Over the last couple of years, one of the firms that has popped up on the radar of firms whose labor conditions I felt were at some point going to come back to haunt them… and I think we have come a bit closer with the above CCTV report, an 11 and a half minute investigative report (in Chinese) where former employees of the Suzhou based Wintek facility speak about the physical ailments they experienced while working at the facility.

It is a report that covers all the bases. Interviews of former employees who detail the illnesses they feel come from working at the plant, people in the hospital who are still recovering, labor bureau officials, the cursory tours, some scientific facts on the chemicals used in the process of cleaning/ finishing the screens, and even a Wintek Manager interview.

It is a report, that while “unverified”, is unlike before when Apple (and its suppliers) had labor issues as it is a report that cannot be contained by suing a reporter or leveraging the brand to keep the story from entering the mainstream, and it is the “report” that I had in many ways been waiting for. That, as the reports of Apple’s supply chain issues were becoming more frequent in the international press, it was the potential spillover into the Chinese press that I was looking out for and in my opinion significantly heightens the risk to Apple locally.

Link to video (Chinese) here

Update: Shanghai Daily is reporting that Wintek admits to having 49 employeees exposed, and “taken care of”, a few months back.  That, the exposures were a failure of managers understanding the chemicals, and how to properly manage them.. and that following the 49 employees being sicked, they took immediate action. Interestingly enough, the hospital says that more than 100 employees have been received thus far, and that they are still coming in.

hmm.. I am guessing there isn’t an Apple employee with direct knowledge of the situation, but given Apple’s plans to open up a Apple store in Shanghai this summer, I would suggest they get books on the ground fast to work out what is going on.  Last thing they would want would be 2500 Wintek employees to go on another walk, but this time move the meeting point to Nanjing road.

Update 2: Turns out that Wintek is also a supplier to Nokia, and Nokia has sent out a very strongly worded message to put a lot of distance between them and the current issues at Wintek. Here are two passages that I believe are the most damning for Wintek – and ultimately Apple (emphasis mine)

#1 – Wintek is a Nokia supplier, and provides components for its mobile phones, but N-Hexane is and has NOT been used on Nokia’s production lines at this supplier. Nokia strictly forbids all use of chemicals which are illegal.

#2 – We became aware of the allegations regarding the use of n-hexane in July 2009 and started our investigation immediately. Although it was confirmed that the n-hexane was not used on our production lines at the supplier, as part of our assessment we agreed on a development plan for health and safety management at Wintek’s Suzhou factory and a series of corrective measures have been taken since then.

So, if I read this right, not only is n-hexane illegal, but this has been going on for nearly a year.

That is would have been more than enough time for Apple to have made the necessary adjustments had they put in the effort when the first Wintek strike occurred, or even the second one.  OR.. even when they did their supplier evaluations in as part of the 2009 supplier responsibility report.

Over the last few weeks, I have been spedning a lot of timethings about the risks of China.  More specifically the risks that either are not thought through, are thought to be too low to consider, or are believed to be removed by a third party relationship.  It is a sitution that, as the interview below will show, is almost systematic in the outsourced manufacturing game, and was highlighted by the recent strike at one of Apple’s Suzhou based suppliers two weeks.

It was a strike that particularly frustrated me because Apple has had 3 or 4 other incidents in the past two years, and had in my mind simply not done anything to address the problems in a productive manner.  So, I asked long time friend and labor compliance specialist Pierig Vezin  (Founder and CEO of WethicA) to answer some questions for me based on his experiences in the field

what are the biggest compliance issues that exist in china?
The more common compliance issue in China is about working time. It is found in almost every factory as the Chinese law is quite strict (40 hours per week), but the reality is that the average working time is among the highest worldwide with around 70 to 75 hours per week.

The toughest compliance issue, bounded labour (i.e. young child labour),  is rarely an issue of big factories. Second to the issue of child labor though is that we regularly meet factories that pay workers once a year only, which essentially means that workers can’t resign from their job once they have started. This kind of practice leads workers to be fully dependent on the factory, even in case of major needs to change.

Do firms (buyers)understand the conditions on the ground? do they plan well?

Most of them don’t understand. Actually to be able to claim you are working with compliant factories only is already an evidence of lack of awareness of real situation.When I do training in companies on social situation in factories, I have people astonished by actual situation, and because many figures are not easily understandable , I spend a lot of time helping them understand the meaning of these figures.

For example on working time. When I explain days are often 12 hours long there is always one in each group to explain we were working that long not so long ago in western countries. Ans I also usually have one who claim to work 12 hours a day him(her)self. Then I point out that working in a factory 12 hours is not as working in an office 12 hours as you take break to talk with colleague, take break to eat, having some not fully efficient meeting… When talking about working time in factories it is 12 effective working hours. Then I explain. And what will you do Saturday or Sunday? In factories they will work as usual up to the end of the month. This is when people start to figure out what 12 hours a day 7 day a week really means.

Starting from this gap in understanding the actual situation it is difficult to imagine a proper plan. Experience shows proper plan on this topic can’t be done immediatly as once as to get involved first to be able to define proper goals.

Has anyone learned anything since Nike?
Even Nike haven’t learn anything since Nike.

They were attacked by a Chinese newspaper in November for wages only half the legal minimum in a factory of Jiangsu.

You also still have many brands claiming they are working only with compliant factories, but are still producing in Asia. If we just look at the working time issue, we know it is impossible all goods are done in compliant factories. Thus there are still many people who prefer to claim they don’t know.

