REVVING UP
GM China has captured the attention of Detroit. To live up to expectations, it has to shake off competition, and shake up its suppliers.
By Abe de Ramos

John Kett, CFO of General Motors China, is rolling up his sleeves for a US$650 million challenge. Barely two years ago, the communist state was nothing more to Detroit than a footnote in its overseas strategy, as vehicle sales there were but a wisp in its global total of over 8 million. Within a year, however, the mad scramble for cars in China knocked off Germany as the third-largest car market in the world. It also became the fourth for General Motors, and by April, CFO John Devine was extolling the Middle Kingdom for driving his first quarter earnings beyond expectations. Devine is eyeing a profit of US$800 million from Asia this year, and if last year is a hint, China should make up more than four-fifths of that. But amid a rising tide of competition and an intractable local environment, the question for Kett is how well he can deliver.

From his fourth-floor office overlooking a busy intersection in Shanghai's industrial district of Pudong, Kett exudes confidence as if success was virtually guaranteed. "The market is growing very fast - you'd be nearly failing if you don't have another record year," he says. While that may sound like hubris, the numbers reinforce the view. Last year, China's nouveau riche bought 2 million cars, almost double from the year before. GM China had a big slice of that pie. Through its joint ventures with state-owned Shanghai Automotive Industries (SAIC), GM sold 486,710 cars, half greater than its sales the year before, a growth rate better than many of its competitors. From a humble 4.5 percent market share since Kett took office in 2001, GM has multiplied that to 9.5 percent as of March.

This record volume growth enabled Kett to post profits that encouraged Detroit to set a lofty target this year. GM China's share of profits in 2003, after splitting them with SAIC, was a cool US$437 million, thrice what it earned in 2002. To headquarters, the figure shines all the more when compared with GM's automotive earnings in North America of US$811 million, especially since unit sales between the two were over 4 million apart. This translates to equity earnings of US$1,130 per vehicle GM sold in China, versus US$145 in the home market. "It's difficult to go past volume growth to explain what underpinned GM's profitability last year," says Kett.

But his ability to meet Detroit's rising expectations is being attacked by fierce competition. While GM China faces up to this challenge by raising its capacity and expanding its product portfolio, for its long-term benefit, Kett has to address the nagging issue of bringing costs down. "The cost base here is nowhere near where it should be, if we're going to compete over the long term and sustain the types of margins we've enjoyed," Kett admits. To be sure, this anomaly affects the entire auto industry in China, but Kett is trying to drive it down with fervent resolve. His strategy: to use GM's clout to shake up the domestic supply industry.

"When you sit down with GM, what you hear from them is that with the tremendous growth in China, they need to form confident suppliers, and it's a challenge for them to develop a supplier base," says Brett Hoselton, analyst at McDonald Investments in the US, who watches the moves of US automakers in China. "They can build assembly plants every day, but if there are no components, they're not going to get anywhere."

A Giant Sucking Sound

Even now, sales and profit growths are closely correlated in China's fairly young auto industry, as supply has simply not been able to keep up with demand. "We've been continually under-sizing the market for the last two years," says Kett. "In fact, we've been constraining our market share growth by our inability to supply." It's an industry phenomenon that has allowed automakers to rake in fat profits in China. US credit rating agency Standard & Poor's estimates that the average margin for the whole sector, including trucks and buses, is about 30 percent, although Kett argues that, as in GM China's case, it is only around 10 percent among car makers - still double the global average of about 5 percent.

All this, however, is about to change. In a bid to grab their slice of the market, all major players have been revving up their manufacturing capacities. Ford plans to increase annual output from 20,000 to 150,000 in three years. Volkswagen, which sold nearly 700,000 cars last year, aims to cross the 1 million mark by 2007.

Latecoming Japanese players such as Nissan and Honda are catching up, as are "non-traditional" Chinese companies. AUX, a home-appliance maker, vowed to make 450,000 vehicles a year by 2008. "The market is attracting not just established manufacturers, but also new entrants who are attracted by the still-healthy margins," says Tom Stanley of audit firm KPMG in Hong Kong.

That means while sales could jump up to 40 percent this year as some analysts predict, the days of heady margins may be over. Apart from the growing number of players, there are concerns that they are building up capacity to dangerous levels. While this remains a contentious issue (see box, "How Much is Too Much?"), most agree the speed of the build-up is enough to make margins come down to global norms in five years. On top of that, the auto industry has been dealing for months with rising prices of commodities from rubber to steel, yet no one has been able to pass the costs to consumers due to cut-throat competition. Michael Dunne, president of research firm Automotive Resources Asia, says selling prices in China have been going down for the past 23 months.

