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Can China's CFOs keep their companies from growing out of control?
Don Durfee and Yang Jian, CFO Magazine
February 1, 2008
Few ways of getting around China are more harrowing than a nighttime taxi ride through the countryside. Invariably, such trips are taken at high speed. With one hand on the steering wheel, the cabbie will accelerate past villages, swerve around ox carts, and honk at each pedestrian and cyclist passing by. There are no streetlights. Farmers walking home from the fields suddenly loom in the dim headlights, causing the driver to slam on the brakes. There's little a passenger can do but hope for the best — there are no seat belts.
Anyone investing in China's stock markets these days knows how such a wild ride feels. But the unruliness — and anxiety — accompanying white-hot growth is also disturbing the country's CFOs. They worry that their companies, like the Chinese stock market itself, may be growing beyond control and could be headed for disaster.
A recent survey of Chinese financial executives conducted by CFO China (one of CFO magazine's sister publications) shows how pervasive that anxiety has become. Just over half of the survey's 359 respondents say that growth isn't under control in their companies. In particular, the CFOs worry about their ability to respond to any problems that crop up. "Risk management is not done well at most Chinese companies," says Louis T. Hsieh, CFO of New Oriental Education & Technology Group, a Beijing-based private education services company, and a board member at several Chinese listed companies. "That's because they haven't faced [risk] yet. These companies are expanding like crazy, and everything they make they can sell."
A growing chorus of market observers is warning that China's market boom won't end well. How damaging a crash would be to China's economy remains to be seen; the Shenzhen and Shanghai markets remain small relative to the country's overall economy. For listed companies, however, any downturn could have severe effects.
True, in interviews and at conferences, China's CFOs display an infectious enthusiasm about their businesses. Most can rattle off IPO details and cite today's percentage rise in their company's stock price. But they see problems, too. Finance executives worry about their rudimentary financial-reporting systems, complain about business managers who focus solely on topline growth, and wonder whether they can achieve the level of financial transparency required of listed companies.
The survey confirmed many of these worries. For CFOs of listed companies, the number-one growth-related concern is that the development of internal controls isn't keeping up with corporate growth, with nearly two-thirds saying this is a problem. Other worries include the lack of attention given to the quality of growth (53 percent), managers who don't understand business risk (46 percent), and a failure to properly analyze investment decisions (41 percent).
The survey also shows that financial executives see weaknesses within their own functions. For example, only 39 percent of listed-company CFOs think they can manage risk well, and just 41 percent say they are happy with the quality of internal financial reporting.
You don't have to look far for problems that can arise under these conditions. Consider Hunan Xiangquan Group, which went bankrupt last year. From its start in the spirits business (the company's flagship business was Jiugui Liquor) Hunan Xiangquan diversified widely. It got involved in tea, ceramics, leasing, printing, workforce training, museums, medicine, animal feeds, five-star hotels, and other businesses. Analysts blamed the failure on bad investment decisions — the hotel business, for one, created a heavy debt load. The CEO had partly funded the expansion by pulling capital out of Jiugui, causing losses in the core business.
Difficult times for other Chinese companies may not be far off. Jerry Lou, Morgan Stanley's China equities strategist, sees trouble ahead. "We think that the A-share market is producing not only a multiples bubble, but an earnings bubble as well," he says. (So-called A shares are issued for domestic investors by companies listed on the Shanghai or Shenzhen stock exchanges, while B shares are available to domestic and foreign investors alike.)
Lou cites speculative investments as a particular cause for concern. The survey of CFOs found that corporate speculation is indeed rampant. Among A-share companies, 66 percent invest in either the stock market or in real estate (other than property used in company operations). According to a Morgan Stanley analysis of the most recent financials of Chinese listed companies (excluding insurers), investment income is 17 percent of absolute market earnings per share. That's possible because of an accounting rule change in 2007 permitting companies to reflect the change in the value of assets on their income statements (see "The Great Experiment," CFO Asia, May 2007).
More startling is that investment gains account for a disproportionate part of earnings growth — 36 percent. Core earnings, meanwhile, account for just 54 percent of overall growth.
Some companies are even taking out bank loans to invest. Last year, regulators cited China Nuclear Engineering & Construction and China Shipping for diverting loan money into the stock markets. China Shipping, for example, received $356 million in loans from six banks and used $324 million of it to participate in IPOs.
The trouble, says Lou, is that as stock-price gains begin to slow (as they have recently), earnings growth will brake sharply. That's what happened on the Tokyo Stock Exchange in 1989, he points out. "[Investors] had included a lot of investment income in their forecasts. So when the market started coming down, the earnings cut was moving faster than the market, which created a snowball effect."
Urging caution during a time of euphoria isn't easy. And the kinds of changes advocated by consultants require a determination that's hard to muster in the absence of an immediate threat. "It's the classic problem," says Nigel Knight, a managing partner with IBM Business Consulting Services in Shanghai. "Until things go wrong, it's hard to change. You need a 'burning platform,' and in many of these companies that may be a major problem resulting from not managing risk effectively."
But when revenues are rising, the threats to a business aren't obvious. "In some ways, China is like the U.S. in the 1990s; when economies are booming, the risks are submerged," says Chris Low, head of China operations for Protiviti, an internal-audit and risk-management consultancy. "But what happens if some of the variables change?"
