Trading with China, by the numbers

Yesterday, President Trump announced trade tariffs on imported steel (25%) and aluminum (10%).  Although such measures were in line with campaign promises, financial markets reacted negatively and many commentators darkly warned of impending doom.  Earlier in the week, the President commented that foreign trade was the one problem which could threaten bilateral relations with China.  What to make of all that?

China’s steel production capacity is almost 8 times that of the US; it employs a lot of people and, like any heavy industry, it needs to operate at a high utilization level to remain viable.  This had led to the creation of a variety of subsidies, ranging from grants to loans at preferential rates, price controls on key inputs, lax environmental regulations, and equity infusions.  Such subsidies, in turn, triggered capacity expansion and the need for further subsidies.

Findings of Chinese anti-competitive practices are not new, nor are they limited to the US: last year, the European Union imposed duties of 17.2% to 28.5% on a variety of Chinese steel imports. 

So far, it is unclear to whom, how and when these tariffs will be applied.  As usual with this administration, seemingly good ideas are weighed down by poor presentation or poor execution.  Furthermore, one can question whether the US should want to expand an industry, steel-making, which is highly polluting and generates modest value-added.

But the steel dispute highlights a much deeper problem, which is how to deal with an economy that is the second largest in the world, yet enjoys a treatment which is normally applied to emerging countries.  The table below points to a striking imbalance which is difficult to ignore:

         US Foreign Trade with China in 2017

US exports of goods	$130 billion
US imports of goods	$506 billion
Trade deficit	($376 billion)

Adding back the US surplus in services would reduce the above deficit by only $30-$40 billion.

Looking into the main components of trade is instructive:

Main components of US-China Trade in 2016

Top US exports		Top China exports
Grains, seeds, fruits	$15 billion	Electrical machinery	$129 billion
Aircraft	$15 billion	Machinery	$  97 billion
Electrical machinery	$12 billion	Furniture and beddings	$  29 billion
Machinery	$11 billion	Toys and sport equipment	$  24 billion
Vehicles	$11 billion	Footwear	$  15 billion

The largest US export to China is low value-added agricultural products;   Chinese machinery exports are 10 times the size of the US ones.

By comparison, the European Union trade deficit with China is about half that of the US, in both absolute and percentage terms.

Much more important than steel imports from China is the ongoing investigation into Chinese practices relating to intellectual property and technology transfer.  These deal with US assets which have far greater value, both strategically and financially than steel and aluminum products.

In parallel, the US (and the EU) continue to oppose recognition of China as a “market economy”.  This goes beyond matters of prestige: such recognition would limit the ability to impose tariffs on China for unfair trade practices.

Taking the broad view, pressure has been building up under the US-Chinese trade imbalance for a long time.  In recent years, it was exacerbated by the Great Recession, yet critics didn’t get much support from Washington as proponents of globalization were better organized and better financed.

This seems to be changing as President Trump made “fair trade” with China a major plank of his campaign and won significant voter support for it.  There is not much argument that the US consumer benefitted from low prices brought by globalization.  The question which is being asked today is whether this should be the ultimate goal.

To the extent that other very large economies make their products artificially attractive and their own markets hard to access, this will result in a hollowing out of their competitors’ industries and result in some social hardships.  In the end, will American consumers willingly trade a somewhat lower purchasing power in exchange for greater social stability?  That is the question.

Steel, aluminum, intellectual property, we are at the beginning of a struggle between the No. 1 and the No. 2 world powers, not about which has the best nuclear arsenal, but how the greatest engine of wealth will work for their respective populations, and indirectly, their political establishments.  The current US administration launched its campaign by lowering corporate taxes and cutting down regulations.  It is now entering the more political and aggressive field of tariffs.

Who will be the winner?  Will there be a (lasting) winner?  I don’t know.  But I would bet that the current system will change. 

Senator Elizabeth Warren’s next crusade?

One the mystifying topics in Finance is the unmovable interest rates that banks charge on credit card balances. For the past decade, these have hovered around 25% p.a. while bank funding costs remained below 3% p.a.

Add to that charge-offs of around 3% p.a. and banks generate gross margins of 19% p.a. from which to pay operating and advertising expenses.  Thanks to economies of scale, large institutions should clear well over 10% p.a. before tax.  And of course, this is before factoring any debt leveraging which boost ROEs.

