GaveKalDragonomics Special Report

BYD: ’s electric pioneer

September 2009

in cooperation with

GaveKal Dragonomics is pleased to present its subscribers with a detailed investigative report on one of China’s most interesting private companies, battery- and car-maker BYD. The firm is one of the world’s biggest manufacturers of cell phone batteries, and recently diversified into automobiles; its low-priced F3 sedan is China’s best-selling model this year.

BYD leaped into the world’s headlines in 2008 when a Warren Buffet-controlled company paid US$232 million for a 10% stake. Media attention has focused on BYD’s stated aim of becoming a leader in electric car production. Close scrutiny suggests that Buffett’s real interest in the company has more to do with its potential to supply large-scale batteries for storage of electricity produced by renewable sources like wind farms.

BYD thus stands at the intersection of two of the most crucial questions facing investors today:

• Can China produce innovative and globally competitive private companies?

• Will the global energy industry find a replacement for oil as a transportation fuel?

This report was prepared exclusively for GaveKal Dragonomics subscribers by Fathom China, a -based consultancy specializing in detailed company background research.

About Fathom China

Fathom China Ltd. is an independent research company that conducts focused due-diligence investigations on firms and executives in China. Our team of researchers include highly trained former journalists, academics and consultants. Solving Chinese business puzzles is our specialty.

Fathom China was formed by Matthew Forney, who served in Beijing for six years as bureau chief of Time magazine and for three years as an investigative reporter for The Wall Street Journal. Mr. Forney then supervised corporate investigations for Kroll Associates before establishing Fathom China in 2008.

Clients include fund managers, investment banks and firms engaging in mergers and acquisitions. Examples of investigations include the following:

ƒ REPUTATIONAL PROFILING. We discreetly speak with a target company’s suppliers, competitors, clients, former employees, industry watchdogs and other informed sources to create a profile of a firm and its top executives. ƒ CRIMINAL AND LITIGATION CHECKS. Fathom China has access to Chinese databases that may include relevant court cases or criminal indictments. Because such databases are incomplete, Fathom China supplements them with interviews and checks of courthouse records. ƒ MEDIA AND DOCUMENT ANALYSIS. A company’s registration documents may indicate questionable investments, hidden shareholders, family members on a board of directors, related-party transactions and other suspicious business practices. In addition, China’s increasingly profit-minded media often deliver crucial information that overseas readers never see. Fathom China assesses these documents in a way that clients can understand.

For more information, please visit Fathom China’s website at www.fathomchina.com, write to [email protected], or call +86-1390-118-6189.

BYD Company Ltd.

( Stock Symbol 1211)

September 2009

BYD Sept 2009 © Fathom China. Redistribution prohibited. 1

Table of Contents

1 Introduction ...... 4 2 Executive Summary ...... 5 3 BYD Basics ...... 6 3.1 : Uncontested Genius...... 6 3.1.1 Absolute Authority ...... 6 3.1.2 Humble Beginnings ...... 7 3.2 BYD’s Advantages...... 8 3.2.1 Making Manual Labor Cool Again ...... 8 3.3 Imitation as the Highest Form of Battery...... 9 3.4 By the Numbers...... 10 3.4.1 Take Over ...... 10 3.4.2 Margins – Collapse, and Recovery...... 12 3.4.3 Gov’t Helping Hand 1: Grants and Subsidies ...... 13 3.4.4 Gov’t Helping Hand 2: Unsecured Bank Lending...... 13 3.4.5 Manageable Debt ...... 14 3.4.6 Miscellaneous...... 15 4 Traditional Cars ...... 16 4.1 Traditional Car Market - Fast Growth, Foreign Domination...... 16 4.1.1 World’s Fastest-Growing Market ...... 16 4.1.2 Foreign Firms Dominate, Especially High End...... 17 4.1.3 Chinese Firms Fight for Survival...... 18 4.2 How BYD Entered the Auto Market...... 18 4.2.1 A Bold Acquisition ...... 19 4.2.2 Unique Resources ...... 20 4.2.3 Cutting Costs ...... 20 4.3 Limited Success...... 21 4.3.1 BYD’s Cheap Cars Sell Great at the Low End…...... 21 4.3.2 …But Less Great at the High End...... 22 4.3.3 BYD’s Down-Market Showroom...... 23 4.3.4 Quality Problems...... 23 4.3.5 Trouble Ahead: The Low-End Trap...... 24 5 Electric Cars ...... 26 5.1 Electric Auto Definitions ...... 26 5.2 BYD’s Battery-Powered Models ...... 26 5.3 The Race for the Electric Car ...... 27 5.3.1 Why BYD’s Electric Cars Make Sense ...... 27 5.3.2 It’s All About the Battery...... 28 5.4 BYD’s Delayed Electric Cars...... 29 5.4.1 BYD’s Foreign Competition ...... 29 5.4.2 So, Where Are They?...... 30 5.4.3 Suspicion of Battery Difficulties...... 32 5.5 Experts Question BYD’s Auto Specs...... 33 5.5.1 How Far Can the F3DM Really Drive?...... 33 5.5.2 How Far Can the e6 Really Drive?...... 34 5.6 Probable Consumer Ambivalence in China...... 34

BYD Sept 2009 © Fathom China. Redistribution prohibited. 2

5.6.1 Private Drivers: Small Payoff for Plug-in Hybrid ...... 35 5.6.2 Fleet Purchases: Higher Payoff for Plug-in Hybrids ...... 36 5.6.3 Buyers Unprepared for Electric Cars...... 37 6 Government Policies and BYD ...... 39 6.1 Top Concern Is Imported Oil, Not Carbon Emissions ...... 39 6.2 New-Energy Vehicle Subsidies – Uncertain Benefits to BYD ...... 39 6.2.1 No Nationwide Consumer Subsidies, Only Local Consumer Subsidies ...... 40 6.2.2 Three Policies Supporting New-Energy Vehicles ...... 41 6.2.3 Thirteen Cities Project...... 41 6.2.4 Auto Industry Revitalization Plan...... 43 6.2.5 Technology Upgrades...... 43 6.2.6 BYD’s Bus Purchase – Why It Makes Sense ...... 44 6.3 Beijing Favors State-Owned Companies...... 44 6.3.1 Turf Battles 1 – Who Will Build Recharging Stations? ...... 45 6.3.2 Turf Battles 2 – Protecting State Enterprises, Possibly at BYD’s Expense...... 45 6.3.3 Cutthroat Local Competition...... 46 7 Intellectual Property and Lawsuits...... 48 7.1 Prominent Lawsuits...... 48 7.1.1 Possible U.S. Battery Lawsuit...... 48 7.1.2 v. BYD, Industrial Espionage, 2007...... 49 7.1.3 BYD v. State Intellectual Property Office, Patent Dispute, 2005...... 50 7.1.4 v. BYD, IPR Violations, 2003...... 50 7.1.5 v. BYD, IPR Violations, 2002...... 50 7.2 BYD’s Corolla Knockoff – Why Doesn’t Toyota Sue?...... 50 8 Recent Developments – , Volkswagen, Another Listing, and More...... 52 8.1 Why Warren Buffett Bought Into BYD...... 52 8.2 Volkswagen Cooperation Makes Sense...... 53 8.3 New A-Share Listing...... 54

BYD Sept 2009 © Fathom China. Redistribution prohibited. 3

1 Introduction

BYD’s story ranks among the most implausible in corporate history. Founded by Wang Chuanfu, a battery scientist from one of China’s poorest provinces, BYD established itself within a decade of its creation in 1995 as one of the world’s biggest suppliers of rechargeable Lithium ion batteries, with Nokia and Motorola among its long list of satisfied clients. After raising a pot of money on the Hong Kong , Mr. Wang shocked his own shareholders by announcing that he would buy a failing car factory that had once produced medium-range missiles. His idea was to start making traditional cars, then pull out the engines and plug in batteries. The idea seemed more loaded with nutty ambition than even the name of his company: “Brings You Dollars.”

Ten years later, nobody calls BYD nutty. The company has already earned a paper profit of a billion dollars for its most high-profile investor, Warren Buffett, who agreed to purchase 10% of the company in late 2008 through one of his subsidiaries. Its compact sedan has been a best-selling model for nearly two years, and automobiles are expected to tally 50% of the company’s total sales this year. BYD has exceeded all expectations for so long that not even its battery-powered car seems silly anymore. Despite delays, BYD will likely release the world’s first plug-in hybrid within the next several months. No less a giant than Volkswagen has approached BYD for help producing the elusive cost-efficient electric car.

But with BYD no longer the underdog, it’s time to take a serious look at what the company can do. The view is not free of worry. All of the company’s products, from batteries to cars, are among the lowest-cost in their classes; as a result, margins were so thin last year that if the local government withdrew its subsidies, BYD’s profits would have fallen by a quarter. Battery sales have collapsed, as have margins for handset sales. Worst of all, observers suspect that delays in BYD’s electric cars have been caused by inferior batteries. BYD doesn’t face a life-or-death struggle, but it does face growing pains. The company now claims a more mature name, “Build Your Dreams,” but its businesses must also mature for BYD to maintain its leading positions.

This report does not attempt a comprehensive analysis of all BYD’s business lines. It addresses only those with the biggest future and the biggest question marks – traditional and electric cars.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 4

2 Executive Summary

ƒ BUFFETT’S INTEREST: Warren Buffett’s interest in BYD grew most likely not from the company’s electric cars, but from the opportunity to use its batteries to store wind and solar power on electric grids operated by the power utility Mr. Buffett controls.

ƒ GENIUS CHAIRMAN: BYD’s Chairman, Wang Chuanfu, is a bona fide visionary who runs an efficient and motivated company.

ƒ THIN MARGINS: BYD in 2008 earned thin margins and a quarter of its profits were attributable to government subsidies paid directly to the company, but surging auto sales in 2009 have restored healthy margins.

ƒ ALL ABOUT CARS: BYD’s cars sell well because they are the cheapest in their class, but BYD will face challenges producing higher-value models. Autos now account for half BYD’s revenue and nearly 80% of its profit.

ƒ DELAYED CARS: BYD’s long-anticipated battery-powered cars remain unavailable, causing observers to wonder if BYD’s battery simply isn’t ready. The company now plans to release its pure electric car in the United States in 2010.

ƒ SUSPICION OF BATTERY TROUBLES: BYD’s low-cost assembly lines enabled it to defeat the competition in producing small rechargeable batteries, but these lines could have trouble making large batteries to power automobiles. One reliable source says BYD scraps at least 15% of its auto battery cells for failing to meet quality standards.

ƒ LITTLE HELP FROM CONSUMER SUBSIDIES: The central government has no plans for nationwide subsidies that will help ordinary Chinese buy battery-powered cars. This will impede BYD’s efforts to become China’s battery-car leader.

ƒ FRACTURED MARKET FOR E-CARS: Competing Chinese auto companies making battery-powered cars enjoy the strong support of their local governments. This could leave BYD as one of many producers in a fractured market – just like the industry for traditional cars.

ƒ DUBIOUS EXPORT MARKET: Export markets for BYD’s battery-powered cars are far from assured because of unanswered questions regarding BYD’s auto quality and the company’s lack of distribution.

ƒ LAWSUITS: BYD faces a worrisome lawsuit in Hong Kong lodged by its top competitor in handset , and has a long history of accusations that it stole technology.

ƒ GERMAN SAVIOR: BYD is exploring a tie-in with Volkswagen to produce electric cars. Such cooperation makes eminent sense.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 5

3 BYD Basics

SUMMARY: BYD’s powerful founder and chairman, battery expert Wang Chuanfu, overcame humble beginnings and created a successful company without the initial benefit of political connections. His low-cost production lines used manual labor where his Japanese rivals used expensive robotics. He also tried to copy his competitors’ products without violating their patents. BYD’s margins declined for five years before rebounding dramatically in the first half of 2009, propelled almost entirely by an astonishing jump in auto revenue and profits.

3.1 Wang Chuanfu: Uncontested Genius

SECTION SUMMARY: Wang Chuanfu deserves his fine reputation – Warren Buffett’s top advisor called him “a combination of Thomas Edison and Jack Welch.” He came from humble beginnings and created a successful company with neither high-level political connections nor any known “original sin” shady dealings. Long-term sustainability, however, will require strong internal institutions and less reliance on a single leader.

3.1.1 Absolute Authority

KEY POINT: Wang Chuanfu enjoys near mythical status for a long series of risky but successful decisions, many of them made against the advice of his shareholders and directors.

Wang Chuanfu runs BYD with absolute authority and makes decisions without fear of contradiction. The chairman has been right so often that he is regarded within his company as a soothsayer. On at least three occasions, Mr. Wang disregarded the advice of his directors and shareholders and gambled the future of his company on risky decisions that yielded spectacular results. In particular:

ƒ In the 1990s, Mr. Wang overcame opposition and added expensive production lines for Lithium-ion batteries to augment the firm’s existing lines of nickel-based batteries. BYD became the world’s biggest supplier of Li-ion batteries. ƒ In 2003, Mr. Wang ignored critics and purchased Qinchuan Auto for Rmb250 mn, launching BYD into the auto industry. BYD is now China’s second-biggest non-JV auto company. ƒ In 2004, when BYD was about to release its first car, Mr. Wang overruled his executives and determined that the car was unfit for the market. The company instead designed a new car, the F3, which became China’s best-selling sedan.

Mr. Wang makes no apologies for his style of command. The company’s long-term sustainability, however, will depend on its ability to institutionalize its decision making outside of a single leader. As he explained to the Chinese-language magazine Chinese Entrepreneur in 2007:

BYD Sept 2009 © Fathom China. Redistribution prohibited. 6

I believe that I can’t leave this company because only I can manage it. Other people’s management styles wouldn’t be the same. Our company has only one voice and it cannot have another. If it does things wrong, so be it. This is the way we ensure a high degree of management efficiency, and only with a high degree of efficiency can we grow with an appropriately high speed.1

3.1.2 Humble Beginnings

KEY POINT: Wang Chuanfu overcame severe childhood hardships and set up BYD without high-level political support.

Wang Chuanfu was born in 1966 as the second-to-last of eight children in one of China’s poorest regions. Wuwei County in Anhui province remains well known across China even today for the massive number of impoverished young women who migrate into wealthier regions to work as housemaids. The area, which lies just north of the Yangtze River in central China, is not known for industry and Mr. Wang is without doubt the most successful executive to come from the area.

