Why BMW's $1 Billion Investment in Mexico Is Another Sign of Strength

German automaker BMW  (NASDAQOTH: BAMXF  ) recently announced a $1 billion plan to build its first production facilities in Mexico. Located in Mexico's central state of San Luis Potosi, BMW's new plant will be able to produce as many as 150,000 vehicles per year, with production beginning in 2019.

For years, automakers have turned to Mexico for its cheap and efficient labor, friendly trade agreements with numerous countries, and prowess in sourcing and manufacturing. Recently, luxury automakers have demonstrated a stronger interest in Mexico's potential to cut costs and gain better access points to key North American markets, and BMW is helping to lead the charge.

BMW isn't the first luxury automaker to tap Mexico, and it won't be the last
BMW's announcement follows just days after Nissan and Daimler AG's Mercedes unveiled plans for a $1.4 billion joint venture to produce luxury cars in Mexico. In 2013, Volkswagen's Audi began construction on a $1.3 billion facility. Some expect Hyundai to soon announce plans to begin production in Mexico. Nissan, Ford, General Motors, and VW have led the rapid growth in recent years, but the shift to luxury manufacturing in Mexico marks a new era of production for the country.

BMW's long-term growth strategy in North America
The announcement to build in Mexico, joined with plans to expand overall North American production, shows great promise to further penetrate one of BMW's largest markets. In addition, BMW plans to bolster its Spartanburg, S.C., plant with a $1 billion investment to increase capacity for sport-utility vehicles, totaling $7 billion in its sole U.S. plant. By the end of 2016, the Spartanburg plant will increase its capacity by 50% to 450,000 cars. BMW production chief Harald Krueger said, "We are continuing our strategy of 'production follows the market.'"

Mexico is the fourth-largest auto exporter and holds third place in auto exports destined for the United States. In 2013, Mexico produced roughly 3 million vehicles, pushing the country closer to passing Japan as the second-highest auto exporter to the United States. Analysts at consulting firm IHS Automotive expect that Mexico will overtake Canada to claim the top spot in 2015.

According to a report published by Deutsche Bank, demand for light vehicles in the U.S. continues to grow. Light-vehicle sales totaled 15.5 million in 2013 and are expected to reach 16.5 million in 2015. So far in 2014, luxury automakers are on track to sell 11% more vehicles than last year. Furthermore, luxury vehicles are flying off the lot faster than midsize cars, which comprise the largest market segment. As production ramps up in Mexico, luxury vehicles may continue to outgrow larger market segments.

Mexico offers an increasingly attractive landscape for BMW
The recent influx of automakers should come as no surprise, given Mexico's positioning to cement its role a global manufacturing powerhouse. Aside from access to the U.S. luxury market, there are a number of benefits to auto production in Mexico. Favorable trade agreements, low relative labor costs, growing technical experience, and a robust network of suppliers jointly make Mexico an enticing site for production.

Trade partnerships greatly affect manufacturing growth, and the impact of trade agreements on Mexico's manufacturing sector is quite clear. Since the North American Free Trade Agreement was signed in 1994, Mexico has grown its share of North American auto production from 6% to 19%. IHS Automotive estimates that this figure will hit 25% by 2020. Mexico has a dozen free-trade agreements that cover 44 trading partners, including the U.S., Canada, and members of the European Union. To put this in context, the U.S. has agreements with 20 countries. China has 18.

As labor costs rise in China, manufacturers are looking to expand production elsewhere. By 2015, Mexico's manufacturing wages, adjusted for higher relative worker productivity, will probably be 29% lower than that of China. Although productivity in China is steadily rising, there remains a significant gap.

Mark Muro, a policy analyst at the Brookings Institution, explained" "You can't compete solely on labor costs. Mexico is developing a good supply chain and a good enough technical workforce to be very competitive." Indeed, the Mexican government estimates that at least 100,000 Mexicans graduate each year, with degrees to enter engineering and technology fields. The network of suppliers is already substantial in Mexico, and it continues to expand. Roughly 90% of the top global auto-parts manufacturers have production in Mexico.

Expansion at what cost?
Announcements to expand production to Mexico follow in the wake of millions of air bag-related recalls, some of which can be attributed to suppliers in Mexico. In response to a question about cultural differences in production, North American BMW President Ludwig Willisch said:

Clearly adhere to the process, and that's it. It really is about the production process. It doesn't have too much to do with the culture. It really is how you produce cars in the first place.

Naturally, the frequency and magnitude of recalls are, in some ways, indicators of quality. BMW has a strong history of quickly responding to issues. According to a study conducted by iSeeCars, from 1985 to 2014 BMW was the automaker most responsive to issues that merit recalls. BMW also maintained a recall rate below Hyundai, Volkswagen, Volvo, Ford, and others. In other words, BMW has done a respectable job achieving quality control while proactively pursuing recalls when necessary. If quality suffers at the Mexico plant, you can be sure that BMW will respond swiftly.

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