Why is it that competition doesn’t squeeze these fat margins?  Is the market really operating as it should?

Bankers will argue that they have nothing to gain by lowering their lending rates as this would attract the riskier clients, those who max out on their cards and have difficulty paying them on time.  Perhaps.  But that still doesn’t address the question as to whether US borrowers are overpaying for credit and, in doing so, suffer undue hardship.

It so happens that the current US situation is not unique, and there is a recent precedent where a government intervened to profoundly recast a seemingly well oiled but uncompetitive consumer finance market: Japan in 2006.

The Japanese consumer finance market

For years, Japanese banks limited themselves to secured consumer lending, namely mortgage financing. 

Unsecured lending is a different ballgame: lenders need to assess their clients’ ability to repay, or roll over loans; this calls for a different kind of credit analysis and for access to extensive credit data bases.  Finally, lenders must ensure that their revenues (and therefore lending rates) cover their expenses.

Lacking all of these, Japanese banks left the field open to money lenders - thousands of them - ranging from small, at times illegal outfits, to large and sophisticated publicly traded firms.

The opening was provided by the Investment Deposit and Interest Law which allowed lending rates of up to 29.2% p.a., well above the 20% p.a. ceiling set by the Interest Rate Restriction Act of 1954 for loans up to ¥1,000,000.

This opportunity to makes tons of money triggered an impressive burst of creativity:  the association of consumer finance companies set up a vast and up-to-date credit bureau; top lenders invented ATM-like terminals through which customers could obtain new loans in under 20 minutes; they developed algorithms that not only helped them approve new loans but size and price them to maximize profits; basically, they outsmarted, outperformed and out-earned traditional banks.

There was however a downside for society.  Borrowers could easily contract several loans from different lenders, and with rates of 29.2% p.a., they stood little chance to repay them, which left them perpetually in debt.  Consumer lenders could  use rough collection methods, sending staff to harass debtors at home, even suggesting they sell a kidney to meet mounting past dues.  Finally, the biggest lenders and their founders became very rich and very arrogant[1].

In 2006, out of the blue, the Japanese Establishment stroke back, hard.  First, the Supreme Court ruled that interest rates in excess of 20% (the so-called Grey Zone) had been illegal.  Then, the Japanese Accounting Board demanded that consumer lenders set aside reserves to meet client demands for repayment of excess interest paid going back up to five years; for the top four lenders alone, the initial reserves topped $7.5 billion.  Finally Parliament voted new lending laws which “defanged” the lending upstarts: credit bureau data would have to be shared with banks, customers would be limited in their ability to contract multiple loans and to a total value of 1/3 of annual income[2], lending rates would effectively be capped at 15%-18%[3], finally criminal penalties were stiffened.

The consequences for the top money lenders were harsh:  Takefuji collapsed, Acom and Promise fell under the control of Mitsubishi UFJ and Sumitomo MFG respectively, Aiful survived as a smaller entity after its founder recapitalized it.

Back to the US

There are substantial differences between US credit card lenders and the Japanese consumer finance companies of a decade ago, particularly with regards to the collection process.  But there are important economic and social similarities.

Unsecured consumer debt in 2006 in Japan was not at levels that threatened the economy, and the same can be said of the US situation today.  But in both countries, underlying tensions were building under the surface.

Here, it is not difficult to imagine a new backlash against banks in general, and credit card interest rates are one area where the big players are both very dominant and apparently uninterested in competing on price.  I, for one, can imagine a political figure such as Senator Warren seizing on the opportunity to take on the Consumer Financial Protection Bureau and ask why consumer credit rates are both so high and so static.

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[1]  I recall a very rich and very smart founder, who had been invited by Nomura Securities to meet investors, openly boast that he was far more bankable than them.

[2]  In practice, the new law made it difficult for customers’ total loans to exceed ¥1,000,000 or ¥500,000 with one single lender.

[3]  18% for loans up to ¥1,000,000 (US$9,400 at today’s exchange rate) and 15% for loans beyond that amount.

GöttErdämmerung?

2017 has not been kind to GE.  The share price is down 43% year-to-date, and there are more financial analysts betting on further weakness than on a rebound.

