External, internal M&As to fuel China's auto industry

Nowadays it's getting to be a hot topic that Chinese automakers are mulling to take over assets from their counterparts in the European and American markets. What would the industry say about this? We've interviewed two leading proessionals from Houlihan Lokey, U.S No. 1 restructuring investment banking firm with extensive experience in transactions involving assets sales and other mergers and acquisitions (M&A) activities.

Mr. Philip Wylie is a Director in Houlihan Lokey's London office. As a member of the Corporate Finance practice, he leads the firm's automotive efforts outside North America. Mr. Wylie is an automotive industry specialist with over two decades of experience in investment banking and professional services organizations. Mr. Joseph Chang is Vice President of Asia-Pacific Investment Banking at Houlihan Lokey where he leads and manages its first PRC office in Beijing. He is focused on originating and executing cross-border M&A and corporate finance transactions for Chinese SOEs, public and private entities. Prior, Mr. Chang used to advise Chinese SOEs, public and private entities on cross-border transactions as the regional leader in the Pacific Southwest for the US Chinese Services Group at Deloitte.

Gasgoo.com: First of all, according to your rich working experience, what are your views about the auto market in China and the world this year and the next few years?

Philip Wylie: We think the auto market in the West will be very difficult. We expect the auto production in the European market to fall anywhere from three to 10 percent, while the North American market will fall close to 10 percent in 2009. This follows a steep decline in North America in 2008 but a more benign market in Europe which only started to hit real problems late this year.  The Chinese automotive industry will also be hit as it relies on Europe and North America in the perspective of components exports. So as the global economy slows down, China will face a tough time.

Joseph Chang: After the Chinese automotive industry for both OEMs and suppliers, especially the Sino-foreign joint ventures, witnessed a tremendous growth over the last five years, many of the players in the market will find it harder to hit their volume and profit targets this year. They are not only impacted by the rising Yuan, raw material prices and gasoline prices, but also new government policies. For example, from September 1, the government raised the consumption tax on vehicles with larger engines, which makes it more expensive for consumers to purchase such vehicles. Diversified OEMs and those OEMs who have portfolio with primarily smaller vehicles will be less affected, although the general direction is slowing consumer demand.

Gasgoo.com: How will China's export be impacted?

Philip Wylie: Despite the economic changes and rising transportation cost, the European and the North American automakers will continue to purchase components from China, but there will be an overall slowdown.  Low added value parts which have high shipping costs, relative to value, will be impacted negatively.  Suppliers in Mexico and Eastern Europe should benefit.

Joseph Chang: If we look at the types of the products being exported, we see more low added value, commodity parts such as tires, wheels, and brake parts rather than higher technology parts with high R&D content.  As demand for new vehicles, hence OEM and replacement parts, for the domestic and export markets slows, some of the Chinese OEMs will struggle to maintain their businesses. We think there will be opportunities for the well-capitalized and well-managed companies with leading positions to consolidate some of the weaker players, first regionally, then nationally, and perhaps, internationally over time.

Philip Wylie: Over the years, we've searched for buyers within particular segments of the automotive industry. We know the industry very well; we know their strategies; and talk to the executives regularly. When I talk to Chinese companies, they're asking us to help find targets and to help people understand their strategy. However, there are only a small number of Chinese companies that are capable of doing overseas transactions. It's the same as the Indian buyers; they're credible and active buyers. (You think they're ready?) Yes, I think in some cases they are. However, they have to be confident that they can manage business which is very far away from their homeland. It's a difficult process.

Chinese players' ambition in overseas transactions

Gasgoo.com: So you mentioned the Chinese and Indian players are making overseas transactions. Is there any difference between their challenges?

Philip Wylie: No, I don't see much difference. The key is to build up customer relationships with large manufactures. They also have to grasp technology opportunities to make sure they're at the forefront of the market. Obviously, given the scale and international focus of many Indian players, they are slightly more advanced in doing this than the Chinese players. Virtually every deal I have worked on in the last 24 months has had some interest from Indian trade buyers.

Joseph Chang: The Chinese companies are quicker in evaluating and closing acquisitions today than they were five years ago. They have more capital from years of profitability and rapid growth in the domestic market to make foreign investments and many leading companies globalize through M&A which is a strategic priority. During the past one or two years, if we look at the larger deals in the automotive industry, you would find the Indian companies have been more aggressive in global auctions for controlling stakes and faster than Chinese companies. There are not many examples of Chinese companies purchasing foreign assets in the automotive industry.  The most successful cases involve Nanjing Automotive acquiring the MG Rover brand and related assets in the Europe, and Wanxiang acquiring multiple component suppliers through primarily minority purchases of distressed assets in the United States.  The operational challenges of managing the complexities of integrating a global business would not be materially different for any foreign companies, whether Chinese or Indian.

Gasgoo.com: Automotive suppliers and private equity groups are the main purchasers of components makers. Do you think Chinese buyers need help from those private equity groups?

