The Globe and a Hard Place

Growing turmoil in emerging markets has U.S. companies gaining control over their foreign ventures. But will that compound the risk?

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Even as the global financial crisis deepens, many U.S. companies see the current malaise as a fine opportunity to step up their investments in foreign markets. “The time to pick up assets is when there is blood in the streets,” says Raymond Niles, a senior analyst at the New York office of London-based investment bank Schroder & Co.

The risk, of course, is that the streets will get even bloodier before prices hit bottom. And that risk could be compounded by the approach favored by a growing number of companies. They are wresting greater stakes in local companies from governments under pressure to raise cash and unload debt.

One of the latest companies to do so is UBS, the Swiss bank, which has acquired three once- ballyhooed ventures with Long-Term Credit Bank, a beleaguered Japanese financial institution. Another is Parker Hannafin Corp., an industrial instrument and controls maker based in Cleveland that has bought out its South Korean partner, HS Group, of Pusan City. Still another is Eastman Kodak Co., which has won China’s approval for control over a joint venture it just signed with two local film manufacturers.

Meanwhile, companies like Ford Motor and Great Lakes Chemical are considering taking control of their Asian partners, and analysts say that UBS’s move may force its competitor, Travelers, to follow suit.

But as U.S. companies seek to control their own destinies abroad, they may have to go to great lengths to keep problems there from showing up on their balance sheets. Even before the crisis, analysts say, few of their investments in emerging markets turned a profit. Many were heavily in debt. But those facts were barely reflected in the U.S. companies’ results. Under U.S. accounting standards, none of a joint venture’s debts or assets need be included in the parent company’s balance sheet. Only the parent’s share of the venture’s losses or earnings has to be included on its income statement, and even then it can be reported separately from the parent’s operating results.

With a stake of over 50 percent, however, all of the former joint venture’s debts and assets would have to be included on the parent’s balance sheet, and the venture’s revenues and costs would have to be reflected in the parent’s operating results. So, a company with heavy investments abroad could find both its leverage increased and its returns on equity and assets diminished.

The impact, to be sure, depends on the size of the venture in relation to the parent’s size. And for many big firms, what might represent a huge investment for a developing market could have only a tiny impact on the parent’s financial profile.

But that wouldn’t be true in the case of Ford’s interest in its Korean partner, Kia Motors. Ford has an 11 percent interest in Kia as a result of its own 9 percent stake in the Korean company and its one-third interest in Mazda of Japan, which owns 7 percent of Kia. While Ford is downsizing plants in Asia, the company was also considering buying control of Kia as this issue of CFO went to press. One of the country’s largest automakers, Kia has been in bankruptcy proceedings since last year, with liabilities estimated at $8.6 billion. If Ford were to gain control of the company, and if Kia’s debt were included on Ford’s current balance sheet, Ford’s own debt level (excluding that for its financing operations) would jump from 25.6 percent of its capital to around 40 percent. And Ford’s returns on assets and equity could be hit hard.

Frank Scheuerell, a project manager at the Financial Accounting Standards Board, says that the prospect of having to load up a joint venture’s debt on their own balance sheets makes many U.S. companies wary of turning their minority stakes into controlling interests.

But that is starting to change, as companies see a greater need to get a grip on these ventures in the face of local difficulties. Parker Hannafin’s $10 million investment to gain control over the HS Group may be tiny, but it provides a means of “protecting their investment on the cheap,” notes Steven Altman, an analyst for the Chicago-based credit-rating agency Duff & Phelps Credit Rating Co. Even so, most companies gaining control over their foreign partners are going to great lengths to avoid the additional financial burden that could impose.

One alternative, of course, is simply to head for the exits. Enron Corp., for instance, has done just that in Nepal, where it once planned to help build a hydroelectric plant slated to cost $9 billion. “We made an assessment that the demands of developing a project in that marketplace would be difficult,” says Joe Sutton, president and CEO of Enron International, an Enron subsidiary.

But in general, companies are pressing ahead. “I don’t believe it makes sense to put investments on hold during the current situation,” says Dominic DiMarco, director of finance for Ford’s businesses in Asia, Eastern Europe, and Africa. As for Kodak, “we believe very strongly that China will be the first- or second-largest film market in the world within the next 5 to 10 years,” says David Swift, chairman and president of Kodak’s Greater China Region.

What’s Viable?

Yet Ford is driving a hard bargain with Kia’s creditors. “A lot of things would have to happen to Kia before we’d invest. One would be to get rid of the debt,” says DiMarco. As for the impact of Ford’s having to consolidate Kia’s operating results, he says that Ford will not buy the company unless it’s assured that Kia can become a viable business. “It’s not viable today,” he emphasizes. In fact, Ford has won the right to negotiate the amount of Kia’s debt that its primary creditor would write off. If Ford took on anything like Kia’s current debt, “it couldn’t get a return for shareholders,” says Duff & Phelps analyst Marvin Behm.

An alternative to heading for the sidelines, of course, is to use off-balance-sheet financing to make new investments. But there are signs that that is becoming more difficult to do. Until recently, for instance, AES Corp. was planning to buy the power business of Hanwah Energy, a South Kore-an power producer, for $873 million. This would have made the Arlington, Virginia-based power company the largest foreign investor in South Korea, assuming Ford didn’t end up with Kia. But AES itself typically puts up only 10 percent to 30 percent of the money it invests in foreign power plants, turning to banks for the rest. And it is increasingly wary of lending in developing markets. Sure enough, when Korean Electric Power Corp., the state- owned utility that is Hanwah’s main customer, couldn’t agree to AES’s nonpricing terms, AES called off the deal. The company declined to comment on the decision, but George Goundry, an analyst for the investment firm ABN AMRO Asia Ltd., in Bangkok, says that AES demanded a 15 to 20 percent margin, while the Korean utility’s own margins are only about 5 percent.