As we explained in a previous post, GE long benefitted from strong earnings from its financial business, one that was built on leverage, itself backed by the AAA credit rating of the industrial parent.

Blaming Jack Welch, the former CEO and architect of this strategy, is easy but to a degree unfair:  the real problem with the financial business was not so much the leverage as the excessive reliance on short-term funding. 

Fast forward to 2017.  The financial business is largely gone, except for the financing of airplanes and jet engines.  But the bureaucratic bloat has soared while the manic focus on performance and efficiency has gone by the wayside.

The worst example of such decay can be found in GE’s biggest division, Power.  There, management so misjudged demand that it is now cutting its 2018 forecast for the delivery of some gas turbines and related technologies by half!  For 2017, group earnings per share have been cut from $2 to $1.6 and now $1, a stunning miss for a US blue-chip.

Is GE on its way to mediocrity and even failure?  The market seems to believe so.  This perception is driven by (1) the realization that turning around a company of this size is difficult and takes times (years most likely, which is longer than most investors can wait for), and (2) the fact that the new CEO gave a sober but far from inspiring vision for the future.

Before addressing these two issues, it is worth considering the scope of this company:

·       It manufactures almost two thirds of the engines that power the world commercial jets, and

·       It manufactures 30% of the world power generating plants.

Just imagine what would happen to the world economy if tomorrow these jet engines and these power plants were suddenly taken off-line…I think this puts GE's global reach, importance and therefore value potential into proper perspective.

Getting back to the market doubts.  Clearly, turning around Power will take several years, especially if the industry overcapacity persists.  But that doesn’t mean notable progress can’t be achieved within the next 6 months.

Likewise, the company’s financial reporting can be much improved (and it already is better), and balance sheet concerns can and must be cleared up (such as long-term insurance liabilities and pension funding overhangs).

Finally, it is true that Mr. Flannery’s delivery is less than inspiring.  But he does have a good management track record, and seems determined to improve efficiency and how capital and cash flows are deployed.  Since these are the immediate priorities, and since he doesn’t have excess funds to do M&As, that should do for the next 12 to 18 months.

After that, investors will need to understand how GE plans to keep growing its profit margin.  That’s when the “vision thing” becomes important, and it is too soon to tell whether Mr. Flannery is the man to deliver and execute on it.  But I am confident somebody will.

As GE is currently in deep crisis, its p/e multiple is bound to look elevated.  It is more useful to look at market cap-to-revenues, or enterprise value-to-revenues[1].  Should it find its way to emulate such peers as Honeywell in boosting its margins, its stock price would reach $40.  Will it, and if so when, that is the question.

I for one believe that Mr. Flannery, or failing him a successor, will turn GE around over the next three to five years.  At a market cap/revenues multiple of 1.25 today it looks cheap.  Honeywell is at 2.8.

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[1]  Considering only the industrial segments net debt.

General Electric, the last decade and the future

GE has been in the news lately, as analysts have pounded on its poor performance and investors have bailed out in trove.  It is a sad state of affairs for one of America’s great industrial companies.

How did it get to this, and how can it regain its footing?  Looking back with the benefit of hindsight can helps spotting what went wrong.

GE in 2006

So we went back to 2006, a year before US financial markets collapsed, and then compared that year’s results with those of 2016.  Two differences jump out:

1.     Financial services were the “special sauce” which boosted the company results, but at a cost that management didn’t seem to realize, and

2.     Financial reporting was clearer, and the books more intelligible, a decade ago.

In 2006, GE reported its results along 6 segments: Infrastructure (Aviation, Energy, Oil & Gas, Transportation), Commercial Finance (Wholesale Commercial and Real Estate Finance), GE Money (Consumer Finance), Healthcare, NBC Universal (Media) and Industrial (Appliances, Lighting, Plastics, Factory Systems).  Some of the manufacturing segments also reported related financial services income. 

