Tiger Woman on Wall Stree

by Junheng Li

  All this led me to believe Yum’s prime growth stage had passed. Going forward, the company seemed likely to face diminishing returns on its continual investments, including new stores and new product offerings.

  From there, things went from bad to worse for the company. On December 18, 2012, China’s national broadcaster once again caught Yum in its cross hairs. CCTV reported that some KFC suppliers in eastern Shandong Province fed their chickens antiviral drugs and hormones to accelerate their growth. The report sparked an investigation by the local food and drug administration, and authorities in Shandong shut down two chicken farms. On January 7, Yum lowered its sales forecasts for its China division, citing “adverse publicity associated with a government review of China poultry supply.” The company’s shares plunged 5 percent in after-hours trading.

  Issuing two guide-downs within a month, as Yum had done, was extremely rare for a multinational company, especially one with a market cap of nearly $30 billion. It showed that the management had little oversight and was unprepared to deal with China’s challenging and unstable commercial environment.

  On January 15, I landed in Miami to attend the annual ICR Consumer Conference, an event that features nearly every major company and investor from the retail segment. I was told that Yum had canceled its annual appearance at the last minute. Rumor had it that the managers didn’t want to be confronted with the persistent questions about its China business.

  By late January, the state-run Xinhua news outlet was still reporting on government findings of excessive levels of chemicals in KFC’s chicken supply. As if this weren’t bad enough for KFC’s business, China was gripped in the spring of 2013 with a new strain of avian flu. The stock was pummeled in the next few months, as bird flu claimed more victims around China. By May, authorities confirmed that more than 130 people had been infected with the H7N9 strain, and dozens had died. In an effort to stem the outbreak, authorities culled tens of the thousands of domestic birds and discouraged people from eating poultry unless it was thoroughly cooked. Sales plummeted: high-end restaurants stopped selling chicken dishes, and Western restaurants in Shanghai all began serving their eggs Benedict over hard.

  Yum announced that sales at KFC restaurants open more than one year plunged 13 percent in March after the outbreak turned many Chinese consumers off eating chicken. I issued a warning note to my clients that the drop in sales would likely persist in April and May as the public panic lingered.

  China’s Anti-Apple Campaign

  Yum is not alone in facing enhanced state media scrutiny. Many other large Western companies have taken a turn under fire from CCTV, including Apple. Chinese people adore Apple products, and many professed their love for Steve Jobs after he passed away, but the country’s state-run TV network obviously did not share their admiration.

  On March 15, its annual World Consumer Rights Day, CCTV aired an annual evening special in which it claimed Apple employed a double standard for its after-sales service, offering far less comprehensive services to its Chinese than its American or British consumers. A series of attacks on Apple, presumably coordinated by some arm of the Chinese government, followed shortly after the CCTV special. The People’s Daily, China’s official government newspaper, weighed in, escalating the campaign by criticizing Apple on a variety of issues, including the “incomparable arrogance” of its initial response to the CCTV exposé, and the amount of tax the greedy company had likely avoided. Regulators even specifically mentioned Apple in a call to increase scrutiny and punishment of “illegal acts” by electronics manufacturers.

  Westerners dismissed the state media reports as mere propaganda, but their long-term impact on Apple’s China market share should not have been dismissed. The consumer tide in China was already turning toward Samsung’s bigger mobile phones, and the bad press gave consumers another reason to avoid Apple. CCTV had launched a similar campaign against Hewlett-Packard on Consumer Rights Day in 2010 that triggered a roughly 50 percent reduction in its share of China’s personal computer market. Over the next year, HP lost 42 percent of its market share in China, or roughly 0.3 percent of its global business. That caused investors significant pain: shares of HP fell from $52 to $42, even though the stock was priced cheaply to begin with.

  Toshiba is another example. The notebook maker lost its top spot in the China market to IBM and Lenovo after it refused to compensate Chinese consumers for a disk drive flaw in its laptop computers that could cause a loss of data—even though it had compensated American customers for the same problem. Consumers launched a lawsuit against the company in the Beijing No. 1 People’s Court, and Toshiba was lambasted by a series of media reports. The company’s market share shrank to 12.6 percent in the third quarter of 2000 from 20.8 percent in the third quarter of 1999.

  A Chinese Conundrum

  The dramatic undoing of Yum! China in late 2012 and early 2013 should prompt any investor in China to ask a vital question: What is the right valuation for a Western multinational that conducts a significant portion of its business in China?

  Generally speaking, investors reward stocks with high multiples when the companies deliver predicable earnings streams, as well as when they have reached or are near the peak of their product cycles. Yum’s string of PR snafus and our detailed research revealed many big-picture issues that all multinationals operating in China should be aware of. The events also suggest that American brands are likely to lose some of their early-stage appeal as China develops. In the case of fast food, local Chinese competitors with or without government backing stepped in to erode the position of the established Western fast-food brands.

