WHAT IS GOING ON IN GUANGDONG?

This month I want to share with you some highlights from my latest trip to China.

I visited ten factories, one real estate project and met with management from three other companies.  The meetings in aggregate provide a representative cross section of economic life in arguably China’s most important province, even if somewhat skewed towards traditional manufacturing industries.  I also encountered a diverse group of corporate personnel from CFOs to shop floor supervisors.

The majority of companies were located in or around Dongguan and Shenzhen, but visits included Foshan, Qing Yuan City, Panyu, Shunde, and Zhuhai.  There was also time to walk around a couple of shopping centres.  We stayed in a hotel owned by a company where some of our clients are invested.  On that note I can confirm that the Ritz Carlton in downtown Guangzhou has an outstanding Chinese restaurant : for food, ambience and service. 

Ritz Carlton Guangdong

Guangdong has been among the most progressive parts of China.  Of course its proximity to Hong Kong has been more than helpful.  Some thirty years back early entrepreneurs began to build businesses across the border.  Thus the main metropolitan areas are mostly mature.  That said there is still modest inward migration into key cities such as Guangzhou and Shenzhen.  Yet as of 2015 most residential real estate activity is driven by upgraders.  Anything built before 2000 looks shabby and second rate.  Interiors too have come a long way as have buyer expectations.  Bare shell still predominates, but fully fitted is the future.

There is plenty of money.  We saw no old cars on the road only in the wrecker yards.  At all levels wages in real terms are still rising as they have done since the 1990s.  One company talked about the days – not so long ago – when it paid R400 per month fully loaded to shop floor workers, whereas the better ones now take over R4,000 back to their dormitory.  R2,000 is the starting point.  Not a lot to live on, but move up the productivity ranks and your net can support a lifestyle that goes beyond the bare necessities.  Expectations are that real wage rates will go up again next year by 3-5%.

This may explain in part comments on several occasions about a shift in priorities and spending patterns.  Maslow’s needs hierarchy is not just a neat theory.  It plays out in practice.  Food first : then shelter.  Something basic to begin with : then the better things.  After that comes appearance; what other people see.  Clothes of course and accessories especially bags.  You can of course have too much of a good thing.

The Daphne store – a mid-end national shoe chain - was tired.  Everything appeared to be on sale.  Our interpreter remarked that the quality of the shoes are not good enough for R299.  Next door Belle – a higher end retailer - looked a lot more appealing.  There were no customers when we were there but the saleswomen seemed happy enough claiming some of the styles in the new collection were selling well at R1,200.  The jewellery area of one mall was deserted.  No one stopped even to browse at Chow Tai Fook or Luk Fook.  Jewellery results may not get better for a while.  Interestingly the following week both companies duly delivered profit warnings for 2015.  We knew things were bad in Hong Kong, but China is not going to bail these businesses out, not based on our sample at least.

Having met basic needs, the question turns to where Chinese consumption will flow.  The anti-corruption campaign does seem to have altered behaviour reigning in   conspicuous spending.  Wine, high end spirit sales and even restaurants are all suffering.  It is not back to noodles, but suckling pigs are a little safer.  One theory is that more money will now go into making homes nicer.  Smart appliances is a possible destination, especially as product upgrades embrace the Internet of Things.  Model cycles seem to be getting shorter if nowhere near the turnover of mobile phones.  Furniture could also see more money.  Decoration is another possibility, such as better floor tiles and lamps.    

In the manufacturing world a strong currency does hurt, though there is a not insubstantial cost offset due to overseas sourcing of raw materials and components.  The TPP was a subject that came up several times.  Some companies have already positioned for this expanding in Cambodia, Indonesia, the Philippines and Vietnam.  Others claim to be less concerned claiming worker productivity, supply chain clusters and lower logistics costs will outweigh duty benefits.  These points have merit.  Yet it was noteworthy that Coach had stopped sending bag orders to one supplier for just this reason, while another claimed it had been wining new business for their plants in countries that stand to benefit; and higher end capacity in those countries is for now so limited that they were able to require customers to allocate part of any order to China if they wanted to secure space in duty friendly locations.

