Profit Margins Shrink as Automakers Charge into India

As they prepared to launch their first small car designed for the Indian market, Toyota (TM) engineers knew they had to do some things differently. India is one of the world's hottest auto markets—and it's also one of the most competitive. So Toyota needed to design its new India compact, called the Etios, to attract India's increasingly affluent middle-class consumers who have plenty of other options for low-priced cars. "When you have at least 10 to 12 other manufacturers eyeing the same segment," explains Sandeep Singh, a deputy managing director at Toyota in India, "you will be under pressure in terms of pricing." That's where Yoshinori Noritake, chief engineer of the Etios, stepped in. He and his team of Toyota engineers decided to rethink some basic systems to lower prices. For instance, a typical air conditioner in a Toyota car uses six major parts, with 12 workers in the factory needed to put them all together. For the Etios, which Toyota will launch later this year, the air conditioner has just four parts and needs just four factory workers for assembly. "India is a price-sensitive market [so] we made sure we designed the car by reducing the number of components needed," says Noritake. With sales in the U.S., Japan, and Western Europe slumping, India is a market Toyota and other automakers can't ignore. At the India Auto Expo, a weeklong show that closed on Jan. 11, automakers like Honda (HMC), Volkswagen (VOW:GR), and General Motors unveiled new cars they plan to launch in India. With good reason: Per capita income has doubled from 2003, rising to $1,700 in the year ended March 2009. Car Sales Up 19%As incomes rise, the auto market is growing quickly. Car sales rose 19% last year, to 1.4 million, according to a Bloomberg News calculation of data released by the Society of Indian Automobile Manufacturers on Jan. 8. That puts India well behind China, which last year became the world's top market, ending a century-long reign by the U.S. Still, India is now Asia's third-largest market, topped only by China and Japan, and by 2014, annual sales of light vehicles (including cars and light commercial vehicles) will exceed 3 million, according to a report by Ernst & Young that cited a forecast by Global Insight. That's up from 1.96 million in 2008. The growing competition is already putting the heat on market leader Suzuki (7269:JP), the Japanese automaker that has long dominated India through its local subsidiary, Maruti Suzuki (MSIL:IN). Tata Motors (TTM) last year launched the most high-profile salvo with its low-priced Nano, with a price tag of around $2,500. Toyota hasn't revealed the price yet for the Etios, but the hatchback version is likely to compete with Suzuki's Swift, which sells for $8,800. An Etios sedan will likely compete with Suzuki's Dzire, which sells for as low as $10,200. Even VW, which is buying a 20% stake in Suzuki, is competing with the market leader by selling its low-cost Polo starting in March. "We are feeling very high pressure" on prices, concedes Shinzo Nakanishi, managing director of Maruti Suzuki. That sort of price pressure means automakers will no longer be able to count on fat profits from their Indian operations. Typically, India has been a good place to sell cars, with profit margins of around 12%, says Mahantesh Sabarad, an analyst in Mumbai with Centrum Broking. That compares with 8 to 9% elsewhere, he says. Because of the influx of new passenger cars designed for the Indian market, Sabarad sees companies boosting spending on incentives and discounts, with profit margins therefore falling to what they are globally. Automakers "will have to live with a lower profit margin in India," he says. Dealing with Profit ErosionFor many foreign players, the goal is to minimize the profit erosion. Honda, for instance, aims to lower its costs by increasing the amount of parts and raw materials it buys in India. "To be competitive, we need local procurement more than before," says Koichi Kondo, executive vice-president of Honda. The Japanese company plans to boost the amount of steel it buys locally, for example. The new small car that Honda will begin selling in India next year will be more than 80% locally sourced, about 10 percentage points higher than the Honda City, one of its most popular Indian cars. As a role model, Honda might look to Hyundai. The Korean automaker has pursued localization aggressively and Arvind Saxena, a director of Hyundai India, boasts the company's Santro hatchback is "92% to 93% localized." Hyundai is No. 2 in the market, behind only Suzuki, and that size means "I can localize because I have the volume and a huge network of vendors," says Saxena. Hyundai now is looking to expand that vendor network further. The company has dealers in close to 260 Indian cities and aims to reach 310 by yearend, Saxena says. There's only so much automakers can do to maintain margins, though. In the crowded Indian market, "competition can easily imitate the steps you are taking," says Centrum analyst Sabarad. "Profit margins will slip regardless." Even an optimist like Hyundai's Saxena admits there's no escaping the price pressure that all automakers in India are facing. "Yes," he concedes, "profitability will be thinner than what one enjoyed five years back."