Martin Currie’s China fund manager, James Chong, has visited a number of industrial companies in China in recent weeks. He saw some evidence of declining margins, but the scale was much less than he had expected. Improving pricing is helping some companies actually improve their operating margins.
To maintain profitability in an environment of rising operating costs, Chong says Chinese companies have adopted the following strategies:
1. Passing on costs to consumers
“This is especially the case for industrial leaders. We talked to Angan New Steel and Baosteel, even though iron ore and coking pricing have risen by 65% and 200% respectively, steel makers in China could pass on more than cost rises to their customers through product price hikes. We talked to Tianwei Baobian, a power transmission and solar panel manufacturer. The management told us that they faced little resistance to their product price hikes, and so can maintain their profit margin. When we spoke to a representative of China’s SME Association, he told us that large international buyers tried to threaten to take the orders away if his association’s members increased their production prices, but that many Chinese suppliers took a firm stance on passing on the rising costs. Ultimately, these international buyers not only didn’t take their orders elsewhere but even increased the size of those orders. This is a strong indication that many Chinese corporations are gaining pricing power.
2. Improving productivity
China’s rising labour costs, which are increasing 10-15% every year, have forced Chinese companies to re-think their operational models and move to more automated processes. The rising cost of materials has also forced many Chinese companies to find ways to use raw materials and energy more efficiently. China’s leading manufacturer of cell-phone batteries, BYD, cited improving efficiency in both its training and automation, which have helped it to offset rising labour costs. Despite being unable to raise the prices of its products, Zhejiang Jiangling Lighting, which produces lighting for GE, has maintained profitability by improving productivity.”
3. Building a brand name
“For most Chinese companies, life as a supplier of vendors means always being at the mercy of bullying customers. The only way to secure profitability is to establish your own brand, allowing you to retain a higher margin and create more value. Companies such as China Ting, the world’s leading manufacturer of silk fabric and garments, has started to build its own brands in the Chinese retail market. The company’s low-margin ODM (original design manufacturing) business will gradually decline in the company’s sales breakdown, while its own-brand retail business will rise along with its overall margin. ”
4. Moving up the value chain
“Rising costs have caused a lot of small companies to collapse or close down, especially in the low-end production and export sectors. Chinese companies have found ways to survive by moving up to higher-end products, which command better margins. Haitian International, which makes plastic injection-moulding machinery and has a 24% share of the Chinese market, has abandoned or phased out some of its low-end products and moved to mid-to-high-end products. Haitian’s cost advantage not only allows it to take the place of Japanese imports from products but also enables it to export higher-end products to Japan. High-end products provide the best buffer for rising costs, allowing the company to maintain its overall margin.
“Shenji Kunming Machinery’s old products were mainly used in agriculture or low-end manufacturing processes, but now its new products have enabled it to penetrate the shipping, mining machinery and industrial chemicals sectors. The management told us explicitly that the best way to fight off margin pressure is to upgrade and launch new products. The company has a target of launching or upgrading at least five or six products every year.
5) Turning to the domestic market to seek higher margin
“In the past, there was always a conception that exports command higher margin than selling in domestic markets. But as China’s currency has appreciated over the past two years, this trend has gradually reversed. In many cases, exporting is now less lucrative, as most exporters settle their transactions in US dollars. Due to the renminbi’s appreciation and declining revenue due to the depreciating US dollar, rising costs are threatening companies’ profitability. Many companies have spotted this trend, and have made timely changes by shifting some of their sales to the domestic market. Dachan Food, an integrated chicken processor and food manufacturer, made the right decision by significantly reducing its exports to Japan, instead selling the products in China. The sales margin in China was more stable and the demand was, surprisingly, less inelastic with regard to price. The company’s blended margin has actually expanded to an easily sustainable level.”
“Through talking to Chinese companies on an almost daily basis, we have found that many of them are nimble, flexible and fast in coping with a worsening operating environment. We have been positively surprised by these companies’ ability to deal with rising cost pressures. Almost all of the companies we have spoken to have managed to get on top of the issues and offset the margin pressure by: 1) passing on rising costs; 2) improving efficiency and productivity; 3) building their own brand names and product quality; 4) Moving up the value chain; 5) turning to domestic market; and 6) diversifying their product mix. We believe that many Chinese companies will continue to shine during the global economic downturn.”