VW, UAW

While I prepare a post on Mitsubishi Motors (I began going through financial statements a couple weeks back) let me point to a post by Jared Bernstein on ironies with the labor movement today. His contention is that we see pro-business, government-shouldn't-constrain us conservatives trying to constrain the ability of VW to invite in the union. Consistency is apparently for small minds. Behind the Veil

China: The Domestic and the Global Industry

In October 2013 sales in China reached 1.92 million units – see the China Auto Industry Association statistics page for details. That's just shy of a 24 million unit rate, and is surely the largest number of vehicles ever sold in a single market in a month. For GM, sales were 282,000 units – 25% more than US sales that month. Everyone is in the market, or preparing to enter there. The Korean neighbors (Kia and Hyundai, but also Daewoo as part of GM), Japan (or at least the Japan Three of Toyota, Honda and Nissan, and Mazda and Suzuki), Germany (BMW, Mercedes, VW), the Detroit Three and now the French, both PSA and Renault. A host of local firms continue, though most as paper entities. Still, Great Wall, Chery, Geely, BYD, Changan and others.

This raises a host of questions. I focus on two: geography and profitability. I frame my brief analysis using the perspective of the OEMs. Since more and more value added lies with suppliers, that may lead to inappropriate conclusions, but for now I will accept the status quo terms of debate.

...the geography of China's automotive industry makes no economic sense...

First, despite very large production volumes, a side effect of government policy has been to disperse production widely. Even though the Third Front policies of the 1960s are widely understood to have been a failure, the political economy of joint venture approvals has led to factories in locations that make little sense. Today, with the market supply-constrained, that matters little. As competition heats up, however, the costs that accompany scattered locations will become more and more burdensome.

Second, there's profitability. On a global basis, the dark secret is the industry depends on the US market for a disproportionate share of profits. Japan's domestic market is in long-term secular decline, and will remain fundamentally unprofitable despite the dominant position of Toyota. (Suppliers seem to be able to collude with impunity – or so they thought – but Toyota hasn't been successful in being a price leader.) Europe is little better, offset only because of a richer product mix. How profitable is China? To my mind that is the single more important strategic variable the industry faces.

Back to geography. Under Mao local governments were expected to fend for themselves, first and foremost in terms of food but extending to a wide variety of industrial products. Fearing a Soviet attack, Mao deliberately dispersed heavy industry into remote locations. So at the onset of post-Mao reforms, every province and most large cities turned out trucks and passenger cars, even if only a handful a year. In total there were perhaps 120 producers. But political power was likewise dispersed; up-and-coming party officials were rotated through a variety of posts, but anyone slated for top leadership served a stint as a provincial governor or mayor of a prefectural-level city such as Shanghai. To be promoted to the senior leadership in Beijing required presiding over economic growth. So when the government looked to joint ventures to improve motor vehicle production, the result inevitably was one factory here, another there. Local protectionism – in Shanghai you found old generation VW Santanas, in Beijing you found jeeps – reinforced this desire to have your own plant.

China has no equivalent to the 600-mile-long I-75 "automotive alley" in the US, with an agglomeration of suppliers, assemblers and associated engineering centers feeding off of each other in a positive manner. Beijing is 1,300 miles from Guangzhou [Canton] in the south, and several automotive operations are another 400 miles to the northeast of Beijing. Similarly, at the western end of the zone is Kansas City, 700 miles from Detroit and 650 miles from Columbus, OH; Chengdu in the Sichuan basis is 1,200 miles to the west of Shanghai, across rough terrain, and Urumqi is 2,400 miles away.

Perhaps Wuhan will become a nexus – a recent Automotive News China story – but there is none at present at the assembler end. Perhaps suppliers are more concentrated, I know of several engineering centers in Shanghai, proximate to those of VW and GM, the two largest car companies in China. But what this means is that as competition heats up, and the segmentation of the country into regional markets eases, there will be numbers of plants whose location will saddle them with high logistics costs coming and going. As long as the government mandates joint ventures, politics will trump sensible plant siting. The geography of China's industry makes no sense, and will cost firms money.

...GM's & VW's Chinese ventures appear to be quite profitable....

Then there's profitability. Perhaps some suppliers break China out as a separate geographic region, but I've yet to find any. (My understanding is that parts suppliers are not under the stricture of forming joint ventures, though likely many of them have because local partners add value.) Assemblers however are limited to joint ventures, and at the two market leaders (GM and VW) their profits are accounted on an equity basis, rather than as part of normal operating profits. Both however provide that number. It's likely to be an underestimate. The biggest potential divergence would be if these ventures paid dividends; that would reduce retained earnings and the rise in book value. That is, equity income falls, though it would be offset by dividend income. However, neither media reports nor financial statements provide any hint of such payments. Indeed, it's clear that at present all funds are being reinvested. Instead, the (post-tax) equity income is an overstatement because both venture partners have an incentive to use transfer pricing to the hilt, as they get 100% of any excess, but only half if they let the venture book a lower price and higher profits. On the Chinese side that includes the provision of real estate; for VW and GM it would include licensing fees for intellectual property. Both firms have relatively new facilities, and continue to invest at a prodigious pace; they likely have high offsets for depreciation. And of course GM and VW can only report half of total profits.

