Traffic or Device Sales, What Matters Most?

James wrote something yesterday that included this graphic:

admob_feb10_US_share.png

What caught my attention, as was the intention of the graphic, was the Android traffic number climbing from effectively zero to more than 40% in just a year and a couple of months. Obviously this was the intention of the graphic (note the green color of the line… designers use green to symbolize wealth) but given that it is published by Admob, which is being acquired by Google, I think you would have to take this chart with a healthy dose of skeptically driven “show me” before you accept it as fact.

The reason I suggest we have some skepticism about this is not because the data is fabricated but because it suggests something very specific that is different from showing Android is beating Blackberry, Windows Mobile, and Palm (although it is believable on the latter) in one statistic that matters, device sales, but rather that application usage on Android is achieving parity with Apple.

I downloaded the Admob Mobile Metrics Report and it is very clear, this chart is derived from an analysis of Admob’s network traffic, not mobile network traffic by device or by carrier. Admob, which serves ads into 15k websites and apps on iPhone and Android, analyzes their traffic and trends it according to the type of OS and type of handset (smartphone or feature phone), but also internet devices like the iPod Touch and the upcoming iPad.

Admob claims 10 billion monthly impressions, which no doubt provides a snapshot of trend data but one subject to a lot of interpretation as it does not include meaningful traffic from Windows Mobile or Blackberry devices as those markets have demonstrated less tendency to browse websites with their devices. Let’s set aside for a moment the strategic implications of this observation by agreeing that Windows Mobile and Blackberry have squandered a big headstart in this market which enabled Apple to brilliantly exploit web browsing as a core competency of the iPhone… and later apps (although as I have pointed out before, Apple was originally hostile to external developers building apps for the iPhone).

This leads me to the main point of this post, which is to ask the question what matters more, how many devices are sold or how consumers use them? There is no denying that the device sales underpin everything for handset manufacturers because that is what carriers respond to and where the handset manufacturers generate revenue, but there is no denying that despite impressive sales numbers by RIM and Microsoft (which isn’t a handset manufacturer but should be considered one for the purpose of this analysis) but at the same time each of these platforms has become less important in the consumer space as the iPhone and Android have dominated the consumer mindset.

I don’t have hard numbers to back this up but I think anecdotal observation is undeniable, consumers use the iPhones and Android devices in a fundamentally different way than their Blackberries and other smartphones. I do recall a statistic that I read recently which said the average iPhone user has 11 installed applications versus 3.5 for the average Blackberry user, and I suspect the divide is equally stark against Windows Mobile devices, and it’s clear that Android was developed to mimic the iPhone in this regard.

If we accept that the iPhone/Android markets are doing more than just reading their email and making calls, does this reflect better capabilities of the devices or a far more simple process for acquiring and installing apps on the iPhone/Android? The answer is clearly yes because the app marketplaces and extensive third party developer capabilities, as well as the unique aspects of the handsets, have resulted in a massively more extensive and vibrant market for mobile applications than on the Blackberry and Windows Mobile counterparts. No denying this.

Now here is where things get interesting. Carriers price their wireless plans with voice and data components, with data predominately offered as all you can eat pricing so with data consumption growing at over 100% annually the carriers are seeing growth in the one part of their network they can’t monetize while at the same time incurring significant capital expenditures for network build out. That data traffic has been surging creates a range of problems for carriers who by all accounts cannot expand their networks fast enough (or afford to when they can’t charge subscribers $60 or $70 a month for data), including degrading voice capability (which is profitable) to add to data network bandwidth.

The other problem that data presents is that it erodes a business that is super profitable for carriers, SMS which generates about 20% or $200 billion of global telco revenues. As apps increasingly provide notification capability and instant messaging, carriers will be put in a real quandary and I suspect we will see them throttle apps that infringe on their core businesses (like voice and SMS), as well as apps that are bandwidth hogs (like Slingbox for mobile).