This is how the business GE looked like:

Segment	Revenue (in $bn)	Profit (in $bn)	Profit Margin
Infrastructure	41.6	7.2	17.3%
Healthcare	16.5	3.1	18.8%
NBC Universal	16.2	2.9	17.9%
Industrial	33.5	2.7	8.1%
Financial	51.4	10.3	20%
Total pre corporate & elimin.	159.2	26.2	16.5%
Total post adjustments & taxes	164.3	20.8	12.7%

In all[1], Financial, which reported mostly as GECS (General Electric Capital Services) contributed over 39% of the GE’s operating profits before corporate and adjustments.

But this profit boost from Financial came with outsized risks.  At 2006 year-end, total GECS borrowings amounted to $426 billion, 98% over group total, 40% of which short-term in nature; $100 billion were in the form of commercial paper with an average maturity of 48 days!  And borrowings were growing at a fast clip: almost 18% over 2005.

Borrowings	GE (in $bn)	Financial (in $bn)	Eliminations	GE consol.
Short-term	2.2	173.3	(3.4)	172.1
Long-term	9.1	253	(1.2)	261

So GECS profits were earned on the back of $426 billion in borrowings which levered an equity base of $54 billion[2].  Put in another way, GE allocated 50% of its group equity to financial businesses which in turn piled $426 billion of debt to earn 39% of its profits.

GE consolidated cash flows were $24.6 billion, including a cash dividend of $9.8 billion by GECS.

GE in 2016

Fast forward to 2016.  The financial reporting has become somewhat opaque.  In the annual report, the Performance Summary’s plain English of 2006 has been replaced with tables in which all the items are heavily annotated and presented on a non-GAAP basis. The business segments have been reshuffled again.  

After rearranging the 2016 activity segments to make them more comparable to the 2006 data, we have the following:

Segment	Revenue (in $bn)	Profit (in $bn)	Profit margin
New Infrastructure	79.7	14.2	17.8%
Healthcare	18.3	3.2	17.3%
New Industrial	15.1	0.3	2%
GECS	10.9	(1.2)	(11.5%)
Total pre corporate & elimin.	124	16.3	13.1%
Total post adjustments & taxes	123.7	9.1	7.4%

More negative adjustments were brought up to corporate than before.  In addition, from 2102 to 2016, only one segment showed major profit growth (Aviation, +63.2%), one showed slow growth (Power, + 14%), two were essentially flat (Transportation[3] and Healthcare), while the rest (Oil & Gas, Renewable Energy, Energy Connections & Lighting) were down.  While Power still managed a good 18.6% profit margin, over-optimism would catch up with management in the third quarter of 2017 when it shrunk to 7%.

The most striking change from a decade ago is the plunge in GECS’ operating cash flows[4] to minus $7.9 billion from $9.5 billion in 2015 and $18 billion in 2014. The following table illustrates the shrinking of the financial segment and its poor performance. 

	2006 (in $bn)	2016 (in $bn)
Financial revenues	51.4	10.7
Financial profits	10.3	(1.2)
Financial borrowings	420	117.3

At the consolidated level, GE cash flows dropped from $16 billion in 2014 to $11.9 billion in 2015 and $6.1 billion in 2016.  One should also note that pension underfunding rose from $6.5 billion in 2006 to well over $30 billion in 2016. 

By the third quarter of 2017, the overall results had deteriorated further, with non-GAAP cash flows falling to $1.6 billion year-to-date, full year earnings-per-share forecast down to around $1.05 vs. $1.6 six months earlier, and cash-flows expected to reach about $7 billion.

In sum, GE’s troubles are threefold:

1.     A failed bet on financial services to “easily” boost growth and profits which backfired badly,

2.     A culture which seems to have gone astray, with such empty concepts as the GE Store and convoluted financial reporting, and

3.     A breakdown in basic management which resulted in bloat and sub-par performance.

I believe that, with time, the new CEO can fix #2 and #3.  #3 won’t be easy as it will likely result in a smaller GE, something corporate managements and boards have a hard time accepting.

The real issue, point #1, is whether GE can grow and improve its returns via a better mix of industrial activities rather than via financial levering.  As great a manager as Jack Welch thought back in the 1990s that finance and its inherent leverage was the easier way to go.

Alternative growth strategies

For inspiration, one could look at successful GE peers, such as United Technologies, Honeywell and Emerson Electric, and how they managed to outperform GE.

While GE stock price is flat for the last 5 years, EMR is up 38%, UTX is up 53% and HON is up 139%.

