I had my TV service disconnected at home for awhile now, don’t want my kids to
become TV-addicts. We reconnected it on Friday so we could watch Olympics – I
am glad we did. The opening ceremony was incredible. It was a demonstration of
Chinese might, but not through a communist-by-the-book parade of nuclear weapons
and marching (expressionless) soldiers – this doesn’t impress anyone, not
anymore. No, the elegant, wonderfully choreographed performance by fifteen
thousand people, the marvels of modern technology (500 feet LCD screen comes to
mind here), virtually unlimited resources of the Chinese government and seven
years of preparation created a spectacular event that will be hard for any
nation to follow. I am sure Russia, the host of 2014 Olympic games, whose
nationalistic ambitions have grown together with its oil revenues is going back
to the drawing board on its opening ceremony.
In the spirit of keeping up with current events and providing
a contrarian take on popular consensus I wrote the following piece about
China.
The pessimist is the optimist who
has seen the future.
- Alexander Katsenelson (my older, wiser brother).
What do Starbucks and China have in common? A lot! Both got
us hooked on consumption: one of fancy, expensive caffeinated liquids; the other
on cheap foreign made goods. Both have defied the conventional wisdom – they
grew faster and longer than common sense told us was possible. They also share
another striking commonality: both are suffering from late stage growth obesity
(LSGO).
The Starbucks story
With the beautiful benefit of hindsight we know what happened
to Starbucks – it grew too fast, opened too many stores, and sacrificed its own
standards to meet unrealistic targets. The company first claimed that it only
had a few hundred stores that it needed to close, and then the few hundred
spilled into six hundred. Weak consumer spending will likely push Starbucks to
re-examine its store count again, doubling or tripling the store closures.
Starbucks percentage of new stores growth in 2007 was only
slightly lower than it was in 1999. But in 1999 it had 2,000 stores; in 2007 it
was pushing a 10,000 company owned stores mark. Let’s put this in perspective:
in 1999 Starbucks opened 447 stores - 1.8 stores per working day; in 2007 that
number more than tripled to 1,403 stores a year - 5.5 stores per working day.
At this level of growth physical limitations come in: there is only so much real
estate that fits a company’s criteria at a certain point in time. Management
started sacrificing
on the quality of their decisions, compromises were made that were
unthinkable several years before. Stores were opened too close to each other or
on the wrong side of the street, expensive leases were signed, they even hired
baristas that would have fit in better at McDonalds – you get the idea.
Unfortunately the present and the future will pay for the
decisions of the past: stores will need to be closed, long-term leases
terminated, charges taken, corporate costs created in hopes of high growth
eliminated, and corporate culture of partnership strained by barista
layoffs.
Starbucks needs to go on a permanent growth diet (at least in
the US), and realize that it has the metabolism of a 37 year old and can digest
fewer new stores. By tightening its standards for opening new stores the
company will be on the way to recovery, though at slower growth. Starbucks is
blessed with financial strength, capable management and unbelievable brand. If
management admits to themselves that the heydays of growth are behind, recovery
should be fairly painless. Starbucks generates tremendous operating cash flows,
which in the past were completely consumed by opening new stores. If the
company were to go on the LSGO diet, its capital expenditures would decline and
free cash flows balloon – the value unlocked.
But this discussion is not about Starbucks, it is about what
is taking place in China.
The Great China story
The benefit of hindsight that provides clarity in analysis of
Starbucks today is not there for China, at least not yet. But if you were to
open your mind and look past today’s cheery newspaper headlines you’d see that
China is suffering from a severe case of LSGO.
Ten for ten. Since 1998 its GDP has grown at about a 10%
annual real growth rate, and its economy more than tripled in size (in real
terms). There were no recessions, just expansion – the Chinese miracle
growth? The origins of China’s tremendous growth are well known: large
population migrating from low (farming) to higher productivity (manufacturing)
activity, cheap labor, a capitalism-friendlier communist government, and
insatiable demand from the US and the rest of the developed world for cheap
goods.
Unlike Starbucks – a private enterprise that has free market
principles deeply inbred in its DNA - China is a communist country. Though it
is moving towards free market capitalism, it is not there yet. The rule of law
is weak, the country infested
with corruption, and due to central planning and tight government control of
the banking system capital is often allocated based on cronyism (or political
relationships) not merit.
Prolonged high growth in this environment results in
inefficiencies that are compounded year after year. In other words, though the
growth is high, the quality of growth is low, thus asset allocation decisions
are likely to be poor. The ten year super-high growth marathon put China at
high risk, actually more likely of a certainty, of a severe case of LSGO.
From today’s perch we can only guess of the consequences of
LSGO, but we’ll gain that clarity after the fact – a luxury we don’t have.
Newspapers that are praising the Chinese growth miracle today will write exposes
on what went and is going wrong in China.
I have absolutely no facts to back up what I am about to say,
but it is not hard to imagine future stories about poverty stricken farmers that
moved to big cities for a better life and found despair; or that inland
migration (from farming to factories) only brings a onetime productivity jump as
poorly educated farmers-turned-factory-workers add little to productivity
improvements afterwards; or how weak and debt ridden the financial system is; or
the devastating impact that pollution has on health and productivity; or how the
biggest shopping mall in the world, that happens to be in China, is almost
completely empty.
