Guangdong Kelon

Company Visit -- September 1999

Guangdong Kelon is the largest manufacturer of refrigerators in China (2.8 million units; 60% of sales). Through a 1998 acquisition, it has also become a leading manufacturer of air conditioners (1.5 million units; 40% of sales).

Despite rampant excess capacity and cutthroat competition in its industries for the last couple of years, (refrigerator prices have been declining by more than 10% annually) the company has continued to grow profitably.

Our favorable impression of the plant we visited corroborated the fact that the company was the first refrigerator manufacturer in China to be simultaneously awarded the ISO9001, ISO4001 and MRPII Class A accreditations. Kelon was also the first refrigerator brand to receive the “Grade A Energy Efficiency certificate” from the Hong Kong government.

The quality of management is no longer a secret. The company was recently selected by AsiaMoney magazine as the “Best Managed Company of the Decade in China”, and it was the only Chinese company included in Forbes Magazine’s list of the world’s 300 best small companies. Normally, such public endorsements are more likely to deter than to attract contrarian investors like us. However, the modest valuation of the shares also reflects concerns that we feel are only of a transitory nature.

1.      There is concern that a reduction of import tariffs (currently 25% on refrigerators and 35% on air-conditioners), as China joins WTO, will exacerbate price-cutting in the white-goods industry. Imported brands, today, have a market share of less than 1% and, while this may increase somewhat with an opening of the market, imports are unlikely to represent a significant portion of the domestic market any time soon.

First, major foreign manufacturers have already set up joint venture production facilities in China: Whirlpool with Snowflake (Whirlpool brand), LIDO with Zhongyi (Electrolux), Matsushita with Little Swan (National), Samsung with Xiangxuehai (Samsung brand). Others, like Sharp, have their own, local production facilities. So, in spite of low imports, international competition is already a reality.

Second, imported products have higher costs at equivalent quality, even without tariffs. As for many companies that assemble semi-finished parts, Kelon’s direct labor visibly amounts to a mere 3.3% of its refrigerator-manufacturing costs. But compressors account for 25.3% and laminated doors for another 5.2%, for example, and Kelon sources as many of these components as it can in China. In addition, 80% of the raw materials used in Kelon’s air-conditioners and 90% of those for refrigerators are also sourced relatively cheaply in Mainland China. As a result, the total direct and indirect Chinese-labor content of a Kelon refrigerator is really much higher than it appears. At only US$ 80/month in the coastal area (twice the $40/month official minimum wage), we are told that China’s unskilled labor remains competitive on a wage basis, even after the sharp devaluation of most Asian currencies.

More importantly, foreign competitors lack domestic distribution, and Kelon’s management makes the case that Chinese consumers focus much more on product features, availability and service than on brand name. Guangdong Kelon sells refrigerators throughout China, with a network of 798 retailing stores and 400 after-sales service centers, which would be difficult and expensive to replicate. In good part thanks to this network, the company’s Kelon and Rongsheng brands have strong market shares throughout the country:

-         14.3% in the Northwest (6.3% of its domestic sales)

-         18.7% in the Northeast (10.4%)

-         16.2% in the North (8.6%)

-         18.3% in the East (24.1%)

-         32.5% in the Mid-South (15.9%)

-         27.8% in the Southwest (12.7%)

-         42% in the South (22%).

2.      There is also a concern that over-capacity will continue to hurt pricing and margins for the foreseeable future -- especially if, as it is often assumed, the markets for refrigerators and air conditioners have already matured. It is estimated, for example, that 80% of potential urban customers in the coastal area already own a refrigerator.

However, a refrigerator has a life span of 10-13 years, while 46% of China’s park of installed refrigerators (essentially the urban areas) were purchased before 1990, and another 21% between 90-94. So, a strong replacement cycle should develop after 2001 in the “mature” urban markets.

As for first-time refrigerator purchases, they occur mostly in rural areas, where current penetration is only about 10%. The principal reasons for this low penetration rate are the lack of basic infrastructure (electrical power grid), low consumer purchasing power in many rural areas, lack of space (traditionally small farmhouses), and the high saving rate caused by unemployment fears. However, China plans to aggressively invest in rural-area infrastructure in coming years, while continuing the ambitious housing reforms aimed at turning most Chinese into homeowners.

Even partial success in these endeavors should release significant new demand for household equipment. If, for example, China’s rural population amounts to 800 million with an average of 6 persons per household (two grandparents, the couple, one daughter and one son), the potential, ultimate rural market adds up to 133 million households. Even assuming that only 20% of these households can currently afford a refrigerator, improved infrastructure could quickly release demand for 13 million refrigerators, which is equal to all the units currently owned by rural households. It should be noted that, with replacement demand in urban areas still small, an estimated 40% of Guangdong Kelon’s refrigerator sales have recently come from rural areas.

