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backASIAtalk August, 2005
Making the case for Asia
As Western multinationals launch a new and unprecedented wave of investment in Asia, the techniques used to judge regional opportunities, and the strategies chosen to pursue them are changing radically.
Back in 2002, staff working in Asia for Jones Lang LaSalle (JLL) were getting more than a little annoyed. Once upon a time, their region had been the fastest growing and most profitable part of the property services group. But now it felt as if their corner of the world had been all but forgotten.
Investment in the firm's Asian operations was in danger of being cut back, and with understandable reason. First came Asia's financial crisis of 1997/98, followed by the internal turmoil of a merger in 1999 between Jones Lang Wootton of the UK and LaSalle Partners of the US. The dot-com bust and world-wide economic slowdown of 2001 only made matters worse.
And yet, managers on the ground in Asia were convinced the region was gearing up for a new round of growth and needed more investment, not less. The problem was, how to help senior managers back in Chicago communicate Asia's potential to JLL's board and the wider investment community and so keep the investment tap turned on. After much deliberation, the team opted for a bold plan: to completely redefine how the company looked at investment spending.
In particular, they decided to carve up Asia Pacific into three categories in order to bring much-needed clarity to the investment appraisal process. Each country would be classed as either core, growth, or platform.
Core markets, such as Australia and Hong Kong, were well established, with healthy margins and strong cash flow but limited opportunities for growth. The attention here would be on boosting margins and growing market share.
Growth markets, by contrast, were those where revenues were rising by more than 20% a year, such as India and China. These markets also had positive margins, although slower cash flow, but the chief focus was revenue growth, and making investments to support that growth.
Finally, platform markets – such as Thailand and the Philippines – were those where JLL provided just a few select services, many of them solely to support the needs of its multinational clients. As stand-alone markets, the business case for investing significantly in these countries simply didn't stand up.
The system let us distil a lot of complicated investment factors into a simple format that was easily communicated and understood,” explains Philip English, JLL's CFO for Asia Pacific. Investment decisions used to get bogged down with lengthy discussions about platform markets, when the focus should have been elsewhere.”
The clarity that came with the new classification helped convince JLL's management committee to increase its investment in Asia, and the results have been impressive. Last year, for example, JLL's revenues in Asia Pacific grew by more than 20% to reach US$221m, or 19% of JLL's overall sales.
Equally satisfying, reports English, JLL has started using the core, growth, and platform classification throughout the company, applying it not only to different countries but to different business lines too. We even use it in our SEC filings now,” he notes.
Feast in the East
The experience of JLL in Asia is typical of many multinationals operating in the region. For one, the past two years have seen Western companies launch an unprecedented wave of new investment in Asia. For another, the way that companies build their investment case for the region and the way they view the risk and return equation of local markets is shifting radically. The strategies that multinationals use to enter these markets are changing just as sharply.
Figures compiled by the Geneva-based United Nations Conference on Trade & Development show clearly how a new wave of investment is hitting the region. At the start of the 1990s, foreign direct investment (FDI) inflows to Asian countries began a heady ascent, only to turn down again after the Asian financial crisis and the recent global economic downturn.
Then, in 2003, a second wave of FDI began, one that is smashing all previous records. Last year, for example, world FDI inflows grew by just 6%, whereas they leapt by 55% in Asia to reach US$166bn. Not only is this figure the highest by far in Asia's history, it also represents 27% of global FDI – the largest proportion going into Asia in living memory. China accounts for a big chunk of the growth, but almost everywhere else in Asia is up too.
It's clear that multinational companies are investing in Asia like never before. And figures released so far this year in places like India, Indonesia, and China suggest there's no end in sight to the investment boom. Of course, a lot of this investment is coming from Asian companies investing within the region, but a big chunk is coming from Western firms too.
The reasons are simple enough. On the one hand, Asia offers giant cost savings for companies prepared to relocate their manufacturing, back office processing, and even research and development functions to take advantage of the region's low-cost labor.
On the other hand – and of increasing importance – Asia is beginning to become a significant market in its own right. Twenty years ago, Asia ex-Japan accounted for a mere 5.7% of the world economy. Today that has doubled to more than 11%. Add in Japan, and the region accounts for almost a quarter of global GDP. Measure by purchasing power parity and the number swells to an impressive 35% of global output. (See tables, right.) What's more, Asia's significance as a world market will continue to grow. Growth rates in the region are double, even triple those found in many Western countries. It's little wonder that growth-hungry multinationals from Europe and the US are clamoring for a piece of the action.
A bruising encounter
But identifying Asia's potential is the easy part. Working out how to harness it is much tougher, as many companies can testify.
In the first wave of investment, Western firms wasted a lot of money,” says Frank-Jürgen Richter, president of Horasis, a Swiss-based consultancy linking Western investors with Asian companies.
