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Europe's automakers scramble to protect profits in China
Christiaan Hetzner | 2019/4/2

About 30 years ago former Volkswagen CEO Carl Hahn sought a cost-effective solution to build vehicles in China with First Automobile Works.

Eager to continue with his pioneering push into the country, it occurred to him that VW's failed U.S. assembly plant might provide the answer. The Pennsylvania factory had closed in 1988 and all the tools needed to build the Jetta were collecting dust.

By moving the entire production machinery to a new plant that would be jointly operated with FAW in Changchun, Hahn had a solution to several problems. Risks would be minimal since everything VW needed had already been written off.

With the launch of the affordable Jetta sedan, VW mobilized a generation by putting millions of rising middle-class Chinese behind the wheel of a new car. The move helped to establish VW, together with FAW and its other local joint venture, Shanghai-VW, as the dominant automotive force in what is now the world's largest vehicle market.

Nearly three decades later, VW Group CEO Herbert Diess's decision to take responsibility for the market after the retirement of the company¡¯s China chief, Jochem Heizmann, underscores the growing importance of the country.

"Today our Chinese operations are the most successful worldwide with benchmark productivity and quality, the best product launches worldwide -- and they are our most profitable operations," Diess told VW's local staff in January.

Earnings risk
But with the country¡¯s economy slowing, large pockets of excess production capacity and key trade talks dragging out, profitability in China is at risk not only at VW Group but at a wide array of automakers. "Life looks grim in China at present," said Bernstein analyst Max Warburton, who believes the situation poses a major risk to earnings. A dreadful second half pushed sales in the market down for the first time since 1990.

Car buyers in China have been postponing purchases in mass numbers because of trade tensions with the U.S. Particularly hard hit are automakers reliant on low-cost cars.

"The total market is cooling down, but the premium market is cooling down less," Audi CEO Bram Schot told Automotive News Europe. "What's more important is the effect on pricing. If everyone has really high expectations for 2019 and they sustain a blow in volumes, they want to correct this with lower prices. It has a huge impact."

Underlying indicators imply the trend will not change anytime soon. Beijing forecast that domestic growth will slow to as little as 6 percent in 2019, down from 6.6 percent last year, which represented the most anemic pace in nearly 30 years. Many economists believe the actual rate of expansion is much lower than government statistics would suggest, and VW Group only expects a stagnant overall car market this year.

"If we don't get a large and determined policy response -- and we are talking a big macro stimulus, not just a tax cut on cars -- then the industry is going to need to make substantial production cuts in the first half," Bernstein's Warburton said.

Following last month's conclusion of the annual plenary session of China's legislature, Prime Minister Li Keqiang promised manufacturing companies a 3 percent cut in the value-added tax to 13 percent.

But China's second most powerful official after President Xi Jinping warned the state would not inject the kind of massive monetary stimulus seen after the global financial crisis.

Ripple effect
The ramifications of China's slowdown for the European auto industry are potentially enormous, which is why automakers are launching plans to cut overall costs by billions.

Fiat Chrysler Automobiles warned it has plenty of problems to fix after sales of locally built Jeeps plunged 40 percent and shipments of imported Maseratis more than halved in 2018. The automaker's Asia-Pacific operations swung to a full-year operating loss of 296 million euros as a result.

"A lot of the work that the team in China has done has been focused on our direct material costs, some of that you can get to quickly," FCA CEO Mike Manley said. "Some of that, because it involves re-engineering and testing, takes a little bit of time."  

The China market¡¯s enormous growth in recent years has meant brands have become heavily reliant on the region to boost global sales. For example, 40 percent of all passenger cars sold last year by the VW Group worldwide were built by FAW-VW and Shanghai-VW. Were the JVs treated as fully consolidated companies, each would have contributed more to overall earnings than any other VW subsidiary last year. Moreover, their pretax margins would have been surpassed only by Porsche.

Premium brands are nearly as dependent on the country, particularly when it comes to high-end models. Last year BMW sold 44 percent of all 7-series models in China, prompting the automaker to choose Shanghai as the backdrop for the launch of the refreshed version of the flagship sedan in January. BMW also took the opportunity to announce that it would start making the X2 crossover in China this year, making it the seventh model to be built there.

That number is set to grow to eight with the addition of BMW's first full-electric crossover, the iX3, which will be built exclusively in China starting next year.

BMW CEO Harald Kr¨¹ger said he hoped that the U.S. and China would end their trade dispute. "It looks as if they will set aside their differences, and that would be positive for our [China] business." Chinese tariffs of 40 percent on U.S.-built BMW crossovers cost the German company a few hundred million euros last year.

But it is not only German automakers that are at risk. The U.K.'s Jaguar Land Rover swung from a profit to a loss of 273 million pounds in the fiscal third quarter that ended in December. Much of the loss was blamed on measures JLR took to address its own bloated inventories in China.

Analysts peppered JLR China boss Qing Pan with questions during an earnings call in February. Eventually PB Balaji, finance chief of JLR parent Tata Motors, took the unusual step of shutting down further discussion, cutting off a Goldman Sachs analyst who sought further clarity on the issue.

At least for now, the German premium brands say JLR's problems are separate and point to their continued growth in the first two months of the year, during which Audi, Mercedes and BMW each delivered more than 100,000 vehicles despite the Chinese New Year holiday. But beneath the surfaces, cracks are emerging.

