THE UNITED KINGDOM OF CHALCO
State-owned enterprise reform is notoriously hard work. CFOs pushing forward the painful process of reinventing their companies require a combination of both sheer determination and courage.
By Percy Zhang

Chen Jihua, CFO of Aluminum Corporation of China (Chalco) is a medium-sized, stout, straight-talking guy - his pet phrase is: "In confrontations, the fearless come out on top". A far cry from your typical cultivated, soft spoken, and sensitive CFO, he never resorts to ambiguous language even with sensitive topics. When he gets excited over the work he has proudly done, he moves his arms and hands rigorously. He is a strong character, sharp and determined - perhaps a character like him is required to deal with the huge job he has assumed. "Capability-wise, I might not be the most brilliant guy. But I am the right one." That's the verdict Chen gives for his work over the past two years. In May 2001, Guo Shengkun, Chairman and CEO of Chalco, handed him the CFO job, along with two big tasks. The first one was to list overseas. "The Chinese might not care, but not the foreign investors - they expect a 'suitable' CFO at Chalco," says Chen. "Morgan Stanley and CICC (local investment bank China International Capital Corporation), which ran our IPO, also demanded no less."

The second task was consolidation. Two years after Chalco was listed, Chen says: "That is our family skeleton. In fact, when we came to the stock market at the end of 2001, the corporate reorganization was not complete. It was still an association of powerful regional lords. No consolidation, no Chalco of today. That was a hell of a job, and we have encountered incredible resistance."

IPO first, a real company later? The story goes back to the origin of Chalco. .

Will of the Matchmaker

Chalco was listed simultaneously on the Hong Kong and New York exchanges in December of 2001. In fact, there was no such "Chalco" until early September of that year. Chalco is the abbreviation for Aluminum Corporation of China, incorporated on September 10, 2001. Its entire assets came from the Aluminum Corporation of China (Chinalco), itself formed only on February 2001. The predecessor of Chinalco was Non-ferrous Metal Controlling Co of China, which managed the industry on behalf of the State, and which was subsequently restructured to become an industry association.

The Government cherry-picked the 12 biggest, relatively well-managed alumina, primary aluminum, and aluminum processing companies to form Chinalco, while the remaining companies were left to be managed by provincial governments. Chinalco then injected into Chalco the businesses and assets "all related to the production and sales of alumina and primary aluminum". They were scattered all over China and given the names of their provinces. Before a series of reallocations of the management of State shares, these companies were de facto independent "warlords", operating as independent legal entities controlling large numbers of employees and assets usually running into billions of renminbi. They were the pillars of their local economies, and senior management had close ties to local governments.

All this needed to change when the government formed Chalco and decided to take it to market. The government believed that the aluminum industry in China was too fragmented. Its leaders wanted to see consolidation and economies of scale - an integrated national aluminum industry that could compete globally. But consolidation on such a large scale, pushed not by market forces, and not of the free will of the participating companies, was destined to be unromantic. As soon as the preparation for listing got underway, Chen smelled unfriendliness in the air.

Despite vigorous protests from the provincial heads, Chalco listed in Hong Kong and New York at the end of 2001. But Chen knew it was only a start. He recalls: "We were not even a company in its true sense. For example, at the time of listing, Chalco had yet to complete a separate taxation registration."

The long anticipated consolidation started three months after listing. The first step was to cancel the independent legal entity status of the provincial companies, which then became Chalco subsidiaries. Fierce resistance came immediately, as the provincial heads felt emotional about losing their kingdoms. "Conflicts were intense," says Chen.

"They were demanding a retention of the original company names. Even if they were no longer independent companies, they did not want to be called subsidiaries. But the Industry and Commerce Bureau said that non-independent legal entities had to be called subsidiaries." Support from central government played a key role at the time, and Chalco senior management demonstrated its determination. In the end, the smokeless war ended with a series of heads rolling - the general manager of Guizhou Aluminum was reappointed as secretary of the Party Committee; the general manager of Qinghai Aluminum was transferred to Beijing; and the general managers of Zhongzhou Aluminum and Great Wall Aluminum were dismissed. Vacancies were filled by new blood. This thunderstorm shook the entire aluminum industry and laid a foundation for the next stage of management consolidation.

Strategy 1-2-3-4-5

It has become a Chinese custom to use numbers to epitomize certain key policies. Government and company leaders alike have adopted the practice. Chalco is no exception. Its new management model is called 1-2-3-4-5. The first three numbers are the most interesting: 1 stands for one management center (the headquarters); 2 stands for two business operations (alumina and primary aluminum); and 3 stands for three management levels (headquarters, strategic business units, and subsidiaries).

