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Richard A. Flax
The rise of the Chinese consumer has been one of the most important structural trends of the last decade. Recently, however, Chinese consumer companies have come under pressure. A weakened macro environment, coupled with curbs on spending by government bureaucrats, has hit a range of consumer businesses and, in some cases, forced a reassessment of expansion plans. On the surface, this poses challenges for equity investors looking to benefit from growing income per capita and purchasing power. Yet in our view, there are both challenges and opportunities. Mass retailers, which face oversupply and low pricing power, are likely to continue to struggle. On the other hand, companies with strong business models in sectors where supply may be constrained, such as casinos, or where powerful brands act as competitive moats, such as luxury goods, are likely to maintain high operating margins and returns on capital.
This is important not just for returns over the next year but also for long-term investment, as our research shows that highly profitable firms tend to remain profitable over time and also outperform the broad market (see the In Depth article, “The Profitability Premium in EM Equities,” December 2013).
Slowing income growth and falling demand From a macro perspective, Chinese year-over-year (yoy) GDP growth has declined from 9.8% in the last quarter of 2010 to 7.8% in the third quarter of 2013, denting consumer confidence. The impact of the slowdown on income growth has been particularly pronounced over the last 12 months, with urban household income growth falling more than three percentage points to just over 9%.
Compounding the impact of slowing income growth, the government has moved to curb spending by bureaucrats by restricting dining, travel and gift-buying. In the spirits sector, for example, a bottle of Moutai, a high-end domestic brand, has fallen from a retail price of almost RMB2000 in 2012 to around RMB900 currently, reflecting weakened demand. Similarly, department store operators are seeing negative same-store sales growth, much of which has been ascribed to fewer gift cards being distributed. With little optimism that income growth will rise in the near term or spending restrictions will be removed, our view is that the cycle of falling demand may continue for another six months at least.
That said, while consumption is slowing, it’s important to recognize that it hasn’t collapsed; nor do we expect it to. Although down from a peak of over 20% in 2008, yoy growth in Chinese retail sales was still running at 13% as of 30 September. Rising secular demand among Chinese consumers still offers a play for a long-term equity investor ‒ it’s just increasingly important to differentiate among the companies in this space.
Oversupply in retail Since mid-2010, valuations of Chinese retailers have contracted, while valuations of Chinese consumer staples firms have expanded. Although it may be tempting to expect some mean reversion, we think there are strong reasons for the underperformance in the retail sector, and believe it is likely to continue.
Same-store sales growth has declined to just over 1% for listed Chinese retailers after peaking at more than 19% in early 2011. This downward trend reflects both the broader slowdown in income growth within the economy and the negative headwinds of the spending restrictions. However, what is compounding problems for retailers is that the slowdown in spending has been exacerbated by an increase in supply. This perhaps echoes some of the oversupply issues we’ve seen elsewhere in the Chinese economy, where easy money has fueled an investment boom.
Although industry data is incomplete, our opinion is that in many markets in China, the expansion in physical retail stores is the root of the problem. While rates of department store density in emerging market (EM) countries remain well below those of the U.S. and U.K., China is comfortably ahead of most of Asia, including richer nations such as South Korea and Japan. This supports our view that Chinese retailers have focused on capacity expansion over the last decade without sufficient regard for operating expenses and capital efficiency. This has now come home to hurt performance in the form of declining margins across the sector in 2013.
Looking forward, we see little evidence of this changing over the cyclical term, even if the third quarter of 2013 proves to be a demand trough. With operating-cost inflation and product-price pressures, retailers may continue to see declining profitability and eroding returns on capital. We think this low profitability is likely to be associated with share price underperformance.
Opportunities where supply is constrained While the retail outlook may be negative, the good news is that Chinese income growth is still far outpacing that of the developed world. And while capacity expansion in the retail sector may be dragging on returns, there are other sectors where supply constraints are providing the structure for sustainable profit growth, or where brands are powerful, allowing companies to extract high returns. These businesses should be able to deliver sustainable, high levels of profitability – and potentially, share price outperformance.
One of these sectors is casinos. Like retailers, casinos generally benefit from a secular trend of income growth. While moderating recently, income growth is still running at more than 9% among the urban population in China and more than 11% among the rural population. Demand has been further boosted in Macau by improved transportation links from the Chinese mainland, including access to high-speed rail. Most important, and in contrast to the retail sector, supply remains constrained. Due to the regulated nature of the sector and limited availability of licenses, supply of tables grew at a compound annual growth rate (cagr) of only 5% between 2008 and 2012. In contrast, total gaming revenues grew at 30% cagr over the same period. By our estimates they are set to continue to grow at double-digit levels with supply remaining constrained. This highly favorable combination of growing secular demand and limited capacity is reflected in consensus profit estimates that far outpace the broader China consumer sector.
Sustainable profitability can also come through powerful brands. Luxury goods companies that sell into the Chinese market are a prime example, benefiting from secular demand growth without facing the oversupply issues of the mass retail sector. Many of these luxury companies are well-known developed market brands, but there are also domestic Chinese companies with powerful market positions. Certain domestic Chinese firms have premium liquor brands, for example, and enjoy strong pricing power through their relationships with distributors.
In addition, outside of the luxury segment, we think consumer staples firms that focus on creating new product categories rather than engaging in head-to-head competition may also be positioned to sustain long-term margins.
Investment implications Overall, while Chinese consumption may be challenged in the near term, we think the impact will continue to be felt most in the retail sector where slowing demand is compounded by oversupply. In contrast, we see opportunity in sectors that benefit from secular demand growth and constrained supply or strong brands. Although valuations in such sectors, notably casinos, have risen over the last 12 months, we believe that opportunities remain, whether in select gaming companies or in other luxury or premium sectors. We do not expect these dynamics to shift in the near term, and believe that investors will be best placed by focusing on these potentially profitable consumer-linked sectors.
Past performance is not a guarantee or a reliable indicator of future results. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Equities may decline in value due to both real and perceived general market, economic and industry conditions. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing insecurities of smaller companies tends to be more volatile and less liquid than investing in securities of larger companies. Investing in distressed companies (both debt and equity) is speculative and may be subject to greater levels of credit, issuer and liquidity risks, and the repayment of default obligations contains significant uncertainties; such companies may be engaged in restructurings or bankruptcy proceedings. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2013, PIMCO.
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