Unprecedented challenges to the Chinese parts industry

If you don't like bad news, don't read this. The American auto industry, on which Chinese parts makers are still far too dependent, is on its end run to self destruction. In 17 days, Chrysler's stay of execution will run out. A month later is the deadline for General Motors, with emphasis on "dead."

The Standard & Poor's ratings agency just cut Chrysler's senior secured first-lien term loan (due 2013) to CC from CCC; and lowered its issue-level ratings on GM's $4.5B senior secured revolving credit facility to CCC-. That's nine grades below investment quality. Next step is "D." Debt rated D is in payment default, it cannot get any worse.

According to the Wall Street Journal, "bankruptcy experts have called a filing by the two companies likely, and both companies and their stakeholders have been actively preparing for that eventuality." According to US media reports, it is pretty much a forgone conclusion that Chrysler will cease to exist, while General Motors will be separated in a "good brands" and a "band brands" company, with the "bad brands" having as much chance of survival as a cancer patient who has just been rolled into a hospice and put on a morphine drip.

Unlike Chrysler, the "good brands" part of GM has chances of survival in the event of bankruptcy, Standard & Poor's recovery analyst Greg Maddock said in an interview to Reuters: "If Chrysler goes into bankruptcy, I would expect it to go into liquidation -- that its assets would be sold in whole or in part. Instead of being reorganized, there would be no carmaker after bankruptcy." The few "good brands" of GM will continue, but at a far lower production level.

Meanwhile in Japan, Toyota prepares for the second year with a multi billion Dollar loss. According to the Nikkei, Toyota's fiscal 2009 loss may exceed the fiscal 2008 loss of approximately $5 billion. For a parts maker, more important than an auto maker's profits is its production. Toyota group companies are forecast to sell about 6.5 million vehicles this fiscal year, falling below 7 million units for the first time in six years. Toyota sees demand in the US likely to remain stagnant in the current year. Sales in Japan and Europe are projected to fall below previous-year levels.

Ever since I've been writing these columns, I recommended to get less dependent on OEM sales and to aggressively pursue the after sales market. Now you know why.

Even in the after sales market it is not all rosy. In Europe and in America, many parts suppliers have declared bankruptcy. This has created masses of distressed merchandise that swamps the market at whatever price the liquidator can get. Lower OEM sales have created overstock that puts pressure on the market.

The Eastern European countries, such as the Czech Republic, Poland, Hungary, or Rumania established quite a parts industry. The countries are just a day's truck drive away from Western Europe, wages are low. They are part of the EU, but many of them are not part of the Euro. Their currencies have taken a big hit. Last year, one Euro bought 3.19 Polish Zlotys; currently, a Euro is worth 4.50 Zlotys. A few weeks ago, a Euro bought nearly 5 Zlotys. In Euro terms, buying in Poland is cheap. As a result, Western Europe gets increasingly flooded with cheap Eastern European parts. We see brake pads being offered for €2.50 a set which cost €5 when bought ex factory in China. Currency-wise, China is disadvantaged. The Yuan is again pretty much tied to the US Dollar at 6.83 Yuan to the Dollar. Not a great rate. On the other hand, the value of the Dollar currently increases against the Euro. When the Dollar goes up against the Euro, the Yuan becomes more expensive against the Euro, making exports from China to Europe more expensive in Euro terms. Would you have ever thought that you have to compete with a cheap Polish Zloty? Well, now you have to.

More and more European countries are establishing a scrapping bonus where people get paid by the government when they scrap their old car and buy a new one instead. By far the most successful program is in Germany. Germany pays €2500 to an owner of a car 9 years or older if he takes it to the wrecking yard and buys a new one. In a few months, this has created sales of over a million of new cars - in a country that sells around 3 million new cars per year. In March, German new car sales exploded by 40 percent.

Unintended consequences for the parts industry: Before being scrapped, the old cars are taken apart and usable parts land on the used or reconditioned parts market, putting further downward pressure on parts prices. In the US, the flagging economy has created a boom in used or recycled parts. There are web based platforms in the USA and Germany that make it easy to find a used part. Finding a container of new parts in China on the other hand involves a huge amount of work. What's wrong with that picture?

The Chinese parts industry has experienced unprecedented growth in the last years. Now it is faced with a series of unprecedented challenges. They cannot be solved with business as usual. China has the choice of profiting from these changes, or of becoming a victim of them. Which one will it be?

About the author: Bertel Schmitt, Gasgoo's columnist, is CEO of Hong Kong based parts sourcing company Sinamotive. Before founding Sinamotive, with the assistance of U.S. venture capital, Mr. Schmitt was a marketing consultant to Volkswagen AG.