Under the 1-2-3-4-5 model, the former warlords gave up their final shreds of control. Losing their independent status had been like depriving mandarins of their hat and fanciful accessories. But the model took away their free hand in allocating and using resources, which had brought them direct benefits. Chalco CEO Guo decided to use finance as a weapon to deal with the problem. Chen puts it bluntly: "Financial management is a sharp knife; I'll use it to cut."

Chalco, as a single entity, took on sales as well as procurement of main raw materials, and each subsidiary became a production cost center. That is, they became true plants - they could no longer allocate any physical or financial resources directly. There was no need for them to consider financing, business strategy, or even financial settlements.

In May 2001, Chen hosted what he called the "New Era" financial work conference, and announced that he would reform Chalco's financial management system along the lines of international standards for public companies. Financial functions of all subsidiaries would report to him directly to be managed by the headquarters. Subsidiaries would not be allowed to have their own cash reserves, nor would they be allowed to seek external financing. Chen implemented a comprehensive budgeting system to control and monitor subsidiary operations. He hardly finished his speech before being challenged. Someone asked: "You do not allow us to borrow? We can borrow at 4.8 percent while your rate is 5.4 percent. That surely is more expensive?"

"What was I going to do, with so many people around?" Chen looks like he is still in that meeting, with many pairs of eyes staring at him. "I said, 'Anyone who gets an interest rate lower than mine, I'll let him take my job." Eventually the pledge did not force him to resign, for he got the lowest rate. "I represented the whole of Chalco to negotiate with Construction Bank of China. How could it be possible that I got a higher rate than what the provincial bank could offer?"

The reason Chen made the gamble, apart from the pressure of the circumstances, might be his personality. Guts, to Chen, is the most important quality for doing the consolidation job under the circumstances. "Chairman Guo is a strategic guy. In addition to his insight into business strategy, the decision to have me as CFO shows his wisdom," says Chen. "I found out later that many people were suspicious about me. Besides the fact that I was an 'unseasoned guy', they asked, surely we could find a suitable guy among Chalco's 16,000 employees? Why did we have to parachute someone?"

Chen's resume does seem unremarkable, considering the big job at Chalco. He graduated from a little-known college in Anhui. Though he got his Master's degree from The Central Institute of Finance and Banking, he never studied overseas. From 1993 to 1995, he worked for a security rating company, and later became CFO of Red Bull Beverage, ADJ China of Saudi Arabia and Jitong Communications, none of them a cool Fortune 500 company. What's more, Chen was only 32 when he became Chalco CFO.

"Looking back, it was really wise to parachute me to Chalco. Why? Because I had no strings. That's very important. And I am the type of guy who does what he believes is the right thing to do," says Chen.

Talking about these things, Chen sounds more like a general just back from the battlefield. His language might not be graceful, but one can acutely sense the battle of wills in the consolidation process. "I said to them quite openly, 'You want to fight with me? Let's see who is more ruthless.'" Here Chen changes his tone and says: "I was quite clear I was going to prevail. First, I am company leader. Second, I was doing the right thing. Third, I had support from above. People who fought with me knew, if I lose, I leave. With my experience, I can easily find a new job. What about them? They have been in their positions for decades. They cannot afford to lose."

Makeover

The next step, in 2001, was to introduce a corporate-wide budgeting system, under which the headquarters would allocate capital resources to the subsidiaries. Unsurprisingly, the implementation of this process was far from plain sailing.

Says Chen: "They (the heads of the subsidiaries) asked me, 'If you control all the money, what am I going to do if things suddenly come up?'" The aluminum industry is a scale business, and the subsidiaries of Chalco are scattered geographically and are in very different situations as far as production is concerned. Central control of capital might indeed cause delay in material procurement, and therefore a pause in production.

To prevent losses like this Chen adopted a "credit card" strategy: each subsidiary would propose a capital requirement plan based on its own judgment. Headquarters assumes the plan's "credibility" and approves it. However, the credit is limited and cheating will be punished. "Credit needs to be used up. If your actual demand is RMB400 million, but you apply for RMB500 million, we will immediately find out," says Chen. To him, budgeting is closely linked to transparency. "Comprehensive budgeting will make information transparent. 'If you feel alright and reasonable asking for the money, I have no qualms giving it to you. If that is the case, there is no need for any concealment,'" he says.

To have transparency in information, Chen also asked subsidiaries to use "cash cost" rather than "accounting cost" when submitting plans and reporting operating financials, since subsidiaries are treated as production cost centers. He believes that cash cost without accounting treatment such as depreciation and amortization can reflect operation reality more directly. "Cash is core to financial management," says Chen. "I can see clearly what is going on. For example, if the product costs RMB100 per ton in cash but you ask for 200, I will ask why. When at the end of the year we know how much has been produced, we will also know how much should have been spent."

The authority of the finance department in information helps internal governance. Cost numbers provided by the finance department are the foremost performance indicator in assessing subsidiary senior management. This performance indicator is linked to a "cost incentive". When actual production costs in subsidiaries turn out to be lower than budgeted, management gets a percentage of the savings. If the reverse is true, their compensation can be reduced. The basis of this incentive scheme is unquestionable, authoritative, and reliable financial data.

