Return to Gunpowder
 This Issue—December 2004
In this second edition of Gunpowder, we print letters from two readers, Sam Kinney, founder of FreeMarkets Inc (before being acquired by Ariba, FreeMarkets was the leading provider of strategic sourcing solutions) and Frank Russo, with Thomas Register. Both provide practical advice on sourcing and negotiation strategy. Next, our free-trading editor, Lisa Reisman, joins with Jason Busch to take a look at how a second Bush term will impact global sourcing. Last, globe-trotting Stuart Burns caught up with Simon Teo on how to succeed in setting up joint ventures in the Chinese market. Simon offers a must-read perspective on China, as his first JV did not work out as planned, and he’s since learned the tricks of the trade which he shares with us here. If you’re considering doing any business in China, you must read his story.
Letters to the editor

To the editor,

Following up on your first newsletter article on negotiation strategy, another tactic to consider for commodity markets is to construct “natural hedges.” In financial markets, borrowers or lenders often pursue a strategy of “laddering maturities.” Let’s follow a bond buyer’s example. When laddering, the buyer makes part of his or her total investment in short-maturing bonds, some with a medium-term maturity, and some with a long-term maturity. When rates decline, the long bonds keep the yield up. When rates move up, the short bonds follow the rates up. Over the cycle, the bond buyer has achieved a naturally hedged (“smoothed”) position even without resorting to special instruments such as futures as hedges. Thoughtful commodity buyers can approximate a similar strategy. Consider buying some fabricated items on longer term fixed price contracts, while surfing the spot market for shorter term volumes of raw materials. While it’s not a foolproof approach, it’s a consideration that should always be part of a contracting strategy.

As to commodity strategy, it’s also important to consider which party is more naturally able to assume commodity price risk. Large customers may be better able to assume commodity risk than that customer’s smaller suppliers. The larger company can often access sophisticated hedging strategies (e.g. futures markets), often has global reach to neutralize some risk, and might also have pricing power to pass along adverse moves to their customers. So another strategy that should never be far from mind is to ask your customer to assume price fluctuation risk in the underlying commodity while retaining for yourself the cost of conversion.

It’s important to recognize both of these as “portfolio strategies.” They’re applicable to overall category management, but may not help one particular buy.


Sam Kinney, Co-Founder of FreeMarkets (currently Managing Director, Firehole Partners)

To the Editor,

My congratulations to you on a great job with this newsletter!

I want to add to your point about one-on-one negotiation as a strategy for sourcing stampings. In my view, it depends on the stamping. Stampings can be highly engineered products loaded with a company’s IP, or they can be commodity-like (with little engineering IP). The underlying value separating these two examples is the development of the tooling itself. Custom tooling for highly engineered stampings are part of a company’s tangible IP assets. So, one-on-one negotiation for these critical, high-value parts makes sense.

Frank Russo, Thomas Publishing / Thomas Register

Four More Years—How a Second Bush Term will Impact Global Trade and Sourcing

Going into the election this November, neither candidate represented the free trading ideal we believe this country needs. Kerry’s protectionist philosophy and ill-informed knowledge of “outsourcing”—made him a scary choice. Bush’s support of indiscriminate tariffs and ties to corporations seeking protectionist policies also raised our alarm bells. But perhaps most important to the US economy, is the ramification of a plunging dollar. We did not hear much from either candidate on that issue.

So what can we expect from a Bush second term? We believe probably more of the same. We’re not expecting Bush to rock the trade boat too much, but we’re planning for the occasional rough seas, as we expect some protectionist waves to slow progress from time to time. Take the case of China. We think that Bush’s support of China’s entry into the World Trade Organization is positive, as is his rejection of proposed tariffs for Chinese made products, from brake parts to wire hangers. But at the same time, Bush has bowed to special interest groups on other China imports, imposing duties on various textiles, from brassieres to dressing gowns.

And we can all remember Bush’s support of tariffs in his first term. From the now infamous steel tariff which temporarily increased prices nearly 30% on imported steel to the farm subsidies which protected domestic producers from foreign competition, Bush was not exactly a model crusader on a campaign for global free markets. We believe that Bush will continue to pull the tariff trigger from time to time, as it suits his political and social interests. Overall, however, new tariffs will be isolated, and US companies sourcing from global suppliers do not have much to worry about, except an occasional hiccup.

But global sourcing and trade is not just about trade politics. Fiscal policy will also play a key role for companies buying and selling around the globe. Since October, the dollar has fallen by seven percent. The problem, according to Fed Chairman Greenspan is that the US account deficit is not sustainable—“because foreigners would eventually lose their appetite for more dollar-denominated assets,” according to a recent Economist article. With the US import market 50% larger than its exports, the trade deficit will continue to widen.

The easiest fix to the situation is to decrease the current account deficit by cutting the budget deficit and paying down our national debt (which would ultimately improve the dollar, and reduce the cost of imports, making global sourcing an even more attractive proposition).

But that’s not likely to happen in a second Bush term, given the Texan’s propensity for spending and tax cuts. Whoever said that a big spending, tax cutting Republican was an oxymoron? Certainly, not us …

Lisa Reisman is Managing Director of Aptium Global Inc., and leads the firm’s US practice. She can be reached at 773 525 9750 or lreisman@aptiumglobal.com. Jason Busch can be reached at jbusch@azulpartners.com
or 773 525 7406. Jason also authors the blog: www.spendmatters.com.

