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Digging Moats in China

Foreign firms that have established competitive advantages in China are well-positioned to profit from consumption growth.

Sumit Desai, CFA, 11/30/2011

If China is to sustain growth rates anywhere close to those achieved in the past decade, consumption will need to play a significantly greater role in China's economy. At this juncture, Morningstar's equity analysts are finding more investment opportunities in consumption-related companies than in fixed-asset plays. Here is a look at firms based outside of China that are well-positioned to benefit from consumption growth there. We'll also identify some firms currently benefiting from growth in China that we think investors should avoid in the face of lower fixed-asset-investment growth in the future.

Consumer: Focus on Middle Class

The road map of transition from a fixed-investment- based economy to a more consumption-based one is visible in the government's new five-year economic plan. The Chinese will see more investments in education, health care, and other social programs to give people a better sense of security. The lack of a meaningful social safety net has been the major factor behind the high savings rate of Chinese households, in our view, and we expect that Chinese consumers will be more willing to open up their purses when they can have reasonable assurance from the government that they have some support to fall back on in times of difficulty. As part of the economic rebalancing plan, we also expect China to allow gradual currency appreciation and wage increases to continue, which will boost Chinese consumers' purchasing power.

Consumer brands such as Yum Brands YUM, McDonald's MCD, Starbucks SBUX, Nike NKE, and adidas ADS, which sell products to China's middle class, are appropriate investment options for investors looking to participate in China's growth. Yum is the leading restaurant owner in China, with 3,400 KFC units and 500 Pizza Hut restaurants. We think those numbers could expand to 15,000 KFC locations, 5,000 Pizza Hut units, and several thousand units apiece from emergent restaurant concepts. McDonald's is a distant second in China with about 1,300 locations, but management has a realistic plan to have more than 2,000 locations by 2013. China also is a key component of our valuation assumptions for Starbucks; the firm has set an achievable goal of more than 1,500 locations by 2015. Nike has considerable opportunities for expansion in China, where the brand is already the leading player with more than $2.3 billion in annual sales projected in fiscal year 2012 and $2.5 billion in fiscal year 2013. Number-two player adidas also has ample growth opportunities.

We think that companies targeting the middle class are more likely than those targeting the wealthy to become ubiquitous over the long run because of economies of scale and other economic forces. Consumer companies that focus on broad sections of the Chinese populations are trading closer to our fair value estimates, versus the shares of luxury-goods makers, such as Tiffany TIF and LVMH MC, which have valuations that could take away the appreciation potential.

Basic Material Firms Will Feed Expansion

A shift toward consumption in China's economy would play to the strengths of a few basic-materials industries, such as agriculture, thermal coal, and paper and packaging. Chinese retail gold demand also could begin to take off. Meanwhile, a reduction in fixed-asset investment growth rates is a major threat to many metals, metallurgical coal, and building materials companies. A rebalancing of the Chinese economy would have a mixed effect on chemical companies, as their products make their way into a vast array of end markets.

Fertilizer and seed companies stand ready to feed a hungry China. Rising incomes in China should allow people to consume more calories and, more importantly, more meat, fruits, and vegetables. Expanding meat production has a multiplier effect on crop demand. It takes more grain to feed the animals that provide sustenance for humans than it takes to feed humans directly. Plus, nutrient-intensive fruit and vegetable crops require greater fertilizer applications. Therefore, producers of potash fertilizer stand to benefit, and global production is highly concentrated in the hands of a few players. Further, China has to import a significant portion of its potash requirements because of its lack of high-quality domestic deposits. On this basis, and in combination with its lower-cost resources, we believe Potash Corp. POT has a wide economic moat. Potash also owns a 22% stake in Sinofert, China's largest fertilizer importer and distributor. Meanwhile, Monsanto MON will benefit indirectly from China's supportive influence on global crop prices, although the firm's direct involvement in China is only a small part of its overall business (in the form of vegetable seed sales).

Growing electricity needs to power consumption would bode well for low-cost thermal coal producers. We expect China's voracious and increasing appetite for thermal coal imports to be a secular trend. More consumption means more lighting, appliances, air conditioning, and space heating, and China's electricity generation capacity would have to follow suit. While coal-fired generation will likely lose share to sources such as nuclear and gas-fired generation, expected strong growth in overall generation demand means coal plants will still need to be added.