Honeywell is 1/3 the size of GE in terms of sales.  Strategy-wise, it differs from GE in that it targeted large niches of higher tech, high margin differentiated products alongside more main stream commercial ones.  Originally a heating technology firm, HON got into precision engineering (clocks) in 1927.  From then on, it expanded into thermostats, aeronautics (autopilot in 1942), and also automation controls and fire detection.  In 1986 it acquired Sperry, thus increasing its aeronautics footprint.  In 1986 HON was acquired by AlliedSignal, a conglomerate involved in aerospace, automotive, oil and gas and chemicals.  By 1999, AlliedSignal had spun off most of its non-aerospace and automotive businesses and adopted the Honeywell name.  Honeywell kept acquiring new companies, focusing on its key segments of Aerospace, Heating/Fire/Safety systems and Performance Materials.

In 3Q17, the profit margin of its 4 segments varied between 15% and 23%.  3Q17 net earnings were 12.9% of sales.  Free cash flow forecast for 2017 was $4.6-$4.7 billion or about 11% of sales.

Honeywell runs a focused portfolio of critical equipments and services.  It is dominant in such areas as business jet engines, cockpit automation and flight systems (where it forms a near duopoly with Rockwell Collins), HVAC/Fire/Security Controls.  It does best in high technology, critical, non-standardized products and services.  Not surprisingly, it is comparatively less profitable in price sensitive, standardized sectors such as HVAC controls.

United Technologies is ½ the size of GE by revenues and another major industrial company.  It is focused on aerospace, HVAC/Fire/Security systems, and Elevators/Escalators (Otis).  Its brands, such as Carrier, Otis, Pratt & Whitney, Goodrich, Hamilton Sunstrand are known worldwide.  UTX is another large conglomerate which diversified away from the military business into commercial ventures such as Otis in 1976 and Carrier in 1979.  Its latest move was the proposed acquisition of Rockwell Collins, to further beef up its Aerospace Systems division.  Of the three companies here, it is the closest to GE in size and approach.

For 3Q17, its segment profits were around 17%, except for Pratt & Whitney at 6% which faces stiff competition from GE and the GE/Safran joint venture. Net earnings were 8.9% of revenues. The free cash flow forecast for 2017 is $3-$3.5 billion, before a pension contribution of $2+ billion, or 5-6% of sales.

Emerson Electric is another diversified manufacturing company.  It is 1/8 the size of GE by revenue, 1/5 by market value.  Originally established in 1890 to manufacture electric motors, EMR expanded to produce equipment powered by small electric motors.  Today, the company operates in a very wide variety of niches which are regrouped into two segments: Automation, Commercial & Residential.  Such niches include valves, actuators, regulators, flow measurement, control and safety systems, firestops, switches, precision welding, HVAC, professional tools, etc.

3Q17 net earnings were 10.2% of sales.  Over the last couple of years, EMR has suffered from the reduced pace of activity in the oil and gas sector.  For the full year, EMR projects revenue growth of 5% (for continuing operations), operating cash flows of over $2.5 billion (or over 17% of sales) and a 70 bps improvement in earnings before interest and taxes to 17.9%; this should translate into an 11-12% net profit margin.

Preliminary conclusions

The comparison between these four companies is interesting in several regards. 

While all four are industrial conglomerates, the only one which went deep into financial services is GE.  In that sense, the other three are proof that a conglomerate can grow and prosper without leveraging its balance sheet as GE did.

These three companies followed different development paths.

UTX went into aviation as well as a number of large, relatively standardized equipment and services such as elevators, HVAC, etc. which enjoy high brand recognition.  It sports a better valuation than GE, but it is not fundamentally different.  It is also the largest.

HON is also active in a variety of sectors, but it has focused more than the others on large, high tech/high value added quasi niches whose products are often integrated into a broader system, have little standardization and are of critical importance.  Generally, for these reasons, price competition is not as acute as it is for commercial jet engines or even healthcare.  Size-wise, it is smaller than UTX but bigger than EMR.

EMR is a smaller version of HON in that it also focuses smaller but more numerous niches which share some technological commonality.  You could say that it had found the sweet spot, although its Oil & Gas related segment has had a tough ride lately.

