Talk of trade wars became a reality this last week but many still hold out to the view that these ar...
Tiffany, Coach Counting on China
12/02/2011 8:00 am EST
So much depends on China, and the ability of its economy to escape a hard landing that crushes growth.
This may be the biggest immediate legacy of the Eurozone debt crisis. With the Eurozone projected to grow by just 0.7%—or less—next year, and the US economy projected to chug along at 2% growth or less, China will be the make-or-break story for a huge number of companies in 2012.
Investors are used to this by now for the shares of companies like Freeport McMoRan Copper & Gold (FCX), Vale (VALE) or Peabody Energy (BTU). Worries that growth in China might be slowing mean lower share prices for companies that supply the commodities that feed China’s manufacturing machine. When growth looks stronger than expected, these shares climb.
But China’s influence has been growing. It now extends well outside the commodity and materials sectors to stocks that don’t immediately seem to have a China connection.
The China risk in many of these stocks isn’t well recognized by investors. And I’d argue that risk is likely to be especially high over the next six months or so, because of the way that many of these stocks are increasingly dependent on China for growth.
I call this the Tiffany (TIF) problem.
On November 29, before the New York market opened, the high-end luxury retailer announced third-quarter earnings for the fiscal year ending January 31 that beat Wall Street estimates by ten cents a share. But the stock plunged 11.2% from the November 28 close to the November 29 open.
The reason? The company announced disappointing guidance for the fourth quarter and the full fiscal year.
Global net sales would climb by a percentage in the high teens for the full year, Tiffany told investors and analysts. But sales would increase by just a low-teens percentage in the fourth quarter.
That’s significant growth, but it’s disappointing after a 20% increase in worldwide sales in the first half of the year. And that, of course, explains the sell-off.
But what interests me is the regional composition of the company’s sales guidance. In the fourth quarter, Tiffany expects sales to slow in the Northeastern US and in Europe. For the full year, that doesn’t have a big effect on projections for sales growth in Europe and the United States. In its full-year guidance, Tiffany kept sales growth projections unchanged at 20% for Europe and in the high teens for the United States.
The only region where Tiffany is projecting an increase in sales from its last guidance is the Asia-Pacific region. In that region, dominated by China’s economy (especially since Tiffany breaks out Japan as a separate region), the company has raised its projections for growth to 35% for the year, from earlier guidance of 30%.
Think about that for a minute or two. Here’s a company saying that it expects sales growth to accelerate from the region dominated by China at a time when China’s growth—which has dropped to an annual 9.1% in the third quarter, from 9.5% in the second quarter and 9.7% in the first quarter—is expected to slow further.
And here’s a company that delivered disappointing guidance on growth for the fourth quarter, ratcheting up its projections for that quarter’s growth from the region where growth is slowing.
I’m not saying that Tiffany won’t make or beat its latest projections. But I am saying that uncertainties about growth in China increase the risk in this stock and others such as Coach (COH)—a member of my Jubak’s Picks portfolio—that are counting on growth from China to make up for slowing growth in Europe and the United States.
I’d break down that China risk for Tiffany and similar consumer companies that need growth in China into two parts.
NEXT: Can China Soften a Hard Landing?|pagebreak|
Can China Soften a Hard Landing?
First, there’s the risk these companies share with commodity and materials companies: China’s efforts to slow its economy in order to fight inflation might just have worked too well.
Last week, the HSBC flash purchasing managers’ index showed a drop to 48 in November, from 51 in October. (Anything below 50 signals a contraction.) The drop took the index down to the lows of April 2009, when China’s economy was still struggling to throw off the effects of the global financial crisis.
That PMI reading suggests that industrial output is likely to fall to 11% to 12% annual growth in the last quarter of the year. That would be the slowest since 2009.
Export growth hit an eight-month low in October. Housing prices moved lower in October for the first time in 2011.
Yep, China’s economy is slowing. The World Bank projects that growth in China will slow to 8.4% in 2012. (That may not seem so bad from the perspective of a US economy that would love to see 4% growth, but economists calculate that 8.4% growth in China is below the economy’s potential. When economists talk about a hard landing in China, some mean that growth would dip below 8%.)
And, of course, there’s the chance that China’s growth will slow below that forecast. The biggest danger here is from the unequal effect of the lending slowdown that the People’s Bank engineered.
