China: Profit from Consumption
Andy Xie (Hong Kong)
Consumption vs. Investment
China’s consumption could become a stable source of profit. Retail sales should reach US$625 billion in China compared with US$3,670 billion in the US this year. Ten years ago, the respective numbers were US$190 billion against US$2,156 billion. If the trend lasts for another 10 years, China’s retails sales could reach US$2 trillion and the US’s, US$6.2 trillion by 2014. China’s retail growth would then be half as great as that of the US in the next decade compared with one-third in the past.
Identifying the businesses that should benefit from China’s growing consumption is the most important task for financial investors who want to profit from the country’s development. China’s consumption is reaching a sufficient scale to allow businesses to establish franchises. Consumption is much less cyclical than investment. Hence, investors are less likely to be misled by cyclical momentum. Finally, most enduring commercial franchises are in the consumer sector.
Investment cycles create excitement in financial markets. However, they are not as profitable as they might first appear. Strong investment growth exaggerates earnings in the short term, as businesses make profits from each other’s investments. When the cycle peaks, profitability falls quickly. The average profitability over a cycle is often below the cost of capital.
Growth vs. Profit
Five years ago, I believed that the infrastructure and export industries would create value for investors. The profitability of the infrastructure segment comes mainly from government protection against market competition. Power generation and toll roads are just two examples. Because the government needs to ensure the financial health of those industries to sustain infrastructure investment, their return on capital has to be above the cost of capital. The trend of declining interest rates has also made the infrastructure area more attractive to investors.
China’s export segment has delivered high returns on capital for 20 years. Even though it has increased 18 times in size to about US$500 billion in 2004, its return on capital appears still to be in the upper teens or low twenties – significantly above the cost of capital. The ability to maintain capital returns through such a long period of massive growth stems from the extent of the labor surplus. Wages for workers at export factories along the coast have not increased for 10 years.
Five years ago, I also thought that consumption would deliver poor returns on capital due to the low purchasing power of China’s consumers and excessive competition among businesses, supported by bank loans. China’s consumption was just taking off. Aspiring entrepreneurs had a gold-rush mentality, which led to recurrent price wars that destroyed capital.
Three factors are changing my view on consumption. First, the market is big enough for scale economies and differentiation to become effective barriers to entry. Second, brands are becoming important, as fake products are doing considerable damage to consumers. Third, the growing ranks of white-collar workers are willing to pay to be different. China’s consumption arena appears mature enough to sustain big franchises. While the consumer industry has destroyed value in the past, it seems things will be different in the future.
Most of the value in satisfying Chinese consumption demand should be created in the distribution system. The distribution networks have greater economies of scale than does production and, hence, are more likely to be profitable. Because consumer protection against fake or substandard products is still weak in China, large distribution companies have the economies of scale to provide such protection, which carries a high franchise value.
The Hyper-mart Revolution
The rise of the hyper-mart in China’s distribution system is a revolution. It is changing how people shop and how businesses produce. China’s hyper-marts essentially roll a department store, a supermarket, and a wet market into one. In addition to offering low prices, hyper-marts are becoming gatekeepers against fake products. Fake products have penetrated the traditional distribution system, dominated by small businesses that do not have sufficient scale to keep them out. A hyper-mart chain has enough economies of scale to effectively control all of its suppliers.
The harm caused by fake products is especially severe for good-quality products. Government checkups often reveal that 40-50% of products do not meet mandated standards. Frequently, fake food products cause public health crises. Even the traditional wet market, which Chinese people favor as a source of fresh products, has become vulnerable to fakes. The hyper-mart chains are creating the scale economies to internalize a wet market.
China has an immature legal system and faces enormous challenges in enforcing product safety standards. It launches crackdowns from time to time to deter businesses from violating the rules. However, as new businesses keep popping up looking for fast profits, the problem just will not go away. The hyper-mart phenomenon is a market response to China’s poor legal framework for the protection of consumers. A hyper-mart chain has the scale to keep out harmful products, which should bring back customers and make it profitable for a these chains to act as a safeguard.
