Schroders: Chinese autos - hitting the (Great) wall?

The Chinese auto market is the biggest in the world, accounting for 30% of global auto sales and a much higher proportion of industry profitability. As such, companies and investors have been perturbed by developments in the market in the last six months. Not only has volume growth slowed considerably, actually slipping into negative territory in June, but there has also been a dramatic swing in market share from foreign to domestic brands.

A maturing market and a slowing economy

Some slowdown in the market was inevitable given that the market is gradually maturing, but the timing, and unexpected severity, of the current slowdown is likely down to a weaker macroeconomic environment. China's economy has been slowing year-to-date, with reported second quarter GDP growth slipping to 7% and indicators such as electricity consumption suggesting the actual slowdown may have been even more pronounced.

Domestic market share growth driven by SUVs

More surprising, and alarming for foreign investors, has been the market share shift from foreign to domestic car brands. While this is partly down to subsidies for small and fuel-efficient vehicles, the more important driver has been rapid growth in the small/budget SUV market, where domestic OEMs enjoy a near-monopoly.
SUV penetration has been driven by a combination of factors, including growing demand for cars that can safely navigate poor quality roads. This is especially relevant in lower-tier cities and central and western provinces, where overall car sales are growing faster. Falling fuel prices have also helped, as SUVs have comparatively poor fuel economy. Furthermore, domestic brands have benefited from a spate of new model launches in the small/budget SUV segment, compared to very few from the foreign brands.

Will this share shift last?

In the near-term, the foreign brands will benefit from a number of significant model refreshes in the second half, and their launch schedule is also more comparable to the domestics’ next year. However, we expect domestic market share to stabilise at a somewhat higher level than seen in the last couple of years, primarily due to further increases in SUV penetration at the low end of the market.

Tomorrow – the world?

We remain sceptical that Chinese domestic brands can make inroads into other auto markets  in the foreseeable future. Yes, Chinese-made cars have come a long way and there is no denying that Chinese brands have made genuine and significant improvements in product quality in recent years. But, in our view, the leap from “poor” to “good enough” is easier than the next stage of transition: making truly globally competitive vehicles. Industry consultants cite a number of obstacles facing domestic companies including poor execution, cutting corners on product development and testing, a lack of basic automotive expertise among engineering graduates (most of whom have never had a car), and insular and hierarchical management. One professional told us that, in terms of engineering expertise, the Chinese are still 10-12 years behind global manufacturers. Furthermore, brand equity is low: even domestic consumers still appear to have a strong preference for foreign brands, providing the price gap is not too extreme, and it is hard to imagine Western buyers embracing Chinese-made cars.

Making headway in emerging markets

That said, domestic brands are already making headway in emerging markets, particularly in frontier markets where price-sensitivity is high, branding less relevant and markets are too small, difficult or “controversial” to attract many global automakers. While unthreatening today, this may pose a bigger problem for global automakers if the Chinese begin to encroach on more ‘mainstream’ emerging markets like Southeast Asia and Latin America, which are generally very profitable and will also drive most of the future growth for the global auto industry.

Implications for investors

We believe that profitability for both foreign and domestic brands will fall as the Chinese auto market normalises. Our preferred area for investment is foreign premium brands as they will benefit from rising incomes, increasing financing penetration, and trade-up demand as the market matures. They are also immune to direct domestic competition.  We also believe that global suppliers and tyre manufacturers have a longer runway for growth in China as the domestic Chinese brands seek to raise their standards by installing more foreign content.

While Chinese brands are unlikely to threaten global automakers on their home turf any time soon, investors should be wary of being complacent and closely monitor the progress being made by the domestic brands. A change in brand perception by domestic customers, especially among younger buyers and those outside tier 1 and 2 cities, would signal a potential shift in the domestic market.

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