  Companies generally attract high multiples after outperforming expectations for a few years. However, no company can sustain this forever (the hype that restaurant chain PF Chang’s stock attracted in 2010 before falling nearly 50 percent is a good example). When hype dissipates for a stock, multiple years of underperformance tend to follow. This is especially true in industries such as restaurants that are highly competitive and subject to multiple regulations. This is why fast-food brands frequently fall into distress, such as Wendy’s and Arby’s.

  It’s not just individual Chinese companies that are headed for a correction. China powered through both the Asian financial crisis and the Great Recession, but every fast-growing emerging market in economic history inevitably experiences a severe economic correction. The United States struggled through multiple depressions while developing from the 1870s to the 1940s, and China will ultimately be no different—especially considering the government’s efforts to stave off a recession have exaggerated structural imbalances between fixed-asset investments and domestic consumption. A correction is inevitable. It’s not a question of if, but when and how.

  For that reason, I believe Yum and some of the other multinationals—potentially the entire luxury group in China including Swiss watches—have passed their peak in China. I’m not saying that Yum is a terminal short whose valuation should be reduced to zero. However, the hype needs to be brought down to earth.

  For those who aren’t invested in Yum, the story still holds a valuable lesson. Yum is another example of how any investment in China requires close monitoring, since market dynamics change quickly and unpredictably. As many companies in China have demonstrated, past performance is not a great indicator of future success.

  CHAPTER 15

  What Keeps Me Awake at Night

  I ADORE BEIJING FOR ITS INCOMPARABLE SIGHTSEEING—THE Summer Palace, the Forbidden City, and Sanlitun. But the escalating pollution and impossible traffic make it a very hard place to stay for long. Thanks to my Americanized lungs, I now typically break down with a cough and a sore throat after staying longer than two weeks.

  China’s capital is also an inefficient city in which to conduct business. The drive between Beijing’s two commercial centers—the Financial District on the west side of the city and the World Hotel and Central Business District on the east side—can take as long as two hours duri
ng peak times. Using the subway is out of the question for me now since my BlackBerry was stolen, along with all the photos and notes I took from the trip—I had thought that the locals only liked iPhones. At other times, I was almost knocked down to the ground by the crush of the crowd during rush hour. Because of the sprawl and congestion, I’ve learned that scheduling four meetings a day around the city is too ambitious. In New York, I would probably do six meetings a day, jumping in and out of the subway with ease.

  So whenever business doesn’t require me to be there, I have gotten into the habit of retreating from Beijing to Shanghai and areas around it, where the air quality and amenities are better. In the summer of 2012, I was traveling from Shanghai to one neighboring city, Nanjing, on the new high-speed rail line that connects the cities.

  I watched eastern China’s industrial landscape zip past my window. Since I had last taken this same journey, more and more factories and new apartment complexes were crowding out the small farms that used to blanket the Yangtze Delta, one of the most densely populated places on earth.

  I found myself eavesdropping on a conversation between two men behind me. After listening for a few moments, I realized they were loan officers from Industrial and Commercial Bank of China (ICBC), a state-owned company that became the world’s largest bank with total assets of 17.5 trillion RMB ($2.81 trillion) at the end of 2012.

  “The Nanjing government is running out of money. But we are still underwriting social housing projects. You get in trouble if you don’t lend to those developers,” one man said to his counterpart. I leaned in, my ear awkwardly pressed to the space between the seats, but I could only hear snatches of the conversation.

  “Private sector? No, we are not allowed to lend to small businesses in this economic environment . . . I could get fired if they go belly up.”

  I was eager to hear their conversation because the men were discussing one of the biggest distortions in the Chinese economy: that China’s so-called commercial banks are by no means commercial. Chinese banks lend at the behest of the government, giving the state the ultimate control over capital allocation and pricing. Investors in the United States had begun asking me about an unsustainable buildup in Chinese debt, and I was hoping to gain some insight into the risk this posed.

  In China, as in most other emerging markets, banks have an outsized importance to the economy. Given China’s relatively underdeveloped capital markets, bank loans fund 80 to 90 percent of all businesses. China’s stock markets remain illiquid, plagued by dysfunctional corporate governance and the ineffective protection of minority shareholder rights, and both the sovereign and corporate bond markets are in their infancy. Almost all external financing for companies is provided by banks (and shadow banks, which are functionally similar and often controlled by real banks but are not subject to the same oversight—I discuss this later in the chapter). In this respect, China is more like Western Europe—where 70 percent of external funding of companies comes from the banking sector and 30 percent from capital markets—than the United States, where these ratios are reversed.

  Banks are the dominant source of funding in China, and the biggest banks are all state owned. This puts SOEs and any private corporate entities that have good connections with the authorities at a huge advantage when it comes to funding their investment programs, regardless of the commercial and economic merits of these investments. This economic reality likely undergirded most, if not all, of the new construction sites I saw that day springing up between Shanghai and Nanjing. Companies with connections to the government and state banks were undoubtedly in charge of these projects and, because of these connections, had received heavily subsidized loans.

