A ‘wow’ business model, The Party, and what China exports

I am not sure what surprises us more, the revelation in the Journal of Biomechanics(1) that a common ant can lift 5,000 times its weight or the fact that the largest IPO till date has stopped taking orders from big investors a day sooner than planned(2)! Jack Ma’s Ant Group Co. is scheduled to raise USD34.5bn and plans to get listed on November 5, 2020. For the IPO, that is most likely to pip Saudi Aramco’s USD26bn record, has already seen retail portion oversubscribed 870x at Shanghai, and Bloomberg reports that mom-and-pop shops in Hong Kong are taking 20x leverage to supercharge their bets.(2)

Ant’s business is interesting. What accounted for more than half the revenue three years ago (Alipay – payments bank), today is just a hook for the real business (credit lending, wealth management and insurance distribution). Alipay’s volumes are staggering (close to USD4tn of total payment value compared to cUSD5tn for MasterCard and cUSD9tn for Visa), but low margins (at c10bps,) translate into transaction take rates that are just 5bps versus say 230bps for Paypal. Hence, little money is made in this business.

But that’s what makes fintech fun; using payments bank to understand consumer behaviour and making money elsewhere. Where, you might ask? Well, last year, Ant disbursed close to 16 consumer loans per second. Not impressed? How about USD300bn loans in one year? Put that into context–it is 22% of what the entire Indian banking system disbursed by ONE company, in ONE year! The best part is, Ant does not take any underwriting risk, the partner banks do (there are a 100 of those); it just gets a fee for sourcing the loan. The company has also tied up with 170 asset managers in the wealth management business, where it manages 680mn users with over USD500bn in AUM. Similar story with insurance distribution; with just a ‘sideline insurance agency licence’, about 107mn people have joined Ant’s health insurance plan and it accounts for 13% of the online premia market. So how much money does the company make? Well, for 3QCY20, it clocked USD6.8bn revenue and USD4.0bn gross margin –a growth of 50% and 75% year-on-year, respectively. That’s just…WOW!

The Party: While Ant’s business model looks stellar, how China’s capitalist corporations co-exist with a communist ideology is even more fascinating. Richard McGregor writes in his book, The Party: The secret world of China’s communist rulers, that Hu’s displacement of Jiang (in 2002) was not only the first peaceful handover in China since the 1949 revolution, which was notable in itself, but also the first in any major communist country. The roots of The Communist Party of China (CPC) were laid with a civil war in division of territory in 1949 as a unitary one-party sovereign state with Mao Zedong as its founding father.

The CPC has a central committee (c370 members), which acts as a kind of enlarged Board of Directors. The committee selects the Politburo (25 members), which in turn selects the Standing Committee (the sanctum sanctorum; currently seven members). The Politburo’s overriding priority lies in securing the CPC’s grip on the state, the economy, the civil service, the military, police, education, social organisation and the media. The Party keeps a lock-hold on state through three pillars: (A) Companies: Within all companies, there is a separate ‘Party Committee’ which has superseded the Board of Directors on occasions. (B) Personnel: The Organisation department maintains files on top-level officials in the public sector and appointments are announced without any accompanying explanation. In 2009, heads of three state airlines were rotated overnight to rival firms to keep competition in check. (C) Army: The People’s Liberation Army was formed in 1927 as a military wing of a revolutionary party, and its key mission now is to ensure that CPC stays in power.

What China exports: Steve Cheung, a Chicago-trained economist, had said, “the Chinese had to deal with corruption, a D-grade judicial system, controls over freedom of speech & beliefs, education & health care which were neither public nor private, exchange controls, inconsistent policies and tens of thousands of riots.” It is surprising that the economy grew nearly at 10% CAGR for three decades. Or maybe it did so because of it!

Lack of political compulsions enables China to operate at levels that do not seem possible for most other countries. For example, prior to China becoming the largest manufacturer of aluminium in the world, it was widely believed that countries with cheap cost of power (since 40% of aluminium smelting cost is energy costs) will have the largest production capacity (e.g., Russia, Canada, Dubai). However, by 2015, China was not only importing key raw materials (bauxite and alumina), but also fuel (coal to generate power), only to export aluminium back to the rest of the world; that too at a price where 30% of global production was losing money. But so was the largest aluminium company in China, Chalco, for four years.

Well, building large-scale infrastructure calls for large quantities of base commodities (steel, cement, including aluminium).  It is my surmise that had China imported all the aluminium it needed from the rest of the world, the eventual cost of building the infrastructure would have been much higher than the cumulative losses incurred by Chalco over many years. The fact that minority shareholders in Chalco, who might not think that huge losses for multiple years is a great idea, apparently did not factor in the equation. The fact that it disrupted economics elsewhere in the world was of little consequence either. A few projects that were commercialised in India (third-largest aluminium producer after China and Russia) during that time faced difficulties as well. This situation was corrected once different economies (starting with EU, then US and now India as well) started deploying trade barriers (duties, import embargoes, etc.) to help their respective domestic industries.

The belief that standalone unit economics (without state intervention) have little relevance in China has kept us wary of investing in businesses where prices are determined at a global level (commodities, textiles, chemicals, among others), and China is a large exporter in that commodity. Over the past few years, however, some businesses have done phenomenally well where either China has decided to vacate the space (chemicals, citing pollution reasons) or were forced to create some space due to clients’ compulsion to diversify their sourcing strategy (specialty chemicals, textiles and EMS). We certainly hope that this trend continues.

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