Fiducia China Focus Newsletter

• China Car Market –Profits on a Downhill Slope?
  
  
• China Compulsory Certification – Deadline extended to August 1, 2003
  
  
• SARS and China
  
  
• Huawei Technologies Co. Ltd.
  
  

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Patrick Kriegeskorte
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All liabilities excluded. This Newsletter is based on information obtained from sources (government, business associates, companies, publications, etc.) believed to be reliable. However Fiducia Management Consultants does not make representations as to it's accuracy, completeness or correctness.

Fiducia Management Consultants is China Partner of Corporate Development International, a global partnership specialising in mergers, acquisitions and divestitures.   www.cdiglobal.com

China Car Market –Profits on a Downhill Slope?

Germany’s BMW recently signed the contract for a EUR 450 million joint venture in Shenyang with Brilliance China Automative Holdings Ltd. in order to produce 30,000 of its 3-Series vehicles in 2003. The bigger and more luxurious 5-Series is scheduled for 2004. BMW’s rival, Daimler-Chrysler, is currently seeking approval for a joint venture with Dong Nan Auto Industry, aiming to produce an initial 20,000 units for the Asian market. But not only foreign manufacturers are raising production several-fold over the next years, domestic producers are widening their capacities, too. In total, experts predict a overall annual capacity of about seven million units 2008.

By the look of these recent headlines the impression seems that China’s car market might be growing forever. Just like the adventurers in Klondike at the end of 19th century, western car manufacturers are rushing into the middle kingdom, driven by the fear of being the last to get a piece of the lucrative market, but also by lacking demand elsewhere. Sales in Europe, for instance, shrank by seven percent last year. Emerging markets, especially China’s, could help to offset the negative trend elsewhere, hurting the auto manufacturer’s books.

The key question is, whether there is really enough space for all competitors. Are the profits in the Chinese car market on a downhill slope?

Starting from a low base and being driven by China’s increasing GDP and an explosion of private demand, the Chinese car market is witnessing exponential growth. Official figures for the first quarter 2003 put car sales to 409,161 units, a 109 percent rise year-on-year. Volkswagen for example, the market leader in China, reported a 94 per cent increase of its sales in the first three months, pushing the sales to 162,00 vehicles in VW’s second biggest market in the world after Germany. VW is planning to sell one million cars in 2007. Indeed, there is still considerable growth potential in a country where fewer than two people in 1,000 possess a vehicle.

However, the total market remains small, about the size of Spain. On the other hand, it is unrealistic to expect mass ownership of cars in a country where disposable income in its richest city, Shanghai, last year averaged just 13,250 yuan (EUR 1,446). Other developing regions, e.g. South America or Eastern Europe have seen similar growth in the past, but the demand has proven to be volatile and the rapid built-up capacities quickly depressed pricings.

An over-supply could lead into a price war, strongly affecting the companies’ bottom line. The future will have to give the answer, but microeconomic theories show clearly that company profits and prices decline with growing numbers of competitors. Car prices in China have already seen a 20% price cut last year and a further decrease is predicted. In 1996, VW was earning a net profit of up to 20,000 yuan (EUR 2,180) per car, twice its average global profit level. Since the entry of new competitors these golden times are long gone.

Due to problems in the implementation of the China Compulsory Certification (see also China Focus March), the timeframe for adopting the new certificate has been extended another three months. The new deadline is August 1, 2003.

The official announcement from April 23rd says that the application, sample delivery, sample testing and factory audit related to the CCC had been “adversely affected by unexpected incident”. The postponement comes as a great relief for many foreign companies, which would have missed the original deadline.

Until two weeks ago there was just denial amongst officials in Beijing about SARS. The mainland authorities even doubted whether SARS was a health risk. Today Atypical Pneumonia is hurting China's health and hurting the economy as well.

The central government's approach to SARS has swung from total ignorance and denial to dynamic overreaction. Whilst China was doing great on WTO, the Olympic Games, the World Expo and many other things, the SARS-crisis has caused a substantial credibility crisis among its own people and the world.

There are some indications that China's lack of openness and delayed action was a result of a political struggle between the new president Hu Jintao and the former president Jiang Zeming. It was during Zemin’s last days in office that the outbreak happened. Jiang, who still heads the powerful central military commission, only commented on SARS one week after the government's disclosure.

SARS is a brutal reminder of the negative impact of globalization. However, at the same time we need to keep people from panicking in times of crises.


Comments and Observations on SARS Related Issues

The Economy
SARS may be scary but what is more scary now is the psychological impact: people have lost confidence and have stopped spending money.

The short term impact of SARS on the economy is immediate - travel and tourism (both inbound and outbound) are severely hit. Domestic service industries like restaurants and retail are facing intense pressure in the affected areas. The fallout is already evident for some listed Chinese companies, including Tsingtao beer, China Eastern Airlines etc.

Otherwise daily business continues largely uninterrupted except for traveling to/from areas like Beijing, Guangdong and Hong Kong. It can be expected that China will make substantial efforts to contain SARS quickly and to compensate for the interruption in business and thus minimizing the impact on GDP. SARS is currently a serious issue but when things are back to normal we should see a marked increase in business activities.

Exports
The first major indicator to the Central government that their policy didn't work was the China Export Commodities Fair (CECF). Having been the main driver of China’s exports since 1957, the CECF was close to dead this year. The fair is normally attended by 120.00 visitors placing orders worth EUR14,3 billion, this year it was down to 23.000 visitors and EUR3,9 billion.