One common trend was moving up the quality curve.  We saw this everywhere if manifested in different ways.  The shift included new products with more features, or better appearance, more emphasis on the QC role, and increased investment in R&D.  Cost is still under the microscope but the cost/quality trade-off is more nuanced as companies reassess customer priorities.   In that hierarchy there appear to be regional variations.  The Japanese are quality fanatics.  Many American companies maintain a focus on cost first and foremost – one supervisor commented that Gap is crap – while Europeans appear to lie somewhere in the middle.  An American brand that will remain unnamed was buying all the leather rejected by Prada.

Still cost was not neglected, but the emphasis was not on cheaper and cheerful, or even plain cheap as used to be the case.  Automation featured everywhere even though the economic advantages varied.  It made an impact in a variety of ways notably through declining defect rates, as well as reduction in the number of workers on the factory floor.  Welling, the world’s largest manufacturer of micro motors, had installed Yaskawa robots since my last visit 2½ years ago.  Among other improvements that investment had contributed to a workforce decline of over 50% during the period. 

Interestingly Sitoy, China’s largest manufacturer of handbags, had such a poor experience with specialised machinery that was supposed to spot defects in leather that they were barely using the semi-automated process.  Experienced people were apparently more cost effective, and getting the most out of such expensive raw material was one of the keys to better margins.  So not all one way – but the trend is more machines and less people.  This trend is only going to accelerate as good workers get harder to find and retain in Guangdong; and of course they cost more each year, bringing down the breakeven point for capital/labour substitution and accelerating the payback period. 

I have pulled out a couple of key points from each company visit to illustrate what is going on at the businesses.

Luen Thai (garment cut and sew plant and separate handbag plant)

Uniqlo growth in China a key driver.  Uniqlo employees sit on the sewing line. Quality similar to shirts that sell at twice the price.

Ballooning business at Batam facility, yet excess capacity in China.  Balance will be a challenge.

Expects to be a big beneficiary of TPP

Skyworth (TV production and set top box assembly : market leader in both products in China)

Is OLED the next new wave?  OLED panel availability a possible bottleneck

Game playing over large panel smart TVs should be a key driver for model upgrades at higher margins

QC area has seen significant automation advances since my last visit 2½ years ago.

Packaging going through automation conversion : will cut the number of workers on that part of the line by over 70%.

Expansion of set top box capacity in purpose built plant will introduce more efficiency and significantly reduce subcontracting.  In-house production should mean better gross margins in 2016/17.

Expanding  commercial real estate portfolio and growing rental roll : 2017 fiscal impact could be material.

Hopefluent (largest real estate broker in Guangdong) 

Market back into positive unit growth and ASPs rising once again though still some patches of weakness.  Shenzhen exceptionally strong.  Shortage of new projects in some places

Banks making life much easier for borrowers both in lending terms and speed of processing mortgage applications.  Sales are easier to close than at start of year.

Disruptive models like Soufun only work in the secondary market and have Kamikaze elements.  Soufun hiring mostly poor producers.

Sitoy (China’s largest manufacturer of handbags) 

An experienced workforce is key to productivity and margin.  3+year cutter can achieve up to 50% less material waste than one with just six months on the job.

Have implemented multi-faceted employee compensation structure.

Developing own brand to capture full channel margin.  Base OEM price gets marked up roughly 6x to retail on Madison Avenue (sometimes more!)

Dramatic variation in leather quality across brands.

Very impressive design studio/capability

Samson (Largest manufacturer of case goods in China)

Sees furniture market picking up in the US after long hiatus.

Now able to justify major upgrade of plant and machinery : first serious cap x since 2008.  Upgrading both for productivity and to reduce pollution.

Veneer application a key element of product quality and cost driver.  Expertise in this area a critical competitive competence.

Hotel industry also in positive refurbishment cycle after long weak period post GFC.

Dongpeng Holdings (one of three major tile manufacturers, probably the market leader) 

Main tile plant impressive with high degree of automation especially in polishing and painting, plus driverless fork lifts on the shop floor and in the warehouse.

