Diversification of cash flows around the world
The three companies that will be evaluated for purchase are LG, Sony and Xiaomi. Some of the report will discuss the individual companies, but a large portion of this report will go into discussing the country situations of these companies. They hail from South Korea, Japan and the People’s Republic of China respectively. The differences between these Northeast Asian countries can be significant, and it is these differences that should capture the attention of the executive evaluating the decisions. There are two elements of risk that are the most important in this report — political risk and financial risk. The former reflects the risk that the value of the investment could change based on changes in the political environment in the target country (Investopedia, 2014). Any evaluation of a major purchase overseas will include political risk as a factor, so when the political risk changes, that should increase the discount rate that was applied to the future cash flows. Thus, when political risk increases, the value of the investment declines; nobody is really worried about a reduction in political risk.
Financial risk comes in a few different forms. One of the most important is foreign exchange rate risk, which is quite different in each of these three countries, but there are other risk as well. For example, some countries have enacted currency exit controls, such that investments made into that country are difficult to repatriate. In other instances, there are issues with the amount that can be converted at any given point in time. These different financial risks will be evaluated in the course of this paper as well, concluding with a recommendation about the best country in which to invest — the choice of company will likely include a number of operational factors that are beyond the scope of this report.
LG was founded in South Korea in 1947, but emerged on the international scene in the 1990s, and it has grown in prominence significantly since then. LG’s structure is typical of a South Korean chaebols, consisting of a holding company, and underneath of that several major groups. For LG, these groups are electronics, chemicals and telecommunications. If Dorchester is interested in one of these groups, there are going to be significant political considerations, since breaking up a chaebols is something somewhat unusual and would be more important than a simple acquisition.
Industry data shows that LG holds 4.8% of the mobile market among vendors in the U.S., making them the fifth largest company is a relatively diffuse industry, where the companies below them hold a 46.7% share (IDC, 2014). Thus, the mobile business is important to LG, and would doubtless come at a premium and would bear significant political risk because the South Korean government has invested a lot of energy into building LG and its compatriot Samsung into global telecom and mobile powers. The political risk factor for LG, therefore, has to be considered to be moderate at least.
There are a few different aspects to consider with respect to LG and the financial risk associated with doing business in South Korea. LG has a global presence, which is favorable in that it results in diversification of cash flows around the world, but the company’s share is particularly strong in South Korea, and most of its employees are there. Thus, purchasing LG will expose Dorchester to the South Korean won to a significant degree. The won has floated freely since 1997. This coincided with the Asian financial crisis, which led to significant and immediate devaluation of the won. It has been since that point that South Korea has been able to substantially grow its export businesses — a weak won is good for a company like LG that exports a wide range of good around the world. Free floating currencies are favorable, because they allow companies ample hedging opportunities. While the market in won is only of moderate size, there are still opportunities to hedge won exposure through futures. The only downside is that the won-USD pairing does not get the best spreads, especially on derivate products.
Exposure to the won also means exposure to the Korean central bank and the Korean economy in general. There is an element of destabilization risk, and it would be remiss to note that both the nation and its currency bear a high level of exposure to the uncertain conditions across the demilitarized zone. North Korea is an a state of uncertain leadership and its political stability will affect the South Korean economy, and in particular the South Korean economy, should something bad happen.
Another consideration is the short-term condition of the South Korean economy. The country is facing long-run expansionary conditions, since 1997, but the current state is characterized as “fragile recovery,” to the point where further stimulus, either through monetary or fiscal policy may be required (Kim, 2014). Monetary stimulus, including interest rate cuts, would result in further devaluation of the won. One thing that is worth bearing in mind is that the Bank of Korea sets monetary policy in part in consultation with the major chaebols, so it is quite possible that LG is able to have a seat at the table when monetary policy is being set. Monetary policy is also often set with China in mind, since the PRC is the major destination for South Korea’s manufacturing and component exports (Kim, 2014). The extent to which a Dorchester-owned LG would have the same privilege is unknown, and if Dorchester only bought one part of LG, it would not have any of LG’s privileges.
Overall, South Korea is a moderately favorable country in which to own a company. The economy is relatively stable and modern, and there remains an emphasis on a healthy manufacturing industry. LG is one of the major chaebols that play a large part in the Korean economy, to the extent that they are invited to sit in with the Bank of Korea on discussions about monetary policy. The South Korean won is freely-traded, which allows for currency hedging, and its trade is with the major nations of the region, along with the United States. The foreign exchange rate risk, therefore, is moderate at best. There is some political risk, mostly associated with instability in North Korea and with the decline in privilege that is likely to occur politically, with any LG unit that is no longer a part of the LG chaebol. Such a decline needs to be priced into any purchase.
A last factor is that any acquisition must be a good fit, not just strategically but operationally. Culture in particular is a significant risk factor in foreign acquisitions, and when the cultural fit is poor it can often be difficult to realize the advantages expected. In this instance, Dorchester is choosing between South Korea, Japan and the PRC, so there is no real difference — they are all challenging cultures for an American company, and all are likely to make for awkward integrations.
