Michel Brekelmans, at L.E.K. Consulting, highlights untapped investment opportunities in China’s promising field of business services.
In the face of current coverage of China’s economic slowdown, one could be forgiven for thinking that Chinese markets present more risks than opportunities. However, while China’s economic transition may pose plenty of challenges, not everything is doom and gloom—particularly in the tertiary sector.
Wheat from chaff
One developing industry which will continue to present attractive opportunities for investors and businesses alike is business services. Said sector encompasses a diverse set of service-focused companies or firms, including:
• Professional services firms for legal services, market research, commercial property advising, consulting, and architectural practice;
• Business process outsourcing including IT managed services, product administration, fund/trust administration and cash handling;
• Facilities management such as catering, cleaning and security/safety work;
• Asset-based services operating ports, car parks, waste management, equipment rental and environmental management;
• Asset management/maintenance, such as in vehicle leasing, property management, storage and warehousing;
• Facilitation/enabling services for inspection/testing, recruitment, training, document management, and logistics/platform support;
• The public sector, as in local authority/social housing support, road maintenance, defence supply chain contracts and infrastructure administration; and
• Other services such as education, business-to-business (B2B) platforms, professional technology services and software development.
Make no mistake: Business services entails more than simply outsourcing. Successful business services operators are innovating and differentiating their offerings in order to gain and retain customers. A high-performing business services provider in China will have five key capacities:
1) A focused growth strategy, often reliant upon initiatives which differentiate service offerings, achieve market expansion and acquire new capabilities and coverage;
2) Provision of a compelling value proposition that beats the competition, often by achieving reduced unit/activity costs, higher quality productivity or efficiencies and data analysis of the benefits of outsourcing;
3) A rigorous commercial focus on customer needs, service quality, value delivery, sales team responsiveness and discipline in the selective allocation of resources to customers/contracts;
4) Operational flexibility enabling a business services provider to be cost-responsive to the broader business environment while growing or expanding a firm’s capabilities and market share; and
5) A performance-oriented culture that places emphasis on data analysis, performance measurement and continuous improvement.
Right time, right sector
We see four key reasons to believe the Chinese business services sector will continue to present attractive prospects for investors and firms in the coming years:
1. Positive growth prospects relative to other markets
In comparison with other countries, the Chinese business services sector is still relatively underdeveloped. As shown in Figure 1 below, the contribution of services to China’s GDP is below 40%. That is significantly lower than in the US, the UK, Singapore, South Korea and Malaysia, where services can contribute as much as 70% of GDP.
2. Diversified yet stable customer dynamics
One of the advantages of business services companies is that they enjoy a diverse customer base which is also ‘sticky’—that is, customer relationships tend to continue unless there is a compelling reason to change to another services provider. The customer mix for business services firms also tends to feature low customer concentration, long-term contracts and opportunities for up-selling or cross-selling
3. Historical performance both globally and domestically
In terms of long-term (five-year) total shareholder returns, the business services sector has been one of the top performing industries worldwide. The global business services index of total shareholder returns between 2011 and 2015 was 22%, outperforming many other industries including airlines, luxury goods, chemicals, specialty retail and trucking.
LEK’s analysis of long-term returns at the world’s top 15 business services companies shows that these market leaders delivered total shareholder returns in the range of 26-35% over five years. In China, the business services sector has also outperformed most other sectors in recent years, with solid revenue growth of 23.8% for 2012-2014. In fact, the compound annual growth rate for the business services sector revenue was the third-highest out of a total of 17 sectors surveyed.
4. Attractive investment and deal prospects
Chinese business services companies currently offer solid value and affordability for prospective investors. The average price-to-earnings (P/E) ratio for the leasing and business services industry in China (78) sits well below that of other industries such as IT (114), health and social work (110), mining (103) and manufacturing (84). Indeed, there are a number of Chinese business services firms with P/E ratios ranging from 18 to 66, as shown in Figure 2 below.
LEK’s analysis has also identified substantial growth in M&A activity in the Chinese business services sector between 2010 and 2014. During those years M&A activity has increased markedly, both in terms of deal numbers and deal size: from 142 deals worth a combined total of almost $USD 1 billion in 2010, to 183 deals worth $USD 6.8 billion in 2014. Private equity/venture capital investors accounted for around 10% to 20% of participation in Chinese business services M&A transactions in 2010 and 2014. These trends are demonstrated in more detail in Figure 3 below.
Analysis of select M&A transactions between 2013 a
nd 2015 also confirms a broad range of Chinese business services M&A activity in terms of industry and transaction value for said period. To name just three:
• Pactera Technology International Ltd, a China-based IT process and management outsourcing company (2013, RMB3.374 billion);
• 99Bill Corporation, the first third party consumer payment services firm allowed by the Chinese government (2014, RMB1.865 billion); and
• Xiamen XTone Animation, which creates, plans and develops animations for mobile phones (2014, RMB1.398 billion).
In light of the above, and in light of diverse scope and tight links to China’s steadily growing services sector, we believe that business services will account for a growing share of China’s GDP in the years ahead, even in the context of the “new normal” of reduced headline GDP growth.
Chinese business services providers with the right capabilities, strategies and positioning will continue to emerge and thrive even as old drivers of China’s economic growth are shuttered. Attractive opportunities await those investors and firms who are attuned and connected to this dynamic and evolving sector of the Chinese economy. ♦
Michel Brekelmans is partner and managing director at L.E.K., and has been co-head of L.E.K.’s China practice based in Shanghai since 2006. L.E.K is a global consulting firm that supports clients in evaluating investments and in developing strategies and organizational capabilities that have significant impact on performance. L.E.K has been operating in China since 1998 through offices in Shanghai and Beijing.
Editor: Hudson Lockett (@KangHexin)