Although details of Mr. Wang’s upbringing are sketchy, he seems to have enjoyed some privilege in his early youth. His father was a Communist Party member and was senior in his commune’s production brigade. This position would have been roughly equivalent to a village chief today.

But the family’s fortunes changed for the worse around 1979 when both of Mr. Wang’s parents died within three years of each other. Mr. Wang’s six older siblings went to work to support the family, which pinned its hopes for the future on Mr. Wang’s education. Despite the hardships, Mr. Wang tested into the respected of Technology in the nearby agricultural province of , and in 1990 earned a Masters at the state-run General Research Institute for Non-Ferrous Metals in Beijing. He then took a supervisory job at the institute.

While working at the institute, Mr. Wang became convinced that China’s underdeveloped battery industry could take on Japan’s and grew impatient with the slow pace of research at the state-run institution. His sought to establish his own company and found a benefactor in his uncle, a successful businessman named Lu Xiangyang, who operated in the southern boomtown of , just across the border from Hong Kong.2 Mr. Lu, who still owns 20% of the total issued share capital of BYD Co., financed his ambitious nephew to move to Shenzhen in 1995 and set up BYD. Three other researchers at the institute joined Mr. Wang in the new venture.

The name Mr. Wang chose, BYD, is not an abbreviation – the company is registered in China as BYD Company Ltd and it is known in Chinese by its transliteration, “Bi Ya Di.” Mr. Wang originally said the letters meant “Brings You Dollars.”3 The company’s website, however, now says they stand for “Build Your Dreams.”

1 http://www.chinavalue.net/Media/Article.aspx?ArticleId=18314&PageId=10 2 Some media reports have referred to Lu Xiangyang as Mr. Wang’s cousin. 3 Mr. Lu’s shareholding appears in BYD Co.’s 2008 annual report, page 27; the reference to “Brings You Dollars” was told to the author by BYD executives in 2003.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 7

Visitors to Wang Chuanfu will have a hard time deciding what kind of gift to present. The man has no known hobbies and works 80-hour weeks. He lives in an apartment complex built for BYD’s senior executives located a ten-minute drive from headquarters, which lie an hour outside Shenzhen. As he explained to a reporter from Fortune magazine, “In China, people of my generation put work first and life second.” 4

Unlike some other top executives of private companies, Mr. Wang has not created a cult of personality for himself within his firm. BYD’s headquarters does not display his portrait, public examples of his calligraphy or quotations from his speeches. He does insist on a corporate induction process that can be considered indoctrination, including daily calisthenics and participation in sports events at the company’s soccer arena and fitness center. Taken in the context of other Chinese companies, however, such measures appear modest.

3.2 BYD’s Advantages

SECTION SUMMARY: BYD took on its Japanese battery rivals by rolling back the clock – it eschewed robotic production lines in favor of old-fashioned manual labor. Then it worked around their patents.

3.2.1 Making Manual Labor Cool Again

KEY POINT: BYD makes full use of cheap Chinese labor.

Wang Chuanfu took a guerrilla-warfare approach to battery production. He couldn’t compete using the same strategy as his massive, well-financed competitors in Japan. Companies like Sony and Sanyo had fully automated production lines with robotic instruments to ensure perfect production of uniform battery cells. BYD couldn’t afford such expensive machinery.

What BYD did have, however, was plentiful and inexpensive labor. Mr. Wang created a battery production process that was far longer than those of his Japanese rivals yet also more simple. In one now famous example, one worker would peel up the corner of a strip of tape covering the battery contacts, and another worker would remove the tape – a simple step broken into two for extreme human efficiency (and stultifying boredom). BYD executives estimate that the production of a in Japan required 20 steps, whereas a BYD battery required 200.5

4 He also offered the reporter a glass of battery fluid to drink. When the reporter declined, Mr. Wang drank it himself. 5 The tape-removal example comes from the Harvard Business School case study, which dwells at length on BYD’s labor advantage over its Japanese rivals; the figure of 200 industrial steps comes from an interview with BYD executive Li Qian.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 8

In a speech in 2004, Wang Chuanfu emphasized the advantage of his firm’s non-automated production lines:6

When Sanyo invests in a new plant, it has to spend a hundred million dollars. If it needed to employ 4000 people, the company would die. We use people as substitutes for machines. That way, with one-twentieth of the capital, we can accomplish all that they can. This advantage provides 30% of our profits…Workers in our factory are even trained to walk at the same speed. In my mind, training is something that makes a worker similar to a robot so that he can accomplish your work and realize your value. A vigorous and strong training can assure an excellent quality system.

At the time, BYD produced rechargeable batteries based on nickel-cadmium that it supplied to nearby factories making toys and consumer products for export. The company’s competitors were small and inefficient battery makers in South China, and BYD’s reputation for quality quickly established it as China’s most reliable supplier. Two years after its establishment, BYD had more than a thousand employees.

By 2002, the year that it listed on the , BYD was the biggest Chinese maker in each of its most important battery technologies – nickel metal hydride, nickel cadmium and Lithium ion – and ranked in the top four in the world in each. The model, which hasn’t changed, was to use cheap labor in a high-volume, low-margin business.

The downside to BYD’s low-cost production lines is quality control. According to Benjamin Thoma of the German consultancy Roland Berger, BYD’s battery “scrap rate,” which is the percentage of product that does not meet quality standards and must be discarded, runs as high as 15-30%. For more on the implications of this high rate, see Section 5.4.3.

3.3 Imitation as the Highest Form of Battery

KEY POINT: A great deal of BYD’s research and development goes into improving industrial processes and copying competitors.

BYD’s innovations are not of the Eureka-inspiring variety. Instead of inventing new products or processes, BYD’s strength lies in adapting traditional technologies to the low-cost labor and enormous scale that China offers. This is not necessarily bad – shaving a few percentage points off the cost of production in low-margin industries can result in a more cost-effective breakthrough than creating, testing and marketing a new product.

That’s why reverse-engineering is not considered a black art at BYD. It’s an everyday practice. A case study on BYD published by the Harvard Business School in 2002, for instance, wrote that “product improvements accounted for only one-third of BYD’s annual R&D spending. The remaining two-thirds of this spending focused on improving the company’s

6 http://it.sohu.com/20040807/n221413843.shtml

BYD Sept 2009 © Fathom China. Redistribution prohibited. 9

manufacturing processes.”7 Wang Chuanfu himself likes to tell the story of importing a luxury Benz sedan so that his engineers could take it apart. At first, his workers were unwilling to have at such an expensive car – until Wang scratched the side of it with a key. “You can dismantle my car now,” he told them.8

The company’s efforts to copy technologies apparently come on orders from Wang Chuanfu. As he explained in 2007, BYD invests a great deal in creating its own technologies and in protecting them. By the end of 2006, BYD had registered 1200 patents, up from just a handful only a few years before. But Mr. Wang says the company also puts a great deal of effort into workarounds:

We not only pay attention to protecting our own patent rights, we also research how to attack the patent barriers or our competitors…In the development of a new product, we learn 60% from public documents, 30% from finished products, and just 5% from our own R&D. Our creativity comes from picking out the patented parts of technology and putting together the parts that aren’t patented. Patent rights should be respected, but they can be avoided.9

3.4 By the Numbers

SECTION SUMMARY: BYD is now first and foremost a car company, with its auto operations contributing to an astonishing 80% of profits. BYD’S margins had shown a worrisome decline for five years before rebounding in the first half of 2009. The company derives a great deal of income from government handouts – factor these out of BYD’s income statement and its profits in 2008 fall considerably. That said, the firm’s debt load is manageable and it faces little risk of financial distress.

3.4.1 Cars Take Over

KEY POINT: BYD is now first and foremost a car company. Car sales surged in the first half of 2009 and now account for more than half the company’s revenue. Battery sales have collapsed and BYD’s handset businesses are struggling.

Auto sales have saved BYD’s numbers. Revenue from car sales increased by 133% to Rmb8.9 bn (USD$1.3 bn) in the first half of 2009 over a year earlier. Before getting to the charts, which tell this story quite effectively, it’s worth putting each segment into context.

ƒ Autos – Revenue from auto sales now exceeds sales of batteries and handsets combined. That revenue enabled BYD to fatten its overall margins in the first half of 2009, reversing several years of margin shrinkage. BYD hopes to fatten those margins even more by introducing lines of higher-end cars. Those cars have not yet hit the market, and BYD will face a considerable marketing task. Its cars so far have always

7 Harvard Business School Case Study 9-606-139, p.5. Emphasis in the original. 8 China Entrepreneur Magazine, Dec 2007. 9 Ibid.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 10

been among the cheapest in their classes, so convincing buyers that BYD also stands for quality and styling will be difficult.

ƒ Handsets – Turnover from handset components has stayed roughly level over the past 18 months, but margins have collapsed. Efforts by branded clients like Nokia to keep costs down during hard economic times had the effect of “creating pressure directly on the upstream manufacturers,” according to BYD’s annual report. The report went on to say the handset business faces an “adverse market condition.”

ƒ Batteries – Revenue has plunged in the past year. Sales of its Li-ion batteries “worsened significantly in the fourth quarter,” says the annual report, while nickel- based batteries used on power tools also suffered as “the overall market for power tools was trimmed, creating pressure on sales volume.” The segment’s fortunes did not improve in 2009, although its margins remained roughly constant. BYD’s continuing success in batteries will likely depend on markets that scarcely exist – those for electric cars and large-scale battery storage systems.

The table below shows BYD’s astonishing rise in car sales, which now account for all of BYD’S revenue growth. Battery sales have collapsed and handset sales remain stagnant.

Table 1: Segment Revenue (billion yuan) JAN-JUN 08 JAN-JUN 09 Batteries 3.3 2.0 Handsets 5.3 5.3 Auto 3.8 8.8 Total 12.4 16.5 (Source: Half year report 2009, p.12)

Profits for BYD’s auto operations tripled in the first half of 2009 compared with a year earlier, while profits at the company’s battery and handset businesses plunged by half, as the chart below shows.

Table 2: Segment Profits Before Tax (billion yuan) JAN-JUN 08 JAN-JUN 09 Batteries 0.34 0.19 Handsets 0.36 0.17 Autos 0.36 1.28 (Source: Half year report 2009, p. 12)

Autos were also the only segment with expanding profit margins - margins for batteries declined by more than half. The table on the following page shows that car sales now provide an amazing 78% of BYD’s profit, up from only 34% a year earlier.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 11

Table 3: Segment Analysis of Revenue, Profits and Margins

BATTERIES JAN-JUN 08 JAN-JUN 09 Revenue % of Total 26.4 12.4 Profit % of Total 31.6 11.8 Profit Margin 10.3% 9.7%

HANDSETS JAN-JUN 08 JAN-JUN 09 Revenue % of Total 43.1 33.3 Profit % of Total 34.3 10.2 Profit Margin 6.8% 3.1%

AUTOS JAN-JUN 08 JAN-JUN 09 Revenue % of Total 30.7 55.0 Profit % of Total 34.0 78.0 Profit Margin 9.5% 14.4% (Source: Half year report, p. 12)

3.4.2 Margins – Collapse, and Recovery

KEY POINT: BYD’s margins had squeezed over the past five years until surging auto sales revived them in the first half of 2009.

The tables below show that although BYD’s revenues more than quadrupled in the past four years, profits stagnated and margins shrank. BYD’s fortunes turned around only in the first half of 2009, when auto sales drove the company’s half-year profits even higher than the previous year’s total profits.

Table 4: Rising Profits but Constant Margins, Then Soaring Margins Income (billion yuan) 2004 2008 2008 (ex subsidies) H109 H109 (ex subsidies)

Pre-tax Profit 1.1 1.4 1.0 1.5 1.3 Revenue 6.4 26.8 na 16.1 na Net Profit Margin* 15% 4% na na na Profit as % of Revenue 16.6% 5.1% 3.7% 9.0% 8.3%

*Calculated by BYD using “profit attributable to equity holders of the parent.” BYD did not perform this calculation in its 2009 half-year report. (Source: Annual report p.02 and 100, half year report, P. 12)

BYD Sept 2009 © Fathom China. Redistribution prohibited. 12

3.4.3 Gov’t Helping Hand 1: Grants and Subsidies

KEY POINT: Government subsidies boosted BYD’s 2008 profit figures by 26%, although soaring profits in 2009 have diminished the importance of subsidies to BYD’s bottom line.

BYD benefits from generous “grants and subsidies” from the government. If subsidies were stripped from BYD’s 2008 income statement, the company’s yearly profit would fall by 26%. BYD uses more than three-quarters of its subsidies for “automotive research and development,” while most of the remainder goes to paying interest on BYD’s bank loans. Grant conditions “did not specify any repayment terms,” according to the company’s 2008 annual report.

Table 5: Real Profits in 2009 and H1 2009

BYD’s Real Profit (billion yuan) 2008 1.36 – 0.36 = 1.00

PROFIT SUBSIDY REAL PROFIT BEFORE TAX BEFORE TAX (Source: Annual report, p. 33)

BYD’s Real Profit (billion yuan) H1 2009 1.46 – 0.12 = 1.34 PROFIT SUBSIDY REAL PROFIT BEFORE TAX BEFORE TAX (Source: Half year report, p. 02)

Most of the government’s grants and subsidies came through the Shenzhen city government. It’s unclear if this money comes directly from the city, which also supports BYD through unsecured bank loans, or if the money was allocated by Beijing and merely distributed through Shenzhen.

3.4.4 Gov’t Helping Hand 2: Unsecured Bank Lending

KEY POINT: State-run banks lend generously to BYD without demanding collateral.

BYD’s outstanding bank loans stood at Rmb9.1 bn by the end of 2008. Of that, 77% was unsecured, as shown in the table below.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 13

Table 6: Unsecured Loans

Loans to BYD (billion yuan) 2007 2008

Secured 7.2 2.0 Unsecured 0.9 7.1 Total Loans Outstanding 8.1 9.2 (Source: Annual report p.83; sums were rounded)

BYD clearly enjoys a close relationship with banks in Shenzhen. That close relationship with the Shenzhen city government, however, is a double-edged sword. On one side, the company benefits from subsidies and easy access to unsecured loans, as demonstrated above. On the other, it faces the possibility that a change in Shenzhen’s political leadership could deprive the company of its generous patrons.