'Heavy discounts'
"The premium market is stable, but what we are seeing are other brands offering heavy discounts," Porsche global sales chief Detlev von Platen said. "That might work if you are a volume brand, but not if you define yourself through exclusivity. We have no interest whatsoever in participating, so we are watching our stock levels very carefully to keep our supply aligned with demand."

Von Platen's job will not be made any easier now that China is taking more drastic measures to tackle massive air pollution. Carmakers this year need to sell a certain number of ultra-low emissions cars called New Energy Vehicles.

The precise number depends on the size of their fleet. In addition, every automaker has to meet new fuel consumption targets. The rules prompted market researcher LMC Automotive to question whether weaker volume brands such as Peugeot can survive in a lower-growth market dominated by VW as well as a number of Asian manufacturers such as Honda, Toyota, and a domestic brand, Geely.

BAIC Chairman Xu Heyi, whose own flagship brand sells fewer cars in China than its JV partners, Mercedes-Benz and Hyundai, was blunt about the struggles of some European competitors. 

"The Chinese market has its own conditions and some of these foreign brands might not have a very detailed and fully comprehensive understanding," he told reporters at the Geneva auto show last month. "Perhaps the team is not talented enough or smart enough."

While undoubtedly challenging, most automakers view the current downturn as a temporary problem that will recede once the U.S. and China settle their trade differences. VW Group, which gained 1 percentage point of market share last year despite an decline in volume, actually welcomes the slowdown.

The group, which controls 18.5 percent of China¡¯s passenger car market, views the tough stretch as an opportunity to expand its control as weaker competitors falter.

Rapid changes
The real concern cited by executives is whether their companies can successfully position themselves for the transformation to full-electric, fully connected and, eventually, autonomous vehicles in China. Nowhere else is technology developing at such a rapid pace, they say, and new competitors are swiftly becoming a threat to their business.

"Just look at how fast China switched to e-scooters. It happened within a couple of years," Thomas Ingenlath, CEO of Volvo subsidiary Polestar, told Automotive News Europe.

Audi, for example, will unveil a new strategy next month that will focus on five core pillars. Developing products that appeal to Chinese customers and securing its leadership of the country's premium segment is the top priority, Audi boss Schot said. The brand has said it aims to nearly double China sales to 1.2 million by 2023.

"I'm in it for the long run," Schot added. "If I get nervous and want to chase volume, I destroy my [profits and losses.]" To fund the enormous investments in technology needed to stay relevant in China, Audi plans to cut its overall costs by 13 billion euros by the end of 2022. That will come in addition to the roughly 2 billion euros already achieved last year under its Audi Transformation Plan.

One newcomer to cost-cutting is Porsche. The sports car manufacturer justified its first major restructuring program since nearly filing for bankruptcy in the early 1990s by citing the threat posed by Chinese upstarts -- not just in this key market but worldwide.

Traditionally, Porsche prefers to quietly tackle operating costs every year. Recent events convinced senior executives that it needed to launch a cumulative 6-billion-euro efficiency plan over six years to motivate middle management, even though it long eschewed drastic announcements as a sign of a company in crisis.

"In the past that was the case. Now I believe it's irresponsible to act otherwise," Porsche CFO Lutz Meschke told  Automotive News Europe. "We know exactly what challenges we will face, what new competitors are emerging in China in the meantime with what kind of cost base and state support."

Departing Daimler CEO Dieter Zetsche found out the hard way just what Meschke means. Chinese automotive tycoon Li Shufu, owner of the Geely, Volvo and Lotus brands, became Daimler's largest shareholder last year when he bought a 10 percent stake in the company. Zetsche and Li agreed last October to form a premium ride-hailing JV, are recasting Smart as a China-based EV brand under another JV, and are exploring further areas of cooperation.  
No alternative
For automakers, there is no country that can pick up the slack for a market of roughly 24 million light vehicles. Even India, with its 1 billion-plus population and comparably low vehicle density, only last year surpassed Germany's 3.4 million in overall annual volume.

"China is a Goldilocks economy and finding the rare set of circumstances that led to the Chinese economic boom elsewhere in the world is unlikely," said May Arthapan, director of Asia Pacific forecasting at LMC.

The good news is she believes China could be in the midst of a shift, a type of temporary valley where growth driven by Tier 1 and Tier 2 cities has largely peaked before smaller urban centers take off in a "second wave of mass motorization." Tier 3 cities such as Huzhou and Nanyang might only have a per capita GDP that is a fraction of Beijing or Shanghai and only 40 percent of the people. But there are far more of them.

"Given that 81 percent of the Chinese population resides in Tier 3 to Tier 6 cities, these locations represent a massive source of potential future growth," Arthapan said.

Young families with a limited budget in these smaller cities are exactly the customers VW Group hopes to attract with the new Jetta entry brand. The car that established the brand's credentials in the market will be spun off to form a new family of entry models. The Jetta brand's lineup will include a rebadged version of the sedan as well as two new crossovers. The trio will debut this month at the Shanghai auto show ahead of their third-quarter launch.

More than 30 years after VW's Hahn set up operations in China, the group's current CEO acknowledged that he will use this year to re-evaluate its entire footprint there. The plan could include taking majority ownership of China JV¡¯s, assuming VW can afford it. By early next year at the latest, Diess aims to deliver an answer.

"There is a need to act, quite simply," Diess said. "I consider it the most important strategic task facing Volkswagen to secure our future."

Douglas A. Bolduc, Nick Gibbs and Andrea Malan contributed to this report.

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