Low cost producer when at full throttle (it was when we were there)

Moving product mix up market with major investment in design and product range expansion

Sales channels shifting as more developers go for fully fitted units, a trend that is likely to continue.  Makes marketing easier.

MIS a key priority with company connecting distributors to SAP system for better information flow and control (and significant personnel savings).

Material value to be unlocked when company moves from Foshan downtown site, but timing unknown.

Goldpac (#4 worldwide and #1 in China for credit cards) 

Amazing that largest centre for card personalisation in the world (900 million cards p.a.) is so small.

Linked in to Union Pay, so benefits from their strategy to go global.

Interesting extension of full service hardware and software card issuance to standalone remote locations.  Is this a major new business?

Conversion to local Chinese chip manufacturers going slowly.  Infineon gaining    share from dominant niche provider NXP.

Healthcare card will be a massive new sector, but who is going to pay?

Welling (World’s largest manufacturer of micro motors for air conditioners and washing machines)

Significant reconfiguration of assembly process with meaningful increase in average employee productivity.

Development of dedicated customer lines for global leaders.

New motor line comes from a Chinese equipment supplier replacing traditional supplier, an Italian machine builder : same efficiency but less than half the capital cost for similar throughput.

Material inventory managed down to 3 days.  JIT in action.

Further workforce shrinkage expected over next three years.

China is changing.  The factory of the world is yesterday’s business model.  Yet industrial public companies can still provide investors with attractive opportunities even as the service sector becomes the main driver for growth.  Some of these HK listed names should deliver solid earnings improvement while available now on single digit P/Es.

All these companies recognise the growing importance of quality of employee versus basic payroll.  Automation was not just a factory floor issue : it is starting to affect the office as well.  Still it seems like there is still a lot of low hanging fruit to pluck, and we were seeing the better companies.  ROCE could and should improve.  Innovation and efficiency gains suggest price deflation (even excluding raw materials) has further to go.  This implies anything beyond single digit sales growth is going to be a challenge, but profitability will be more in focus and therefore profit growth could be relatively easier.  Companies that do not participate in these changes will disappear.  If the management of companies you own do not embrace these trends, consider transferring investment allegiance to those that do.  There are plenty to choose from.

2003-2013 was all about the top line and getting bigger fast.  2015-2025 could be about getting more profitable and making more careful use of capital.  Too early to be sure but some encouraging signs are there.

Please feel free to give me your feedback if you have seen similar trends or disagree.  Thank you.

CAN IT GET ANY WORSE IN UKRAINE?

It has been more or less a year since I was last there in Kiev.  There has been a lot of change, and sad to say things have generally got worse for the average Ukrainian.  It is the way of change that the bad tends to come before the good, and it is also the case that there have been some positive developments particularly in respect of policies passed by the new parliament.  Implementation is of course another matter.  That has been patchy with plenty of resistance from vested interests, some of whom are close to the President.  Still given the flow of events Ukraine is now considered to be a better environment than the country of two years ago; but the price to get from there to here has been very high for Mr and Mrs Dnipro.  

Of course silly things still happen that retard a return to normality.  What is the point of aggravating Russia by cancelling flights between Moscow and Kiev when there are still significant economic activities between the two countries despite what is going on in the east?  There conditions seem a little bit better though one must hope it is not just a calm before another storm.  Cutting any channels of communication is particularly stupid just before officials have to go and tackle the one large residual debt not dealt with in the recent sovereign restructuring :  a loan from Russia.  Clearly the left hand does not know what the right hand is doing in Kiev or perhaps they do not care.  Pre the regional elections political point scoring was all the rage, though in fairness Ukrainian politicians do not have a monopoly on promising voters the sun and delivering Pluto.

