A Little Medicine for a Big Pharma Deal

In the Hutong
Making Dastardly Plans
1650 hrs.

I am starting to follow with interest the current effort by Charles River Laboratories International to buy Chinese pharmaceutical research outsourcing company WuXi PharmaTech for US$1.6 billion.

The deal, which was announced on April 26th, has not been covered extensively, but is starting to get some attention because an activist hedge fund holding 7% of Charles River’s stock, Jana Partners, is opposing the deal, suggesting WuXi PharmaTech is overpriced.

What fascinates me, though, is the silence (thus far) of the Chinese government.

China’s Foreign Investment Vortex

China is in the midst of trying to build industries around a small cohort of local firms in clean, high value-add, science and technology-based sectors, in the hopes of pushing the nation’s economy past reliance on the export of cheap manufactures. As a company engaged in contract pharmaceutical research, WuXi PharmaTech would seem to be right in that hot spot.

The central government has a history of opposing the outright acquisition by foreign companies of all but the smallest or most crippled local firms. What is more, they have shown their willingness to do so in industries that are not central to the government’s planned direction for the economy. The two most memorable examples are The Carlyle Group’s failed effort to purchase a stake in construction machinery giant Xugong, and Coca-Cola’s blocked purchase of local juice maker Huiyuan just over a year ago.

As I noted in my post-mortem of the latter deal, “Seven Reasons for the Coke-Huiyuan Epic Fail,” government policy is emphatic that foreign companies not be permitted to purchase a majority interest in a “large and successful established Chinese company.”

What is more, Charles River has a bit of a timing challenge. We are going through a period during which Beijing’s policy makers are, for a range of reasons, questioning the value – and the need – for foreign direct investment in China’s industries.

None of this is to suggest that the deal will not go through. WuXi PharmaTech is listed in the Cayman Islands, which may limit the central government’s ability to oppose the deal (though I doubt it, given China’s recent insistence on examining large mergers of non-Chinese firms.) The team handling the deal may have done their spadework with the government and obtained buy-in in advance. Or the government may not consider WuXi PharmaTech a large and successful established Chinese company.

Just in case, though, I am going to offer some free advice to the Charles River/WuXi PharmaTech deal team: 

1. Explore with competent and wise local legal counsel the extent to which this deal might fall under provisions of China’s anti-monopoly law, make sure you skirt it with a wide margins, and make sure you are prepared to make that case in the face of public opposition by your biggest local competitor.

2. Familiarize yourselves with the full range of FDI policies, written or not, understand the mood in Beijing and around the country around foreigners buying local firms, and be prepared to address it well with all audiences.

3. China’s government wants value-add from foreign investors, not just a fat check. Make very clear what China is going to get out of the deal, and make it a lot.

4. Be prepared to make a logical, intelligent, and sensitive case for the deal to the general public. You may think you operate outside the scope of public interest because you are in pharmaceuticals, but don’t bet on it.

5. Don’t ever let up or appear to hesitate. They can smell weakness on you when you do, and it will be all over.

6. Keep the people at the Department of Commerce, the FDA, and the U.S. Embassy in Beijing informed all the way. You may need their help at some point.

7. Finally, don’t take the current silence as assent. You need to begin your charm offensive now

Good luck, Charles River.

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China, Brands, and Black Swans

In the Hutong
Grokking the term “sheet lightning”
1734 hrs.

In my recent Op/Ed in AdAge Magazine, I explained why China was going through its most disruptive changes in three decades, and that this slow-motion change has largely been missed by many in the mainstream media.

But for me, the crux of the issue is this: just as China is going through all of these changes, we are giving Chinese policymakers and consumers reasons to doubt their long-held faith in Western institutions, and corporate brands are every bit as succeptible as “Brand America” or “Brand Europe.”

A commentator on the piece correctly pointed out that the Chinese are hardly abandoning foreign brands, and I agree. It would be overstating the case to suggest that, given the choice, Chinese consumers would rather drive a Geely than a Mercedes, wear Li-Ning instead of Nike, or even Changhong over Sony.

Unfortunately, I think as marketers and marketeers we tend to focus a bit to much on past performance and the current situation, and draw straight lines into the future, when we really don’t have that luxury. How much better to anticipate the emergence of strong local competitors and use that as an impetus to raise the level of our game than to wait for their arrival and scramble to deal with them then? And how much wiser to expect the disruption of our market position by entropy, disruption, or “black swan”  events than to be surprised or defeated by them?

Too much of what passes for planning in our business is little more than glorified scheduling. Enough of that, especially here in China: it is time to don our binoculars, scan the horizon, and reclaim the future of our companies and our clients.

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Three Better Questions for Counsel

In the Hutong
California Dreaming
1522 hrs.

Going through my backlog, I came across this brief interview of venture capital attorney Richard Kline, of the Shanghai offices of Wilson Sosini Goodrich & Rosati.

I don’t doubt that Mr. Kline knows his stuff (I don’t agree with everything he said, though he gave reasonable answers), but the softball questions that the reporter from The San Francisco Chronicle tossed at him hardly gave him a chance to prove it.

