Lunar 2016 Outlook Remains Positive

We started 2015 with enthusiasm for the Chinese consumer, A-shares generating 53% annualized returns, and healthy private equity performance. This year begins with severe pessimism about China’s economic transition, public markets all sharply lower, and private equity returns in question. One friend complained that his clients were demanding to know why anyone even still focuses on China, adding bluntly “why are you wasting your time?” So feeling a bit on the back foot, battered but not bruised, we are going to stick our necks out and predict that the long arc of our investment horizon bends toward private equity outperformance generally, and upside for our strategy specifically.

China’s economic transition will remain on track

Investor pessimism is overdone. The slowing rate of growth and concerns over misallocation of capital in a tightly controlled economy overlook a magnitude of upbeat data that show China’s economic transition remains well underway. While the headline rate of growth and industrial production in China has fallen by half over the past decade, the economy grew nearly five-fold, a reminder of the law of big numbers and the fallacy of obsessing over whether GDP is 5% or 8%. Private consumption has risen from 32% of GDP growth last decade to 41% in the past five years, and will hit nearly 50% for the remainder of the decade, already overtaking heavy industry in terms of contribution.

Where we predict a few surprises in 2016

Despite the volatility, our team feels that China’s fundamentals today are not that different from where we began last year. China never fails to surprise though, and here are some areas where we would stick our neck out and make some predictions for the coming year:

Positive: Better demographics and many billions of RMB of new consumption will result from the scrapping of the one-child policy and reform of the household registration, or hukou, system. More than 70% of families with one child now want to have another, so expect demand for bigger houses, better education and a new wave of internal migration. Hukou reform will drive further urbanization and millions being brought under the social security safety net, resulting in a redirection of income toward consumer spending.

Positive: The size of the upper-middle class, by McKinsey’s definition, will stay on track to half of all households by 2022, up from 12% in 2012, and surprises will come from the non-linear growth of consumption. Expect certain sectors to sharply outpace overall income growth as households cross from one income threshold, i.e. middle class, into another, i.e. upper middle class.

Positive: The weaker RMB and lower equity valuations will result in domestic opportunities looking more attractive by the second half of the year, resulting in higher demand for local acquisitions and benefitting the businesses we control.

Negative: Expect richly-valued listed companies to continue to drop, led by A-Shares, while H-Shares, especially in the consumer sector, hold their own. For the past few years, overvalued stocks got richer, and cheaper H-shares got cheaper. This will finally reverse.

PE in China is changing

Signs that Chinese private equity is migrating toward developed market models are clear. Capital deployed in buyout transactions has jumped from US$5.4b in 2014 to $16.7b in 2015, while investment in growth capital deals fell to US$22b from $24b, the first decline since 2012. We believe this is partly due to economic challenges, succession and lifestyle issues, and also the limited attractiveness of minority investing, especially pre-IPO stakes. However, most buyouts remain heavily predicated upon multiple arbitrage – such as take privates in the US with the intention to relist domestically. The competition for these transactions has been extremely fierce, prices paid have been rising, and relisting comparables falling. The number of transactions predicated on control and operational improvements remains very limited, and this is where we will continue to specialize.

These changes highlight the growing opportunity for our Lunar Way

These three pillars of our investment strategy will grow stronger in 2016. First, our experience buying and building platforms in the mobile, baby, kids, beverage and snack foods sectors have taught us that focus works, and will continue to provide us an edge in sourcing, diligencing and managing investments. Secondly, the greatest value, certainty and risk-adjusted returns we have generated historically have resulted from the transparency, daily involvement, improved governance and lower risk of adverse selection that comes with control. Thirdly, our track record of effecting the necessary transition from founder-led to professionally run management, in Yeehoo, Linktone, Yonghong, Yaotaitai, Joysun and many other businesses, is becoming increasingly valuable.

We foresee our addressable opportunity set growing in 2016, influenced by three factors. First is the economic slowdown, which is taxing founder-led management and creating the need for a fresh approach. Second is succession, a growing problem whereby 82% of China’s aging private entrepreneurs lack a successor. Thirdly is the desire for better quality of life amongst entrepreneurs nearing retirement, a marked departure from the “all work, no play” culture of the past three decades. In aggregate, we estimate that at least $20 billion of consumer businesses will turn over in 2016, with that number rising to $35 billion per annum by 2025. These themes are all evident in the current pipeline we are pursuing in snack foods, women’s apparel, baby products and other target sectors.