Such a political change recently took place in Shenzhen when the city’s mayor was detained in June on suspicion of graft. His removal will doubtless lead to wholesale personnel substitutions at the top levels of the Shenzhen government. How this will play out for BYD is unclear. It seems unlikely that the company, a local champion, will be met with disfavor by the city’s new leaders. The future relationship, however, might not remain so cozy.

3.4.5 Manageable Debt

KEY POINT: BYD recently refinanced its debt, extending much of its payment schedule to 3-5 years. It is conservatively geared with a manageable debt load, the company is not exposed to derivative risk, and its prompt collection of debts indicates good organization.

Not only does BYD carry little debt, but, it can walk away from what it owes because nearly all of its borrowing is unsecured (see Section 3.4.4). The company also benefits from government subsidies earmarked for debt repayment.

Table 7: Falling Debt-Asset Ratios 2007 2008 2009 (H1)

Assets (bn yuan) 29.2 32.9 33.6 Bank Borrowings (bn yuan) 8.1 9.1 7.0 Debt-Asset Ratio 27.8% 27.7% 20.8% (Source: Annual report, p.34 and 84; half-year report, p. 4)

BYD is conservatively geared, and its debt load is becoming even more manageable. In the first half of 2008, it was geared at 69%. That percentage fell to 48% is the first half of 2009.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 14

3.4.6 Miscellaneous

BYD collects its debt. The average time required for BYD to collect on its bills was 75 days in 2008, or roughly the same as in 2007. That’s a respectable speed, and indicates good organization within the company. Inventory is growing, but not too fast. Inventory turnover increased to 97 days in 2008, up from only 83 days in 2007. The company says the growth owes to efforts to increase inventory reserves “to meet the demand from markets and customers,” but given the precipitous decline in battery sales, a slump in demand cannot be ruled out. Small derivative risk. The company’s derivative exposure in 2008 was zero, down from Rmb42 mn a year earlier.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 15

4 Traditional Cars

SUMMARY: BYD surprised the world’s fastest growing auto market by producing a popular sedan that outsold most models produced by famous foreign brands. BYD accomplished this by trading margin for market share – its cars are by far the least expensive in their class. For BYD to build on its initial success, it must follow its domestic rivals and produce higher-value cars. This will be difficult.

4.1 Traditional Car Market - Fast Growth, Foreign Domination

SECTION SUMMARY: BYD competes in the fastest-growing car market in the world. Government efforts to consolidate the auto industry have failed, leaving more than 50 different passenger-car brands engaging in cutthroat competition. The market is dominated by foreign firms, especially at the high end.

4.1.1 World’s Fastest-Growing Market

KEY POINT: China’s car market is the fastest growing in the world thanks to a rising middle class and explicit government support.

China’s market for passenger cars will surpass that of the United States this year, if it hasn’t already. Sales of passenger cars in July increased 70% yoy to more than 832,000 units even during the worst global economic crisis in 80 years.10 China seems on track to sell 10 million passenger cars this year, exceeding the US figure for the first time.11

This growth comes with explicit government support. Whereas autos were once the playthings of transportation companies and work units, the government now encourages ordinary citizens to slip behind the wheel. Auto loans from state-run banks are readily available to consumers. Reforms have greatly increased the availability of private drivers licenses, which only 20 years ago were unavailable to almost anyone except demobilized soldiers. In an effort to spur the industry this year, Beijing cut in half the purchase tax of cars with engines smaller than 1.6 liters. And with only an estimated four cars on the road for every hundred people, the market will continue to race ahead – seven in ten buyers are first- time car owners.

The Chinese government has fed this demand with policies to encourage auto use. Most important, car owners now have somewhere to drive. Even before Beijing announced its economic stimulus package last November, China was the world’s biggest builder of roads, and any repeat visitor to China will notice the growing availability of smooth high-speed roadways cutting through even the most remote inland provinces and, in cities, the

10 China Association of Automobile Manufacturers - http://www.caam.org.cn/ 11 It’s worth remembering that this impressive growth is difficult to compare to that in the US. China’s sales volume is now roughly equal to that in America, but its value of sales remains significantly lower. Also, China uses a broader definition of passenger cars that also includes many multipurpose vehicles.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 16

conversion of bicycle lanes to vehicle traffic. On top of that, the central government’s stimulus program has tacked on another 20,000 km of rural roads.

4.1.2 Foreign Firms Dominate, Especially High End

KEY POINT: Of China’s top ten car brands, all but two are foreign, and BYD ranks eighth.

Sino-foreign joint ventures dominate China’s auto market. Volkswagen, which now sells more cars in China than anywhere else in the world, has been China’s premier auto maker for two decades. Japanese and Korean brands now crowd the top, and sales in China provide a rare point of light for General Motors.

The table below shows that of China’s top-ten car brands, all but two are foreign.

Table 8: China’s Top Ten Passenger Vehicle Brands by Sales, Jan-Jul 09

COMPANY UNIT SALES % GROWTH % SHARE

1. Volkswagen 604159 19 13.6 2. Hyundai 338,935 69 7.6 3. Toyota 321,929 -8 7.2 4. Honda 304502 13 6.9 5. 283,328 47 6.4 6. GM Buick 230,567 36 5.2 7. (Chinese) 228,196 2 5.1 8. BYD (Chinese) 205,190 180 4.6 9. Chevrolet 147,524 10 3.3 10. Suzuki 135,386 7% 3.0% Source: JD Power Note: All foreign brands participate in joint ventures with state-run automakers.

The reason foreign companies dominate China’s car market are too many to enumerate in detail but include better design, marketing, after-sales service, dealer networks, lack of legacy issues and general cachet. Foreign firms draw on decades of experience, whereas of the three non-joint-venture Chinese firms that made the chart above, the earliest to begin auto production was , which rolled its first car off its assembly line only in 1998. BYD entered the auto market in 2003.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 17

4.1.3 Chinese Firms Fight for Survival

KEY POINT: China’s unruly auto market produces 51 brands of passenger cars, all fighting for survival, and efforts at consolidation have failed.

The central government in Beijing has released at least three automobile industry consolidation plans in the past decade, and the accumulated impact has been essentially nil. China still has one of the world’s most fragmented auto industries, with more than 100 makers producing 51 brands of passenger cars. This is unlikely to change.

In one typical example of failed consolidation, Beijing in 2000 released a plan to crunch all of China’s myriad car companies into the three biggest, state-controlled entities. Almost immediately following this, a small car concern formed by a city government in poor Anhui province, Chery, began selling a cute mini-car called the QQ. Rather than force Chery out of business, Beijing in 2001 required it to sell 20% of its shares to one of China’s biggest auto groups, -based SAIC. The deal enabled Chery to survive, and today its QQ is one of China’s most popular models. Three years later, Chery bought its shares back from SAIC, and rather than consolidating its market, China had produced yet another car maker.

This crowded market challenges BYD in two ways.

First, it puts BYD under immense pricing pressure. Chinese are fickle consumers with scant brand loyalty, as studies across many product sectors have shown. BYD has joined its domestic counterparts at the bottom end of the auto market. Without consolidation, those firms will likely remain where they are, jousting for incremental gains in a low-end space with paper-thin margins, while foreign firms reap greater profits with more expensive cars. In the higher-margin midsize and luxury car sectors, not one Chinese brand lands in the top nine sellers.

Second, a crowded market increases local protectionism. City and provincial governments protect their local auto industries with preferential loans and fleet purchases. Taxi fleets, for instance, use locally produced cars wherever possible – Volkswagen in Shanghai, Hyundai in Beijing, and so on. And local governments in cities without auto industries tend to buy from state-owned companies, which BYD is not. BYD’s impressive sales figures for its F-series cars show that local protectionism can be overcome, at least with low-cost models, but lack of industry consolidation still presents a long-term hurdle.

4.2 How BYD Entered the Auto Market

SECTION SUMMARY: BYD entered the auto market by buying a faltering car maker that once produced medium-range missiles. It designed its own cars and took advantage of China’s extensive network of parts suppliers, a resource unavailable in most countries. It cut costs by using its expertise in manufacturing to assume production of as many components as possible. Unlike its domestic competitors, BYD has wisely limited the number of models it releases – it places all its eggs in one basket and then guards that basket.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 18

4.2.1 A Bold Acquisition

KEY POINT: BYD’s unexpected success in the auto industry came thanks to good leadership and a bold acquisition by Chairman Wang.

At first, BYD’s audacious move into the auto sector seemed doomed to failure. The company it purchased in 2003, Qinchuan Motors, had once been a military factory producing medium-range missiles that could be used in a war with . When production of that missile type was discontinued, the factory was converted into an auto plant making the Suzuki Alto, a cheap mini-car. When that business failed, the company began producing a car of its own design, a boxy hatchback called the Flyer. It flopped too, and Qinchuan looked for a buyer.

BYD wasn’t the first corporate dilettante to enter the auto industry. Three such companies, Midea, Bird and Aux, which make microwave ovens, cell phones and air conditioners respectively, all bought auto companies over the past decade in hopes of becoming the country’s next Volkswagen. All failed – in fact, BYD bought Midea’s bus plant in July 2009 at a bargain price.

At first, success eluded BYD. A Shanghai-based design shop helped BYD build its first prototype in 2004. After a great deal of investment and shortly before the car was to go into mass production, Chairman Wang nixed it. “It was a hard decision, and a lot of people in the company opposed it,” says Li Qian, director of investor relations. “But Chairman Wang decided the car wasn’t good enough and we had to start over.”

Instead of hiring an outside design house, BYD took design inside. It poached the head of the Shanghai firm that had designed its failed prototype and allowed him to hire a team. The result was the F3, a compact modeled on the Toyota Corolla. It spent many months as the best-selling car in its class, and is ranked third so far this year.

One especially wise decision by BYD has been to concentrate its design and marketing energy on very few cars. BYD’s Beijing showroom at Auto Mall, for instance, carried only the F3 and F6. At the time of printing, the only available BYD cars are as follows:

Table 9: BYD’s Traditional-Car Models

MODEL TYPE

F0 Mini Hatchback F3 Compact Sedan F3-R Compact Hatchback F6 Midsize Sedan S8 Roadster Convertible (availability uncertain)

By contrast, BYD’s domestic competitors, Chery and Geely, have released dozens of models each, diluting their brand and confusing their potential buyers.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 19

4.2.2 Unique Resources

KEY POINT: BYD came from nowhere to produce successful cars thanks to China’s vast array of parts suppliers, a resource unavailable in other developing countries (and most developed ones).

One of the biggest questions asked about BYD’s car operation is, “How did they do it?”

The answer is that BYD took advantage of a unique supplier network that was built and perfected by foreign firms. Domestic makers of car components have been nurtured over the past 15-odd years by foreign firms such as Volkswagen and GM, which have provided extensive training and support. Yet exclusive supplier contracts are rare. Suppliers sell to a variety of manufacturers. This network of suppliers capable of making everything between the radiator grille and the exhaust pipe means an automaker like BYD can piece together a car with parts of a reasonable quality, says Michael Dunne of JD Power & Associates:

You’ve got first, second and third tier suppliers right in BYD’s backyard. They’re supplying Japanese, Europeans, Koreans and Americans. BYD can make some alterations and the job is done. It’s a great asset to have, and it’s getting better, which means making a car is easier. It’s not like even ten years ago, when finding qualified suppliers was a problem and fewer parts were standardized. It’s still not easy, of course. Others have failed. I think BYD was more successful because it has a brilliant guy in charge.

A senior executive at a company that provides cooling systems to both Volkswagen and BYD compared them in an interview with Fathom China as follows:

VW audits to make sure we’re an A-level supplier. It comes to our plant to inspect and make sure we maintain our A-level certification. We once lost that certification because one of our suppliers changed a part and didn’t tell us. That’s how strict Volkswagen is. BYD doesn’t do that. It has never sent anyone to inspect us. It’s just interested in a cheap price. It figures that if our parts are good enough for Volkswagen, they’re good enough for BYD.

With the right resources, building a car can be like clicking together a Lego set. Building a good car, however, is not. As section 4.3.4 shows, BYD still has far to go before it can produce a car that meets minimal levels of customer satisfaction in developed-country markets, or even on the high end of China’s market.

4.2.3 Cutting Costs

KEY POINT: BYD controls costs by producing as many of its own parts as possible, although its best-selling F3 sedan still relies on foreign suppliers for engines and drive trains.

BYD works with its suppliers to take over as much parts manufacturing as possible. This approach cuts costs, but could lead to quality-control problems as industry standards change and BYD tries to maintain expertise across a tremendous spectrum of processes. In interviews, Fathom China uncovered the following two examples:

BYD Sept 2009 © Fathom China. Redistribution prohibited. 20

Example 1: A major European components maker produces windshield-wipers for BYD. Over time, BYD learned to make the rubber wipers and the metal braces that held them in place. “We received requests from BYD to send only the wiper motor, not the rest of the parts,” says the European firm’s general manager in Beijing. “I imagine that over the next few years, BYD won’t need the motor anymore either.”

Example 2: A senior executive at European components maker Continental says his firm used to undertake “calibration” for BYD – an essential process that coordinates the engine with other car functions. The cost was high at about a half-million dollars per calibration. According to the executive,

BYD now does its own calibration. This is important not just because it saves money. It’s also moving closer to understanding the logic of the controller, which is the software that makes sure everything works together. Designing controllers took Delphi and Bosch 20 years, so I don’t think BYD will crack that very fast, but it will do applications that work with a controller. BYD has made very impressive progress.

Two things that top-level car makers never outsource are engines and drive trains. BYD’s best-selling F3 compact sedans, however, outsource both – its engines come from Mitsubishi and its drive trains from Delphi. In the midsize range, BYD’s F-6 sedans use BYD’s own engines and drive trains, and the company says future models will as well.

4.3 Limited Success

SECTION SUMMARY: BYD has sold a lot of inexpensive cars. This may prove unsustainable. As Chinese consumers grow more savvy, they will demand better quality and service from Chinese auto companies. When that happens, BYD’s reputation for providing low-end cars may prevent it from selling higher value, more profitable cars.

4.3.1 BYD’s Cheap Cars Sell Great at the Low End…

KEY POINT: BYD’s compact sedan sells well because it is cheapest.

