Topic: China Automobile Industry Date: 14th July 2011 Analyst: Terrence Tey Summary U.S.

Automobile Industry: A Proxy to China Automobile Industry

U.S. Vehicle Sales
From Chart 1, U.S. automobile industry exhibited cyclical trend since 1963. The duration of one complete cycle (from trough to trough) increased from 5 years in the 70s to 10 years in the 80s, and further extended to 18 years (1991-2009).

Chart 1
Source: WardsAuto.com Lower auto sales could be due to several reasons such as higher gasoline prices, larger used-car market, declining disposable income, lower population growth and etc. During the oil crisis back in late 70s and early 80s, oil price surged 4 fold from 1973 to 1980 based on inflation-adjusted price. In 1973, 1 barrel of crude oil only cost US$4.75. But the crude oil price surge to US$37 dollars in 1980.

Chart 2
Source: http://www.fintrend.com/inflation/Inflation_Rate/Historical_Oil_Prices_Table.asp

U.S. Total Vehicle Sales Market Share by Company

Despite the higher vehicles sales in the 90s and first decade of 21st century, the industry boom did not save U.S. auto manufacturers

from bankruptcy during the recent financial crisis. From Chart 2, General Motors and Ford have been losing their market share to more competitive Japanese Automakers such as Toyota and Honda since 1962. The falling of General Motors and Ford is due to several reasons such as higher labor cost and pension liabilities, fuel inefficient products, price uncompetitive, aggressive acquisitions and etc.

Chart 3
Source: WardsAuto.com

U.S. Total Motor Vehicles

U.S. total motor vehicles increased from 189 million in 1990 to 248 million in 2008. During the time, number of automobiles only increased by 5 million while trucks and buses accounted for the other increase. Although U.S. total population increased from 249 million in 1990 to 288 million in 2002 (15.6%), however, population between 15-44 years old only increased from 118 million to 125 million (5.9%) during the same period. Currently, the vehicle penetration rate in U.S. is about 81.7%. Also, 20% of the population is under age of 14. In other words, every adult who has a driving license drives a motor vehicle. Based on recent data of all motor vehicles in U.S., it is equivalent to around last 15 years of automobile production. This rough calculation also suggests that there is lots of used-vehicles circulate in the market. According to National Automobile Dealers Association (NADA), number of used-vehicle sales is higher than new vehicle sales. In 2010, more than 18 million used vehicles were sold and the average unit price was US$16,474.

Table 1
Year 1990 1995 2000 2001 2002 2003 2004 2005 2006 All motor vehicles (000) 188,798 201,530 221,475 230,428 229,620 231,390 237,243 241,194 244,166 Automobiles (000) 133,700 128,387 133,621 137,633 135,921 135,670 136,431 136,568 135,400 Trucks and buses (000) 55,097 73,143 87,854 92,795 93,699 95,720 100,812 104,626 108,766 Automobiles / Total 70.82% 63.71% 60.33% 59.73% 59.19% 58.63% 57.51% 56.62% 55.45%

2007 247,265 135,933 111,332 54.97% 2008 248,165 137,080 111,085 55.24% Source: U.S. Federal Highway Administration, Highway Statistics, annual.

U.S. Gasoline Consumption in 2010

U.S. consumes 19.13 million (22% of worldwide consumption) barrels of crude oil every day in 2010. 94% of crude oil is used to supply transportation sector, this translates to 1440 million litres of gasoline consumption per day by Americans. Dividing daily U.S. gasoline demand by U.S. registered motor vehicles in 2008, estimated U.S. gasoline consumption is about 5.8 litres per day per vehicle.

Table 2
U.S. Gasoline Consumption in 2010 U.S. petroleum consumption 19.13 million barrels per day in 2010 U.S. gasoline demand 9.06 million barrels per day in 2010 U.S. gasoline demand 380.00 million gallon per day in 2010 Demond for crude oil 88.00 million barrels per day worldwide in 2011 Americans travelled 8.22 billion miles per day in 2010 Americans travelled on average 33.00 miles per vehicle per day U.S. imports 11.96 million barrels of oil per day in 2010 U.S. gasoline demand 1,440.42 million litres per day in 2010 U.S. registered motor vehicles 248,164,738 vehicles in 2008 Gasoline consumption 5.80 Litres/day/vehicle Source: U.S. Energy Information Administration, http://www.eia.gov/petroleum/reports.cfm?t=164.

China Automobile Industry: The Past and The Future

Brief History
In 2002, China government allowed SOEs to establish 50-50 JV with foreign automakers so that SOEs could learn the technology knowhow to manufacture higher quality products. Initially, the import tax was set at 100% in 2002 and reduced to 25% in 2006.

