spencer Phua Senior Credit Analyst, U.S. Credit Not only is China the fastest-growing major auto market in the world, it is also the largest by size and volume. Emerging trends in this somewhat idiosyncratic market will have a profound impact on the global automakers and their credit profiles. In this article we provide a credit investors perspective on the very important Chinese market. Automotive forecasting firm IHS Automotive expects that Chinese auto sales could rise about 8.8% in 2013 to reach 20.5 million units, which contrasts favorably with about 15 million in the U.S. and about 18 million for all of Europe (including Eastern Europe). At only about 60 cars per 1,000 people (per IHS Automotive), China s car density is significantly lower than that of developed western countries like the U.S., the U.K. and Germany (where densities range from 450 to 650 cars per 1,000 people) and advanced Asian economies like Korea and Japan (250 450 cars per 1,000 people). Clearly, there is much potential for growth in auto ownership in China. Moreover, as economic development and wealth generation has spread beyond first-tier cities like Beijing, Shanghai and Guangzhou, industry analysts have noted a higher growth rate of car demand in second-tier cities Figure 1. China s Market for Light-Vehicle Sales Is Growing Fastest Ryan Mitchell Analyst Seasonally Adjusted Selling Rates 2.5 2.3 2.0 1.8 1.5 1.3 1.0 0.8 0.5 Indexed to 2007 = 1 0.3 0.0 2006 2007 2008 2009 2010 2011 2012 Greater China ASEAN India South America Eastern Europe Japan/Korea North America Western Europe Central Europe Figure 2. China Led the World in Light-Vehicle Sales During 2012 35 6% Light Vehicle Sales (Millions of Units) 30 25 20 15 10 5 5% 4% 3% 2% 1% % Share of Imports 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 0% A B C D/E HVAN Imports Note: Auto classes A through E indicate rising vehicle sizes; HVAN refers to heavy vans. INVESTMENT MANAGEMENT

and inland areas 1, which should support the auto market for the near to medium term. Factors like traffic congestion and local laws that limit vehicle population in the first-tier cities also serve to constrain their vehicle growth rates compared with the second-tier cities. Figure 3 shows the top 20 auto brands in China for 2012 note that this list includes most major global automakers. Toyota (Aa3/AA-/A) and Ford (Baa3/BB+/BBB-) are the two carmakers on this list whose bonds can be found in the Barclays U.S. Corporate Index, and GM (Ba1/BB+/BB+) may eventually return to this status. While VW, BMW, Nissan and Honda are not part of the U.S. Corporate Index, their debt carries investment grade credit ratings. Hyundai and Kia are investment grade emerging markets issuers. Chinese trade policy slaps tariffs on imported vehicles; hence, global auto makers generally establish joint ventures with one or more domestic Chinese partners in order to produce their vehicles locally. These joint ventures include: Ford: Changan Ford Toyota: First Auto Works, Guangzhou Auto Mercedes Benz: Beijing Auto Industry Holdings Hyundai/Kia: Beijing Hyundai, Dongfeng Yueda Kia General Motors: SAIC GM Wuling, Shanghai Automotive GM Volkswagen/Audi: Shanghai Automotive VW, First Auto Works VW/Audi Honda: Guangzhou Auto, Dongfeng Auto BMW: Brilliance Auto Nissan: Dongfeng Auto Investment Grade Automakers Are Committed to the Chinese Market Global automakers continue to invest in Chinese production capacity in order to take advantage of rapid growth in the auto market. For example, Ford Motor has started construction at two new plants in China (Chongqing and Hangzhou) in the last two quarters, and it has reported rising market share in sales. While Ford s pretax earnings in the Asia-Pacific region remain small at $39 million in the fourth quarter compared with $1.3 billion in total pretax earnings management seems committed to growing the brand s presence in China. Daimler has acknowledged the need to revamp its China business. It has exhibited its commitment to the market through increased equity investments in both its Chinese import company (of which Daimler now owns 75%) as well through a 12% equity stake in joint venture partner Beijing Auto. Daimler plans to grow its Mercedes dealer network by 50 dealers annually over the near term and recently established a new management board position to focus on the China business. Figure 3. Many Global Automakers Have Significant Market Shares in China Rank Parent Company 2012 Sales Market Share 1 Volkswagen 2,870,911 15.3% 2 SAIC-General Motors-Wuling 1,440,764 7.7% 3 Hyundai 1,425,732 7.6% 4 General Motors 1,403,927 7.5% 5 Changan 969,607 5.2% 6 Renault/Nissan 938,988 5.0% 7 Toyota 873,899 4.7% 8 Dongfeng 724,015 3.9% 9 BAIC 642,917 3.4% 10 Honda 608,129 3.2% 11 Great Wall 547,221 2.9% 12 Ford 468,304 2.5% 13 PSA 465,161 2.5% 14 Brilliance Auto 464,713 2.5% 15 BYD 428,998 2.3% 16 FAW 424,666 2.3% 17 Geely 415,421 2.2% 18 Jianghuai 397,322 2.1% 19 Chery 358,132 1.9% 20 BMW 326,783 1.7%, ING U.S. Investment Management calculations 1 These second-tier cities include Chongqing, Tianjin, Shenyang, Nanjing, Chengdu and Wuhan. 2

