Tiger Woman on Wall Stree (25 page)

Even so, these realities didn’t stop the Muddy Waters report from triggering a sharp decline in New Oriental’s stock. Sell-side analysts were as clueless as the scared investors and jumped ship as quickly as they could, lowering their target prices for the stock and downgrading the company from buy to sell.

The other allegation that contradicted common sense, at least for a Chinese person, was Muddy Waters’ suspicion about the fact that Michael Yu, the CEO, had transferred 26.4 million shares to his mother. In fact, gifting stock to immediate family is fairly common among Chinese managers. It’s also often used as means
to protect wealth in case of divorce, because a Chinese wife has no claim on assets that are in her mother-in-law’s name. The experience of Tudou, a Chinese video site, demonstrates this point nicely: its 2011 IPO was delayed for almost a year because the founder’s wife claimed a large portion of his equity interest in the company during divorce proceedings. If only Tudou CEO Gary Wang had transferred more shares to his mother! In addition, a mother would be considered a safer parent with whom to entrust such an interest than a father. In the case of a split between parents, the probability of an elderly woman getting remarried (thus giving the new partner a claim on the assets) is far lower in China’s patriarchal society than for an elderly man.

But the allegation that was most damaging and hardest to rebut was that many of the schools in New Oriental’s network were franchises, rather than directly owned. Muddy Waters claimed that New Oriental had misrepresented certain franchise schools as fully owned businesses. In the view of Carson Block, Muddy Waters’s founder, that allowed the company to maximize its store base growth, helping it to justify its fast revenue and profit growth, as well as counting its franchise fees as company cash.

To investigate this claim, Goldpebble developed a proprietary algorithm to sift through 107,517 of New Oriental’s class records and 14,468 opening course records from its online enrollment website. To examine the potential for financial reporting fraud, Yifeng’s team checked this database with schools and learning centers in China’s major cities. The survey team also interviewed senior management of other nonlisted private schools, compared New Oriental’s financials with those of other listed private schools, and performed on-site visits to private school associations, the
Ministry of Education, and the tax bureau to identify potential frauds in the corporate structure.

To ascertain the scale of its franchise network, Goldpebble conducted comprehensive surveys of 48 schools and 680 learning centers to verify the stated revenue and issued invoices. All 48 of the schools invoiced their revenues to New Oriental subsidiaries, indicating that they were directly owned. Thirty-five supplied bank details or postal remittances to prove that the funds went directly to New Oriental. Goldpebble received survey responses from 564 out of 680 learning centers, and those that answered all issued invoices to their local New Oriental branch. In addition, none of the 564 schools said they were aware of any franchise operations in their cities. Based on these data, we estimated that less than 1 percent of New Oriental’s income was franchised and was therefore insignificant for New Oriental’s operating and financial reporting purposes.

After completing this extensive investigation, we concluded that Muddy Waters’ allegations were groundless. There was no trace of fraud, and all the issues Muddy Waters raised—from New Oriental’s franchises to its accounting practices and corporate structure—appeared to be false. We urged our clients to buy the stock at less than $10 per share in July 2012. By November, it had bounced back to $20, a more than 100 percent gain in less than four months, our biggest win in 2012.

Our experience with New Oriental showcased the power of investigative research—in the words of Ayn Rand, “not to trust, but to know.” This was the only way to invest in China, not through the “he said, she said” of analyst reports, unverified news, and rumors, but through exhaustive bottom-up research. Only with this rigorous methodology could an investor develop a level of conviction that would allow him or her to withstand market volatility and pursue profit-making opportunities by betting against
the crowd. Of course, this type of research is beyond the reach of most retail investors due to resource constraints.

This is one of the main reasons that I suggest retail investors stay away from individual Chinese stocks. Again, losing money is a lot worse than not making money.