There is a fellow by the name of Andrew Odlyzko that you should take the time to read up on if you are interested in these topics. Andrew is a Professor in the School of Mathematics at the University of Minnesota and by all accounts one of the most accomplished researchers who specializes in the economics of network consumption. Odlyzko believes that voice is seriously underrated as a market and carriers are making a strategic error by not improving the quality of voice and seamlessly integrating voice with data, but he also asserts that data traffic rates will fall from their aggressive growth rates to somewhere around 30%.

Where this brings us is full circle, if mobile network traffic does trend down then the lines on the network traffic graph provided by Admob would converge, or put another way, normalize. It’s not to suggest that Admob is wrong, only that you have to look at their data with a complex set of filters that put into perspective the limited solar system they are measuring. The other implication of all this is that all you can eat data is likely a phenomena that consumers will not enjoy in perpetuity, or access to mobile apps will be filtered according to the bandwidth they consume. I think it is also plausible to consider that mobile data pricing plans will be tiered according to the device the consumer is using, as in Blackberry users typically use less data therefore have a cheaper data plan than iPhone users.

Whatever the eventuality, one this is clear and that is the wireless market is getting much more complex.

1906 Cable Car Video

This video from the Prelinger Archives is reported to be one of the earliest 35mm films and it is from a camera mounted on the front of a cable car that makes it’s way down Market Street to the Ferry Building Clock Tower. What makes this video extraordinary is that it was taken just 4 days before the 1906 earthquake that destroyed much of San Francisco, so what you are seeing is not only one of the oldest films in history but also one of the last images of pre-quake San Francisco.

What really stood out for me in watching this film is the number of cars plying the streets of SF (and they have license plates indicating a government bureaucracy from the earliest days of the car!), and how wide the avenues were at the with pedestrian and vehicle traffic happily co-mingling. Looking at Market Street today I am not sure if we have evolved or devolved from this earlier time.

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Expand Accredited Investor Class, Not Shrink It.

There is a banking reform bill working through Congress… in case you hadn’t noticed. Fred Wilson points out, rightly so, that the banking reform does a lot more than just reform banking rules, it goes to the very heart of who can invest in non-banking activities and how.

1) Changing the definition of a “qualified investor” in angel and venture deals. Not just anyone can invest in a startup company. You have to be a qualified investor. A qualified investor is currently defined as anyone with a net worth of over $1mm or net income of over $250k. Dodd’s bill would increase that to $2.3mm and $450k respectively. And then index those numbers to inflation.

[From Startups Get Hit By Shrapnel In The Banking Bill]

The term “qualified investor” is also known as “accredited investor” and is governed by the landmark Securities Act of 1933, Rule 501 of Regulation D. It states that an accredited investor is someone who has joint or sole net worth exceeding $1m and an annual income of exceeding $200k (Fred is incorrect on this detail point in his post, but it’s not a material mistake) or joint income exceeding $300k for the 2 most recent tax years.

This is not the first time that this status has been the focus of redefinition… in 2006 the SEC proposed redefining this class to limit access to hedge funds and at the time they calculated that 8.5% of U.S. households qualified as accredited investors under the Rule 501 Reg D rules but only 1.3% would qualify under the rules they were proposing.

It’s time we get over our national panic about the investor class and stop trying to kill it off. Nothing good will come from shrinking access to private equity markets and to those who claim these represent eventual financial armageddon if left unchecked I will remind you that the damage done to the financial system by quasi-governmental entities like Fannie and Freddie (in other words run in partnership with the political class) far outstrips the risk that private equity markets pose.

The point of setting a minimum net worth for accredited investors is not to create a means test that limits access to everyone but the very wealthy, it is to provide some assurance that the investors making these investments are not gambling with grocery money. There is no evidence to date that suggests, even remotely, that losses among accredited investors have created a financial crisis that threatens their livelihood, as opposed, for example, no doc interest only sub prime loans.

