Whether you like it or not, the PRC (People?s Republic of China or, in this piece, simply ?China?) is making great strides in becoming the manufacturing centre of the world. China?s presence is slowly but surely being felt in every corner of the investment world. It has been sitting on the sidelines for most of our lives, no matter how young or old you are. Pearl Buck once wrote, ?Nothing and no one can destroy the Chinese people. They are relentless survivors. They are the oldest civilized people on earth. Their civilization passes through phases but its basic characteristics remain the same. They yield, they bend to the wind, but they never break.? I find this a bit melodramatic but it doesn?t detract from the fact that China is growing its share of the world?s manufacturing industry every single day.

I have recently encountered Chinese influence in the investment world in two places. First was researching an outstanding company called Expeditors International of Washington D.C. Now is that a mouthful, or what? Great company though. I found their 8k statements a real treat (copies can be found at http://www.investor.expeditors.com/). In my opinion, Expeditors is the best run global NVOCC. A NVOCC is a Non-Vessel Operating Common Carrier. This is a fancy name for a freight forwarder that doesn?t own any planes or ships. Expeditors are of the broker type. They are a great company with great financials and an incentive culture that is out of this world. What is more important for this discussion is that Expeditors International of Washington D.C. is set to benefit greatly in future due to its presence on the shipping routes connecting the Far East with Europe and North America. These shipping lanes will be direct beneficiaries of China?s increasing share of global manufacturing. Raw materials need to be shipped to China and, in turn, finished products need to be shipped out. In addition, Expeditors has been doing business in China for almost ten years now and has a great quasi-government partner called Beijing Kang Jie Kong. Though, whether it makes for a great investment is another matter.

I encountered Chinese influence for a second time through my research of an Italian company, Natuzzi S.p.A., which is another outstanding company. Natuzzi is the world?s largest manufacturer of leather sofas and couches. It is number one in the U.S. and Europe. It also manufacturers other upholstered furniture and addresses the higher end of the market. There is a lot to like about the company. It has admirable management with a large stake in the company, virtually no debt, high return on equity, etc. However, this company (and the whole Italian furniture manufacturing industry) was probably in for a bit of a surprise when they recently learned that, according to the Shanghai-based INTERNATIONAL FINANCE NEWS, China had surpassed Italy in 2002 as the largest player in the global furniture market. It now holds 16.2% of the global furniture market. Say hello toChina!!

So, what does a company do when faced with this situation? It might be instructive to quickly look at what happened to Dexter Shoes, the Berkshire Hathaway-owned company. I will quote from one of my previous letters on Dexter.

?The problem to a certain extent is Harold and Peter?s thinking. I do believe they saw the problem coming long ago. Shoe manufacturing is still very labour intensive. Countries like China, Indonesia and Mexico simply have significantly cheaper labour. John Stollenwerk of Allen-Edmonds (U.S. shoe manufacturer), light heartedly puts this in perspective; ?China manufactures more shoes than any other place in the history of the world. We'll never go to war against China because we'll be barefoot?. For years they had the cheap labour but they could not reproduce the quality of American workmanship. I believe Dexter was too slow to recognise the quality ?catch-up?, and to only shift production when more than 90% of American shoes were imported was a gross mistake. Although their desire to save jobs in their factories is admirable, it just goes to show that you cannot fight change. In business you need to roll with the punches because in the end you will be forced to adhere to the business reality of the economy and your industry. This is unfortunately the price that you sometimes have to pay when partnering with people of outstanding integrity. Let?s just call it an honest mistake.?

It was interesting to me to see how Natuzzi approached the problem of the erosion of their manufacturing base in light of the above. Manufacturers of high-end products face the problem that they cannot outsource production to China because Chinese factories cannot meet the required quality standard. However, it is simply a matter of time before they can - as Dexter found out to its detriment. The first thing Natuzzi did was to create a brand to address the lower end of the market. Italsofa is manufactured in three factories, located in Romania, Brazil and China. Location is more important in sofa manufacturing than in shoe production because of the value/dimensional characteristics of sofas. It is more expensive to ship sofas than shoes and therefore you need to be close to your markets. The factory in Romania produces for the European market, Brazil for North America and China for the Far East. Obviously, these distribution areas also include the local markets.

The salient fact worth noting is that Natuzzi is moving its manufacturing to low cost centres. Training centres have been established alongside the factories to train the employees. This is in order that these low cost centres can eventually manufacture the high-end product. However, in the meantime Natuzzi is earning a return on its investment with its low-end product and it used an innovative way to give employees ?on the job training ?. Otherwise it probably would have had to train employees in Italy for a couple of years, which is a strategy fraught with problems. At the end of the day it will still have an edge on a Chinese manufacturer because, apart from having the same manufacturing costs, it will have a powerful brand.

Before I go, it might be instructive to note the following. Berkshire Hathaway purchase Dexter Shoes for 25,203 shares in 1993. Today, those shares are worth $1.8bn. However, the Berkshire Hathaway 2001 annual report states ?Our shoe operations (included in ?other businesses?) lost $46.2 million pre-tax, with profits at H.H. Brown and Justin swamped by losses at Dexter?. Berkshire Hathaway is wearing expensive shoes!

Whatever you are up to, I hope it is profitable and ethical!

Mr. B

mail_mrb@yahoo.com

Posted: 2003/03/10 09:18 View Archive