The hyper-mart model, of course, offers a significant pricing advantage. It has vast bargaining powers over its suppliers. It will become more and more difficult for producers of goods to maintain pricing power. With a fragmented distribution system, production companies are at the center of the value chain and invest heavily in advertising to ensure product quality. Hyper-mart chains are internalizing the reputation premium of thousands of producers with a procurement control system.
Urban population density in China’s cities is three to four times as high as that in most Western countries. Hyper-marts covering just one neighborhood are sometimes viable. This removes the biggest disadvantage of the hyper-mart model – convenience relative to other channels of distribution.
The above factors explain why hyper-marts are expanding so rapidly in China. This is likely to become the dominant channel for the distribution of consumer goods, in my view. Because this business has large economies of scale, the entry barrier should be significant. Hence, this industry should create a franchise value for investors.
Kiddie Power
In the middle of every small town in Europe or the US stands a church. In China, it is usually a Kentucky Fried Chicken or a McDonald’s or both. As I trekked through the Yangtze River Valley two years ago, I became more and more impressed with their success. I toured Northern China this summer and continued to be impressed.
KFC and MacDonald’s have probably created the most valuable Western franchises in China, in my view. When I convey this view to American fund managers, I usually get a mixed reception. Most American investors associate the US’s competitive advantage with high technology or Hollywood. Why fried chicken?
These two franchises have expanded rapidly, even though they charge three to four times as much for a quick meal as would a local restaurant. Many local imitators have come and gone while KFC and McDonald’s have withstood the test of time. I see three reasons for their success. First, China’s one-child policy in major urban areas has created a common family structure of two working parents and one child. Spoiling the children, while it may have negative consequences for the country’s future, is a major motivation of consumption for working parents. KFC and McDonald’s have decades of experience in marketing to children. Also, as the two franchises become bigger, the marketing hurdle for potential domestic competitors rises.
White-collar workers are becoming another major source of demand. Social differentiation is the major motivation here, in my view. I noticed a strong presence of white-collar types at KFC or McDonald’s in Northern China. Northern Chinese cuisine is – how should I put it – not very appealing to upwardly mobile youths. The two franchises are filling a void.
Hygiene concerns also generate demand for these two chains. Food safety has always been an issue but has become more acute recently, mainly due to the growing challenge from fake products. Law enforcement in this area is still quite patchy. Therefore, consumers are looking for a market solution. International restaurant chains have the scale economies to ensure food safety and are motivated to do so to protect their reputation.
What’s surprising is that there are not more businesses like KFC and McDonald’s. What’s so hard about selling fried chicken? Marketing costs, as mentioned earlier, are one entry barrier. The complexity of managing a vast logistics system is, I believe, a bigger entry barrier. It appears that such organizations are difficult to duplicate.
Selling Dreams
In addition to the normal value-maximizing consumption, selling dreams is becoming a big consumer market. The dieting industry in the West falls into this category. It is much more diverse in China. The key driver of this market is the lack of government regulation. One can make wild claims about the efficacy of a product without having to prove them. “It may work,” is the main motivation behind consumer demand.
Products that claim to deliver certain health benefits comprise a big part of this market. There is a belief in Chinese culture that some substances can enhance certain bodily functions. Without the equivalent of an FDA, businesses can try to capitalize on this belief by offering products with specific claims. Liver-strengthening juice, pancreas poison reliever, and eyesight booster are a few cases in point. Many such products, I presume, may be useless and, in some cases, harmful.
Improving appearance is another selling angle. Whatever the deemed blemish in appearance, someone will provide a product claiming to solve the problem. Some products claim to take 10 years off your appearance instantaneously. A human height stretcher is widely advertised on TV with exaggerated stories of success.
