The first time I went to China was in 2007. I was a wide-eyed young analyst ready to be wowed by the world's fastest-growing economy. And wowed I was. Everywhere I looked, I saw dynamism. In Xian, I couldn't sleep because welders were working overnight to build a new skyscraper next door to our hotel. In Beijing, the lines were out the door and down the block to sign up for the city's most famous English class. And in Shanghai, we rode a maglev train to the airport that easily topped 200 miles per hour.
Looking back, of course, I realize that I saw what I wanted to see. In doing so, I ignored many of the problems that have since come back to bite China. Those welders, for example, weren't wearing safety harnesses. And we now know that China's hasty efforts to build an impressive rail network were fraught with corruption and cut corners.
After a 2011 high-speed rail crash caused by bad equipment killed 40 people near Wenzhou, the government began to investigate the realities of rapid development. One of the results of that investigation was that former railway minister Liu Zhijun was sentenced to death with reprieve for accepting bribes and abusing his power.
Will the real China please stand up?
Going back to China today, I find it much easier to recognize its difficulties and complexities. Not only have I come to learn much more about the Middle Kingdom over the past eight years, but some of the country's sleights of hand have been exposed for all to see -- foremost among them the corporate-governance issues that plague many of the companies in the market.
More than a handful of U.S.-listed Chinese companies have been exposed as outright frauds over the past few years. And even for many companies that aren't frauds, questions abound. For example, Chinese fast-food noodle chain Ajisen (China) Holdings (AJSCF) decided to start making significant "investments" in property. I have to ask myself: If the economics of its restaurant business were so good, why would it waste capital speculating in the seemingly overvalued property sector? I can't come up with a good answer.
Similarly, there's a good argument to be made for staying away from Alibaba (NYSE:BABA) because of its track record for related-party transactions and lack of full disclosure to outside investors.
Then there was the uncomfortable conversation I participated in at a recent China investment conference, where analysts questioned state-owned Guangshen Railway (NYSE:GSH) regarding whether it might be forced to "acquire" assets from the government to help the state offload its massive debt load to foreign investors. After noting that the company hoped to get a geographically complementary asset at a fair price, management finally admitted that shareholders' only recourse would be to mount a proxy campaign, which would be likely to fail, against any deal it didn't want the company to make.
About that debt
That brings us to another difficult reality for China: debt -- and lots of it. According to management-consulting firm McKinsey & Company, China's debt has increased from $7.4 trillion when I first visited in 2007 to more than $28 trillion today. Much of that capital was spent (or wasted, some would argue) on public stimulus projects designed to keep China growing even in the face of a global economic downturn. While China was able to sustain a GDP growth rate greater than 7% over the past few years, the nation's spending appears to have simply put off -- rather than solved -- its structural problems. Among these problems is the country's over-reliance on public-sector spending and state-owned corporations to spur growth -- a problem that was no doubt exacerbated by the 2007-2014 government stimulus binge.
Real estate is an important source of local government revenue, and now, with the country's property market weakening and land sales slowing, that overinvestment in property and infrastructure will result in a double-whammy in 2015: lower growth because of reduced government participation in the economy and lower government revenue, which will prevent the government from reinvigorating growth.
For investors, this slowing economic outlook means that China is no longer the blue-ocean market many once thought it would be. With demand no longer materializing as a rising tide that lifts all boats, business in many verticals must increasingly be aggressively fought for.
The new China
There is perhaps no better example of China's new reality than its online travel industry, where three main players appear poised to duke it out to the bitter end. Those players are Ctrip.com (NASDAQ:CTRP), a first mover and former leader in the space that once earned handsome profits helping Chinese travelers book rooms and air tickets; eLong (UNKNOWN:LONG.DL), an entity backed by Expedia (NASDAQ:EXPE) that purports to do the same, albeit with sleeker technology; and Qunar (NASDAQ:QUNR), a search-driven provider backed by Chinese Internet giant Baidu (NASDAQ:BIDU) that's focused on nothing but low costs and high relevance.
Before China's slowdown and Qunar's entry into this marketplace, both Ctrip and eLong earned handsome margins, as there was seemingly no need for them to compete aggressively against one another, given the rapidly growing total-market opportunity. The dynamics, however, have changed. Leveraging its technology, Qunar has emerged as the low-cost provider in this space, charging a 1% to 2% net take rate on air tickets and about 4% on hotel rooms, versus my estimate of 4% to 5% on air tickets and about 10% on hotels charged by the others. This approach has helped Qunar achieve top market share in air tickets and rise to No. 2 in hotels.
The competition is now being forced to respond, and it has seemingly done so by starting to slash prices. Ctrip's operating margin is down from 30% in 2011 to just 6% over the trailing-12-month period, while eLong's has dropped from 8% in 2011 to sharply negative territory today. The effect of competition was most obvious in eLong's fourth-quarter results, which showed a year-over-year gross-margin decline from 72% to less than 16%. One might expect a similar dynamic to show up in Ctrip's forthcoming results.
Yet no one is going away. Expedia noted on its call that eLong has more than $300 million in cash, access to Expedia's $1 billion in annual free cash flow, and a huge market opportunity in China. And that seems to be the plan for every entity that has overinvested in China over the past decade in hopes of achieving outsize emerging-market growth. But the environment has become much more difficult and will probably remain so for the foreseeable future. Even if China cleans up its corruption and governance issues, succeeding in this new Chinese reality may be more difficult for investors than ever before.
But be alert
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