Chinese Automotive Industry Case Study Geely Motor

China started its economic reforms and adopted its open door policy in 1979. In that period of time, China’s automotive industry was rather unproductive. Geely Motor, a Chinese domestic car producer was one of the smallest domestic automotives producers in 1990s. The robust economic prospect and favorable policies in China have contributed to the success of Geely. Over the “good year”, Geely maintained a rounded 13% growth rate in sales volume of sedans over past years, and the profit level reached record high in 2008.

Behind the success, the short term liquidity of the company remained a major issue. More annoyingly, two emergent threats- intensified competition in the low-end market and rapid growth of wage level in China, were regarded as the biggest obstacle on the open road ahead.

Opening statement

In my final year at university, I attended an economics course which was related to the foreign trade and investment in China. It was the first time I came across with the Chinese automotive industry. The course coordinator, a professor from mainland China, was an expert at the Chinese automotive industry. Under his thorough guidance and inspiration, I gradually developed my interest in the rise of the Chinese automotive industry. Furthermore, having witnessed the entry of china in the WTO, which brought prosperity but also uncertainty to the car industry, as the domestic car market would be more open to the world but also face tougher rivals in the Chinese market, and these factors would make the car industry an interesting topic for further study.

Geely Motor, a Chinese domestic car producer, which is also the focus of this study, was one of the smallest domestic automotives producers in 1990s. To appreciate the favorable condition in the car industry, Geely has evolved to a multi-billion enterprise and captured more than 3.5 % of the market share, which was equivalent to 35 billion yuan. This study attempts to reveal the key attributes that contribute to the success of Geely and discuss the challenges that are likely to encounter in the near future.

Chinese automotive industry

China began its economic reforms and adopted its open door policy in 1979. Before that China’s automotive industry was rather unproductive. Facing the market reforms and import competition, the Chinese car industry has been through several radical transformations since the economic reforms. In 2001, china’s entry to the WTO brought greater opportunities to the car industry, but, simultaneously, it also meant competition within the industry would intensify. To assure the benefits of entry to WTO outweighed the corresponding costs, the Chinese official regulated the industry to protect the small domestic producers against giant rivals by only allowing competitors to enter the Chinese market through joint venture partnership with the domestic car producers (see appendix 1). This policy did not only avoid domination of foreign resource-rich competitors, but also allowed immature domestic producers to better integrate and to share resources with other technological advanced partners, in which it should allow the domestic producers to grow roots and firmly establish themselves in the long term.

Today China’s car industry has already overtaken the US and become fastest-growing automobile market in the world (Hogg 2009). Given the robust economic prospect and favorable policies in China, Chinese car industry should maintain its higher growth rate (see appendix 2). In the near future, we may expect to see consolidation in the car industry. However, the intensified competition should be benign as it will help to shape the domestic market in a better way and further segment the market to meet consumer needs.

The rise of Geely

The performance of Geely has been robust in the last few years. Despite the prolonged economic downturn, Geely has been able to maintain a rounded 13% growth rate in sales volume of sedans over the recent years, and the profit reached record high in the last financial year, where net profit had a threefold increase to RMB 866.05 million from last year’s RMB 305.77 million ( see appendix 3).

There were several favorable financial attributes that might contribute to Geely’s success. The decline of COGS, which reflected the effectiveness on costs control, has apparently improved the gross margin level, after gone through a substantial restructuring of the company’s subsidiaries (note 1). It was important to note that the ‘one-off’ impact of the restructuring on the cost reduction was mainly due to the favorable economies of scale and removal of excess resources. An ongoing tight control on costs, such as distribution and selling expenses, would be the key to success if Geely wanted to secure a larger market share (see appendix 4).

The short term liquidity of the company should be given priority attention, after the restructuring (appendix 5). The sharp increased in company’s assets, to 10150 million, which was almost 3 times of that in 2007, could have burdened the Geely’s short term liquidity. More worryingly, the dramatic increase in assets and the low level of current and quick ratio could reveal an early sign of overtrading, in which Geely could become vulnerable and exposed to cash flow issue. Given the global economy was remained uncertain, it would be wise to possess sufficient liquidity in order to be better prepared for unexpected circumstances unless Geely was fairly certain about the surplus amount of cash that would be provided in the future operating activates.

Apparently, the long term creditness of the company appeared to have deteriorated. The sharp increase of debt ratio was mainly due to the accounting effect after the restructuring of the company’s subsidiaries. Despite that, the increased earning power of Geely has diluted the burden of interest expenses to the company, and the gearing ratio has maintained at a exceptional low level, implying the fact that the company was relying on equities rather than debts to finance its expansion. A healthy capital structure, a low level of long term debt and a corresponding high level of equity, should allow Geely to shield against unplanned economic swings and neutralize the pressure on cash flow.