China’s price-sensitive consumers have thrown their support to BYD because of its low, low sticker price. The table on the following page compares the price and sales figures of BYD’s best-selling F3 sedan with other cars in its class.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 21

Table 10: China’s Top Ten Compact Car Models, Jan-Jul 09 BRAND MODEL UNIT SALES PRICE % YEARLY (000 YUAN) INCREASE 1. BYD F3 137,826 56-87 101 2. Hyundai Elantra Yuedong 135,146 100-130 203 3. Buick Excelle 131,559 104-150 26 4. VW 126,246 75-102 -1 5. Hyundai Elantra 99,111 90-127 32 6. Toyota Corolla 85,273 128-173 -14 7. VW Lavida 78,448 113-150 1327 8. Ford Focus 72,965 119-154 1 9. VW New Bora 64,664 108-144 N/A 10. VW Santana 60,097 76-79 -15% (Source: JD Power and Associates)

4.3.2 …But Less Great at the High End

KEY POINT: BYD’s more upscale midsize sedan struggles for market share despite costing less than half the price of its main competitors.

BYD’s upscale F6 sedan costs less than half the price of its main competitors, yet has lagged far behind in sales:

Table 11: China’s Top Ten Midsize Car Models, Jan-Jul 09 BRAND MODEL UNIT SALES PRICE % YEARLY (000 YUAN) INCREASE 1. Honda Accord 96,029 182-340 6 2. Toyota Camry 85,782 190-274 -3 3. VW Passat 59,616 177-302 -19 4. Nissan Teana 56,643 191-366 119 5. Mazda Mazda6 45,746 164-250 14 6. Buick New Regal 43,004 180-256 1033 7. VW Magotan 35,148 193-280 4 8. Buick Lacrosse 32,324 220-320 -5 9. FAW Besturn B70 31,254 130-189 19 10. BYD F6 26,658 80-160 486 (Source: JD Power and Associates)

BYD Sept 2009 © Fathom China. Redistribution prohibited. 22

4.3.3 BYD’s Down-Market Showroom

KEY POINT: A visit to a BYD showroom in Beijing reveals the link between the F3’s cheap sticker price and its top-selling status.

To understand how BYD pitches its no-frills cars, stop by the Auto Mall market on the northern outskirts of Beijing. On a lot the size of 50 football fields, you’ll see the red-carpet showrooms of major brands such as GM, Volkswagen and even Chery, China’s former champion of low-end cars that’s now pitching upscale SUVs.

Tucked into the lot’s far corner is what passes for BYD’s showroom. It contains only two sedans, one of them missing part of its hood. The floor is so caked in soot that visitors leave footprints. A tangle of electric wires fills one corner, the only sales materials are flimsy one- page handouts, and the overworked sales staff doesn’t seem to know that BYD also makes hybrid cars. This place is here for one thing: to sell China’s cheapest cars as cheaply as possible.

Yet more customers shop here than at any other showroom on the lot. “Not a bad car,” says a man from the country’s Manchurian northeast as he sits in an F3, China’s top-selling sedan. “And it’s cheap,” he adds. He’s traveled a thousand kilometers to save a few hundred dollars off the sticker price offered in his hometown. Other visitors come from Beijing’s rural outskirts where personal cars are so rare that even bottom-line sedans “give face,” says another prospective buyer. Not one customer entering the BYD showroom during Fathom China’s visit comes from downtown Beijing – all hail from outlying counties where private car ownership is rare and even a cheap car bestows status.

BYD has secured its place at the low end of China’s car market, but its showroom at the Auto Mall could be a victory lounge in the race to the bottom.

4.3.4 Quality Problems

KEY POINT: BYD’s cars suffer quality problems that affect customer satisfaction.

BYD’s cars haven’t suffered serious problems, but maintaining customer satisfaction has been a problem, says Michael Dunne of JD Power:

If we look in our studies of initial quality, BYD does not do well. Owners have experienced a lot of problems. The car looks good, and sales are up, but its reliability and quality are not there yet. We have an industry average [for customer satisfaction], and they’re well below that average. We’re not talking about transmissions dropping out or anything. More like windows not rolling up or down properly, uncomfortable seats, soft brakes, air conditioner problems, stuff like that. They’re not major malfunctions, but they do affect driver satisfaction.

To be fair, Chinese consumers may be willing to overlook many of these problems. They’re buying BYD cars because they’re inexpensive. BYD’s cars sell best outside of major cities like

BYD Sept 2009 © Fathom China. Redistribution prohibited. 23

Beijing and Shanghai. In those tony cities, autos are examples of conspicuous consumption and discerning buyers don’t want ultra-economy models like BYD – that’s why BYD’s cars are nearly invisible in tier-one markets. BYD’s buyers in tier-two markets, by contrast, want an affordable car that looks just nice enough to say, “Sedan.”

One of the most important factors in determining what cars are acceptable to Chinese buyers, says Mr. Dunne, is exterior design – it’s far more important than in mature Western markets, where buyers pay more attention to reliability, after-sales service and warranties. BYD benefits from this emphasis on styling. Its cars have an acceptably standard look. The introduction of uniframe car designs in the past few decades has made cars more uniform. Gone are fenders and bumpers, leaving most sedans with short trunks, low fronts, high rears and the general shape of a jellybean. At a glance, it’s now hard to tell the difference between a Benz, a BMW and a BYD. Since BYD’s sedans come in an acceptable mold, they’re popular among price-conscious Chinese buyers.

4.3.5 Trouble Ahead: The Low-End Trap

KEY POINT: BYD will likely face difficulty selling higher-end cars, and delays in its first roadster have forced the company to downplay its potential impact.

BYD sells the cheapest cars in every class it competes in. This has contributed to the company’s historically poor margins (see Section 3.4.2). To capture more value, BYD will need to create higher-quality products. As Michael Dunne of JD Power explains, other Chinese companies have employed a strategy similar to BYD’s, and have faced trouble selling high-end cars:

BYD’s predecessors were Geely and Chery, which are a few years ahead of BYD. They needed market share and volume, otherwise they’d never get off the ground. So they came in with aggressive pricing, and succeeded. But the trap is that after they had volume, they still weren’t making money. They had to move up and sell nicer cars. But by then their brand was associated with cheap cars. That’s the juncture where Chery and Geely find themselves now, so they’re releasing upscale models. But these are brand new concepts for them. Toyota worked for 40 years before it added Lexus. The Chinese are trying to do it in five years. It’s not so simple.

One warning sign regarding BYD’s sales figures is that the car is almost invisible in Beijing, where incomes are significantly higher than in other parts of the country and where car buyers are more sophisticated. Many Beijing drivers, if not most, are behind the wheel of the second or third car they’ve bought. Experience has taught them that it makes sense to pay more for a car that will stay longer out of the mechanic’s shop.

Only ten years ago, the car most commonly seen on Beijing roads was the cheap Xiali hatchback built in . That model is now nearly invisible in the capital, but remains widely seen in second-tier cities. Beijing’s transition from cheap cars to quality cars is one that will take place in other cities over the next several years. When that happens, BYD’s inexpensive price will no longer guarantee a market.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 24

BYD hopes to avoid becoming known as China’s cheapie by introducing new, higher-end models such as its S8 Roadster Coupe, a hardtop convertible that carries a 2.2 liter engine and will sell for around USD$30,000. Initial indications, however, are not good. Chinese media reports say the car went on sale in July. Now, only a few months later, company executive Li Qian is trying to lower sales expectations:

We have no big expectations for the S8 convertible. The market for convertibles in China is small. We just want to show off our technology and elevate our brand. Consumers will see that our quality is improving, and then they will be more willing to by BYD’s cars, even if they’re not interested in the S8.

BYD also plans to introduce four more new gasoline-powered cars in the next few months. Two of them, the G3 and L3, are compact sedans that are slightly higher-end versions of the best-selling F3. The S6 is a luxury SUV that resembles the Lexus RX, and the M6 is a multi- purpose vehicle that resembles the Toyota Previa.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 25

5 Electric Cars

SUMMARY: The most important component of an electric car is its battery. BYD’s extensive experience in researching and producing Lithium ion batteries gives it a significant advantage in the race for the world’s first mass-produced electric car. That said, BYD’s electric cars have suffered repeated, unexplained delays. Observers now wonder if BYD is having trouble producing a quality-sufficient battery, and question whether the performance of BYD’s electric cars will match their announced specs.

5.1 Electric Auto Definitions

1) Hybrid Vehicle – A general term for a car with wheels that can be powered by batteries but that also contains a traditional internal-combustion engine (ICE).

2) Parallel Hybrid – A car that can power its wheels with a battery and with an ICE. The Toyota Prius is a parallel hybrid.

3) Series Hybrid – A car with wheels that can be powered only by the battery, which is recharged by the ICE.

4) Plug-In Hybrid (PHEV) – A hybrid car with batteries that can be recharged either with an ICE or by plugging the battery into an external power source. BYD’s F6DM and the Chevrolet Volt are PHEVs.12

5) Pure Electric Vehicle – A car that can be powered only by the battery. If the battery runs down, the car stops. BYD’s e6 is a pure electric vehicle, as is the Tesla Roadster.

5.2 BYD’s Battery-Powered Models

KEY POINT: BYD will offer two hybrids and one pure electric car. Their styling is that of simple economy cars; their handling is largely unknown. The hybrids cannot accelerate 0-60 mph in less than ten seconds, which is considered minimal for acceptance in the American market.

A quick reference guide to BYD’s three battery-powered cars is as follows13:

1. F3DM – A low-end PHEV, this car will be available in China in late 2009. It is modeled on the Toyota Corolla and will retail for around USD$22,000. It claims an electric-only range of 100km (62 mi), after which the internal combustion engine

12 Even though both are PHEV’s, the F6DM and the Volt have a significant difference: The F6DM is a “parallel hybrid,” meaning its gas-powered engine can drive the wheels directly; the Volt is a “series hybrid,” meaning its gas-powered engine only recharges the batteries, which then drive the wheels. 13 Specs for all three models are available on BYD’s website: http://www.byd.com/showroom.php?car=f3dm&index=2

BYD Sept 2009 © Fathom China. Redistribution prohibited. 26

powers the wheels. It weighs 1540 kg (3,395 lbs) and accelerates from 0-60 mph (0- 96.5 kmh) in 10.5 seconds. The batteries take 7 hours to replenish using a household socket, or 10 minutes to fill halfway using an unspecified method.

2. F6DM – A higher-end PHEV, this car will be available in China in late 2009 and may become available in the United States and Europe, although it’s unclear when. The car is modeled on the Honda Accord and will retail for under USD$30,000. BYD has not announced an electric-only range. It weighs 1882 kg (4,150 lbs) and accelerates from 0-60 mph (0-95 kmh) in 13.5 seconds. The batteries take 7 hours to replenish using a household socket, or 10 minutes to fill halfway using an unspecified method.

3. e6 – A pure electric car that BYD says will be available in the United States in 2010. It will retail for USD$40,000. It claims an electric-only range of 400 km (249 mi). It weighs 2020 kg (4053 lbs) and its acceleration is unknown. As with the hybrid models, its batteries take 7 hours to replenish using a household socket, or 10 minutes to fill halfway using an unspecified method.

5.3 The Race for the Electric Car

SECTION SUMMARY: BYD’s extensive experience in producing Lithium ion batteries gives it an advantage in the race for the electric car market.

5.3.1 Why BYD’s Electric Cars Make Sense

KEY POINT: As the only company in the world that produces both cars and Lithium ion batteries, BYD enjoys great natural advantages in the race for marketable electric cars.

By most accounts, Chinese automakers, including BYD, remain 15 years behind their overseas competitors in terms of quality and the overall driving experience of their products. And with the growing complexity of even low-end cars, that gap is growing. China’s roughly 100 automakers will likely remain mired at the low end of the market while global players like Volkswagen and Toyota claim the market’s higher end.

Nor does exporting present much of an option to BYD. The company’s most logical markets are in Asia, where demand is strong and markets are growing. But Asian markets are highly protected, with Malaysia, Thailand and Vietnam all nurturing ambitions of creating their own auto industries. Western markets present insurmountable quality hurdles – the last attempt at selling an ultra-cheap import to Americans, a box-shaped Eastern European hatchback called the Yugo, flopped spectacularly in the 1980s, and BYD’s sedans would likely follow the same path even if they could pass safety and emissions tests. This leaves Africa and the Middle East, where some Chinese automakers have made inroads, but these aren’t exactly the markets where automakers’ dreams are realized.

With nothing but niche markets and low-end buyers available to car-makers like BYD, the rise of battery-powered cars suddenly presents a welcome alternative. Estimates of when

BYD Sept 2009 © Fathom China. Redistribution prohibited. 27

hybrid and electric cars will become commonplace range across decades, but the race for the electric car has already begun, with more than a million Toyota Priuses already on the roads and with every major automaker planning its maiden hybrid release.

The advantage of battery-powered cars to a company like BYD is that the playing field is level. Much of the expertise of the world’s major automakers is irrelevant to the production of electric cars. Nobody even knows what technology will prevail – Lithium ion batteries of the type produced by BYD seem the likely winner, but the Prius uses nickel metal hydride. Furthermore, barriers to entry are low. A battery-powered car has roughly one-third the number of moving parts found in an ICE car. Supply networks are shorter, and cars are assembled more quickly and easily. Many executives in traditional car companies could face radical obsolescence once purchasing departments no longer need things like pistons and spark plugs.

That’s a long way off, but BYD is better positioned than any carmaker to move into electric cars for one simple reason: it’s the only company in the world that produces both cars and batteries.

5.3.2 It’s All About the Battery

KEY POINT: The most important component in an electric car is the battery, and BYD possesses the right technology in Lithium ion iron phosphate.

Gone are the days when Lithium ion batteries were so unstable they sometimes exploded. BYD executives repeat, often and correctly, that their company has never faced a recall. Sony cannot say the same. It recalled some 8 million notebook computer batteries in 2006 after several exploded – in one case, a Sony battery ignited a Dell computer and forced the evacuation of Yahoo’s offices.

Lithium ion batteries are now more stable and have become the battery of choice for electric vehicles, thanks to their capacity for and long life cycles. While a detailed explanation of how Lithium ion iron phosphate batteries work is beyond the scope of this document, suffice to say the breakthrough was significant and that BYD was an early adapter – both BYD’s PHEV and its pure electric car use this battery technology.