The questions:

1. Why is the trend of Chinese companies seeking financing in U.S. markets an important one to watch?

2. Why has China become such a rich source of IPOs?

3. What do you make of concerns of lower-quality companies entering the listings and starting a Chinese listings bubble?

These are what we in the corporate flackage trade call “warm-up questions,” not the sort of questions you would ask when you only get three chances to force a lawyer to come up with some worthwhile insights. 

I don’t blame the reporter: that he did not have the knowledge of China to ask some really penetrating questions is his editor’s fault. In my mind, this is one more proof that media cannot hope to cover China with any cogence from six thousand miles away.

The questions I would have asked Mr. Kline:

1. What are you doing to improve the transparency and reporting standards of the Chinese companies you are bringing to western capital markets? What more could you be doing?

2. Even prominent Chinese executives bemoan the dearth of management talent in China, and the difficulty of keeping talented people from defecting to go build their own business. What must Chinese companies do right now to address the growing talent gap in the top ranks of their leadership?

3. Given the uncertainties faced by companies operating in a country where the government is constantly changing the rules and the playing field, and given the lack of sophistication about China even among supposedly sophisticated institutional investors, are current risk disclosure practices really adequate? Why/why not?

But that’s just me. What would you ask Mr. Kline, Esq.?

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Not So Easy to Replace

In the Hutong
Six Days
1250 hrs.

Elizabeth Holmes at the WSJ explains how apparel retailers like Coach, Guess, and Ann Taylor are starting to look around Asia for sources of low-cost labor as wages in China grow in the low-double digits.

That prospect has sent retailers scrambling to find new ways to reduce production costs. If they fail, they will have to absorb the higher costs, battering their margins, which have just begun to recover from the recession. Or, they could pass the costs along to consumers, a risky move at a time when shoppers are beginning to regain some of their appetite for spending.

A New Day for Labor

It is a sucker bet that this is going to get worse, and fast. Labor relations in China have entered a new era over the past month. The Foxconn suicides and the Honda strikes, resulting as they did in significantly improved wages, look to be the impetus of a wave of copycat labor actions around China.

And why not go out on strike? The past four years have proven that China’s supply of labor, while large, is not bottomless. Workers are starting to feel like they have less and less to lose, and the government, determined to nip any public display of discontent in the bud, is siding with the workers in a growing number of these cases (particularly those involving foreign or non-Mainland-based companies.)

This could all peter out, or we may witness a massive increase in labor actions, with the result that 2010 could witness not just a significant increase but a large jump in labor prices.

The Only Substitute for China?

At the moment, there aren’t many ready alternatives for the schmatte business. Indian labor is even more expensive than China’s, and transit times (and costs, as fuel prices rise) add to prices. Vietnam is limited in what its workers can do with a piece of fabric. And Mexico is most notable in the article by its absense: one can only assume that the escalating violence and unrest in the country’s border regions are making buyers in the rag trade say “maquiladora” with much less excitement than before.

You would expect Li & Fung’s Rick Darling to deliver the money quote: “The only replacement for China is China.” And for now, he’s right. But that will change, and despite the protestations of China’s leaders that they want to lead the nation out of the realm of low-end work like textiles, in truth China wants and needs to keep the mid- and high-end apparel industry right here at home.

In the near-term, this is going to mean that the industry will migrate to the west and north of China as long as shipping costs and transit times are held in check. That’s not a given for China: the expense of moving products manufactured in China’s interior to a major seaport can make up as much as 40% of the products FOB cost, and physically getting the goods to port can be time-consuming and fraught with delays. The nation is building superhighways and railroads to help address those challenges, but we are years away from a time in which it is as easy (and fast) to move a container of goods from Gansu to Shanghai as it is to move that same container from Seattle to St. Louis.

Fashion Capital

Eventually China will fix the logistics problem, but in the meantime I am betting that we have found the bottom for apparel prices in China, and those prices are about to start rising. I also think we are on the cusp of a major restructuring of the industry in the PRC based on several trends:

  • Consolidation among manufacturers, leaving in place those with appropriate scale and with the most efficient operational processes.
  • A shift in focus away from exports and toward a greater emphasis on serving the local market.
  • For manufacturers still focused on global markets, a renewed effort to move parts of the process offshore to Vietnam, Southeast Asia, Southwest Asia, Africa, or Mexico.
  • Vertical integration of manufacturing to incorporate the full process from threads all the way through to branding and marketing (“looms to labels.”)
  • A wave of new or enlarged domestic apparel retailers similar to Li-Ning, Zara, or Giordano who become the primary locus of domestic fashion design. (Expect design in China to be retail-driven, rather than following the European model, which is somewhat the other way around with its design houses and haute couture.)
  • Government assistance (tax breaks, etc.) to manufacturers to relocate to rural, remote, or revitalizing parts of the country and away from higher-cost regions like Guangdong and the Yangtze River delta.