The problem Chen has had in the past two years is in defining a reasonable "budget target". Usually it is reached through painful and prolonged negotiations between headquarters and a subsidiary, in which one party tries to manipulate information for more bonus, while the other fights for cost control. Chen, with characteristic aplomb, is trying to solve the problem his way - an idea called "cost target auction". He explains: "I have on my table apples of different sizes (cost target), there are candies (compensation) in the apples. There are big candies in big apples and small candies in small apples. I am not arguing with you how big the apples should be. I decide how many candies to put in how big apples, and you pick the apple you want."

Once decided, the budget cost target is not subject to adjustment. All the operating risks related to cost have to be taken into consideration by subsidiaries at the "cost target auction". As production cost centers, subsidiaries are responsible for both financial results and cost risks.

Part of Something Bigger

There's a saying that bitter medicine can have good effects. Almost two years have passed and financial management in Chalco is now very close to the preset target. Unit cash production cost of alumina keeps going down - by nearly 16 percent over two years. The production cost of primary aluminum has fluctuated, but is still down by 10 percent. Management cost is also down, by 19 percent. These prove that in a short period Chalco has achieved a big step forward in management standards. Yet, it is also obvious that Chalco's economics are very much susceptible to the price fluctuation of its products. Net profit goes up and down with the raw material prices of alumina and primary aluminum. The fluctuations can easily offset any achievement through internal improvement.

Even so, at least for the moment, the lucrative domestic alumina market is enough to convince the capital market of Chalco's prospects (Chalco raised the price of alumina again last December to RMB3,700 per ton, the seventh consecutive price rise in 2003). On January 6 of this year Chalco accomplished the biggest second-round equity placement in Hong Kong and raised US$400 million, with which it plans to expand its capacity in alumina production.

And it is only a small part of Chen's grand plan. Chalco's CFO is pretty sure that in the foreseeable future - up to 2010 - all Chalco's planned production plus that of potential competitors will not be enough to satisfy domestic demand. Local and foreign professional institutes endorse this view. Wang Feihong, senior analyst of Antaike, a local information provider on metals, says: "That is indeed the industry consensus. The development in construction, transportation, and packaging sectors is creating huge demand for electrolytic aluminum, and consequently the demand for alumina."

Adam Rowley, an analyst with Australia's Macquarie Bank points out that with regards to international supply, some overseas companies are adjusting their capacity with an intention to supply spot alumina to the Chinese market.

Alcoa, for example, recently closed several production facilities for other products, in order to use them to produce alumina for shipment to China. On the other side, he believes that "since most of the capacity of international manufacturers is locked via long-term contracts, spot supply to China will still be very tight."

In contrast with the competition from overseas suppliers, the emergence of domestic competitors poses a more realistic challenge to Chalco. Leaving aside the controversy of Chalco's monopoly, Chen has to agree that it is only normal that some new domestic alumina manufacturers should appear.

But he is convinced of his company's competitive strengths, especially on technology. "For commodities, it comes down ultimately to cost and quality," he says. "Chinese bauxite is some of the worst in the world. Our technology has been developed and refined gradually over the past 50 years. It is very difficult for new entrants to develop technology on their own. They can surely use imported bauxite and even apply imported technology. But then they will have very high production costs. Local bauxite for one ton of alumina costs RMB150; it goes up to RMB600 for imports."

To Market, To Market

Chen is impressed with the speed with which Chalco has marched towards the market over the past three years - faster than he had originally hoped. Yet the sky is far from cloudless. Competition and monopoly, cost versus quality, independence and market ways - these pairs of words frequently surface in Chen's agenda, not to mention the ever increasing demand for return on the part of investors.

Fortunately for him, he has not been on his own. After three years Chen has changed his "assumptions" of his colleagues. He admits that when he joined the company, he expected to work with many "stone-faced officials". But it did not pan out that way. He now uses these words to describe his colleagues: "Far-sighted, professional, seasoned." He is also full of admiration for the CEO of Chalco, Guo.

Still, he acknowledges there are some voices in the company that are out of step with the company's goals. "There is some misunderstanding from the outside world. True, we do have some practices that are not entirely in line with market ways. Most of our comrades come from SOEs. There is only one Chen. How can you expect everyone else to speak like I do, think like I do?"

Even so, the 35-year-old Chen is happy with the choice he made over three years ago and what he has accomplished since. "No consolidation, no Chalco of today," he says. A little pause, and he cannot refrain from a bit of self-congratulation. "The good thing about me is that I always thought I would make it É" He hardly finishes the words before bursting into a hearty laugh.

The united kingdom of Chalco has taken shape.

Percy Zhang is editor at CFO China.