Automobile Sales
In 2000, China automobile industry accounted for 3.38%. In 2010, this percentage increased to 10.2%. China automobile sales had undergone double digits growth in the last 10 years. Automobile sales increased from 2.35 million units in 2001 to 18 million units in 2010. Currently, there are 80 million registered motor vehicles in China. Vehicle penetration rate is only 6% of total population, relatively low as compare to 81.7% in U.S.

Government Policy
Since government rolled out a series of stimulus package to revive its economy, automobiles sales grew by a staggering 45.5% in 2009 and another 32.5% in 2010. In 2009, the government introduced several favorable policy such as tax rebate of 5% for cars with engines of 1.6L or below, trade in old for new in rural areas, rural area subsidy and cash clunker program. In 2010, tax rebate was reduced to 2.5%, but the government gave out RMB 3k of subsidy to consumers who buy fuel-efficient vehicle. Besides, Beijing also subsidizes RMB 60k for EV and RMB 50k for hybrid to the manufacturers.

Chart 4
Source: wind, Haitong Securities Research.

Chart 5
Source: wind, Haitong Securities Research.

Growth Drivers
In my opinion, I think the high growth rate in the last two years is a result of favorable government policy, strong economic growth and small used-vehicle market. From Table 3, automobile sales growth in 2009 mainly came from vehicle with engine below 1.6L. The growth rates are 80% for engine below 1L and 69% for engine between 1-1.6L respectively. Selling prices in these two categories are below RMB 100k and RMB 3k of government subsidy is quite significant to the buyers. Besides, strong economic growth also boosted sales of higher power engines as wealth effect kick-in among higher income group. Also, used-vehicle sales were only about 20% of new vehicle sales. In U.S. used-vehicle sales is higher than new vehicle sales in the last 10 years. According to Chinas State Information Center, automobile replacement normally occurs after 3-5 years. Given the high sales growth in the last two years, I expect the supply of usedvehicle market to increase in the next two years to increase and cannibalize some new vehicle sales. Having said that, rising household income will also increase new vehicle sales and it is more likely to dominate over used-vehicles cannibalization effect.

Two Reasons: 1. Immature used-vehicles market a. Consumer lack of confidence in the quality of used-cars. 2. Supply of used-vehicles will increase but not sufficient a. China automobile market still in growth period, supply of used-vehicles is unlikely to cannibalize new vehicle sales significantly.

Table 3
PV Sales by Engine Size - 1.6L and below outperformed 2009 sector growth

Passenger Car Total Domestic-made Total Displacement<=1L 1L<displacement<=1.6L 1.6L<displacement<=2L 2L<displacement<=2.5L 2.5L<displacement<=3.0L 3L<displacement<=4L Over 4.0L Source: CLSA.

2008 6,755,584 6,619,505 708,235 3,491,262 1,599,158 710,531 96,777 11,986 1,043

2009 10,331,315 10,088,787 1,273,832 5,905,120 1,892,604 866,635 139,901 10,615 80

YTD 52.93% 52.41% 79.86% 69.14% 18.35% 21.97% 44.56% -11.44% -92.33%

2010 13,757,794 13,437,259 2,006,391 7,454,371 2,685,144 1,068,321 205,685 17,241 106

YTD 33.17% 33.19% 57.51% 26.21% 41.88% 23.42% 47.02% 62.42% 32.50%

Sino-Foreign JVs and Local Manufacturers Sino-foreign JVs generally have high utilization rate of 100% in 2010. Some JVs utilization rate even exceeded 100% by increasing the production time. For local manufacturers, the utilization rate was 75% in 2010. The foreign partners have very little motivation to expand capacity aggressively. Given their experience in foreign market, higher utilization rate will result in higher profit margin. One of the causes of U.S. uncompetitive auto industry is their low utilization rate of less than 50%. Over the next three years, Sino-Foreign JVs production capacity will grow at 10% CAGR while local manufacturers will grow at 15% CAGR.

Table 4
China Passenger Vehicles Production Capacity in next 3 years ('000) Sino-Foreign JVs Local Manufacturers 2010 7,210 8,110 15,320 Capacity 2011E 2012E 7,530 9,170 9,080 12,200 16,610 21,370 2013E 9,560 12,450 22,010 2010 Production ('000) 7,210 6,060 13,270 2010 Utilization Rate 100% 75% 87%

Source: Zhongxin Securities Research.

