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Volkswagen Sets Up To Take Over China With Budget Cars

|Includes: General Motors Company (GM), VLKAY

Volkswagen (OTCPK:VLKAY) is building a new factory in Changsha, part of China's Hunan province. Production at the 300,000 vehicle-capacity plant should begin by early 2016. Considering that last year, General Motors (NYSE:GM) sold 2.84 million cars in China, coming in just ahead of Volkswagen's 2.81 million, the additional capacity provided by the Changsha plant could prove extremely valuable in helping the German auto giant trump General Motors in the world's largest car market.

According to the Wall Street Journal, Volkswagen's new Changsha factory is only the beginning. "Last month, Jochem Heizmann, head of Volkswagen in China and a member of the company's global management board, said that Volkswagen was in negotiations with Changsha authorities as part of the company's plan to build seven new plants in the country." All in all, the company plans to increase its production capacity in China to 4 million vehicles annually.

INCREASED CAPACITY

There are several reasons why opening a plant in Changsha is very smart for Volkswagen. The car manufacturer already has 12 vehicle and component plants in China, but by looking to Changsha it can access a variety of benefits. "The location of Changsha may be a result of Volkswagen's strategy to move production inland to central and western China and its consideration of local policies, which might offer tax incentives to support the investment," said Jia Xinguang, managing director of industry group the China Automobile Dealers Association.

Further, just 2.6 million of the vehicles Volkswagen sold in China came from in-country production. If the auto maker can produce all the vehicles it sells in country, it would save a variety of transportation costs and tariffs. More importantly though, Volkswagen is not building the Changsha plant alone. The project is actually a joint venture between the German car company and the Shanghai-based SAIC Motor, which helps limit the potential downside for both companies. No details have been released as to which models would be produced or how the deal between the two companies is structured.

EXPANDED RISKS

But, it isn't without its risks. While management consulting firm McKinsey said last year that China's passenger car market should grow at an average of 8% per annum through 2020, annual auto sales in the country grew by just 4.3% in 2012 to 19.31 million units. The growth in the market was curtailed by limits various cities in China pose on cars in an effort to reduce traffic congestion and pollution.

Moreover, increasing capacity in China comes at a cost -- plants don't build themselves -- and all this is coming at a time when sales in Europe have contracted for six years straight. As it stands, "China sales are forecast to grow to 37 percent of Volkswagen's global vehicle volume in 2015 from 28 percent in 2010," reports Bloomberg.

"Volkswagen Group said today that sales of its core VW brand rose 5.4 percent in April to 480,900, powered by gains in China which helped offset a weak Europe and a slowdown in other global markets including the United States," reports Auto News Europe. "Through April, deliveries in China, including Hong Kong, rose 20 percent to 783,900, but in the United States, they remained flat at 131,800, falling 0.1 percent," while "VW brand sales in western Europe sales, excluding Germany, fell 7.9 percent to 279,300 in the first four months. In Germany, volume fell 10.9 percent to 180,500 in the same period."

COPING WITH COSTS

In addition to a shrinking European market, Volkswagen has also had a variety of costs with which to contend. The company "last month recalled 384,181 vehicles in China after state television featured complaints about vibrations, loss of power and sudden acceleration in Golfs and other cars," says Bloomberg. "The VW recall may cost as much as $600 million." Then, there is the issue of warranties.

The German car maker agreed last May that it would "extend the warranty for the transmissions to 10 years in China, the carmaker's biggest market, in response to customer complaints," writes Bloomberg. "The standard is two years." Jochem Heizmann, VW's board member for China justified the extreme action. "Customer satisfaction remains a key priority for us, that's why we established a task force with experienced professionals in Beijing," said Heizmann. "We're in a proactive dialogue with all relevant government agencies."

BUDGET CARS

One way that Volkswagen is working to remain relevant is by launching a budget car brand in China, but "expanding into budget cars is not without its risks for a group which makes more than half its 11.5 billion euros operating profit from luxury marques like Audi and Porsche," writes Reuters. "And competitors are not standing still."

"The opportunity looks huge. Global sales of cars priced up to $11,000 are forecast to surge 39 percent to 33.1 million cars by 2020, accounting for about a third of the world market, from 23.9 million last year," reports Reuters. "At the same time, the two largest markets for budget vehicles, China and India, are expected to see sales in the segment increase 44 percent and over 100 percent to 7.02 million and 5.03 million respectively."

But, just because the opportunity is there, doesn't mean the expertise is. "It's difficult for any carmaker to unlearn many decades of engineering," said managing director of research firm IHS Automotive, Deepesh Rathore,, in reference to Volkswagen's "traditional focus" on "technologically advanced vehicles".

CONCLUSION

In other words, it takes time to get used to the idea of manufacturing something inexpensively without sacrificing those attributes for which the brand is known, such as its advanced engineering and superior quality. In addition, by producing a "lesser" version of its popular vehicles, Volkswagen risks diluting its brand image, which could cost the company its more upscale clients down the road.

But that is a couple years ahead.

Right now, Volkswagen is looking good. The stock is trading at $39.60 and expected to hit $45.26 in the next year, and it is priced at only 3.5 times its earnings. With numbers like this, buying in now has little risk, especially for a long position -- just be sure to watch the market for any changes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.