This Congress and Administration has done a pitiful job of encouraging job creation and at the core it is because they don’t seem to understand how investor markets operate and the critical role they provide for job creating activities. At every turn they have demonstrated a desire to punish, control, and constrain investors and it is doing real damage to our current and future economy.

Eye Tracking

I read the linked post below and had to think for a couple of days about the notion of eye tracking as a result of augmented reality products will result in a new advertising currency.

The idea of eye tracking in advertising is not new, indeed eye tracking as a field of study is not new having first been credited to the work of Louis Émile Javal in the late 19th century who discovered that when we read our eyes don’t follow the text in a smooth motion but a series of short jerky ones. From the 1970s to the present this field of study has expanded dramatically as technology has enabled the precise measurement of corneal reflection, which is how eye tracking works.

It is in the field of automobiles that the research has been most successful in commercial applications. Mercedes, and others, have developed systems that alert drivers when fatigue overtakes them (falling asleep when driving) and in combination with onboard radar systems to alert drivers when they are approaching a hazard and not responding accordingly, in extreme cases the computer will take over the car and force a slow down.

Basically these applications are focused on safety issues, not what Thomas Carpenter is suggesting, that this technology could be used to fuel new growth in advertising.

[From Eye-Tracking Will Be The New Click-Throughs]

As augmented reality products use eye-tracking to achieve a realistic virtual overlay like in the recent GM augmented windshield, they are getting more information than just how to align the graphics. Eye-tracking adds a new dimension to the data exhaust. As any professional poker player will tell you, the eyes are the window to the soul, and to the tell. Someone holding pocket kings might look down at their chips the moment they see their cards in anticipation of seeing a bigger pile later. Players wear glasses for a reason. The eyes can give away important information.

Eye tracking has been applied in advertising in public venues, such as on billboards, and in web usability. In the latter it is performed in controlled environments and with control groups, not broadly deployed to the public. The reasons for these cases being in a public venue or in an opt-in basis is obvious… privacy. In order to track the eye you are by definition tracking the person who is attached to said eye and that simply should not be possible without consent.

The privacy issue is exactly why I believe Carpenter is way too early in applying this to automobiles or any other mass market device that operates as a private space. There are other concerns related to how governmental entities would access such data for purposes other than originally intended, such as is the case with automotive communication technology. Despite all the feel good advertising by OnStar about remote vehicle shutdown capabilities, these requests can only be initiated by the owner, in other words the police chasing a vehicle for failing with some drunk guy behind the wheel will be met by a wall of silence if they call OnStar to have the vehicle disabled.

There are legitimate privacy issues that need to be resolved, or at least make eye tracking (or gaze) capabilities related to advertising purely an opt-in technology which would force advertisers to offer something of value to the audience in exchange for the additional data.

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A Well Intentioned Bad Idea That Should Not be Stopped

Like everyone who has looked at the issue of immigration, I came to the conclusion long ago that it is a broken and outdated system. Just consider that every H1-B visa is snapped up within 12 hours of becoming available and you see how not only demand outstrips supply but an industry has grown up around a flawed system for the sole intention of gaming it for profit.

Pascal-Emmanuel Gobry wrote a piece in Business Insider today that highlights a move by some influential VCs (who also have political clout) to enact a Startup Visa Act that would provide foreign entrepreneurs who receive a minimum amount of funding and hire a minimum number of employees a visa that would convert to a “green card” in two years.

Before I get to Pascal-Emmanuel’s article, let’s cover the basics.

The visa that this act would empower isn’t new, it is the EB-5 visa for foreign investors who commit at least $500k of capital and create 10 jobs according to a complex matrix of “allowed activities” dependent on whatever regional center the investment is located in. Presumably the Startup Visa Act would create a new EB-6 visa that mimics the EB-5 (even takes the allocation) and reduces the required initial investment to $250k and number of full time jobs to 5. Over a 2 year period beginning with the date of visa issuance the entrepreneur has to create 5 full time jobs, raise an additional $1m in investment capital or generate $1m in revenue.