Adding to the pressure, the cheaper cost of imported cars thanks to China's WTO membership will force prices down by another 30 to 60 percent by next year, estimates accounting firm Deloitte & Touche in Canada. In short, the roar of growing demand will soon be accompanied by the sucking sound of declining profits. "China represents growth, and market volume should grow," says Efraim Levy, analyst at Standard & Poor's in New York. "But with competition, the question is, how low will the profitability go?" As such, if GM China is to stay ahead without compromising the earnings that Detroit has come to expect, the company - in fact, the whole industry - must look beyond sales and come up with new strategies to enhance margins, analysts say.

The task is especially tricky for Kett, as GM China is clearly in expansion mode. Since rolling out its first Chinese-made car in 1998, its goal has been nothing less than to knock down the market leader, Volkswagen, which has been making cars in China for 20 years. GM has gained ground; its rise came at the expense of the German carmaker whose market share has gone down from over 50 percent in 2001 to just above 35 percent now. To this end, Kett is spending to boost GM China's annual capacity by 50 percent to 750,000 by 2006, and restructured a joint venture to boost production of sports utility vehicles. His marketing budget is also on the rise, having signed GM as a principal sponsor of the 2008 Beijing Olympics.

Scaling back these plans is not an option. "We're not going to stop now, otherwise, we'll be handing market leadership to someone else," says Kett. Not surprisingly, his thoughts on cost management are influenced by GM's vision of market leadership. "We can get very caught up with margins issues, but we have to recognize that we don't sell margins; we sell vehicles," he says. "From a cost-base perspective - what physically goes into the vehicles, the general operations of the plants, and the expenses in selling and marketing the vehicles - we're refining them year after year, understanding what's really required to fund our strategic market share objectives." Translation: it's a classic case of margins versus market share, and to GM, the priority at this time of increasing competition is clear.

That doesn't mean, however, that Kett has lost sight on margins. Quite the contrary, his vision is long-term, and his strategy is to bring GM to a "normalized cost structure". That essentially entails getting cheap components from local suppliers. But as any old China hand knows, the success of this strategy depends as much on external factors as it does on execution.

Think Globally, Source Locally

Paul Gao, principal at consulting firm McKinsey in Shanghai, offers a three-pronged approach for automakers in China to sustain their margins: increasing local sourcing of parts, adding focus to service businesses such as financing and leasing, and leveraging China as a production base for international markets. "China, at the right production scale, can be globally competitive as a manufacturing base," says Gao. Stanley of KPMG adds to the equation: "They should make products that they can charge a premium price for, by differentiating the product through technology, features, and image."

If these are winning strategies, then GM is on the right track. Kett says GM is localizing content, broadening its product range, and introducing car financing. "Our plan is to seek opportunities in high-growth, high-volume segments, and localize those vehicles for China," he says. To spur demand, it will support sales through auto loans. GM China is bringing in General Motors Acceptance, the financing unit that actually earns more in the US than the car-making business. Kett says it is on track to start operations within this quarter. (See box, "Betting on Credit")

Of these, however, localization is the most crucial, since it will determine how much Kett can bring his cost to a "normalized" level. That implies that the costs of producing cars in China are not normal, and indeed, they're not, at least based on global benchmarks. "It's a misconception to believe that a car in China is cheaper than a car in the US or Europe," says Kett. "We need to get there, to do better, but it's not quite true yet."

One reason is the high cost of components. Victor Tong, China expert at Deloitte, says prices of components made in China can be 50 to 100 percent higher than world markets, thanks to poor economies of scale. To illustrate: China has only 10 million cars in circulation, according to S&P estimates, while the US rolled out 16 million new ones last year alone. Importing these components may be a cheaper proposition, even if they come with an average of 25 percent tariffs which, under WTO, will even go down to 10 percent by mid-2006. But that doesn't tempt Kett to import more. "The 25 percent tariff differential is still a significant number," he says.

As such, Kett's localization strategy is driven by at least one major factor: logistics. "Sometimes, you take a decision to localize simply because by [sourcing] closer to the plant, you have a quicker lead time of order to delivery, and the ability to switch models," he says. The latter is of great importance to GM China, given that it aims to increase the number of its models available in the market within its four existing factories.

