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Case Study

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Volatility Matters Less Than Risk

by Francis Bassolino Owner, Alaris Volatility is just a temporary phenomenon (assuming you survive it financially) and investors shouldn’t attach as much importance to it as they seem to. –Howard Marks Turbulence in global markets has fueled a cottage industry in geostrategic analysis where the dominant narrative concludes that war with China—cold and likely hot—is inevitable and that companies must follow the theory of Gwyneth Paltrow and consciously uncouple. Like anyone who asks Bono about the pathway to world peace, we question the intelligence of the person asking and the ethics of the pundits who talk of things they do not know. It will pay to keep a few things in mind while scanning the deluge of commentary foretelling China’s future. First, in July 1989, nobody predicted that three years later Deng would declare “To get rich is glorious and poverty is not socialism”. Second, none of the commentators have shared tea or an unscripted moment with anyone two steps removed from those in power. The new inner circle in Xi’s China is tight and tightlipped. As Laozi taught us, “Those who know, do not speak. Those who speak, do not know”. 知者不言,言者不知. And third, an open rigorous dialogue with Xi’s inner sanctum would not reveal just how China will navigate the near to mid-term challenges. There are just too many variables. Emerging from Covid will be turbulent and messy. Notwithstanding these challenges and unknowns, many companies are weighing downside risk more than is warranted. In this piece we consider the risks and probabilities, concluding that the biggest hazard is focusing on defense when the true winners will be the ones who aggressively develop strategies that can capitalize on the most probable outcomes which include growth and a return to practical engagement.

China is not taking over the world

First, let’s consider something that recent history has revealed. China will not dominate the 21st Century. Geographic constraints, ineffective education systems, financial institutions that misallocate capital, and demographic challenges combined with ill-conceived socioeconomic policies stifle the proven path to dominance which is productivity growth. Labor and capital inputs have been generating diminishing returns for some time and the Chinese institutions have been slow to respond to this fundamental reality. It is increasingly difficult to argue that China is led by omniscient technocrats outsmarting the market. Indeed, the heavy hand of the vision of the anointed have made many choices that hamstring development. Long-time China watchers—even the optimistic pollyannaish ones—bemoan the coming decline, hoping for a shift back to the practical realism and liberalization which has served China so well. Second, many leaders in China do not aspire to join the liberal world order. For a long time, many Westerners assumed what was tactlessly yet concisely articulated in Full Metal Jacket, that “Inside every gook is an American trying to get out”. This thesis found a more sober rendering in Fukuyama’s The End of History, which postulated that the world had settled on liberal democracy as the optimum and desired operating model. The tiger economies were the poster children for this movement. But alas, engagement has not converted all the heathen and many of those who voted for engagement have now concluded that China is the leading strategic rival. On this Democrats and Republicans agree! The current Chinese leadership has rejected this liberal world order, preferring homegrown systems and processes to set strategy and maintain stability. Some label China’s systems authoritarian, others benevolent dictatorship. The Chinese tend to refer to it as traditional values or even the Singaporean model which holds appeal for most of the population. Regardless of the labeling or considering whether it is the right or wrong path, we suggest that those who engage with China need to understand that there is no urgent or inevitable movement to converge with Western thinking on social structures and contracts. And perhaps here another Buddhist acolyte might be worth listening to, “We cannot choose whether to engage with the world, only how to.”

Our Model is Better

A central debate for much of the nineties was “Should China be allowed to join the WTO and if so on what terms?” In the end, China joined under vague conditions which set milestones for continued reform. As China grew stronger, and particularly after 2008, China concluded the West was in decline and that many reforms were optional. China began to espouse a belief summed up as “China has now stood up and we will no longer adhere to the contracts which we signed under distress. We have a better model.” The most ardent spokespeople for this belief system now come to us as wolf warriors, zealous diplomats on a mission to spread the word of China. This mission posits that China’s development model is more utilitarian and egalitarian than liberal democracy. The model “Benevolent Paternalism”—aka Daddy Knows Best—is an intellectual framework loosely built on an ideological and institutional foundation of Lenin and Confucius, favoring Legalism’s strict rules and decorum over live-and-let-live Buddhist principles which are also still floating around the minds in China. Rather than debate the merits of such a framework, let’s discuss “How does it impact business and what’s next?”