Many companies are also having a more pragmatic approach while trying to manage the social f-grade of factories for the best and asking continuous improvement. Thus the understanding is improving, but not everything is done on that topics. Still many need to be taught

Are there industries that have always had high risk or labour noncompliance or cutting corners?
As soon as you work with many workers, that the wages is an important part of your turnover, you are more likely to try to cut “staff cost”. So obviously hand labour intensive users as garment, shoes, jewelry, luggage… small stuff are first in line. But many other industry are huge user of hand labour, even if we don’t think of it. mobile phone, computers,… are high tech goods, but they are also goods that needs to be assembled. The assembly lines are still mainly manual and it is an important part of the production of such goods. Thus they are at risk too.

What are the areas that pose the trouble for firms who are trying to do things right?
The working time is obviously the most difficult one, as it is the one where the gap with the requirement is the biggest. Wages is also a difficult topic as it is directly linked to cost. moreover, the wage system in China is complex and depends on a city level. Thus you can have a factory which pay better wages than another one 10 km away, but this one is not compliant while the other is. The compliance on wages isn’t actually something really important for factories while talking with local government. Thus sometimes you also found factories which give wages lower than legal minimum but many advantages. They could make calculation job to keep wages same level and it appears compliant. they usually don’t bother with that. So asking for improvment in that matter is often not understood as it is always seen as increasing wages.

Safety on the opposite is usually quite achievable while health of workers is a much more difficult topic.

Have things improved over the last 5 years?  Still the same?
Yes things have improved. the average wage has increase, the management of the age of workers is usually better even from time to time we have period of higher child labor. But I guess what has the most improved are the living conditions, with cleaner and healthier dormitories. Safety in China is also usually correct.

How have conditions changed over the last 18 months with the recession?
We thought the economic downturn would lead to less work in factories and decrease the overtime. Actually the opposite happens. As factories had no idea of the future they refuse to hire workers, and ask the present ones to do more. Since this summer the situation is going back to “normal” (not compliant) level. Actually the main consequence has been the stop of some action taken by the government. In January 2008 started the new labour contract. It wasn’t much different from the previous one, but it was a way to claim for its implementation. It as actually started , but then stop soon, and we still find as many workers with no contract at all than before. We also see factories who has understand they won’t be able to continue to compete only on price with other countries. Bangladesh is already much cheaper than China for basic garments. Thus some are changing their approach by trying to upgrade their level. it is going also in a social upgrade as they need to keep the best workers.

How much does it cost to do it right? What are the costs of doing it wrong?
It depends on what right and wrong means. Wrong is sometimes prison where labour cost close to zero. If right means compliant, then you’ll have not to produce in China. You can’t ask a factory to work 40 hours a week when all others are working 70 or 75. Actually if you ask it to strongly and refuse to see it is impossible, then you ask the factory to lie to you. Asking for better than the average is reachable. Asking for compliance is not.

Now on how much it cost, it is very difficult to answer. It depends on the good, it depends on what is expected, and it depends on how you implement it. Workers productivity in Chinese garment industry for example is very low. it is low because of lack of training, of organization, of rest. If you have workers waiting for goods to be worked, and the same workers making overtime all night because they are late, it is not talking about cost, it is talking about organization. Thus you can’t take the cost of social requirements separately of the whole factory organization. Another important topic on cost is the cost of the work on a global product. In a trouser, the cost of the fabric is usually much higher than the cost of the workers who cut an sew it. But pressure is done on this step as it is the most seen. To finish about costs, western buyers should sometimes rethink their buying process. I have seen so often company switching from suppliers for few cents per piece, while cost of changing supplier was to count in dollar per piece.

What do you make of the recent news of Apple’s compliance issues( should apple be doing more? What could they do?
Apple has decided long ago to work with a supplier well known for workers abuse. Every one or two year problems are raised on this topics. this summer it was about the student who “had been jumped” from his apartment window. before that it was about the sickness of girls working on Ipod. Apple has never shown any real action on that matter. We talked about Nike before. Even if not every thing perfect with Nike, when facing such challenge, they act and try to improve the situation. The current situation in Nike factories is better than the average of comparable factories. It is not the case for Apple. I guess that’s my answer about Apple actions.

Do codes of conduct really help? Can suppliers be trusted to follow these?
COC are guidelines, they are just reminder of what is asked; It is just a way to remind “we don’t want you to work with children…”; But they are not dynamic and most if not all of them have the same flaws in. They are not dynamic. They ask the factory to comply today. They are written in a western point of view when they have to be applied in Asia. The very notion of a law or a rule is different in Asia and in western countries. This it is most of the time impossible for factories to comply and sometimes even not fair. Let’s take the example of Young workers. The young workers are the one above child age (usually 16) but still minor. In local legislation young workers must usually be protected (avoid dangerous job…). In India for example (but it is seen in China even not so directly) most of factories forbid workers below 18 years old. Thus they don’t have to manage these workers; Thus young workers can’t found job in structured factories and have to work in unofficial workshops. Should the factory who is hiring young workers from time to time but not perfectly managing them be considered of lower social grade than the one refusing young workers?

What role can the market play to improve conditions?  Are Apple and Nike still at risk of consumers pushing back?
The market can surely play a role. The toy industry is a good exemple. Even if not everything perfect the Mattel case have stressed the risk for the brands of lack of control on the supplier. They have act together on the whole toy industry and worst factories have been closed. But there are still problems of huge subcontracting not always managed by the buyers. Even if they ask factories not to do so, it is not always respected and sometimes they prefer not to know. Managing the supply chain is probably the key factor on that matter as well as consumer safety. To answer your question on Apple and Nike, as Apple has done nothing effective yet, they are still at risk. The last fall example of Nike been attacked for lower wages also shows they are still at risk. But in the case of Nike, an important part of their goods is properly managed and the risk is lower.