Lower JVs Auto Sales Growth

As a result, Honda and Toyotas sales growth was lower than industry growth rate in 2009. In 2010, only Volkswagens sales growth matched the industry growth rate. Other than capacity constrain, the growth driver in 2009 and 2010 was come from low-end and high-end vehicles. Most of the products from Sino-Foreign JVs are mid-end vehicles, which has lower growth rate. Having identified the industry growth driver, along with governments endeavor to promote fuel-efficient car, these JVs start to enter low-end market by introducing foreign design with local components vehicles. Selling prices are below RMB 100k, mainly ranging from RMB 60k RMB 90k.

Table 5
Sino-Foreign JVs Auto Sales in China ('000) Year 2007 2008 General Motors 980 1,050 Volkswagen 940 1,030 Hyundai 380 480 Honda 470 520 Nissan 280 360 Toyota 510 620 Subtotal 3,560 4,060 % of Total Auto Sales 40.52% 43.36% Total Auto Sales 8,785 9,363 Source: CAAM. 2009 1,830 1,440 900 610 540 710 6,030 44.27% 13,622 2010 2,350 1,920 1,090 660 690 850 7,560 41.90% 18,042

Table 6
Sino-Foreign JVs Auto Sales Growth Rate in China ('000) 2007 2008 General Motors 7.14% Volkswagen 9.57% Hyundai 26.32% Honda 10.64% Nissan 28.57% Toyota 21.57% Source: CAAM. 2009 74.29% 39.81% 87.50% 17.31% 50.00% 14.52% 2010 28.42% 33.33% 21.11% 8.20% 27.78% 19.72%

More Competition

In the next 3 years, competition is expected to intensify. In fact, competition has intensified since 2H2010. According to Yuanta Research, many automakers had higher selling and distribution expenses and lower ASP in 2H2010 although the sales grew strongly. In order to earn higher profit, automaker has to increase sales volume or ASP. From Table 7, we did not see sales volume and ASP increase together. Based on this observation, we may conclude that even in growing market, competition will always force the seller to lower ASP for more sales volume. However, if ASP declines more

than the increase in sales volume, the total profit will decline. So, product quality is the determining factor for automaker to increase profit over the long run.

Table 7

Long-term Growth Rate

China has about 80 million vehicles currently and vehicle penetration rate is only 6% of total population. If we assume China could 18 million of new auto sales for the next 5 years, and 10 million cars would be disposed, China would have 160 million vehicles, double of current number of vehicles, by 2015. Assuming 80 million of vehicles, gasoline consumption is 5.8L/vehicle/day, China would consume 6.28 million barrel of crude oil per day. If the number of vehicles doubling to 160 million, assuming gasoline consumption/vehicle/day remains the same, China would need extra 6.28 million barrel of crude oil per day to satisfy demand. According to GLG Research, Chinas gasoline consumption only increased by 5.8% in 2010 despite astonishing new auto sales growth of 32.45%. Chinas gasoline price is RMB 7.8 per Litre now. If a low-end car owner consumed 3L of gasoline everyday, annual gasoline bill would be RMB 8,541. Although a low-end car in China only costs about RMB 40-60k, however gasoline expense in one year will account for 19% of the car value.

Global demand for crude oil is about 88 million barrels per day. If global supply were to increase by 2-3% in the next five years, global crude oil supply would be 97-102 million barrels/day by 2015. The extra demand from Chinas automobile alone would account for 4570% of the supply increase. Crude oil supply is extremely inelastic; any small increase in demand will cause oil prices to shoot up. Given the tight supply in global oil market, I do not think Chinas vehicle penetration rate could increase to 50% like U.S. did in 60s and 70s even though China is the second largest economy in the world. The penetration rate will only match global level when there is major technology breakthrough in fuel efficiency or renewable energy (EV).

Conclusion
In the first half of 2011, Chinas auto sales only grew by 3.78%. The slow down is mainly because of components shortage and higher base in 2010. Auto sales will significantly slow down if Chinese government does not extend the subsidy program for fuel-efficient car. Because of higher base, capacity constrain, tight global oil supply, automobile sales growth will slow down significantly in the future. Besides, China Association Automobile Manufacturers (CAAM) also lowered their sales growth forecast to 5% this year. As automobile sales volume has peaked, good quality automakers will find it very difficult to increase their sales volume in the next few years. In order to achieve earnings growth, the only way is to gain market share from competitors. During industry consolidation, manufacturers with lower utilization rate (lower margin) and low quality products will be squeezed out of the market. Just like U.S. Auto market and Airplane Manufacturing Industry, only efficient producers will survive and emerge with significant market share.

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