A clear roadmap for deploying capital

We will deploy capital to buy and build privately held, mid-market consumer companies that remain the sweet spot for Chinese private equity, but will strive to build greater scale. We will accomplish this by leveraging our experience successfully building platforms, such as Linktone, Little Star and Yunnan Forestry, to aggregate a number mid-market acquisitions similar in scale to Yeehoo and Yonghong, smaller spinouts like Peekaboo and SmartPay, and synergistic bolt-ons like Soho Baby and Pinco Pallino. This will allow us to benefit from our middle market focus, operational value add, and entrepreneurialism, while building the scale necessary to maximize operating efficiency and routes for exit. Expect us to build platforms in sauces, seasonings, women’s apparel and others, while continuing to invest in snack foods, baby, kids and agriculture.

We have the vision and roadmap to build about six platforms over the coming investment period, comprised of a number of acquisitions, spin-outs and bolt-ons, financed initially by LCP-IV, and expanded through co-investment capital and increasingly available domestic financing. We are furthest along in building out our snack food platform, Castle Snack, which recently acquired a majority controlling stake in Yaotaitai for its brand, distribution, potential for e-commerce, and opportunity to attract younger, more affluent consumers concerned with health and lifestyle. As with previous acquisitions, our first goal will be to transition Yaotaitai from founder-led to professional management. We are simultaneously working on a pipeline of additional acquisitions – most notably, one of Shanghai’s most famous snack food brands, and another with established leadership in the Beijing market.

Lunar | January 29, 2016

Lunar Capital 2014: Progress to Date

We believe the coming decade will be marked by an emergence of individuality, a shift from savings toward consumption, and government policies that support the growth of a strong consumer-led economy. Managing these changes is a challenge for the consumer businesses that we target for investment.

The recent slowing of growth, in addition to scarcity of credit, has resulted in the need for a different approach to managing consumer businesses. Businesses solely reliant on growth will face particular challenges; no longer will all boats be supported by rising tides. We are entering a phase of development where robust management processes are necessary at every level. Top-line growth must be driven through better distribution and product offerings, not simply through discounting. Efficiencies must be generated through more aggressive supply chain management and stronger human capital.

Energy and talent that entrepreneurs and founding shareholders brought to their businesses must now be complemented by professional management with the necessary skills and clear decision making processes. Many companies will continue to build strong professional management teams and delegate accordingly. We anticipate that others will turn to Lunar as a solution, in which we offer fresh management talent, streamlined decision-making, and a win-win partnership with shareholders facing generational, succession or other issues. We believe that we can do our job best as investors when we position ourselves to provide a solution to these challenges and create a fresh new wave of growth and opportunity.

We are confident that our processes are the best way for us to deliver value and create the platform for further entrepreneurial growth across a growing and increasingly diverse set of companies. Many of the same business processes we apply in our Yeehoo baby wear business are directly applicable to Peekaboo, and influence how we think about managing Yonghong or expanding Joysun’s product offerings. Regardless of the industry, the challenges we face during product development, distribution, marketing, supply chain management, logistics and human resources share many similarities.

We also believe that these processes allow us to deliver the transparency necessary to make informed decisions, generate realizations, and serve as the best possible fiduciaries for our partners, which have been hallmarks of Lunar Capital’s culture. We understand that we are custodians of capital with a responsibility to ensure compliance, best practices and an ethical work culture, all of which we take very seriously.

We are pleased to report our progress year-to-date in 2014:

·         We have now generated full or partial exits on more than 75% of our historical investments. Realizations can roughly be classified as 55% Trade Sales, 30% IPOs and 15% recapitalizations or other distributions of profits. We believe this balanced mix of realization proceeds through multiple channels is a differentiating characteristic of our investment strategy, and demonstrates the resiliency of our businesses and the resourcefulness of our professionals.

·         Distributions in our most recent two funds continue to outpace our peers despite the challenging environment for IPOs in China. To the best of our knowledge, LCP-II and LCP-III both lead their vintages in China.

·         We began exiting two investments that are nearing the end of our investment process. This resulted in partial realizations in WH Group, now the world’s largest pork processor, and Yunnan Forestry, our timber and wood-related products business.