Indeed, Richter served as the CFO for China at German engineering giant Bosch during the 1990s and witnessed much of the carnage first-hand. Multinationals got into bed with the wrong partners, they structured their joint ventures poorly, they misread the market and suffered for it,” he recalls.
Today, he says, multinationals are trying to be much more sensible”. For example, in China it's now possible to operate wholly foreign-owned enterprises in many sectors, so making management simpler and helping to prevent the theft by local partners of sensitive technologies.
Vikram Chakravarty, Singapore-based principal at AT Kearney, a strategy consultancy, agrees that multinationals were burned by their first forays into Asia. In the past, many companies used overly bullish projections to get into Asia and suffered the consequences,” he observes.
More recently, Chakravarty sees multinationals changing their investment approach. In particular, he notes, Asia is redefining the way companies do planning.” Instead of hockey-stick projections showing economies growing exponentially into the future, some companies are learning to inject greater realism and flexibility into their investment decisions.
A good example is American Express, the US$29bn-a-year credit card and financial services firm. Christophe Le Caillec, the company's CFO for Asia Pacific and Japan, believes that assessing investment opportunities is one of the most challenging things we do because there's no right answer.” In Asia, he adds, the task is doubly tough.
Not least that's because certain markets remain highly unpredictable, with Le Caillec singling out China as a good example. Uncertainty about the currency, lack of clarity about new legislation, poor brand protection, and the fact that few Western companies have been able to establish a resilient business model means it's very hard to get any sort of visibility about the future,” he says.
Hence, concludes le Caillec, trying to use traditional tools to make investment decisions is next to useless. Classic NPV analysis is clearly very challenging in China,” he sighs. There are simply too many unknowns to come up with meaningful NPV numbers.”
It's for this reason that Le Caillec and his team have turned instead to real options analysis, a technique whereby managers use esoteric option-pricing theory to assess the merits of real-world projects. Importantly, says Le Caillec, such an approach brings much greater flexibility to his investment planning. In particular, it helps him to enter new markets one step at a time, with each incremental investment giving him a variety of options for the future development of the business. The idea is to be ready and adaptable enough to respond to any one of a number of different scenarios, rather than betting on just a single future.
In December 2004, the company signed a deal with Industrial & Commercial Bank of China (ICBC) to issue the country's first American Express-branded credit cards. ICBC will issue and distribute the cards, and carry the receivables risk, but operate on the American Express merchant network. Under WTO rules, American Express can't issue cards directly in China until 2007. Nonetheless, says Le Caillec, the deal with ICBC is an example of how he likes to take a stepped approach that leaves open as many options for the future as possible.
James Ahn, a Hong-Kong based associate principal at McKinsey & Co, a strategy consultancy, says that variations on the options-based approach at American Express are being implemented by more and more companies in Asia. Trying to model exactly what will happen in future in places like China is a fool's errand,” he says. The potential upside and the potential risk are unlike anything the world has seen before. It's much better to use an options-based approach that prepares you for lots of possible outcomes.”
Ahn says that banks like HSBC and Citibank are pursuing one distinct sort of options strategy that he calls plant and pounce”. The idea is to plant many different seeds – or options – in a market, for example by taking small equity stakes in local companies, and then to pounce on the seeds that germinate and grow.
The mistake is to nurture just one or two seeds,” Ahn concludes. You need a big portfolio of options. And you have to be ready to pounce quickly because many of these opportunities will only come along once.”
Big and profitable?
Another trend characterizing the second wave of multinational investment into Asia centers on the debate over whether to build market share or to concentrate on profitability instead, says Chakravarty at AT Kearney. Many companies face a quandary,” he explains. What they want is large, profitable firms, but what they've built are large, not very profitable ones. They're now torn between wanting to get larger still as Asia's markets expand and wanting to reap profits.”
For Angus Lai, the answer to this quandary wasn't immediately apparent. As Asia Pacific CFO of Trane, a US-based manufacturer of air-conditioning systems, Lai oversees what many would call impressive top-line growth. In 2004, the company's regional sales grew by 10% – with China expanding at double that rate – to reach US$600m.
And yet, says Lai, many of Trane's competitors are growing a lot faster still. The reason is simple: Trane's investment approach is highly conservative. For example, in China the firm demands 80% up-front payment for its air-conditioners before delivery. Equally, the company is determined to maintain its margin, positioning its products as the market leader in terms of price.
Last year, I thought we were investing too slowly in Asia,” concedes Lai as he watched rival firms carve out ever bigger shares of the market.
But this year, Lai is thankful his bosses in the US stuck to their conservative ways. It's easy to build market share but at what cost?” he asks. This year the macro-economic picture is not so healthy, but thankfully we have low inventory, low days sales outstanding, good cash flow, and are very profitable. If you look at some of our competitors they are already experiencing big trouble.”