Q&A with Simon Teo—Setting up Joint Ventures in China

Based in Singapore, Simon Teo has owned and operated several trading and manufacturing operations throughout Asia. As a strategic partner to Aptium Global, Simon is in a great position to offer useful commentary on the Chinese market, as one of his investments in China did not pay off, while another has gone well. His current venture prints aluminum foil for color labels for beer, wine, and food packaging. His first relationship in China soured when he found that his local partner was selling off capacity from the venture and pocketing the proceeds (while also failing to maintain the plant and facility).

What drove you to consider China as a manufacturing base in the first place?
It’s a very straight forward answer—China represents a huge consumer market plus it offers very cheap labor costs. My product is aimed at the consumer market and such a product does not have high demand in Singapore due to its low population. From a labor cost perspective, China is only 1/10 of our local cost in Singapore. And that’s before we consider factory rents, and corporate tax, etc.

Why did you go the partner route rather than the wholly owned subsidiary route?
Wholly owned businesses in China are subject to many constraints. There are many government policies to watch. Many times you will find regulations change overnight. Moreover, depending on the location, you might have to go to at least five departments to register and apply for a business license. At this point, you may encounter many unreasonable requests such as requests for donations to speed along the process. Partnering with an established local company can help by-pass an enormous amount of this hassle and red tape.

Did you encounter any problems working with your first JV partner?
As an investor, I had the majority share in my first joint venture in China. However my local JV partner felt that after working so hard for the JV company, that we (the foreigners) were the ones getting the largest benefit. Hence, our “partner” started to work for his own objective. Negotiations got me nowhere so in the end I terminated the agreement and moved the manufacturing equipment out of his premises.

In what way was the set up of your second venture different from the first?
My initial approach was to market our products specifically in the Chinese consumer market, but after the bad experience of my first venture I re-thought this strategy. In my second approach, I reduced our share holding to below 50% and remained as a minority share holder. Also I tuned our sales and marketing focus to make it 50% domestic / 50% export. By doing so, I made my new partner think that we were indispensable. And our contribution also plays an important role to the company’s financial returns especially when it comes to tax exemptions and tax rebates. Tax issues are a crucial issue in dealing in China and there are advantages that a JV with local and foreign involvement can exploit.

One should be aware that financially speaking, the Chinese are becoming less dependent on foreign investment for working capital. Many Chinese investors are now capable of supporting the full investment themselves. This begs the question: what can an outsider contribute? Let’s walk through one example to show how to “sell” a JV concept to a Chinese company. If you are manufacturing products and selling them to the Chinese market from the USA, you already have market share instantly when you start your JV in China. With the JV established, you can now re-export Chinese made products back to USA and you are in control of the sales and marketing efforts, both locally and overseas. This is an ideal case. In short, you must become indispensable to the JV company, as the Chinese are very pragmatic in how they approach partnerships. At this point in time, if your Chinese partner feels that the JV will benefit both parties, the relationship will be solidified.

How does the structure of the Chinese commercial market differ from that in other parts of Asia like Singapore?
There are two items worth noting. One is the legislation of the commercial rules and laws (R&L) and the other is the culture of the business community. In Singapore, the commercial or manufacturing market is governed by a British-based set of well written R&L. China, though, is different. Every Chinese province down to the city—and even the neighborhood—level has a different set of rules. This can be very confusing to outsiders! The second point is that in China, business is often done based on relationships or friendships. Sound advice from outside advisors is therefore absolutely crucial to success, if the investor does not already have a strong base inside China.

What is your advice for identifying the right JV partner in China?
When you are partnering with someone in China, ask yourself what you look for when you are seeking a potential partner back at home. It’s similar. First, you don’t jump in to it just because you have the urge. You will need to know the background of the potential partner and find some opportunity to work together in dealings before launching a full blown JV. Like marriage, don’t try to change your partner but try to improve them. Relationships can take time to build. 1 to 3 years is usually enough for partners to become comfortable working together in the Chinese market.

What would you consider the key ingredients for a successful JV operation in China?
This is a tricky question. Also my answer will not be universal to all trades. But based on my experience, these ingredients together can be a recipe for success:

1. Define the market for the product and how to sell it before launching operations

2. Take a very close look at the commercial rules and laws of the province, town (and even neighborhood) of the place where you are planning to set up the JV

3. Take time to understand the business and human culture of the place you are going to

4. Ask yourself why your partner needs you. If the answer is they need working capital from the investor then think twice

Only when it’s a win-win situation to both parties will the JV work out fine.

   
This newsletter is published by Aptium Global Inc a direct material advisory firm based in Chicago, IL. With offices in the UK, China, India and a network of global associates, Aptium Global works with small and medium sized manufacturing companies to save money on direct material purchases. Smaller companies face the same cost pressures as the Fortune 500, yet often lack budgets for cost reduction services. Aptium Global works with organizations on a pay-as-you-save™ basis, minimizing impact on cash flow and maximizing impact on the bottom line. We aim to publish this newsletter on a monthly basis but reserve the right to miss a few deadlines here and there.

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