What can brands do together to make improvements? do brands work against each other?
In my opinion the most important thinks brands can do to make improvements is to stop to hide themselves the true. When an audit report is perfect, you have to wonder how it is possible. How can a factory be so different from the prevailing practice. Why (as it is the perfect factory) there is no a queue of 1000 workers waiting each morning to be hired. By accepting lies from factories brands are pushing factories to lie more and more and to invest on better lying system. There is automated IT system to generate compliant time records, wages… simultaneously as the real one. This is pushing to invest on non transparency. So if Brands were wanting improvement they should first accept the actual situation and starting from here instead of starting from where they want Asia to be. Then it would be possible to favor factories that really try to improve and not the one that looks like. So every brand that accept to work with lying factory is working against the ones who push for improvements

This afternoon I was asked by someone why I am involved in CSR and sustainability.  It is a question that I seem to asked frequently, but one that I am not sure I ever answer with any measure of clarity as I have worked in a very wide range of issues related to these big topics, and my interests for each issue hit me in different spots.

But, if there is one common thread that I feel binds each of the issues I work on (see a recent list of 35 projects I am managing through my class at CEIBS), it is that of responsibility… or the lack there of.

That, regardless of the issue under the microscope, at any one time there are up to 5 different groups that share a role and responsibility, and that should one of those groups fail to assume their responsibility, or should one of those groups act in a deliberate manner to upset the balance, then they are by their very nature irresponsible and are taking on a measure of risk to their person or organization.

If this sounds a bit alien, then think back to Nike circa 1996-1997 when the entire world was given a glimpse into the realities of Indonesian labor standard.  It was a classic case of a model that was unsustainable. Nike outsourced all their manufacturing to largely Asian owned/ operated contract manufacturers (still does today), but with little oversight or belief that they had any responsibility of the conditions on the ground.  It was a denial of responsibility that lead to a huge PR disaster for them, and they took win huge losses as consumers walked away from them in what I would call an act of consumeristic responsibility.

Fast forward to 2006 when the international press got wind of an issue related to the dormitory conditions of the Suzhou factory that manufactured Apple’s famed iPod.  It was a story that immediately became controversial as Apple and Foxconn tried to skirt the stories and admit no wrong, but ultimately Apple did send over a team of investigators to Suzhou who:

In response to the allegations, we immediately dispatched an audit team comprised of members from our human resources, legal and operations groups to carry out a thorough investigation of the conditions at the manufacturing site. The audit covered the areas of labor standards, working and living environment, compensation, overtime and worker treatment. The team interviewed over 100 randomly selected employees representing a cross-section of line workers (83%), supervisors (9%), executives (5%), and other support personnel (3%) including security guards and custodians. They visited and inspected factory floors, dormitories, dining halls, and recreation areas. The team also reviewed thousands of documents including personnel files, payroll data, time cards, and security logs. In total, the audit spanned over 1200 person-hours and covered over one million square feet of facilities.

.. and what they found was:

Our audit of on-site dormitories found no violations of our Code of Conduct. We were not satisfied, however, with the living conditions of three of the off-site leased dorms that we visited. These buildings were converted by the supplier during a period of rapid growth and have served as interim housing. Two of the dormitories, originally built as factories, now contain a large number of beds and lockers in an open space, and from our perspective, felt too impersonal. The third contained triple-bunks, which in our opinion didn’t provide reasonable personal space.

To address this interim housing situation, the supplier acquired additional land and is currently building new dormitories. These plans were in place prior to our audit, and will increase the total living space by 46% during the next four months.

It was a report, a process, and reaction that while initially grabbed some press, was  in the end chalked up to  just another problem that overseas brands faced when outsourcing.  As the Wired article Judging Apple’s Sweatshop Charge seemed to conclude in their assessment:

The situation is too murky for a rush to judgment on Apple’s ethics here, and it may well meet minimum global standards. But for a company that has staked its image on progressive politics, Apple has set itself up as a potential lightning rod on global labor standards. Sweatshops came back to bite Nike after its customers rose up in arms; and Apple can expect a similar grilling from its upscale Volvo-driving fans in the months ahead.At this point,

It is at this point that Apple appears to have been genuinely woken up, or at least rattled, because 18 months later Apple released its first supplier Responsibility report (download here) where the findings of a complete review were released.  It was a report that was opened with the passage below:

Apple is committed to ensuring the highest standards of social responsibility throughout our supply chain. The companies we do business with must provide safe working conditions, treat employees with dignity and respect, and use environmentally responsible manufacturing processes wherever Apple products are made.

For the past several years, Apple has required suppliers to commit to a comprehensive Supplier Code of Conduct as a condition of their contracts with us. We drive  compliance to the Code through an aggressive monitoring program, including factory audits, corrective action plans, and verification measures.

Apple’s approach to supplier responsibility extends beyond compliance monitoring. We also provide detailed standards and ongoing training support to help suppliers continue to meet our expectations. And by making social responsibility part of the way we do business, we ensure that suppliers take our standards as seriously as we do.

.. but, it was a report whose contents were shocking as more than half of their suppliers were not in compliance.  There were material issues that were across the board (as the graphic below shows) with overtime, wages deductions, age limits, and so on, and regardless of whether or not these could be explained away or were “problems of the past”, the fact is that Apple should have at this very moment stopped dead in their tracks, realized that they were sitting on a problem, and made changes.  Changes in their partner relationships, changes in the way they monitor and measure relationships, and changes in their attitude about who is ultimately responsible for labor abuse (and other issues of corporate responsibility) within one’s supply chain.  Outsourced or not.

