A year ago, General Motors (GM 2.19%) seemed to face major problems in China: its second-most important market. At that time, the General had posted year-over-year sales declines in China for five consecutive months. Sales rebounded in late 2015, but growth ground to a halt again during the first quarter of 2016.
Since then, GM has been on a tear in China. In September, it continued a string of double-digit sales increases in the Middle Kingdom. Some of these gains represent real improvement, but GM's return to strong growth in China could prove to be fleeting. Even so, investors shouldn't be worried about the company's future in China.
GM gets back on a growth path in China
Through the first three months of 2016, General Motors had posted a paltry 0.2% year-over-year increase in vehicle deliveries in China, well below its medium-term target of 3%-5% annual growth.
However, GM got back on track in April, posting a 7.5% year-over-year increase in deliveries, and sales have strengthened from there. For the past five months, GM has delivered consistent double-digit gains in China.
As a result, deliveries are now up 9% year to date. The Cadillac luxury brand has fared particularly well. In September, it posted its third consecutive sales increase of more than 50%.
Government incentives and easy comparisons are helping
Government sales incentives are a key reason behind GM's improving performance in China. In late 2015, China temporarily cut its sales tax from 10% to 5% for vehicles with engines of 1.6 liters or less. More than 70% of the vehicles sold in China qualify for the tax break, according to The Wall Street Journal. Not surprisingly, this has stimulated auto sales in 2016.
Easy comparisons are also helping General Motors post strong growth. GM's sales in China declined for every month from May to September in 2015. It's no coincidence that GM started recording double-digit sales gains in May of this year and has done so for every month since then.
This suggests that GM's growth will slow down in the coming months. (Indeed, GM executives acknowledge that sales in China have dramatically exceeded their expectations this year.) GM will face tougher year-over-year comparisons starting this month. Moreover, the 5% tax break is set to expire at the end of 2016, which would probably lead to a downturn in demand next year.
With economic growth slowing in China, its government seems eager to prop up the auto industry. Thus, it's possible that it will extend the current tax breaks. However, most analysts think that China will allow the sales tax for small vehicles to increase to 7.5% in 2017, less than the "normal" 10% rate but higher than the 5% rate currently in place.
What does it mean for GM?
Assuming that the sales tax on smaller vehicles does rise from 5% to 7.5% (or higher) next year, GM will be hard-pressed to post sales growth in China. Still, with GM on pace to sell nearly 4 million vehicles in China this year, a year of flattish deliveries wouldn't be a disaster.
To keep deliveries flat in a tougher sales climate, General Motors will lean on improvements to its product portfolio. Most importantly, it is continuing to steadily roll out new SUVs in China to meet rising demand for larger vehicles. GM may also have to offer more discounts in price-sensitive market segments, which could pressure profitability.
Fortunately, the growing success of Cadillac in China gives GM an opportunity to offset this potential margin pressure. Cadillac set an all-time record for monthly deliveries in China last month, and customers seem to love its new XT5 crossover.
Not surprisingly, automakers earn higher margins on luxury vehicles than on mass-market cars. Furthermore, the Chinese luxury vehicle market isn't benefiting from big tax breaks this year, so there is less risk of a sales slowdown in 2017. If Cadillac maintains its momentum in 2017 and beyond, GM should be able to keep churning out big profits in China.