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China-US trade tensions and TIC: Collateral damage

Nov 8, 2018

SGS’ downward adjustment of its 2020 margin goals, and the fact that the No. 1 of the TIC industry to a certain extent attributes this to US/China trade tensions and tariffs, has underlined the importance of the topic. Global trade growth has been one of the key tailwinds in the “Golden Age of TIC” until 2014. Escalating trade tensions between the US and China could have the opposite effect, i.e. cause declining product testing revenues and harm the TIC industry’s growth.

The trade dispute with China has been a distinct element of the Trump presidency from his very first day in office on, when he decided to withdraw from the “Trans Pacific Partnership” free trade agreement. The trade controversy reached new heights this summer and autumn when President Trump ordered further tariffs on imports from China and the People’s Republic retaliated in similar vein. At the moment, US tariffs of 10% cover USD250bn of the ~500bn imports from China, and similar Chinese tariffs around 50% of US exports. Hence, a large share of bilateral trade is already affected by the trade dispute.

Tension will automatically heighten further by January 2019, when US tariffs will increase to 25%. Moreover, if trade talks fail in November, the Trump administration will impose additional tariffs on the remaining Chinese trade volume of ~USD 250bn so far not covered.

This is already putting the established sourcing and supply chain patterns under stress and may trigger their re-alignment, i.e. a shift or “migration” of sourcing and exports to other countries. The exact extent of this is difficult to assess, as for example one factor will be how much of the tariff-related cost could be passed on to secondary buyers and consumers. If furniture from China is still cheaper than that from North Carolina, even at a 25% tariff, then this will not affect the sourcing pattern and rather lead to (somewhat) higher prices for consumers. If not however, relocating production might make sense – unclear at the moment. This might explain why many TIC customers are still in what SGS has called the “wait and see”-mode, creating uncertainty for the TIC industry.

But what if this Sino-American trade confrontation escalated into fully-fledged trade war, with blunt import bans or prohibitive tariffs? In this next level of escalation, global supply chains and trade patterns would clearly re-align significantly. Direct, bilateral trade and sourcing relationships between China and the US would unravel and fully shift to other countries not involved – i.e. to/from Europe, Latin America and South East Asia.

Global trade relationships would potentially re-organize in two separate hemispheres / around two separate hubs. In general, “neutral” regions could benefit from such further heightened tensions, if the adversaries do not demand loyalty from their allies/partners and mutually exclude “membership in both hemispheres” in strict “negative preferential trade agreements”.

Consequences for Chinese exports to the US: The US predominantly buys electronics and IT equipment in China (e.g. mobile phones, computers, telecommunication equipment) and machinery. One could expect that the former would in part experience a certain “re-shoring” and in part be re-shifted to South East Asia, whereas the latter might be an opportunity for European OEMs.

Consequences for American exports to China: China’s major imports from the US are passenger aircraft, soybeans and vehicles. South American producers will happily try to fill the gap for soybeans – Brazil has already overtaken the US as the most important exporter. US-substitute soybean exports could be a lottery ticket win for Argentina’s much-battered economy and create unusual new friendships. Reg. planes and cars, China would most likely try to promote its own OEMs, albeit this could turn out to be a problem in the short-term, at least in the Aerospace sector (can’t do without Western technology at the moment). Shifting to European OEMs of course would be an option, but one that would contradict many of the Chinese government’s strategic goals.

What would all this mean for the TIC industry?

As a result of significant re-shoring of electrics/electronics manufacturing from China to the US, the “Chinese export-driven TIC business” in this field would be hit in a core area – harming a major source of revenue and profits in “Consumer Products”. In this case, the “Consumer Products” segment as a whole could lose some of its growth potential and appeal, which would exacerbate the TIC industry’s strategic challenges. Such a re-shoring scenario is not too implausible, considering the US’ still strong industrial base in E/E manufacturing and interest to regain technical sovereignty (at least reg. computer motherboards, maybe not reg. toasters or blenders). Technically, trade-related TIC activities would be transformed into US domestic market access services.
In addition, further fostering trade and exports does not seem to be a priority for the Chinese government anyway. Most of China’s growth has recently resulted from domestic consumption, and the Chinese government pursues additional efforts to encourage this further and to spur the shift towards an economy driven by domestic consumptions – also to counter potential “losses on the trade front”. In this context, China has even lowered certain tariffs to encourage consumption. In a nutshell: The “Chinese exports-driven TIC model” is most probably “topping out” anyway.
This means that the TIC industry would have to adjust its lab networks and footprints – maybe a painful adjustment for some. Players with strong market position in “relocation” countries would benefit, whereas those strong in the “Chinese exports business” would be disadvantaged.
As a side-effect, a trade-war could foster and accelerate the Chinese efforts to build a national TIC champion, in order to gain further/more control over trade and exports. A Chinese TIC champion could be a useful tool for enforcing “negative preferential trade agreements” and controlling imports.
On the other hand, those TIC players positioned and able to support the “substitute sourcing efforts” of the two adversaries would benefit. For example, TIC players with a decent footprint in Latin American agriculture, especially in soybeans in Brazil and Argentina, might embrace and celebrate the development.

