China’s Auto Market Is Now the 'Big Long'
China’s car market presents investors with a new, uncomfortable normal. Never before in the history of the automobile has so much demand expanded so quickly for so many years in row.
Naturally, automakers are ecstatic. Record growth and profits in 2009 are giving them confidence to take a “big long” position on the mainland.
But should they be tempering their optimistic feelings with some good old-fashioned vigilance?
Demand for car sales in China grew 46 percent in 2009, the same year in which most of the world experienced its greatest economic reversal in 80 years. China’s auto industry also made more than $6 billion in profit in 2009 - another all-time high.
China - with 70 percent growth in the first quarter of 2010 - is racing far ahead of the United States, the former perennial number one car market. The market is projected to reach 16 million cars and trucks this year - three times the size of Japan.
There is very strong momentum off of a giant base.
Global car brands and their Chinese rivals are hurrying to add new plants. Market-leading Volkswagen revealed plans this week to lift its capital expenditures in China to 6 billion Euros from a previous level of 4.5 billion. This fresh money will pay for two new plants in Guangdong, China’s largest provincial car market.
At the Beijing auto show Toyota , Hyundai, Nissan and GM each said they planned to revise 2010 sales targets upward and to invest in additional capacity. Geely, the privately-owned Chinese carmaker that recently announced a binding agreement to purchase Volvo, is preparing an onslaught of new products to be channeled to customers in one of three new brands: Emgrand, Englon and Gleagle (Global Eagle).
BYD, the Shenzhen-based Chinese maker of small cars, offers an excellent illustration of the extreme pace of growth. The company sold 170,000 cars in 2008, more than doubled the number to 460,000 in 2009 and expects to top 800,000 in 2010.
BYD’s shares are currently trading at better than 80 times earnings. Ford Motor , like most other auto companies, trades in the range of 15 times earnings.
All of this exuberant activity has given some financial investors enough reason to pause and ask questions.
Is Chinese demand for cars sustainable? Or are these dramatic growth numbers – like the housing market in America circa 2006 – simply too good to be true?
An initial look into the obvious places indicates that this market has far to run.
- Most customers still pay in cash. An estimated 75 percent of new car buyers purchase without a loan from the bank.
- Buyers are young. The average BMW buyer in China is in his mid-thirties. The majority of Mini Cooper owners are twenty-something.
- Inland cities are a genuine, new catalyst. According to companies I talked to at the Beijing Auto Show, most of the current growth is driven by cities off the coast, like Chengdu, Wuxi, Kunming and Shijiazhuang.
- Demand is uniformly strong from small cars to luxury models. The 2009 tax cut car with engine size of less than 1.6 liters definitely spurred higher sales of small cars. But luxury makes are also on a tear. Mercedes-Benz achieved better than 105 percent growth in the first quarter of 2010.
But because this is China, we cannot rely on the traditional, obvious indicators alone - however compelling they might be. Instead, we must remind ourselves that demand for cars can change abruptly, as happened as recently as the latter half of 2008.
After growing by 35 percent in the first half of 2008, the market limped in with year-on-year growth of just 7 percent. The traditional demand indicators cited above did not change, so what happened?
First, the government took dramatic steps to tighten credit. In China, that means the central government instructed banks to slow or stop lending. This had an immediate knock-on effect, as working capital got scarce. There was less room for money to be re-purposed for doing things outside of the daily, conventional business like making money available to friends, business partners and family for car purchases.
Second, it is important to realize that most people buying cars in China today are doing so firstly for image and secondarily for function.
When in the second half of 2008, the stock market fell and property prices weakened, there was a collective notion among prospective buyers that “now” was not a good time to buy a car.
The prevailing peer pressure question of the first half of 2008 - “You’re not buying a car yet?” - shifted later in the year to the opposite question: “What, you’re thinking of buying a car now?”
Chinese car buyers tend to behave in ways similar to school of fish on a feeding frenzy. Once the word goes out that charter boats have arrived and are dropping bait with deadly hooks into the water, the fish get spooked and quickly scatter.
With their bold new investments in capacity, automakers are behaving as if Chinese car buyers are now impervious to such frightfulness. They may be right.
But China is now working to reign in excessive economic growth. Investors would be smart to keep and eye on creeping inventory levels at the dealerships.
Editor's note: Disclosure - Michael Dunne does not personally own holdings in the below mentioned companies.
Michael Dunne is president of Dunne & Company, a business advisory company working with clients investing in China’s automotive industry. Prior to that, he was managing director of J.D. Power and Associates in China. He has been a featured guest speaker at the JP Morgan China Investor Conference annually from 2006 to 2009, and also appears regularly as a guest expert on CNBC. Dunne is now writing a book on the future of the Chinese automotive industry, with an aim for publication in 2010.