Different Strokes: Time For A Strategic Portfolio Review In China

We have entered a period when many international companies are conducting portfolio reviews in China, and we expect this trend to continue for another 12 to 18 months.

A set of factors have combined to prompt them into action. First, while China’s rapid economic growth over the past two decades has lifted the fortunes and profits of many, some have become somewhat bloated, with inefficient structures and operations. Second, an increasingly diverse economy means that their different activities in China face contrasting prospects, some stronger and some weaker. Third, a tenser geopolitical environment has upped the level of uncertainty in China, challenging the old risk-reward equation.

The outcome of a portfolio review is likely to be to double down, turnaround or divest. Drawing on our recent experience, we outline below the approach international companies are taking to the process.

Macro forces driving demand

The impact of a number of interlinked macro forces in China are driving demand for portfolio reviews today:

• A Low Growth Environment: International companies are being forced to reshape their cost structures in response to the slowing down of the Chinese economy.
• Overcapacity & Competition: In certain sectors, fierce competition is eating into the profit margins of international companies. Rising competition from local competitors creates an intense pricing environment that puts huge pressures on cost structures.
• Geopolitical Tensions: Export-led businesses are particularly vulnerable to the impact of potential tariffs, as are those operating in sensitive sectors which might be subject to retaliatory actions by governments across the world.

Given this rapidly changing backdrop, many international companies seem to have reached a ‘what to do?’ juncture with their China businesses. This is particularly the case in sectors affected by muted consumer sentiment, production overcapacity and intense competition, and for companies that are highly leveraged and suffering margin squeeze.

Framing the portfolio review

Responsible for returns to shareholders, capital allocation is a critical task for the senior leadership of any international company, whatever its size. Portfolio reviews are therefore used to drive the active, efficient reallocation of resources.

The best-performing companies conduct regular portfolio reviews, particularly in uncertain times when visibility is low. An essential starting point of any review is its framing. This determines the scope of business interests being assessed and potentially subject to resource reallocation in the pursuit of optimum returns.

From a China perspective, there are different options. The scope may be (a) the entire China business, for comparison with opportunities in other regions (b) the China operations of a given division or business unit, again for comparison with other regions (c) all activities in China, in this case for comparison with each other.

A division-focused review enables a company to take a more granular approach, particularly relevant where a given division is active across a wide set of products or applications.

A review of all activities in China is most relevant to larger international companies that have, over the years, built up a diverse range of operations in the country with contrasting future prospects.

Key metrics of a portfolio review

A portfolio review should develop a detailed picture, not just of today, but also of various future scenarios. It will need to determine the sustainability and potential of the China business.

• Market Position And Potential: A deep understanding of market picture, key growth drivers and size, and whether there are major disruptive forces in the market.
• Competitive Position: Benchmarking against key competitors in terms of differentiation, financial performance, pricing environment, cost structures, and likely expansion plans.
• Material Risk In Medium & Long Term: Exposure to export markets, potential policy changes, regulatory environment and over-capacity risks.
• Synergies/Interdependence With Global Business: Connectivity of China to the global portfolio, extent of synergies with the core business.

• Long-Term Funding Needs: Capex and gearing required to maintain growth.
• Return On Invested Capital: Assessment of margins and ROIC. This can be critical for reaching a conclusion on whether to divest, especially if ROIC is significantly below shareholder return requirements, long-term performance improvement appears difficult, and synergies with the global business are lacking.

Potential outcomes from a review

The outcome from a portfolio review should be a set of options for action, as continuing with the status quo is rarely the right path forward in China.

• Double-Down: Portfolio reviews may help international companies find better ways to compete, anticipate changes in the market, and stay ahead of the curve. This could mean acquisitions. Even for those international companies currently running localized, competitive and profitable business in China, they may lack sufficient scale to remain sustainable. Faced with rapidly advancing Chinese competitors in a huge market, the review may determine that inorganic growth is needed to secure the future.
• Turnaround: Economic headwinds in China are exposing more and more companies to value erosion situations. Earlier this summer we published a white paper on how international companies can distinguish underperformance from a cyclical market fluctuation, and intervene with a performance improvement plan to reverse the value erosion cycle before it is too late. The paper, “Turning The Tide”, is linked here.
• Divest: Alternatively, effective portfolio reviews can help international companies reach a decision quicker on whether a divestment is actually the best option for the wider business, often where delaying such a decision would have a profound negative effect on the company in the longer run. Importantly, divestitures may also release capital that can be reinvested in more strategic initiatives with higher returns on capital.

That said, divestment does not necessarily mean withdrawing from China. Indeed, an increasing number of international companies are inviting Chinese strategic investors to take a stake in their China operations, effectively a return to forming joint ventures.

A partial divestment as such allows the international company to ‘stay in the game’ while benefiting from the capabilities and resources brought by the Chinese partner. This may or may not involve ceding control, but either way gives international companies exposure to a growth upside that they may not have otherwise had.

Wider benefits of a review

Portfolio reviews help decide how to deliver better value to shareholders, whether that be through doubling down on further expansion, turning around operations at risk of value erosion, or full or partial divestment.

But an effective portfolio review also has other less apparent benefits. For instance, regular involvement of the board in the review process can strengthen strategic decision-making, enhance agility and responsiveness to market changes, ready the organization for divestment if there is an interested party, and also improve shareholder communication.

One of the biggest hindrances to the process may be internal inertia and bias. This can be overcome by engaging an external party to run the portfolio review. By providing an outside view, an external party can help leadership teams not only overcome inward-looking mindsets but also any biases and vested interests that may exist.

Author

Barry Chen (Partner-In-Charge, Corporate Finance, Shanghai Office)

Barry Chen provides overall leadership to InterChina’s M&A advisory, corporate finance, and investment advisory?practice. Barry has 20+ years of cross-border M&A, corporate finance, and strategic planning experience in theinfrastructure/logistics, consumer, technology, manufacturing, retail, and financial service sectors. He has led?and advised over 200 M&A and divestiture transactions, in the North American, Asia Pacific, and Europe at sizes?ranging from $50 mn to $8 bn.

About InterChina

InterChina is a leading strategy, operations and corporate finance boutique specialised in China. Our multinational and Chinese clients choose to work with us because we provide real understanding, deliver practical results, and know how to get things done. We are a partner led firm and distinguish ourselves by the deep level of commitment our partners have in client engagements.

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