An effective battery is the holy grail of alternative-energy cars. Past efforts to introduce electric cars have foundered on the battery. Absent the high energy densities available only in recent years, makers could offer either glorified golf carts rolling around on the same lead- acid batteries found under the hood of traditional cars, or else massive, heavy cars with no commercial potential. Until recently, the most successful electric vehicles have been forklifts and some delivery in the UK known as “milk floats.”

As the world’s leading producer of Lithium ion batteries, and with a strong commitment to research and development, BYD is the front-runner in the race for the electric car within China. But BYD’s auto-battery technology also suffers the same drawbacks that afflict the industry generally and which will outweigh their benefits for an undetermined period of time, as outlined in the table below.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 28

Table 12: Li-ion Batteries for Cars

ADVANTAGES DISADVANTAGES

Reduce oil dependence Expensive Reduce emissions Heavy Limited range Long recharging times Not price-effective without subsidies High replacement costs Complex temperature regulation Inadequate long-term testing No Moore’s Law for batteries*

*Moore’s Law, named after Intel co-founder Gordon Moore, states that the power of an integrated circuit will double every two years, with no increase in cost. This is not true of battery chemistry. Lithium-based batteries for cars will grow incrementally smaller and more powerful, but their great size and weight will remain a design impediment.

5.4 BYD’s Delayed Electric Cars

SECTION SUMMARY: BYD’s hybrid cars are not yet available in China, despite media reports saying they went on sale last year. Many observers now wonder if BYD is experiencing problems with its batteries. BYD has also quietly pushed back the release of its hybrid cars in the United States, which was to have begun this year and has now been postponed until 2010.

5.4.1 BYD’s Foreign Competition

KEY POINT: BYD’s battery-powered cars will face stiff competition, most directly from the more upscale Chevrolet Volt, and will likely compare unfavorably in styling and handling.

The charts below show the specs of BYD’s two battery-powered cars, as well as a sampling of BYD’s international competitors. All data comes from the automakers themselves and must therefore be accepted with some skepticism.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 29

Table 13: Leading Producers of Electric and Hybrid Cars

CORP MODEL TYPE ELEC RECHARGE PRICE RELEASE RANGE (HOURS) (USD) DATE

BYD F6DM PHEV 100 km 8 22,000 Dec 2008

BYD e6 Electric 400 km 8 40,000 2010

GM Volt Hybrid 55km 6.5 40,000 Nov 2010

Toyota Prius 2010 Hybrid N/A* N/A 24,000 Available

Tesla Roadster Electric 400 km 8 109,000 Available

*The Prius has a battery-powered motor and an ICE that work together, and the car therefore has no battery-only range.

The most important point in comparing BYD’s cars to those of its foreign competitors is that BYD’s models are ultra-economy. This is certainly true of its PHEVs, and most observers believe it is also true of the e6, although the car has not been examined enough to draw strong conclusions. This may cause problems, especially because the e6 is priced roughly the same range as the Chevy Volt, which is significantly more upscale.

Success in the world of pure electric cars requires more than a car with a battery that works. What may be needed is the automotive equivalent of the iPod – a new product with such exquisite design and functionality that it catches the imagination. Aesthetics matter a great deal. Chinese firms in general don’t do aesthetics well, and BYD has no record at all of producing sexy cars. Its reputation is instead for producing inexpensive, workmanlike autos.

BYD’s battery-powered cars have generally caught a break in the mainstream media – they have not been subject to much critical scrutiny, and many commentators seem pleased to see a Chinese underdog taking on Detroit’s once-mighty Big Three. But that won’t last. Writers for the auto magazine Car and Driver took a hard look at BYD’S hybrid cars at the 2009 Detroit Auto Show and came away decidedly unimpressed. Regarding the F6DM’s sluggish acceleration, they noted, “We drive faster in our driveways.”14

5.4.2 So, Where Are They?

KEY POINT: BYD’s highly anticipated battery-powered models remain unavailable due to unexplained delays that raise questions about the quality of the cars and their readiness for the market.

In a March letter to shareholders, BYD Chairman Wang Chuanfu confirmed the “launch” of his company’s hybrid F3DM sedan. Chinese and Western newspapers, including the New

14 http://www.caranddriver.com/news/car/09q1/byd_f3dm_f6dm_e6-auto_shows

BYD Sept 2009 © Fathom China. Redistribution prohibited. 30

York Times, reported that BYD’s hybrid had been available to Chinese buyers since Dec 2008.15

In fact, it’s still not available. As of September 2009, authorized BYD dealers in Beijing had no hybrid cars to sell, no brochures to distribute, and salespeople seemed wholly unaware that the car was supposed to be on the market at all. One dealer just a few km from BYD’s headquarters in Shenzhen said he had started a waitlist for F3DM buyers but couldn’t say when he might actually have one to sell.

The F3DM is ostensibly available to government departments. Only two are known to have bought them – the city government in Shenzhen and the Shenzhen branch of the together purchased a total of 80, according to Chinese media reports. Even these sales have apparently not gone smoothly. Departments within the Shenzhen city government have defied orders and refused to buy the F3DM because of “certain reasons,” most likely the high sticker price and a lack of power outlets for recharging, according to the state-run Xinhua news agency.16

Meanwhile, BYD has quietly decided not to export its hybrid car to the United States until after it begins selling its pure-electric e6 there in 2010 – even though a company spokesman at the Detroit Auto Show in January 2009 said the hybrid F6DM would be the first BYD car available in America. No announcement accompanied the hybrid’s delay. Its news was relayed to Fathom China by BYD’s director of investor relations, Li Qian, during an interview in August 2009:

First, we’ll sell the e6 in the United States starting in 2011. Maybe we’ll move that up to 2010. Then we’ll sell the hybrid car. We have an export sales team that is looking for American distributors now. The target market will be individual buyers, not fleet purchases…The e6 still hasn’t finished its crash tests in China. It probably will by the end of the year. It’s applying for tests in the United States.

It’s hard to know what to read into these delays. They could be nothing more than poor corporate communication by a young company. BYD generated a tremendous amount of positive media attention when it announced that its PHEV would beat General Motors and Toyota to world markets. As this scenario has become less likely, it may be difficult and possibly costly for BYD to set the record straight.

What is clear is that BYD must accomplish a great deal to hit its target of releasing the e6 in 2010. BYD’s Li Qian acknowledged that as of August 2009, crash tests for the e6 had not begun even in China, much less in the United States, and that the company has no overseas distributors. These are significant hurdles to clear even before addressing the question of whether American consumers will buy a cheap electric car that could be described as a Yugo with the aspirations of a Prius. According to Michael Dunne of JD Power, BYD is unlikely to hit its target date of exporting to America by 2010:

15 http://www.nytimes.com/2009/01/13/business/worldbusiness/13chinacar.html?scp=7&sq=BYD&st=Searc h 16 http://news.xinhuanet.com/english/2009-04/13/content_11178761.htm

BYD Sept 2009 © Fathom China. Redistribution prohibited. 31

Every Chinese company going to the US has to pass safety tests. Those have been show stoppers so far. No Chinese company has passed. By 2011, I could maybe see a city in California playing around with a BYD car, buying 100 units and using them to ferry around mail carriers or meter maids or whatever. But not on any large scale. It’s almost 2010 already. They’ haven’t even started selling in China. Selling in the US? That’s really ambitious.

5.4.3 Suspicion of Battery Difficulties

KEY POINT: Some observers suspect that delays in BYD’s battery-powered cars may be caused by battery problems, which may in turn result from BYD’s use of non-automated production lines with “scrap rates” of 15%.

Producing batteries for electric cars is not a matter of making a bigger battery; instead, it is a process of lashing together hundreds or thousands of cells, each about the size of a cigarette pack, that must charge and discharge together with absolute precision. Ensuring “cell uniformity” among so many cells is significantly more difficult than producing a single-cell battery for a mobile phone, or a 5-6 cell battery for a notebook computer.

Several observers believe that BYD’s manual production lines, which have provided tremendous cost advantages in the production of small batteries, could contribute to problems with cell uniformity in auto batteries. By way of background, BYD’s spokesman, Li Qian, confirmed to Fathom China that BYD’s car-battery assembly lines, like assembly lines for its other batteries, still rely on manual labor and not robotics. He denied any problems with cell uniformity.

The German consulting firm, Roland Berger Strategy Consultants, recently interviewed former BYD employees in an effort to estimate BYD’s “scrap rate,” which is the percentage of battery cells that must be discarded because of inferior quality. Roland Berger discovered a scrap rate significantly higher than the industry average of less than 5%, according to company executive Benjamin Thoma:

We found that BYD has a scrap rate of 15%, and sometimes as high as 30%, for Lithium ion batteries. BYD has missed a key tolerance level, and this shows that BYD has not mastered key process parameters that are crucial to quality control. The high scrap rate is a sign that BYD is not able to control the production of batteries in an efficient manner…This may be the main reason BYD hasn’t been able to come out with its electric cars.

An expert on electric cars at Tsinghua University in Beijing, Qiu Bin, also suspects that BYD’s assembly line presents a problem. He emphasizes that his opinions are based on his knowledge of batteries, not on inside information from BYD:

Think of BYD’s car battery as a barrel made of wooden slats. If any slat has a hole halfway up, then you can fill only half the barrel. Car batteries are similar. One bad cell can damage a battery’s performance…My impression is that BYD’s battery problem is cell uniformity. It needs a great battery management system to compensate.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 32

Japanese work with mechanized production lines that can control the quality of each cell. Mobile phones don’t have a problem with battery uniformity because they’re one cell. Laptop computers are 4-5 cells. So this uniformity problem doesn’t exist. BYD has a big advantage in battery production for small batteries. But for car batteries, it has less advantage. And how can you guarantee that a battery management system will work?... I think BYD’s technology is still immature. Will it work in the northeastern cold or southern heat, with never a recall?

Ensuring that battery cells operate together to power a car requires a battery management system (BMS), which is a large and complex piece of machinery that constitutes most of a battery’s weight. Its minutely calibrated, temperature-sensitive components must operate flawlessly at extremes of heat and cold, stand up to tens of thousands of kilometers of road rattle, and withstand an accident. It’s not easy. An American executive from a firm that plans to release an electric car and who requested anonymity explains:

Even with a good battery-management system, your battery is only as good as your worst cell. So first you have to get all your cells exactly right. Then, your battery management system has to ensure that all those cells charge and discharge in absolute balance. And you need to control the temperature, which will vary greatly. And it can never go wrong. All of this is not trivial. That’s why we haven’t seen electric cars before.

If cells aren’t precisely the same, they increase the complications of their Battery Management System. The more differences among the cells, the more complicated the BMS must be, and the greater the chance that the battery will degrade, lose performance and enjoy fewer effective recharges.

One of BYD’s competitors is Don Harmon of LiFeBatt, a company with headquarters in Las Vegas that makes Lithium ion iron phosphate batteries at a production facility in Taiwan. His company invested in mechanized production lines specifically to avoid the problems pointed out by other experts quoted in this section:

We use robotic arms that cost a lot of money. I’d never trust assembly line workers to fill the cells with slurry. What if some guy comes in one day with a hangover? You end up with one bad cell and a couple of years later the battery doesn’t work.

5.5 Experts Question BYD’s Auto Specs

SECTION SUMMARY: The specs that BYD has announced for its battery-powered cars are so ambitious that industry observers wonder how they can be true – either BYD has scored a significant, unknown breakthrough in battery technology, or its specs are overstated.

5.5.1 How Far Can the F3DM Really Drive?

KEY POINT: Observers think BYD may have overstated the distance that a hybrid F3DM sedan can cover without recharging.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 33

BYD says its hybrid F3DM can drive 100 km without a recharge, and that its battery can be recharged 2000 times.17 That may be possible, but observers say it would be unwise. Lithium ion batteries degrade faster when they are fully discharged, and driving 100 km would require a full discharge. Regular full discharges would, in turn, impede the battery’s ability to recharge 2000 times.

Other car companies routinely understate the distance that their cars can drive under battery power. General Motors, for instance, limits to 65 km (40 miles) the distance that its hybrid Volt can drive under battery power, even though the car could probably cover twice that distance. William Moore, editor of the online magazine EV World, explains why:

You can’t do a deep depth discharge and expect your battery to achieve 2000 cycles. The battery degrades. The GM Volt uses only half of its battery capacity before the generator kicks in and recharges it. If it used up all its battery power, it would go 80- 100 miles. But GM wants the car to go 40 miles under battery power in its tenth year, not just in its first year. BYD expects sixty miles and 2000 cycles? Nobody thinks that’s possible unless BYD has discovered some special sauce that nobody knows about.

5.5.2 How Far Can the e6 Really Drive?

KEY POINT: Observers think BYD may have overstated the distance that its fully electric e6 sedan can cover without recharging.

BYD seems to have overstated the distance covered by its pure electric e6, which is due for release in the United States in 2010. The car’s specs say it can travel 400 km on a single charge. To some, this seems doubly suspicious. First, it probably means a full discharge, which is unwise. Second, even with a full discharge, the battery would have to weigh so much to cover such a distance that it would affect the car’s handling, safety and room for passengers.

The chief engineer for Tianjin Qingyuan Electric Vehicle Co, which is producing an electric car to compete with BYD’s, openly questions BYD’s claim that the e6 can drive 400 km. The chief engineer, Zhou Rong, told Fathom China in an interview that

to drive 400 km, you need a 300 kg battery. But with a battery that heavy, you’d have to change all your other systems to go with it. Most electric vehicles are done on existing platforms. It’s not easy to change your platform. If person carries too much weight on his shoulders, his body will change. Cars the same. Maybe an electric car that can go 400km can carry only two people, but not five.

5.6 Probable Consumer Ambivalence in China

SECTION SUMMARY: Without consumer subsidies, BYD’s plug-in electric cars will be too expensive for ordinary Chinese consumers.

17 http://www.BYD.com/showroom.php?car=f3dm&index=2

BYD Sept 2009 © Fathom China. Redistribution prohibited. 34

5.6.1 Private Drivers: Small Payoff for Plug-in Hybrid

KEY POINT: Although the government subsidizes companies that make battery-powered cars, it has no plans to subsidize the consumers who would buy them. In which case, a rough calculation shows that Chinese drivers would have to drive BYD’s plug-in hybrid for nearly 20 years before fuel savings would balance out the additional cost of their cars.