Sadly though, their own internal document did not provide the “come to Jesus” that it should have and last summer, again at a Foxconn site, a 25 year old employee committed suicide after he was interrogated by Foxconn employees over the theft of a prototype iPhone.  an event that I covered in my article Apple’s China Supply Chain Issues Require IMMEDIATE Attention and Action, and believe to this day that Apple should have taken the following actions:

1. Contact Nike to learn lessons of how to develop an IN-HOUSE program that manages and monitors the factory conditions
2. Get boots on the ground.  Pay the money for a team of people who will make inspections and be given the power to make corrections
3. Invite in third parties to not only verify what Apple has found and done, but to give public credibility to the process in place
4. Do the right thing and begin making better decisions about who their suppliers are, and what is expected.  If the profit from an iPhone is 50USD, spend the extra buck now to do the right thing.  It is not an expense, it is an investment
5. Make materials improvements, or make materials adjustments.  Give suppliers a chance to change, but do not wait long.  Begin developing parallel supply lines and force suppliers to comply through the threat of lost business (partial or whole).
6. Open Up

Once again, this event would not serve as a learning lesson for Apple either (they largely skirted their responsibility of this once again), and 7000 employees of another Suzhou based supplier Wintek went on strike in May of 2009 over poor working conditions, and another 2000 employees again went on strike this week over working conditions and pay.   As the China Daily article Workers protest over pay, toxic chemicals highlights:

He said at least four workers had died from overexposure to hexane, a toxic chemical workers had been asked to use for cleaning touch panels manufactured at United Win (China) Technology Ltd Co. The company is a subsidiary of Taiwan-based Wintek Corporation, one of the world’s leading producers of small mobile phone panels and touch panels. [...] Media previously cited local authorities as saying workers had been provoked by rumors that the company planned to cancel a year-end bonus, which company executives later dismissed and promised to distribute before the Chinese Spring Festival that is less than a month away.

But Zhu said it was not just about the money. “What we feel angry about is the company authorities’ apathy to our workers’ health,” he said.

Unconfirmed deaths aside, the fact that employees are being exposed to these chemicals at all should have been something that Apple’s inspectors should have picked up on.  Unless of course the team of inspectors were outside to Apple’s process, and really had no idea what they should have been looking for.  Plausible?  But, if it was Apple’s team, then they should have been looking for this type of issue, and had they found a chemical exposure issue, they should have taken action right away to make sure that employees had the equipment (suits, ventilation, etc) to protect themselves from exposure.

It just begs the question.  Does Apple feel any real sense of responsibility for the conditions of their supply chain, and why is it that a firm that is trying to crack the China market so willing to risk so much?

Is it that Apple is ignorant of the fact that these problems exist? Is it that they believe the brand is impermeable?  Or are they just scared of standing up their suppliers?

It is a horrible miscalculation in my opinion, and when speaking to a friend this evening who is in the audit business about the situation we were stuck on why a company with Apple’s size and cash position wouldn’t spend the 2-3 million USD it would take to fix this problem.

For me,it is a sign that Apple’s model is broken.  That regardless of how well they are selling now, or what the next gadget will be, that they will at some point experience the loss that Nike did in the late 90s, or larger.  That while there seems to be little recognition of Apple’s supply chain issues in the U.S, and no sustained pushback in China, Apple is playing with fire.

It has clearly set up a supply chain that allows suppliers to structure their operations in a manner that exploits the living conditions of employees.

A structure that, getting back to my first point, will become an issue of economic sustainability for Apple.

One of the more interesting discussions I had last week was surrounding how one (a firm or an individual) could position themselves against China in the markets. That, if one believed, China’s economy was in a bubble – and that the bubble was going to pop – how would one position themselves favorably.

It was an interesting discussion as the person I was speaking with historically would have loaded their portfolio with short positions on those he thought would be the first to fall. In China this option is largely negated by the fact that you can’t short Chinese stocks in China, and that there aren’t really enough firms listed overseas (or at least not the right ones should the fit hit the shan).

Typically a topic I would avoid on All Roads, I figured it was worth a post as the “recession” seems to be over, people are turning back into good consumers, but then there was an article that forced me out of my cave. So, in my first random act of amateur journalism, let’s get right into it and take a look at the Pulitzer prize winning author Thomas Friedman’s latest article  Is China the Next Enron. Friedman, , who is a leading expert on war, globalization, global warming, and NOW US/ China economic structures, writes a piece that questions the logic of James Chanos who recently said that China is “Dubai times 1,000 — or worse”, and he offers up two gems of advice for Mr. Chanos:

First, a simple rule of investing that has always served me well: Never short a country with $2 trillion in foreign currency reserves
Second, it is easy to look at China today and see its enormous problems and things that it is not getting right. [...] I am reluctant to sell China short, not because I think it has no problems or corruption or bubbles, but because I think it has all those problems in spades — and some will blow up along the way (the most dangerous being pollution). But it also has a political class focused on addressing its real problems, as well as a mountain of savings with which to do so (unlike us).

Now, correct me if I am wrong, but neither of those have ANYTHING to do with the real estate market, and while I would agree that having 2 trillion in reserves and a focused government help, perhaps Friedman is just a bit overly optimistic about China? or perhaps it is just that he is so pessimistic about the US that anything looks better?

The second half of his article gets even better as he lays out WHY China is long term in the stronger position. Having lunch with some students from HK, he comes to understands (not sure if this is a watershed moment for him) that China’s sea turtles are retyrning home (note: a sea turtle in Chinese is someone who goes abroad to study, perhaps work for some time, and then returns home), and that the represents a long term advantage for China:

One of the biggest problems for China’s manufacturing and financial sectors has been finding capable middle managers. The reverse-brain drain is eliminating that problem as well.

On this point, I would agree, but I would also say that this belief that all sea turtles are coming home is not only false, it is misleading. Many are only returning because there is an opportunity right now, but few that I have spoken to plan on staying in China forever. This is, for many (not all), a short term proposition, a feast of you will, where everyone is trying to get their piece of the action and then go home with as much fat sotrage as possible.
These are not people returning to the “motherland” to build the nation, and that is the flaw in Friedman’s belief.

Friedman wraps up his article with the following assessment on a China Short:

“So I asked several Taiwanese businessmen whether they would “short” China. They vigorously shook their heads no as if I’d asked if they’d go one on one with LeBron James.”