Conclusion

Given GE’s crisis situation, a comparison of price-earning ratios is meaningless in trying to explore GE’s revaluation potential.  A ratio of market capitalization to revenues is more revealing.  To that end, we compared 2016 revenues[5] with today’s market capitalization.

Company	Revenues (R)	Market Cap. (M)	M/R
GE	$123.7 bn	$186.1 bn	1.50
UTX	$57.2 bn	$95 bn	1.66
HON	$39.3 bn	$111.2 bn	2.83
EMR	$17.3 bn	$42.6 bn	2.46

Setting aside EMR which is much smaller, we could argue that GE, once it upgrades its culture and management practices AND finds an appropriate growth strategy, could earn a value to revenue ratio anywhere between UTX and HON.  Matching UTX is mostly a matter of better management; the HON model requires greater strategic innovation.

This exercise is obviously very rough, but it shows that GE’s stock could eventually rise to the $24-$40 range. 

To succeed, this strategic refocus will most likely require GE to shrink and shed those segments which can’t accommodate high margins or are too capital intensive.  Already, GE is rumored to explore shedding its locomotive segment.  Its Oil & Gas business is cyclical by nature, has little bargaining power when dealing with oil supermajors and national oil companies; it should probably go as well.  Finally, GE will have to deal with such headaches as its unfunded pension and contingent liabilities in GECS; these could well cost it tens of billions of dollars.

There is of course no guarantee of success.  But GE starts from dominant positions in Power and Aviation.  These represent 50% of its non financial revenues.  Its core GECS business is sound and should be retained.  Management seems determined and so far sound in its approach.  More importantly, as daunting as the task looks, it can be done: GE can look to some of its peers for inspiration.

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[1]  Earlier in the year, GE had spun off its insurance business, Genworth.

[2]   GECS net worth only, the GE consolidated net worth at 12/06 was $112 billion.

[3]  Albeit on shrinking revenues.

[4]  From continuing and discontinued operations.

[5]  For EMR we considered its FY 2016 which ended in September 2016.

Far East Showdown

Movie buffs surely remember this scene from Shane: Joe Wilson, the hired gun played by a malevolent Jack Palance, goads pint-sized but big mouth Stonewall Torrey into a gun-fight.  Knowing he has little chance to win yet unwilling to back down, Torrey bravely goes for his gun; Wilson easily outdraws him, cracks a smile and then shoots him down.

For some reason, as Kim Jong-Un and Trump have escalated their war of words, I haven’t been able to get this scene out of my mind, as I see a number of parallels.

For one, the US are much more powerful than North Korea, yet until recently had let the latter have a free hand on its nuclear armament, and a succession of Kims have threatened to incinerate Seoul and its population every time the US tried to force its denuclearization.

The US now seem determined to force the issue, and Kim Jong-Un, like Torrey, is loathe to back down and increasingly desperate as he contemplates the situation.  Like Wilson, Trump looks like he enjoys pushing and pushing Kim, sardonically smiling at his opponent’s mounting worries.

Finally, like Wilson, the US don’t really want Kim Jong-Un to (politically) survive the showdown, as they and Kim know that his reign of terror can’t survive a massive and public backing-down.

Of course, Shane is a movie and one can’t push the comparison with a real crisis too far.  But as it masterfully depicts human aspirations and quarrels, high and low, it can serve as an effective allegory of a real conflict.  In particular, I believe that both the US and NK realize that, for the current crisis to result in an effective agreement (including the denuclearization of the Korean peninsula), Kim Jong-Un is unlikely to be a party to it.

I expect that China must realize that as well.  In the end, it will have to decide between (1) letting NK keep its nukes and ICBMs and risking US military action, (2) Japan rearming and nuclear weapons returning to South Korea if the US don’t take military action, and (3) helping manage a government change in North Korea and the denuclearization of the peninsula.  None of these outcomes are what China would like. 

The 19^th Congress of its communist party is less than a month away.  Assuming President Xi achieves what he wants there, will he feel strong enough to then try and solve what is, under any circumstance, a dangerous situation?  Will the US provide him with the necessary assurances to jointly design and implement a lasting solution to the NK crisis?  We should know in a couple of months.  Until then, the pressure on Kim will keep rising.