It’s difficult to calculate the exact fuel savings that an average private Chinese car owner can expect from a hybrid or electric car. Variables include the number of km driven, city driving versus highway driving, and maintenance. The table below provides Fathom China’s best estimate.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 35

Table 14: Hybrid Savings for Individual

Traditional Car Fuel Cost

15,000 x 0.51 = 7650 AVERAGE KM YUAN PER ANNUAL FUEL DRIVEN, YEAR KM COST, YUAN

Hybrid F3DM Cost

7650 / 2.75 = 3060 I.C.E. ANNUAL HYBRID HYBRID ANNUAL FUEL COST SAVINGS FUEL COST, YUAN

Plug-in Hybrid Cost Savings

7650 - 3060 = 4590 I.C.E. FUEL HYBRID ANNUAL HYBRID COST FUEL COST SAVINGS, YUAN

Explanation: Annual km driven is estimated by auto dealers; yuan per km assumes the current gasoline price of 6.37 yuan per liter and fuel consumption of 12.5 km per liter; hybrid savings are estimated by Morgan Stanley. 18

As the chart above shows, drivers can expect the F3DM to save them roughly 4590 yuan per year on their gasoline bills. Knowing that, we can calculate the number of driving years required before savings at the gas pump will compensate for the up-front cost of BYD’s plug- in hybrid car:

Plug-in Hybrid Savings Over Time

90,000* / 4590 = 19.6 ADDED COST OF ANNUAL HYBRID NUMBER OF YEARS F3DM, YUAN SAVINGS, YUAN TO COVER PURCHASE COST

* The F3DM will cost 150,000 yuan. The sticker cost of an F3 with options is roughly 60,000 yuan. The difference is 90,000 yuan.

The tables above lead to the conclusion that, absent significant government subsidies, private Chinese drivers will pay a tremendous premium to drive BYD’s plug-in hybrid cars.

5.6.2 Fleet Purchases: Higher Payoff for Plug-in Hybrids

KEY POINT: Fleet purchases of plug-in hybrids can pay off quickly, assuming very high use.

18 Morgan Stanley’s figure of 2.75 assumes that gasoline costs USD$3 per gallon, whereas China’s current gasoline cost is around USD$3.50 and therefore its savings could be greater. Morgan Stanley also assumes the US electricity rate of 12 cents per kW, whereas China’s electricity costs 7.2 cents. Fathom China nonetheless feels that, absent an in-depth study, the table above gives a fair estimate of the up-front, incremental cost of a hybrid car in China.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 36

Plug-in hybrid cars used in fleet purchases could pay off in fewer than three years, assuming intensive use of the car. By factoring in government subsidies of Rmb60,000 for each plug-in hybrid vehicle (USD$8,800), the up-front cost of buying a BYD battery-powered car could, under these conditions, diminish to almost zero. It’s worth remembering, however, that government subsidies for BYD’s cars may be rare outside of Shenzhen (see Section 6.2.3).

The calculations below show that a fleet purchase of hybrid cars could cover up-front costs in as little as three years. In fact, given the hurdles faced by private buyers, fleet purchases are the only possible market in China for battery-powered sedans.

Table 15: Hybrid Savings for Fleet

Traditional Car Fuel Cost

100,000 x 0.51 = 51,000 AVERAGE KM YUAN PER ANNUAL FUEL DRIVEN, YEAR KM COST, YUAN

Hybrid F3DM cost

51,0000 / 2.75 = 18,545 I.C.E. ANNUAL HYBRID HYBRID ANNUAL FUEL COST SAVINGS FUEL COST, YUAN

Plug-in Hybrid Savings

51,000 - 18,545 = 32,455 I.C.E. FUEL HYBRID ANNUAL HYBRID COST FUEL COST SAVINGS, YUAN

Plug-in Hybrid Savings Over Time

90,000 / 32,455 = 2.7 ADDED COST ANNUAL HYBRID NUMBER OF YEARS TO OF F3DM, YUAN SAVINGS, YUAN COVER PURCHASE COST

5.6.3 Buyers Unprepared for Electric Cars

KEY POINT: Concerns facing Chinese buyers when considering a battery-powered car include battery life, maintenance, and the unavailability of such basic infrastructure as an at-home socket to plug in the car.

Nearly all of China’s 600 million urban dwellers live in apartment buildings. Most of these buildings don’t have parking spaces. Even buildings that do provide parking do not provide electrical outlets. In short, most Chinese car owners will have nowhere to plug in their cars.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 37

This lack of home outlets is far more significant than the lack of public recharging stations. Much media attention has focused on the lack of petrol-like recharging stations, an approach that considers China’s market through the glass of advanced Western car markets. In fact, as Wang Zhenpo of the Beijing Institute of Technology notes, the lack of outlets for people living in urban apartments will likely prove an insurmountable obstacle:

The only people in China who have a place to plug in their cars are the ones who live in the countryside. And they’re exactly the people who can’t afford them. The market for these cars is in the cities, where people live in apartments. Even in Beijing, where would anybody plug in their car? 19

The cost of batteries in hybrid cars is generally one-third the price of the car. In BYD’s case, that’s around USD$7000. Given that battery technology for cars is so new that it benefits from no long-term studies, Chinese buyers can be forgiven for wondering if they’ll get their money’s worth out of their batteries. Buyers will have to consider the possibility of purchasing a new battery to extend the life of their cars, or that battery degradation may destroy their car’s resale value.

Fixing a hybrid car will require trained mechanics who currently don’t exist. BYD will likely respond to this problem in its warrantees, but it’s unclear that the company’s young dealer network is up to the task. Right now, most dealers don’t even know when they’ll be able to sell a hybrid car, much less fix one.

Other uncertainties include whether batteries will achieve their stated driving ranges, whether the government will offer consumer subsidies in the future to reward those who delay purchases until that time, and the inability to recharge a pure electric vehicle from the road.

With massive hurdles facing the medium-term purchase of plug-in cars by individual consumers, the only market right now is for government fleet purchases.

19 Fathom China interview.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 38

6 Government Policies and BYD

SUMMARY: The central government has no plan to issue broad retail subsidies to consumers that would jump-start the market for hybrid vehicles. Beijing is instead offering subsidies to local governments for fleet purchases of new-energy vehicles, mostly buses. BYD is not the government’s electric-car champion, and the market for e-cars will likely be split among many producers, with BYD as one of the bigger players.

6.1 Top Concern Is Imported Oil, Not Carbon Emissions

KEY FINDING: The central government has not thrown its full support behind electric vehicles, preferring to focus scarce resources on renewable energy.

Compared with the United States and Europe, Beijing is relatively unconcerned with the effect of auto emissions on the environment. Instead, “The goal of Beijing’s electric-car policies is to limit imports of foreign oil,” says Benjamin Thoma, a Beijing-based expert of China’s auto industry at Roland Berger, the German consultancy.

This helps explain why Beijing’s efforts at fuel efficiency have not focused on electric cars. An estimated 40% of China’s oil demand goes to transport. To offset imported oil, Beijing has channeled tremendous resources toward hydroelectric and nuclear power stations, and its interest in wind and solar power are growing. By comparison, electric vehicles are more of an afterthought.

Beijing now imports roughly half of its oil. Although the State Council’s policy is to generate 20% of its power through renewable energy by 2020, many experts believe that China will miss that target by a wide margin.

6.2 New-Energy Vehicle Subsidies – Uncertain Benefits to BYD

SECTION SUMMARY: The central government has no nationwide plan to offer subsidies to consumers who wish to buy battery-powered cars. The absence of such subsidies will inhibit the development of a nationwide consumer market for new-energy cars, including BYD’s. City or provincial governments may in the future provide such subsidies to their residents, although these payments would likely support local companies that compete with BYD. A different type of subsidy currently goes to local governments for fleet purchases of new- energy vehicles. These subsidies mean little for BYD right now because they focus on buses. BYD’s recent purchase of a bus company, however, may enable buyers of its future electric buses to receive subsidies.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 39

6.2.1 No Nationwide Consumer Subsidies, Only Local Consumer Subsidies

KEY POINT: The central government has no plans to provide subsidies to consumers for the purchase of electric cars, but provincial and city governments will likely provide subsidies to consumers for the purchase of electric cars that compete with BYD.

Chairman Wang himself emphasized the importance of consumer subsidies when he told The Wall Street Journal in late August that BYD had delayed the release of its hybrid cars because it “is waiting for government incentives for private buyers in China.”20

Unfortunately for Chairman Wang, such incentives do not appear to be coming anytime soon. If nationwide consumer subsidies arrive at all, “I don’t expect them for at least 3-5 years,” says Wang Zhenpo, an expert on electric vehicles at the Beijing Institute of Technology who follows government policy closely. This inaction will likely keep the cost of BYD’s hybrid and electric cars too high for most interested Chinese buyers for at least several years.

Thibaud Voita, an expert on China’s electric-car industry at the Paris-based Asia Center, concurs that Beijing has no nationwide consumer subsidy plans:

The central government is timid regarding electric cars. There’s no real policy to support the industry or to issue subsidies to consumers. That’s odd, because the Minister of Science and Technology, Wan Gang, is a specialist in electric vehicles. My sense is that he dislikes Wang Chuanfu and BYD. It’s unclear why. Maybe because BYD is too secretive.

We’re not seeing significant government policies to support the electric car industry. Unified standards would be something to watch out for – making sure charging stations can serve all cars.

Despite the absence of nationwide subsidies to consumers, some city governments have taken matters into their own hands. At least three have announced consumer subsidies to fund the purchase of battery-powered cars. The catch is that these subsidies apply only to the purchase of locally made electric cars. The likely result will therefore be more competition for BYD. For example:

ƒ The city of in May announced subsidies of USD$6300 to individual consumers who purchase the Jiexun brand of hybrid sedan made by state-run Changan Auto, which is located in Chongqing.21 This subsidy has already gone into effect, although its usefulness is subject to debate since the car is not yet on the market. ƒ Shanghai announced subsidies of USD$3000 to individual consumers for the purchase of electric cars produced by Shanghai Corp.22 The

20 http://online.wsj.com/article/SB125085247014949083.html 21 http://www.reuters.com/article/rbssConsumerGoodsAndRetailNews/idUSSHA1453120090515 22 http://www.chinadaily.com.cn/bizchina/2009-05/20/content_7794342.htm

BYD Sept 2009 © Fathom China. Redistribution prohibited. 40

status of that subsidy is uncertain, however, and subsequent Chinese media reports quote unnamed Shanghai officials denying that the city will offer subsidies.23 ƒ Shenzhen, where BYD is located, announced subsidies of up to 60% of the price of BYD’s hybrid F3DM, according to Chinese media reports.24 That subsidy has not yet taken effect.

6.2.2 Three Policies Supporting New-Energy Vehicles

KEY POINT: The central government’s policies to promote electric vehicles could make a large amount of subsidy funds available to BYD for research and technology upgrades. Other subsidies could jump-start BYD’s sales, which the company says will begin as early as this year.

Beijing has announced three main policies to support the development of new-energy vehicles: ƒ Thirteen Cities Project: The Ministry of Finance and the Ministry of Science and Technology in January announced subsidies in 13 cities to promote electric vehicles. Subsidies of up to USD$8,800 are available to local governments for fleet purchases of passenger vehicles, but the project focuses more on buses than cars.

ƒ Auto Industry Revitalization Plan: The State Council in January announced its “Adjustment and Revitalization Plan for the Auto Industry.” The plan could benefit BYD because it earmarked Rmb10 bn to support technological improvements for auto makers. It also set a short-term goal of building enough production capacity for 500,000 new-energy vehicles. ƒ Technology Upgrades: The State Council in May announced Rmb20 bn for industry technology upgrades. The industries listed included new-energy vehicles as well as petrochemicals, textiles, big infrastructure projects and many others.

These three projects are discussed in detail below.

6.2.3 Thirteen Cities Project

KEY POINT: China’s most ambitious effort to promote battery-powered vehicles means little for BYD because the project targets buses and encourages local protectionism. If BYD can ramp up bus production at its new facility, however, the project could channel subsidies toward BYD.

The Thirteen-cities project announced on Jan 23, 2009 represents the high-water mark in the government’s support for new-energy vehicles. The government will invest USD$3 bn to finance the purchase of 60,000 electric vehicles in thirteen cities. 25 If successful, it could put enough electric and hybrid vehicles on the roads to create the beginnings of a mass market.

23 http://sh.xinmin.cn/shms/2009/05/19/1978250.html 24 http://news.alibaba.com/article/detail/cars/100103138-1-shenzhen-subsidize-buyer-BYD-hybrid.html 25 The 60,000 figure came in a speech by Vice Minister of Finance Zhang Shaochun on May 21. A Chinese- language news report on the speech can be viewed at http://finance.ifeng.com/roll/20090522/693152.shtml.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 41

By some estimates, those thirteen cities comprise nearly half the expected future market for electric vehicles. Subsidies run as follows:

Table 16: Thirteen-City Project Subsidies

VEHICLE SUBSIDY (YUAN)

Hybrid Sedan 50,000 Electric Sedan 60,000 Hybrid Bus 420,000 Electric Bus 500,000

Yet the Thirteen-cities project means less for BYD than meets the eye.

Most of the thirteen pilot cities were chosen because they already support auto industries, making it likely that vehicles will be supplied locally.26 Immediately after the policy was released, for instance, the mayor of Wuhan announced that Nissan’s joint venture in that city would provide electric vehicles there. Even in the cities that do not support their own auto industries, BYD will face a big challenge pitching its cars. The city of has already announced that it will buy hybrid cars from BYD’s competitor, Chery, for use as taxicabs.

One person who has monitored the implementation of new-energy vehicles in many of the thirteen cities, Wang Zhenpo of the Beijing Institute of Technology, told Fathom China that BYD hasn’t entered the picture: “The thirteen cities are mostly running electric buses. They’re not talking about sedans. The subsidy announcement barely even mentions sedans.”