.. damn, he is a good writer, but is he write? (UPDATE: Read this post by Barrett Brown who really tears into Friedman)

In short, no.  I think that Friedman’s analysis is flawed, his sourced (based in TW and HK) are the wrong ones for the story, and there are signs that I would say present a concern for many.  Including Chinese leaders, banking officials, and those in commodities.

At the heart of it for me, the main issue I see everyday, the low hanging fruit, comes in the form of real estate.  Walk down Huai Hai road, Nathan in HK, or visit the latest SOHO project in Beijing, and you will see that retailers are turning over.  A LOT.  Some will say that it is a heathy sign of an economy that there is turnover, and typicallly I would agree, but at this time what I am seeing instead is a phase where established retailers are closing shops and landlords are offering up firesale deals to fill spots.  Spots that vacate after 4-6 months becuase the concept did not work.  A condition that is not limited to a single store, but to entire blocks.

Looking a bit higher, and moving  bit further from the inner ring roads, and it becomes clear that the next real problem is in the vacany rates in all the recent commerical and residential buildings that have been built.  18 months ago, these projects were DEAD. Cranes were idle. Trucks were not moving. Workers were clearly on a siesta.  Then, 9 months ago everything changed over night (hello stimulus!) and my entire district become a construction pit with 24/7 dump trucks going down the road, cranes whirling steal beams around, and migrant laborers flowing back into the city.

It was a period of manufactured economics, and it has created a condition where many supporting industries began to find themselves in a situation where there was more capacity in the market than demand.  Everyone rushed in for stimulus money, and with that largely drying up we are looking at some very interesting times as China’s banks (who issued the largest proportion of the debt) will now be left to collect on that money.

This was just one sector of the domestic expansion that was inflated to offset the export market deflation.  there are others.

Which leads me back to how I would place a short on China.

For me, China has been a market that offered a diverse number of opportunities for years, and while there may be a move from low to high end, the fact is that the leading indicators of this economy are still (and going to be for a long time) in the raw materials  sectors.  Ore. Coal. Metals. Oil.

It was in the immediate aftermath of the financial crisis that these prices plummeted, and it is in recent weeks following the snow storms that we saw an equal inflation in energy inputs.

So, that is where I would start (were I one to believe that the economy was about to double dip).

Next, I would look at the stocks overseas of firms who service these sectors – Autralian resource firms, American construction equipment, bulk logistics, etc – as candidates, keeping in mind that there are some who are more exposed than others

Finally, and this option is the option that should only be exercised were there be a serious meltdown…  look at all those companies who saw China as their holy grail market.  Easy to identify, if there are firms who are counting on China to return 30-40% of their future growth targets, then their stocks are going to get hammered.

Now, all this being said, would I short China at this point, and are there areas of growth that I see going forward?  I am an optomist by nature, and while I would not short China on a broad base just yet, there are some stocks that I am pretty sure are rip for a reduction in growth expectations and are certainly candidates for a reduction of their share prices.

So, that wraps up my first post for the year.  Hope you enjoyed it.

Earlier this week I received an email titled Five Pitfalls of Metals-Based Sourcing from old friend Lisa Reisman of Metalminer (her husband Jason writes Spendmatters) where she laid out what she sees are the five essential mistakes people make when sourcing metals in commodity form.

1. Misreading the supply market can result in the placement of large resting or standing orders as prices decrease, or in failing to place large, timely orders to avoid price increases.
2. Using a 3-bid monthly buy. Here the buying organization believes it has purchased at or below market because it went with the supplier who offered the best pricing and terms on a monthly basis, for that month’s orders. But bidding on a monthly basis is almost never the best lowest total cost option. In fact, we’d go so far as to say that companies that deploy this practice, nearly always have a substantial cost-savings opportunity available to them.
3. Failure to implement index-based buying strategies. The result here is a lack of visibility into the actual costs that comprise the delivered price.
4. Assuming that a buyer’s size or reputation guarantees that it receives the best price. Without using data to validate its assumption, the buying organization believes that because a particular supplier has been a “partner” for many years and receives $Xm of business from a customer annually, the supplier must be supplying at “better than market” prices.
5. Making purchases by unit or each, rather than by weight. There are a couple of exceptions where this practice is advantageous, but it generally is not. We have seen instances where suppliers/producers “ship light” selling metal on a unit cost basis that results in the buying organization overpaying for materials. Moreover, buying on a unit or each basis can prevent the buying organization from seeing the true costs (such as the raw material and the fabrication costs) that make up the total price.

It is a piece that is backed up by her recent white paper (download here), and I have a few comments on the above based on my own experience.

1.  Her first observation is spot on.  There is a lot of speculation in the market about the true source of demand for metals, and there is plenty of evindence to suggest that a lot of recent demand driving prices up is artificial (investors and mis-allocated funding from SOEs).  It is a dynamic market that has seen large swings in pricing, and while opportunities to buy on the dips exist for manufacturers/ traders, if one were a commodity trader the market could easily swing against you.

For myself, the last 6 months were a great time to stock up.  AL pricing was off nearly 50% from the highs of 2 years ago… and there was space in the warehouse.

2. This is an observation that I would say largely depends on the purchase cycles, sizes, and needs of the buyers.  3 month averaging is a great way to flatten things out, but if you were buying at 24,000RMB/ ton 2 years ago and it is swinging from 13,000 to 16,000 now, then perhaps some firms may find going to a month to month or spot market advantageous.  Especially if holding cash, and are willing to store for a few months

3.  Totally agree. For our largest client, we actually provided a spreadsheet where current RMB and metal pricing could be changed, and the final landed price would appear.  they really liked that level of transparency.

4. Without knowing the spot market prices in China, companies are in the dark, and trusting someone else to manage a commodity purchase in the blind is just asking for it.  Firms need to play an active role in managing these commodity costs, especially if the order sizes are significant.

