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HighlightsThethirdlargestautomakerintheworld:ChinaexperiencedphenomenalgrowthinautodemandfollowingtheWTOentryinDecember2001.Itisnowthethirdlargestmarketintheworld–aftertheUSandJapan–withtotalsalesof4.4mnunitsin2003.InthisreportweexamineChinaasamarket,asanexporter,andasaglobalsupplierofautoparts.Welookforre-accelerationinautosaleswithin2005:Anumberoffactors–credittightening,contractioninautofinancingservice,constantnewsaboutpricereductions–havetogetherresultedinamarkedslowdowninautosalesgrowthinrecentmonths.Basedonastatisticalapproach,weforecastcarsalestore-acceleratein2005aheadofmarketexpectations.Likecostreductions,volumesalesgrowthiskeytoprofitability:Althoughweexpectcapacityutilizationwillcontinuetotrenddown,theextentofdeteriorationin2005shouldmoderatecomparedwiththedrasticshiftfrom2003to2004.Morepricecutslookinevitable.Costreductionsthroughraisinglocalcontent,economiesofscale,andlowertariffonpartsimportswillhoweveralleviatemarginpressure.Volumesalesgrowthiskeytoprofitability.Weexpectautoexportstoremainrelativelysmallscale:LocalChineseautomakersarekeentoexportgivenrisingcompetitioninthedomesticmarket.Itwillhowevertaketimeforthemtoestablishreputation,andsetuptheirdistributionandservicenetwork.WebelieveChinaisnotyetcostcompetitiveandreturnsareprobablynotcompellingenoughformostforeignJVpartnerstoshareprofitswiththeirChinesecounterparts.Chinalooksmorereadytoexpanditsroleinglobalpartssupplies:China’sautopartsexportsareestimatedtoaccountforlessthan0.4%oftheworld’stotal.GrowthpotentialisenormouswithglobalautomakerssuchasGMandFordplanningtosharplyincreasepurchasesfromChinaforusesinglobalautoproductionoverthenextfewyears.Costadvantageplusalessstringentregulatoryenvironmentencourageexportsoflabor-intensiveandmaterial-intensiveproducts.Stockhighlights:Amongthecarmakers,Hyundai(Buy),Toyota(Buy),Honda(Neutral),andGM(Neutral)aregainingmarketshareamidrisingcompetition.Nissan(Buy)isintheprocessofrebuildingitsfranchiseandVW(Sell)continuestoloseground.Denway(Neutral)shouldbenefitfromtheexpectedmarketrecoverythoughitislosingitsuniquenessfromtheemergenceofHonda’snewJVpartner.Exportcapabilitiessupportlong-termgrowthpotentialforFuyaoGlass(Buy),amajorautoglassmanufacturer.CHINASERIESAutos/CarManufacturersContributorsChinaGraceMak(852)25363108grace_mak@ml.comJingChenjing_chen@ml.comEuropeStephenReitman(4420)79962676stephen_reitman@ml.comJapanChristopherRichter(813)62258528christopher_richter@ml.comKoreaMarkYoon(822)37070557mark_yoon@ml.comUSJohnCasesa(212)4498431Jcasesa@exchange.ml.comDavidFandrich(212)4490239david_fandrich@ml.comJohnJ.Murphy(212)4497045john_murphy@ml.comJacquelineS.Weiss(212)4490239jackie_weiss@ml.com4January2005ChinaAutosABumpyRoad–LeadingtoLandofOpportunityRC#60200401MerrillLynchdoesandseekstodobusinesswithcompaniescoveredinitsresearchreports.Asaresult,investorsshouldbeawarethatthefirmmayhaveaconflictofinterestthatcouldaffecttheobjectivityofthisreport.Investorsshouldconsiderthisreportasonlyasinglefactorinmakingtheirinvestmentdecision.CustomersofMerrillLynchintheUScanreceiveindependent,third-partyresearchoncompaniescoveredinthisreport,atnocosttothem,ifsuchresearchisavailable.Customerscanaccessthisindependentresearchat–4January20052Refertoimportantdisclosuresonpage79.KeyThemes–WhattoLookFor...TooBigtoIgnoreChinaexperiencedphenomenalgrowthinautodemandin2002-03followingitsentryintotheWTOinDecember2001.Autodemandgrew37%in2002,and35%in2003amountingto4.4mnunitsfortheyear.Itisthethirdlargestmarketforautosalesintheworld,aftertheUSandJapan.Passengervehiclesgrewatafasterpace(57%and75%in2002and2003,respectively)versuscommercialvehicles(29%and14%).Passengervehicles,primarilysedans,currentlyaccountforaround45%oftotalsales.However,marketpenetrationremainslowatonlyaround2%,comparedwithanestimateof50-60%intheUS,EuropeandJapan,andaround30%inSouthKorea.GivenhugegrowthpotentialinChina’sGDPpercapita,whichwasonlyUS$1,087in2003,demandlookssetforrapidexpansionoverthecomingdecade.ChinaautodemandgrewataCAGRof12%during1993-2003.Assumingasimilarrateofgrowthforthenextsevenyears,weforecastthatannualvehiclesaleswillreach9.6mnunitsin2010,equivalenttoaroundhalfthesizeoftheUSmarketin2003.Intheconservativescenarioofzeroscraprate,therewillbe73mnvehiclesinChinain2010–thismatchestheestimatedmarketpenetrationof5%shouldGDPpercapitareachUS$2,100duringtheyear(ie,+10%pain2003-10).TheSetbackin2004FollowingontheheelsoftheChinesegovernment’scredit-tighteningmeasurestoclampdownonover-investmentinanumberofindustries,autodemandgrowthshrankfrom31%in1Q04,to22%in2Qand8%in3Q.Growthinsedansdroppedconsiderably.2004islikelythefirstyearthatsalesgrowthofpassengercarswillfallbehindthatoftruckssince1999.Chart1:ChinaMonthlySedanSalesGrowth,Jan01–Oct04050,000100,000150,000200,000250,000Jan/Feb01Ju