This slowdown was an inconvenience to China’s big state-owned companies, which, by and large, continued to be able to borrow. But it has turned into a credit crunch for smaller companies.
A campaign to require that at least half of a commercial bank’s clients be small or medium-sized companies seems to have headed off a full-scale credit crunch for now. But the worry is that in the first quarter of 2012, when many companies have payments to suppliers and workers due just before the Chinese New Year (which falls in January in 2012) these companies won’t have the cash to pay their bills.
Even if they can borrow, these companies are paying more for the funds. Only 13% of small and medium-sized businesses have access to bank loans; the rest are borrowing in the shadow banking system, where interest rates range from 14% to 70%.
Add those higher borrowing costs to higher prices for labor and raw materials, and you’ve got a profit crisis in this part of China’s economy. A survey by e-commerce provider Alibaba Group and Peking University found that so far in 2011, the average profit margin for China’s small and medium-sized businesses is down 40%.
A recent survey by the Federation of Hong Kong Industries reported that up to one-third of factories in China owned by Hong Kong companies could downsize or shut by the end of 2011.
There’s certainly potential there for a hard landing.
That’s why, on November 30, the People’s Bank cut bank-reserve requirements to 21% from 21.5%—a record high—effective December 5. The move will allow banks to lend out more capital—an additional $61 billion.
But it’s more important as a signal that the central bank has decided to move to a looser monetary policy, and more quickly than expected, too. This is the first reduction in the reserve ratio since 2008, and the first reduction after six increases in 2011 alone. I’d expect another cut in January to free up funds for the New Year crunch.
And it’s why the latest five-year plan calls for the construction of 36 million units of low-cost rental housing by 2015, with ten million units to start this year. That’s an effort to make up for the effects of efforts to slow China’s private-sector real-estate boom.
The real-estate sector accounts for 15% of China’s gross domestic product. Without a pickup in government-sponsored housing construction, a slowdown in the private market would crimp companies from concrete to steel.
NEXT: Is a Rescue Forthcoming?|pagebreak|
Is a Rescue Forthcoming?
The second risk to Tiffany and similar consumer companies counting on growth from China is a result of the peculiar structure of the Chinese economy.
In the United States, consumer spending accounts for about 70% of GDP. In China, the number is closer to 35%, according to World Bank data. In fact, consumer spending as a proportion of GDP has been falling for most of the past decade, according to Yasheng Huang, the founder of MIT’s China Lab.
That means that getting China’s GDP growth stabilized and then gently accelerating again may not translate into a proportionate increase in consumer spending. If the increase in bank lending, for example, goes to state-owned enterprises rather than to private-sector businesses, it will produce GDP growth all right. But it will mean less job growth—and less income growth—than you might otherwise expect.
The state sector accounts for 80% of bank borrowing but just 20% of jobs, MIT’s Huang calculates. The private sector gets just 20% of bank loans but accounts for 80% of jobs.
China’s top-down, government-mandated approach to growth is extremely effective at generating GDP, but less effective at growing incomes and consumption, data for the last two decades show, says Huang. And frequently, the commands from the center have perverse effects.
For example, the 15% annual increase in the minimum wage mandated in the latest five-year plan is an attempt to increase incomes and reorient China’s economy toward consumers. But it will boost consumer spending less than projected, Huang notes, because most of the increase in the minimum wage will go to migrant workers who don’t spend.
Because they don’t have resident status in the cities where they work, migrant workers save for the services that they aren’t entitled to as nonresident workers. They put aside money for health care, for education of their children, and for retirement.
That doesn’t mean that increasing the minimum wage is a bad idea or that it won’t pump some growth in consumption into China’s economy. But it means that companies depending on China’s consumers to bail out their growth projections—in a year when Europe won’t grow at all and when the US economy will continue to struggle—stand a good chance of missing estimates.
What Investors Should Do
You don’t have to dump your shares of Tiffany or Coach or Yum Brands (YUM) or General Motors (GM). But you should certainly include these two kinds of risk in your decision to buy, sell, or hold over the next six to eight months.
Why six to eight months? Because by June, investors will know how slow China’s growth will be in 2012.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares in Coach and Freeport McMoRan Copper & Gold as of the end of September. For a full list of the stocks in the fund as of the end of September, see the fund’s portfolio here.
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