Russian automotive market update: what would be the real cost of sanctions?

Russian automotive market update: what would be the real cost of sanctions? Moscow/Munich, September 2014 Amy Walters / Fotolia

Management summary > With 12% decline in the first eight months of 2014, Russia is in the middle of our pessimistic market scenario, which we developed in May 2014 Quick return to growth path is not expected > Potential sanctions against the automotive industry create additional pressure and uncertainty > Roland Berger analyzed three scenarios for potential sanctions, ranging from an increase in duties for vehicle imports from EU/US to a full import embargo on vehicles from EU/US > Conclusions of this analysis: Market volume would decline in each scenario due to higher prices and lower variety of vehicles An import duty increase is the only sanction that is advantageous for Russia though the overall impact is limited Import embargos on EU/US vehicles for part of the fleet or in full damage the Russian state 3x more than affected OEMs and result in up to EUR 1.4 bn lower state budget income The only winners of such import embargos would be Asian OEMs Impact on Russian OEMs limited > Instead of sanctions, we recommend the Russian state should rather address two main issues: Long-term stable and attractively high market volume Cost-competitive local vehicle production > Nonetheless, the potentially affected OEMs should consider sanctions as a possible scenario in their strategic plans and be prepared with proper mitigation strategies 2

The Russian automotive market continues to be in crisis mode, further decline expected Light vehicle 1) sales development in Russia, 2008-2014 Sales 2008-2014 [m cars] Sales Jun-Aug 2014 ['000 cars] 3.0 2.7 2.9 2.8-6% -2% 0% -8% -12% -17% -23% -26% 1.5 1.9 1.0 1.8-20% -12% 2.4 0.8 1.6 September- December January- August 153 206 243 227 201 199 181 172 2008 2009 2010 2011 2012 2013 2014F Jan Feb Mar Apr May Jun Jul Aug 1) Light vehicles include passenger vehicles and light commercial vehicles Change vs. Jan-Aug 2013 Source: AEB, Autostat 3

Almost every OEM in Russia is facing dropping sales volumes Sales of major brands in Russia, Jan-Aug 2014 vs. Jan-Aug 2013 [%] 32 24 23 124 85 82 56 43 40 123 103 103 46 31 29 247 42 26 16% 18% 15% 1% -5% -3% -10% -2% -5% -7% -18% -19% -20% -18% -20% -20% -27% -43% Premium Volume EU/US Volume Asian Russian Jan-Aug 2014 vs. Jan-Aug 2013 XX Sales in Jan-Aug 2014 ['000 vehicles] Source: AEB 4

Russia is on the path of our pessimistic scenario Quick return to growth track is not expected Roland Berger sales scenarios, 2012-2020 [m units] > Until recently, positive development of automotive market in Russia expected > Sales forecasts exceeded 4 m vehicles by 2020 > In May 2014, Roland Berger published a study "Russia at the crossroads" and developed updated market scenarios, taking into account: Weakening macroeconomics Implications of Russia's WTO accession Emerging Crimea crisis > Since then, the situation has worsened > Russia is currently following our pessimistic case > Quick return to growth track is not foreseeable 3.6 3.3 3.0 2.7 2.4 2.1 1.8 1.5 Light vehicle sales 1) [m units] 2.9 2.8 2.5 2.5 2.4 2.7 2.2 2.5 Base case 1.2 2012 2013 2014 2015 2016 2017 2018 2019 2020 2.9 2.5 Optimistic case Pessimistic case 2.8 3.1 2.6 2.9 3.2 2.7 3.0 3.4 2.8 3.1 FORECAST 3.6 3.2 2.8 1) Light vehicles include passenger vehicles and light commercial vehicles Source: IHS; Roland Berger estimates and analysis 5

The ongoing conflict and exchange of sanctions between EU/US and Russia put additional pressure on the automotive market Key events of Russia-Ukraine crisis and resulting sanctions March May August September Referendum, held in Crimea in March 2014, resulted in the accession of Crimea to Russia in April 2014 1st ROUND OF SANCTIONS > Sanctions against Russian individuals (first Russian and Crimean officials) by the EU and US > Sanctions against Russian entities (banks owned or controlled by government) by the US > Sanctions against selected US and EU citizens (lists are not disclosed) at the end of March > Restrictions on the operations of global payment systems in Russia Start of military conflict in Donetsk and Lugansk regions of Ukraine 2nd ROUND OF SANCTIONS > Sanctions against Russian individuals (state officials, businessmen incl. Rotenberg, Timchenko) by the US and EU > Sanctions against companies (largest banks, oil, defense companies) by the US > Extension of the list of people who are banned from entering Russian territory Boeing 777 passenger plane shot down. Further escalation of the situation in Eastern Ukraine 3rd ROUND OF SANCTIONS > Sanctions against Russian companies (oil, infrastructure and defense, dual-use technology, Crimean companies, banks incl. Bank Moskvy, VTB, Rosselkhozbank) by the US and EU > Extension of the list of banned individuals by the EU > Embargo on selected agricultural products from the countries that imposed sanctions on Russia RETALIATION BY THE RUSSIAN FEDERATION? Claims of presence of Russian troops in Ukraine. No significant de-escalation despite truce. Gazprom's gas threats 4th ROUND OF SANCTIONS (from September, 12) > Restriction of access to the capital markets for oil & gas companies (Gazprom, Rosneft, Transneft) and defense firms (UAC, UVZ, Oboronprom) > Tightening of access to long-term funding for Russia's largest banks > Broadening the ban on sales of dual-use technologies > Asset freezes and ban on visa issuing for Russian officials ESCALATION OF CONFLICT -? Source: EUR-Lex, US Department of Treasury, press 6