Toyota recently disclosed a portion of the sales impact from the geopolitical dispute between China and Japan over claims to a few small islands; while Toyota had planned to sell 1 million units in China during calendar 2012, actual sales came in 16% lower at 840,000 units. Due to timing differences between calendar years in Japan and China (and thus the multi-month reporting lag between Toyota Motor Japan and its Chinese joint venture), we don t expect the complete negative impact of lower China sales to be revealed until the release of Toyota s fiscal full-year results in May 2013. Despite these challenges, we believe that Toyota, as the world s largest auto maker, will remain committed to the China market, as it needs to maintain a significant long-term presence despite current difficulties due to political circumstances. Hyundai Motor added a third plant facility in China in the second half of 2012 and continues to view this market as its strongest growth region. It reported 11.8% year-over-year sales growth for the fourth quarter, as it benefitted from the geopolitical fallout between China and Japan. Hyundai s new plant was reportedly working at nearly full capacity in August 2012, just one month after it opened. We expect Hyundai to continue to make good progress in China. According to IHS Automotive, a few other global automakers will start operations at new China plants in 2013, including VW and PSA (Peugeot). VW is reportedly going to build the Audi A3 in Foshan in 2013, which will be the first luxury car to be produced in China. There are reportedly plans to build Mercedes A and B class vehicles and the BMW 1 series in China as well. It s worth noting that global automakers have adapted their vehicle models to suit the tastes of Chinese consumers: for example, Chinese car buyers prefer larger vehicles such as SUVs or mid-size sedans. Automakers like Hyundai and Nissan have adapted their Elantra and Sylphy models with longer wheelbases to account for Chinese consumer tastes. China Auto Production Is Mostly for Domestic Sale Chinese auto production is mostly domestic-focused, setting it apart from European and North American production, which both have a significant export component; this also stands in sharp contrast with other manufacturing industries in which China is a major exporter to the world. Figure 4 illustrates this point. Even global automakers plants in China (as opposed to local Chinese automakers) generally do not export their production out of China. For the local Chinese automakers (Chery, Geely, Lifan and Great Wall none of which are in the investment grade index), there is some minor export component to their production mostly targeted at developing regions like South and Southeast Asia, South America, the Middle East and Africa and we believe they will most likely attempt to expand their export efforts to other emerging markets. Figure 4. Autos Are Mostly Made in China for Sale in China Sales Region Europe Greater China Japan/Korea North America Middle East/ Africa South America South Asia Production Region Europe Greater China North America 2007 86.40% 0.30% 1.70% 2013 87.00% 0.30% 2.20% 2007 1.30% 96.40% 0.30% 2013 3.10% 93.80% 1.10% 2007 3.70% 0.00% 0.40% 2013 4.40% 0.00% 1.10% 2007 5.20% 0.00% 76.30% 2013 6.10% 0.00% 77.10% 2007 11.30% 0.70% 5.30% 2013 13.90% 1.50% 6.10% 2007 2.20% 0.60% 3.90% 2013 2.00% 2.60% 5.90% 2007 4.10% 0.00% 0.60% 2013 2.80% 0.20% 0.60% 3

