The Coming Wave of Consolidation in Chinese Industries

Companies should understand consolidation trends in China to better handle changes within their industries and take advantage of investment opportunities.by Seth Harlem and Ron SchrammConsolidation within industries will be a central theme in China’s efforts to restructure its industries and promote industrial modernization in the coming years. The significance of consolidation for China and why it is likely to take place are particularly acute questions during the current economic crisis, when firms within certain industries are under great pressure to perform, merge, be acquired, or vanish.

The consolidation process can be thought of as a rationalization within an industry where firms that are not operating at their full potential either go out of business or are folded into more efficient firms. The competitive process generally leads to firms operating at an optimal size within an industry, depending on such factors as market-based or geographic niches. In the early stages of an industry, when companies usually make above-average profits, firms of varying levels of efficiency are able to stay in business. Furthermore, with new entrants the number of firms in the sector surges. Eventually, though, inefficient firms drop out and industries stabilize with fewer, but on average larger, companies. Innovation and regulatory changes put pressure on inefficient firms, and the macroeconomic slowdown will reduce profits; these developments force inefficient firms out of business and are among the major causes of industry shakeouts.

These major causes—combined with government encouragement—set the stage for widespread industry consolidation. China’s industries are just beginning this process. As Andy Rice, senior vice president for International Business at the Jordan Co., puts it: “There will be a lot of opportunities from consolidation in China, and many reasons for consolidation to occur.” As consolidation unfolds in China, a number of opportunities will emerge that could provide enormous benefits for Chinese consumers, surviving companies and employees, investors, and businesspeople who assist in the process.

Examining China’s industrial landscape

To determine the likelihood and readiness of industry shakeouts or consolidations, China Macro Finance, LLC (CMF) recently examined a sample of 10 industries in China: bituminous coal, cement manufacturing, auto parts, motor vehicle manufacturing, metal shipbuilding, dairy products, cotton and chemical fiber, sewage treatment and recycling, pharmaceuticals (original drug manufacturing), and rubber parts. The first five industries were selected because the PRC government has announced plans to consolidate them; the second five industries were selected at random from CMF’s database on private Chinese companies.

The 10 industries contained 33,651 companies and totaled 12.3 million employees. The data allow analysis of the current state of particular industries and the future of those industries—specifically the possibility of industry consolidation. Furthermore, combining this information with PRC government consolidation goals highlights opportunities for investors and key due diligence insight for companies seeking healthy, stable partners that will be on the right side of an industry shakeout.

For instance, China’s auto industry is one of the industries slated for consolidation. The auto industry revitalization plan, released in March 2009, aims to consolidate many small, regional manufacturers into a group of “Big 10” internationally competitive auto manufacturers. CMF data suggests that the auto industry is ripe for consolidation. How does consolidation in an industry such as auto manufacturing benefit foreign companies? A February Wall Street Journal article explained: “The weeding out of [small Chinese auto] companies…could in the short term benefit big foreign auto makers such as Toyota Motor Corp. and Volkswagen AG by reducing competition in the world’s second-largest car market after the US. Upstart auto makers have put enormous downward pressure on retail prices for cars in China, hurting foreign players’ profitability.” Of course, as the article points out, consolidation could also help the remaining domestic companies.

An analytical look at the consolidation potential

Though Chinese industries appear to follow the same theoretical statistical distributions for firms in an industry found anywhere else in the world, the specific underlying metrics differ and are revealing. Industries around the world tend to have a large number of small firms (1-5 employees) and a small number of large firms, where the latter are responsible for producing the lion’s share of industry output. Such a pattern leads to an average firm size greater than median firm size, which in turn is greater than the modal firm size. This pattern also holds for China, but Chinese industries have not yet reached the metric norms that one would expect in a mature, consolidated industry.

CMF’s proprietary data on private Chinese companies were used to examine the above 10 industries in China to see how they compare to benchmarks for consolidated industries; CMF reviewed benchmarks indicated by numerous studies across industrialized countries and thousands of companies. Firm size for each Chinese industry was gauged based on the number of employees at each firm. (Number of employees has been shown to be an effective measure for firm size, but results using revenues would be similar.)

The table compares Chinese industry consolidation with international benchmarks. The row marked “C parameter” is an index of how consolidated an industry is, based on the Zipf statistical distribution model. (C values close to zero suggest great potential for consolidation, while those close to one suggest that the industry has already consolidated. Values lower than one suggest that more consolidation is still possible.) In the United States, where industry consolidation is mature, “C” is close to one. The C parameter data indicates that each Chinese industry examined has great potential for consolidation.

The figure shows a typical distribution of firms in China’s rubber parts industry compared to what a mature, consolidated industry would normally look like. The figure reveals that China has too many small and medium-sized enterprises (SMEs) and not enough large firms. China has 44 rubber firms with more than 500 employees; the largest is the Zhongding Group with 9,565 employees. In contrast, the United States has 129 rubber firms with more than 500 employees. The average number of employees in the United States for all industries is around 840 per firm—in China the figure is 239. Over time, the rubber and other industries in China will likely gravitate toward the degree of scale and concentration found in the United States.

