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VODAFONE S latest figures appear at first glance to vindicate the most powerful
management idea of the past two decades: that firms should expand in
fast-growing emerging economies. Sales at the mobile-phone company fell in the
rich world while those in the developing world rose smartly. Corporate strategy
is usually a contentious subject: there are fierce debates about how big,
diversified and financially leveraged firms should be. But geography has
seduced everyone. Vodafone is one of countless Western companies that have bet
on the developing world.
Look closer, however, and those figures contradict accepted wisdom. At market
exchange rates Vodafone s sales in the emerging world fell, reflecting the
widespread currency depreciations in mid-2013, when America s Federal Reserve
signalled it would taper its bond purchases. This drag may linger: in January
the lira and rand tumbled in Turkey and South Africa, two biggish markets for
Vodafone. On longer-term measures things look cloudy, too. Over a decade
Vodafone has invested more than $25 billion in Turkey and India. These
operations made a paltry 1% return on capital last year. Vodafone has created a
lot of value for its shareholders but through its American investments, which
it has sold to Verizon for a stonking price.
This year Western firms giant bet on the emerging world will come under more
scrutiny. Most multinationals are far more profitable in emerging markets than
Vodafone. American firms made a 12% return on equity in 2012, roughly in line
with their global average. But having grown fast, profits are now falling in
dollar terms. There has been a long bout of share-price underperformance as
investors have lost their euphoria. An index run by Stoxx, a data firm, of
Western firms with high emerging-market exposures has lagged the broader S&P
500 index by about 40% over three years (see chart 1). And the recovery in the
rich world will mean there will be more competition for resources within firms.
All this will bring strategic questions into sharp relief. Divisional chiefs
from Brazil or Asia will no longer get a blank cheque from their boards.
Although the average company has prospered, there have been disasters; plenty
of firms and some whole industries need a rethink. The emerging-market rush may
end up like a giant version of the first internet boom 15 years ago. The broad
thrust was right but some big mistakes were made.
The companies suffering a slowdown in profits come in three buckets. Consumer
firms including Coca-Cola, Nestl , Unilever and Procter & Gamble have suffered
a gentle weakening in demand and a currency drag. Most are still upbeat about
the long term, says Andrew Wood of Sanford C. Bernstein, an analysis firm.
Companies in the second bucket face a sharper slowdown. They are in cyclical
and capital-intensive industries. Fiat Chrysler s profits in Latin America, a
vital cash cow, halved in 2013. This week Volkswagen and Renault joined the
ranks of Western carmakers warning of weak emerging-market sales. Last month
Peugeot wrote off $1.6 billion of assets, mainly in Russia and Latin America.
Emerging-market sales have fallen at Cisco, a technology firm; its boss, John
Chambers, reckons it is the canary in the coal mine . Industrial giants such
as ABB and Alstom have seen orders falter for infrastructure projects, for
example the building of power stations, says Andreas Willi of J.P. Morgan.
Those firms with mismatches costs or debts in firm currencies but sales in
depreciating ones face a nasty squeeze. Margins in emerging markets have halved
at Electrolux, which makes fridges and other appliances. Codere, a Spanish firm
with an empire of gaming and betting shops in Latin America paid for with debts
in euros, is now on life support and restructuring its balance-sheet.
In the third bucket are firms with idiosyncratic problems. China s war on graft
has hurt luxury-product makers that have grown fat by selling bling to the
Middle Kingdom. Sales at R my Cointreau, which makes cognac that Communist
Party big-shots quaff, fell by a fifth in the quarter to December, compared
with the previous year. Russia s once-frothy beer market is shrinking as the
country conducts one of its periodic crackdowns on alcoholism.
All this may be breezily dismissed as short-term turbulence. But
emerging-market wobbles can have a profound impact on corporate strategy. After
the 1997-98 Asian crisis many multinationals tilted back towards the rich
world. Citigroup and HSBC, two big banks, played down their Asian heritages and
spent the next decade building subprime and investment-banking operations in
America. Unilever s operating profits fell in 1997. It felt obliged to tell
shareholders that the rich world was its backbone and by 2000 it too had made
a huge American acquisition, of Bestfoods.
Rising exposure
The emerging world s troubles are not as bad as in 1997-98. But the exposure of
rich-world firms is far higher than then (see chart 2). Big European firms make
one-third of their sales in the developing world, almost triple the level in
1997, reckons Graham Secker of Morgan Stanley. For big, listed American
companies the total has doubled, to about one-fifth. For Japanese firms it is
about one-tenth, says Kathy Matsui of Goldman Sachs. The bigger a firm is, the
greater its exposure tends to be. Rich-world firms do business across the
emerging world, with China accounting for 10-20% of it. Consumer goods, cars,
natural resources and technology are the industries with most exposure.