As with LG, Sony is a major conglomerate and a wide range of industries. Some of Sony’s businesses are photography, televisions, video, storage, computing and entertainment. Sales for Sony are geographically diversified, with the United States as the largest market, followed by Europe and then Japan. Where LG is a chaebol with very strong political ties, Sony is not considered to be part of the Japanese equivalent, the keiretsu. Instead, Sony operates more as a typical multinational, which actually reduces political risk because it is less critical to the health of the Japanese company and national pride than a keiretsu would be.
Japan is a modern, stable economy, a full participant in global trade. Japan has a strong manufacturing base but it moving towards a service economy, certainly moreso than the other two countries. Japan is one of the world’s largest economies, both by raw size and on a per capita basis. Japan is therefore the closest to the United States in terms of development. This does not mean, however, that the two countries have a lot of other similarities — they don’t — and there will definitely be some cultural issues with any acquisition of a Japanese company or subsidiary.
Sony, being a global business, brings with it a different foreign exchange rate risk than LG or Xiaomi. Sony’s sales offer a fairly even split between USD, JPY and EUR, with some GBP and other major currencies thrown in. However, the vast majority of costs are in JPY. The majority of sales are in the world’s three major currencies, and the other big markets for Sony tend to be in other major currencies — CAD, AUD, CHF, and the like. This is good news for Dorchester. The U.S. is the biggest market for Sony, which minimizes exposure for that revenue, and the diversified nature of Sony’s revenue streams among the world’s major pairings reduces the need for hedging. When hedging is required, it will be very easy, as the USD-JPY, JPY-EUR and USD-EUR pairings are among the most liquid in the world. Foreign exchange rate risk with Sony is therefore low.
There is some measure of economic risk, however. Though Japan is a wealthy and stable country, it is in an interesting macroeconomic position, which gives rise to some financial risk. The overnight rate is 0.1%, and the bank rate in Japan has basically been at zero for almost all of the last fifteen years (Global Rates.com, 2014). This means that the central bank has limited flexibility to deal with recessions and spur economic growth through conventional monetary policy. As a result, Japan may well be more susceptible to economic downturn, particularly in Asia, than just about any other country. The long-run economic sluggishness has also put the Japanese banking system in a precarious position, something that a company about to take stake in a major Japanese corporation should bear in mind (IMF, 2012).
The political environment in Japan is considered to be stable, and Japan is valued as a business partner because of its stable democracy and well-educated, wealthy populace. Political risk would be categorized as low. There is basically no risk of nationalization. Sony is not keiretsu, so there is less likely to be government involvement in any sale of a Sony company, particularly if Sony management promotes the idea with the Japanese government. As a general rule, Dorchester can expect few difficulties with such an acquisition, particularly if it commits to maintain employment levels, which is the only real touchy political issue.
Culture is definitely going to be an issue in Japan, which does not have a great history of successful mergers with Western companies. Though one example, Renault-Nissan, shows that it can work given enough time and effort, there is something in the language and culture barriers that increases the risk that the acquisition will not mesh well with the parent company, and this will make it more difficult to extract value from the investment.
Overall, Japan is a fairly low-risk company in which to invest, particularly if the local management of Sony (or its subsidiary) is essentially left in place. To do this would reduce political risk. Sony has a diversified revenue flow from around the world, in major currencies, something that reduces foreign exchange rate risk. While there is some risk in the Japanese economy and banking system, this a major world economy and it is unlikely to even if a crisis hurt the Japanese economy that it would be out of commission permanently.
Xiaomi is a Beijing-based company that is much smaller and more focused than the other acquisition targets. It was founded in 2010 and has rapidly built a business in consumer electronics and apps, to the point where estimated revenues in 2014 are CNÂ¥33 billion, or around $5.3 billion USD. Being a smaller company, Xiaomi’s operations are mainly in China, which is the company’s primary market, though it has moved into other Asian markets as well. That this is a Chinese company makes it much riskier than carving out an acquisition from within the extensive LG or Sony families.
The first element of risk is the overall financial risk. First, this is a young company and while its growth has been nothing short of astonishing, those cash flows are not nearly as reliable as those of LG and Sony, both of which have been around for decades and built global market shares. If Xiaomi can grow that rapidly, it stands to reason that another company could emerge and win market share from Xiaomi just as quickly.
Foreign exchange rate risk is also much, much higher with the Chinese yuan than with either the yen or the won. The yuan is not a freely-traded currency. The rate is set by the central bank, which sets a bound in which the yuan can trade. This is roughly based on the USD, but the problem is that the lack of free float means that many observers believe not only is China manipulating the value of its currency but that such manipulations are unsustainable (Palmer, 2012). So while the value of the CNY is pretty stable, that value is not reflective of the intrinsic value of the yuan, and as such there is the risk that the yuan is undervalued. This is especially given the high rates of inflation reported in the country — though current rates are at five-year lows (BBC, 2014).