5. This is an area where my experience differs a bit.  We have largely used per piece pricing, but we have people on the ground checking for quality and cross counts occur at multiple steps in the process.  Were we an offshore buyer with no one to count, then I would agree..  however, then the issue of alloys can easily become an issue, nd weights can be fudged.

Anyone else out there have a similar/ different experience to report?

Check out MetalMiner for more.

While it has been 2 years since Lead Paint Barbie hit the store shelves, I have seen a flurry of related activity over the last two weeks. From books on “Made in China”, to two Posts at China Law Blog The Six (Not Five) Keys To China Quality and Six More Keys To Quality Product Made In China., and wrapping up with another recall.

A recall whose roots are in poor design, much like those 18 million magnets that forced Mattel’s recall, and are now bring out the entire “Made in China” quality fade debate. The specific product that is forcing the recall is a plastic nail that is about 3 1/4 inches (7.6 centimeters) long

The Little Tikes Co. is recalling about 1.6 million toy workshops and trucks, after an 11-month-old boy got a plastic nail lodged in his throat.

… and to make sure they cover their bases, they are recalling 15 years worth of product!!

Now, I do not want to take anything away from this boys pain, nor do I want to suggest that brands like Mattel and Little Tikes do not have a responsibility to design products that cannot be swallowed, but I would like to once again What Level of Product Failure is Acceptable?

Is 1/1,600,000 a percentage that warrants the return of the remaining items?

If yes, then does it make sense to recall the entire set, or should (in the name of waste management) Little Tikes simply tell parents to mail in the nails for an exchange of a new product?

Over the next few weeks, look for more on this. Following my read of “poorly made in China”, my brain has been on fire over the subject. It is one of those books that offered an opportunity for me to see things between lines … and I will be putting together a series of posts focused on the myth that is quality fade, the underlying issues, and some strategies I have for minimizing supply chain failures.

A lot of discussion surrounding the recent metals/ materials pricing volatility, and China’s role in driving that volatility.

Many of the recent reports I have seen seem to indicate that the purchases (and imports) of raw materials are a good sign, a sign that China’s factories are turning the light back on as a result of increased orders. Other reports take an entirely different approach by pointing to stockpiling of materials, stockpiles that will take years to work off and should be viewed as a sign of inefficiency.

It was a topic that we myself and several others discussed last week as part of our What if beers, and after come further thought, and through this post I wanted to offer up some different theories.

Before I do that though, I thought it best to frame the issue a bit with some other unrelated discussions I have been having, discussions that I believe show the manufacturing economy is not the driver. The first discussion was with a member of the risk consultancy community last week, a person whose business has seen the number of factory closures increase over the last year and says are still ongoing. The size and breadth of the closures was still fairly unknown to them as their clients were those who were not locking the doors and skipping town, but were large enough to be negotiating upfront, and it was clear that the numbers and the firms involved were not insignificant.

The second conversations were not really a conversation, but and emailed response to a question I sent to two friends of mine inside large global logistics firms… “howz business” . The first response… “DEAD”. The second response… “Inventory replenishment orders not occurring as hoped for… bad”. That was all I needed to know that despite the recent upturn in Shanghai’s port figures, that the logistics industry was clearly not seeing an increase in containers, and that (as I have written about before) was an indication that the manufacturing economy was not back on.

So, what is causing the surge in metals and materials? Why are Chinese firms importing these goods when the demand for their processes/ finished goods has not returned?

Here are a few of my theories:
1) Speculation – First, quite clearly there are a number of groups who see this as a chance to speculate. Many of the commodities that were at all time highs last year have seen their markets fall out from underneath them, and that leads some to believe that investing in these assets will bring returns… once the economy pops back.

2) Counter inflationary investments – The inflationary issues that China faced during 2007-2008 with inflation, were issues that nearly brought parts of the country to a standstill. Oil was in short supply, coal was unable to make it to producers, metals prices were reaching the stratosphere… and China’s competitive postion as low cost leader was being questioned. IT was a condition that lead to the central government putting up the money and infrastructure for a strategic oil reserve, but it was the bottoming out of oil that lead the reserves to be filled up 9 months early. That, in short, with so much cash on its hands, counter inflationary stock piles can be built so that if there is a run up in prices the stock of cheap supplies can be used.

A tactic that only China could pull off right now, and a tactic that could give Chinese firms a significant advantage going forward as the industrial machine overheats again.

3) They have nothing else to do with the money – During the recent round of beers one of the participants said that as part of the government stimulus “Banks have a responsibility to loan money, and firms have a responsibility to spend it”. the problem was, as we all agreed, that we were not seeing the money spent in the ways that one would hope for. That the massive expansions in operations and investments have not been occurring, but leaving the money inside a savings account is going to do no one any good either. The traditional asset markets (real estate and equity) have already seen a huge run up in the last 12 months, and so these goods are seen as a way to park their cash for a while and perhaps make some money.

For me, while the first theory is the one that the Chinese government is most concerned with (due to its tie to hot money), it is #2 that I find most interesting as the implications could be significant in the context of global manufacturing.. and it is this one that I will keep my eye on as it will potentially have the greatest impact on the real economy.

If anyone else out there has other theories, feel free to post them in the comments section.

Last week’s Newsweek article Generic Giants: Why China Can’t Create Brands took a stab at answering the question many have been asking: Whee are China’s brands.

It is one of those debates that has been ongoing throughout the duration of my time here, and is usually partnered with the equally unanswered question. When will Chinese firms begin acquiring foreign firms in mass.

China is famous as the factory to the world, but even its best companies enjoy little if any fame. That paradox has become a vexing problem for China’s leaders. The nation is now too rich to continue growing at a double-digit pace by simply putting more peasants to work in factories, and then underselling its Western, Japanese, and South Korean competition.