  This reality also explained the effectiveness and timeliness of China’s economic stimulus in 2008 through 2010 and again in the second half of 2012. Beijing launched a massive stimulus program in late 2008 that was successful at warding off the immediate impact of the global financial crisis on China’s economy. China’s fiscal stimulus seemed especially effective in comparison with the limited effect of the U.S. Federal Reserve’s quantitative easing policies and the modest fiscal stimulus of the Obama administration.

  Once the Chinese central government approved the 4 trillion RMB stimulus policy, banks immediately began lending toward infrastructure projects such as roads, bridges, airports, subways, highways, and railways. Except for the construction of the rail network (including the high-speed network), which was funded by the Ministry of Railways, local governments funded most of the spending. Since the local governments were banned from borrowing from banks directly, special-purpose vehicles (SPVs) guaranteed by the local authorities were created to borrow directly from the banks.

  It is estimated that new bank loans rose to 17 trillion RMB in 2009 and 2010, while nonbank loans or private lending came to approximately 5 trillion RMB—many times more than the 4 trillion RMB stimulus amount rubber-stamped by the government.

  Economists warned that most of these investments would never yield adequate financial returns and would ultimately result in surging nonperforming bank and shadow bank loans, in addition to excess capacity in sectors heavily subsidized by the government. The Chinese government countered that the investments yielded positive social returns, highlighting new toll-free highways and subsidized housing projects constructed for migrant workers.

  Yet even if the government’s arguments are correct, the resources to subsidize these socially worthwhile but commercially not-so viable projects have been made available at the expense of the rest of the economy—primarily, the Chinese taxpayers and the Chinese people who receive benefits from the state. Resources spent on subsidizing projects have crowded out other forms of public spending, such as healthcare, education, social security, retirement benefits, and R&D on socially beneficial projects.

  Because banks are mostly state owned and state controlled, the debt they rack up is essentially government debt. In principle, the state is only an equity owner with limited liability, and it can avoid responsibility for servicing debt should banks become insolvent. But limited liability didn’t stop the capitalistic United States from rescuing “too-big-to-fail” financial institutions such as Citigroup, Bank of America, AIG, Fannie Mae, and Freddie Mac, nor did it keep the governments of the EU member states from propping up dicey zombie banks in the United Kingdom, Ireland, Germany, the Netherlands, Belgium and Southern Europe.

  There is even less chance that China will allow a state-controlled bank to fail. Chinese banks are huge. At the end of 2012, ICBC overtook Bank of America to become the world’s largest bank in terms of Tier-1 capital, a measure of a bank’s financial strength. As of 2013, China was home to 4 of the world’s 10 largest banks for Tier-1 capital, the same number as America. This means that, regardless of the ownership structure of these banks, they are too big, as well as too politically connected, to fail. Just as was the case during previous bank recapitalizations, the Chinese government is not likely to let the depositors of the banks get haircuts if the banks become insolvent. Instead, it would likely write down some of the banks’ nongovernment-owned equity.

  Those in the bank lending chain, from creditors to depositors, know this, and therefore believe the Ministry of Finance implicitly guarantees their debts. That is why Chinese banks weren’t that worried about piling up nonperforming loans with the lending spree in 2009 and 2010.

  In return for that implicit guarantee, Chinese banks willingly carry out the government’s bidding. When it comes to loan approvals, fulfilling political obligations is far more important for Chinese banks than a project’s financial viability is. This is yet another fact that most investors coming from market-based economies find hard to comprehend.

  Since the beginning of China’s economic reforms under Deng Xiaoping in 1979, local governments have had to pay a dramatically rising share of total public expenditures, while the central government’s share has fallen. At the same time, the local governments’ share of taxes and fees has declined st
eadily. But as China’s economy expanded at an unprecedented pace over the last decade, local governments found a way to close this growing gap by selling land.

  Land prices rose quickly as China developed, giving the local authorities abundant collateral and resources with which to pay off debt or meet their obligations to the often loss-making SPVs they created to borrow on their behalf.

  In China, the government technically owns all the land; however, land titles can be leased to private groups for periods of 40 to 70 years, depending on how the land is zoned. Local governments are responsible for auctioning off these parcels and make huge sums of money in the process. They often obtain these land titles, though, through a combination of inadequate compensation and intimidation or coercion, giving rise to social tensions among the very people whom developing is aimed at benefiting. But with few other revenue sources and such large sums of money available from reclaiming land at low prices and selling it to developers, most local governments find land sales hard to resist.

  This financing model proved highly risky when there was an economic contraction. Local governments, rather than the central government, account for most of China’s infrastructure expenditures. But when the Chinese economy began to decelerate as stimulus spending wore off, real estate and land markets cooled and local government revenues from taxation and land sales collapsed. At the same time, local governments faced increasing pressure to stimulate the economy by boosting investment. As local governments took out more loans through SPVs, their borrowing caught up with and then eventually exceeded their capacity to service, let alone repay, their debt.