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Strong Euro, CO2 Regs, Burgeoning East Set European Agenda in 2007

Executive Summary

Eastern Europe was emerging as a bigger player in the capacity expansion plans of many Western vehicle manufacturers, with Russia, in particular, seen destined to become Europe’s biggest market by the next decade.

Special Report

2007 Year in Review

European auto makers ultimately may view 2007 as the calm before the storm.

Markets held tough, with sales in Western Europe flat with 2006 levels and Eastern Europe collectively providing the industry with a little positive momentum.

But the wheels were very much in motion on a number of fronts expected to have near- to long-term impact on the industry.

The euro’s growing strength vs. the U.S. dollar was taking an increasing toll on profit margins for those auto makers heavily reliant on the export market for revenue, and several were beginning to eye new capacity in North America as a way to compensate.

Eastern Europe also was emerging as a bigger player in the capacity expansion plans of many Western vehicle manufacturers, with Russia, in particular, widely seen destined to become Europe’s biggest market by the next decade.

And all auto makers found themselves under the gun from pending tougher carbon-dioxide regulations forcing development of more fuel-efficient vehicles by 2012 and driving several into collaborative relationships designed to curb development and production costs.

Western Europe finished 2007 with passenger-car deliveries totaling 14.79 million units, a 0.8% gain on 2006’s 14.67 million. The big winners were BMW AG, which enjoyed a 7.7% rise to 834,000 units, and Fiat Automobiles SpA, up 6.7%, according to data from the ACEA, the European car manufacturers’ association.

Related document: Western Europe Sales - December 2007

Japanese auto makers continued to pile up ground, however. Honda Motor Co. Ltd. notched a 10.4% increase on volume of 278,000 vehicles, while Suzuki Motor Corp. sales soared 14.5% to 235,000. Mitsubishi Motors Corp. deliveries jumped 9.6% to 125,000.

Toyota Motor Corp. enjoyed a 3.0% rise to 860,000 and was targeting 5% growth in 2008 and a 5%-10% gain in 2009.

Other key Japanese auto makers, as well as South Korea-based Hyundai Motor Co. Ltd. suffered declines, but overall the Asian companies accounted for 17.0% of the West European passenger-car market, up from 16.7% in 2006.

As a group, the French appeared to take the biggest hit, as flat sales at PSA Peugeot Citroen and a 5.5% drop at Renault SA translated into a 0.7-point decline in passenger-car market share during the year.

The intensifying competition had European-based auto makers looking East. Among countries posting solid sales gains in 2007 were Czech Republic (up 6.9%), Latvia (26.8%), Romania (23.1%) and Slovenia (12.1%), though overall volumes remained low.

“Central and Eastern Europe have been strong,” noted Walt Madeira, manager-European sales analysis for CSM Worldwide. “Going forward, we’re seeing double-digit growth.”

Overall, Global Insight Inc. was forecasting light-vehicle sales in Eastern/Central Europe to grow from an estimated 5.4 million in 2007 to 6.6 million by 2010. By then the region would account for 27.9% of the European market overall, up from 24.6% today, the firm said.

Russia in particular was eyed as a critical future engine of growth, as sales shot up 36% in 2007 to 2.4 million vehicles and Western auto makers were scrambling to establish production bases in the country.

“By 2012, Russia will overtake Germany and Italy to become the biggest market in Europe,” declared an Ernst & Young report.

Perhaps the biggest deal was the one Renault closed in February 2008 to purchase a 25% stake in Russia’s OAO AvtoVAZ for $1 billion. The pact, signed in December, wrapped up a bidding war in which Renault beat out General Motors Corp. and Fiat for the Russian auto maker. Plans called for Renault to supply engine and transmission technology to AvtoVAZ and sell Lada-brand vehicles internationally.

But Renault wasn’t the only one making capacity plays in the burgeoning market.

GM moved to more than double the original capacity planned for its assembly plant under construction in St. Petersburg, Russia, to 70,000 units annually.

Targeted to launch production at the end of 2008, the facility was slated to build Chevrolet Captiva cross/utility vehicles and a new generation of small cars.

GM was investing $300 million in the new plant, which was seen as a complement to the auto maker’s joint venture operations with AvtoVAZ in Togliatti, Russia, and ZAO Avtotor in Kaliningrad, Russia.

Renault partner Nissan Motor Co. Ltd. and OOO Suzuki Auto Mfg. Rus also began work on new assembly lines in Russia slated to start producing vehicles in 2009. Nissan had plans to assemble 50,000 vehicles (X-Trail CUVs and Teana sedans) annually in Russia by 2009, while Suzuki was slated to build a 50/50 JV plant with Japanese trading house Itochu Corp. in St. Petersburg, with start of Grand Vitara CUV production scheduled for second-half 2009.