My visit had to be brief due to the reduced level of our investments in the country that do not allow a greater allocation of time.  Sadly a couple of our companies have ceased to exist.  In one case the main manufacturing facility was vaporised by the fighting.  Against that other companies have managed to prosper at least relatively.  Our biggest holding is Ovostar.  Ovostar has worked its way up to be the number two producer of eggs in the Ukraine and is the market leader in dry and liquid egg products: actually the only producer of liquid in the country. Management have been careful with both the balance sheet and the pace of growth.  They also emphasised exports where they can to ensure they make the most of higher external prices and stronger currencies. The first half of 2015 showed reasonable results even expressed in US$, and excellent numbers in local currency terms. In terms of currency the company is net long the $ both in the income statement and balance sheet, but net short the Euro, and of course over 70% of its activities are in Hryvnia. Still it has avoided the problem too many companies in the country faced with 80% devaluation. Ovostar has the lowest debt/equity ratio and highest debt service coverage ratio in the listed sector.  This is a well-run concern that is a survivor and long term leader.
While quoted in Warsaw the company reports both in local currency and in US$ for the benefit of foreign investors. In one the growth is massive; in the other slightly negative. Capacity and production are planned to rise by a middle double digit amount through 2017. This looks achievable. The P/E for this year is probably around 5x. With about 50% of its output in branded product were Ovostar located anywhere else it would be valued much more highly, arguably between 10-12x. All of which is why it is the largest position in the portfolio.  Nice to see that legendary Canadian value investor Prem Watsa of Fairfax agrees.  He recently bought a stake in the company.  Please note this commentary does not constitute investment advice especially since the share is hard to buy or sell.  It is by way of context.  

There is not much left of what was once a flourishing stock exchange.  There are almost no companies still listed with a market capitalisation over $100 million.  The equity world is a wasteland with little trading.  Fixed income investors have had a more interesting ride.  Those brave few who took the plunge earlier this year before the renegotiation have done rather well.  So there is quite a bit of activity in that asset class; but for those of us more focused on equities, it is slim pickings for now; and likely to stay that way.  Reform of the Stock Exchange is on the agenda for April 2016.  A lot of good stuff is percolating through from the work of Dymtro Tarabakin, who has been seconded from Dragon Capital to drive the process.  Until the President signs off, we can only hope he will be able to find a way to close the loopholes that have allowed unscrupulous adventurers (and not just local oligarchs but foreign firms as well) to trample on the fig leaf of minority protection and demonstrate that no such thing exists in Kiev even 20 years after shares formally began trading.      

General impressions are that Kiev is a bit more lively than when I was there a year ago. To start with the Hyatt hotel had more guests; by no means a sell-out but closer to 40% occupancy than 20%. There was more traffic on the roads. Road side billboards were full of advertising and not just political stuff but plenty from real businesses presumably paying something. The atmosphere as I walked around was less tense.

Against that traffic at shopping malls is down about 20% y-on-y, and some retail sites off the main shopping areas look empty. The official numbers continue to show an economy in contraction, even if economists are predicting growth in 2016.  After what happened in 2014 and 2015 it is not out of the question, but a real sustainable recovery awaits resolution of political issues that are emotional as well as substantive.

Still all of this was before the regional elections. While these are local and in theory the central parliament is in place until 2019, stability could have been called into question if the voters showed a big shift away from the governing coalition. As one coalition party is not on the ballot some erosion was certain.  A bad result could even trigger a realignment. The polls suggested a modest, and therefore manageable decline, but pollsters have not had a good year anywhere, and one cannot put much faith in these ones. There are a lot of undecideds out there; and growing concern over government lethargy.  The first round was largely inconclusive with only moderate shifts in key cities.  Since a second round is required these results bear careful watching.

That aside there have been patches of genuine progress of late that underpins the potential for the economy to improve next year. Renegotiation of the sovereign debt was no victory but could be considered a necessary step. The relationship with the IMF, EBRD and other multilaterals remain supportive; and their support is vital.
Arguably most important the situation in the East is at least temporarily calmer. Long may that last even if no permanent resolution is in sight. Lastly an agreement has been reached with Russia for gas prices to be reduced, allowing subsidies to shrink, helping the balance of payments and taking pressure off the budget. Foreign reserves rose last month. Perhaps that is why government employees just got a 10-20% pay hike; or perhaps that was more to do with October's regional elections? Either way more hryvnia in their pockets should give a lift to local consumption and cover the cost of utility bills this winter that will be higher due to the IMF mandated subsidy reduction.

