CHINA - Its Past, Present, Future

The following is an op-ed article written by Tony Gleason of Neuberger Berman. In this interesting work, Mr. Gleason studies essential history, reviews present issues, and predicts future trends, regarding business within China. It is very helpful for those of us, who have operational dealings and investments in China. Extremely worthwhile reading:

China Wakes, the World Shakes
by Neuberger Berman’s Tony Gleason - November 17, 2009

As we have all witnessed, the economic system that drove much of world trade buckled in the financial crisis of 2008. It appears that the U.S. will no longer be the insatiable source of demand for the world’s manufacturing countries. Our credit has unfortunately hit its limit with our creditors, namely China and Japan. From an investment point of view, understanding the new financial, economic and political system that is evolving from the 2008 crisis will be a key to making and preserving capital in the decades ahead. China, as I will explain, is re-emerging on the world stage and will likely play the leading role in this evolution. Within this piece I offer my perspective on China today and how I believe it will influence the investment landscape.

I’ve had the extraordinary good fortune of traveling frequently to China. Each time, I’m startled by the progress the country has made since my previous visit. The most recent trips are no exception.

Cities visited in the past few months include:

• Tier one cities: Beijing, Shanghai, Guangzhou, Hong Kong
• Second tier cities: Nanjing, Hangzhou and Chongqing
• Small, but important cities: Li Jiang and Macau
  

Along the way I met with over 60 companies, various government officials and many interesting people. Since the crisis began almost a year ago it’s become abundantly clear that the Chinese government recognizes they can no longer grow the country’s economy based on exports to the United States and Europe. Recognizing that economic growth is necessary for harmony and its own ability to stay in power, Beijing has shifted gears quite dramatically and so far has managed its way through one of the most significant financial crises in a century. Many will argue with how it got there, but China is on track to leave 2009 growing at a better-than-8% rate. While China has many goals, in our view, the three with the greatest implications for the investment business are to:

1. Increase domestic consumption;
2. Accelerate infrastructure; and
3. Diversify away from the U.S. dollar.
   

In the investment business, getting the big picture right is key; we believe the ability to appreciate what is going on in China—and act on it— will have a significant impact on investment results. For some perspective on where China is headed, it pays to look back a few years. Therefore I’d like to provide you with some history intertwined with my observations on this most fascinating country...

An Op-Ed on Federal Spending and Legislation

The following is an op-ed article written by Dave Farr, Chairman and Chief Executive Officer of Emerson Electric Co. His concern is the affect federal spending and legislation are having on the ability of USA manufacturers to compete globally, and to successfully invest in USA operations. It is a non-partisan, truly objective article, and thus worthwhile reading:

To: Emerson U.S. based employees

Attached is a copy of an op-ed that I recently wrote and submitted to local St. Louis newspapers relative to my concerns as the CEO of Emerson -- a global manufacturing company.

As the leader of this company of 120,000 employees, hundreds of thousands retirees, and 350,000 shareholders, I must be concerned about strategic global issues that will impact Emerson and our ability to survive, compete and win.

We are a diverse company and I realize that opinions vary. My responsibility is to do my best to represent the overall interests of our shareholders, our employees and our customers. In this instance, I want first to share this piece with you as employees of this great company.

I wish all of you a very special and joyous holiday season and a prosperous new year.

My personal regards,
David N. Farr

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America's Survival as a Prosperous Nation is at Risk

Major manufacturers today must compete in global markets if they want to survive, prosper, and grow. Emerson is no exception. We compete head-to-head with Asian and European companies here at home and in virtually every market of the world. The ability to manage quality, innovation, logistics, customer support, manufacturing cost and many other factors determines which companies survive or don't.

Ford Motor Company Reports Profit – Positives and Negatives

The Positives:

“…the only major U.S. automaker to avoid bankruptcy, posted third-quarter net income of $997 million and its first operating profit since early 2008…”.

“…finished the third quarter with $23.8 billion in automotive cash, up from $21 billion at the end of the second quarter.”

“…U.S. market share increased to 15.8 percent for the first nine months, compared with 14.8 percent from a year earlier…”.

Certainly, registering a third-quarter 2009 positive profit with a market share gain are excellent and solid signals. Unfortunately it overlooks Ford’s negatives, which give pause and concern for the future.

The Negatives:

“…workers have overwhelmingly rejected contract changes that would have allowed the automaker to cut labor costs.” “Ford sought the deal to bring its labor costs in line with Detroit rivals Chrysler Group LLC and General Motors Co….”.

Bringing Ford's hourly labor costs in line with General Motor's and Chrysler's should not be the priority. The priority is to become cost competitive with USA based Japanese automotive manufacturers. Ford's, GM's and Chrysler's hourly base wage rates and benefit costs are reportedly $20 to $30 per hour higher than Japanese competitors. Doubtful these costs were reduced in the GM and Chrysler bankruptcies. This remains a huge problem.

“…workers felt they were being asked to sacrifice more than the company's executives. Ford CEO Alan Mulally made $17.7 million last year…”.