Quantify the risks and forge ahead

For many companies, China’s political philosophy is of little relevance to their bottom line or investment thesis. Indeed, given the fluid unstructured, immature and fragmentated nature of many markets, even near term macroeconomic and sociopolitical trends are second-order priorities. For example, in a rapidly growing market with no clear leader, economic results are driven by more pedestrian issues of leadership, strategy, and execution. Said differently, success or failure boils down to calculating expected outcomes and effectively deploying capital to capture opportunities. And moving fast. Often much faster and in directions that challenge global HQ operating norms and reporting lines. Naturally it is ridiculous to ignore the macro environment and institutional structures. And everyone wants to know “Is China in decline?” The answer is we don’t know. It is too early to tell. The demographic dividend has switched to a massive burden. And the rigid institutional infrastructures are ill-suited to manage complexities of the size, scale, and dynamism of this current era. The inability to shift away from zero covid is just one very visible and recent manifestation of this challenge. The clumsy mishandling of tech giants another. However, the global consensus on China on a whole host of issues rests on too few data points to proceed with the certainty we see many assume. For example, the attention-grabbing narrative that Xi is emperor for life ushering in the next cultural revolution is a simplistic unproven hypothesis. Yes, he broke precedent with a third term, but does he fancy himself as Mao or Lee Kuan Yew? Many corrupt officials are still waiting out the anti-corruption drive attached so closely with Xi. And there is a rationale argument to consider that changing captains mid storm is less than ideal. Americans may be loath to recall that the beloved FDR also broke precedent with his third term! The extension of Xi’s term has set China on a path that is prone to end badly but this is not a foregone conclusion. Only time, and events over the next few years will reveal the trajectory. In an odd way, even after 10 years in power, no one really knows what this dude is thinking and how the CCP will respond to the power Xi has amassed. But as our table below indicates, consensus seems to be the Xi is going to become a monster that leads the next Cultural Revolution. We think that this is a crude argument and unlikely outcome even if this is what Xi wants. Figure 1–A look at probabilities and trends China is not on a path to nationalize assets. Yes, Jack Ma has been knocked off his pedestal as were many entrepreneurs who challenged the state’s monopoly of opinion or industries viewed as central to control, e.g., information, education, entertainment, and finance. But there is a good argument that the current administration has read Rajan and Zingales and they are trying to “Save [Chinese] Capitalism from the Capitalists”. Clearly there is an attempt to concentrate power in state-owned companies, or oligopolists easier to control, but these efforts have not been successful. Contrary to popular belief, private enterprise is not losing ground to the State. From capital formation to employee headcount, the private sector continues to grow faster than the State. The recent downturn in the economy will have a disproportionate impact on private enterprises, but the longer-term trend seems clear. Over the past decade, employment in the private sector has grown at 10% per annum while State employment shrunk by 2%. Today, about seventy-five percent of employees work in private companies. Killing the private sector would be suicidal as the State continues to generate poor returns. Unemployment plus inflation and stagnation equals revolution with pitchforks. Three other common misconceptions were outlined in our last piece “Profits of Doom”:
  1. The US and China will not have a hot war over Taiwan because the military risk is just too high. China would probably fail. And even if China wins, they lose.
  2. Companies will continue to source from China due to deep, dependable, and competitive supply chains, plus the human capital and infrastructure to activate
  3. Companies will continue to be attracted to the compelling demand opportunities in China. There are 500 million “middle class consumers” with disposable income profiles and market dynamics that offer double digit growth opportunities. Most markets lack category leaders. Therefore, the right product in the right channel can grow exponentially and command outsized profits.

We can’t see the bottom, but we should jump in

In the fog of war it is difficult to predict outcomes. The next twenty-four months will reveal the true intentions of this government and the future of China. What seems obvious at this junction, however, is that China will implement a massive stimulus, the currency will remain “competitive” and, perhaps with a little luck, the US and China will find some path to détente—or at least rational civility as was on display at the G20 in Bali. Avoid the fallacy of incredulity, the belief that because something is difficult to understand, it is false. We are dealing with an ambiguous situation and lack of information. Rather than fall for the illusion of validity, concluding China is the antichrist, we encourage fact-based scenario planning. In our estimate the most probable scenario is that China will return to the table as a practical partner because the other paths are dead ends. Use this as a strawman. The West cannot dictate the terms of engagement demanding that China institute political pluralism, particularly when its own house is in such disarray. China has a system that has delivered impressive returns. It would fail miserably in the US and frankly if history is repeated, “common prosperity” will create “common poverty” and peasant rebellion. But prepare for the converse. China will be a viable and valuable market in 2-5 years. And odds are that China will surprise on the upside at least in the medium term. The biggest risk for most companies is not being in the water when the wave comes. Stop talking about Taiwan and add that thought for more positive outcomes to the boardroom agenda. Is your aversion to volatility financial or emotional? –Warren Buffet Francis Bassolino runs Alaris, an investment and advisory firm. Francis_bassolino@alaris.com.cn

Manufacturing Footprint Optimization: Global Expansion (ASEAN)

Background

Global firm needed to increase China/Asia manufacturing capacity. EWA was engaged to develop and implement an Asian Manufacturing Footprint Strategy to drive long-term profitability.

