Why GM Is Already Losing in China

October was another solid month for General Motors (NYS: GM) in China. Sales were up 14.3% over year-ago numbers, enough to give GM its best October ever in the Middle Kingdom.

GM leads the Chinese auto market, though lately it has run neck-and-neck with Volkswagen (NASDAQOTH: VLKAY), which has a huge presence in the country with several strong-selling models.

The race between VW and GM for Chinese sales supremacy will be interesting to watch, though it really shouldn't matter all that much to investors - both are posting big sales numbers and solid gains.

But in one respect, GM has already fallen far behind its German rival in China.

The secret to VW's big profits in China
Ponder this: While GM outsold VW in China in the first half of 2012, it sure didn't out-earn its German rival. VW earned 1.8 billion euros (about $2.3 billion) from its Chinese joint ventures through June. GM? About $700 million.

So what accounts for that huge difference?

Here's the difference: Product mix. About half of the vehicles GM sells in China are Wulings, cheap and simple minivans often used by small businesses in interior China. GM sells lots of them, but because they're cheap, profits per vehicle are small - and that's before GM splits the earnings with its joint-venture partners.

VW has joint venture partners too, but its product mix in China is much more profitable. Of particular note, VW is selling about 35,000 Audis a month in the Middle Kingdom, where the luxury brand has become the favored ride of the wealthy and powerful.

That's only around 15% of VW's total sales in China, but it's enough to deliver an outsized profit. Audi sales worldwide are dwarfed by sales of VW-branded vehicles, but Audi still accounted for 46% of VW's profit in the second quarter.

Clearly, Audi's margins - and profitability - are huge. Just as clearly, GM CEO Dan Akerson would dearly love a piece of that action. But sales of GM's own luxury brand, Cadillac, have been tiny in China - just a few thousand a month.

That's why GM is planning some big changes for Cadillac.

A new look for a very old brand
GM's market research has shown that Chinese customers are willing to consider Cadillac, but many find the company's designs to be too bold. GM's current design paradigm for Cadillac, which it calls "Art & Science," is inspired by stealth military planes - sharp lines and jagged edges. Chinese consumers seem to respond much better to cars with smoother shapes, like... well, like Audi's current designs.

Cadillac has already come a long way in recent years. Its newest models, like the small ATS sedan, have largely closed the perceived quality gap that long existed between Cadillac and the German luxury brands. That's a huge step forward: Cadillac, long treated as a tired joke, is now being taken much more seriously by sophisticated buyers. But Cadillac needs more great models - and it needs styling that will play well globally.

Those are both on the way, with the ATS (and last year's stunning Ciel concept car) showing the first hints of a softer-edged style for Cadillac. Akerson wants Cadillac's sales in China to equal its sales in the U.S. by mid-decade, and he's planning to invest heavily to get there. GM is said to have an overhauled, larger version of its midsized CTS sedan on the way, as well as a new large "flagship" to compete with cars like Audi's A8. And the brand got a new chief last month.

GM's not the only one with this idea
Like GM, rival Ford (NYS: F) is investing in its own long-neglected luxury brand, Lincoln, with an eye on China's booming market for luxury cars. Ford just appointed its well-regarded marketing chief, Jim Farley, as Lincoln's new boss. And the company has a new lineup of Lincolns on the way, marked by - you guessed it - smooth-edged styling that should play quite well in China.

But the stakes are arguably bigger for GM. Ford is an up-and-comer in China, but GM is an established market leader. Its big investment in Cadillac is likely to be taken seriously in China - if the cars are good enough. We shall see.

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