Automotive Technology Adoption in China While the span of automotive technology is wide, improving Chinese fuel-efficiency standards and the likely development and adoption of Chinese fuel-efficient technologies serve as one indicator of the country s embrace of the cutting-edge. Notice in Figure 5 that the slope of anticipated increase in fuel economy standards in China is steeper than that of the U.S. and Japan and matches that of Europe. Thus, we expect the Chinese auto market to be characterized by higher adoption of advanced transmissions as well as the increasing use of turbocharging technology. Figures 6 and 7 show projections from IHS Automotive and Borg Warner (a market-leading transmission and turbocharging technology company) to illustrate expected changes in Chinese adoption of fuel-efficient auto technologies over time. Fuel-efficient dual clutch and continuously variable transmissions are expected to grow at a faster pace than older-technology manual transmissions over the next few years. Similarly, turbochargers which allow greater power output from a smaller engine in order to increase efficiency should far outstrip the growth of vehicle production in China. Figure 5. Like All Major Global Regions, Chinese Fuel Economy Standards Will Rise Miles per Gallon Equivalent (CAFE/Local Test Cycle) 65 60 55 50 45 40 35 30 25 20 E.U. Proposed Japan Proposed China Proposed U.S. Proposed Japan Enacted E.U. Enacted China Enacted U.S. Enacted 2005 2010 2015 2020 2025 Source: International Council on Clean Transportation, August 2012 Figure 6. Advanced Transmission Adoption Is Expected to Rise in China Figure 7. Growth in Automatic Transmission and Turbocharging Technologies Should Outpace Vehicle Production in China Millions of Transmissions 25 20 15 10 5 0.6 1.6 11.9 0.6 0.2 3.2 3.1 16.2 1.9 0.3 Dual Clutch (CAGR: 40%) Continuously Variable (CAGR: 26%) Step Automatics (CAGR: 14%) Automated Manuals (CAGR: 8%) Projected Growth in China, 2012 17 180% 150% 50% 0 2012E 2017E Manuals (CAGR: 6%) Automatic Transmission Turbochargers Vehicle Production, Borg Warner projections, Borg Warner projections 4

For the sake of brevity, we will not cover other aspects of automotive technology adoption in this article; suffice it to say that we expect the Chinese market to exhibit greater adoption of occupant safety, collision avoidance, hybrid technologies, etc. over time. Naturally, rates of adoption will remain behind that of developed country auto markets in the near term. The Chinese Auto Industry Is Developing Quickly Figure 8 illustrates how China s auto industry has developed and where it may be headed in the near to medium term. Essentially, we could be near the end of the imitation/reverse engineering phase, while being well into the collaboration and joint development phase. The next phase in which China has independent engineering development and higher technology and R&D for autos could be a few short years away. Figure 8. China s Auto Industry Development Path Basic Transport Low-to-Medium Full Lineup Highly Diversified Local Industry Consolidation/ Repositioning Accelerate Overseas Expansion Phase 4: Compete with global OEMS? Phase 3: Independent engineering development, increased technology transfer and R&D capabilities Phase 2: Collaboration with global suppliers joint development and use of external R&D capabilities Phase 1: Imitation, reverse engineering of foreign OEM models. R&D completely outsourced Pre-2000 2000 15 Beyond 2015 Conclusion China is currently the largest single auto market in the world and thus obviously requires the full attention of those of who study the global auto sector. Investment grade credit investors will need to consider how this important market will affect financial results among major global automakers like Ford, Toyota, Daimler and Hyundai i.e., companies that have index-eligible debt. In addition, China remains important for some investment grade names that do not have U.S. index-eligible debt but issue paper in U.S. investment grade debt markets from time to time, such as VW, BMW, Honda and Nissan. While we do not profess to be experts on this far-flung region of the world, we will attempt to be assiduous students regarding the Chinese auto market in order to better understand the companies we cover for U.S. investors. The authors would like to acknowledge the assistance and perspective provided by the Emerging Markets Corporates team (Jennifer Gorgoll and Rob Turner) in preparing this article. 5

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