Another CFO grappling with similar issues is Ng Wai Lun, who manages the finances in China and Hong Kong for AstraZeneca, a US$21.4bn-a-year Anglo-Swedish drugs giant. In 2004, AstraZeneca's sales in China grew by 30%, propelling the country into the company's list of top-ten markets for the first time. After several years of investing, suddenly China has reached critical mass for us,” enthuses Ng.
Almost immediately, senior managers at AstraZeneca demanded that the firm's first ten-year plan for China, written in 2002, be ripped up and replaced with a new one. A revised plan was drafted calling for more investment in sales and marketing, expanded production facilities, and more extensive clinical trials. Growth forecasts were redrawn and by 2015, the new plan said, China would be a top-three market for the company. In February this year, AstraZeneca even flew its head of marketing and strategic planning for China back to London to co-present to the analyst community alongside Jon Symonds, the company's group CFO.
Yet despite the bullishness, Ng remains determined to see that AstraZeneca doesn't fall into the trap of chasing sales at the expense of profits. We have to keep ourselves aware of the risk,” Ng cautions. Over the next ten years we'll see plenty of bumps in the road and the economy won't keep growing at 8% every year. In China things can change very quickly and very unexpectedly so you have to try to build that into your calculations.”
In fact, says Ng, he's having a hard time spending all the investment dollars that are being made available to him. Our investment process is very stringent,” he says. You see enough companies investing recklessly in this market and chasing growth at all costs to know what trouble lies that way.”
Of course, in many parts of Asia another issue influencing investment strategies, especially for companies making acquisitions, lies in the quality of corporate governance and financial reporting. Thierry Artaud, finance and IT director in Asia for Saint Gobain Abrasives, a division of France's E32bn-a-year (US$39bn) Saint Gobain group, is only too aware of the risks. Last year, Saint Gobain had sales in China of E273m, but plans to double that this year, partly through internal growth, but also via a string of acquisitions.
However, frowns Artaud, The quality of disclosure at many target firms is poor.” One big area of concern centers on tax, with some state-owned enterprises being exempt from certain taxes that suddenly come into play once the acquisition goes through. Equally, notes Artaud, Many firms are very adept at hiding expenses.”
It's thanks to this poor level of transparency that Saint Gobain has determined to do only asset deals” and not equity deals”. As he explains, If we're buying physical assets we have much better control.”
To further improve the odds of its investments being profitable, Saint Gobain likes to take a majority stake, usually of around 75%, but with an option to buy the rest later on. Keeping a local partner engaged for the first two years after an acquisition is important, says Artaud.
Just as important is knowing when to say no to an investment. In Asia that's not easy, for the region is often hyped up beyond all reasonable bounds. With the media, analysts, bankers, and many other parties lauding the arrival of the Asian century, it's no easy task trying to distinguish genuine signals from general hullabaloo.
At Dow Chemical, Sam Ong, the company's credit risk process leader for Asia Pacific and regional finance director for South Pacific, is a seasoned hand at assessing investments in the region. Currently, his company, a US$40.2bn-a-year American chemical giant, is notable for the way it has resisted the temptation to pile into China over the past ten years.
Many of Dow's rivals – the likes of BASF, Exxon, Shell, Bayer, and others – are all currently building multi-billion dollar integrated chemical plants in the Middle Kingdom. In contrast, Dow has invested in just a few specialized plants and has chosen instead to import the bulk of its products from countries like Malaysia and Thailand in a bid to grow its China business without the need for giant capital outlays.
There are many people who claim that you can't afford not to build facilities in China, but at this stage we aren't so sure,” says Ong. The petrochemical industry frequently invests based on very optimistic projections, especially in peak phases of the cycle, and my feeling is that a lot of companies in China will see their payback period stretch out a lot further than they're expecting.”
That's not to say that Dow Chemical isn't bullish on China. The company's revenues there grew significantly to reach more than US$2bn in 2004, and long-term it expects China to be the world's biggest plastics market by around 2025. However, for the next three to five years, Ong sees the country as a demand story, rather than a production one, especially given issues such as China's high energy costs, its lack of developed natural resources, and the embryonic state of local feedstock technologies.
To that end, Dow Chemical is focusing its China investments on building its customer base and brand recognition, on investing in its sales and marketing teams, and on setting up the necessary shared services infrastructure to support the company's expected revenue growth. While other companies concentrate on building capacity, we'd rather establish a business franchise first,” says Ong.
And, adds Ong, it's important to remember that China isn't the only market worth looking at in Asia. For example, Dow Chemical's sales in Southeast Asia are growing by around 20% a year and generating handsome cash flows and profits.
Source: CFOAsia.com - GAI
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