BREAKING POINT
Are China’s listed companies growing too fast?
By Don Durfee, Yang Jian, and Wu Chen

Few ways of getting around China are more harrowing than a nighttime taxi ride through the countryside. Invariably, such trips are taken at a high speed. One hand on the steering wheel, the driver will accelerate past villages, swerve around ox carts, and honk at each pedestrian, cyclist, and army truck passing by. There are no streetlights, so it’s very dark. 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 seatbelts.

Anyone investing in China’s stock markets these days knows exactly how such a wild ride feels. But the unruliness—and anxiety—accompanying white-hot growth is also disrupting the country’s CFOs. They worry that their companies, like the stock market in which they often speculate, are growing beyond control and could be headed for disaster.

A new survey of 359 CFO China readers shows how pervasive that anxiety has become. Just over half of 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 and board director 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 it yet. These companies are expanding like crazy, and everything they make they can sell.”

This gap between growth and the ability to manage it brings back memories of U.S. companies during the dotcom boom of the 1990s, and of Japanese companies riding the investment bubble of the late 1980s. Neither boom ended happily, of course.

A growing chorus of market observers is warning that China’s market boom won’t end well, either. 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. But for the CFOs of listed companies, any downturn could be severe. Can China’s new CFOs avoid the fate of their American and Japanese predecessors?

Fragile Giants

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 own 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. One question asked CFOs about their main growth-related concerns. For publicly listed companies, the number one concern was a worry 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 finance executives see weakness 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 the 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, a name that means “drunkard” in Chinese), 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.

David White, a consultant with Oliver Wyman in Beijing, believes that now is the time for CFOs to provide more direction to the business. “From the vantage point of Chinese CFOs, this is a very exciting time,” he says. “You do your business strategy, launch an IPO and get capital and start thinking about acquisitions. Right now things are profitable, but that profit will erode over time as competition increases and labor rates rise.”

What is needed, says White, is for CFOs to help the business managers run a better business by setting up a fact-based decision making process. For that to happen, finance needs a clear picture of performance across the enterprise. Finance also needs to develop the skills needed to run scenarios and help management understand the economic impact of different business strategies. Ultimately, CFOs will need to be able to generate accurate forecasts so that they can make predictive statements to investors and deliver on those forecasts. “Chinese CFOs simply haven’t had to do that yet,” says White. “But eventually the commercial markets will drive it.”

In fact, difficult times for Chinese listed 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,” says Lou.

He 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 listed Chinese companies (excluding insurers), investment income is 17 percent of absolute market EPS. That’s possible because of an accounting rule change at the start of this year permitting companies to reflect the change in 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 account for just 54 percent of overall growth.

Some companies are even taking out bank loans to invest. Earlier this year, regulators cited China Nuclear Engineering & Construction and China Shipping for diverting loan money into the stock markets. China Shipping, for example, received US$356 million in loans from six banks, and used US$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) that will show up as a sharp slowdown in earnings. This is what happened on the Tokyo Stock Exchange in 1989. “[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,” says Lou. The same thing could happen in China.

No Time to Change

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?”

And, for A-share companies at least, there isn’t much pressure for financial improvements coming from the retail investors who currently dominate China’s domestic stock markets. “The average investor is poorly educated,” says Lou. Rather than careful analysis, they are trading on themes, and doing so quickly and often. He 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 necessarily being 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. Only 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. This 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.

In any case, it’s not as if finance executives have little else to do. “[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 September, 2006. “You are setting up the finance function, setting up employee share plans, investors are calling you, and you have to handle SEC filings and comply with Sarbanes-Oxley.” Finding qualified employees—particularly in finance—is another drain on the CFO’s time. Hsieh should know: this year, his company 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 barriers, 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, which is distinct from employee share management. 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 White. Asked about the challenges confronting finance, 45 percent of respondents cited a narrow CFO role.

The lack of authority becomes a problem when CFOs 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 lack of clean financial data across the enterprise. “As companies go public, the CEO wants better line of sight and asks finance to help,” says 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 integrated real estate service provider 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.”

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 Chinese 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 meant 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 it may not actually 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.

Taking Control

CFOs realize that there’s work to do. According to the 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. Before he was recruited by New Oriental founder Michael Yu, he had worked as a corporate lawyer, investment banker, and private-equity investor, in addition to a stint as a Silicon Valley CFO.

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 (approximately 150 people, mostly working in operations) compiles management reports, which the senior managers review. “Before we had financial 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,” comments 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 concedes that he’s 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—it encompasses finance, investor relations, human resources, M&A and legal.

All of this, Hsieh believes, means that New Oriental will be able to respond to any downturn better than other Chinese companies. “If you have good reporting, it’s easy to see where the divisions are that aren’t making money,” he says. “Like a doctor, you can’t cure an illness without the proper diagnostic tools.”

Clearly, no successful CFO can focus only on risk and control. China’s economy and its businesses are growing remarkably fast—that entails risk, certainly, but also tremendous opportunity. May Wu, the CFO of Home Inns, a domestic chain of budget hotels listed on Nasdaq, says that it’s a balancing act. “As the CFO of a fast-growing company, the focus has to be on supporting the growth of the company, while not sacrificing efficiency and control,” she says.

That’s a fair description of her approach to the CFO’s job. Home Inns is adding new hotels at a rate of 60-70 percent annually. Wu says her first job is to ensure adequate capital for the company’s growth. So far, in addition to the US$70 million raised through its 2006 IPO, the company has done a secondary offering and a convertible bond.

The second part of Wu’s job—ensuring that growth remains under control—is just as important as the first. “Many companies in China see all of these opportunities in the market, but they don’t have a lot of experience in really dealing with this growth,” says Wu. “We think that only good growth is sustainable in the long term.” To that end Wu has established a straight-forward process for reviewing investments. Before a new project is funded, business leaders have to deliver a presentation to the investment committee. They must clearly show that the investment will exceed Home Inns’ internal rate of return.

Wu has also worked to establish a standard set of financial processes. As a result, it is easy to train new employees and integrate the finances of a new hotel into the financial reporting processes. That helps ensure management doesn’t lose visibility at a time of rapid growth.

Unfortunately, New Oriental and Home Inns still appear to be in the minority in China. Many more, as our survey shows, are growing fast but are not well prepared to steer around the obstacles that appear in their headlights.

Those CFOs will increasingly need to ask themselves how to balance growth and risk in their own firms. “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.”

It may be easy to avoid difficult decisions today, but doing so can carry a high price. Just ask the American CFOs who presided over the last great bubble.

Don Durfee, Yang Jian, and Wu Chen write for CFO in Hong Kong and Shanghai.