Reading the text of the bill it is clear that this bill:

  • takes existing visa and allocates them for the startup visa program
  • defines “super angels” as an accredited investors (yes this is a defined category of investor, look it up on the SEC site), who makes at least 2 minimum $50k investments every 3 years and is a U.S. citizen. Venture capital operating companies are also defined according to existing standards but in order to qualify the fund must be based in the U.S. and be comprised of a majority of partners who are U.S. citizens, have capital commitments of $10m and have been operating for 2 years with actual investments in that period.
  • After 3 years if the conditions of the program are not met the visa, called “conditional permanent resident status”, will be revoked. BTW, it seems like a contradiction in terms to have a conditional permanent resident status… why not just call it what it is, a visa. It’s supposed to be a 2 year time period but the text of the bill explicitly says after 3 year the visa will be revoked if the requirements are not met.
  • It is not clear if the 5 required full time jobs also includes the founding entrepreneur(s).

The bill is a welcome 7 pages long but the brevity, while making for easy reading, also opens it up for potential abuses and Gobry actually has some very good points here. I will also take a moment to submit that the whole exercise of legislative sausage making is incremental and there’s no way this bill would proceed through committee, get voted on and signed into law with 7 pages of text… so let’s assume that I’m not breaking any new ground or discovery here.

Gobry’s primary criticism is that the bill makes entrepreneurs a servant of the investor and on that point I agree. I can’t imagine a situation primed for more potential abuse than one where the entrepreneur is dependent not only for funding from a VC but also residency in this country, a dream of many foreign entrepreneurs despite the state of our economy. While $1.25m dollars is a modest amount of capital, for a seed stage company it is a good sized amount of capital and likely to be allocated not at once but over time as the entrepreneur progresses in planning and execution.

Under this legislation, as the entrepreneur burns his timeline not only is he/she dealing with the pressures of business survival but the threat of deportation that depends solely on whether or not their investors will release more capital when needed. Can you imagine how those discussions would transpire if the investor in question possessed less than altruistic motives?

Another potential problem with this is what happens if the venture firm ceases to exist (it happens all the time to $10m’ish sized funds) over that 3 year period and in the process of disappearing fails to meet the funding requirements of the business? What happens is deportation.

The only “out” for foreign entrepreneurs to get out from under the thumb of investors when operating with conditional permanent resident status is to race to $1m in revenue over the 3 year period (the bill does NOT say annual revenue), in which case they have satisfied the requirements of the program assuming they have also employed 5 people who are not relatives.

The single minded focus on revenue rather than sustainability is another area ripe for abuse and fraud, only in this case it’s not just the integrity of the visa program at stake but also investors. While it is arguable that the incentives are overwhelming for investors to keep things honest, the fact remains that what qualifies as disclosure in private companies is subject to a lot of interpretation.

Lastly, as Goby points out, there is nothing in this bill that requires the entrepreneurs and investors to be focused on technology sectors… as opposed to real estate or automotive painting or whatever. I could foresee a scenario where this program is used by U.S. investors to establish companies onshore with cheap offshore entrepreneurs in exchange for green cards… again it empowers investors to turn foreign nationals into indentured servants.

So where do I stand on this? Well from my reading the initial bill is pretty weak and has few guarantees that the aspirations of professional and reputable investors like Fred WIlson, Paul Graham, and Brad Feld will be met. The weakness is not only in the provisions of the act but in the fact that is will draw on a limited allocation of visas which all but ensures that a legal specialty industry will attach itself to it like a parasite for the sole purpose of selling off access to the visa program. Basically we’ll end up right back where we started.

All of the weakness that I, and others, have identified are not reasons to kill the bill; what they should do is go back and address these weaknesses with draft language that passes muster and puts reasonable checks and balances in place that ensures the intentions of lawmakers and investors are being met.