The elephant in the room remains corruption.  Progress there has been disappointing. Some people feel the country has swapped one set of crooks keen to enrich themselves for another. Certain countries have been expressing concern, including Canada and the UK.  The US Ambassador came in for criticism from some people I spoke to for not putting pressure on the government, presumably on the basis better our crooks than their crooks. Yet others feel he has been vocal in attacking this the most difficult challenge for the country.  Failure extends to limited reform of the legal system. At least one oligarch appears to have established his own local army. So resentment in the street is growing. As we know the street in the Ukraine can be a powerful force.

Property is always a good place to look to assess what is happening to the economy of a country. Here the statistics remain dire. Retail rents are off 50% even for prime sites - reflecting the currency collapse. Many landlords are switching to a low base plus a turnover percentage to retain tenants. Vacancy rates appear to have stabilised this year. Yet in office vacancies reached 20% the same level where they were briefly in 2009, while industrial rents are down 20%.

The residential picture is less transparent due to the growing gap between posted prices and clearing prices, but available data suggests that real deals are being transacted at per sq. ft. prices comparable to 2004, and raw land prices are down by over 70% or more from their 2008 peak. While conversations with people in the business suggest the floor has yet to be found, the view is that with construction at close to a standstill it would not take much to get a good bounce - especially in Kiev. The crane index is encouraging in the sense that there isn’t one! I only saw four during my visit, and none were moving. It is not often residential prices in a capital city decline by two thirds, as has happened here. This space starts to look tempting for investors without liquidity constraints, but only if there can be greater comfort that the security situation in the East really is stabilising, as it does appear to be doing.

Economic statistics are usually dry.  This blog tries to be both informative yet interesting.  Still I do think the best way to convey what has been going on in Ukraine is to add here an edited extract from a recent report on the country’s economic situation produced by SP Advisors, in the second week of October 2015.  

“The pace of economic decline continues to decelerate.  All data suggest the economy is touching the bottom. Nearly all the major sectors are close to launching a recovery.  The first green shoots are becoming visible. We maintain our view that 4Q15 will be the first quarter of growth (in qoq terms) after 7 straight quarters of decline and that the economy will be on a recovery path through 2016.

Growth in consumer prices gained pace in September (+2.3% mom) mainly driven by seasonal apparel and footwear, a ripple of deep hryvnia depreciation in 1Q15. Still, annual CPI decelerated to 51.9% from 52.8% in August. On balance, the disinflationary path Ukraine is currently on will continue, with weak consumer purchasing power playing the key role. We affirm our end-2015 CPI projection of 46% and expect a further drop-off to 10-15% in 2H16.

The latest news from the FX market is encouraging. The UAH/USD market rate has remained in the NBU's implicit UAH 21-23/USD target corridor.  The central bank grew gross reserves 1.2% mom in September to USD 12.8 bin (+70% YTD).”

SP tends to look at life from a local perspective through somewhat rose tinted glasses.  Perhaps they need such colour to preserve sanity in what has been a miserable place for residents.  Still one gets the sense - as I did - that provided nothing gets worse in the east, the country could see improvement next year.  For now when you look at the chart on monthly industrial output and retail trade, it really is a depressing picture.  Imagine having to live through that lot and then thank the stars for where you live.  The charts bellow are courtesy of the NBU.  They are a horror show.  Even Greece looks good compared to this lot.

       
I believe we are one of only three organisations left still managing an Ukraine investment portfolio, so if SP is right it would be a welcome development.  As investors, however, we have to put emotion and prejudice to one side : fight the fear and hold back the greed.   Ukraine in 2016 might just be one of those places where the brave will do well.  One thing we can say is that since 2013 it has been the worst formal equity market in the wold for $based investors.  It is unlikely to win in that booby prize three years in a row.