Ford Motor Company's Production Dilemma in China

A glimpse at Lincoln's advertising for 2017 models. Image source: Ford Motor Company.

As the saying goes, one man's trash is another man's treasure. And while investors and folks at Ford Motor Company (F -0.41%) alike will hate that phrase in regard to the Lincoln brand, there is some truth to it. Consider that until recently Lincoln sales were in a steep and unrelenting downward spiral since the brand's peak in the late 1990s. Ironically, despite its slowing sales and its vehicle innovation stagnating in the U.S. until recent years, Lincoln's brand image is highly regarded in China.

"It's different in the U.S. than in China," Kumar Galhotra, head of Lincoln, said of the brand's standing in a January interview with Bloomberg. "In China, our heritage plays very strong. Our favorable opinion in China is actually ahead of Lexus and on the factor of prestige, we're actually ahead of Audi."

Because of that, and the fact that China's luxury auto market is expected to overtake the U.S. to become the largest in the world sooner rather than later, there are some serious changes being considered with Ford's luxury lineup.

To import, or not to import

Naturally, producing vehicles in a multitude of different markets across the globe comes with challenges distinct to each market. In China, for instance, the automakers have a decision to make when it comes to production versus import. On one hand, if you produce vehicles in China, you can avoid a 25% tariff that comes with importing vehicles. But that comes with a catch: To produce vehicles in China, you must partner up with a Chinese company to form a joint venture.

Ford has a joint venture, CAF, to produce non-premium passenger vehicles, in which it has a 50% equity investment. It also has two similar joint ventures, JMC and CFME, which produce trucks and commercial vehicles, and engines, respectively. Ford has a 32% equity investment in JMC and a 25% equity investment in CFME.

Meanwhile, as Ford is gearing up to accelerate sales of its luxury Lincoln lineup in China, it's currently paying the import tariff but reaping 100% of the rewards for those vehicles. That's working so far, but Lincoln's story in China is still in the early stages. If it's going to turn into a major player, the automaker will need to produce vehicles in the region.

Here is a good sign for investors hoping for Lincoln's success to take off in China: It appears Ford is already discussing with its Changan Automobile Group partner about producing Lincolns in Chongqing as soon as 2018.

Why does this matter?

This is an important development for a couple of reasons. Obviously, sales of luxury vehicles represent higher transaction prices and juicier margins for automakers, and have the advantage of not cannibalizing an automaker's non-premium vehicle sales. In addition, Ford potentially producing Lincoln vehicles in China means the company will have the flexibility to produce more vehicles in a scenario where demand for luxury vehicles surges.

Here are a couple of interesting statistics to ponder.

According to the China Automobile Dealers Association, the vast majority of Chinese consumers purchase vehicles with cash, and only 17% of China's auto sales were financed with loans. The picture here in the U.S. is much different, with nearly 85% of consumers financing their vehicle purchases in recent years. Also, according to the Dealers Association, profit margins for the 100 largest dealerships in China dropped to 1.22% last year. 

With such low profit margins, it's not hard to imagine a scenario where dealerships begin to push luxury vehicles -- rather than less profitable alternatives -- to consumers through financing. That would help dealerships in two ways: producing incremental profit from financing and loans as well as selling the more profitable luxury vehicles.

Also, while it's no guarantee that the culture around debt and vehicle purchases in China will change, it's not unthinkable that as China's middle class grows it will follow a trend in taking on more debt for consumer products such as vehicles. If that happens, it could unleash many untapped luxury car buyers, and without a manufacturing presence in the region, an automaker like Ford could miss out on the opportunity to boost sales and grab valuable market share with its luxury brand.

Ultimately, investors hope that Ford can turn its business in China into a solid second pillar of revenue and profits. The company has definitely taken steps in the right direction over the past couple of years, and Ford's pre-tax profits were up 110% in its Asia-Pacific region in the first quarter on an 18% rise in revenue. A key part of that going forward will be Lincoln's success in China, where the brand remains a diamond in the rough.