August 15, 2014 at 12:41 pm

European Perspective

Russia, China, slowing economy threaten Europe car sales rally

The new C class Mercedes was set to make fat profits in China, but recent government action puts that in jeopardy. (Mercedes)

Western Europe’s car market was heading for a slow but steady recovery as sales finally hit rock bottom last year after the great recession, but evidence is mounting that even this unspectacular recovery might be in jeopardy.

The prospect of a slow but sure recovery also promised that Europe’s chronic problem of over-capacity might finally be addressed, but that hopeful vision is also starting to recede.

News Thursday that Germany’s economy contracted in the second quarter – output shrank 0.2 percent – added fuel to the fire, ignited by a spectacular fall in share prices for the European automotive industry.

Between the end of July and mid-August the Reuters index measuring the performance of 600 auto companies in Europe dived 12 percent, much faster than the overall market’s four percent drop.

This coincided with the publication of half-year financial results, but also reflected concerns about the market in China, a source of massive profits for German companies. Bearing in mind that the non-German car makers have been losing massive amounts of money, the half year results weren’t too bad. But news that China has begun to harry foreign auto companies with demands about over-pricing ate into investor confidence. Worries about developments in Russia aren’t helping either. Russian car sales aren’t very significant yet, but fears that the political aggravation between Russia and Ukraine might turn into a military conflict is worrying car buyers, particularly German ones, into keeping their wallets firmly shut.

Zero growth

Economic data from the European Union showed growth in the 18-nation euro currency zone was zero in the second quarter. Given that harsher sanctions against Russia are now taking effect, investors are now expecting at least a mild recession, threatening the viability of the slow recovery of car sales, and thoughts of restructuring too. However, the conventional wisdom remains that sales in 2014 will rise by between 3-1/2 and 4-1/2 percent.

“So far to date we’ve seen a gradual recovery (in West Europe car sales) but now with Russia and the Ukraine, there’s a bit of concern that might affect the economy. We can see with the latest GDP (gross domestic product) data, that Germany is not the locomotive anymore pulling the European economy behind it and this is really a potential risk to car sales. We don’t think there’s a significant risk they will tank again, but there is risk to the strength of recovery,” said Equinet analyst Tim Schuldt.

Germany provides more than a quarter of the euro zone’s output.

Schuldt said action from China was also spooking investors. Equinet is a German investment bank.

The Chinese government is investigating foreign automakers’ alleged monopolistic pricing, which might call into question the big profits made there by BMW, Daimler’s Mercedes, and VW’s Audi and Porsche. Sales in China, now the world’s biggest car market, have been like a license to print money for luxury car makers. China accounts for one fifth of BMW’s sales and around 30 percent of its operating profit.

Impatient

Max Warburton, analyst with Bernstein Research, is getting impatient with German car buyers. German car sales are flat-lining at around three million a year, despite huge incentives and price cuts.

“Come on Germans, don’t worry be happy. Consumer confidence is struggling to pick up amidst geo-political uncertainty in Ukraine and Iraq. Consumers in Germany have remained wary and the business outlook has deteriorated in the first half of 2014,” Warburton said.

Warburton though said trend analysis suggest that the German market could grow another 10 percent.

The recuperating European market promised that, slowly but surely, the long-term problem of too many factories producing too many cars might finally be addressed. One day the industry, which employs some 12.9 million people — or 5.3% of the European Union employed population — will be forced to face reality, and either slim down or face extinction.

Alan Mulally, recently retired Ford CEO, warned recently that European manufacturers must do more to slash excess capacity and bring production down to a sustainable level. Mulally was probably confident that Ford Europe was beyond criticism having shuttered 27.2 percent of its capacity. GM Europe has eliminated about 28.7 percent.

But the loss of more than three million car sales a year in Western Europe since the financial crisis started in 2008 has led to many non-German mass car makers stumbling into billion dollar losses.

Andrew Bergbaum, a consultant at AlixPartners, said over 50 percent of the top 100 European automotive factories are functioning at below operating capacity. Factories operate efficiently above 80 percent capacity.

Will we see any U.S.-style action, which led to the closure of 10 plants and a serious shedding of inefficient capacity, thanks to much financial help from taxpayers?

Three million cars a year

“It is unlikely that we’ll see a coordinated European approach. The current outlook for Europe is for continued over capacity and price pressure. Outside of Europe many are relying on China for a large part of their growth, but a forecast slowdown to the recent growth and a subsequent push from domestic brands will make that market tougher,” Bergbaum said.

Bergbaum said sooner or later there will be restructuring in Europe but this will probably be a slow process. He estimates that it needs to amount to cutting the capacity to make up to three million cars a year, or about 10 average sized plants.

Macquarie Research also reckons 80 percent is the magic number for a car factory’s utilization rate. In a report called “Capacity Utilization — above 80 percent lies gold”, Macquarie said moving the rate from 80 to 85 percent can lift a company’s operating profit margin by almost two percentage points.

“Once utilization drops at a company or in a market, the fight for incremental volume heats up leading to an erosion in pricing and further downward pressure on margins,” the report said.

But Macquarie doesn’t expect much action on European restructuring because of the high costs of layoffs, and political pressures to maintain national production facilities and to keep struggling companies alive.

Meanwhile the question remains; will the expected sales rally in Europe sputter?

Equinet’s Schuldt thinks that the current worries won’t have that big an impact on sales.

“It is very hard to say but my view is that we will still see a gradual recovery, maybe a bit slower than originally thought and not like the one in the U.S.,” Schuldt said.

Neil Winton, European columnist for Autos Insider, is based in Sussex, England. E-mail him at neil.winton@btinternet.com