To the numbers: in the first 9 months of 2013 GM International Operations, under which China falls, realized equity income of $1.4 billion; total consolidated GM profits were $4.3 billion, so the Chinese joint ventures accounted for 32% of the total (and 32% of unit sales). Another way to view the China side is to compare profits in North America with profits in China. GMNA is 6% larger unit sales, and GM China lacks the gold mine of full-sized pickups. But given GM's 50% share, GM's joint ventures in China earned $2.8 billion while North America pulled in $2.2 billion. China makes money.

VW's numbers paint a similar picture. The increased equity valuation of VW's China operations came to €3.5 billion in the first 3 quarters of 2013; total profits were €8.8 billion. China thus accounted for 40% of the total, on 32% of global volume. Of course at present Europe weighs down VW's profits. Nevertheless given its 50% stake, its joint venture partners in China earned €7.0 billion. Its operations are older than those of GM, so it will have lower depreciation charges; its Santana plant in Shanghai, which contained used equipment, is likely fully amortized. Its Audi brand is also the dominant luxury vehicle in China. Still, at roughly US$9 billion it substantially out-earned GM. The bottom line again is that China makes money.

So perhaps we will move towards a bipolar world, in which North America and China come to dominate global automotive profits. As the industry is currently structured, though, China's geography will remain an impediment.

Thanks to David Wiest for discussing equity accounting with me.

China: all's well ... for now

Today VW claimed sales of 2.35 million units in Jan-Sep. Meanwhile GM's PR machine releases brand sales monthly. I track these, out of curiousity and because I teach a course on the Chinese economy (in which I use Michael Dunne's American Wheels as one of 4 books I ask students to read). GM's 9-month total is ... 2.35 million units.

At one level it seems rather silly for a manufacturer to seek to be the market leader – after all, you can typically boost sales through aggressive discounting, and while a price war is great for consumers and car dealers, it's really, really bad for manufacturers. However, journalists find "who's first" makes good copy, and from a corporate perspective that's free PR. Does it solidify brand image and encourage people to shop your vehicles? Maybe. But whether being first is a good image to create among potential consumers is at base an empirical question, about which I've not the foggiest idea.

it seems rather silly ... to seek to be the market leader

Let's think about this from another perspective. [I round everything – these are back-of-the-envelope calculations.] Given market growth, another 3 months ought to add another 35% and 40% to their annual total – let's call it 6.5 million units between the two. With a total market of perhaps a bit under 20 million this year, and somewhat less if we focus on passenger-oriented vehicles, that comes to a 35% market share.

Now in the hypercompetitive US market Ford and GM, the top two firms, have a combined market share of 34% over the past 12 months. If we expand to the Big Three – GM, Ford and Toyota – their joint share is 48%, down over the past several years. I don't track the Chinese market closely enough to have put together a spreadsheet; my sense is that Ford (story here) is growing its share, while Hyundai and Nissan are strong (and Toyota weak). The purely domestics are much, much smaller though Great Wall with its Haval (web site here, Bloomberg story here) has what is by far the best-selling SUV.

In a market expanding as fast as China's it's possible to preserve margins despite this level of rivalry. First-movers can push down costs and try to build share, thinking of the long run. But in that long run the market will likely have more brands and certainly more manufacturers than either NAFTA or the EU. Once sales slow, profits will plummet towards the global normal, which is such as to make being an assembler barely sustainable.^{Note 1} [The parts sector is different in that regard, with far few players for many of the major vehicle systems.]

That will be worse news for some, because virtually all production in China is through joint ventures.^{Note 2} As long as the market is expanding, well, that can be made to work. However, joint ventures are inherently unstable, and when – not if – profits disappear, China will prove no exception. (Indeed, while I know of no breakdown the past few years, in an earlier era Beijing Jeep imploded, and a Peugeot venture stalled. Indeed, an October 14th Bloomberg story notes they may sell a portion of their stake in 3 factories jointly owned with Dongfeng, among other measures designed to raise cash amidst the 6th year of declining sales in the EU.)