Shanghai GM, the main venture with SAIC, currently makes the Buick Regal midsize sedan, the Buick Excelle lower-medium sedan, the Buick Sail small car, and the Buick GL8 executive wagon. Soon, it will start making the Cadillac in its premises too - the first time this nameplate will be made outside the US. "If I can get a part locally as opposed to importing it from another country, what I've done is I've given the manufacturing plant more flexibility to change its production overtime," he says.

For now, most of the parts that would go into the Cadillac would be imported. After all, as a result of the trade tiff between China and the US last year, the Chinese government granted General Motors a special right to import US$1.3 billion worth of cars and parts without the use of a local partner in the next two years. But knowing that the same parts are, or will be, available locally means GM can produce the Cadillac in China - which will finally allow it to compete head to head with BMW and Mercedes Benz - even after the special importation rights are used up.

Normal Delivery

Still, all these strategies and advantages don't nearly normalize cost, because they don't solve the issue of finding cheaper sources of components. By "normalized cost structure", Kett envisions that the cost of producing a part, and consequently a car, in China should be equal to, if not cheaper than, the rest of the world. Although he has the option to import due to declining tariffs, he calls the move "false economy".

Instead, GM is taking a strategic step to work with suppliers in bringing down their cost. "The supplier cost base, to us, is part of an overall cost-base challenge."

"When I see a part being imported at a dollar, I want to make sure that I can get it here for a dollar or better," he adds. "Just because I have a local supplier that can build it at US$1.10 doesn't make it a right decision [to accept that price]. We have to go to that supplier, work with them and say, 'You have to build that for a dollar, or 99, or 97 cents. Let us work with you to achieve that.'" That means engaging the suppliers with GM's own technical experts on issues ranging from the supplier's layout, to their investments in machinery and equipment, to training them to improve their scrap rates.

But it also means GM is prepared to give scale orders to local parts suppliers, with the hope that they will eventually be able to produce the same parts cheaper in the near future. "There is a tremendous amount of resources within our purchasing community to develop and help suppliers, so they can become a strong supplier to GM in China, if they can lift their quality and volume," he says.

Is it practical? Arguably not, simply because imports are getting cheaper. But it could be manageable at a certain level, which is why Kett has capped the ratio of GM's local versus imported parts to 60:40. "Economically, we think around 60 percent is the right level of localization we would aspire to on a majority of our products to make the investments here worthwhile." That number wasn't plucked out of nowhere; it was within the range of the requirement imposed by China on foreign-invested automakers. As such, it is comparable to what GM's competitors are doing, so that GM is not necessarily at a disadvantage.

Also, scale is just what the industry needs to mature, and in fact this is improving. All the world's biggest suppliers - Delphi, Visteon, Johnson Controls, and Bosch - are building up in China, as the foreign carmakers "force their international suppliers to relocate to China," says Gao. Also, indigenous suppliers are gaining competence as Beijing forces consolidation, and more of them hook up with the foreign suppliers. Delphi, a GM spinoff that counts GM China and Volkswagen as its largest clients in China, already has nine joint ventures, and plans to expand.

Although the minimum local content requirement has been scrapped since China joined WTO, Yale Zhang, director at auto research firm CMS International in Shanghai, says local sourcing is growing anyway as the number of capable suppliers in China grows. "Localization of new models is low, but it gets higher where volume gets bigger," he says. "Importing CKDs (completely knocked-down vehicles) will enable you to introduce new models really fast, but when volumes go up, the manufacturers themselves will consider to localize without being pushed by other people to do so."

All told, KPMG estimates that total domestic sales of locally produced vehicle components in China more than doubled from US$5.7 million in 1995 to US$15.1 million in 2001. "Before, market demand was small, but with 2 million cars sold last year and growing, the scale issue is being resolved," adds Gao of McKinsey. That has improved their cost base. "In terms of capabilities and cost, we have started to see China already becoming an export base for components, both labor- and process-intensive components."

This capability, if sustained, will eventually help auto companies in China to use the mainland as an export base. Indeed, Honda is already building a facility in Guangzhou to make compact cars for Europe and Asia. For Kett, however, it is enough for now to see its domestic suppliers improving their own cost base, and not to lose focus on growing its market share in China, which analysts expect will overtake Japan as the second-largest car market in the world by 2010.

"Every company has aspirations of wanting to export, but given the fact that we can't build enough cars today to meet our objectives, it will be a long time before we would consider exporting," he says. In the meantime, he is counting on beating the competition and improving his cost base in China to satisfy headquarters. "You have to continually beat your targets versus this time last year. We're tremendously excited, but the challenge is huge." Detroit, for sure, is holding its breath.