Sanctions directly against the automotive industry are potentially the next countermeasures in response to new sanctions from the EU/US Selected quotes of Russian officials Possible areas of future sanction policy > Restrictions on imports of industrial goods (especially cars, ships, aircraft) > Prohibition of transit flights and flights within Russian airspace > Embargo on household chemical goods imports > Embargo on fashion and textile products imports " There are a number of consumer goods where our European partners are more dependent on Russia for example, car imports Andrei Belousov, Russian Presidential Aide " " It is not inconceivable that in the nearest future the government will consider measures restricting the import of light vehicles costing less than 800,000 rubles (~EUR 17 k) " Vladimir Gutenev, 1st deputy chairman of State Duma industrial committee " We are potentially ready to introduce protective measures in aircraft, shipbuilding, automotive and other industries Dmitry Medvedev, Russian Prime Minister " " One of the potential sanctions is the complete or almost complete restriction of car imports from unfriendly states " Federal official Source: Press 7

We analyzed three basic scenarios for possible sanctions against vehicle imports from Western countries (EU/US) Overview of potential scenarios relating to sanctions in the automotive industry 1) ECONOMIC IMPACT High Low Scenario 1 Increase of CBU import duties (+10%) 2) Scenario 2 Embargo on CBU imports (<EUR 30 k) 3)4) Scenario 3 Embargo on all CBU imports 3) Scenario 4 Subsidies elimination Scenario 5 " if sanctions are taken, then only to provide better conditions for ourselves" Vladimir Putin Russian President Import embargo on components Basic scenarios further evaluated > Damage to Western producers/governments > Stimulation of domestic production > These or similar measures are therefore possible Extreme scenarios not considered further > Significant negative impact on domestic automotive industry > Likely to be avoided by the Russian government 1) Sanctions only evaluated for light vehicles. Similar sanctions may be introduced for commercial vehicles, additional further sanctions with minor impact possible 2) Assumption: 10 percentage point increase for CBU imports from EU/US 3) Imports from EU/US 4) 30 k retail price in EUR, including VAT 8

The case study of Iran suggests that production-related sanctions are likely to be avoided Example: Impact of sanctions on the Iranian automotive industry SANCTIONS Prohibition of the sale, supply or transfer to Iran of goods or services relating to the automotive industry supported by the EU (since March 24, 2012), US, Japan and South Korea (since July 1, 2013) COST INCREASE > Due to restricted supply from South Korea (supplied >60% of all components), OEMs' production costs increased by 40% PRODUCTION DECLINE > Foreign OEMs (PSA, Renault, Fiat, GM, Hyundai, Toyota) decided to adjust capacity/ production volumes due to cost increase and lack of specific components > 20% of 860 component suppliers in Iran halted production DEMAND DECLINE Production of LV in Iran ['000 vehicles] 1,649 2011-52% 794 2013 > The market dropped by 35-40% due to the price increase and limited supply Source: US Department of Treasury, OICA, press 9

Key assumptions for assessing the impact on the market, OEM profits as well as the Russian economy developed Overview of key assumptions Reduction of EU/US imports of which replaced Split of replacements: EU/ US Asian brands brands Russian brands Additional assumptions Scenario 1: Increase of import duties Scenario 2: Embargo on CBU imports (<EUR 30 k) Scenario 3: Embargo on all CBU imports Retail price [EUR '000] <30 1) 40-80% 80-100% 50-70% 10-40% 0-10% >30 10% 20% 50% 50% 0% Retail price [EUR '000] <30 1) 100% 60-80% 50-70% 10-60% 0-10% >30 0% Retail price [EUR '000] <30 1) 100% 60-80% 50-70% 10-60% 0-10% >30 100% 40% 50% 50% 0% > Profit contribution per vehicle: < EUR 30 k: EUR 1,000-2,000 > EUR 30 k: EUR 5,000 > Avg. vehicle price: < EUR 30 k: EUR 12,500-22,500 > EUR 30 k: EUR 50,000 > VAT 18% > Scrappage fee: EUR 500 per vehicle 1) For calculation purposes split into two price categories: <EUR 15 k and EUR 15-30 k Source: Expert interviews 10

