Andrew co-founded Platinum in 1994 as the Deputy Chief Investment Officer, having worked alongside Kerr for several years at Bankers Trust and perfecting the craft of.. More
In late March 2017, I visited China, meeting people from a wide range of different businesses and backgrounds.
Many of the meetings were with representatives of unlisted businesses, which ranged from distributors of consumer products, commodity traders, Internet-based finance companies, to small state-owned coal miners and regional banks. This type of schedule differs from our usual meetings with management of listed companies, but over the years we have found that these trips provide a very different perspective on China from our traditional schedule and, as such, can offer valuable insights on what is always a rapidly changing landscape.
The Rise of Local Brands
One meeting was with the distributor of fast-moving consumer products (shampoos, soap powder, etc.) that represented a very large and successful multinational company in a region within Guangdong province. He highlighted that one of the challenges for the business was the rise of new local brands. In the past, these start-ups had been kept out of the market because of the sheer cost of large scale advertising on TV and in print. The advent of digital advertising has opened a door for these companies and, what is more, it enables them to target very specific groups, such as 15 to 25 year old women. Interestingly, many of these new brands are having success with products priced at a premium to foreign brands. Together with digital marketing, e-commerce is a distribution channel that has also reduced the barriers for smaller local companies.
A meeting with a company that manages the online presence for some of the smaller multinationals in China highlighted that selling online is much more than just setting up an e-store on T-Mall (the Alibaba e-commerce platform) and sitting back and waiting for sales. There is an ongoing daily need to adjust the offering, put on promotions, bid for keywords and the like. According to the distributor we spoke to, this poses another challenge for his multinational principal who, while well aware of the need to respond to these challenges, simply cannot move fast enough.
The rise of local brands highlighted in these discussions comes as a direct contradiction to the often-heard mantra in the financial markets that the multinationals have a sustainable advantage in China due to concerns around product safety. An amusing story, though, is that of one successful local company which had given itself a name and brand to create the impression as if it were a Korean company. This worked well until China’s recent fall-out with Korea for facilitating the US anti-missile defence installation which led the Chinese government to direct its patriotic citizens to avoid all things Korean!
The other observation on local brands came from the auto market. An industry expert (an American who has had a long involvement in the Chinese market) reported that the difference in quality between good local Chinese carmakers and foreign brands is by and large imperceptible to the Chinese buyer. This may well be somewhat of an exaggeration, but the independent JD Power survey on product quality actually supports the claim with respondents citing only a minor difference between local and foreign makes in terms of product quality. Of course, more important than perceptions are sales, and numbers have spoken louder than words with the domestic producers’ market share having risen from 30% in 2012 to over 40% in 2016. In this period, China’s passenger vehicle market increased by approximately 10 million vehicles annually, of which 5.7 million were supplied by domestic brands in 2016.
The Ubiquity of Alipay
Alipay is an electronic wallet or online payment system that grew out of Alibaba’s e-commerce platform in much the same way that PayPal had developed hand in hand with eBay. In China, however, Alipay has evolved to be much more than a way of settling online payments and, in the absence of a deep network of credit card and EFTPOS terminals, has become the way of settling essentially any transaction. Payments can be made from the app on one’s mobile phone directly to the recipient. Setting up an account is straightforward and funds are transferred into and out of one’s Alipay account via one’s Chinese bank account. The best news for merchants is that no fees are charged, making the system very attractive. What we were continually told by the locals is that there is simply no longer a need to carry cash, ATM cards or credit cards, as everyone from the street vendor of snacks to taxis and organised retailers accepts Alipay. This claim I suspect is somewhat exaggerated and was difficult to test, as, without a Chinese bank account, I couldn’t complete my own registration. Alipay claims to have 450 million active users and settles 200 million transactions daily. Annual transaction value is estimated at US$3 trillion. Needless to say, Alipay has many competitors, most notably, Tenpay, which is Tencent’s e-payment platform and is integrated with the hugely popular WeChat app. It is once again an interesting example of how China has bypassed the developed world’s approach and may well be moving to a cashless system faster than the West.
While the transfer of funds within Alipay attracts no fee, the platform hosts a universe of services by third parties from which Alipay does make money. One company we met is in the business of providing small (RMB 1000, or A$200) short-term (30 days) loans to university students. The company is having great success and incurring only a trivial level of nonperforming loans. The key lending criteria are based on the credit rating data provided by Alipay, which of course has quite a rich pool of data on the applicant’s payment history. This is notable because a group of consumers are gaining access to credit they never had. Similar businesses operate in the field of small business loans. In these transactions Alipay makes money only from the sale of the credit rating data. Other products on the Alipay platform include managed funds and insurance.
If the Alipay model were replicated in developed markets, the implications for credit card issuers and merchant acquirers as well as others who make a living off the payment system could be quite dramatic. Of course, this may be easier said than done, but undoubtedly many will be trying to emulate Alipay’s success. Ant Financial, the company that owns Alipay, is currently privately owned. But the listed Alibaba Group has a right to purchase 33% of Ant Financial’s shares when it becomes listed. Alibaba is held in both the Platinum International Fund and the Platinum Asia Fund.