Financial pyramid schemes are quite common in China. They also sell dreams. People who fall for such schemes harbor the “I feel lucky” emotion. Financial pyramids are no different from products that promise to strengthen the liver or cleanse the pancreas. They succeed through people’s credulity. Government tends to react to misleading advertising only when there is a public health disaster.
Selling dreams will always be big business. People need to buy into fantasies. There is enormous peer pressure to get ahead in China. Many who are left behind fantasize about an easy way out. Market forces, when unchecked by government, obviously take advantage of such needs. For better or worse, the share of profits from China’s consumers is going disproportionately to this segment of the market.
Health improvement and private education may eventually emerge from this industry as legitimate and large-scale businesses. The Chinese believe that health derives from continuing attention to sustaining or improving bodily functions. This is a different concept from Western medicine that focuses on a cure when something goes wrong. So, there is huge potential demand for health products that can show some effectiveness.
Private education could emerge as a huge business in China. Even though public education, which actually charges a lot, is available to most, Chinese parents continue to look for alternative sources. The main motivation is to gain an advantage in the exam system against those who cannot afford the extra fees. It would be much better to expand private education, which should be more efficient in offering a differentiation in education for those who can afford it.
Luxuries for Social Branding
Luxury demand in China appears to be disproportionate relative to the country’s national income. China accounts for 4% of global GDP but two to three times as much in the sales of certain luxury goods. This reflects the country’s wide income inequality and a strong desire for social status. Virtually all the luxury consumer goods in China are from Europe.
Most European luxury firms are expanding rapidly in China. As Europe opens up to tourism from China, sales of European luxuries are likely to increase even faster. China still imposes high tariffs on luxury imports. European luxury companies are among the best plays on China’s consumers.
There are some exceptions to the European success story. Taiwanese businesses, for one reason or another, are becoming successful in wedding gowns and other accessories. Modeling shows of wedding gowns by Taiwanese businesses are a common sight, even in second-tier Chinese cities. Hong Kong businesses are becoming successful in retail diamonds. Diamonds, historically, have not been viewed as valuable in China. Massive advertising has changed the popular perception.
It is, in general, an uphill battle for domestic firms to compete in this market. Some businesses (e.g., encasing diamonds on mobile phones) become successful due to lack of knowledge on the part of the consumer. Domestic firms could achieve success by owning the distribution networks. Partly due to regulatory constraints, many European luxury firms have gone into joint ventures with Chinese firms that help in distribution.
Foreign vs. Local
I believe that most value-creating stories in China will be associated with the consumer sector. This sector is also the most challenging for domestic firms. China’s consumers usually expect discounts from local firms similar to those offered by foreign competitors. This puts domestic firms at a major competitive disadvantage. Foreign firms also possess deeper pockets to advertise, better brand recognition and more experience in management. Domestic firms face an uphill battle to succeed in the consumer area.
In industries that require scale economies and management of a large logistics network, Western companies are likely to dominate. Indeed, the best plays on China may be global consumer companies. Local companies may succeed in niche markets that require in-depth local knowledge.
Food production may be a case in point. Western firms may not understand China’s markets well and may not be able to innovate fast enough. Local firms may be able to win the battle by frequently coming up with new products. Taiwanese companies also have an advantage in this area.
China’s appliance manufacturers have already succeeded in dominating the market through price competitiveness. Indeed, the industry has become an export success as an OEM for Western brand owners and major distributors.
China’s success stories are mostly in production. Distribution appears to be a local weakness. Most profits in the consumer sector are on the distribution, not the production, side. Western companies understand this and are moving aggressively into this area. The foreign domination of China’s distribution system will likely become apparent in the next few years.
Bottom Line
In the past five years, export, infrastructure and materials industries have captured most of the profits from China’s development. As China’s investment cycle cools, profits are likely to shift to the consumer sector. The distribution system, in particular, could capture the lion’s share of the profit in the consumer sector. Foreign firms may benefit disproportionately from China’s consumers. Local firms may, however, become successful on the production side. |