So far, by analyzing the past records of Geely offered little clues about the company performance. To better reflect the potential of Geely, it might be helpful if we benchmarked its performance with other direct competitors (see appendix 6). In this case, two domestic car suppliers, Great Wall and Denway, have been chosen for comparative analysis, given they had a similar background and market capitalization as Geely. By undertaking a comparative financial analysis amongst the three firms, we were hoping to obtain a better understanding of Geely’s financial performance from a different standpoint.

Two distinct perspectives have been highlighted in the comparative analysis. Firstly, the income generated from the share of jointly controlled entities would provide a stable source of income to the company. Moreover, jointly controlled entities would also benefit the company in many other dimensions, such as marketing, distribution and technological development, as both sides would endeavor to share its accumulated knowledge in order to optimize their competence. That meant, Geely, a wholly domestic owned enterprise, could lose it competitiveness to those joint venture companies which enjoy the prescribed advantages.

Another prominent issue was that the receivable and inventory turnover rate of Geely showed a significant variance between that of Denway and Great Wall. One possible explanation was that Denway offered a longer purchase installment period than that of Geely in result to a lower receivable turnover rate. However, longer installment periods which were more likely to favor the consumers could burden the company’s cash flow. In this case, Geely would have to carefully balance the two opposing effect in order to optimize its marketing strategy, and at the same time, maintain a healthy cash flow balance. Similarly, efficient production planning would improve the availability of the products and avoid excess tied up of working capital in form of inventory. The importance of the these two factors should not be underestimated as it might not only improve the company’s profit margin, but also offered an alternative solution to Geely’s short term liquidity problem.

The road ahead

There were two major challenges that Geely countered – intensified competition in the low-end market and rapid growth of wage level in China. The impact of these factors was likely to weight differently to other competitors. From the standpoint of Geely, it could be regard as a threat to the company especially its core business was focusing in the low end segment. Although the entry barrier to the car industry was reasonably high as it incurred a high exit and sunk cost, the joint venture requirement would sufficiently lowered the capital requirement for newcomers to enter the car industry, particularly to the low end segment, by sharing resources with their partner. This mean enterprises which initially were not able to compete in the market, could able to enter the market if it could take advantage of the synergy effect from their partner. Secondly, the constantly rising price level in china has substantially increased the component cost, which would cause the Chinese automotives to lose its attractiveness in the global market. Furthermore, in domestic market, Geely could lose sales to rivals with advanced technological that were capable to sufficiently lower the cost of the products to satisfy the price sensitive buyers. Even Geely absorpted the increased cost by lowering its margin, decisive action was required otherwise the profitability of the company could be severely damaged.

One of the many possible solutions was to expand into higher end market. By introducing add-valued premium car should allow Geely to enjoy a greater margin by charging a higher price and reduce the reliance on the low end market where Geely might no longer possess any cost advantage. To be successful in the higher end market, Geely would have to invest substantial amount of resources in R&D in order to differentiate themselves from competitors. Given the limited amount of working capital, however, Geely would have to look for external finance. Besides equity, the favorable interest coverage and gearing ratio might imply that Geely could also consider debt financing. Another attribute, however, had yet to consider in deciding the source of external finance was the cash flow provided by the strategy. Since the strategy would incur a huge cash outflow in the initial stage of the R&D and the financial benefits generated by the development process was regard as being indefinite. Thus, it would be sensible to raise fund by equity to avoid unnecessary liquidity pressure from the interest payment, despite the future earnings to shareholders would be diluted.

There were two alternative approaches that Geely could opt. The first approach proposed the transformation of Geely to a jointly controlled entity by integrating with another foreign partner. This might not only improve the technological competence in developing more efficient fuel engine to secure the future market needs, but also expand the customer base by introducing the brand to foreign market, in turn to avoid over reliance on the domestic low end segment. The extent to which Geely benefited from this approach would depend on whether Geely could find a suitable partner. The optimal outcome would be a joint venture partnership with a company possessed an international brand image and advanced technology, in order to maximize the synergy effect. However this also meant Geely would have to give up the full control of the company, which could lead to dispute and slow decision making, become less responsive to market change.

Another approach was to remain full control of the company, and established a new brand image by repositioning to a higher end segment. The initial R&D cost and the delay effect of the repositioning strategy would likely to burden the Geely’s short term profitability in exchange for a long term growth of the company. It was important to note that both approaches should enhance Geely’s current technological competence. But, the beneficial effect should be greater if Geely initiated its own development process than ‘feeding’ by its partner company. More worryingly, over reliance on joint venture partner would reduce the bargaining power of Geely when it comes to decision making in the future.

In conclusion, both strategies had their merits and drawbacks. In deciding which strategy to adapt, Geely would have to consider how important was for the company to retain full control of its operations, and whether the short term liquidity issue would prolong in the near future. If it was the case that Geely continued to suffer from shortage of working capital, the company should prefer the joint venture partnership in which the corresponding synergy effect and economies of scale should relief some pressure on short term liquidity.