For A-share companies, at least, there isn't much pressure for financial improvements coming from the retail investors that currently dominate the domestic stock markets. "The average investor is poorly educated," says Lou. Instead of doing careful analysis investors typically trade on themes, and do so quickly and often. Lou has seen some investors suggest in online discussions that it makes sense to buy stocks that are "cheap" — in other words, a 5-yuan stock would be a better deal than a 10-yuan stock.
Indeed, the survey shows that China's CFOs feel relatively little pressure from retail investors, and only slightly more from institutional investors. Just 15 percent of listed-company CFOs claim to feel significant pressure for change from individual investors, while 32 percent feel such pressure from institutional investors. That shouldn't come as a surprise. In many of the recent instances where listed companies were punished by Chinese regulators, their share prices actually rose, buoyed by overall optimism about the market.
If investor pressure on Chinese CFOs is low, other pressures more than compensate. "[Running finance] is a massive challenge during the first year after an IPO," says Hsieh of New Oriental Education, which listed on the New York Stock Exchange in 2006. "You are setting up the finance function, setting up employee share plans, investors are calling you, and you have to comply with Sarbanes-Oxley."
Finding qualified employees — particularly in finance — is another drain on the CFO's time. Hsieh should know: this year, his firm has opened 38 facilities and has added 1,200 people to the payroll, bringing the total number of employees to 5,900.
There are structural challenges, too. The broad-based CFO position that's common at U.S. and European companies is rare in China. At many Chinese companies, treasury is separate from financial control. Nor do many CFOs have the authority of their Fortune 500 peers. "Here in China a lot of CFOs are just now earning the right to sit at the [decision-making] table," says David White, a consultant with Oliver Wyman in Beijing. Asked about the challenges confronting finance, 45 percent of CFO China's survey respondents cited the narrowness of the CFO role.
The lack of authority becomes a problem when finance chiefs try to address challenges arising from a company's fragmented structure. Big Chinese companies typically have many divisions and governance models that require complex diagrams to comprehend. One result is a lack of clean financial data across the enterprise. "As companies go public, the CEO wants a better line of sight and asks finance to help," says IBM's Knight. "That brings finance into some conflict with the divisions."
Major change can't happen without support from the CEO. "You need a CEO who is open to someone new and to a different way of thinking," says Cheng Li-lan, CFO of E-House, an online real estate brokerage in Shanghai. "Particularly if you want to do an overseas IPO, you need to have a balance between going for the absolute highest return and risk. You need diversification and dilution of decision making and a higher level of transparency."
Unfortunately, at some companies — especially state-owned enterprises (SOEs) that have gone public — it's hard to reach that kind of understanding. The CEO and chairman of such companies are typically appointed by the Communist party, creating a conflict of interest. According to a senior executive of one state-owned enterprise, because many top SOE officials hope for a powerful government appointment later, they typically feel more responsibility to the party than to shareholders. At this enterprise it has resulted in a short-term focus on topline revenue.
This is a common problem, according to Jamie Allen, secretary-general of the Asian Corporate Governance Association. "The business decisions of these companies are being influenced by state policy, not what's best for the shareholders. It could result in a manufacturer setting up a factory in the area to provide jobs, which may help provide a stable and harmonious society but may not be in the interest of the minority shareholders." The outcome is that CFOs of SOEs can find themselves restrained by the CEO from making decisions needed to get the business on the right track.
Chinese CFOs realize that there's work to do. According to the CFO China survey, their top priorities are internal controls, risk management, higher profitability, and providing better analysis for decision making. And, in fact, consulting firms such as IBM report a sharp rise in the number of companies launching large-scale finance-transformation projects, which aim to improve basic financial processes and enable finance to help the business make wiser decisions.
Not surprisingly, the CFOs of successful high-growth ventures are acutely aware that they need control to keep their businesses growing. Hsieh of New Oriental Education is one of them. He had worked as an investment banker and a lawyer in addition to a stint as a Silicon Valley CFO when he was recruited by New Oriental founder Michael Yu.
Hsieh has set up a system of financial controls to wield some control over New Oriental's far-flung operations. Each week, his financial team (about 150 people, mostly working in operations) compiles management reports, which the senior managers review. "Before we had controls in place, the CEO and the SVPs didn't know if a school was broken for six months or a year, because the school could hide it," says Hsieh. "They didn't know until the end of the year, when they did the accounts, and people would say, 'Wow, you didn't make any money.'"
Hsieh says he is fortunate to have a boss who recognizes the importance of good controls. The CEO assigned him to build New Oriental's finance and administrative functions, and as a result his job has a wide span, encompassing finance, human resources, M&A, and legal.
All of this, Hsieh believes, means that New Oriental will be able to respond to a downturn better than other Chinese companies. Unfortunately, companies like New Oriental still appear to be in the minority in China. Many more are barreling ahead, growing fast but ill-prepared to steer around the obstacles that appear in their headlights. Costly mishaps may await them.
"Profitability and growth are always the most important things in a company like ours," says Cheng of E-House. "But at the same time, if you ignore good management, it will come back to bite you."
Don Durfee, Yang Jian, and Wu Chen write for CFO in Hong Kong and Shanghai.