Philip Wylie: Actually, according to our study, suppliers made about 60 percent of the 300-plus supplier company acquisitions completed last year. Eighteen months ago private equity deals were the majority (maybe around 65 to 70 percent). But now many private equity groups are facing difficulties raising debt as the financial crisis deepens, so the game has changed. As a result, these private equity groups are sitting on the sideline.

Joseph Chang: For Chinese companies who intend to expand into international markets through M&A, it could be an alternative to team up with a private equity group for not only financing (albeit at the cost of sharing ownership), but also operations and governance support.  In today's tougher market environment from the global financial crisis, private equity groups who have dedicated industry expertise and established industry relationships could assist Chinese companies value, negotiate, and integrate the deal, which could be less risky considering the nature of managing distressed assets, restructuring insolvencies, and growing through a contracting automotive industry.

Philip Wylie: The problem in the US or Europe is that purchasers need to improve the business and the structure. This takes time, effort, commitment and often times, cash. Having a private equity partner through the cycle, it could be quite efficient. You may have noticed that most of executives in the Chinese auto industry are managing mainly in an up-cycle during the last 10 years, but they find it difficult to manage through a tough down-cycle. So having a skillful financial partner could be a key benefit for the Chinese companies.

Gasgoo.com: What's the risk and benefit of doing such transactions?

Joseph Chang: We believe access to patented technologies, proven R&D capabilities, strong engineering and product development teams, and established customer channels are the biggest benefits.  Having global brands and top management skills are also important factors.  As for the risks, apart from the transaction risks such as paying the "right price" and achieving balanced terms and conditions to align all parties after closing, and getting regulatory approvals, there are the operational risks.  The Chinese companies have to retain key management, employees, customers and suppliers while striking a balance with the cultural difference.  The unions and labour laws need to be understood.  Since the underlying purpose of pursuing any deal would be achieving synergies, being realistic and having a defined integration plan with clear accountability is paramount.

Internal M&As in China's auto industry

Gasgoo.com: I know Houlihan Lokey is working on some deals for foreign tier-one suppliers making acquisitions in China, so what's the reason and intention behind it?

Philip Wylie: The intention of these Chinese acquisitions is not drastically different from those that took place in the US and European market where parts manufacturers have bought suppliers to gain access to new customers and technology. What do the overseas buyers want to achieve when they buy Chinese companies? In some cases the target companies are joint ventures, or offer a low-cost production base, but actually the key is to gain a foothold and acquire those companies enjoying good relationships with customers that will develop within the Chinese market. All in all, the rationale should focus on those relationships.  This will ultimately have a significant influence on whether the deal is successful in the long term.

Gasgoo.com: Those purchasers are foreign companies that have not yet had a footprint in China?

Philip Wylie: Well, there are indeed some suppliers that haven't established a local production base in China. But many of them want to have more operations in China because, as you know, the Chinese auto parts industry is quite fragmented and diversified and being present in just one region may not be enough to capture business across the country.

Privately-owned companies that are well-positioned and are performing well with strong customer relationships and modern equipment… are very attractive to the buyers.

Gasgoo.com: When could the wave of M&A come inside China?

Joseph Chang: China has a large, highly fragmented automotive industry that can be generally segmented into different regions by domestic OEMs and suppliers and complex ownerships of foreign-sino JVs.  China has the second largest market in terms of new vehicle sales today and is projected to be the largest in five years.  With such rapid growth for vehicle ownership over the three years, the infrastructure for ancillary support and service needs to be established.  Slowing demand from consumers, decreasing vehicle prices, higher material prices, wage inflation, and slowing export sales have already started the consolidation in China.  Last year, SAIC Motor acquired Nanjing Automobile, which owned the MG Rover brand.  We have observed the profits of most of the market players dropping, thus it'll be logical to consolidate the companies, turn them into privately-owned companies, or acquire foreign companies based on record lows in valuation.  The government policies acknowledge the structural overcapacity in the industry and promote consolidation.  We have been working on evaluation of several parts companies, and that's going to be a trend in the next few years.

Impact on Low-Cost-Country-Sourcing

Gasgoo.com: To cope with the global recession, will the big players (foreign OEMs) become conservative in doing global outsourcing or will they pursue more outsourcing in Asia?

Philip Wylie: As the big automakers try to improve their financial position, and achieve economies of scale, they'll likely look more and more for low-cost country sourcing as well as reducing their supplier base. As the demand declines the western parts-makers have to cut their capacities, and this will also lead to consolidation in the western market. This offers potential for the low-cost countries to expand their capacity, provided their markets continue to grow.

I think China will remain a low-cost country for some years. But Eastern European countries will also be a threat and in some cases will be the first choice for Western European companies as they struggle to reduce costs and keep their local customers happy.

Joseph Chang:  Every manufacturer has been negatively affected by the significant increases in commodity prices.  The cost competitiveness of sourcing from China is not as great as it was five years ago due to the wage inflation, RMB appreciation and transportation costs.  This makes the sourcing decision much less clear cut than it was and underlines the need for suppliers to secure local customers in China and not simply rely on export lead demand.