It’s expected that the city of Shenzhen, which is one of the cities included in the project, as well as home to BYD’s headquarters, will buy BYD’s cars for its taxi fleets. But the city hasn’t made any such announcement yet, and evidence suggests that the city is dragging its feet. According to the state-run Xinhua news agency, many departments within the Shenzhen city government have defied orders and refused to buy the F3DM because of “certain reasons,” most likely the high sticker price and a lack of power outlets for recharging.27 At the time of this writing, the Shenzhen government is thought to have committed to buying fewer than 100 of BYD’s PHEVs.

But the Thirteen-city plan’s emphasis on buses could eventually bring benefits to BYD, which in July purchased a bus maker, Hunan Sanxiang Bus Co. BYD has since announced that it will begin sales of electric buses by the end of this year. If BYD can produce battery-powered buses quickly, it’s possible that one or more of the thirteen cities included in the subsidy plan could buy BYD’s buses – Shenzhen seems a likely candidate – or that BYD could avail itself to

26 The 13 cities are Beijing, Shanghai, Chongqing, Changchun, Dalian, Hangzhou, Jinan, Wuhan, Shenzhen, Hefei, Changsha, Kunming and Nanchang. 27For an English-language version of the Xinhua report, see http://news.xinhuanet.com/english/2009- 04/13/content_11178761.htm

BYD Sept 2009 © Fathom China. Redistribution prohibited. 42

other subsidies, which are listed in this report’s following subsections. (BYD’s purchase of the bus factory is discussed in 6.2.6.)

6.2.4 Auto Industry Revitalization Plan

KEY POINT: The central government’s Auto Industry Revitalization Plan should make a large amount of government grants available to BYD for technology upgrades and research.

The Adjustment and Revitalization Plan for the Auto Industry, announced by the State Council in Jan 2009, extends far beyond battery-powered cars. It is a sweeping document that lays out the government’s policy regarding autos for the next several years. It declared a 50% cut in the purchase tax on cars with engines smaller than 1.6 liters, set forth a policy of consolidation in the auto industry, and made money available in the countryside so that farmers can trade in low-efficiency tractors and receive discounts on multipurpose vehicles in return.

It also declared that the central government will make Rmb10 bn available over three years for “technological improvements” in the auto industry. The relevant section says the project will offer “firm support for new technologies, technological improvements, and new-energy vehicles, parts and components.” 28 BYD, along with its competitors, should be eligible to receive this largess.

Included in the revitalization plan is the stated goal of increasing production capacity for new-energy vehicles to 500,000 by the end of 2011. It’s worth noting that “production capacity” does not mean production – some observers have conflated the two. In fact, the government does not intend to put a half million battery-powered cars on the roads in the next 18 months. The government instead wants to prepare its industries to supply a market that does not yet exist. By comparison, Japan and South Korea are expected to produce a combined 1.1 million hybrid or all-electric light vehicles by the end of 2011, and North America will make more than a quarter million.29

How the increased production capacity will be funded is unclear. It seems likely that the plan’s allocation of Rmb10 bn for “technological improvements” will fund the expansions.

6.2.5 Technology Upgrades

KEY POINT: The government’s Rmb20 bn in subsidies for “technology upgrades” cover such a broad array of industries that it’s impossible to know how they will affect the auto industry and BYD.

The State Council announced Rmb20 bn in May for industrial technology upgrades. The effect on BYD is unclear. This bears mentioning only because some media reports have

28 A detailed summary of the revitalization plan is available in Chinese at http://news.xinhuanet.com/video/2009-01/15/content_10662612.htm. 29 Figures for Japan, South Korea and North America come from CSM Worldwide. See http://www.nytimes.com/2009/04/02/business/global/02electric.html?scp=1&sq=china%20500,000%20hyb rid&st=cse

BYD Sept 2009 © Fathom China. Redistribution prohibited. 43

indicated that the bulk of the available money will flow into new-energy cars. Evidence for this is so far nonexistent. The industries on the government’s list include petrochemicals, textiles, big infrastructure projects and many others, including new-energy vehicles.

6.2.6 BYD’s Bus Purchase – Why It Makes Sense

KEY POINT: BYD’s plan to produce battery-powered buses could give its buyers access to government subsidies.

BYD announced in July that it would spend Rmb60 mn to purchase a bus factory in central China’s breadbasket province of Hunan. The Hunan Sanxiang Bus Company was previously owned by Midea, a white-goods manufacturer that tried to move into vehicle production but failed to create a viable business.

BYD further announced that its acquisition would concentrate on “manufacture and sale of bus and coach [sic] with a focus on new energy models,”30 – in other words, battery-powered buses. As the sections above show, government purchase of new-energy buses are far more likely to receive government subsidies than are purchases of sedans. By moving into electric buses, BYD seems to be shaking the right subsidy tree.

A month after the purchase, BYD said it would begin selling battery-powered buses by the end of the year. That laudable goal seems very optimistic. The company already has a history of announcing ambitious release dates for its plug-in hybrids, only to face later delays. “It’s not that hard to produce prototypes of electric vehicles,” says Zhou Rong, chief engineer of Tianjin Qingyuan Electric Vehicle Co., a competitor of BYD, “but mass producing them is very hard indeed.” It seems likely that BYD will be able to produce a small number of buses quickly, but ramping up large-scale production will likely take far longer than a few months.

Beyond availing itself to subsidies, BYD’s recent entry into the bus market could prove lucrative for the company in its own right. Assessing the profitability of China’s bus industry, however, lies beyond the scope of this report.

6.3 Beijing Favors State-Owned Companies

SECTION SUMMARY: To the extent that the central government promotes battery-powered cars at all, it will likely favor state-owned companies and not private firms like BYD. And given the government’s past inability to enforce its will on the auto industry, it seems likely that provincial and city governments will promote their local producers of battery-powered cars, creating e-car fiefdoms. Meanwhile, infighting among ministries could hinder key infrastructure projects, such as recharging stations.

30 BYD’s purchase announcement is viewable at http://www.BYDit.com/upfiles/2009072708360970133.pdf

BYD Sept 2009 © Fathom China. Redistribution prohibited. 44

6.3.1 Turf Battles 1 – Who Will Build Recharging Stations?

KEY POINT: Building public infrastructure, such as public auto recharging stations, will require a high degree of government coordination, and the process has not yet begun.

In the United States and Europe, it’s easy to imagine petrol stations installing high-voltage power outlets so that drivers can enjoy a quick cup of coffee while a recharger tops up their batteries. The decision to install such recharging stations would presumably be up to the gas station’s owner. Not so in China.

In China, recharging stations would fall under overlapping bureaucracies. According to professor Qiu Bin, a Beijing-based expert in electric vehicles at Tsinghua University, the State Grid, which runs electrical grids, would have to be involved, and this will likely cause tussles:

In China, gas stations are owned by . But if Sinopec wants to open charging stations, that’s the responsibility of the State Grid. There’s no reason to think these two ministries will work together. After all, a fast charge could still takes 30 minutes, and it could be dangerous. Only State Grid can do it. And the State Grid is not now considering putting charging stations in gas stations. If the two don’t work together, then it will be very difficult for electric cars to gain acceptance.

Such problems seem like they could be resolved on orders of the State Council. Mr. Qiu’s point is that the process has not yet begun. As Thibaud Voita points out in Section 6.2.1, the government has not even considered unified standards for recharging stations so that all battery-powered cars could use them. Much, much work remains to be done.

6.3.2 Turf Battles 2 – Protecting State Enterprises, Possibly at BYD’s Expense

KEY POINT: Beijing is more likely to promote the interests of state-owned automakers than the interests of private firms like BYD.

BYD is one of only a handful of Chinese private automakers producing at scale. Most Chinese automakers are state-run and fall under the purview of the State Council, China’s cabinet. The State Council, in turn, administers these automakers through the State-owned Assets Supervision and Administration Commission (SASAC).

In addition to operating state-run auto companies, the State Council also regulates the auto industry. This creates an obvious potential for conflict of interest. The State Council’s regulatory bodies that oversee battery-powered cars are as follows:

ƒ National Development and Reform Commission ƒ Ministry of Science and Technology ƒ Ministry of Industry and Information Technology ƒ Ministry of Finance

BYD Sept 2009 © Fathom China. Redistribution prohibited. 45

That Chinese state-run companies enjoy preferential treatment from the government, usually through government purchases, inclusion in regulatory decision-making or via direct and indirect subsidies, is well established and does not require vigorous proof here. Suffice to say that the consensus among independent observers interviewed for this report is that BYD, a secretive private company located a thousands miles from Beijing, does not enjoy close relations with the line ministries that regulate it.

One tetchy relationship that does bear mention, however, is that between BYD and the Ministry of Science and Technology (MOST). MOST’s minister, Wan Gang, is a former senior executive of Bosch, the German auto components maker, and an expert in electric cars. Yet Mr. Wan and his ministry have not shown an affinity for BYD, says Thibaud Voita, the expert at the Paris-based Asia Center who researches China’s policies for new-energy vehicles:

For the past ten years, MOST has been a big supporter of [state-run] Changan Auto, which also makes a hybrid car. And it’s also the case that MOST and the Ministry of Industry and Information Technology [MIIT] don’t get along. They both want to have a say in the electric-car industry, and there’s a lot of bureaucratic overlap. My sense is that MIIT opposes Changan, and will therefore support companies that compete with it, including BYD. So BYD probably has the support of MIIT but not MOST. I realize this is not a satisfactory kind of analysis. It sounds more like a pair of brothers fighting. But I’ve followed this for a long time and the decisions they make adhere to this pattern.

6.3.3 Cutthroat Local Competition

KEY POINT: China’s market for battery-powered cars is likely to follow the model of traditional cars – lots of players scratching for market share and struggling with local protectionism.

China’s market for traditional cars provides a likely model for how electric cars will develop, which is to say, chaotically. Despite numerous efforts over the past quarter century to consolidate China’s car makers into a smaller number of conglomerates modeled on Detroit’s Big Three, China still has roughly 100 vehicle makers. The result is cutthroat competition, with China’s domestic automakers selling cheaper, low-margin cars while foreign brands supply most profitable upscale markets.

Wang Zhenpo of the Beijing Institute of Technology thinks the trend is clear:

Electric cars will develop the way traditional cars did. Every province will promote its own electric car. It’s already happening – everybody wants to make an electric car. How hot is the market? I received a phone call from an iron foundry the other day. The guy wanted to buy our technology for electric cars. He said he’d find a car designer, and he had cash and wanted to get into the auto business. I said no thanks.

The table below shows the companies most likely to challenge BYD in the China market.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 46

Table 17: Domestic Producers of Electric Cars

COMPANY CAR TYPE MODEL NAME BATTERY TYPE BATTERY MAKER

BYD Electric e6 Li-ion Iron BYD Phosphate BYD Hybrid F3DM, F6DM Li-ion Iron BYD Phosphate Brilliance Electric Zun Chi Nickel Metal Bai Le Hydride Changan Hybrid Jie Xun, Nickel Metal Infineon Zhixiang Hydride Chery Hybrid A5 Nickel Metal Forever Battery Hydride Chery Electric S18 Li-ion Iron Unknown Phosphate FAW Hybrid Hong Qi, Nickel Metal Forever Battery, Hydride Hunan Shenzhou Geely Hybrid Panda LC-E Li-ion Unknown Great Wall Hybrid Ou La Li-ion Unknown Haima Hybrid H12 Lithium Unknown Polymer Tianjin Electric Saibao Li-ion Lishen Qingyuan Zong Tai Hybrid 2008EV Li-ion Headway

Source: SYWG Research and Consulting; Fathom China

Other sections of this report have shown that Beijing has not made a concerted effort to consolidate the market for new-energy cars. In particular, section 6.2.3 showed that the 13- cities plan will enable local governments to spur their homegrown makers of battery- powered vehicles, and Section 6.2.1 showed that at least three local governments have announced consumer subsidies for the purchase of locally produced new-energy cars. The likeliest result is that Chinese firms will engage in a race to the bottom, with all competing to make the least-expensive models – exactly as has happened in traditional-car industry.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 47

7 Intellectual Property and Lawsuits

SUMMARY: Senior BYD executives essentially argue that copying is part of the company’s strength. This causes two concerns. First, BYD could face damaging litigation. Second, BYD might prove unable to generate innovations that will win market share for original products. BYD’s handset business now faces a significant legal challenge from competitor Foxconn, and in the event that BYD sells its battery-powered cars in the United States, it will likely face lawsuits from holders of battery patents.

7.1 Prominent Lawsuits

SECTION SUMMARY: BYD faces the high probability of a lawsuit over its battery technology when it begins selling its electric cars in the United States. The company has been accused many times of intellectual-property violations, but has so far avoided losing major lawsuits. Yet an ongoing lawsuit by BYD’s top handset competitor, Foxconn, raises the possibility that as BYD sells more products abroad, it will open itself to lawsuits outside of China.

7.1.1 Possible U.S. Battery Lawsuit

KEY POINT: A US-based patent holder for Lithium ion iron phosphate batteries has sued some of the world’s leading battery companies and will likely sue BYD as soon as it sells its cars in America; in Europe, BYD’s patents will likely be recognized.

The Lithium iron phosphate technology that BYD uses in its auto batteries is the subject of a number of lawsuits under US jurisdiction that target some of the biggest producers of Li-ion batteries. Such lawsuits could further delay the release of BYD’s cars.

The type of battery in question, Lithium ion iron phosphate, was patented in 1997 by the University of Texas based on the work of Professor John Goodenough. The university then licensed the technology to a state-run Canadian electric company, Hydro-Quebec, which, in turn, licensed it for the development of some applications to another Canadian firm, Phostech Lithium Inc.31 According to Phostech Lithium, any company producing a battery cathode using Lithium iron phosphate should pay a licensing fee. Many do. “We pay a licensing fee to Phostech,” says Don Harmon, CEO of Nevada-based LiFeBatt, which produces batteries for everything from motorcycles to electricity grids. “People who don’t will be sued when they try to sell their batteries in the United States.”