Why do I call this a “well intentioned bad idea”? I know the investors who are pushing this and I know their intentions are honest, they want to fix a problem that impacts foreign entrepreneurs who would otherwise be welcome in the U.S. and available for U.S. venture capital. It’s a bad idea because it doubles down on the existing visa system that is plagued with so many problems… and because it operates under the constraints of a limited supply visa allocation it is going to be gamed by lawyers and that will increase the costs and lock out smaller funds who would otherwise be ideal participants in such a program. As it is written now, the big VC funds would have all of these visas locked up within hours of the allocations being made.

Housing Woes in Atherton

This is how someone’s dream home becomes a $6 million nightmare…

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If you live in the area you will recognize this house in Atherton that has been under construction for about 3 years, the last 12 months at more or less a full stop. If I recall correctly the previous house was purchased between 4-5 years ago (pretty much the absolute peak of the market so it was at least a $3.5 million price tag) and the house was promptly torn down and the lot sat vacant for another year and a half.

When construction started it was an epic affair with a lot of excavation for a full basement and pool with the requisite separate pool house and probably a combo guest house. It’s tough to tell from the picture I took but this house is massive, probably a combined square footage of 10,000 if not more. This is a big house.

Construction was in full swing and then it simply stopped, the green fence went up and everybody went home. At that time it wasn’t even stucco’ed, just wrapped in Tyvek with a roof on… I think the town of Atherton made the owner put a stucco “scratch coat” on as it was close to achieving blight status on what is a pretty busy street.

I talked with a contractor who works in the area and what he said is that Atherton is now requiring groundwater reclamation systems but it’s a new thing and there is a lot of confusion about how to build them. The owner put in a system consisting of a big underground tank and a bunch of other parts (getting technical!) but it wasn’t engineered properly according to the town and on top of this the basement flooded so the owner was faced with an additional $500k of expense to tear out the system already in place and retrofit a new system that would meet requirements and work properly. I don’t know how accurate this is but the contractor is one of a dozen or so companies that primarily work on multi-year housing projects so if anyone would know it would be my source.

Did I mention that this was right about the time that the economy tanked and the floor fell out of housing and then credit markets seized up?

So here it sits, probably $6 million tied up in a house that is far from complete in a market that can’t possibly recover the sunk cost and construction financing practically non-existent. I take no pleasure in writing this and only do so because it is a very tangible example of how a complex regulatory environment and an uncertain economy can conspire to hurt anyone. I really feel bad for the owner(s), if it were me I don’t think I could ever drive down that street again without my stomach turning inside out.

BTW, 2 blocks down the road from this one is another home that is completed minus landscaping that has never been occupied that is now on the market and if you stand in that driveway and throw a stone you could hit 15 for sale signs. I keep hearing about how the economy is out of recession and growing again but when you see this many for sale signs in Atherton, California you know something isn’t right.

Risk Pools and Healthcare Reform

The fundamental challenge the health insurance, or any insurance business for that matter, faces is how to blend risk pools so that the customers who consume few services pay for those who consume many services.

In other words, my premiums will go down because healthy young people who currently get by without insurance will be forced to buy policies they may not even want. (When I was young and healthy, I got by quite happily with a bare bones Blue Cross policy that only covered catastrophic expenses). It’s a wealth transfer from the young and uninsured to the old and insured.

[From Making us old farts better off by screwing the young 'uns - ProfessorBainbridge.com]

This concept is at the core of why health insurance has been linked to employment, it forces a blending of risk pools for what otherwise would diverge if left to market forces alone. Personally I am an advocate of decoupling employment and health insurance but am opposed to the so-called “public option” because it would fail to remedy the basic problem facing our society when it comes to health care, which is that we have removed market incentives for healthy lifestyle choices and the restrained use of health care services.