In the event of a full import embargo, there is a risk that there will be no substitution for up to 50% of affected vehicles Overview of sanction effects on the market [m units] Scenario 1: Increase of import duties Scenario 2: Embargo on CBU imports (< EUR 30 k) Scenario 3: Embargo on all CBU imports Total market, 2015 (pessimistic case) Import reductions from EU/US Affected volume Affected volume Affected volume 230 2,240 230 2,240 230 70 135 230 2,240 Replacement by Local EU/US production 30 Russian brands 1 Asian brands 25 40 1 40 60 1 60 Total market after sanctions 2,226 14 k 2,186 54 k 2,131 109 k Price increase and shift in market shares Majority of affected volume substituted Lower variety of supply Delayed purchases and partial switch to Asian brands Significantly lower variety of supply Delayed purchases, especially in > EUR 30 k segment 11

EU/US OEMs could lose about EUR 550 m, while Asian OEMs emerge as key winners; limited impact on Russian brands Impact on OEM groups Sales in Russia and global profits Scenario 1: Increase of import duties Change in sales ['000 units] Scenario 2: Embargo on CBU imports (< EUR 30 k) Scenario 3: Embargo on all CBU imports 200 150 100 50 0-50 -100-150 -200-250 No impact Asian brands Russian brands EU/US brands 200 150 100 50 0-50 -100-150 -200-250 Asian brands Russian brands Only winner EU/US brands 200 150 100 50 0-50 -100-150 -200 Asian brands Russian brands EU/US brands Only winner Loss of EUR 550 m -800-600 -400-200 0 200 400 600-800 -600-400 -200 0 200 400 600-800 -600-400 -200 0 200 400 600 Change in global profits [EUR m] 12

The biggest loser would be the Russian state: up to EUR 1.4 bn lower budget income under full embargo scenario Impact on Russian budget income [EUR m] Scenario 1: Increase of import duties Scenario 2: Embargo on CBU imports (< EUR 30 k) Scenario 3: Embargo on all CBU imports VAT -90-170 -600 Import duty, volume effect -160-280 -750 Import duty, higher rate effect +300 Scrappage fee -20 Profit tax +15 Employment tax +10 0-50 +20 +15 0-130 +40 +20 Total +55-465 -1,420 Positive, but very low impact Significant loss in tax/duties income Only limited positive impact from higher local production 13

Key take-away: Import embargos are harmful to all sides and should not be introduced Summary of impacts and conclusions [EUR m] Scenario 1: Increase of import duties Scenario 2: Embargo on CBU imports (< EUR 30 k) Scenario 3: Embargo on all CBU imports Budget impact for Russia +55-465 -1,420 Profit loss for EU/US OEMs -100-175 -550 Conclusions > Limited impact of an increase in duties for EU/US OEMs only most likely not worth the effort > Greater short-term and long-term self-damage to Russia though import embargos: Short-term: budget revenue shortages higher than "punishment" effect Long-term: strengthening of Chinese/Asian brands as direct competitors to Russian brands 14

Instead, the Russian state should address two main issues Longterm market stimulation and cost-competitive domestic production Possible measures to support the Russian automotive industry Measures by the state Current status Further steps Long-term market stimulation Costcompetitive domestic production Lifecycle regulation/ other Sales support Support for localization Financing/ hedging > New program introduced in September, including recycling and trade-in compensation (limited impact expected overall) > Age limitation of vehicles in use under consideration > Implementation of age limitation measures > Streamlining of vehicle check-up process to increase quality on the road > In addition: improvement of road infrastructure > Loan rate subsidy program stopped in 2013 > Introduction of sales support mechanisms (especially in rural regions) > Simplification of legal framework for private car leasing/sharing > Review of import duties for select articles under consideration > Provision of state guarantees to Kamaz > Subsidy of loan rate for AvtoVAZ's modernization projects > Long-term increase of import duties on CBUs (for all OEMs) > Support for localization of key raw materials (e.g. automotive-grade steel) > Introduction of a special agency for component clusters development > Reduction in import duties for sub-components > Provision of subsidies for exports > Controlled ruble devaluation 15

In any case, we recommend that EU/US OEMs should adjust their risk profile and prepare for possible sanctions Recommendations for EU/US OEMs What to expect? Market recovery is not expected in the near future, rather a further decline is anticipated Crisis likely to last another 1-1.5 years, further escalation is possible Automotive sanctions even if not economically reasonable are possible Our recommendations Adjust local cost base to new market scenarios Keep production in Russia and increase local content (at low investments) Maintain relations with Russian counterparts/authorities Investigate supply alternatives for imported goods (e.g. from Asia) Examine opportunities for support programs 16

Recommended further readings Russia at the crossroads BRIC study for suppliers Impact of economic sanctions > Derivation of three market development scenarios > Assessment of regulations and cost competitiveness of local production > Implications and action need for key stakeholders > Assessment of market and business environment in BRIC > Implications for supplier growth strategies and funding allocation > Overview of economic sanctions related to Russia > Scenarios for further crisis development > Impact on Germany and selected industries 17

Amy Walters / Fotolia