Can multinationals really make a profit in China? Yes but not without perseverance and planning, as is shown in this extract from Merrill Lynch’s recent report, Multinationals in China.

FDI in China has surged over the last decade, as chart 1 shows. China attracted a record $52.7bn of FDI in 2002, and China overtook the US as the premier destination for global FDI. For Q1 2003, FDI was up a further 57% year-on-year, although April – affected by SARS – saw growth slow to 37%. Between 1994-2003 as a whole, China is likely to have attracted some $430bn of FDI.

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In the last couple of years, in particular, as growth in developed markets has slowed, China seems to have become an increasingly important component of multinational companies’ long-term strategies. Investment in China has reflected a faith in that country’s long-term growth prospects.

Is China profitable?

We [Merrill Lynch] share this optimism about the country’s long-term real GDP growth prospects but have had some doubts about the extent to which this will be reflected in profits. China’s economy would appear to manifest all the symptoms of an artificially low cost of capital, reflecting the impact of the state banking system – in other words, one sees strong capex, excess capacity and weak pricing power (though the pace of deflation has eased of late). So the question is: are multinationals making money in China?

In 1999, AT Kearney and the Economist Intelligence Unit (EIU) surveyed 70 multinational corporations operating in China. While they found that 52% had failed to reach their profitability goals, 45% were profitable, 25% broke-even and 25% were unprofitable. Factors that were cited by respondents for disappointing results included:

overestimated market demand;

intensive local competition;

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poor productivity;

inability to develop local management skills;

industry over-capacity.

On the other hand, earlier this year, Merrill Lynch’s TJ Bond noted that the total profits being generated from cumulative FDI has continued to rise in recent years.

In order to investigate this issue further, we looked at seven industries – mobile phones, consumer durables, autos, retailers, household goods, IT and capital goods. [Mobile phones and consumer durables are reprinted in this extract.] We searched for company information on operations in China, grilled Merrill Lynch analysts in these sectors and reviewed any relevant third-party research.

Limited data on profits

Our first finding was that, while information on the importance of China to sales is generally widely available, there is very little data on profits and margins. One is forced to rely more on anecdotal evidence. This evidence certainly throws up examples of multinationals who say they make money in China – such as Dell, VW, Nokia, Motorola, Carrefour, P&G, Unilever, Coke. But there are a number of examples where foreign investors have struggled. Regulatory uncertainty, counterfeiting and poor infrastructure are among the problems experienced. But the key theme that emerges in our research is how rising domestic competition has accentuated pricing pressures. Most multinationals are boosting production, admitting prices will fall, and hoping that margins can be supported by cost cutting and scale economies.

Mobile phones

The multinationals claim that the handset business is currently very profitable in China, although little detail is provided. However, there already appears to be evidence that domestic competition will force handset prices to fall far faster than the global average, eroding margins.

The growth in the Chinese mobile phone market has exceeded all expectations. At the end of 1998, China had 24 million mobile subscribers. By end-April 2003, total subscribers stood at 226 million.

China contributes 10% of Nokia’s total global sales – up from about 5% in 1999. Average selling prices (ASPs) are reported to be in line with the global norm. And with substantially lower logistics costs, Nokia claims to have a higher earning before interest and tax (EBIT) margin in China than in Western Europe (while the company does not disclose regional EBIT’s, the global EBIT margin is currently 24%). China contributes 25% of Motorola’s total global sales – up from about 13% in 2001. However, we could find little guidance as to the margins generated by the Chinese business.

The global players have seen a noticeable fall in their market share. In 1999, Nokia had 32% of the market, but this had fallen to 18% at the end of 2002. In 1999, Motorola had 40% of the market, but this had fallen to 26% at the end of 2002. Market share has been lost to domestic producers, who have ramped up production aggressively. Ningbo Bird and TCL are the most popular with a combined market share of around 30% currently – up from under 5% in 1999.

The key issue for the multinationals is the extent to which this trend serves to undermine pricing power. For what it is worth, Nokia expects global ASPs – including those for China – to follow the trend of the last 10 years – declining by an average of 5% a year. In other words, China is not expected to see particular weakness in this area.

Cyclically, there would certainly seem to be some near-term risks to prices. Inventory levels appear to be quite high, and domestic handset makers are very willing to cut prices. In April alone – as the SARS virus bit into retail sales – a domestic handset manufacturer, Ningbo Bird, dropped prices on one of its CDMA models from Rmb3500 to Rmb2300.

Structurally, the temptation is also to conclude that an army of marginal domestic producers may push prices significantly lower. For example, Chinese telecoms equipment provider ZTE Tech estimates that the ASP for CDMA handsets is likely to fall by between 30%-50% in the next two years. It’s difficult to believe that, in this environment, GSM handsets would only see prices decline by 5%. Moreover, as with most new technologies, it is the higher income earners in China who have so far purchased mobile phones, but this section of the market is beginning to look tapped out. And the economics of the next 200 million subscribers is likely to be far different from the first 200 million. Both Motorola and Nokia have entered into agreements with local companies to produce low-cost CDMA handsets.