Approach

Step 1: Identifying the expansion criteria
  • Company analysis
    • Expansion criteria: labor supply/costs, government incentives, inflation rates, availability of raw materials, transport & export logistics, supply chain vendor availability
Step 2: An in-depth comparative analysis of 6 selected countries
  • Philippines, Malaysia, Indonesia, Vietnam, Thailand & China
    • Expansion recommendation: Thailand
Step 3: On the ground interaction
  • Negotiated conditions for property purchase & property management (waste removal, perimeter security, etc.)
  • Negotiated investment incentives with Secretary General of Royal Thailand Board of Investment
  • Qualified local Thai vendors to support the company’s manufacturing location
  • Met with local legal and accounting firms to identify the necessary criteria for establishing a business entity
Step 4: Hands-on implementation
  • Property was purchased and all pre-construction permits/licenses/registrations were acquired by October 2017
  • Plant designs, construction budget/timeline & all construction partner contracts were finalized in November 2017
  • Plant construction and equipment installation began in January 2018 and was completed in April 2019
  • Identification and recruitment of supply chain, distribution & logistics partners was completed in February/March 2019

Results

  • Government Incentives
    • 8 year tax holiday from CIT, 50% tax reduction for an additional 5 years
  • Cost Reduction
    • $22.0M tax savings over 10 years
    • $4.3M annual labor savings after 5 years
    • $1.8M annual material savings after 5 years
    • $120/unit average freight savings
  • Company Growth
    • 42% increase in sales over 5 years
    • 53% increase in revenue over 5 years

Company Forecast

Manufacturing Footprint Optimization: Plant Closure

Background

  • As part of a global restructuring of business units, a multinational chemical company was closing one of their Chinese production facilities.
  • EWA engaged as Project Leader with responsibility for closure implementation.

Approach

Six months prior to plant closure
  • Closure strategy (budget, timing, expenditures, government relations, etc.)
  • Defined implementation team (Operations, HR, Legal, Security, IT, etc.)
  • Development of communication plans (staff, government, external, etc.)
  • Security risk assessment (employee unrest, physical & IP assets theft, etc.)
Three months prior to plant closure
  • Implementation of operational and protective security measures
  • Finalized equipment & inventory disposition, decommissioning plant, etc.
  • External stakeholder negotiations (governmental agencies, landlord, etc.)
  • Obtain approvals from business zone, governmental authorities, etc.
  • Identification of compliance and payment issues, severance packages
Upon plant closure and after
  • Finalization of equipment disposition and plant demobilization
  • Filing government documentation in keeping with the registration, business license, board resolutions
  • Filing of all necessary financials, bank accounts, tax, VAT rebates, registered capital and customs documentation
  • Competition of all de-registration and governmental documentation and plant turnover to the landlord

Results

  • No theft of IP assets, physical violence or governmental authority repercussions
  • 100% of employees signed employment forms

Manufacturing Footprint Optimization: Site Selection

Background

  • German-owned chemical company with an ageing facility was being pressured by local authorities to relocate to an “official” chemical processing zone, as part of the Chinese government’s initiative to combat industrial pollution
  • EWA was engaged to conduct a comprehensive site selection process and provide the client with quantified site recommendations

Approach

Step 1: Create functional definition of plant
  • Purpose for expansion, customers, supply chain, products, capital equipment, etc.
  • Definition of the site requirements & specifications:
  • Size of plant, land requirements, structural requirements, utilities and consumption, logistics, labor force requirements, ground compaction, water table, number of employees, manufacturing space, office space, employee facilities, etc.
Step 2: Analysis of company performance influencers
  • Logistics, location of customer base, location of suppliers, location of business partners, freight & transportation costs, current property costs, current operational costs, government incentives, etc.
Step 3: On the ground interaction
  • Identification of 7 business/chemical parks for further exploration based upon site & company criteria
  • Personal site visits, face-to-face negotiations, meetings with other companies located in the individual business parks & interaction with local government officials
  • Tours with company executives
  • Negotiations and confirmations of land price and tax incentives
  • Analysis of the impact on startup and operational costs
Step 4: Recommendation of the 3 quantified location options with full analysis

