January 1, 2015 — China’s car dealers’ inventory battle with automakers shows the need for strong franchise laws. Also, what do the current challenges in the Chinese automotive market mean for the U.S. and the potential entry by players such as Volvo’s parent Geely or the Warren Buffett-backed BYD Auto? 

The recent spate of stories highlighting the struggle Chinese automotive dealers are having to stay profitable while automakers force them to take on hundreds of additional vehicles highlights the critical role state franchise laws play here in the U.S. market.

With a history dating back to 1917 of defending their business model against manufacturer and government interference, American car dealers are better organized at both the state and national level. Even so, U.S. dealers have some of the same challenges their Chinese counterparts are encountering with automakers pushing inventory to make sales numbers look good. (Read our account of how BMW aggressively plays the “punching” card here in the U.S.).

The Chinese automotive market is still maturing as is its dealer body, which now stands at approximately 22,500 rooftops, up 17,000 just a couple of years ago.

Buoyed by strong growth in recent years, both Chinese and foreign automakers began increasing production and sales targets in in 2013. About the same time, the government began restricting sales in several of China’s big cities in an effort to combat pollution and traffic congestion. The government also began an aggressive anti-corruption campaign which has started to hurt luxury auto sales.

China’s automotive sales growth rate hit 14% in 2013 but fell to 7% in 2014 and likely would have been much lower had dealers been able to push back against manufacturer demands to buy vehicles. It’s expected to drop to its lowest rate in a quarter of a century this year. While automakers are still making a profit, only 30% of their dealers are profitable today, down from 70% in 2010 reports the Chinese Automobile Dealers Association. It’s been a growing problem, but dealers have put up with it because they were still selling cars. Now they are in a position where they have to fight back just to survive. Supply has far surpassed demand leading to bloated inventory levels which are putting many dealers at risk. Even if adjustments are made — and some manufacturers such as Honda and Toyota are working with their dealers to provide more realistic targets — analysts estimate as many as 10% of China’s new car dealers could go out of business in 2015.

For BMW, the numbers look great on the surface. It reported a 17% increase in sales in the first 11 months of 2014, but that number represents how many vehicles BMW dealers were forced to order from the manufacturer. Many of those vehicles are now sitting on dealers’ lots as the average dealer now has about 1.8 months worth of vehicles. BMW dealers apparently have drawn a line in the sand telling the manufacturer they will not order any more new vehicles until BMW lowers its sales targets and begins paying an aggressive incentive to dealers based on the inventory they order.

There will be a shakeout in the Chinese market this year as numerous smaller automakers and weaker dealers will likely disappear from the landscape.

Stronger dealer groups will begin diversifying from new car sales and focusing on strengthening used vehicle and service operations while adding F&I products.

One other note: China appears to be shifting its national focus toward what it calls “New Energy Vehicles,” or NEVs — mainly, fully electric vehicles. Numerous statements from government leaders coupled with emerging policies designed to spur growth in the EV market indicate an area to watch closely.

What are the takeaways for the U.S. market?

1. As big name investors are looking to get into the automotive retail market here in the U.S, in 2015, it’s important for them to realize that manufacturer and dealer business objectives are often not aligned. For the manufacturer it’s more about volume — that’s what drives their profitability. For dealers, it’s less about how many new car sales they can generate and more about managing that line between pricing, floorplan financing and inventory to maintain profitability. Meanwhile, used vehicles and service also play a large role in determining a dealer’s profitability.

For example, one of General Motors’ top selling dealer groups, the Bill Heard organization, went bankrupt in 2008 when it was stuck with too much inventory when credit suddenly became unavailable in 2008. It was a stunning collapse that took less than a month. At the time, we were writing stories of how dealers could sell themselves into bankruptcy. 

2. Those disparate business models is one reason why the state and local associations along with the National Automobile Dealers Association, American International Automobile Dealers Association and the National Association of Minority Auto Dealers are so important today — they exist to defend franchise dealer’s business interests.

A strong retail franchise system is why the the automotive market is so strong in the U.S. It allows independent business owners make the decisions that best for their own companies. If China wants to have an similarly strong market, the balance of power is going to have to shift from the manufacturers to one where the power is more equally shared with their dealers.

3. The challenges in the Chinese market are going to push its entrance into the U.S. market back even further. In recent years, despite talking big, Chinese automakers had little interest in tackling the U.S. market because the opportunities in their own market were so great.

Now the opposite is true. The challenges are going to be so great in the next couple of years, Chinese companies are going to be forced to defend their own turf. Decreasing sales along with growing market share from the foreign players is going to keep Chinese automakers preoccupied on the home front.

Two automakers that have expressed the most interest recently in entering the U.S. market are Zhejiang Geely Holding Group Co, Volvo’s parent, and BYD, a Chinese electric automaker in which Warren Buffett has nearly a 10% stake.

For Geely, the plan has been to leverage the Volvo retail network here in the U.S. to sell Geely-built vehicles by 2016.

But with Geely’s 2014 first-half net profits plunging 22% and November sales falling also 22%, Geely finds itself completely revamping its brand and focusing on becoming more upscale just to remain viable at home. It’s likely any thoughts of coming to the U.S. are being pushed to the backburner.

BYD, meanwhile, a year ago announced it would begin selling four separate models here in the U.S. this year. And then in October, Warren Buffett announced he was acquiring the the largest privately-owned dealer group in the U.S. — the 79-store Van Tuyl Group, creating speculation that perhaps Buffett planned to bring BYD to the U.S. using Van Tuyl.

It’s an intriguing notion, but it’s doubtful Buffett would want to mess with a formula that has turned Van Tuyl into one of the most profitable groups in the U.S.

Meanwhile, BYD is building electric buses for the U.S. market in a factory in California delivering the first two in May 2014.

Two weeks ago BYD’s shares mysteriously plunged nearly 30% on Hong Kong’s stock exchange losing about $1.2 billion in equity, perhaps fueled by unfounded rumors that a major investor was pulling out. Last week the company’s CEO Wang Chuanfu purchased one million shares showing confidence in BYD.

Despite company projections from both BYD and Geely that they’ll be in the U.S. in the next several months, it is unlikely either company realistically will be able to make that happen.

Perhaps there will be news at the auto show in Detroit in 10 days, but it’s doubtful.