We have to be realistic: the China price will not sustain the apparel industry here, but Shanghai is not going to become Paris or Milan anytime soon. The industry in China is entering an awkward adolescence that could either kill it or see China become the fashion capital of the world. Getting to the latter won’t be easy, and it is still not clear that the industry – even with the above trends – is capable of getting there.

The easy days are over. The Chinese apparel business is about to grow up. Whether it will do so in time to remain the manufacturing capital for the global fashion retailing sector is another matter entirely.

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Creating a Tipping Point for 3D TV

The Silicon Hutong Suite, Singapore
Running to Clark Quay
17:38 hrs.

Media Asia is running an interesting article describing how some of the first content to be available for the upcoming 3D televisions will be pornography collections.

No surprise there. As Arik Pre pointed out to me, the uptake of many major home entertainment technology innovations, beginning with cable TV and the VCR, have been driven by a desire to enjoy prurient content in one’s own home.

I actually think the industry has another major market for 3D televisions: hotels. Not only would it give the manufacturers an opportunity to show off the innovation to people who otherwise might not get a chance to see 3D TV, it would be a shot in the arm, as it were, to their pay-per-view revenues, both for standard fare and for videos that appeal to a more mature crowd.

If retail sales stall, watch for the manufacturers to undertake a major effort to seed the devices in airports, sports bars, and hotels.

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How Deng’s Ghost Threatens China’s Innovation Economy

In the Hutong
Contemplating Demographics
2051 hrs.

In what is probably the most interesting and thought-provoking part of an article in Policy Review comparing the economic trajectories of China and Russia, Paul Gregory and Kate Zhou debunk a popular myth about China’s reforming and opening: that the credit goes to Deng’s policies. Not so, say the authors:

Our narrative contradicts much received doctrine. The standard account is that China succeeded because a wise party leadership deliberately chose gradualism, retained the monopoly of the Communist Party after rebuffing democracy at Tiananmen Square, and carefully guided the process over the years. The narrative says that Russia failed because the tempestuous Gorbachev ignored the Chinese reform model, moved too quickly, and allowed the party monopoly to fall apart. This standard account is incorrect. Deng Xiaoping and his supporters, contrary to popular legend, did not agree on a reform program at the Third Plenum of the Eighth Party Congress in 1978, which installed him in power. A Chinese reform official by the name of Bao Tong later admitted as much: “In fact, reform wasn’t discussed. Reform wasn’t listed on the agenda, nor was it mentioned in the work reports.”

Throughout the reform process, the Chinese Communist Party simply reacted to (and wisely did not oppose) bottom-up reform initiatives that emanated largely from the rural population. Deng Xiaoping’s famous description of Chinese reform as “fording the river by feeling for the stones” is not incorrect, but it was the Chinese people who placed the stones under his feet.

Now, before you start tossing zongzi at me for being a revisionist, I give due credit to Deng Xiaoping and the leaders around him for yanking China out of its ideological stupor and creating the political headspace within the Party to allow this evolution to take its course. Even if they were not great policy virtuosos, their political acumen – and their willingness to give the country a little rope – was laudatory.

And we have to pause for a moment and consider our source: Gregory and Zhou are publishing in the house organ of the Hoover Institution, an entity that might be fairly labeled the West Coast headquarters of neo-conservative thought. Naturally, therefore, they would posit a soft version of Thomas Paine’s old adage “That government is best which governs least.”

Believing Their Own PR

Yet, as China’s central government undertakes a long-term effort to foment “independent innovation” through industrial policy, one has to ask whether this effort is based on a received myth among policy makers that, basically, stuff happens when the government makes it happen, and the last 30 years of economic development in China are living proof? If this is the case, that mistaken perception may be one of the core blockages to the nation undertaking policies that will actually restart China’s innovation engine after several idle centuries.

Trying to change that perception among regulators would be a waste of time: wagering on China’s bureaucrats arguing against their own importance (or power bases) while debunking a leader who has been all but deified in the national canon is a sucker bet.  If anything, regulators look set to deepen their involvement in technology driven industries. The government’s core economic policy document for the next five years, the Twelfth Five Year Plan, is being drafted. My gut feeling is that the plan will not only mention independent innovation, it will enshrine it in the form of specifying industries and sectors to be supported by the government in its effort to jump-start China’s innovation economy.

C’mon, People Now…

The answer, of course, is parallel efforts. The government will focus, as it does, on large-scale projects and enterprises as the nexus of economy-changing innovation. The government is comfortable with such efforts, and they are not entirely wrong: many of the innovations that lie at the core of American competitiveness emerged from government or defense research in universities or large enterprises.

But critical mass – and the kind of opportunistic development work that drives an innovation economy – comes from small enterprises, and this is the part of the equation with which the Chinese government is least comfortable. The challenge will be for China’s entrepreneurs to understand what they need from to be successful, to communicate that to the government, and to band together to make sure they are not steamrolled by the more politically powerful SOEs.

And the last bit is the hard part. Chinese entrepreneurs are a tough bunch to get to trust one another, and in order for grass-roots innovation to be allowed its role in China’s development, innovators need to generate a powerful, unified voice. The questions are: can they; and how long will it take?

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