Partnering In China Can Turn Into A Wild West Shoot Out

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The troubles being experienced by YUM! Brands (NYSE: YUM) and Caterpillar (NYSE: CAT) with what could collectively be called deceptive business practices is a big issue to watch in China. While the story of growing along with the increasingly wealthy population is a good one, it doesn't always work out as smoothly as expected for outsiders.

Bad Accounting

In mid-January, Caterpillar sent out a news release stating that an internal investigation had “uncovered deliberate, multi-year, coordinated accounting misconduct” at a recently acquired Chinese company. Cat fired the people responsible and put a new management team in place.

While the details of the problems are a little light, there is one fact that every shareholder should note. The company took a goodwill impairment charge of $580 million dollars. That may not sound large for a company like Caterpillar, but it amounted to an $0.87 drag on the company's fourth quarter results. That's a pretty big headwind to deal with.

Bad Food

The problem at Yum! is related to substandard chicken from suppliers that KFC had been using. An investigation by a television station sparked a government review of KFC's suppliers. Although Yum! hasn't been accused of wrongdoing, the damage to the company's image has been notable.

Management reported that January sales were down over 40% at KFC in China. That's going to be a huge hit to the top and bottom lines. The bigger problem for Yum! is that there appears to be spillover into its other food concepts, particularly Pizza Hut, which saw a 15% revenue decline. This problem is going to be around for a little while, too, with management admitting that the only way to heal this wound is time.

Bad Employers

Apple (NASDAQ: AAPL) has even had to deal with Chinese issues. Normally seen as an upstanding citizen, Apple came face to face with a public relations nightmare when employees at one of its Chinese suppliers started to commit suicide as a way to protest the poor working conditions under which they were being forced to live and work. While Apple was relatively quick to act, and was able to maintain its corporate image as a socially sensitive company, it could have easily gone the other way.

The problem, of course, is that Apple is just hiring a company to build stuff; it has little control over how that company treats its employees. But in the eye's of U.S. citizens, that distinction doesn't matter. This issue came at the beginning of Apple's most recent ascent, when investors were more willing to overlook underlying problems because of heady growth. If a similar problem were to find its way to the media today, investors may not be as forgiving.

Bad Blood

These aren't the only companies finding the going rough, or perhaps a better word would be shady, when working with Chinese companies. For example, International Business Machines, Pfizer, Wal-Mart (NYSE: WMT), and Avon are among a growing list of companies dealing with questionable business practices issues in China.

This is a big deal for many of these companies. For example, Wal-Mart has nearly 400 stores in China, a market it entered in 1996. China is a particular focus within the company's International division. The retailer is looking to gain scale in the e-commerce space, an area it was late to in the United States. It purchased a big position in Yihaodian, a local web retailer. If problems at Yihaodian were to surface, it could be a notable blow, and meaningful delay, to the company's online efforts in a country that it has targeted as a growth platform. While Wal-Mart, as well as Caterpillar and Yum!, clearly have the financial wherewithal to handle such problems, that doesn't mean that these types of problems aren't notable risks.

It Started with Reverse Mergers

That the legal and regulatory framework in China is less rigorous than in the United States shouldn't come as a surprise to anyone. Several years ago, Chinese companies made a big show of entering the U.S. market with reverse mergers, in which a U.S. shell company was purchased simply because it was listed on a U.S. exchange. Once bought, the Chinese company could claim that it was listed in the Untied States.

Two niche research shops, Muddy Waters and Citron, helped lead the way to discovering some of the most egregious problems. Citron's website makes some startling claims: “Citron has been covering stocks related to China since 2006. Over that time, we have researched and published about 20 companies. Of these, 16 have suffered losses of 66% to 100%, which we would deem catastrophic, and 7 have been delisted.” Many of the company's this pair of investigative researchers highlighted were reverse mergers.

So, the problems that Cat and others are seeing in China aren't really that new.

Long-Term Issue

This issue has long-term implications because of the restrictive nature of the Chinese market. There is, no doubt, huge potential in China. However, it can be something of a wild west because of the less stringent regulatory controls. However, you can't just walk into the country and set up shop. The government, generally, won't allow it.

This leaves companies with no choice but to partner with local companies or purchase them outright, if they are allowed. For example, PepsiCo (NYSE: PEP) recently teamed up with a Chinese bottler in its effort to gain scale in the Chinese soda wars. It basically gave its operations to the bottler for a sizable ownership position in the company. If irregularities were to show up, Pepsi's position in the country could, overnight, be materially impaired.

Watch and Diversify

Investors should be looking to benefit from the transition of Chinese citizens from poverty to the middle class. While there are long-term population headwinds that the country will face, its industrialization still has many years to run. However, it's best if conservative investors take a balanced approach to China. It simply isn't like investing in the United States. If companies like Cat can get duped, the risks for individuals is that much greater. It's probably best to stick with U.S. companies looking to expand in that giant nation, while making sure to keep a close eye on the results.

Yours,
 

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Reuben Gregg Brewer has no position in any stocks mentioned. The Motley Fool recommends Apple and PepsiCo. The Motley Fool owns shares of Apple, International Business Machines., and PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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