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.