(The Wall Street Journal)
Updated: 2007-08-02 15:26

In the eyes of many investors, bigger is better for Shanghai Automotive Industry Corp - but there's no guarantee a greater size would smooth the road for China's leading car maker.

Shares of SAIC's listed unit, Shanghai Automotive, have been surging for months, in part on speculation of a merger with smaller rival Nanjing Automobile (Group). In the first four weeks of July alone, Shanghai Auto's share price climbed 38%.

Then, during the past weekend, SAIC said it signed a letter of intent with the parent of Nanjing Auto for "full cooperation." Details haven't been provided, and it's unclear whether cooperation will entail the full-fledged merger on which synergy-minded investors have bet.

In the first two days after the weekend announcement, shares of Shanghai Auto -- which trade only in Shanghai -- stayed high. Yesterday, as all Asian markets fell, Shanghai Auto's share price dropped 4.2% to 22.89 yuan ($3.02). The Shanghai composite index lost 3.8%.

Merger speculation wasn't the only factor fueling gains for Shanghai Auto, as it has reported sharply higher earnings and many analysts like its outlook. Even with yesterday's drop, the share price is more than four times higher than a year ago.

The recent ascent in Shanghai Auto shares makes some analysts wary. "Probably the mainland investors got too excited about the acquisition -- the bigger the better, that kind of mindset," says Lehman Brothers analyst Yankun Hou. A full-scale tie-up between the two groups could be a drag on Shanghai Auto, at least in the short term, says Mr. Hou, noting Nanjing Auto has posted operational losses in recent years. And in big mergers, there's no guarantee the execution intended to knit the two together will be smooth or successful in the long term, he says.

Shanghai Auto already faces challenges. Its income depends heavily on the performance of its joint ventures with General Motors and Volkswagen. Goldman Sachs warns that sales-volume growth at those ventures could weaken "as core models become increasingly obsolete." Goldman also says competition in China's full-size car market, pivotal for Shanghai Auto, could intensify.

Goldman initiated coverage on Shanghai Auto in early June with a "sell" recommendation and a 12-month target price of 11 yuan, below where the shares were trading at the time. So far, Goldman hasn't altered its view on the company.

Moves by SAIC and Nanjing Auto to find common ground fit with China's aim to consolidate its fragmented auto industry and create national players that can take on the global auto giants. It's a policy that Beijing has used in other industries, such as retail and steel, and is sometimes carried out despite much resistance from the players involved.

For sure, analysts see potential benefits for SAIC from a partnership or tie-up. Zhang Xin, an analyst at Guotai Junan Securities in Beijing, says SAIC could benefit from Nanjing Auto's truck business, an area which the Shanghai auto maker has been trying to beef up. Nanjing Auto has a profitable but small joint venture with Fiat's truck unit Iveco, producing light commercial vehicles. It also holds Yuejin Vehicle, which produces heavy-duty and light trucks.

In 2005, SAIC and Nanjing Auto collided head-on in bidding for collapsed MG Rover Group of Britain. Nanjing Auto won the bid, but in 2004 SAIC had already acquired some intellectual-property rights for the Rover 25 and Rover 75 models.

SAIC's joint ventures with GM and Volkswagen have catapulted it to the top of the Chinese car industry, with sales last year of 1.34 million vehicles. Meanwhile, Nanjing Auto's joint venture with Fiat has been one of the poorest performers in China, and relations between the two are strained.

More-modest cooperation that focuses on developing the MG brand could be more beneficial for SAIC. SAIC used the Rover platform to launch its own brand, the Roewe, which it started selling this year. So far, it has sold 8,000 Roewe 750s, which are based on the Rover 75 model.

For its part, Nanjing Auto inaugurated its production line in Nanjing in March for MG model sports cars, and aims to begin selling them in China by September. It has started production at MG Rover's former sports-car plant in the U.K.

"For Nanjing Auto...rolling out its Rover platform needs a lot of capital and [SAIC] will be a strong financial backer," says Citigroup analyst Charles Cheung. "For [SAIC]...on the Rover side, they only have two models. In order to ensure future continuous new models development, obviously it makes sense for them to work with Nanjing Auto."

Citigroup initiated coverage of Shanghai Auto on July 3, with a "buy" rating and target price of 23.20 yuan.

Shanghai Auto's net profit is expected to triple or quadruple this year and the company has drummed up excitement with its new brand of Roewe cars. But Mr. Zhang of Guotai Junan warns against reading too much into earnings growth this year, which he says will be the result largely of restructuring. He has a target price of 25 yuan for the company. Last year, SAIC injected auto-related assets of 21.4 billion yuan ($2.82 billion), including stakes in the GM and Volkswagen joint ventures, into the listed company. That turned what was mainly an auto-parts maker into China's top car maker.

According to Thomson Financial, the full-year average earnings forecast by five analysts is 4.74 billion yuan, or 71 fen a share, and 5.68 billion yuan for 2008, for a per-share earnings of 86 fen. In 2006, net profit was 1.42 billion yuan, or a earnings per share of 22 fen.