On May 30, 2012, I sat down with a reporter from Bloomberg TV in the China World Hotel, a historic landmark on the western side of Beijing, for a televised interview on how to invest in China. I told him that I thought highly of Muddy Waters’ work. Carson Block had shown, not just told, people how to conduct exhaustive and meticulous research, and in the process he had helped to combat opacity and generally poor Chinese corporate governance. Every serious investor should invest and build a research infrastructure capable of conducting this level of due diligence, but even so, there is no guarantee of getting it right 100 percent of time.

The interviewer asked how investors could capture Chinese growth. The best solution, I told him, was to invest in multinationals with defensible models and significant exposure to China. Multinationals give foreign investors a way to benefit from Chinese growth without investing in Chinese stocks directly, thereby circumventing Chinese corporate governance issues.

One of the multinationals I mentioned was Yum! Brands, an American quick-service restaurant (QSR) chain that operates 39,000 restaurants in
110 countries
. Its brands include KFC, Pizza Hut, and Taco Bell, but its crown jewel is KFC China. With approximately 5,700 stores, Yum! China generated more than 50 percent of Yum! Brands’ operating profits, and KFC China generated approximately 85 percent of Yum! China’s profit. For this reason, the stock attracted the interest of global money managers and investors
seeking a proxy for the booming growth in the disposable income of the Chinese middle class.

Since its first store opening in Beijing in 1987, KFC China achieved great success in branding itself to appeal to the swelling ranks of middle-class Chinese consumers. KFC in China managed to localize its menu but still have its customers think of it as a quintessentially American brand. The Chinese middle class was fascinated with American fast food, and unlike in the United States, the restaurant was considered an appropriate place to have a birthday party or even take a first date.

I was no different. I indulged in KFC in the mid-1990s, before I learned how unhealthy it was. The price tag, almost 20 RMB for a sandwich, was not exactly cheap, but I savored every bite of the delicious (and at the time unusual) combination of a fried chicken fillet, mayonnaise, and uncooked lettuce.

I have never bought Yum’s stock. The valuation was above what I was willing to pay for a fast-food chain restaurant business. But it had been a darling for many global fund managers who wanted China exposure without China risks such as corporate governance and accounting issues. The stock took off from a level of $50 in October 2011 and ripped all the way to $70 in early 2012, as the company planned hundreds of new store openings in China. By late 2012, the stock traded at more than 20 times forward earnings, a huge valuation for a company that sells fried chicken.

I have been cautious of the stock for several reasons. The QSR industry is highly competitive. It has what analysts describe as a low switching cost for the customer: many consumers go to KFC one day, McDonald’s the next, and Chipotle the day after, unlike other retail segments where consumers stay relatively faithful to one brand. That should ultimately spell volatile profits and leave the company vulnerable to competition in the long run. For such a segment, Yum had an extremely high valuation. In comparison, the stock of Swiss luxury watchmakers, another category in the retail
space including Richemont and Swatch Group, is valued at around 12 to 15 times forward earnings—even though the luxury industry in theory provides a similar China growth story and even though the barrier to entry for companies, including brand equity and customer service, is much higher than in the fast-food segment. Even Apple, a great China discretionary spending story, typically trades at a multiple between the high single digits and the low teens.

By then, Yum had been hit by a string of events that prompted me to pay close attention to this “Chinese” company. It all started with the “45-day chicken.”

On November 23, the Chinese media reported that one of KFC China’s chicken suppliers, known as the Su Hai Group, had fed toxic chemicals to its chickens to accelerate their growth cycle from 100 days to a mere 45. On the same day, KFC China responded, denying the allegations and stating that a 45-day growth cycle was the industry standard.

Knowing that the chicken we consume in the United States is mostly, if not all, 45-day chicken, I wanted to understand why Chinese people were having such a strong reaction. I decided to delve into the nitty-gritty of the chicken breeding cycle. I learned way more than I ever wanted to know about poultry.