There is some justification in the Unionized Employees position on this issue. Hourly employees are well aware that officers of a major company have significantly higher incomes. This is not an issue in healthy economic times. But in poor economic periods, if Management is perceived as not sacrificing with all on board, then a disconnect is created, and polarization with contract rejection occurs.

A helpful signal for Unionized employees, to convey Management is being serious about reducing overhead costs, is if Ford has cut back on some Executive perks. Does Ford still have an executive dining room, replete with waitresses, multi-course menus, and silver finger bowls?

“He (Alan Mulally, CEO) hasn’t presided over an annual profit at Ford, which has posted three straight full-year losses totaling $30 billion.”

Other questions exist. For example, did the quarterly profit rely heavily on favorable product mix and pricing? Will these same conditions be available in future fiscal years?

The list of negatives should not detract from the solid job Mr. Mulally and his team has done in beginning Ford's turn around. The challenges are enormous, and Mr. Mulally has clearly moved it in the right direction.

Sun Tzu - “The Art of War”

Sun Tzu’s book “The Art of War” was written in 400BC. Peter Drucker’s and Sun Tzu’s management tenets for success are essentially the same.

Sun Tzu was China’s first professional General. Prior to him the Sovereign (i.e., King) led his army which was frequently disorganized, under-funded and unsuccessful. He developed strategy and tactics of war but also detailed financial budgets, manpower required, basic training and logistics (e.g., the number of helmets, chickens)

It is a surprisingly practical manual of war with basic advice, such as: “Dust spurting upward in high straight columns indicates the approach of chariots.” “There are five methods of attacking with fire. The first…, the second…”.

In his tenets listed below, I suggest as helpful guidelines for substituting a Board of Directors, an Owner, a Ruler, or a Chief Executive Officer.

1. “There are five qualities that are dangerous in the character of a general..."

• "If he is reckless..."
• "If he is cowardly..."
• "If he is quick-tempered, he is obstinate and hasty - does not consider difficulties. The essential temperament of a general is steadiness..."
• "If he is defensive. One anxious to defend his reputation pays no regard to anything else..."
• "If he is too much of a humanitarian..."

"These five traits of character are serious faults in a general and in military operations are disastrous.”

2. “The ways in which a Ruler may bring misfortune upon the army is by interfering with its administration and operations. He whose generals are able and not interfered with by the Sovereign will be victorious. There are occasions when the commands of the Sovereign need not be obeyed.”

3. “If one ignorant in military matters is sent to administer the army, then every movement will be hamstrung. This engenders doubts in the minds of the officers. A confused army leads to another’s victory.

4. “He whose ranks are united in purpose will be victorious. Thus, command them with civility and imbue them uniformly with martial ardor and it may be said that victory is certain.”

5. “And therefore the general who in advancing does not seek personal fame, and in withdrawing is not concerned with avoiding punishment, but whose only purpose is to protect the people and promote the best interests of his Sovereign, is the precious jewel of the state. Few such are to be had.”

6. “It is the business of a general to be serene and inscrutable, impartial and self-controlled. If serene he is not vexed; if inscrutable, unfathomable; if upright, not improper; if self-controlled, not confused.”

Basically his book describes the development and execution of a strategic plan. His emphasis on doing the unexpected is a synonym for Peter Drucker’s innovation.

Bankruptcy and the Financial Crisis

On June 30, 2009 New York University held an excellent seminar on “Bankruptcy and the Financial Crisis".

The link to view NYU's webcast of the seminar is included below.

The subjects discussed included:

1. Federal government policy on large financial institutions and managing too-big-to-fail firms.

2. Creditor’s rights particularly reconciling Chapter 11 filings with section 363 of the federal bankruptcy code. Has anything changed in the distressed trading markets based on the handling of the Chrysler and General Motors bankruptcies?

3. Will a large bank fail? Actions the federal government will take if there are failures. Is capitalism affected and sacrificed to expediency?

4. Bankruptcy trends and risks – increase in distressed businesses.

The “Creditor’s Rights” panel:

• Moderator: Thomas Cooley, Dean, NYU Stern School of Business
• Barry Adler, Professor, NYU School of Law
• Edward Altman, Professor, NYU Stern School of Business
• Gerald Rosenfeld, Deputy Chairman, Rothschild North America

The keynote speaker: Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City:

1. Mr. Hoenig rejected the notion that some firms are too-big-to-fail. He laid out a three-step plan to address troubled, large institutions and the need to avoid ad-hoc approaches.

2. He suggested that large firms be held accountable including replacing management.

The “What if a Large Bank is Failing?” panel:

• Moderator: Matthew Richardson, Professor, NYU Stern School of Business
• William Ackman, Pershing Square Capital Management LP
• Edward Altman, Professor, NYU Stern School of Business
• Micheal Krimminger, Special Advisor, Federal Deposit Insurance Corporation
• Nouriel Roubini, Professor, NYU Stern School of Business
• Myron Scholes, Chairman, Platinum Grove Asset Management

Click here to access the webcast link to NYU’s seminar.