China’s total refrigerator production is around 22 millions units a year, but the capacity utilization rate is estimated to be only 60%. If these figures are to be believed, new rural demand and the onset of a major replacement cycle in southern urban areas would absorb the excess capacity only progressively. But the industry is already consolidating: last year, the top five manufacturers had a 70% market share, up from 40% in 93.

Furthermore, many small companies have old, inefficient facilities, which they lack the financial resources to upgrade. China, as a member of the Montreal Protocol, has agreed to phase out the use of environmentally hazardous materials, such as CFC, before 2005. The Central Government will force companies to close down CFC refrigerator facilities before the deadline. Two thirds of Guangdong Kelon’s refrigerator production is already in the non-CFC category, and the company was recently endorsed by the Montreal Protocol as an example of successful CFC substitution technology in developing countries.

To capitalize on market-share opportunities created by the industry’s consolidation trend and at the same time maintain overall profit margins, Guangdong Kelon – like many of the better consumer product companies in Asia – has been carefully segmenting its product offering according to consumer purchasing-power categories. High-end brands (18.7% of current refrigerator sales) are priced 48% higher than standard products (45.3%). Low-end, no-frills offerings (32.6%) – currently the best-selling category, particularly in rural areas -- are priced 13% cheaper than standard models. The remaining 3.4% are small refrigerators exported to other countries.

While our comments so far have concentrated mostly on refrigerators, Guangdong Kelon has developed a similar strategy for its relatively new air conditioner business.

It has built a distribution network of almost 800 stores in China, of which 558 are in cities with more than 1 million persons. Market shares, while less commanding than for refrigerators, are still important for the more fragmented air conditioner market:

-         5.6% in the Northeast (0.9% of domestic sales)

-         8.5% in the North (16.8%)

-         6.7% in the East (33%)

-         9.6% in the Mid-South (18,9%)

-         6.3% in the Southwest (6.8%)

-         9.6% in the South (23.6%).

Most of the air conditioner sales are still in the coastal areas and the company has not yet penetrated the Northwest market.

With the urban penetration of air-conditioning at less than 20% and much less in rural areas, there is still ample room for growth notwithstanding the industry’s current excess of productive capacity. This is especially true, as young urban professionals who are moving into new apartments routinely place air-conditioners at the top of their priority list for future purchases. As in the case of refrigerators, the company’s best-selling air-conditioners are currently in the low-end category, which sports prices 20% below those of premium brands.

The company’s strategy is to take advantage of the current depressed state of the air conditioner industry to rapidly create a powerful competitor through acquisitions followed by rationalizations. After its initial foray into the air conditioning business in 1998 (through the acquisition of 60% of Kelon Air Conditioner), the company also acquired Huayi Compressor in July 99, as a step toward greater vertical integration. Finally, Kelon has just won a court-ordered auction to buy the air conditioner and plastic molding assets of troubled Huabao (November 1999). The acquisition price of 600 million RMB (including commission) is below the book value of the acquired assets (no debt assumed) and can easily be financed from current resources. Between various economies of scale (although it has committed to protect Huabao’s work force) and greater integration, Guangdong Kelon expects to reduce its operating costs by about 18% over time.

In June 99, Kelon issued 110 million “A” shares, in its first offering open to private domestic investors. This offering increased the number of shares outstanding by about 10% and raised 1,067 million RMB. Although the offering price of 9.7 RMB was equivalent to recent quotes for “H” shares in Hong Kong, the issue was 88 times over-subscribed, indicating the hunger for listed shares on the Mainland.

As of mid-1999,  Kelon had cash net of all debts equal to 1,040 million RMB, and a quick ratio of 1.5. Unaudited profits (under Chinese GAAP) for the first half of 1999 were 435.8 million RMB, which is equivalent to 428.1 million RMB or 0.48 RMB per share under International Accounting Standards. This brings 12-month running earnings per share to 0.69 RMB per share (about HK$ 0.64).

The company’s goal is to become one of China’s dominant, vertically-integrated manufacturers of white goods. To that effect, the company will continue to expand its product ranges and distribution networks, so that further acquisitions during the current propitious period are likely. However, before the recent acquisition of Huabao’s assets (no debt), Guangdong Kelon had equity of about RMB 5 billion and total debt (short and long term plus pensions) of about RMB 1.1 billion. With strong cash flow, 5 billion RMB in available credit lines and an estimated long-term borrowing capacity of $3 billion, the company’s growth strategy should easily be financed for the foreseeable future.

Valuation and Prospects

At HK$ 6.70, the “H” shares reserved for foreign investors are selling at about 10 times earnings for the last twelve months. (Note that this price represents a significant discount to the “A” shares reserved for local investors, which are selling for the RMB equivalent of about HK$ 18.00).

In today’s buoyant financial markets, it is hard to find financially solid companies that are market leaders with good, communicative management and double-digit growth trends in sales and earnings, but whose shares are selling at only 10 times trailing earnings. Guangdong Kelon is such a company.

Eam Soun Chhoa

December 1999