The Pearl River Delta
In Taiyuan, the capital of Shanxi province, we met with managers of the local Foxconn plant. Foxconn is part of the Hon Hai group, the world’s largest contract manufacturer for electronics and best known for manufacturing iPhones for Apple. This Foxconn plant is a producer of components for the Hon Hai group. Taiyuan is coal mining territory and some 500 km from the coast, not quite the typical location for this type of endeavour. The Taiyuan operation, however, has an impressive 75,000 person workforce, up from 50,000 a year earlier. When one thinks of the challenges of hiring and training 25,000 workers in a year, the idea of moving this type of operation to the US becomes difficult to imagine.
Another meeting in Guangzhou later in the week with an expert in the design and manufacture of IT products made it even more apparent that President Trump’s plans of moving this type of activity back to the US, to any significant degree, has little chance of success. In the Pearl River Delta at the south-eastern end of China, there is an entire ecosystem of service providers, from design, manufacturing and packaging to logistics and transportation, that deliver goods to the rest of the world at extraordinarily low cost. For the individual with a product idea simply sketched out on a piece of paper, there are service providers who will turn the sketch into CAD drawings and create working prototypes using 3D printers, all at a trivial cost. Or, more questionably, if you would just like to copy someone else’s products, there are providers who will reverse-engineer the product right down to the semiconductor and printed circuit board level. Of course, custom packaging can readily be created for your "new" product. All of this can be done in a matter of weeks, and from your desk anywhere in the world. Once you are ready to produce, there are traders who can provide standard components, and who, because of the extraordinary volumes they handle, will supply to you well below list prices. And then, of course, there are plenty of contract manufacturers.
Then comes the logistics side of the equation. If, for example, you wanted to sell your new widget on eBay, you can have the whole fulfilment and shipping run out of China. Assuming you earn at least US$0.75 on your product, you would, we were told, in most cases be able to afford to offer your customers free shipping to anywhere in the US! The one downside to this is that the delivery time is measured in weeks. The most telling story is that many apparel and footwear manufacturers who have moved production to places such as Vietnam and Bangladesh are shipping their products to Shenzhen prior to shipping to the US or Europe, in order to hook into the logistics and fulfilment supply chain of the Pearl River Delta.
Supply Side Reform
An important development in China during 2016 was the supply side reform in the steel and coal industries. A directive from the State Council early in the year called for sub-scale plants and mines and those not meeting environmental or safety standards to be closed. The policy was directed at the state-owned enterprises (SOEs). Historically, such directives from the centre have often had little impact, but this time, and perhaps as a result of President Xi’s consolidation of power within the Communist Party, the directive was followed. It is estimated that 85 million tonnes of steel capacity and 290 million tonnes of coal capacity have been closed down, though, admittedly, some of these closures were of capacity that was not operational. Production limits were also placed on remaining coal mines which were restricted to 272 days of production annually. The response to these measures was a more than 100% rise in coal prices in less than six months and a return to profitability for the steel and coal industries. This is all well known.
The interesting insights came from meeting with people who were familiar with some of the coal mine closures that took place in Shanxi. They described the closure of two small mines in the province owned by a local SOE, which not only had low output, but also very short mine lives. These were mines that had in recent years been loss-making. Asked why they had not been closed earlier, the response was simply that the local SOE had responsibilities to maintain employment in the province, though a fund established by the central government to compensate redundant workers had allowed them to pay laid-off workers sums equal to two years’ wages. Asked about any outstanding debt to banks on these operations, we were informed that the burden of these debts was now being borne by the SOEs in other operations, which are now very profitable.
The other interesting observation is how the local provincial government and banks view the issue of overcapacity in industries. As the coal industry has now returned to profitability in Shanxi, the local government has seen a significant rebound in taxation revenues, and presumably also benefits from being the owner of profitable entities. The coal mine closures and the production restrictions have created shortages in the coal market, and the production restrictions have been removed. However, in Shanxi, the provincial government is considering making the limit on production days a permanent measure, having seen the benefits of a profitable industry.
Similar benefits have been felt in the banking system. The coal and steel industries collectively account for around RMB 7 trillion in debt, and the unofficial view was that nonperforming loans were running as high as 40% of the total loans. Today, post the supply side reform, the vast majority of these loans would be performing. This makes the cost of redundancies of RMB 100 billion look very attractive for the government who otherwise would have ultimately been on the hook for these nonperforming loans. Many are sceptical about the sustainability of this supply side discipline in China, and, undoubtedly, some closed capacity has been re-opened, given the more favourable market conditions. However, we also heard from banks that were refusing to provide working capital loans to steel and coal companies that needed funding to restart operations.
One foreign businessperson that we met on the trip referred to the unholy trinity of local governments, local SOEs and local banks that keeps capacity open where it should be closed, ensuring that the next new area of growth would be overwhelmed by excess capacity. The success of this supply side reform has potentially broken this nexus, though this risks being too strong a conclusion. Certainly, there is discussion of these reforms being applied to other areas where the SOEs are responsible for excess capacity in the market.
DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.
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