Property, construction and health care have the least.
Many of these operations pre-date the boom. European firms have footprints in
Asia and Africa from colonial times. American firms dominated foreign direct
investment (FDI) flows in the 1970s and 1980s. By the 1990s manufacturing firms
were creating global production chains. A wave of privatisations in Latin
America enticed a new generation of conquistadores from Iberia and North
America.
But by the mid-2000s the process had accelerated dramatically as executives and
boards latched on to the idea of the fast-growing BRICs (Brazil, Russia, India,
China) and their ilk. Once the subprime and euro crises began, the urge to
escape the Western world was irresistible. FDI into China in 2010 was more than
double the level in 1998. Takeovers became common. In 2007 purchases in
emerging markets by rich-world firms reached $225 billion. That was five times
the level just half a decade earlier. One measure of how discipline slipped is
the valuation of those deals. In 2007 rich-world buyers stumped up a dizzy 17
times operating profits for their targets, double the multiple paid in 2000-03.
Some firms had unexpected identity changes. Suzuki, a Japanese carmaker, found
that its formerly sleepy Indian arm accounted for the biggest chunk of its
market value. Portugal Telecom s Brazilian unit kept it afloat during the euro
crisis. Having taken control of a beer firm in St Petersburg, Carlsberg, a
Danish brewer, became a Russia play . Mandom, an 87-year-old Japanese firm,
found itself a giant of the Indonesian male-cosmetics market.
Other firms efforts to peacock their emerging-market credentials look, with
hindsight, like indicators of excess. Having been bailed out for its toxic
credit exposures back in America, Citigroup rebranded itself as an
emerging-market bank. Schneider Electric, a French engineering firm, and HSBC
relocated their chief executives from Europe to Hong Kong (HSBC has since
backtracked).
Historians may judge the peak of the frenzy to have been in June 2010.
Nathaniel Rothschild, a scion of a banking dynasty (some of whose members are
minority shareholders in The Economist), raised $1.1 billion for a shell
company in London, set up to buy emerging-market mining assets. Months later it
invested in Indonesian coal mines with the Bakrie family, known in that country
for its political ties and web of businesses. According to Bloomberg, Mr
Rothschild shook hands on the deal without visiting the main mine in question,
in Borneo. The transaction was a terrible mistake , he later admitted.
Every corporate-investment cycle creates triumphs and disasters, and a lot of
mediocrity. The emerging-markets boom will be no exception. Hard figures are
elusive but the book value of the equity that Western firms have invested in
the emerging world has probably risen by at least $3 trillion since 1998. This
is a colossal sum, equivalent to 11% of the emerging markets combined GDP in
2013. Many firms have prospered, such as the banks that braved Mexico in the
1990s. But there is plenty of rot, too.
Start with takeovers. There have been $1.6 trillion-worth since 2002. A rule of
thumb is that half of all deals destroy value for the acquirer. Like Vodafone,
many firms paid dizzy prices justified by pepped-up forecasts. In 2010 Abbott
Laboratories, an American drugs firm, paid $4 billion for the small Indian
drugs unit of Piramal, predicting it would grow at 20% a year for a decade. Two
years later sales were stagnant in dollar terms. Daiichi Sankyo, a Japanese
drugs firm, has been badly burned in India, as the company it bought into,
Ranbaxy, has hit serious quality problems. Lafarge paid $15 billion for
Orascom, a North African and Middle Eastern rival, in 2007. The French cement
giant predicted sales would rise by 30% a year. Since then its shares have
almost halved, partly due to the crippling debt burden incurred.
Big greenfield projects have broken hearts, too. ThyssenKrupp, a German steel
colossus, launched an ambitious project in 2006 to make steel slabs in Brazil
and process them in America. Rising costs have made it unviable, and most of
the $10 billion sunk has been written off. The firm s boss has labelled the
episode a disaster . Anglo American, a mining company, buried $8 billion and
the career of its former chief executive, Cynthia Carroll, in a Brazilian
project called Minas-Rio. Cost overruns have led to a $4 billion write-off.
Besides such eye-catching failures, there are pockets of serious
underperformance tucked away in corners of sprawling multinationals.
Consumer-goods firms have made hay in emerging markets, but even the best have
some iffy businesses. Procter & Gamble s margins outside America are half those
it enjoys at home. Profits are weak in India and Brazil, where it is a laggard.
A.G. Lafley, who returned as the firm s boss last year, has promised more
discipline.
It is the same story with Spanish investments in Latin America. Telef nica
makes good money across most of the continent, says Bosco Ojeda of UBS, a bank.