Further escalation even beyond this is of course possible. At the moment, all political wrestling affects direct trade flows, but not indirect trade. In an extreme scenario, even such products from a “neutral” country but with a considerable share of American or Chinese parts or assemblies could fall under trade rules. This would imply a further disintegration of global trade and manufacturing patterns. Sounds ludicrous? Some might have said this about Chinese spy chips on motherboards as well…

If there’s one takeaway for the strategist in TIC, from our point of view, then this: Don’t build all your dreams on Consumer Products – or they might be over sooner than you think and leave you with a nasty headache.

Consumer Goods: Looming overcrowding?

TIC providers and investors love Consumer Goods testing. It’s highly profitable, it’s stable and it’s growing nicely. According to the established narrative, this is driven by the world’s seemingly insatiable demand for T-shirts and electronics, from which however only incumbent TIC providers can benefit, due to certain barriers to entry (such as the need to have an extensive and costly lab network).

The segment’s attractiveness has repeatedly given rise to concerns that it could become a “battleground”, a hotly contested remaining green pasture in a more and more barren TIC environment. In this thinking, price wars and overcapacities would subdue growth and reduce profitability.

In contrast to such fears however, Consumer Goods testing in the last years still expanded quickly enough not only to steadily yield enchanting margins and growth rates for the incumbent larger TIC players, but also to comfortably accommodate two noteworthy newcomers (AsiaInspection and AQF, now both achieving considerable revenue).

And it continues to attract TIC players, even those who traditionally did not have a significant presence and competence in the field. For example, DEKRA has repeatedly confirmed and underlined its ambitions in the segment with several acquisitions and partnerships, and even Eurofins has recently begun to strongly expand its footprint in the segment, especially in the UK with now at least seven sites for Consumer Goods testing there.

[Especially the latter is a bit puzzling, as up to now most industry participants and observers liked to perceive Eurofins as an “Agriculture & LifeScience” pureplay. We will investigate the question further whether this is purely opportunistic or constitutes a strategic move.]

We believe that the fundamental analysis of “Consumer Goods as a TIC battleground” is quite compelling – to this end, “trouble is maybe postponed, but not called off”.

With global trade frameworks deteriorating and even larger parts of the TIC industry placing their hope on Consumer Goods, it remains to be seen if the segment can continue to reliably deliver on everybody’s aspirations and growth expectations. Will everybody be able to grow as planned? Let’s see.

B2G TIC: Boon and bane

Some parts of TIC have a parastatal character –governments outsource certain testing or inspection tasks to TIC providers, who then perform these on behalf of them. Prominent examples include Trade Inspections, Pre-Shipment Inspection or Statutory Vehicle Inspection.

Such B2G TIC is far from being unattractive, even though it can be bureaucratic. In fact, government outsourcing schemes create (temporary) monopolies, with two appealing features: Inspections are often made compulsory by law, and prices are set by the government. In other words: Nobody can escape and price competition does not exist.

With clever contract design, B2G TIC can be a money-printing machine – as for example indicated by Applus+’ enviable margins in SVI of close to 20% (cp. the 2017 results presentation, p. 17). Winning such contracts can thus provide a nice source of profit, and naturally many major TIC companies are active in B2G TIC.

Yet, the blessing can also turn out to be a curse, as SGS’ experience with Statutory Vehicle Inspection in Uganda tells (http://allafrica.com/stories/201803050136.html ; https://www.independent.co.ug/inside-sgs-contract-saga). In short, the Ugandan government decided to reintroduce SVI, and SGS won the contract and set up operations. But parts of the Ugandan Parliament became more and more unhappy with the whole thing, finally accusing SGS of bribery, not meeting promised job creation targets and implicitly of expropriation.

We’re leaving it to others to judge and determine whether or not these accusations are correct. For us, this colorful story of what B2G TIC can be like is a stark reminder that it can hold significant risks. As tempting the honey pot of large B2G TIC profits may be, TIC companies must be aware that corruption risks are real and that they effectively put themselves at the mercy of governments, whose decision-making is politicized, not necessarily commercial.

In our opinion, TIC providers should not depend too much on B2G TIC businesses with their high risk of potentially erratic and intransparent political decisions. It’s okay as an icing on the cake, but not as the cake itself – because unfortunately, governments at times decide to give the cake to someone else or to close the bakery.