Oh wait, the story about the shopping mall is not a figment of my imagination
(I am not that good) but has already taken place. In 2005 NY Times ran an
article titled China,
New Land of Shoppers, Builds Malls on Gigantic Scale, it talked about the
biggest shopping mall in the world that happened to be in Dongguan, China. The
article said:
“Not long ago, shopping in China consisted mostly of lining up to entreat
surly clerks to accept cash in exchange for ugly merchandise that did not fit.
But now, Chinese have started to embrace
America’s modern “shop till you drop” ethos and are in the midst of a
buy-at-the-mall frenzy…. by 2010, China is expected to be home to at
least 7 of the world’s 10 largest malls… Already, four shopping malls in China are larger than the Mall
of America. Two, including the South China Mall, are bigger than the West
Edmonton Mall in Alberta, which just surrendered its status as the world’s
largest to an enormous retail center in Beijing.” (emphasis added)
Fast forward three years and you find a
very different story: the biggest mall in the world - the South China mall,
with space for fifteen hundred stores, only has a dozen stores open for business
– it is empty. Shoppers never materialized. Billions of dollars have been
wasted.
Analyzing the Chinese economy while it is growing at
superfast rates is like analyzing a credit card company or a mortgage originator
during an economic expansion – all you see is reward – the growth. But the
defaults – the risk – are masked by a healthy economy and constantly increasing
new business that is profitable at first. The true colors of that growth only
appear after the economy slows down and new accounts mature. (In fact, the
banks or credit card companies in the U.S. that showed the lowest loan growth
during last expansionary cycle have a lot fewer credit problems than those that
did – U.S. Bank Co comes to mind here.)
The consequences of LSGO are likely to be very painful for
China. As of today we don’t know how much of the recent growth came from
wasteful, unproductive growth. Only after a slowdown will the true problems
surface.
The Speed. What makes things even worse is that China cannot
afford a slow down. I discussed this in the past but it is worth repeating.
The Chinese economy is like the bus from the movie “Speed”. In the movie the
bus is wired by a villain (played by Dennis Hopper) with explosives, and will
explode if its speed drops below 50 miles per hour. The Chinese economy has 1.3
billion unsuspecting people on board. It could blow if economic growth drops
below its historical pace.
A combination of high financial and operation leverage
sprinkled with past high growth rates will send this economy into a severe
recession if growth rates slow down. Let me explain:
High operational leverage. China has become a de facto
manufacturer for the world. With the exception of food products, it is difficult
finding a product that was not, at least in part, manufactured in China.
Industrial production accounts for 49%
of GDP, double the rate of most developed nations (i.e. industrial
production for the United
States is 20.5 % of GDP, UK
18.2% , and Japan
26.5%).
Chinese miracle growth is largely
driven by the manufacturing sector; historically its industrial production grew
at a faster rate than GDP. The manufacturing industry is very capital
intensive. Building factories requires a large upfront investment. High
commodity prices and rapid wage inflation has driven those costs up. Once a
factory is built the costs of running it are to a large degree independent of
the utilization level – they are fixed – a classical definition of operational
leverage. On top of these factors, laying-off workers is a politically
sensitive process in China, which creates another layer of fixed costs.
High financial leverage. Debt is
the instrument
of choice in China. Due to a lack of equity-fund- raising alternatives
(their stock market is very young), bank debt and underground finance companies
that charge very high interest rates are the predominate sources of capital in
China – this generates a great degree of financial leverage. (Though according
to my friend Bill Mann, The Motley Fool’s advisor of Global Gains newsletter, a
frequent visitor to China, state owned enterprises are much more leveraged than
private enterprises.)
Total operational leverage. Large
piles of debt (financial leverage) combined with high fixed costs (operational
leverage) create a very high total operational leverage.
Total operational leverage in
China is elevated further as factories are built to accommodate future demand –
this is a classical byproduct of LGSO. It is a human tendency to draw straight
lines and thus making linear projections from the past into the future. During
the fast growth period the angle of the straight lines is tilted upward, causing
an over investment in fixed assets, as inability to keep up with demand may
cause manufacturers to lose valuable customers. (Fear of over investment is
overrun by fear of losing customers.)
This type of thinking results in
tremendous overcapacity when demand cools. Here is an example: let’s say a
company saw demand for its widgets rise 10% year after year. It builds a new
factory to accommodate future demand, let’s say five years. It will likely
model a 10% annual increase in demand as well. But what if demand comes in at
6% a year over the next five years? This will translate into overcapacity - not
4% but 20% (4% per year times five years). Suddenly you don’t need to build
factories or add capacity for awhile.
This greatly leveraged growth is
terrific as long as the economy continues to grow at a fast pace: sales rise,
costs rise at a slower rate (in large they are fixed) - margins expand - the
beauty of leverage. However, leverage is not so sweet and soft when sales
decline. Overcapacity is a death sentence in the manufacturing (fixed costs)
world. As companies face overcapacity or slowdown in demand, they try to
stimulate sales by cutting prices, which in part lead to price wars (similar to
what we observed in the U.S. between Sprint, MCI and AT&T in the long
distance business during the mid 90s) and to a fatal deflation. Sales decline,
costs remain the same – margins collapse.