If I am a consumer of insurance for my family health care needs and my premium costs are directly related to the risk pool I can position myself in, there is great incentive to eat healthy, avoid known risk factors like excessive drinking and/or drug use and smoking, and to establish a long term relationship with an insurance provider (like life insurance… get it early and the premiums stay low).

If I can self-select the risk pools that I want to join for insurance needs I will have a great incentive to improve my risk profile. For catastrophic coverage, which is a fact of life as we get diseases and have medical emergencies that defy our risk profile, the market could offer a separate catastrophic coverage plan that spans multiple pools. If I am a young person and relatively healthy this is exactly what I would want to buy if forced to buy anything, and spanning multiple pools evens out the distortion that would occur if restrained to individual risk pools.

Americans are living longer and consume more health care services as a function of increasing longevity but also because more services are available for us to consume. We have all been sold a bill of goods with regard to the value of preventative care services, that they both make us healthier and save us money.

None other than the CBO itself has pointed out the fallacy of the cost savings argument, in an Aug. 7, 2009 letter to Rep. Nathan Deal, CBO Director Doug Elmendorf writes: “Researchers who have examined the effects of preventive care generally find that the added costs of widespread use of preventive services tend to exceed the savings from averted illness.”

More medicine isn’t necessarily better but it certainly more expensive.

In 1960 it was estimated that 47% of medical expenses were paid out of pocket while today that number is only 12% and like in any market where the consumer is not responsible for the financial payments (remember these are largely obscured by the linkage to employment as well) the consumption of services as well as the pricing of services behave in a manner far different than when the actual consumer is also responsible for the payment.

Whole Foods CEO Mackey was much maligned for his op-ed detailing how Whole Foods manages health care insurance options for it’s employees. At the core of their strategy is linking the economics of consumption to how their employees consume covered services by offering a plan with a high deductible, $2,500, but 100% of the premium covered by Whole Foods, and in addition to that they kick in dollars to personal accounts. What was lost in the ensuing brouhaha following Mackey’s op-ed piece is that Whole Foods has lower health care costs than the average employer and higher satisfaction with the plans offered… and critics also ignored that Whole Foods only offered plans that were voted on by the employees so rather than criticizing Mackey they should focused on the employees who decided what plans to offer.

IT Expansion in China

Last week I wrote a post that covered many of the observation I made on my recent trip to mainland China. Given my background in IT, a natural area of interest for me was the build out of IT in China businesses that are not directly aligned with U.S. or European counterparts… in other words, what are the independent businesses doing when left on their own.

I don’t believe it is surprising to assert that growth in China to date has come independent of any investments in technology made by the government or business. Cheap labor has made possible productivity gains that would require substantial technology investment in developed countries, but as a I pointed out in my last post, wage inflation is no longer a hypothetical, it is happening as we speak therefore it is timely to consider what the IT implications are in China.

I’m tempted to write about telephony solutions but will resist the urge because irrespective of any other factor this is a given growth area, it simply has to be and growth estimates for 3G network expansion over the next couple of years are in mid-double digit rates. Consumers will be the primary beneficiary of 3G network expansion with businesses lagging as mobile applications are dependent upon a centralized IT methodology that does not currently exist in small and mid sized China businesses.

That last point was the key takeaway I learned in my site visits, the enterprise application market in China for everything but the very large and multinational businesses does not exist. When you visit a mid sized manufacturer, say 1-2k employees, what you will find is a networked PC environment rather than a server based environment. White collar workers use personal productivity applications, email, and file sharing to conduct business.

I did see some rudimentary data center buildout, mostly focused on networking and file storage, and interestingly the rack-based equipment I saw was predominately coming from U.S. based secondary markets rather than purchased new in China. The expansion of data center capability could foretell a scenario where server based applications expand but I believe that is still remote given the lack of local support and consultancy options and significant expenditures for the acquisition and support of such applications.