Of particular concern as well is the fact that China has currency controls. This means that while it encourages foreign direct investment, getting money out of China can be difficult. For a firm that hopes to invest in the country and build market share, this is not a big deal because retained earnings would be reinvested back into Xiaomi anyway, but the inability to repatriate profits over the long run does increase the risk. The risk is already high because the international market for the yuan is illiquid. The controls and the artificial price, as well as official Chinese policy, make exchanging the yuan for hard currency difficult. There is tremendous risk associated with this lack of liquidity, and that risk must be priced into the acquisition.
Financing costs are another major risk. Whereas Sony and LG represent opportunities for Dorchester to acquire a subsidiary from countries where financing options are myriad, Xiaomi is a privately-held company in a country where investment banking options are perhaps not as well developed as in Korea or Japan. Dorchester will need to pay cash, and financing a deal like this in China is a lot more difficult than in more developed economies.
Political risk is another consideration, and it is higher in China. The government is not open, and this creates a situation where there is tremendous corruption and abuse. Foreign companies can often take the brunt of this, facing political action to a level that would be unheard of in South Korea or Japan — companies like Google and Starbucks have had major clashes with the Chinese government that cost them millions in revenue. As a Communist state, China remains a risk for nationalization as well. All told, the vagaries of the Chinese legal-political system, the corruption and the occasion direct hostility from government towards foreign-owned companies results in a higher degree of political risk than might be the case in a stable modern democracy. It is unlikely that a full takeover would even be feasible, and Dorchester at best would be able to acquire a minority stake in Xiaomi, especially if it intends to minimize political risk.
Culture is also going to be a challenge in the PRC, though arguably only to the same degree that would be found in South Korea or Japan. Dorchester would be advised to be more of a silent partner or take Xiaomi products to the international audience, allowing Xiaomi a reasonable level of autonomy, in order to minimize destabilizing and expensive culture clashes between the acquired company and the purchasing company.
Each of these companies carries with it a different risk-reward profile. The final decision would come down to what is best for Dorchester shareholders, and what is within the scope of Dorchester’s long-term strategy. This report is not going to guess what that strategy might be, but will make conclusions about these three potential acquisitions.
The riskiest of the three acquisitions is Xiaomi in China. China has far greater risk in terms of its currency, which is not freely traded, and in terms of market risk and political risk as well. That said, this is a company that has grown from nothing to $5.3 billion USD in revenue in four years, and that is an astonishing rate of return. Typically, the project that has the highest risk should have the highest rate of return. Xiaomi remains almost entirely a Chinese company, but it is beginning to internationalize to some extent. There are significant, overriding political and cultural issues that only add to the risk. Further, with Xiaomi’s performance to this date, it is quite likely that a high rate of growth will be priced into the company’s asking price. This is an incredibly risky purchase for a number of reasons, but depending on Dorchester’s confidence in their revenue streams, Xiaomi offers the best upside by far, to go along with that risk.
Sony, or a subsidiary thereof, represents the safe route for Dorchester. Sony’s revenue streams are diversified, coming from all of the world’s major economies in fairly even numbers. There is also a relatively low level of political and economic risk, and most of the risks associated with the Japanese market are not existential in nature, and the currency exposure can be almost completely hedged. Sony has a long-term track record in its businesses, and as a result its revenue streams are fairly reliable. This is the safest of the three options, by quite a wide margin, thought it also offers little upside, as most of Sony’s major businesses are fairly mature at this point.
LG is the middle path. LG, in particular its mobile division, still has growth potential because it is entering new markets and making money is growth industries. South Korea has a moderate risk, but on the low side of moderate. The currency trades freely. The downside risk is political, since LG is politically important and buying part of it might reduce its advantages in the Korean economy. Also, LG’s cash flows are less stable than those of Sony. Overall, this is a relatively risky purchase for the upside potential.
It is recommended that from a country perspective, either Xiaomi or Sony be Dorchester’s target, depending on Dorchester’s overall strategy, and its level or risk aversion.
BBC. (2014). China inflation slows to near five-year low. BBC. Retrieved October 25, 2014 from http://www.bbc.com/news/business-29625011
Global Rates.com (2014). BoJ overnight call rate. Global-Rates.com. Retrieved October 25, 2014 from http://www.global-rates.com/interest-rates/central-banks/central-bank-japan/boj-interest-rate.aspx
IDC. (2014). Smartphone vendor market share, Q2 2014. IDC. Retrieved October 25, 2014 from http://www.idc.com/prodserv/smartphone-market-share.jsp
IMF. (2012). Health of Japan’s financial system tied to growth, government debt and deficits. International Monetary Fund. Retrieved October 25, 2014 from http://www.imf.org/external/pubs/ft/survey/so/2012/car080112a.htm
Kim, C. (2014). South Korean Q3 GDP rebounds but global headwinds raise uncertainty. Daily Mail. Retrieve October 25, 2014 from http://www.dailymail.co.uk/wires/reuters/article-2805800/South-Korea-Q3-GDP-rebounds-global-headwinds-raise-uncertainty.html
Palmer, B. (2012). If currency manipulation is so great for exports, why don’t we do it? Slate. Retrieved October 25, 2014 from http://www.slate.com/articles/news_and_politics/explainer/2012/10/china_currency_manipulation_how_does_it_harm_the_u_s_and_what_can_we_do.html
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