The University of Texas or its licensees have already sued some of the biggest-name battery makers in the world, such as A123 and Valence. Those cases continue today. In one instructive lawsuit, Japan’s leading telecoms company, NTT, agreed last year to pay USD$30 mn to the University of Texas.32

31 http://www.phostechlithium.com/index.php 32 See http://techon.nikkeibp.co.jp/english/NEWS_EN/20081007/159256/

BYD Sept 2009 © Fathom China. Redistribution prohibited. 48

The patent claims of the University of Texas and its licensees were recently strengthened. The US Patent and Trademark Office in April and May upheld two of the university’s two patents.33 That ruling enabled license holder Hydro-Quebec to continue its lawsuit against Valence and A123 for their use of Lithium ion iron phosphate battery technology. Hydro- Quebec is also suing powertools maker Black and Decker Inc., as well as Chinese battery maker China BAK Battery Inc., in a Dallas court. BYD will likely face a similar suit if it introduces its cars in America.

In Europe, battery makers have a stronger position. The European Patent Office in December last year revoked the University of Texas’s patents in Europe for lack of novelty. The revocation should decrease the likelihood that BYD would face patent-infringement lawsuits in Europe.

7.1.2 Foxconn v. BYD, Industrial Espionage, 2007.

KEY POINT: Foxconn’s lawsuit in a Hong Kong court presents BYD with a significant and high-profile legal tussle.

Taiwan-owned Foxconn International Holdings Ltd. is the world’s largest contract maker of mobile phones by volume. Its lawsuit, filed in 2007 in Hong Kong, accuses BYD of hiring three senior Foxconn executives in 2005 who arrived at BYD with electronic files containing secrets involving aspects of cell-phone handset manufacturing. Foxconn says BYD used that information to set up its own production lines, and now seeks hundreds of millions of dollars in damages.

Foxconn says the material BYD stole enabled BYD to dominate an industry that has since become its top sales generator.34 Foxconn seeks punitive damages, a share in the profits that BYD’s handset business has generated and an injunction forcing BYD to hand over its industrial blueprints. It contends that BYD lured away the three senior employees, including a chief operations officer, from two China-based Foxconn subsidiaries, Shenzhen Futaihong Precision Industry Co. and Hong Fu Jin Precision Industry (Shen Zhen) Co. Ltd. Foxconn has separately said that BYD hired away a total of 400 employees.

The Hong Kong judiciary seems determined to hear the case, which could drag on for years. Hong Kong courts are considered impartial, and an outcome is impossible to predict. Foxconn has so far proven unable, however, to convert its legal battles into victories in the court of public opinion. Terry Kuo, the CEO of Foxconn’s parent company, Hon Hai Precision Industry Co., in May accused Warren Buffett of investing in a company that had “stolen” his technology and dared Mr. Buffett to drive to work in a BYD hybrid car. His comments never gained traction in mainstream Chinese or English language media.

33 The ruling is available at http://bioage.typepad.com/files/US-6514640C1.pdf 34 A Hong Kong court rejected BYD’s contention that the trial should be held outside of Hong Kong, where both BYD and Foxconn are listed. That court decision contains a useful summary of Foxconn’s complaint and BYD’s response. It can be viewed at http://legalref.judiciary.gov.hk/lrs/common/search/search_result_detail_frame.jsp?DIS=61578&QS=%28%2 4BYD%29&TP=JU

BYD Sept 2009 © Fathom China. Redistribution prohibited. 49

7.1.3 BYD v. State Intellectual Property Office, Patent Dispute, 2005.

BYD sued the State Intellectual Patent Office (SIPO) in 2005 after the office invalidated a BYD patent for a component in a rechargeable battery pack. SIPO had at first approved BYD’s patent, but its decision was overturned following an appeal by a BYD competitor, Chaoba Battery Co., which said it had already patented the same technology. SIPO agreed, and BYD responded by suing SIPO to have its patent reinstated. The lawsuit failed, and the patent remained in the hands of Huizhou Chaoba Battery Co.

7.1.4 Sony v. BYD, IPR Violations, 2003.

Sony accused BYD of violating two patents for Lithium ion batteries that Sony had filed in Japan. Sony’s lawsuit in 2003 asked the court for an injunction blocking the sale of BYD’s Lithium ion batteries in Japan. The Japanese court decided in favor of BYD.

7.1.5 Sanyo v. BYD, IPR Violations, 2002.

A US-based arm of Japanese electronics giant Sanyo Electric Co. sued BYD and its US subsidiary, BYD America Corp., for infringing on Sanyo’s patents for Lithium ion battery technology. Sanyo requested an injunction from the US federal district court in Southern California that would have barred BYD from exporting its batteries to the US market.

A statement from Sanyo at the time said the “constitution of the bare cell of lithium ion batteries and the structure of the battery pack” infringed on two Sanyo patents filed in the United States.

The two companies settled out of court in 2005 and have not released the terms. A BYD statement at the time said that “the settlement at least does not contain any disadvantageous subjects for BYD.”

7.2 BYD’s Corolla Knockoff – Why Doesn’t Toyota Sue?

SECTION SUMMARY: Toyota has likely chosen not to sue BYD because of the risk of adverse publicity within China, a key Toyota market.

BYD has faced intellectual-property lawsuits over nearly all of its product sectors, but not cars. This seems odd, given that even a casual observer would notice the striking similarity between BYD’s F-series of automobiles and the Toyota Corolla, on which the BYD product is clearly based. Chinese auto writers state as fact that BYD’s cars are built on a Corolla platform and that BYD’s more upscale series of plug-in hybrid cars are copies of the Honda Accord. Yet Toyota and Honda have not indicated plans to sue. Why?

Foreign car makers now recognize the futility and bad publicity of suing Chinese companies inside China. General Motors sued China’s upstart car company, Chery, in 2004 for releasing what seemed to be a perfect knockoff of the Chevrolet Spark. GM came across looking like Goliath, lost its case, and Chery’s car, the QQ, went on to become a top-selling model long before the Spark reached dealers in China.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 50

Five years later, such copying is now common. A little-known Chinese company called Shuanghuan this year showed up at the Frankfurt Auto Show with its new model, the Noble, which looked just like a Smart car from Mercedes Benz and even bore the legend, “Smarter Than the Rest.” A racy-looking Chinese compact called the Lifan 320 is clearly based on the Mini-Cooper. And in one of the most brazen cases, private car maker Geely this year unveiled an ultra-luxury sedan so closely modeled on the Rolls Royce that it even includes a version of the British firm’s iconic “Spirit of Ecstasy” hood ornament, although Geely did add one fresh component of its own – instead of a back seat, it installed a throne.35

In all the above cases, the Chinese firms aim their cars at a significantly lower-income market than do their foreign rivals. Foreign car makers, it seems, have ceded the low-end market to knockoffs, including BYD, and hope that these firms won’t climb the value ladder and produce successful high cost, high margin cars. So far, that bet has paid off. The most profitable car companies in China are without exception Sino-foreign joint ventures.

Of all foreign brands, Toyota is perhaps the most shy of suing Chinese companies. Toyota accused Chinese auto maker Geely in 2002 of stealing its logo, but a Beijing court rejected Toyota’s claim, and China’s anonymous Internet chat rooms filled with anti-Toyota vitriol. One year later, Toyota released advertisements showing a pair of traditional Chinese lions bowing down before a Toyota Land Cruiser. The Communist Party’s mouthpiece, People’s Daily, revived memories of Japan’s brutal invasion of China in the 1930s by accusing Toyota of being “tyrannical” and “hegemonic,” and Toyota issued a public apology. Toyota likely feels scant desire to rile up China’s consumers by suing so popular a brand as BYD.

35 So rampant are Chinese car copies that Road and Track magazine produced a slideshow with side-by-side comparisons: http://www.roadandtrack.com/article.asp?section_id=15&article_id=6760

BYD Sept 2009 © Fathom China. Redistribution prohibited. 51

8 Recent Developments – Warren Buffett, Volkswagen, Another Listing, and More

8.1 Why Warren Buffett Bought Into BYD

SECTION SUMMARY: Warren Buffett was at least as interested in using BYD’s batteries on power grids as in electric cars, and if a test project now underway in Oregon is successful, demand for BYD’s batteries on power grids could exceed demand for its batteries in cars.

Investment guru Warren Buffett generated tremendous interest in September 2008 when a company he controls, MidAmerican Energy Holdings, bought 10% of BYD Co. for USD$230 mn. By the time the deal was approved in August, BYD’s share price had soared 400% and Mr. Buffett’s company earned a paper profit of more than a billion dollars (thanks in part to the gravitational pull of the “Buffett Effect,” which drew investment into BYD’s shares).

Most observers assumed that Mr. Buffett’s interest in BYD focused on the company’s plans to export hybrid and electric cars to the United States. Fortune magazine’s cover story about Mr. Buffett’s investment, for instance, reported almost exclusively on the potential future success of BYD’s electric cars.36

In fact, MidAmerican had another market in mind when it bought into BYD. MidAmerican owns power utilities, and these utilities generate about a quarter of their electricity from renewable energy resources. That’s more than any other major American utility. Much of that energy comes from wind, especially in Oregon, where MidAmerican owns the major utility, PacifiCorp.

PacifiCorp recently began testing BYD’s batteries to store energy on its electricity grid. BYD’s Lithium-ion iron phosphate batteries – the same technology that will by used in its cars – are housed in a building the size of ten 40-ft storage containers. The batteries are capable of storing 1-2 mW of power, which is a great deal smaller than the 750 mW generated by a typical coal plant, but the project in Oregon is still considered a test. PacifiCorp’s vice president Pat Egan described the project to Fathom China:

We may need somewhere to store extra energy, so the notion of on-grid, large-scale batteries gives us a flexibility that we otherwise wouldn’t have. Wind in particular can cause some complications. If the wind suddenly stops, or if it blows all the turbines, then we need to balance that load, and a battery can function that way…On-grid storage has long been the Holy Grail.

36 Fortune, April 27, 2008. The writer, Marc Gunther, later wrote a blog post saying that subsequent interviews, MidAmerican executives revealed their interest in grid batteries. See http://www.marcgunther.com/tag/midamerican-energy-holdings/.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 52

Months before MidAmerican’s investment in BYD, Mr. Egan and other executives from PacifiCorp traveled to BYD’s headquarters to examine BYD’s batteries and to discuss the Oregon test project. Mr. Egan says other utilities have tried using lead-acid batteries for storage, but without success. “No large-scale projects have been successful,” he says, but PacifiCorp hopes that BYD’s new Lithium ion iron phosphate technology will prove “cheaper and safer” than lead acid and will provide a breakthrough in on-grid power storage.

Mr. Egan added that the use of BYD’s batteries for power storage was “pretty important” in convincing MidAmerican’s executives to make their investment:

BYD is a vast company with a lot of products. That’s important in itself. We wouldn’t invest in a company with one technology or one product. It’s good at a number of things. The logical extension is for us to commercialize the use of batteries for power storage.

When issuing public statements explaining their company’s interest in BYD, MidAmerican’s executives have always placed equal emphasis on the usefulness of BYD’s rechargeable batteries for solar, wind and electric car projects.

Other MidAmerican executives have explained more directly that their interest in BYD’s potential for on-grid power storage exceeds their interest in electric cars. William Moore, the Omaha-based editor of EV World, spoke with senior executives of MidAmerican at the 2008 annual meeting of Mr. Buffett’s investment company, . “They explained that the real reason MidAmerican was interested in BYD was for battery storage technology for energy,” Mr. Moore told Fathom China. “That’s where they see the growth. Not in cars.”

8.2 Volkswagen Cooperation Makes Sense

SECTION SUMMARY: Volkswagen and BYD are exploring ways to cooperate in the production of battery-powered cars. Such cooperation makes eminent sense. Volkswagen is far behind its international rivals in new-energy cars, and BYD would benefit from Volkswagen’s help in designing and producing upscale auto models.

In the race for a battery-powered car, Volkswagen is widely considered to be running last among major carmakers. That perception changed on May 15, 2009 when Volkswagen and BYD released a memorandum of understanding saying they would explore ways to cooperate in the production of batter-powered cars.

A statement from Volkswagen at the time noted that “hybrids and electric vehicles will play an increasingly important role, or course. Particularly for the Chinese market, potential partners such as BYD could support us in quickly expanding our activities.” A senior Volkswagen executive who requested anonymity told Fathom China that Volkswagen takes cooperation with BYD seriously. China is now Volkswagen’s biggest market by volume, and the company has dispatched teams of senior engineers to spend weeks at a time at BYD’s production facilities to review its electric cars. Although Volkswagen also has agreements with other battery producers, notably Toshiba, “it makes

BYD Sept 2009 © Fathom China. Redistribution prohibited. 53

sense for Volkswagen to find a battery partner in China because that’s where the growth will come,” says the executive.

Just how business cooperation between these two firms would work is anybody’s guess, although a joint venture seems unlikely within China. Foreign firms are allowed only two joint ventures, and Volkswagen already reached its limit. A third seems improbable.

BYD executive Li Qian indicated that a supplier relationship is more likely:

The goal is to provide batteries to Volkswagen for electric cars. The speed of this cooperation depends on Volkswagen. We can help them move faster. Volkswagen has been talking to other providers too, but we’re confident. Volkswagen engineers are here working with us.

8.3 New A-Share Listing

SECTION SUMMARY: After an 18-month delay, the Chinese government has approved BYD’s request to list shares within China.

BYD plans to list 100 million shares on China’s A-share market, which is available only to Chinese investors and some foreign institutions. The listing was approved in July and will likely take place in the middle of 2010. It is expected to raise a bit more than Rmb3 bn.

The listing will likely allow BYD to reduce its high gearing ratio and expand its capital- intensive auto manufacturing, as well as provide ready cash as the company starts selling its all-electric e6 in the US next year.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 54

Disclaimer

This Fathom China Ltd. publication has been prepared in accordance with Fathom China compliance policies and has been approved by Fathom China for exclusive distribution to clients of GaveKal Research and Dragonomics Research. Fathom China is committed to the integrity, objectivity and independence of its research. To that end, Fathom China researchers are prohibited from investing in companies covered in Fathom China’s reports.

Although the information contained in this publication is obtained from sources the company considers reliable, the accuracy and completeness of such information cannot be guaranteed. This report is intended primarily to provide education and information to market professionals and institutional investors; it should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. This report should not provide the sole basis of any investment decision. Neither Fathom China nor any of its employees, nor GaveKal Research, Dragonomics Research or any of those firms’ respective employees, shall be responsible for any investment decision.

Fathom China publications may not be reproduced, distributed or republished without the consent of Fathom China Ltd.

BYD Sept 2009 © Fathom China. Redistribution prohibited. 55