Foreign buyers have virtually stopped their trips to China. But some companies in exports have taken appropriate measures, like Hong Kongs Li & Fung (EUR 4,24 billion annual sales) who moved managers to their US and European offices to maintain personal contacts with customers now less willing to travel.

So far Guangdong, China's export powerhouse, has had no noticeable interruptions.

FDI
How are foreign companies coping?
Companies have taken preventive actions to protect its employees and are making contingency plans. Additionally, companies like Siemens are helping with donations of equipment and material.

In the immediate term especially areas like Beijing, Guangdong and Hong Kong are suffering from travel hindrances. Thus company's sales and service calls may be affected at this moment and there are delays in launching new products and accessing new customers. Because of SARS trips to China have been postponed and thus the pace of new FDI will slow down.

Nevertheless, SARS should have no impact on the fundamental China business and investment strategies.

The Corporate World Needs Transparency
There is clearly a strong disparity between China's impressive economic development and the openness of government and freedom of information - they did not develop in tune. The reporting on SARS demonstrates how far China has come, and how far she has yet to go. For those working in China the SARS crisis is a high profile example of the daily frustrations one encounters: The information available on financial markets and listed companies, the dubious quality of statistical data and the legislative procedures lack the transparency and credibility required for sound decision making and an efficient market mechanism.

China needs to address this information deficit in a serious way by giving the media a free hand to conduct investigations and to report and also to curtail the influence of the party on the press. Companies, whether local or foreign, need transparency to make sound business decisions.

China's companies, especially those publicly quoted also need to learn about transparency and openness. Two examples:
China Southern Airlines (which is listed in New York and Hong Kong) was rather cagey disclosing the SARS impact on its business when asked by Financial Times in early April. The answer was either "no comment" or "no impact" whilst Cathay Pacific at the same time reported a drop by about 50%!
At the close of the China Export Fair in Guangzhou spokesman Mr. Xu would not take any questions at the press conference - he just announced the figures.

The problem may be that mainland companies are not willing to disclose details because of the government's tight control on news coverage - but how can the market function under such circumstances?
Having absorbed so much foreign investment and in the interest of an open market it is right to continue pressing China to become more open.

Hong Kong
When the crisis started in March China failed to protect and support Hong Kong's well being by their denial and inaction. Hong Kong, already suffering from an economic adjustment process, was left on its own to deal with the fallout from SARS.

On the other hand, Hong Kong did little to question China or Guangdong province on the situation and no measures were taken until mid April to stop the influx of SARS from Guangdong province.

China's Health System
China’s health system is fundamentally weak: under funded (China's spending on health care has actually dropped over the last few years), decentralized and unequal access to health care. China is already plagued by diseases usually associated with much poorer countries, including tetanus and hepatitis B, their sickness rate is among the worst in Asia.

Furthermore, Beijing has still not officially dealt with its AIDS crisis yet affecting more than one million people today. Experts estimate that this figure could rise to 10 to 20 million by 2010.

How Does SARS Affect Us and Our Services?
For us it is by and large business as usual. In spite of the epidemic we still have overseas visitors, but at a much reduced level. According to WHO traveling to China/Hong Kong is okay if one takes extra precautions with respect to personal hygiene and avoids close contacts to people. We have started to take precautionary steps in March enforcing strict measures with respect to hygiene and infection control in our office premises. We have curtailed traveling within certain parts of China and are using web casting, web and video conferencing instead to maintain contacts within the company and our clients and business partners. As a contingency we have arranged for staff to work from home, should the need arise.
We are pleased to say that, so far, we have not had any staff developing SARS syndrome.

Let’s hope for a quick end to this crisis and thank you for your continuous support during this difficult time. SARS is not the end of the world and life goes on!

One of China’s top companies that have been creating a commotion is Huawei Technologies Co. Ltd. Established in 1988, Huawei is a high-tech company specialised in product development, production and marketing of communications equipment and customised network solutions. Its solutions are divided into the following categories: Fixed Networks, Mobile Networks, Optical Networks and Mobile Data Communication.

Huawei's customers include China Telecom, China Mobile, Hutchinson Global Communications and China Unicom. The success at home has been the base for Huawei’s international expansion. In a declining economic environment, international revenues saw a strong growth of 68%, reaching US$552 million in 2002 compared with US$328 million in 2001. In an effort to attract additional funding, the company may spin off parts of its assets to be listed in Hong Kong and the US. Unlike many other Chinese companies, Huawei is highly innovative, investing 10% of its revenues in R&D this year and engaging 48% of its 22,000 employees in R&D.

In 2002 Huawei was involved in what was one of the largest M&A deals between a private Chinese company and a foreign investor: US based Emerson Network Power acquired for US$750 million the telecom and data power conversions provider Avansys, a subsidiary of Huawei.

But recently Huawei has been facing less joyful news, being accused by its main competitor Cisco Systems of breaching patent and copyright laws. Cisco alleges that Huawei plagiarized its operating software and source code - Huawei denies the allegations. Some analysts and experts have called Huawei a “Cisco Clone”. Others say the lawsuit might be aimed at protecting Cisco’s revenue and margins against competition. Huawei’s strength in Asia and its desire to push into developed markets scares Cisco and cuts into its sales. Huawei’s price level is up to 50% lower than the Americans’.

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