Moreover, rising domestic costs and internal infrastructure, transportation, and political issues are making it more difficult for China to be self sufficient in thermal coal. Infrastructure constraints in Australia, South Africa, and Indonesia are restricting these traditional exporters' ability to meet that demand. The Powder River Basin of Wyoming has ample low-cost thermal coal reserves, but until recently, this coal had not found its way to Asia because of the huge shipping distances involved. However, thanks to the rise in Asian coal prices in recent years, the Powder River Basin has the potential to be a major player in the Pacific Basin as a critical "pressure release valve" swing producer. Cloud Peak CLD is the largest Powder River Basin exporter, and both Arch Coal ACI and Peabody Energy BTU are pursuing port-development projects. Peabody, Arch, Cloud Peak, and Alpha Natural Resources ANR control nearly 100% of the Powder River Basin, which contains some of the largest and most accessible coal deposits on the planet. Cloud Peak is the pure-play on the Powder River Basin, and we award the company an economic moat. Powder River Basin production also makes up a significant portion of Arch's and Peabody's overall production, and we think these two companies have economic moats, thanks to that low-cost advantage. Further, Peabody is investing heavily in Australian coal to meet China's growing demands for both thermal and metallurgical coal imports. We caution that both Alpha and Peabody have metallurgical coal exposure, which would come under threat should China shift away from fixed-asset investment.

As a nation's middle class grows in size, the convenience and need for paper products likewise expands. Toilet paper, tissues, and paper towels are parts of consumers' daily lives that are unlikely to be significantly curtailed by a slowdown in fixed-asset investment. Global demand for tissue should steadily increase for many years to come, thanks in no small part to growing consumption in China. Fibria FBR, the Brazilian pulp giant, is poised to capture this growth. More than 50% of the demand for Fibria's pulp comes from global tissue manufacturers.

More wealth would mean more gold jewelry and investments. The growing middle class in China is spending some of its newfound wealth on gold. Many factors influence gold prices, so a rebalancing of the Chinese economy would have an indeterminate effect on gold prices, in our view. However, to the extent that other forces in gold markets remain generally favorable in the long term, additional demand from Chinese consumers can only help. Eldorado Gold EGO is the only gold miner within our coverage universe to have an economic moat, and mines in China are one key contributor to its low-cost advantage. Eldorado has a significant presence in China, a country that most Western gold miners eschew. Economic moats in mining are almost entirely predicated on sustaining a low-cost position, which in turn depends on three major factors: low production costs, long reserve lives, and prudent capital allocation. Eldorado scores near the top of the industry on all three of these metrics, which should help the firm to generate economic profits throughout most of the gold-price cycle.

Rebalancing "losers" include metals, metallurgical coal, building materials, and, to some extent, chemicals. In 2010, China consumed more than 35% of the world's aluminum, copper, steel, and zinc. Much of this metal finds its way into electrical wiring, pipes, siding, and beams. These metals would suffer from a slowdown in China's capital expenditures. Aluminum's pain would be mitigated by the fact that consumption is a major end market—think aluminum beverage cans and automobiles. And while weakness in Chinese steel consumption would have negative effects on U.S. and international steel companies, the fallout would likely be moderated by lower input costs.

China will play a pivotal role in the fortunes of the global seaborne metallurgical coal market. While China's metallurgical coal import volume remains modest compared with the roughly 500 million metric tons the Chinese steel industry consumes annually, it is large relative to the 200-million-metric-ton global seaborne metallurgical coal trade. Continued growth in Chinese steel production, if not matched by domestic metallurgical coal output, would have major consequences for the seaborne market. On the flip side, a reversal in the nonstop expansion of Chinese steel output would have deleterious consequences for the seaborne metallurgical coal market, making sub-$100-per-metric-ton prices a distinct possibility.

Building materials producers within China would suffer from a slowdown in fixed-asset investment. However, Chinese cement production contributes only a small portion of global cement producers' profitability. We think the infungibility of cement would shield non-Chinese production from weakness in Chinese cement markets. Because it's costly to transport cement over land, plants typically have a shipping radius of no more than 300 kilometers.

A slowdown in China's capital expenditures would be a mixed bag for global chemicals companies. While end markets for chemicals include construction, consumption-driven markets such as agriculture, electronics, and consumer products are just as important to overall profitability.

