Moving Production Share To Emerging Markets Can Unlock Substantial Value For Automakers

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A new report by IHS automotive points out that by 2020 over 50% of the global vehicle capacity share will come from emerging markets such as China, Brazil, India, Eastern Europe and the Middle East. [1] The report points out changing trends in the automotive landscape, as companies seek financial stability and risk reduction via alternative ways of manufacturing vehicles in an effort to maintain long-term competitiveness. Below are the key trends highlighted in the report:

  • Rising incomes in emerging markets have led to the majority of new vehicle sales coming from emerging markets. The ability to meet the growing demand for vehicles in these regions is often impaired by supply-side problems.
  • Tariff and non-tariff barriers to imported vehicles mean that major automakers cannot afford to simply export vehicles to these regions. According to the report, importing into a high growth market with tariffs reaching 35% is uncompetitive.
  • In the face of this, it makes sense to shift production as close to the buyer as possible. As a result, the trend of companies sourcing finished vehicles and components closer to market where the sale is intended.

According to data provided by the OICA, around 40% of the world’s vehicle production is from China, Brazil, Eastern Europe and the Middle East.((OICA Production Statistics, OICA[PDF])) Considering the expectation that China is expected to contribute roughly 30% of the world’s vehicle sales by 2020, up from 25% last year, a 10% increase in local production can bequeath several advantages to automakers. Producing locally and avoiding import tariff and non-tariff barriers unlock a lot of value to automakers. This means that car companies can afford to sell vehicles at much lower prices and therefore target a much larger pool of potential customers. By shifting production to these regions, companies like Toyota Motor Corp (NYSE:TM) and Honda Motors (NYSE:HMC) can expect to grab a larger share of the expected growth in the vehicle market sales than they would be able to if they remain exporters.

Below, we take a brief look at the potential impact that shifting production to emerging markets can have for Toyota and Honda.

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Toyota

Toyota’s market share of vehicle sales outside Japan and North America currently stands at 7%.  If we assume the same share for China, South America, Eastern Europe and the Middle East, the benefits the company can receive from shifting production to these regions are substantial. The company produced roughly 30% of its vehicles in these regions, while getting 40% of its sales from the same. [2] Local production can enable the company to sell vehicles at lower prices while expanding its gross margins. This will allow the company to reach a larger pool of customers, thereby increasing potential sales and market share. Assuming a 3% rise in market share, through a 1% rise in gross margin and 16% reduction in average vehicle prices, the company can realize a 23% increase in gross profits from the regions. However, producing locally will also mean higher selling, general and administrative (S,G&A) expenses and higher capital expenditures (CapEx). Keeping the proportion of expenditure on S,G&A and CapEx of total revenues constant, this implies roughly a 11% upside to the current Trefis price estimate for Toyota.

See our complete analysis for Toyota Motors here

Honda

Honda’s market share of vehicle sales outside Japan and North America currently stands at 2.56%. If shifting production to the emerging markets allows Honda to increase its market share to 4%, through a reduction in average selling price of 12% and an increase in gross margin of 1%, it can increase its gross profits by as much as 12%. Keeping the percentage of S,G&A and CapEx of total revenues constant, this translates into a 9% upside to the current Trefis price estimate for Honda.

See our complete analysis for Honda stock here

Another potential benefit that the automakers can realize is avoiding the challenge of currency fluctuations. The IHS report points out that “changes in vehicle costs driven by currency are difficult to absorb into sticky vehicle prices”. Producing locally will give companies more flexibility in regards to pricing and allow them to avoid exposure of profit streams to fluctuating currencies. Toyota recently had to shut down operations in Venezuela as currency controls made it difficult for the company to import parts necessary for production. [3]

Having said that, production in a new place is not always smooth sailing. Companies usually have to ride the bump of initial inefficiencies before they manage to streamline their production and delivery processes. Moreover, economic and political instabilities can impede economic growth in developing economies. Rising labor costs and impact of inflation on raw material costs are also felt more sharply in these regions. Therefore, car makers will have to be cautious in scoping out how they plan to utilize the potential offered by these regions.

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Notes:
  1. IHS Forecasts That By 2020 Emerging Markets Will Represent Over 50% Of The Global Vehicle Capacity Share, Polk, May 2014 []
  2. Toyota Financial Results Summary[PDF] []
  3. Venezuela car industry slips into idle, USA Today, February 2014 []