According to a study published by China’s Ministry of Agriculture in 2003, China is home to about 100 chicken breeds: 95 native to China and 5 imported. The local breeds have yellow feathers, while imported ones have white feathers. Compared with the white chickens, the local yellow chickens require more feed to yield the same amount of meat, have a longer growth cycle, and command a higher wholesale price. In addition, white chickens are generally bred and raised in a more adverse environment to encourage them to gain weight. On average, white chickens are given only 130 square inches of farming space, not much bigger than a shoebox. Yellow chickens, on the other hand, are mostly free range and thus are considered more natural. So Chinese people
have come to see yellow chicken as the premium product. In contrast, Chinese people often associate white chickens with chemical injections, poor nutritional value, cheap meat, and inferior taste.

After domestic media reported that KFC relied on the lower-quality white chicken, Sina Weibo and other social media networks in China lit up with consumer complaints. Netizens (a popular Chinese phrase for “citizens of the Internet”) decried the added hormones, and a picture of a chicken with six wings and four legs, ostensibly the product of too many hormones, even went viral online. The chicken’s defects could have just as easily been caused by China’s polluted water, but that wasn’t what mattered most for Yum. What was most important at the end of the day was consumer perception, and that had gone ahead of reality.

As the events unfolded, Goldpebble and I closely tracked the reaction to the story on social media sites. We realized that mainstream media and Wall Street analysts had greatly underestimated the public’s disgust and outrage. Online, chatter about “KFC’s 45-day chicken” multiplied. Three leading Internet services, Sina Weibo, Tencent, and MSN, surveyed their users on the safety of KFC’s food. On average, nearly 80 percent of respondents declared that they wouldn’t buy KFC in the foreseeable future, while 85 percent said they considered KFC food to be unsafe. Jokes began to circulate: “Next time I get sick, I’m going to KFC. I’ll get my antibiotic fix from their chicken—it’ll save me a trip to the hospital!” All the conversation was in Chinese, however. In English, the U.S. media and American analysts continued to report that concerns over KFC’s performance were overblown.

I was rather surprised by the controversy the issue provoked. One would think that in a country where food safety practices are as infamously lousy as they are in China, the scandal would blow over quickly. With the huge number of food quality problems in China, from gutter oil to the sale of dead pigs for meat, why did the Chinese choose to care about this one?

To answer that question, I studied the KFC menu and those of its competitors. I started to realize that there was a critical difference between KFC in China and KFC in America: in China, menu items were viewed as luxury fast food. That might be an oxymoron to Americans, but it wasn’t to the Chinese. The price of a KFC meal in China, perhaps 25 RMB, or $4 per head, was often double or triple the price at local fast-food chains with similar offerings, such as Country Style Cooking, a local KFC knock-off. KFC’s claim to the premium segment lay in its environment—by Chinese standards, clean, spacious, well lit, and well staffed. KFC in China was not just a fast food but rather a dining experience that symbolized the quality and convenience of American life. So when Chinese consumers realized that the fried chicken they were paying a premium price for was the cheaper, fast-growing chicken rather than the 100-day chicken they typically ate, they felt extra disappointed.

Yifeng, who happened to own a takeout delivery service in Shanghai, pointed out another factor that had thus far gone unnoticed but was highly relevant to KFC China’s future success. While most Wall Street investors considered the 45-day chicken scare a one-time event, a separate long-term trend was weighing on the KFC business model. Even more so than Americans, Chinese people were spending an increasing amount of their time shopping online.

One of China’s most notable business success stories is Taobao, a shopping site that reached a record-high gross merchandise volume of 1 trillion RMB in 2012. Shopping on Taobao has simply become the new way of life, especially for young urban professionals. Yifeng connected the dots: online shopping means fewer trips to shopping malls, where most KFC stores in China are located. As the foot traffic in commercial areas falls, so will KFC’s profits.

KFC clearly realized that it was losing business to the takeout services that were feeding China’s growing couch-potato population. So the company responded by rolling out new value combos
to go, with free delivery services. But Chinese customers weren’t converted, for the simple reason mentioned above: they had gone to KFC not for the menu but for the dine-in American fast-food experience. For takeout services, consumers were more sensitive to price and therefore opted for cheaper local competitors.