Overcapacity turning into China’s Damocles sword

China’s association of Automotive Manufacturers (CAAM) has predicted that more than half of Chinese domestic passenger vehicle brands would cease to exist in the next three to five years. Excessive market competition – especially from foreign brands – is cited as the main reason.

While a rapid extinction of brands would likely produce a measure of turmoil in the short term, such a shakeout would likely have a positive effect on China’s automotive industry, and Chinese consumers, in the long-term. Here’s why. Slower sales are not the biggest challenge facing China’s automotive industry. In fact, new light vehicle sales are expected to reach 19.4 million units in 2012, up 8 percent (or 1.5 million units) compared to 2011. While this is not the double-digit growth that China regularly experienced in years past, 8 percent growth is still healthy, and is especially vigorous for what is already the world’s largest market for new vehicle sales.

John C Humphrey – senior VP, J D Power and Associates, says the real challenge facing China’s industry is its massive production overcapacity. There are 72 light vehicle brands being built in China today, and the automakers behind those brands have capacity to produce an astounding 28.5 million vehicles annually, says LMC Automotive. That is as much as the world’s next largest automotive producers – Japan, the US, and Germany – combined.

The general business formula for any manufacturer – regardless of industry – is to invest in new products and manufacturing capacity, produce their new wares, and sell them to consumers, bringing in revenue to pay off their initial investment, while realising a reasonable profit. That’s pretty straight forward. In the automotive space, however, this formula is much more complex. That’s because the mass manufacture of a single vehicle regularly requires years of planning, vendor coordination and big investments. All this must be made before a single vehicle is produced or sold.

Therefore, automakers are under tremendous pressure to utilise as much production capacity as possible to recoup their initial capital outlays. The general rule of thumb is that a vehicle production plant needs to operate at 80 percent capacity to break even on operations.

In 2012, light vehicle makers in China are expected to produce about 18.5 million new vehicles, according to LMC. This translates to an industry-wide utilisation rate of just 65 percent, far below the threshold required for profitability.

Characteristically, OEMs won’t cut production but cut retail prices, in order to stimulate demand. This action, in turn, causes other automakers – both the competitive and non-competitive ones – to also cut their prices. This reduces revenues for all, driving the weakest competitors into even more desperate circumstances. This is happening in China today.

When revenue and profits are slashed, automakers naturally tend to look for ways to reduce overhead. This might include using cheaper materials to manufacture products, de-contenting of vehicles to cut costs, hiring cheaper (and less capable) vendors among other things. So vehicle quality suffers and customer satisfaction declines.

Of the 72 light vehicle brands being produced in China today, roughly 66 percent are domestic Chinese brands. China’s domestic brands account for only about one-third of sales in the country's largest and most profitable automotive segment, passenger vehicles. Quite simply, there are too many competitors pursuing too few sales opportunities in a slowing market.

There are also other issues. These include lagging product performance in areas such as quality, technology, safety and refinement; relative inexperience in marketing, branding and distribution strategies; satisfaction gaps in sales and customer service. Only a few Chinese domestic brands will be able to address successfully. However, for those brands that survive, such a thinning of the ranks should lead to a much healthier industry. Automakers can then focus on building better vehicles and providing superior value, while retaining current buyers and winning over new ones.