Ford Motor Co. was in the midst of expanding its Vsevolozhsk Focus operations to add its bigger Mondeo sedan to the mix and boost capacity 74% to 125,000 vehicles by 2009.

In December, Hyundai picked St. Petersburg as the site of a new $400 million, 100,000-unit capacity plant, while Mitsubishi moved in on a deal to add Russian capacity of its own, possibly in a JV with PSA.

The year’s final month also saw Toyota open its first Russian assembly plant. The $200 million St. Petersburg facility was tooled for 50,000 vehicles annually, with first-year output of Camry midsize cars targeted at 20,000 units.

“We are hoping that one day the plant will produce 200,000 to 300,000 units per year,” Toyota President Katsuaki Watanabe said during an opening ceremony at the facility. “Then we can start considering production of budget-class cars.”

China’s Chery Automobile Co. Ltd. in early 2008 disclosed plans to acquire a former Kia Motors Corp. plant controlled by Russia’s SOK Group for $422 million. The facility was sized for 300,000 vehicles annually. Russia already was Chery’s biggest export market, with reported sales of 37,100 vehicles in 2007.

The expanding market was being fueled by increasing availability of credit. Auto makers with their own finance arms in Russia included Nissan, Mercedes-Benz and Toyota, with BMW and PSA promising to begin to offer services in 2008.

Ernst & Young reported that 48% of all vehicles sold in Russia in 2007 were financed, with average loans approaching $15,000.

But whatever growth there was to be had eastward wasn’t enough to offset the downward pressure on profits as a result of a weakened U.S. dollar, the effects of which only intensified as 2008 began to unfold.

“We expect the euro to keep appreciating through mid-2009, and we think it is headed for $1.50,” a prescient Nariman Behravesh, chief economist for Global Insight, warned in the fall.

The euro-dollar exchange rate reached €1:$1.48 at year’s end, with the gap continuing to widen in early 2008.

Among auto makers studying the possibilities for new production beachheads in the U.S. were Germany’s Volkswagen AG and Audi AG and reportedly Italy’s Alfa Romeo Automobiles SpA.

“We clearly have to consider a production location in North America,” Volkswagen of America Inc. CEO Stefan Jacoby told analysts earlier in the year. By April 2008, VW had narrowed the potential plant locations to three states: Alabama, Tennessee and, surprisingly, union-stronghold Michigan. It promised to pick a winner by mid-2008.

BMW already was in the midst of expanding its South Carolina operations from 140,000 vehicles annually to 240,000 by 2012, and Sweden’s Volvo Car hinted it might consider sourcing vehicles from parent Ford’s U.S. network of plants as a currency hedge.

Cost pressures also had auto makers looking to shore up operations closer to home.

In September, BMW signaled it would cut headcount as part of a belt-tightening program, following through in early 2008 with elimination of 8,100 jobs worldwide, most of those temporary positions and all but 600 in Germany. The plan was to be completed without layoffs for fulltime employees, the auto maker said.

The goal was to boost its bottom line in three key areas by 2012, including achieving a return on capital employed of 26%, an increase of 8%-10% in return on sales for the automotive business and an overall €6 billion ($9.1 billion) reduction in costs.

The biggest portion of that €6 billion in savings – €4 billion ($6.1 billion) – was to come from cuts in materials purchasing, now totaling €25 billion ($37.8 billion), the auto maker said.

BMW didn’t detail how it would achieve those savings, though in October it established a new Purchasing and Supplier Network division “primarily responsible for lowering material costs” under the direction of Management Board Member Herbert Diess.

Much of the remaining €2 billion ($3 billion) in cost cuts was to come from the staff reductions and continued productivity improvements, BMW said.

The overall job cuts were needed because BMW continued to improve its productivity and because it expected slower sales growth over the next few years. However, its target of 1.8 million car and light-truck sales annually by 2012 still marked a 20% gain from 2007’s 1.5 million vehicles.

The plan also called for some investment and new hiring. BMW said it would open up 500 new positions in engineering and information technology in 2008.

BMW wasn’t alone in attacking the cost side of the equation. PSA set a goal of slashing 7,000-8,000 jobs in 2007, including 4,800 in France. And like BMW, PSA was focused on cutting procurement outlays, in part by switching some sourcing to lower-cost countries.

PSA said it spends 87% of its €23 billion ($35 billion) parts budget in Europe, but by 2010 was targeting a reduction to 75%.

More OE-to-OE cooperative deals also took hold in 2007 as auto makers looked to trim development costs, particularly where expensive, more fuel-efficient powertrains were concerned.

