Are some global companies too reliant on China?
It has been a banner quarter for some international brands: 聽Apple鈥檚 record profits nearly doubled from a year ago. Adidas鈥檚 profits were up 38 percent. BMW saw earnings rise 19 percent; Starbucks, 18 percent.
These companies share more than standout quarterly earnings. Their success comes, in large part, from a surge in sales in China. That鈥檚 good news, as long as Chinese consumers keep buying, but with that nation鈥檚 economy slowing, these companies face a troubling question from skeptical investors: Are they too reliant on China for growth?
The answer is nuanced. It depends on investors' time horizon, of course. The short-term picture gloomier than the long-term outlook. It also depends on the sector. Industrial companies with heavy exposure to China are not faring well. Consumer companies, by contrast, especially those with recognizable global brands, are going gangbusters. Some analysts see this dichotomy as evidence that China is beginning to make its long-awaited transition to a consumer economy.
鈥淚t鈥檚 risky to extrapolate from a few examples,鈥� warns Nicholas Lardy, senior fellow at the Peterson Institute for International Economics in Washington. 鈥淚t鈥檚 a $7 trillion economy and only $2 trillion is consumer-based.听 However, urban income, in real terms after tax and after inflation is growing at a rate of 9.8 percent vs. 8.1 percent [for] GDP鈥� or gross domestic product, which measures a nation's overall output. Since three-quarters of consumption takes place in China鈥檚 urban areas, that's a telling statistic.
If the consumer economy is growing nearly 2 percentage points faster than the economy as a whole, then that could explain why Apple and other consumer brands are doing so well.
China, with its billion possible consumers, has long been a holy grail for Western investors and companies. The rush to get a foothold in the country has served some companies extraordinarily well. Apple, for example, enjoyed $7.9 billion of sales in China alone in the first quarter of 2012, tripled the revenues of a year ago, and representing 20 percent of total revenues.
Adidas, whose first-quarter聽 earnings climbed 38 percent from a year ago, owes much of that growth to sales in China, which were up 26 percent (nearly four times its sales increase in Europe). The German sportswear company also raised its earnings target for the year, sending its stock price up nearly 9 percent on the announcement.
The picture was similar for Bavarian Motor Works (BMW), which saw a 19 percent increase in profits for the first quarter to $2.8 billion because of higher prices in the US market and increased China sales. China is now the biggest market for the maker of BMWs, Minis, and Rolls-Royces.听
Such reliance on growth from a single country might prove troublesome if its economy is slowing. That's the case with China. For example: China's industrial production rose 9.3 percent in April, down from nearly 12 percent in March, and the lowest rate since the financial crisis. Construction and factory equipment for 20.2 percent for the first four months of the year, down from 25.4 percent the year earlier. Real estate investment also fell and imports last month were flat. Some global industrial companies took a big hit in the first quarter because of their bets in China.
Heavy equipment manufacturer Caterpillar beat analysts' estimates with sales of $15.9 billion and profits of $1.6 billion, but its shares fell because its sales in China fell $250 million to $300 million, forcing the company to find other markets willing to buy the equipment it had made in China for China. Weak demand in China caused Swiss engineering company ABB to report weaker-than-expected earnings. United Technologies experienced a 9 percent decline in sales for its Otis elevator division in China, because of a slowdown in construction there.
In the short term, there's no question China is slowing. Foreign investment has dropped for five months in a row, according to China鈥檚 Ministry of Commerce. The economy is growing at its slowest pace in three years. But at 8.1 percent, that's still double the world average. Many analysts forecast a so-called "soft landing," a brief period of slower growth, followed by a pickup in activity.
鈥淎n emerging market usually experiences a few years of very rapid growth, then it slows, and then it reaccelerates again," says聽 Stephen Volkmann, machinery analyst for Jefferies & Co. in New York. "There is a lot of capacity being added over there and nobody seems to be willing to take their foot off the accelerator.鈥�
Companies will wind up with overcapacity in China in the not-too-distant future, but that capacity should right itself, with demand catching back up to capacity, within one to two years, he says. 鈥淢y colleagues in China say the government is actively trying to better balance the consumer and asset sectors.鈥�
A presence in China is no guarantee of success. Ford profits fell by nearly half in the first quarter compared with a year ago, because surging sales in the US weren't matched overseas. In China, falling sales caused an operating loss of $95 million, compared with a profit of $33 million the year before. Ford has spent $4.9 billion there in hopes of doubling sales.
聽鈥淵ou can鈥檛 decide to be a player in China overnight,鈥� says Michael Robinet, managing director of IHS Automotive Consulting in Detroit. Companies like BMW, Daimler and Audi have spent time developing relationships, including dealer networks, as well as brand identities. 鈥淐hinese consumers think highly of German engineering,鈥� he adds.
If China can avoid a "hard landing," some companies with strong brands may not even notice the slowdown. With its popular iPhone, for example, Apple may ride the boom in demand for smartphones. With more than 1 billion subscribers, China has now surpassed the United States as the No. 1 market for smartphones, according to analytics firm Canalys. Sales in the first quarter of 2012 doubled from a year ago (up only 5 percent in the US).
Starbucks, for one, is betting big. Its China sales have grown at least 20 percent for each of the past seven quarters. That's where the coffee company earns its highest profit margins. So Starbucks is accelerating its expansion in China.听
All of this may signal a shift into more of a consumer society in China, an economic rebalancing that could provide a more stable foundation for long-term growth. Many analysts believe this process has yet to begin in earnest. But Huang Yiping, an economist at Beijing University, argues that the process is further along than most people believe.
鈥淐hina鈥檚 consumption share of GDP was probably underestimated by an average of 3.1 percentage points during the past decade,鈥� Mr. Huang wrote in a recent article for East Asia Forum, a quarterly and online policy publication for the Asia-Pacific region.听 鈥淭hese figures could mean that China鈥檚 long-awaited economic rebalancing has already begun鈥�. Reports of聽China鈥檚 declining consumption聽share are exaggerated, and the official statistics are partly to blame. Rather, the opposite appears to be true, with China鈥檚 consumption share already starting to expand.鈥�
While that bodes well for China's economy in the long term 鈥� and for those companies that can capitalize on it 鈥� the transition may be bumpy.
聽鈥淓verything will depend on policy,鈥� says Mr. Lardy, senior fellow at the Peterson Institute. 鈥淚n the last five years, China has relied too much in investment and real estate for growth. The role of property can鈥檛 continue to expand as it has over the last eight years."