·         We generated an additional two partial exits through bringing on board minority investors that we believe will be of substantial strategic benefit. This includes the sale of a minority stake in Little Star Brands Group to one of the largest department store owners in China, and the sale of a minority stake in I Pinco Pallino to one of China’s most famous international movie stars.

·         We distributed substantially all of the proceeds realized from the above four transactions, maintaining our commitment to deliver returns in a timely manner, favoring distributing cash versus increasing the perception of unrealized value.

·         In all cases, we believe that our operational involvement has been a key driver of what we were able to accomplish. We have observed in our own portfolio that investments with the highest relative degrees of control have generally performed better and benefited from more exit options, with less risk. We remain convinced that operational value-add is our best way of driving investment performance.

While the past six months in China have largely been characterized by reports of slowing growth and politics, we see China re-balancing towards a healthier and more sustainable economy. Whether overall growth rates are surging higher in the 8-10% range, or merely robust around 6 -7%, there is clear indication of a strong shift toward domestic consumption driven by the rise of the Chinese consumer. Policy makers are supportive of these objectives, and reforms are well underway. With these powerful trends in place, we are confident that investing in well-positioned consumer businesses and helping them with intensive operational value-add will yield success as capital markets continue to liberalize, the IPO markets reawaken, and our investment strategy benefits from substantial tailwinds.

Lunar | September 30, 2014

The Rise of the Blue Collar Consumer

The Chinese economy give labor leverage – in other words, rising wages. This is resulting in a visible redistribution of wealth and an increasing number of blue-collar consumers entering the marketplace.

The One Child policy has begun to take its toll on China’s labor force. Although China’s population has remained relatively stable – 1.36 billion people today versus 1.19 billion 20 years ago – its working age population has peaked, dropping by 3.45 million in 2012 to 937.3 million people. In order to remain competitive, China decreased its reliance on capital-intensive manufacturing industries over the past decade, with manufacturing dropping from over 50% to 34.8% of the workforce between 2001 and 2011. Service industries have taken up most of the slack, now representing 35.7% of the workforce. Improving productivity and increasing economic output has also led to better working conditions and rising wages. The minimum wage increased 21.7% in 2011, with government policy-makers targeting to raise it to 40% of the average local salary by 2015. Thanks to government legislation and employer initiatives, worker safety, housing, and social insurance have all had major improvements. This all has led to more demand for labor at increasing wages.

We have seen the effect of the rising power of blue-collar workers in our forestry business, which is based in Pu’er, Yunnan Province. Rural land reforms and the demand for agricultural products like timber and world-famous Pu’er tea have played a role in rising living standards for locals in the region. When our company was founded in 2003, forestland in the local counties was priced at RMB 200 per mu, and the average forestry worker was paid RMB 1000 per month. Nowadays, forestland is sold at RMB 2,000 per mu and the same worker takes home RMB 3- 4,000 per month. In 2003, Pu’er tea was known to sell “at the same price as lettuce and cabbage.” Today, tea sells at over RMB 100/kg, fifty times as much as a head of cabbage that now sells for RMB 2/kg. It is now the norm for farming households in this sleepy municipality to earn RMB 100,000 to 200,000 per year to grow tea, coffee, walnuts or timber. For those who prefer to avoid the physical toil of farming, there’s also the option of seeking work in the many factories and businesses that have sprung up in nearby Chengdu and Kunming, which has resulted in provincial economic growth averaging 13.5% per year for the past 3 years.

Workers have been becoming continually more difficult to attract and retain. Worker recruitment companies from the Pearl River Delta promise Yunnanese increasingly favorable conditions. We need to match their offers, and currently offer workers and their families free dormitories, subsidized utilities and free meals during their shift at our two wood processing facilities. At the same time, these increasingly affluent blue-collar workers are becoming good consulters for businesses in the region. In the provincial capital of Kunming every day, consumers swarm the central shopping districts with crowds that would rival any Boxing Day or Black Friday in western countries. Similarly, in the storefronts of Pu’er, cellphone stores hawking Samsung, Apple and HTC seemed to stretch on for miles. Local Pu’er residents have upgraded from bicycles and tractors to motorcycles and Dongfeng minivans. Within the city, construction has begun on Puer’s first Walmart and KFC, and mid-tier brands like Wyeth and Adidas have set up local flagship stores.