If on premise server applications are an unlikely growth area then does that mean SaaS and other hosted applications have an advantage? I think that this is unlikely because regional data networks are spotty in terms of robustness and the trust issue related to data storage.

Salesforce.com has been hosting a China edition for several years but in reviewing their materials it is evident that their successes are coming in the Hong Kong region which might as well be a separate country from Mainland (you still have to go through a border crossing when entering Mainland from Hong Kong and the internet in HK is far different from Mainland). You simply cannot run a Mainland focused business from Hong Kong… different language, cultures, governmental controls, etc.

In reviewing the current and near term IT capabilities I believe it is plausible that workgroup solutions will expand that enable better project management and collaboration with near-network and far-network resources. Centralized financial management solutions are less likely given the cost and specialization required for such applications, and server based solutions that control factory shop floor resources are so far off that I wouldn’t even try to predict what the future holds for them.

Shop floor automation will develop over time, and point in fact I did see an expansion of CNC equipment in operation from my last visit. Labor cost inflation is also causing manufacturers to expand CNC investments in areas beyond core milling and machining; I saw a pretty cool CNC carving machine that produced wax moulds for lost-wax bronze casting, a process previously done with a small staff of highly experienced craftsman.

So what would I do if I were running a mid-sized enterprise software company targeting manufacturing sectors? For starters I would establish a base of operations in Mainland with strong local or Taiwanese partnership (never underestimate the influence of Taiwan in businesses operation in China). I would also focus on offering low cost and quick to implement solutions that target workgroup constituencies with business benefits firmly rooted in team efficiency and workflows. Lastly, on pricing you have to start from scratch… whatever you are selling your products and services for in other markets won’t apply in Mainland China, whether on a per user or per server basis.

The Business Climate in China

I just spent a week and a half in southern China visiting a range of manufacturing facilities and meeting with senior executives, and the learnings were significant, some of which I want to share with you today. This is the kind of information that is really challenging to get from analysts and journalists simply because analysts and journalists tend to hang out in Shanghai or Hong Kong and get their information in filtered form and they focus on large multi-national companies that are not affected by the same dynamics that smaller companies in the area are.

Here’s the setup: Guangdong Province is the industrial heartland of China, responsible for the single largest slice of GDP for all of China. In fact the GDP of Guangdong alone is greater than the entire country of Taiwan (the word “country” in reference to Taiwan being subject to definition if you are Chinese!). The reasons for Guangdong’s economic prominence are really pretty easy to understand, a moderate climate, stable infrastructure, and a naturally formed network of waterways make the region easy for manufacturing businesses to set themselves up in, and the close proximity to the port in Hong Kong make it a natural location. The electronics industry, automobiles, consumer packaged goods, and textiles are all based here (to name just a few) and their attendant supply chains have developed here as a result.

201003120838.jpg

I spent my time in the Dongguan area, specifically in Chang’an, Foshan, Guangzhou, and Shenzhen. These areas are robust in terms of business activity yet at the same time are subject to a great wave of pending changes as a result of population patterns, among other factors.

Guangdong Province has a population of roughly 100 million people and, enviably, has full employment for those able and willing to work. The key learning I observed was that the employment picture is foisting upon these businesses the greatest degree of future uncertainty… although unlike the U.S. where we have a sideways employment picture, the situation in Guangdong is a lack of workers. Without exception, every business executive that I spoke with stated that they were experiencing a shortage of workers that on average ran 30% but was as high as 50% in some places. There was consensus among the executives that I spoke with that the area was short 2 million workers.

The reasons for this shortage are complex but also understood. Beijing has in recent years invested heavily in improving living conditions in the rural areas of China, which has been a primary source for workers in the industrial areas. As education, water, health and safety, and transportation in the rural areas has improved the locals have fewer reasons to leave and it is evident that they are not. The near term consequence of the worker shortage is that wage inflation is already a reality, as well as worker perks and benefits.