It's common to find policymakers thinking of technology as a set of blueprints. In that case, transferring technology is a function of bargaining power. In the real world, however, it's the ability to engineer a car. That is "embodied technology" in the literal sense: it requires building a large team backed by sophisticated management and computer tools for purchasing and other functions. Some firms, notably GM, have chosen to build such capabilities in their ventures, while stressing that the ventures remain independent from either partner. For now GM can use a variety of strategies to increase its own returns – China is part of its global operations, and the vehicles sold in China rely on engineering done elsewhere covered by licensing fees. The longer run though is that it will become more and more a stand-alone operation, paying less in fees to outsiders and even generating some revenue from its own engineering efforts. GM (and SAIC and other partners) will become shareholders, and finesse the underlying tensions of the joint venture structure.

GM [may] finesse the ...tensions of ... joint venture[s]

However, my educated guess^{Note 3} is that GM has been far more proactive than other ventures. So along with falling profits I predict rising feuds. Chinese government policy in principle promotes fewer players and the pursuit of economies of scale (while in practice proving unable to prevent new entry, most recently through formal permission to allow the domestic assembly of Volvos). There used to be 120 or so domestic makers, but now there are only a few dozen, and some of those exist mainly on paper, selling trivial numbers. Given the instability of joint ventures, though, for some ventures the road ahead will be bumpy and may in fact lead to a dead end. In the coverage I read of the Chinese market, I see an almost single-minded focus on sales and rates of expansion. I read almost no analysis of whether that expansion is taking the right path.

Note 1: for economists, think "monopolistic competition".

Note 2: For general background see China Auto Web. Then there's Automotive News China. Others obviously cover this, such as a nice IBT article. After all, how can you not write about the world's largest car market?

Note 3: I use the phrase "educated guess" very deliberately. I read a lot and strive to integrate that using the analytic skills for which a PhD represents but one step. However, while my Chinese is sufficient for navigating web sites and is improving, my reading speed is still too slow to be a practical research tool – unlike my Japanese and German.

mike smitka

Toyota as Number One

...remember Japan as Number One?...

I'm just back from a meeting of the Japan Foundation American Advisory Board, where part of the discussion was on the ups and downs of the field, such as high enrollments into the mid-1990s from those approaching the region in an instrumental way. Do you remember a prominent book of that era, Ezra Vogel's Japan as Number One. [mea culpa: he was the advisor for my undergraduate senior paper]

So what of Toyota as Number One? Is this a similar transitory phenomenon? – in many ways, yes. Despite all the doom-and-gloom reportage, though, Japan remains the 3rd largest economy [ahead of Germany, behind China and the US in absolute size] and overall a prosperous place. No, Japan never was going to take over the world. It remains important. Similarly, neither Toyota nor any other single firm will dominate the global auto industry, but Toyota is here to stay.

The metric that is in the headlines is total unit sales. That's not the only such metric; total revenue is another one. As an economist, I look to profits relative to assets. We could also look at quality measures, at the volume of top products (segment leadership), at "car of the year" and similar awards, and at positioning in growth markets. These give different answers – even if we can agree to an objective standard for how product in the industry's shifting array of joint ventures ought to be counted.

Total sales matters to Toyota in several ways. First, the impetus for this post, regaining the lead generates free (and favorable) publicity. After a period of supply disruptions (the 3/11 quake/tsunami followed by the floods in Thailand) and demand shocks (consequent to the US unintended acceleration incidents), this also is an important morale booster at Toyota and its dealers. Gloomy sales staff and gloomy sales go together, though which causes which may be ambiguous. In the US, what Toyota has done though is recover partway (14% of the market, down from 17% a few years back), while it's lower post-bankruptcy fixed costs allow GM to pursue profits rather than volume (18% of the market, rather than 21%). Only VW is picking up market share in North America.

In terms of total revenue, however, it is Volkswagen that has the lead by a hair. Yes, Toyota has Lexus and Hino, but VW has Audi and Porsche and its own truck division; VW has the Golf and other small cars; Toyota has its minicar subsidiary Daihatsu. GM is more focused on cars and light trucks. So in the 3 months ending September 30, 2012 VW had revenue of €48,848 million, Toyota had ¥5,406 billion and GM US$37,567 million. Using end-September 2012 exchange rates (US$1.00 = ¥78 = €0.78) gives revenue of $62.6 for VW and $69.3 for Toyota. At todays rates (US$1.00 = ¥90.5 = €0.74) the ranking shifts: $66 billion for VW and $60 billion for Toyota. So while Toyota may outsell GM and VW this year in unit terms, current exchange rates suggest VW is #1 in revenue. (GM is a distant #3.)

Then there's profits. Here the ranking is slightly different. VW earned a 4.2% return on €309 billion in assets; Toyota earned 0.9% on its ¥30 trillion in assets; GM earned 1.2% on its US$155 billion in assets. Here Toyota is third, not first. Now these companies are different in their structure; in particular, GM has only a very small finance unit, contributing only 7% to its profits. Similarly, VW gets about 11% of its profits from financial activities. It survives on vehicle sales. In contrast, 25% of Toyota's profits come from finance. So if we think of vehicles as the core of these firms, looking at the recent past we find Toyota trails in profitability.