We believe that this trend of blue-collar workers commanding increasingly good wages will continue, and lead to a new source of increasing consumer demand.. As business owners and operators, we must continually refine our worker engagement strategies to maintain and improve productivity, and also enact socially responsible policies. As investors, it opens further opportunity for us to identify consumer-focused businesses well positioned to take advantage of this new and growing customer base.

Lunar | June 17, 2013

Two Meetings, One Goal: Rebalancing Toward a Richer Consumer

In China’s recent Liang Hui — the annual meetings of the National People’s Congress and Chinese People’s Political Consultative Conference — raising the size and living standards of the middle class were the primary policy objectives. China believes the answer is to urbanize, raise disposable income, and widen the social security net. These new policies fuel our desire to build businesses that deliver products and services to a larger base of wealthier and more discerning consumers in China, but give rise to corresponding challenges, which we discuss in more detail in this month’s commentary.
A scant majority of China’s population lives in urban centers. The current level of urbanization, 52%, has risen over the past 10 years from about 44%. The goal is for this to reach 60% in the coming 7 years through moving 100 million citizens from the countryside into cities. An estimated RMB 40 trillion development package has been authorized to achieve this goal before 2020, which will generate infrastructure development, commercial investment, and job creation to expand regional economies. Even if achieved, China will have a long way to go to reach the urbanization rates of South Korea, the United States and Taiwan, which all exceed 75%. Urbanization will lead to a tremendous addressable market over time, but in the near term is likely to exacerbate regional disparities in taste and affordability. The challenge for Lunar will be customer segmentation within our businesses. This reality drives our thinking in many ways. For example, it has heavily influenced our business plan for our babywear businesses, where we are increasingly pushing our managers to customize their offerings and target clearer segments and price points.
Disposable Income 
The government has targeted a 100% increase in disposable income, from RMB 21,986 to RMB 43,792, by 2020. To achieve this goal, one of the measures the government will implement is a new minimum wage, resulting in the potential for a 32% wage increase across China by the end of this decade. Although wage inflation will put labor-intensive industries under pressure, the hope is that this will create the impetus for migration to third- and fourth-tier cities, with a corresponding rise in development and incomes. Current wages for typical regions in China, and the estimated effect of new wage policies, are as follows:
The implication for our investment strategy is to focus on higher value added businesses with strong brands and which capture consumer’s desires. For this reason, we remain focused on brands – Yeehoo, Joysun, Yeehoo, Niutou – to a greater extent than labor-intensive services, for example startup fast-food restaurants, which have been a target of significant investment over the past three years. However, it also is a reason why we are so focused on operational value add. Running businesses with the need to relocate work forces and manage rapidly rising wages, all while creating better products, requires more operational value add, i.e., sweat equity, versus cash, i.e., typical Chinese private equity. We need smart managers, and we need the processes to help them do their jobs better.
A Broader Safety Net
China remains fiscally healthy, but is increasing debt to fund the government’s secondary income re-distribution programs. Debt to GDP will rise to 2% this year, versus prior years in which the government ran a surplus of close to RMB 1 trillion. The program will target expanding social benefits on healthcare and social security, and will seek to alleviate the disparity between high rural savings and their lower urban peers. The goal is to create a greater sense of security, and thereby free up capital for consumption and for taking risk. We believe that the lack of a sense of security drives more than savings in China. It also creates the need for brands that address health, safety and quality issues, which remains a challenge and a significant opportunity.
Early Signs of Rebalancing, and the Opportunity to Succeed
While the recent Lianghui brought renewed focus on urbanization, this trend has, to be fair, long been underway. In the cities and provinces where most of our businesses are located – Yunnan, Guiyang and Sichuan, for example – growth rates are already steadily higher than first tier counterparts. Retail sales growth also demonstrates that while concerns persist about slowing demand, the purchasing power for higher quality products is strong. However, these trends are occurring in the context of a highly fragmented market, evident in businesses like snack foods where local tastes have created nationwide interest, but barriers for companies trying to expand. The clearest example may be KFC, which has become China’s most admired fast food franchise, but offers menus that differ dramatically between areas like Beijing, Shanghai and Chengdu. These complexities create barriers to entry and difficulties for management, but also opportunity for those providing the operational expertise and sweat equity necessary to succeed.
Lunar | March 15, 2013