The weakness in the US and European economies will temper
demand for Chinese made goods. China is already showing first signs of
slow down - inflation is increasing and rate of real growth is
decreasing.
It gets worse: high commodity prices
Chinese demand for stuff (oil, metals, machinery etc…) has a
tremendous impact on commodities, driving their prices many fold. High (and
rising) commodity prices are negative for developed world economies but they are
catastrophic to developing economies – they bring comparatively higher inflation
and often stagflation. Here is why:
Inflation is sourced from two broad categories: commodities
(stuff) and wages. Emerging markets are twice as cursed when it comes to
inflation:
- Commodity prices (less shipping costs
and government controls – the Chinese government limits price increases on
certain commodities, but we know that doesn’t work in the long-term) are the
same around the world. Thus the U.S. and China will see a similar increase in
commodity prices (at least in dollar terms). But the commodity component
represents a larger portion of the total product cost in China than in the U.S.,
as wages in China are a less significant component of a total cost. For
instance, bread baked in the U.S. and China will require the same amount of
wheat and wheat will cost as much. But baker wages will be significantly larger
in the U.S. than in China and will result in a much higher cost of the finished
product. Therefore, a spike in wheat prices will have a larger impact on the
loaf of bread in China than in the US.
- Wage inflation: the US and Europe
have little wage inflation, as rising unemployment has diminished the already
weak bargaining power of the labor force, keeping wages in check. Economic
expansion has put significant upward pressure on wages inflation in
China (and India as well).
In combination, these two factors were responsible for
inflation in high single
digits in China, double the rate of inflation in the U.S.
China is not the cheapest place in the world to manufacture,
not anymore. To its benefit, cheaper countries (Singapore, Vietnam etc…) are
not big enough to steal a significant amount of capacity and the US
in many cases doesn’t have the needed infrastructure to bring manufacturing
back. Appreciation in the renminbi and high oil prices (which are driving
shipping rates up, placing a significant premium on the distance factor) are
making Chinese produced goods even less attractive. Something has to give:
either the U.S. will consume less or China will keep prices low to stimulate the
demand, swallowing the loss, or a combination of both.
It gets even worse…
I constantly catch myself wanting to say “the story only gets
worse”, but unfortunately it does. The US and Europe can cope with energy and
food inflation a lot better than China and other developing nations, as we spend
a lot less on food and energy as a percent of our income and have a lot more
discretionary income. (Just take a look at magazine section in the book store.
There is probably a fishing magazine for the left handed fishermen.)
Though the Chinese consume a lot less gasoline than
Americans. They don’t have as many cars and don’t drive as much, but they do
have stomachs – they eat. High energy prices have translated in food inflation
that in China runs in the high teens. The average American family spends only
15%
of their household budget on food, whereas the Chinese
spend 37% . Maybe this is one of the reasons their shopping malls are
empty. People that pay high gasoline prices but are full don’t riot, but hungry
people do. The current situation raises political risk in China and also the
chances that government (social) intervention will rise. This also puts in
doubt the significant development of a Chinese middle class, at least in the
near future.
When I wrote an article for Financial Times in May discussing
risks in stuff stocks (commodities, energy and industrials) I called today’s
environment “a global commodity bubble”. I was imprecise, after a conversation
with the brilliant Ed Easterling of Crestmont Research (by the way, Ed wrote
“Unexpected Returns” - a must read) and reading a wonderful interview with James
Montier by Kate Welling, I’d like use James’ more precise definition of
today’s environment: a “global growth expectations” bubble. After all, it is
the supply demand (to a large degree) that was responsible for this
unprecedented growth in “stuff”, shifting the mentality of the market into “this
time is different” gear. It is not.
In the past “stuff” stocks were cyclical, their margins
played a very predictable foxtrot of bouncing together with the whims of the US
economy. Today they are behaving if as Google is their middle name – their
sales are climbing in double digits, margins keep expanding and now they are
called “growth” stocks. They are not. It is just Chinese late stage growth
obesity, which has disproportionately impacted the demand for stuff, creating an
expectation that the “growth story” will continue forever. Nothing is forever.
Starbucks discovered that and so will China. China is likely to have a bright
future, but it doesn’t consist of straight to the sky growth trajectories.
Implications. Demand for commodities will decline, while more supply from
past investments (there is a significant lag) will be coming to the market –
they’ll come crushing down to earth. Companies that make stuff will suffer,
their margins are at multi-multi-multi-year highs, margins pendulum will swing
the other way, to the other extreme. Suddenly they won’t appear to be as cheap.
(Take a look at my January Barron’s
article in which I discuss the risk in corporate margins and May Financial
Times article which explores China and stuff stocks.)
Vitaliy N. Katsenelson, CFA, is a
Director of Research at Investment Management Associates in Denver and teaches a graduate investment class at
the University of Colorado at Denver. He is also the author of Active Value
Investing: Making Money in Range-Bound Markets (Wiley 2007).