Where Is China Heading?

Mark Leonard's book “What Does China Think?” presents a number of China's modern beliefs and challenges.  Mr. Leonard discusses China's current struggles and the new priorities the Chinese State has determined are essential to address contemporary problems.

It is interesting, for the first time in China’s history, the State's 11th five-year plan does not list economic growth as the top focus. The plan includes mantras, such as: “put people first”…“respecting the natural environment”… and introduces a model which resembles some Scandinavian attempts in Social Welfare to address existing concerns.

The Book suggests China’s most pressing problems are:

1. The rise in protests,
2. The gap between rich and poor,
3. The near bankruptcy of the rural economy,
4. The lack of domestic consumption,
5. The pervasive corruption of the political elite,
6. The environment.

Official records cite 87,000 protest demonstrations in 2005, which is a ten times the amount of such displays since 1993.  It is most likely, the actual number of organized public protestations is much higher.

Mr. Leonard maintains the theory, modern China hopes to develop into an “Asymmetric Superpower”.  This conception believes the USA has an unhealthy obsession with military production, and this is the United States' greatest weakness, blinding policy-makers to the wider picture of military strategy.  Mr. Leonard's offering suggests the current Leadership of China, must include the use of economic, legal, and political tools as well, which is referenced: “non-military warfare”.  This modern version of China's “Economic Warfare” includes investing billions of dollars in “Special Economic Zones” within foreign Nations.

However, today China invests billions to improve it's military might, as Chinese Leaders correctly believe economic power without a strong Military, in context to the rest of the World, will reduce China as an overall power.  They prefer to obtain a Military Force which will become equal to the United States.

“China is attractive to other nations because of its economic power but this attractiveness will not last. It will need to change its political system to become a ‘Hyper-Power’ equal to the USA”.

But for China to achieve this status, the State will need to eliminate its incongruous and obsessive policy on a number of issues, it has mistakenly elevated to threats to its survival: Taiwanese and Tibetan freedom, the relationship with the Dalai Lama, the rise of Falun Gong, and various radical Muslim Enclaves.

The GM & Chrysler Bankruptcies

“The General Motors Corp. Chapter 11 bankruptcy marks the humbling of an American icon that once dominated the global car industry and sets up a high-stakes gamble for USA taxpayers.”

Reportedly both General Motors and Chrysler will exit from Chapter 11 Bankruptcy Court in 60 to 90 days. This sounds like wishful thinking and may involve some public relations imagery. To “correctly” restructure a significantly less complex and smaller manufacturing company, would require at least one year. The rush may produce more problems for all involved.

Regardless, one of GM’s and Chrysler’s most significant problems is that hourly labor costs are reportedly $20 to $30 per hour higher than their USA based Japanese competitors. It doesn’t appear that this most fundamental weakness has been addressed in a serious manner.

Most of the Japanese competitors have non-union hourly labor in their USA manufacturing operations. As such, their labor costs will not significantly increase over time. In addition, for the past few years, the Japanese Automakers have made higher capital investments to improve productivity. The cash strapped Big Three have not been able to match its competition.

Recent GM and Chrysler plant closings and operational restructurings have reduced their overall costs by billions of dollars, as well as their hourly headcounts by the thousands. However, the overall impact is misleading. The hourly cost for direct labor employees has not been reduced. And will continue to prove to be a vivid Achilles’ heel for the legendary USA manufacturers.

While the total of manufactured GM and Chrysler automobiles have declined significantly, the actual cost of each automobile continues to be higher than its Japanese competition. The Automakers will continue to prove unable to compete with this inherit weakness. Besides overt Labor commitments, another higher cost factor to consider is unabsorbed manufacturing overhead, since production is lower in existing plants. This is not a healthy sign.

However, the most important factor remains, has the UAW agreed to reduce the total cost for hourly direct labor employees?

Regretfully, there is no evidence of a reduction in hourly labor rates...

It is doubtful any labor cost concession will be meaningful if this is true:
"The fear at the UAW was that ownership in GM could eventually be worth very little.”

Thus, as it stands, GM and Chrysler will continue to lose money and will probably be forced to return to bankruptcy protection. We will have to wait to see what structure the FIAT buyout of Chrysler will produce. But, if there is a next time for GM in bankruptcy, it may have to execute liquidation under the Chapter 7 bankruptcy code. That is, if the US Government, which now owns 70% of the company, will allow it.

In addition, salaried headcounts appear too high. While this can be dealt with outside of the bankruptcy process, GM and Chrysler should analyze their salaried organizations and adopt Toyota’s performance target of 10% improvements in salaried productivity every year.

Regardless, neither company should exit from bankruptcy protection until the operations are restructured to allow a competitive, best cost manufacturing operation to emerge. We shall see, both GM and Chrysler face enormous challenges for survival.

Have two of the Big Three suffered such a loss in reputation over the years, their brands are too damaged beyond repair for today’s marketplace?

No, quality management can turn anything around with the right strategy, capital, cost structure, and culture. But it requires the tools needed to compete. Anything is possible.