When investors look at automakers such as Ford Motor Company (NYSE:F) and General Motors (NYSE:GM) as investments, one common bullish theme is simply the mouth-watering growth that China represents for new-vehicle sales, which will inevitably fuel revenues for automakers that find success in the country. Think about it: some analysts expect new-car sales in China to top 30 million by 2020, compared to just under 20 million in 2014, whereas the U.S. and Europe are respectively estimated to reach roughly 17.5 million units and between 15-16 million units by 2020. That would equate to China accounting for nearly one-third of every new car sold on planet Earth by 2020 -- that's ridiculous.
Another way to emphasize China's potential is this: at the end of 2013 China had fewer than 100 cars for every 1,000 people, compared to the U.S. and Europe which respectively have 800 vehicles per 1,000 people and 600 vehicles per 1,000 people.
While that growth potential is absolutely tantalizing, and would certainly help fuel revenue and profits for automakers growing in China, it's not nearly as lucrative as many investors believe. Let me explain.
Sales on the cheap!
One of the main reasons behind China not being as profitable as investors would like to believe is the difference in top line revenues, or average transaction prices for vehicles sold. Let's try an exercise here. Last year China's new-car sales were 19% higher than new-car sales in the U.S -- 19.7 million vs 16.5 million. Would you guess that transaction prices in the U.S. were at least 19% higher than in China, for the U.S. market to be more valuable overall in this aspect?
The answer is a definitive yes. China's average transaction price on new vehicles was $20,805, according to TrueCar, which was 66% lower than the average MSRP here in the U.S. at $34,537. That suggests that the U.S. value of new car sales would be around $570.9 billion, compared to roughly $409.9 billion in China -- a gigantic difference.
Part of the reasoning behind that is simply the difference in vehicles sold in the two markets. The top two selling vehicles in the U.S. are two perennial favorite full-size trucks, the F-150 and Silverado, and it's not even close. Those trucks represent significantly higher transaction prices. In fact, Ford's F-150 trumps any luxury vehicle for the number of vehicle sales topping $50,000, with almost a quarter of F-150 sales with a price tag of over $50,000 in 2014, according to estimates by TrueCar.
Looking forward, the gap in transaction prices between the U.S. and China will close, as SUVs and crossovers are quickly catching on with the Chinese consumer -- but for now it's clear that larger vehicles fuel more overall value in the U.S. market than China.
There's also a bigger factor in play for why China isn't as profitable as the U.S. market for automakers.
With the sheer size and growth pace of China's auto market, the country knows foreign automakers are drooling to get a piece of the pie. Because of that, China is only allowing foreign automakers to sell vehicles in China if they form joint ventures with local automakers. The idea is simple: China wants to develop its own automotive manufacturing industry, and what better way than to learn from the best in the world through joint ventures – though that has proven more difficult than China initially thought.
"We have been trying to exchange market access for technology, but we have barely gotten hold of any key technologies in the past 30 years," said Liao Xionghui, vice president of Lifan Industry Group Co., a car and motorcycle manufacturer, according to Bloomberg. "China's auto industry is still in its infancy. How can a two-year-old beat someone in his thirties?"
Each foreign automaker is allowed to partner with up to two local groups, and the biggest reason that China isn't as profitable for foreign autos is because this requires splitting the profit between the foreign automaker and its local partner. If China ever lifts or even loosens its joint venture requirements, look for foreign automakers' profitability to increase rapidly.
Still extremely valuable
While lower average transaction prices and joint ventures are putting pressure on the profits foreign automakers can generate in the region, it will only improve in the years ahead. Consider that luxury vehicles generate higher transaction prices than regular passenger cars often found on China's roads, and that China is expected to surpass the U.S. as the world's largest luxury market as soon as 2016, according to Beijing Business Today. In addition to increasing luxury sales increasing transaction prices, sales of SUVs in China are expected to outpace overall market growth in the years ahead, which will help boost overall revenues and margins for automakers.
While China is still extremely valuable for automakers and their investors, and is a popular bullish theme for automakers, keep joint ventures and average transaction prices in mind before jumping into an investment based on China's impressive unit sales growth alone.