But Mexico is a running sore. For 14 years Telef nica has poured in billions of
dollars without threatening Carlos Slim, who dominates telecoms there. Even the
world s two biggest brewers, Anheuser-Busch InBev and SABMiller, which have
been huge successes, have bought some businesses with low market shares and
commensurately weaker profits and returns on capital.
In some cases the underperformance is spread across an entire industry. During
a boom every firm thinks it can be a winner, leading to excess investment and
saturation. The more capital-intensive the industry is, the greater the pain in
store for its weakest members. Insurance is a case in point. India has more
than 20 foreign firms slugging it out for tiny market shares while bleeding
cash. Turkey is also an insurers graveyard. Most European firms have a motley
collection of emerging-market assets, but only a few, such as Prudential, AXA
and Allianz, have scale. There are trophy markets where everyone has decided
they have to be in. Typically they don t make a lot of money, says an
executive.
The car industry also has a long tail of flaky businesses. It has invested more
than $50 billion in factories in China, with great success, reckons Max
Warburton, also of Bernstein. But China has affected the judgment of a lot of
chief executives, making them too bullish about other emerging markets. More
than $30 billion has been invested in developing countries other than China.
New factories are opening just as demand has slowed. Ford s number two, Mark
Fields, this week expressed worries about excess carmaking capacity building up
in Brazil, Russia and India. Mr Warburton thinks such operations could burn
billions of dollars this year. Everyone is bracing to lose a lot of money.
Taking the beer goggles off
Some rich-world firms need to take a long, cold look at their emerging-market
businesses and work out if they make sense. But there are psychological
barriers to this. One is that most Western businesses have low gearing usually
it is only when they have a debt problem that they make difficult decisions
quickly. Without their emerging-markets pep pill many firms would have dire
revenue growth. The developing world has supplied 60-90% of the growth of
Europe s big firms in recent years. And a whole generation of chief executives
has learned that quitting emerging markets is a mug s game. Bosses who panicked
and left after the 1997-98 crisis ended up looking like idiots.
Yet companies should allocate capital carefully, regardless of the spare funds
they have. Sales growth without profits is pointless. And comparisons with
1997-98 are imperfect. Most industries have become more competitive, as
emerging economies local firms get into their stride. The low-hanging fruit is
gone. Reflecting this logic, a few big industries have already begun to trim
their emerging-markets arms.
Exhibit one is banking. After being bailed out, some firms such as ING and
Royal Bank of Scotland have largely retreated from the developing world. Bank
of America has sold out of its Chinese affiliate. But even big, successful
firms which are dedicated to emerging economies are trying to boost returns by
trimming back. HSBC has got out of 23 emerging-market businesses. The world s
biggest five mining firms are also adapting to lower emerging-market demand.
They have cut capital investment by a quarter since 2012, says Myles Allsop of
UBS.
The supermarkets are in retreat after decades of empire-building that led them
to invest $50 billion in the emerging world. Synergies have proved elusive,
local rivals have got stronger and tastes more particular. In Turkey shoppers
prefer discount stores to hypermarkets the four biggest foreign firms there
lost money in 2012. Aside from Walmart s Mexican unit, most rich-country
grocers operations in the developing world have low market shares and do not
cover their cost of capital. Casino, a French firm, has already shrunk, says
Edouard Aubin, of Morgan Stanley. He thinks Carrefour could slim down to five
countries from a peak of more than 20 (although it said this week it would keep
expanding in China and Brazil). Walmart is cutting the number of stores it has
in emerging markets. Tesco seems to have abandoned its dream of controlling big
businesses in Turkey and China.
In the next few years more firms may follow the example of some supermarkets
and retreat from the developing world. Most, though, will adapt, cutting
capital investment and pruning their portfolios. All this will create
opportunities for rising local firms. On February 19th, as Peugeot announced
its giant write-off of emerging-market assets, Dongfeng, its Chinese partner,
said it would take a 14% stake in the French firm and that technology-sharing
between the two would speed up. There are rumours that General Motors may sell
its loss-making Indian plant to its Chinese partner, SAIC. In 2011 ING sold its
large Latin American business to Grupo Sura, a Colombian conglomerate intent on
becoming a regional player.
The rich-world firms that remain will need to make their business models
weatherproof, not just suited for the sunny days of a boom. That means shifting
even more production to emerging markets and borrowing in local currencies both
are a natural hedge against currency turbulence.
As others falter, the strongest multinationals are making bolt-on acquisitions.
In 2013 Unilever bought out some minority shareholders in its Indian business
for $3 billion and Anheuser-Busch InBev took control of Grupo Modelo, a Mexican
rival, for $20 billion. The year before Nestl spent $12 billion buying Pfizer
s baby-food business, which is mainly exposed to the emerging world. Rather
than being the panacea envisioned by many Western firms during the boom,
emerging markets are governed by the oldest business rule of all survival of
the fittest.