Investors looking for a way to maintain exposure to metals and mining while protecting against the likelihood of a rebalancing of China's economy should consider Anglo American AAL. Anglo has less exposure to fixed-asset-investment-tied iron ore than other major miners do. Further, Anglo's outsized platinum and diamond businesses (larger than those of any diversified peer) are well-positioned to benefit from growth in Chinese jewelry consumption that is likely to accompany strong household consumption growth. Rising Chinese vehicle-ownership rates, a staple of middle-income status, would also benefit platinum, owing to its use in vehicle catalytic converters.

Health Care Evolves

China's health-care system evolved into one of haves and have-nots when China kicked off its economic reforms in 1979, which resulted in the widespread privatization of public health facilities. Two years ago, the government embarked on a reform effort with an investment of $125 billion to accomplish goals such as universal medical insurance by 2020 and infrastructure improvements. Against this backdrop, we see several dynamics that should contribute to continued robust growth of health-care spending in China: 

- China's profit-driven, fee-for-service system leads to care levels that correlate with patient wealth levels. Wealthy, urban patients are demanding modern medicine practices with high-priced new technology that is highly profitable to caregivers.

- The government is focused on growing the domestic biotechnology sector, which should spur a rapid build-out of research and drug development centers, which in turn would be a boon to the lab-supply industry.

- The government is cracking down on collusion between health-care providers and drug companies. Firms that make generic drugs will benefit most from this initiative.

- China is set to become the second-largest prescription-drug market in the world by 2015. (It's seventh now.) The market is extremely fragmented, with no single firm having more than 2% of total prescriptions, so it looks ripe for Big Pharma firms.

The health-care firms with the widest moats in China are the large multinationals. Sanofi-Aventis SNY was one of the first multinationals in China when it entered the market in 1982, and its head start has given the firm nearly 30 years to build its brand and its wide moat. The firm's broad presence in prescription drugs, vaccines, and over-the-counter medications creates strong brand awareness and makes the company one of the best-positioned pharmaceutical firms to take advantage of China's explosive growth.

Roche's RHHBY cancer biologics platform brand serves as a foundation of its moat in China. And although Roche's biologics, like Herceptin and Rituxan, do not have patent protection in China, they function as patented products because of lack of generic competition.

As one of the first multinational medical-device makers to establish a footprint in China, Medtronic MDT has a head start over its rivals. The firm has stepped up investments over the past five years, just as sales have reached critical mass. Medtronic unveiled a new patient education center in Beijing, a manufacturing facility in Singapore, and headquarters for its wholly owned subsidiary in Shanghai. Meanwhile, most of its competitors have taken a more cautious approach to China through joint ventures or technology licensing.

Thermo Fisher TMO is a "picks and shovels" company that benefits indirectly from the rapid investment into the Chinese health-care system. Thermo Fisher is a preferred vendor for many pharmaceutical and research firms, and its one-stop-shop operating model works particularly well in the highly fragmented lab-product field in China.

Foreign Automakers Rule the Road

Over the past decade, China has been the go-to place for growth among many industrial companies. In particular, automotive manufacturers and heavy-equipment manufacturers have enjoyed robust gains because of the country's emerging middle class and government- funded infrastructure boom. We expect these gains to continue, although we caution that rising capabilities among domestic Chinese manufacturers could crimp the market share of many foreign producers.

In 2010, as the global automotive industry rebounded sharply from its recessionary lows, China surpassed Europe as the largest passenger and light commercial vehicle market in the world. Foreign manufacturers dominate sales, comprising the top seven market shares and eight of the top 10. Volkswagen VOW leads all others with an 18% share, with General Motors GM and Toyota TM closely behind. We expect China to continue growing at a solid clip over the next several years, and we expect these manufacturers, therefore, to enjoy robust results. We expect much of this growth to stem from luxury brands such as Audi (a division of Volkswagen), Mercedes (a Daimler DAI company), BMW BMW, and Cadillac (a GM brand). All have posted double-digit sales gains in China through the first half of 2011, and the continued rise of affluent citizens within China is likely to spur further demand, even if mass-market autos face headwinds.

Sumit Desai, CFA is a senior stock analyst with Morningstar.
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