The article provides some interesting examples of brands, Huawei and Haier, that have done well globally but have yet to establish a “brand”, while at the same looking through a wider angle:

The simplest explanation for China’s failure to build global brands is cutthroat domestic competition. In most product categories, hundreds or thousands of firms compete for domestic market share, leaving profit margins razor thin. China has 150 firms licensed to make cars and other motorized vehicles, and more than 500 bicycle manufacturers. And because foreign brands have taken much of the market’s high end, most companies are forced to compete on cost, leaving little room for investment in R&D or marketing. China’s weak protection for intellectual-property rights—the patents and ideas that are the solid core of any brand—makes it risky for companies to invest heavily in innovations that could make them famous worldwide but could easily be stolen by rivals at home. Finally, the recent string of product recalls—including poisonous pet food and faulty tires—has left consumers wary of made-in-China goods.

A theory, that when broken down into bit size chunks offers insight… and perhaps room for improvement.

1) Domestic competition
Name an industry, and what you will find is that the market is highly fragmented. That, 150 car firms, 200 solar panel firms, 80,000 logistics firms, are all trying to make their mark on “China”. It is something that I have seen over and over and over again as I have mapped out competitive landscapes in China, and without exception, the most interesting dynamic within these industries is just how fast things change.

Yes, the industries are fragmented, but to say that this inhibits anyone I believe fails to account for the fact that of the 150 of the auto firms, only 10 have a China brand, and than of those 5 are poised to become global brands within the foreseeable future. That, like a pachinco machine, many industries are seeing rapid funneling of firms. Firms that are being forced to compete first at the village level (live or die), city level (live or die), Provincial level (live or die) , regional level (live or die), the national level (live or die) and then at the global level.

Barrier certainly include cutthroat competition and margins, but more importantly it comes down to each firm’s ability to develop markets that are foreign to them, even if they are a single province over. A process that includes being able to market, distribute, and service a market at a level of quality that improves the brand image.. and in a manner that can then be scaled out.

As an example, looking at the logistics industry, there have been several firms that have done this successfully, that moved from local brand, to regional, and are developing their national brand. Kerry logistics (HK based), SF Express (Shanghai based), and others have slowly been creeping across China developing partners, buying up assets, and branding all along the way.

2) Foreign brands owning the luxury market
This is also an issue that many of my clients have faced, and has always provided some of the most interesting conversations as foreign clients have looked to leverage their luxury position and hit the middle market.. realizing that their Chinese competitors were looking to leverage the middle ground to rise up and capture the positions foreign firms hold in China, and abroad.

Again, in the current market, there is no denying that the foreign brands still own much of the luxury and top of the middle markets. Due in large part to their quality of products, marketing campaigns, stronger cash positions, and management prowess, we have see firms like Porsche, GUCCI, and San Pellegrino sweep across China.

The fact that these products exist and own the market is a bit of a head fake as the author assumes that their were (1) Chinese Brands capable of competing at this level (2) that foreign brands capturing the market is sustainable and most importantly (3) that the luxury market is what matters. That, while many foreign firms may see the luxury market as their market, Chinese firms are focused on developing products that provide profits in volumes.That , while the 100 million or so who are able to consistently afford luxurious lifestyles, it is the 400 million or so (and 600 million more to join) that are buying mid level brands that are more interesting to them.

.. and, more importantly, that those billion customers will provide the profits they need to afford to build a luxury brand of their own. Or at the least afford purchasing one of their own.

3) Domestic IP Protection & “Made in China”
Externalizes to the economists and process that many firms are working with to develop brands, I have brought these two together as I see neither as a true barrier to developing a global brand. FAW, Shui On, Huawei, and other national brands have all had their issues with IP theft, but none of those would say that it limited their market potential on the national or global level anymore than the recent release of the Geely GE does the Rolls Royce Phantom.

Many fakes and ripoffs in China are known to be fakes (note: food and pharmaceutical industry are an obvious exception to this), and firms that are ripping of the larger brands are doing so because hey have been incapable of developing their own products, have not developed a sustainable competitive advantage, and will more than likely will fall by the wayside as the national firms marginalize their products through more sophisticated products and marketing.

Other thoughts:
Outside of the above, there is one question that was surprisingly unaddressed. do Chinese firms really want to compete on the global stage? Do they want to have global brands at all, and if so… why?

Sure, there is nothing that will sell papers than a decent trade war, or brand competition, but does that make it true? Referencing the author’s own words:

During a Guangdong road trip in April, Wen called the crisis an opportunity for Chinese firms to innovate and expand abroad. Beijing has ordered state banks to make tens of billions of dollars in loans available to firms eyeing the global market.

A statement that leads me to believe that Chinese firms, some who have developed capabilities, are simply not interested or enticed even with money being thrown at them. Which leads me to the next question.

Why aren’t Chinese firms interested in developing global markets?

the recently released 8 page report Manufacturing in China Opportunities in a competitive market (download here) is the first in a series of regular reports from AMCHAM, and it is well worth the read.

A report that draws on AMCHAM’s large membership of firms operating in China, its Small Manufacturers Business Council, and Booz & Company, the opening statement says it all:

Regardless of when China’s economy recovers, it is clear that the manufacturing landscape for foreign-invested companies has changed. Focusing on China only as a provider of low cost labor for exports is unlikely to be a winning strategy moving forward. With increasing competition and continued rising costs, implementing industry best practices is no longer an option but a necessity.

Perhaps more than any other report I have seen to date, this report presents what companies are experiencing on the ground and uses that as the foundation for putting forward their recommendations:

• Develop a strategy to capitalize on the continued growth of the middle class while reducing dependence on export markets by moving beyond the premium segment and down the price/performance ladder.
• Develop new business models for the domestic market and tailor current products to meet local preferences and conditions.
• Align manufacturing and purchasing strategies and link local activities with the extended global supply chain to build and capture economics scale and scope, harnessing the duality of China in the process.
• Continue to invest in manufacturing best practices to take advantage of “latent productivity” that exists in most operations to offset rising costs.