Results

  • Significant tax and land incentives were attained by EWA negotiations
  • Client approved EWA recommendation and final negotiations are currently in process.
  • Client has engaged EWA in the role of “Owners Representative” for follow-on activities including coordinating design and overseeing construction

Supply Chain Optimization: Global Expansion (Mexico)

Background

  • EWA was engaged to develop and implement a Mexican supply chain footprint strategy
    • (identify and qualify local suppliers, evaluate options for assembly operations, identify 3rd party logistics providers, negotiate tax incentives, hire local senior management and evaluate existing DCs)

Approach

Step 1: Define Project Objectives and Requirements
  • Align on opportunities, volume requirements, cost targets
Step 2: Deploy Formal Process & Develop Core Elements for Analysis
  • Identify Products to be outsourced – one product was 48% supplied from China to US
  • 80% of component spend can be supplied from Mexico
  • Labor & Logistics savings favored Product Assembly in Mexico – faster than In-House
Step 3: ID Potential Suppliers and Obtain Analytical Data
  • Identified component suppliers within Mexico
  • Interviews and factory visits to develop supplier “short list”
  • Suppliers provided detailed proposals with pricing, QC control plans, price breaks for increased volumes, samples for performance testing
  • Same process for identifying & qualifying Assembly and Packaging contractors
Step 4: Hands-On Implementation
  • Negotiations conducted with suppliers to finalize
    • Cost, payment terms, projected productivity improvements, forecasting lead times
    • Sharing of productivity/volume benefits, Inventory stocking requirements
  • Negotiations conducted with contractors to finalize cost and value-added services:
    • Provide incoming QA inspection and manage supplier returns
    • Monitor and expedite deliveries from suppliers
    • Assemble and Package product & shipment to customers or distribution centers

Results (Outsourced Product Line)

  • Cost Reduction
    • Reduced inventory vs China ($21MM cash) and shorter lead times, better cash flow
    • Cost reduced 5% ($6MM) vs sourcing from USA, with potential for additional reductions
    • Eliminated tariff impact
  • Other Benefits
    • Quick set-up
    • Low cost to implement
    • Good access to suppliers for USA-based QA and technical staff
    • Good quality outsourced assembly and packaging
    • Elimination of 2 DC’s from proximity to Western USA customers
    • Stable trade environment

Supply Chain Optimization: Supply Chain Assessment

Background

  • Asia-Pacific manufacturing operations of a global chemical company was struggling to make on-time deliveries, carried excessive inventories, and had excessive freight and logistics expenses (primarily from expedited shipments)
  • EWA was engaged to identify operational problems and to develop/implement corrective actions to improve logistics & supply chain processes

Approach

Step 1: Onboarding & Alignment
  • Gain thorough understanding of client’s overall business, markets, manufacturing operations, current supply chain, and logistics network
Step 2: Model current state of client’s supply chain and logistics operations
  • Current logistics network
  • Process assessment
  • Determine customer requirements
  • Organization structure analysis
Step 3: Analysis to identify required changes and potential opportunities
  • Performance
  • Voice of Customer
  • Processes
  • Organization Design
Step 4: Develop recommendations and action plan
  • Short term actions
  • Medium term actions
Step 5: Hands-on implementation
  • Interim Supply Chain Manager
  • Develop RFP for logistics services
  • Implemented significant organizational changes
  • Support transition of new organization & process (bi-weekly project implementation meetings)

Results (Outsourced Product Line)

  • Savings achieved through rate negotiation & reduction in expedited shipments
    • Carriers were consolidated & outbound logistics processes were improved, with 15% reduction in freight costs
  • Improvements were made to forecasting & planning generated the expected results
    • Inventories were reduced by nearly half, generating US$MM cash
  • Customer service levels improved dramatically
    • On-time deliveries improved to > 90%
  • Organization stabilized & capabilities improved

Performance Improvement: Growth Development

Background

A manufacturer of returnable packaging materials for the automotive industry with stagnating sales engaged EWA to identify and qualify sources of business growth potential.