Trusted brands

However, it is worth pointing out that there is some evidence that dubious quality and lack of after-care service from many smaller manufacturers is encouraging consumers to opt for well-known, trusted brands – allowing a core of larger domestic and multinational producers to consolidate their position in the market. In the final analysis, much will rest on the extent to which handsets become a commodity item or as the technology develops, are perceived as being more of a luxury good.

A second risk for the multinationals in this sector is regulatory risk. The Ministry of Information Industry (MII) controls all facets of telecoms regulation including

competition policy in the wireless space;

what technologies can be used in China;

what products companies are allowed to sell.

As the authorities attempt to promote the locally developed TD-SCDMA wireless standard, multinational manufacturers of GSM phones might find themselves partially sidelined. Nokia and Motorola claim to have circumvented any regulatory issues by maintaining a close relationship with both the MII and the national government.

Bottom line: so far this sector appears to have been profitable for multinationals, although hard data is difficult to come by. But competition from domestic producers has been increasing, and there is a risk that this will weaken pricing power and margins in the future.

Consumer durables

Competitive pressures in this sector have been particularly acute, and multinationals have experienced difficulties. There are a multitude of domestic producers, and there have also been significant distribution challenges.

Until very recently, the ability of foreign white goods manufacturers to sell into China was extremely restricted. But since China began aligning [its trade regime to the global market] prior to accession to the WTO, their access to the market has increased significantly. For example, foreign companies controlled only 15% of the Chinese washing machine market in 1999, but by 2002 this had risen to 42% – with Whirlpool, Siemens and LG Electronics as the principal players.

Although the lure of selling to the Chinese consumer has been irresistible, the experience has tended to be less encouraging. The problem has been one of excess competition. There is significant government involvement in several of the largest manufacturers – including Haier, Changhong and Peony – and the enterprises themselves seem to focus far more on cash flow generation than returns on capital. The typical reaction of a Chinese producer to slowing sales momentum in one branch of the industry has been to attempt to diversify into another. The entrance of foreign competitors in certain segments has only served to exacerbate these underlying pricing pressures.

For example, Electrolux, warned last month that it was seeing lacklustre performance in China, with negative operating income in China in Q1 2003. Sales fell considerably, mainly due to consolidation and restructuring and downward pressure on prices. That said, Whirlpool claims that it has been profitable in China since 1999, when it sold off its refrigeration and air-conditioning ventures. Maytag entered the Chinese market in 1996 in a joint venture with Rongshida. They invested $70m in the enterprise. In 1999, after several loss-making years, Maytag put its own management team in place to run the company. By early 2002 the Maytag team was back in the US and the company announced plans to sell its 49.5% stake in the venture. They have had a negligible presence in the country since.

GE’s appliance division has largely stayed away from China. In the late 1990s, GE Appliances was seeking a partner to set up a pan-Asian manufacturing operation. However, none of the potential deals passed GE’s unbreakable rule of 20% return on investment.

Distribution challenges

Besides margin compression, multinationals attempting to enter the Chinese market also face significant distribution difficulties. For several years, foreign firms’ forays into China’s interior have only led to missed sales targets, due to distribution hassles, unco-operative retailers who attempt to levy excessive charges to display merchandise and politically-connected local competitors.

Yet, to continue to grow, foreign companies are going to have to move into the Chinese countryside. Over 90% of Chinese urban households already own the big-ticket household items, colour TV set, refrigerator and washing machine. This drops to less than 30% in rural areas. More than half of the washing machines Whirlpool sold in China in 2002 were in just four – relatively affluent – markets; Shanghai, Beijing, Guangdong province and Chengdu. In a country where more than half of all middle and high-end washers are sold outside the 26 largest cities, the ability to penetrate the hinterland is going to be key.

The best solution to this problem is the expansion of Chinese – and later possibly foreign – chain stores. Foreign white goods companies tend to have distribution agreements in place with retailers like Carrefour and China’s Guomei Electronics. As the retailers expand, this will allow the manufacturers to easily and cost effectively widen their distribution network. In 2001 Shanghai-based Guomei Electronics built stores in Xian and Zhengzhou. Whirlpool went with them and now successfully sells its goods through these stores.

Despite the gains in market share that foreign brands have made in recent years, domestic brands are unlikely to be sidelined. The EIU recently noted that Chinese manufacturers – such as Changhong, Haier and Peony – are cleaning up their act, offering comparable quality products designed with borrowed technology with minimal overheads. And competition from other multinationals, notably the Japanese, will intensify. Matsushita, the manufacturer of Panasonic wants to boost its market share from the current 3% to 10% by 2005. And Toshiba has plans to manufacture refrigerators and washing machines in China from 2004.

Bottom line: the sector in China is commoditised and there seems little sign of consolidation or supply-side discipline. In this environment we would question the ability of white goods manufacturers – be they domestic or foreign – to make sustained profits in China.

Merrill Lynch’s full report contains sections on the auto industry, retailers, household goods, information technology and capital goods.

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