Now, none of this is particularly new to firms who have been in China for a while (I remember being at an event 5 years ago where the majority of attendees (250+) were selling into the China market), but the report does add some perspective on the fact that while many of the largest firms in the world are no longer able to leverage CHina as an export base.

A message perhaps that the central government would find more interesting than the average reader?

One of the more interesting comments, and one I had not heard before, was this:

Even with the current economic conditions, manufacturing in China has become more expensive. Companies reported that costs are still rising – up to 15 percent in 2008 compared to an increase of 10 percent in 2007 – particularly in compensation costs for management, support staff and blue-collar workers as well as raw materials. Although labor and raw materials costs have come down from the premium levels of last summer, they are expected to rise again once market conditions improve.

Keeping in mind that there has been a run up recently in raw materials (primarily from China building safety stocks), I found the staffing costs very interesting, and would be very interested in seeing if this is a function of firms paying more to keep staff, paying layoff packages, or simple business as usually merit raises.

News of a 25 year old committing suicide at Apple’s primary China supplier (Foxconn) has once again brought to the front burner the difficulties of managing outsourced operations, and the risk to the brand that these arrangements bring when improperly managed.

It is a situation that sadly I believe could have been avoided, and that unlike the 1997 Nike scandal where it took NGOs and the media to highlight the problems (for the first time), labor problems – particularly with its supplier – are neither new nor unknown.

Go back 36 months, when news (and pictures) hit the wires that Apple’s Suzhou supplier (Foxconn) was improperly housing employees, forcing overtime, and paying poor wages. A huge story for both the domestic and international press, Apple responded very quickly by sending their “crack” team to investigate the allegations. Allegations that ultimately Foxconn and Apple would own up to, almost.

However, more recently, signs that Apple’s China supply chain were really in poor shape came through another report that one of their suppliers, Wintek, was wrapped up in a number of disputes and strikes over labor conditions.   Conditions that violated Apple’s own Code of Conduct.

The most recent warning sign came in the form of Apple’s own internal document the release of the Supplier Responsibility 2009 Progress Report (download here) where the following highlights went public

45 of the 83 factories that built iPhones and iPods in 2008 weren’t paying valid overtime rates for those workers that qualified, while 23 of these weren’t even paying some of their workers China’s minimum wage.

A deeper look at Apple’s findings found that about 25 of the 83 also discriminated to some degree against people based on ethnicity, biological issues like disabilities, or political leanings. 22 didn’t meet environmental standards, while almost exactly a fifth also had problems with on-site living conditions and safety.

It is quite simply a report that should have set off an all hands on deck response in Cupertino, and were the press not obsessed with the health of the Dear Leader, perhaps the release of this document would have been a leading story.  Instead, it largely passed under the radar, and over the last few days we have come to see how poorly Apple assessed the risks and severity of the problems.

I by no means want to imply that had Apple taken steps beforehand that this situation would have been avoided, however I think it is important to point out that through its own issues in 1997, Nike began putting 1 full time inspector on site of factories.  inspectors who were independent of the supplier, an moved on a regular basis.  Suppliers who were the eyes and ears of the corporate, and could alert HQ of issues and manage the programs meant to minimize code of conduct infractions.  Infractions that Nike still admits openly it struggles with.

Apple’s consistent issues are a problem that goes far wider and deeper than a single guard, and like Mattel’s paint line, is in need a change. A systematic change.  A change that will be difficult, as they have completely outsourced all operations, I have a few suggestion of where I would start:

1) Contact Nike
Why contact Nike?  simple.  Nike and Apple are essentially one in the same, they are design and marketing firms who rely on others to bring their designs to the market.  At the same time, they take no equity stake in these firms, and like everyone else who outsources, are focused on the bottom line.

So, by contacting Nike to learn lessons, Apple will essentially be reaching out to a peer who has been through the same things.

2) Get Boots on the Ground
Simply allowing their suppliers to “manage” things is at this point negligent at best, and perhaps criminal.  Their own code of Conduct is simply being breached on a regular basis by an unacceptable number of their suppliers, and they need to take the reigns of this wild horse.

So, get inspectors from Cupertino on the ground.  NOW.

3) Invite in third parties.
Clearly Apple needs assistance in the process, and firms like Business for Social Responsibility would bring a significant amount of experience, independence, and credibility to the issue. Quite simply, at this point, whey would anyone trust another Apple report, and more than that, what is the risk that now external agencies, NGO, and media are given the access now (think Indonesia).

4) Do the Right Thing
Foxconn is not the one on the firing line, Apple is.. and it must make sure to either hold Foxconn’s head to the fire, or take the bullet themselves because in the end, it is Apple that lawyers will sue, that reporters will write up, and consumers will boycott.

5) Make materials improvements, or make materials adjustments
Going forward, breaches must end.  Period. Otherwise, Apple will need to look at being a manufacturer again.  That,while manufacturing is seen as expense by investors, the point will be made that the risk of brand damage will need to be made.

That it is a much better use of money to bring it inhouse vs. burning down the house.

6) Open Up
Apple’s previous life as the introverted firm with cool stuff is over, and like Nike, it will have to open itself up.

Managing global operations is not an easy task, and while this post is focused on Apple, the point that this could have happened to anyone needs to be made. 2 years ago, when we were in the middle of the “Made in China” crisis, I made the same point, and at the core the issues behind both are the same.

It comes down to investment. Investing in a process. Investing in people.

That treating China like a McDonald’s drive-thru is not sustainable over the long term, and regardless of whether or not breakdowns occur in China, the fact that breakdowns do occur is not a “China” problem.