Tuesday, May 31, 2011

Beware the Hype in China's Story

Beware the Hype in China's Story


A raft of planned stock listings are betting on the future spending power of the Chinese consumer. The trends underlying this rush to market are real, but investors should avoid heedlessly buying all the hype.

The big picture is familiar: China's long-term growth trajectory is creating a vast middle and upper class eager to buy clothes, cars, cosmetics and cashmere scarves in ever-larger quantities. The story has gained allure amid China's moves to promote domestic consumption as a future growth engine.

So far, signs of a slowdown in China that are weighing on the country's broader markets haven't damped enthusiasm for the consumption story, which appeals in part because it offers a longer-term bet on spending patterns that should outlast any short-term market downturn.

Two big global brands, Prada and Samsonite, highlight the power of the China story as they prepare to list on the Hong Kong exchange. The Italian fashion house is raising around $2 billion in an initial public offering, pitching itself as a play on China's demand for luxury goods. Luggage maker Samsonite, the subject of several buyouts and messy restructurings in the past, is seeking $1.51 billion. Its growth prospects in Asia, and China especially, are the offering's top selling point.

Other China retail plays in the pipeline include Vancl.com, a Chinese online clothing retailer that aims to raise up to $1 billion in a New York listing, and Chow Tai Fook, a jewelry chain controlled by Hong Kong billionaire Cheng Yu Tong. Chow Tai Fook's credentials as a premier vendor of Chinese bling are emboldening it to seek $3 billion to $4 billion in a Hong Kong offering early next year.

Bankers and fund managers say at least 15 IPOs, and as many as 30, that play on China consumer demand are in the works. But a rush of similarly themed companies coming to market means sellers smell opportunity—and buyers should beware. That's particularly true for the many domestic Chinese retailers, including many online retailers, looking to go public and targeting the mass market.

"That's what we had with the Internet bubble—too many me-too adopters" that lacked strong business fundamentals, says Stephan Schäli, head of private equity at Partners Group, a global private-markets investment-management firm that happens to own a stake in Samsonite. He notes that China's retail space remains hugely fragmented and it's difficult to identify which companies are best positioned to survive when consolidation eventually thins the ranks.

There are other risks with domestic Chinese companies of the entrepreneurial variety that predominate in retailing, including occasional corporate-governance problems and accounting shenanigans—stuff that has drawn the attention of U.S. regulators in the wake of alleged fraud and mismanagement at more than a dozen U.S.-listed Chinese companies.

The more-established foreign brands listing in Hong Kong offer a certain level of comfort. Multinationals benefiting from China's growth have long been a safer way for global investors to gain at least some indirect China exposure. What's new is the idea that some are now choosing to go public in Hong Kong, closer to the region they believe will drive future profits.

Prada's growth prospects in China look solid. Goldman Sachs figures that already about 30% of its global sales go to Chinese buyers, many of them making their purchases overseas. It also forecasts that by 2025 Chinese luxury consumers will number 200 million, up from 15 million now.

One Prada perk: Luxury sales could do well even if China doesn't successfully shift more of the economy toward consumption. The plutocrat class will likely keep expanding regardless, unless China runs into bigger problems, such as a banking crisis.

However, high tariffs on luxury goods in China could crimp expansion plans on the mainland, and keeping up the brand's image of exclusivity will be harder once its goods become more ubiquitous.

Samsonite is pitched toward a lower rung of Chinese affluence, and therefore a bigger market.

As a whole, Asia already makes up about 40% of Samsonite's earnings before interest, taxes, depreciation and amortization, a common measure of the company's core business. But even though China is the company's No. 2 market, it is a surprisingly small portion of sales at less than 10%, and boosting that share requires getting consumers in a market flooded with cheap suitcases and rolling carry-on bags to shell out extra yuan for a brand name.

Investors would be right to harness the rising power of the Chinese consumer to boost their portfolio returns. They just need to look carefully where they fasten the harness.

Write to Peter Stein at peter.stein@wsj.com

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