Another way of looking at the shortfall in consolidation in China is to use the “80/20 rule” (or er ba dinglu in Chinese), which is used in the West and China. According to this rule of thumb, based on the Pareto statistical distribution model, about 80 percent of output will come from the largest 20 percent of the firms in an industry in a mature, consolidated economy. The table shows that few industries in China exhibit this characteristic. The cement industry falls short by the largest amount with 32 percent fewer firms in the top 20 percent than expected, followed by the sewage treatment and recycling industry down to the auto industry, which is close to what one would expect for the top 20 percent of firms. Interestingly, the bituminous coal industry appears to have an excess of firms at the top, perhaps because of its central role in the historical development of industry in China. Examination of other industries (auto parts, for example) shows an excess of small firms compared to the norm in more mature economies. Though each industry has its own characteristics, the general picture is the same across the industries examined: the industries have too many SMEs relative to large firms, and the largest firms are still too small.

Drivers of China’s industrial consolidation

A variety of China-specific factors will lead to greater concentration in Chinese industries in the next five years:

• Falling provincial barriers Since economic reform began, local and provincial governments have built their own enterprises, often protecting them with measures that keep out competitors from other parts of China. For example, the top 10 cement firms in China—including the Shandong Shanshui Cement Group Ltd. and the Conch Cement Co., Ltd.—are located in seven provinces, implying that each province has protected local industry and promoted its own “cement champion.” As market forces and the central government pull down provincial walls, several factors—some of which are discussed above—will likely drive a few of these firms to merge. (CMF’s research examined the consolidation potential of each industry from a national perspective—not from provincial and local perspectives. Provinces and cities in China that have many small companies in an industry designated by Beijing for consolidation may view such policies as damaging to their economies. Firms operating in consolidating industries in China will need to cooperate with all levels of government and balance central policies with local conditions.)
• Tax and legal reforms In the past, provinces attempted to block consolidation because local officials feared that a local company’s acquisition by a company from a different province would reduce the jurisdiction’s value-added tax (VAT) revenue. In recent years, however, China has reformed national tax laws to allow VAT to be reallocated based on where in China value is added.
• Financial system enhancements As the country’s financial system becomes more sophisticated, new financing modes will make China’s vast pool of savings increasingly available for domestic mergers and acquisitions.
• Economies of scale As discussed above, many firms in the 10 industries examined are not large enough to produce goods at low, competitive costs. Compared to more mature industries in advanced economies, China has fewer large enterprises and many more SMEs.
• Economies of scope Firms can find economies of scope in producing a wider range of complementary products, but most firms in China produce a limited range of products. Mergers and acquisitions are an excellent way to edge into new product lines.
• Quality standards China has leveraged its cost advantage, but quality standards have not kept pace. In the coming years, consolidation will allow for a new focus on quality. Key Principal Partners Corp. Chair John Sinnenberg says: “In markets growing as quickly as some of the markets in China, the ability simply to supply product qualifies one as a supplier. Customers will eventually factor in quality (including on-time delivery), and marginal players will disappear. The problem at the moment is that quality suppliers cannot get paid for their service as their customers are not used to measuring the total cost of quality.”
• Integration of operations As some firms move operations and transcend provincial boundaries, other firms will follow their suppliers and customers, consolidating and integrating operations in even more industries.
• Rise of Chinese competitors China hopes to create globally competitive firms to expand sales around the world and to protect domestic industries from foreign competition. Large firms that can generate domestic profits will be best placed to compete globally, particularly in areas such as research and development and marketing.

The significance of consolidation in China

China’s real economic growth in the next few years will rely less on the raw accumulation of resources, such as capital, land, and human resources, and more on productivity improvements realized through technological progress. Part of this progress will occur as a result of industrial consolidation. The merging of firms and the shutdown of inefficient firms will be a major driver of China’s economic growth and prosperity. This type of transformation will improve living standards in China and reap returns for foreign and domestic investors in successful companies.

In contrast to Western economies, where consolidation usually occurs as a result of market forces, in China, the government plays a significant role in prescribing certain industries for consolidation—the cement industry being a prime example. The alignment of market forces and government goals will likely drive industry consolidation in China. Nevertheless, private sector firms, such as domestic and foreign private equity and process improvement firms, will see great opportunities no matter what drives industrial consolidation in China. The growth of truly global Chinese firms will profoundly affect China and the rest of the world as global players across a wide variety of industries will find that there are a few very large “new kids on the block.”

Greater competition will change the landscape of global business. Previously unrecognized brands will rise to prominence. Consumers will find a new array of products and designs at more competitive prices. Some multinationals will find themselves on the outside looking in as new domestic giants are created in China; others will find themselves part of a process of acquisition-fueled growth, becoming giants themselves.

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China Macro Finance (CMF) Analytics

To provide financial and investment insights on private Chinese companies and industries, CMF collected and analyzed data on 430,000 private Chinese companies for its proprietary financial tool and database, CMF Analytics. The companies covered in CMF Analytics represent 49 percent of China’s non-agricultural gross domestic product. CMF covers 39 key industries in the mining, manufacturing, and utilities sectors.

—Seth Harlem and Ron Schramm[/box]

[author]Seth Harlem is senior business development advisor, and Dr. Ron Schramm is managing director and CEO, of China Macro Finance, LLC in New York.[/author]