How about quality? In the eyes of Consumer Reports and others, Toyota is no longer an automatic safe choice. Indeed, this past year they've recalled 4.5 million vehicles, more than their rivals. JDPowers ranks everyone very close to each other (look at the absolute numbers, not the rank order!). No one goes to the service bays of the big multibrand dealers but hearsay is that Toyota does not stand out from the standpoint of mechanics and warranty costs. (I don't know of any hard data.) That doesn't mean Toyota's vehicles aren't good; basically, everyone's vehicles are good, and compared to two decades ago, they're very good. No one is ahead in quality – thanks in part to Toyota's leadership in that area and the competitive pressure it exerted.

Similarly, in "xxx of the year" metrics Toyota is present but no single firm is dominant. Toyota doesn't appear in Ward's "best engines" list, while GM appears only once (Cadillac) and VW once (Audi). Honda, Ford and BMW lead their three regions. Another best car list – sorry, I deleted the email! – had a wide variety of makers as tops in specific segments; my recollection is that Toyota did well in minivans and entry luxury, but had no "winner" in regular cars. No one is outstanding in the sense of capturing a majority of "best" ratings.

Now going forward Toyota's profitability has headwinds and tailwinds. It continues to suffer from the political tensions between Japan and China that affect its sales in the latter market, where VW and particularly GM continue to forge ahead. Its domestic market is weak; as the number of licensed drivers falls, firms producing inside Japan will struggle to match capacity with sales.

In contrast, at an exchange rate of ¥90/$1.00 exports will be much more attractive. In particular, most of Toyota's Lexus brand are exported from Japan, so even without better volume, revenue and profits will rebound. They won't make money in Europe, but GM will lose a small fortune. So far VW seems to have come through well amidst the Euro crisis, but we'll see whether that persists. My hunch is that VW will remain at the top of the global Big Three in profitability, while Toyota will pull ahead of GM. But in terms of sheer volume, over the next few years growth in China and Brazil will benefit GM and VW relative to Toyota, while the US market is unlikely to improve much for anyone. So the #1 sales slot will shift back and forth.

...mike smitka...

Reverse Import Deja Vu?

...a strong yen should boost exports to Japan...

In 1992 I wrote a paper about Japanese car imports, later picked up by the Economist, in Japanese by Toyo Keizai (東洋経済) and by the MIT International Motor Vehicle Program about the growth of Japanese car imports. Ah, but what news was in that? Well, I was writing about "reverse" imports by Japanese of their cars from the US to Japan, alongside the sales of German firms, the only foreign companies to set up proper dealership networks and import processing infrastructure. The recent strength of the yen against the US dollar and particularly against the Euro, made me wonder if we will see a return to that era.

A headline in the May 24th Sankei Shinbun web site thus caught my eye: Mercedes-Benz will sell the "Smart for Two" for ¥1.59 million (US$19,992; €15,950), about a 14% reduction in price. Other forthcoming models of M-B and BMW will likewise carry lower sticker prices or add a lot of options without raising the price. Now the article doesn't make it clear whether the base is appropriate -- it uses year-on-year comparisons, and in general spring 2011 was not a normal time. Still, it cites rises of 37% for M-B and 27% for BMW.

I've only glanced quickly through recent data: given the volatility of the global economy in general, and the post-3/11 economy of Japan in particular, I was expecting to find the data too noisy to interpret. That's not the case.

First, overall imports are at the highest level in the years for which I have (FY1999 to present), even though at 4.0 million cars FY2011 sales are 10% below their mid-2000s level (and 20% below the 5.1 million unit sales peak at the top of Japan's bubble in 1990).

Second, while the German firms are doing OK, both BMW and Mercedes are down from 2007 and the onset of the global recession; only VW and Audi show signs of a sustained increase. What really is driving the increase is Nissan, which now accounts for about 17% of imports or 50,000 units. This is surely consequent to their moving the production of certain vehicles (such as the March) entirely out of Japan.

Still, total imports of 295,000 units remain rather short of the 393,000 level of 1996. While the Japanese media may be full of hand-wringing about the impact of the yen, the evidence so far is modest, when looked at through the lens of vehicle imports. Realistically, it's probably too soon to tell; vehicle sales strategies are penciled in a couple years in advance. We aren't seeing "reverse imports" of Japanese-brand cars from the US -- yet. So from that perspective we're also not back in 1996, when 85,000 Toyotas and Hondas went westward across the Pacific. But it is worth watching.

Source: 「１５９万円のベンツ 円高追い風、価格抑え輸入車加速」 which freely translated says "Fanned on by the strong yen, a Benz at ¥1.59 million will accelerate imports." From sankei.jp.msn.com of 25 May 2012.

...Mike Smitka...