China Rate Cut: Unintended Consequence

Summary
China announced interest rate cut of 25 bases points during the weekend after recent disappointing macro-economic data. There is hope that the easy monetary policy can help China reverse the slowdown.  However, the rate cut may have unintended consequences. Since 2008, there has been a pattern of US dollar flowing into China through carry trade. This source represented an important part of the liquidity to the local market. But the whole carry trade is based on an unsustainable system. Further rate cuts in China and possible hikes in US later this year will risk pushing carry traders to disorderly wind down their positions.

Carry trade is an important part of liquidity in China
Since the financial crisis in 2008, China has increased its foreign exchange reserve by around USD2.5tn, among which trade surplus contributed USD1.8tn. There has been a lot of comments about the fake trade which helped investors move money into China. No one knows the exact number of the carry trade and some analysis even suggested that it may be over USD1tn. But at least two indicators can help put some light on this issue. Since 2010, accumulated difference between reported China export to HK and HK import from China has amounted to over USD400bn. Another indicator is Hong Kong banks’ total international claims which also increased by around USD300bn. Mainland companies can use off shore entities and complicated structures to bring trade finance into China. Although there is some double count here, the total amount can be easily above USD500bn and it has not counted any other source of money flow.

An unsustainable triangle
For the carry trade, when US dollar moved into China, the real dollar became currency reserve for central bank while RMB was issued for investors to buy wealth management products. Most of the money ultimately went into property and infrastructure projects. As long as there is liquidity, the products can always be refinanced:
Figure 3: Carry trade system

Source: Estimation

However, the system was based on three basic assumptions: interest rate difference, stable currency and return on (of) the projects. While the system has been running for five years, it becomes partly self-fulfilling. Wave after wave of incoming money, supplied by US central bank, guaranteed a rising currency and easy refinance of even the worst projects.

Interest rate difference: The rate to borrow the US dollar in Hong Kong was around 2.5% for companies in China and they can easily reinvest the money into wealth management products that yield 6% and the products were implicitly guaranteed by government. The rate difference has been constantly around 3% or higher which created a perfect environment for the carry trade.

Stable currency: Besides the self-fulfilling effect from more money coming in, investors also have some kind of belief that Chinese government will let the currency gradually rise in the foreseeable future. Because since 2005, the trend of ever rising currency has been the case. A lot of carry trade investors did not even bother to hedge the currency and enjoyed extra gains from the currency move.

Return or refinance of the projects: Nowadays, it was rare for a wealth management product to return cash when it is due because of the project had made money and cash flow. Almost all of the products were refinanced by another one. A lot of the money ultimately went into the property and infrastructure projects that may never make money. But the investors believed that they will not be the last one to hold the products or government will save them from any problems.

Rate cut and death spiral
The whole carry trade system was very attractive to investors because it did not require a lot of initial capital. It was like making money out of thin air. But it is completely wrong to think that the system can be sustainable. The Chinese rate cut and possible US rate hike may put enormous pressure on investors. The intention to ease the monetary policy is good but the combination of policies may quickly kill the carry trade investors. When everybody runs to cover the trade, currency will be under pressure, the bad projects will run out of money and the selling of assets by central bank will further squeeze the interest rate difference and currency.
Figure 4: Interest rate difference between 2 year Chinese government bond and US treasury
Source: Yahoo finance

Conclusion
The only thing that can prevent the breakdown is central bank’s USD3.8tn reserve and market believes that the worst consequence can be avoided. That may be the case but the whole system is still not sustainable in the long term. It is amazing how easy money and ‘implicitly-guaranteed-by-government’ assets can distort the market and lead people to invest in low return projects and ever rising properties. But the reverse of the process will be very painful. If central banks in China and US resume their course, we may see the crisis sooner than we thought.

IBM: Hidden value in underutilized industry knowledge

Summary
IBM has been in trouble for some time with declining revenue and market share. Comparing to ever more innovative products from cloud computing and mobile companies, IBM’s mainframe and traditional software never seem so obsolete. However, the belief that IBM is a technology company is fundamentally misplaced. Almost all of its profits are somehow related to consulting services. The main drive behind its profit, the deep knowledge of different industries, has not changed. Although IBM is late to the cloud and mobile, that is always the case for past several generations of technology. It is amazing for this company to constantly earn +$10bn when they do not get the technology right. Currently, you can buy this stock with 11x PE on the do-not-get-it profit. With the help of recent transformation to better integrate cloud computing, the true value and earnings power of its deep industry knowledge will be gradually reflected in the market price.