Approach

Step 1: 360° Opportunity Assessment
  • An extensive review with the client of the construction and technical aspects of the current product portfolio, the market, adjacent verticals, competitor products & customer base.
Step 2: Opportunity Identification
  • Identification and validation of 12 key industries as qualified verticals for expansion – based upon ease of adaptation, market size, growth potential and profit margin
  • Total of 1300+ potential new customers
Step 3: Short-listing of 5 core industries of focus for a deep dive analysis
  • Off Road Vehicles, HVAC, Outdoor Power Equipment, Pharmaceuticals, Consumer Electronics
  • Total of 370 potential new customers
Step 4: Opportunity Leveraging
  • EWA prioritized the top 10-12 companies per sector (sales channels, geographical location, etc.)
  • EWA conducted an in-depth investigation of each company & senior management and then delivered a biographical summary and contact information for 63 companies

Results

  • The client signed contracts with 9 new business partners
  • 13% increase in sales within 18 months

HR & Executive Recruitment: Interim General Manager & Recruitment of a Permanent General Manager

Background

  • A metal fabrication WOFE located in Changzhou with a US parent was faced with a situation involving an ineffective General Manager
  • EWA was engaged to:
    • Recruit and supervise an Interim General Manager
    • Identify, qualify and recruit a permanent General Manager

Approach

Step 1: Recruitment & Supervision of an Interim General Manager
  • Preparation & alignment
  • Selection
  • On-boarding & engagement management
Step 2: General Manager Candidate Criteria, Development & Assessment
  • Hard & soft skills definition
  • Individual interviews
  • Selection of 3 top candidates
Step 3: General Manager Candidate Due Diligence
  • Determination of scope
  • Desk-top audit & field research
  • Forensic review
  • Legal issues
Step 4: General Manager Candidate Final Report
  • Analysis, recommendation & rationale

Results

  • Successful search to find a General Manager fitting a specific set of client requirements:
    • Integrity
    • Employee relations
    • Financial
    • Operational skills
  • Six-week search resulted in:
    • 3 highly qualified referrals
    • 1 individual was hired
  • Three months after the new GM reported to work:
    • Plant productivity increased from less than 55% to over 85% and rising
    • Staff productivity increased 15% in the same time frame
    • Customer complaints reduced to less than 1 per month (vs. 7+ over the previous 12 months)

HR & Executive Recruitment: Organizational Improvement Initiative

Approach

Step 1: Organizational Assessment
  • 360° assessment of factors impacting performance
  • Diagnostic individual & team structured interviews, which found:
    • Lack of trust
    • Hoarding of information
    • Lack of shared goals
    • Unacceptable individual & group meeting behavior
    • Conflicting perception of goals
Step 2: Organizational Development
  • Group behavior improvement
  • Individual behavior improvement
  • Interdependence
Step 3: Organizational Design
  • Revised organization structure & reporting processes
  • Development & implementation of a new internal communications plan

Results

  • Follow-up surveys (individuals & group) reported significant improvement:
    • Cooperation
    • Information sharing
    • General trust
  • Dramatic improvement of key performance indicators (6 months later):
    • Time to market rate improved by 50%
    • Unwanted staff turnover was decreased by 15%
    • SG&A costs were reduced by 21% on an annualized basis
    • 18% reduction of inventory costs
    • Sales costs were reduced 14% due to improved expense controls

HR & Executive Recruitment: Organizational Development

Background

A US privately-owned manufacturer of semi-custom industrial conveyor accessories had experienced a severe decline in performance over the last 3 years and was also unprofitable for the last 2 years. EWA was engaged to develop solutions to improve organizational efficiency.

Approach

Step 1: Comprehensive organizational assessment
  • Structured diagnostic interviews were performed with individuals, interdependent functional teams and department teams)
  • Observations were conducted of department teams, cross-functional teams and senior management interaction and interdepartmental communication
  • Information flow and reporting processes were also monitored
Step 2: Analysis of individual and group goals
  • Assessment analysis identified several key issues which negatively affected the company’s organizational effectiveness including lack of trust, hoarding information, no shared goals, specific non-constructive meeting behaviors, and overlapping perceptions of individual roles
Step 3: Development of corrective actions f to increase performance through improved interaction
  • Supporting groups and members to develop their interactive abilities, information sharing, trust and becoming more self-aware of their impact on others
  • Working with individuals on negative behaviors, being a better observer of how others reacted to them and self-tallying instances of back sliding
  • An internal event was conducted and all stakeholder viewpoints, inputs, finding and action steps were presented and discussed with the teams, new interaction norms were established and agreed and then teams were trained

Results

  • Company attained breakeven status at the end of the year
  • Sales grew by 10%
  • Time to market decreased by 50%
  • 15% reduction in staff turnover