BMW and PSA announced in February they would expand their engine co-development program, adding a 1.4L derivative of their 1.6L engine used by BMW’s Mini brand and the Peugeot 207. Production ultimately was expected to reach 1 million engines, including about 200,000 to be built at the Mini factory in the U.K. and 800,000 under the direction of PSA.

Work also was said to be under way on more 4-cyl. engines, reportedly including a 2L. BMW said the joint program saved it 10%-20% of the cost of development, with even larger savings coming from shared parts sourcing.

“We get much better pricing on 1 million engines per year than Mini would get by itself,” noted Erich Sonntag, BMW product manager-Mini engine family.

Similarly, Fiat and Daimler AG linked up on development of light-duty diesel engines. The deal called for Fiat to supply 80,000 3L powerplants to Daimler subsidiary Mitsubishi Fuso Bus & Truck Corp. beginning in 2009.

GM went to Italian engine specialist VM Motori SpA for a new 2.9L diesel to be installed in its Cadillac CTS car for sale in Europe beginning in 2009. GM officials said they decided to tap VM Motori because their own engineering resources were stretched too thin and VM’s flexible manufacturing operations were better equipped to build the low-volume diesel.

Ford, meanwhile, appeared destined to have closer ties with India’s Tata Motors Ltd. – at least near-term, agreeing to sell its U.K.-based Jaguar Cars and Land Rover operations to Tata early in 2008. Ford put the marques on the block in June 2007 as part of a restructuring and recovery program designed to sharpen its focus and zero in its investment on its core Ford-brand operations.

Under the deal, Ford was to continue supplying the two brands with powertrains, stampings and other components, in addition to a variety of technologies. It also would provide engineering support, including research and development, information technology and other services.

Ownership change also was under way at Volkswagen, with the much smaller Porsche AG taking a controlling stake in Germany’s biggest car maker. The fallout from that, including a power struggle at the very top, continued into 2008.

But the biggest hurdle that faced auto makers as 2007 wound down may have been the pending emissions legislation that threatened to reshape the new-vehicle market and pressure profitability.

And although the European Union was still putting the final touches on new rules to limit carbon-dioxide emissions after 2012, the “Green” movement – backed by advertising encouraging consumers to keep tires inflated and avoid revving their engines in the name of clean air – already was having an effect on the market.

SUV demand was growing at a slower rate, analysts said, and the mix was shifting more to diesel power, particularly in the U.K., where graduated, carbon-based vehicle excise duties already were on the books and stretched out through 2011. For example, a gasoline-powered vehicle that produced up to 120 g/km of CO2 was subject to a tax of £40 ($82), while one emitting 168-225 g/km was taxed at £190 ($388).

“There’s been strong growth with SUVs, but we’ve softened our forecast going forward due to the (upcoming CO2) legislation and anti-SUV sentiment in general, particularly in the U.K.,” CSM’s Madeira said.

Conversely, small-car demand was expected to continue gaining, thanks in part to a bevy of new products.

“Small, A-segment cars, led by the new Fiat 500, are exploding,” Madeira said. “That’s a segment that had been dormant for awhile until manufacturers began to pay attention to it again,” he added, pointing to the Toyota Aygo, Citroen C1 and Peugeot 107 launched in 2005, the revamped Renault Twingo and Smart Fortwo and upcoming restyled Ford Ka, plus new entries that were expected from Toyota and Honda.

Nigel Griffiths, group management director for Global Insight, said the end to the vehicle upsizing movement of recent years already was at hand in Europe, pointing to cars that were becoming smaller and/or lighter, such as the third-generation Mazda2, which chopped a few centimeters off in overall length from its predecessor.

In February, Peugeot Automobiles declared it would insist that all new vehicles developed be lighter than outgoing models, taking advantage of lighter-weight plastics for body panels, for example.

“We will keep improving motors and reducing friction,” declared Bruno de Buibert, Peugeot’s director of product and markets. “But weight is the most important factor in fuel consumption in urban driving.”

Longer-term, Griffiths said, the tightening emissions requirements – along with an EU-wide proliferation of U.K.-type CO2-based tariffs by 2010 – will cause additional shifts in consumer buying patterns.

“Car makers may have to change their products,” Griffiths said, predicting the “decay of the SUV trend after 2012” and a similar decline for the too-heavy multipurpose vehicle, or MPV, sector.

“There’s a wedge being driven between car makers and their customers by the tax structure,” he said.

The trick for survival will be to find a way to make money from fuel efficiency.

“The problem is, the industry is making its biggest profits on (the largest, highest-powered vehicles),” Griffiths pointed out. Most manufacturers “will have to transform their business models or their profitability will be decimated.”


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