A consulting rather than technology company
In the Enterprise IT space, there are many ways to make money but most can be categorized into three segments. The first two are providers of hardware or software as a function. The third is a consulting firm that helps customers integrate and create business value. The general perception is that IBM makes money from technology products. However, a detailed look will reveal that IBM is more like a consulting company rather than a technology provider. Considering that part of IBM’s software sales were also a result of the consulting projects, a big part of IBM’s profit depended on consulting and integration.

Figure 1: Industry breakdown

Source: Company data

IBM makes money from its industry knowledge
The business model change in IBM can be traced back into 1990s’. The strategy to create value as an integrator rather than a provider was set during the time of Louis Gerstner. In his book, he mentioned:

“Sure, there are supply chains, and there are enterprises at various points in the chain that offer only one piece of a finished product: steelmakers in the auto industry; component makers in consumer electronics; or providers of a marketing or tax application in financial services. But before the components reach the consumer, somebody has to sit at the end of the line and bring it all together in a way that creates value. In effect, he or she takes responsibility for translating the pieces into value. I believed that if IBM was uniquely positioned to do or to be anything, it was to be that company.”

Unlike software or hardware companies who just provide functions to the customers, IBM developed most of its solution with the biggest companies in the world. During this process, it accumulated the knowledge of how the actual business works. This knowledge does not show up in any financial statements, but it is the real building block for the whole company. I would argue that customers pick IBM not because the products are better, but because IBM knows how business works with technology. Among system integrators, IBM has the biggest market share covering almost all industries.

Why IBM is not growing
The main reason that IBM makes money in the past is because it knows how to integrate, not only its own products but also others’. The rapid growth in the cloud computing market is definitely a shock to IBM’s traditional business model. The small and medium size companies now purchase individual software functions like CRM or HR from cloud computing providers at a very low cost, creating a boom in the market where IBM is not presented yet.

Figure 4: Business model difference

Source: Company data

IBM was never supposed to directly compete with those software providers. But as an integrator, IBM was not able to leverage its vast industry knowledge base to create integration solutions for smaller companies. There are several factors that contributed to this: 1) IBM’s mind set of creating complete solution to big customers. Its old business model was not able to incorporate the new cloud computing platform; 2) IBM’s organization that was slow to adopt new technology. This is not the first time when new technology forced IBM to change; 3) Smaller customers that are more focused on gaining access to IT infrastructure that they cannot afford previously rather than building a strategy around IT.

Market misconception about IBM
Despite lagging in the cloud computing, IBM’s most important competitive advantage, the deep knowledge of industry, has not been weakened. It enjoyed margin expansion as an integrator because of a lower input cost (software and hardware). While market thinks that IBM is only for big customers, the industry knowledge can be applied to smaller companies. But acquisitions are not the way for IBM to figure out how to serve smaller customers. The buyback was actually a better reinvestment at current stage.

• Declined price in software/hardware lowered IBM’s cost

If you think of IBM as an integrator, the current cloud computing products become part of its input. The rapid price decline of software and hardware is a big contributor to the margin expansion in recent years. Moreover, the fast growing earnings (or may be just revenue) in software industry can be delusive because of the intense competition and price decline. But it is much harder for competitors to accumulate the knowledge about industries.

Figure 5: IBM service revenue vs. margin

Source: Company data

• Potential growth from serving smaller companies

Thanks to the fast growth in low cost cloud computing services, smaller companies had the chance to use more sophisticated software functions. Some companies are using Salesforce.com for CRM, Workday for HR and some online database for transactional data. Each service is easy and cheap enough on standalone basis, but the customers can definitely get more from an integrated point of view with those existing systems. The fragmented services and a large customer base have created a perfect environment for future integration and business value creation. The growth rate of IBM’s Strategic Imperatives will be an initial sign of whether IBM can get it right.

Figure 6: Growth from IBM’s Strategic Imperatives

Source: Company data

• Buy back is the appropriate choice for now

Buying one cloud computing provider to enter the market cannot help IBM release its underutilized industry knowledge. It is up to IBM itself to figure out a profitable way to provide integration to those small and medium size companies. So when it is still trying internally, buyback is an ideal way to compound return. It is true that IBM needs to invest more on the business, but small acquisitions they made in recent years should be enough to help understand the economics and customers behind the new technology.

Figure 7: IBM’s use of cash vs. EPS

Source: Company data

Conclusion
If you just look at the current earnings and growth trajectory, IBM will never seem to be an attractive investment. But if you think of it as the biggest technology consulting company and an integrator, its accumulated industry knowledge is clearly underutilized and undervalued. The potential market size can be huge considering the fast expansion of fragmented cloud computing services among smaller customers. Current valuation of 11x PE on below-normal earnings can be very attractive to the investors in the long term.

Figure 8: Comps within IT consulting and outsourcing segment:

Source: Company data