I want to take a moment to explain how worker compensation works in China. There is a base salary, which is the norm as opposed to piecemeal work which I think most Americans assume how China works, housing and meals, and lastly there is health insurance. All of the factories I visited had dormitories and cafeterias attached to the primary production complex, as well as full time security… the complexes are really fully equipped and while the worker population can come and go as they wish, while in the complex they have housing, meals, and recreation (basketball is very popular, apparently). Interestingly, the work/housing arrangement applies whether you work in a factory or at Kentucky Fried Chicken (also very popular)… how many fast food employees in the U.S. get housing, meals, and health insurance?

To put some numbers to this, a typical entry level factory worker can expect a monthly salary of about ¥2,000 Renminbi (RMB), a housing and meal component that is valued at approximately ¥1,500 RMB, and health insurance that costs the employer about ¥150 RMB a month. I’m hesitant to convert this to USD because that conversion is pretty meaningless when faced with living expenses that are far different in China than the U.S.

The reason why the wage inflation issue is significant is because the manufacturing economy is really a pretty low margin business and wage increases for workers translate into higher product prices, just like here in the U.S. Compounding matters is that wages are not the only issue putting pressure on these business, raw materials are also getting more expensive. Copper is a great example, doubling in price over the last year in spite of the ongoing global economic slowdown in construction industries (which is a primary consumer of copper). Wage and commodity inflation in China will certainly result in product price inflation in the U.S. and/or pressure on financial results for U.S. companies if they are unable to increase end user pricing for their products.

The second issue driving the shortage of workers is the One Child Policy that has been in force in China for decades now. The results, and the Chinese realize this as well, is that the population has gotten older as 2 parents have been replaced by 1 child in the workforce. I wrote about this a few months ago and what I heard in China just last week confirmed the view that policies that encourage low birth rates are economic suicide… China recognizes this and has been taking some very public moves to change the policy.

The other big issue driving business uncertainty in China is the declining influence of United States and the declining value of the dollar. The consensus view in China is that the U.S. has lost influence in global matters over the last year and the Obama administration is weak relative to Beijing. Whether or not you believe this is not relevant, the Chinese business community believes it and they are forming strategies to accommodate this risk that will affect how relationships with U.S. companies evolve.

The currency risk is very real because Chinese companies are paid in USD, which has a fixed exchange rate against the RMB but commodity and raw material purchases, as well as transportation costs, are paid in USD so the currency risk for these businesses is very real. I heard a number of executives talking about “patches” they would buy every month to deal with the currency issue.

It took me a little while to figure out what they were talking about but after some pointed questions I realized they were doing currency swaps with Hong Kong banks whereby a principal amount is swapped with a counterparty at a predetermined rate, the effect being that it locks in forward currency valuation like a forward contract. This is actually a pretty clever way to get around the fixed exchange rate risks that the RMB presents… you swap the risk with Hong Kong Dollars, one of the most traded currencies globally.

The last issue that I want to cover is one that quite frankly caused me to do a double take and it involved Walmart but is really much broader than just Walmart. As Chinese manufacturers have moved up the food chain from being simple offshore manufacturing to high value design and engineering, the appreciation for intellectual property has risen to a front burner issue. Every company I talked with told me of their distrust for Walmart, telling me of examples where “hot” products they were supplying to Walmart were then white labeled by the company using different manufacturers. These companies are well aware that Walmart has over 1,000 purchasing agents in the Shenzhen area that do product sourcing and oversee manufacturing for the company.

The larger issue is that the rise of China manufacturing IQ is mimicking what we saw happen in South Korea where raw manufacturing escalated into global brand prominence, in that case eclipsing the Japanese brands in many cases. I think it is an absolute certainty that we will see Chinese companies exert marketing influence in western consumer markets and this will put increasing pressure on American and European brands.

That’s all for today but I do want to write in detail about the implications of all of this for the IT industry in a future post next week… stay tuned.