Strange Bedfellows

Instead of using its own money, Enron also looks to others to help develop new Asian projects. And it is confident of its continued ability to get such financing. As it assesses opportunities in that region, Sutton notes that the company may use “unique financings” as well as equity injections or outright acquisitions.

But anything short of an outright acquisition may do nothing to enhance the company’s control of such projects. And the emerging- market meltdown has pointed up the perils of not doing so. For one thing, that all too often puts U.S. management in bed with corrupt officials. Kia again is a case in point.

Last May, South Korean prosecutors sought an arrest warrant for Kim Sun Hong, the company’s former chairman, as part of an investigation into Korea’s debt crisis. Kim is accused of using company funds to purchase shares for management and to guarantee debt payments of affiliates. That has no direct financial impact on Ford. But the company’s association with Kim could make it more difficult for Ford to get what it wants from creditors, if only for political reasons. DiMarco dismisses this possibility. “We’re concerned about it like anybody would be,” he says. “But it really hasn’t complicated” the negotiations.

In fact, the crony capitalism that characterizes emerging markets threatens to ensnare a number of U.S. companies with joint ventures there. Among the more obvious examples is Freeport-McMoRan, a $2 billion (in revenues) New Orleans-­based conglomerate that long had questionable dealings with former Indonesian president Suharto. Indeed, public anger toward such business arrangements helped fuel the protests that toppled Suharto. And while Indonesia’s business environment is considered particularly corrupt, similar practices are not uncommon throughout the developing world.

Good Luck

Enron’s Sutton concedes that his company “lucked out” in Indonesia, where it has a contract to build a $525 million power plant in East Java, but has not committed any capital nor started construction. The project is on hold. “We’re waiting to see what the government does,” says Sutton.

Despite the risk of putting control into the hands of corrupt officials, Ford is continuing to invest in joint ventures in which it maintains a minority stake, again because it sees opportunities too attractive to resist. One of its joint ventures has just opened up a new plant in Thailand, although it is running at half the originally anticipated capacity.

“We’re trying to remain nimble and flexible” so that Ford can expand quickly if the economics change, says DiMarco. The battered currency has cut local costs, making the vehicles attractive for export. But DiMarco doesn’t foresee Ford ever assuming control of the venture, if only because its partner, Mazda, is “very supportive.”

In China, Ford is negotiating with Beijing to increase its 20 percent stake in a local auto company to 30 percent. Overall, Ford plans to invest $1.5 billion throughout Asia over the next five years, much of it in ventures it won’t control. In that sense, DiMarco considers Kia a special case. Elsewhere, he says, “we depend on our joint venture partners for local expertise.”

In many cases, of course, governments simply won’t allow foreign companies to control their ventures. And even when they do, the companies may want only to test the waters and so keep their investments limited to minority stakes. Or, like Ford outside of Korea, they continue to require the help of partners to grow the business. But once committed and where possible, companies generally would prefer ventures that they can control, as Kodak has made clear in its recent deal with China. The American film manufacturer gained an 80 percent stake in Kodak (China) Co. Ltd. and 70 percent of the shares of Kodak (Wuxi) Co. Ltd.

Unmired

Swift says that gaining control of the operation was critical for Kodak to proceed. “Our intelligence of companies doing business in China showed that those that did not have a significant majority position tended to get mired in bureaucratic issues,” he says. “With our goal of making this a world- class enterprise, a key requirement was being able to move quickly.”

And what of the impact on Kodak’s balance sheet? That’s impossible to say at this point. The company will capitalize only part of the $1 billion­plus investment, expensing the rest. But Kodak hasn’t yet indicated what the breakdown might be. Yet whatever the immediate impact, the investment could rise over time, since Kodak plans to upgrade the plants’ capacity, and it’s unclear how much money that will require.

The biggest fear of shorter-term investors in China is that the government will devalue its currency in the face of continued economic weakness in the region. That could actually work to Kodak’s advantage, as Thailand’s devaluation has helped Ford in that country. For one thing, a devaluation would reduce the amount that the company would have to pay in dollars to upgrade its partners’ facilities. What’s more, Kodak is currently exporting a substantial amount of product from the United States to China, and since its venture there is designed primarily for the domestic market, getting up and running with production could give Kodak a big leg up on its primary competitor, Fuji, if there is a devaluation. “The sooner we can get the assets operational in China, the better off we will be,” says Swift.

Yet Kodak is being careful to ensure that its Chinese distributors are in good shape. “We’ve asked them to be as open as they can be with their books,” says Swift. And he notes that “most are so hungry to get the business they are willing to oblige.” Still, Kodak won’t be financing the distributors. Instead, they’ll turn to local banks.

What all this shows is that even as companies like Ford and Kodak seek a firmer grip on their businesses in Asia, they are trying hard to steer clear of financial pitfalls. “We’re not going to take financial risks that would put Ford in jeopardy,” says DiMarco. Yet that might become far more difficult. Under a proposed accounting-rule change under consideration by FASB, minority stakes might no longer offer U.S. companies a way to limit their exposure to a joint venture’s poor operating results. The rule could require a company to consolidate the results of its joint ventures even when it owns less than 50 percent.

In other words, if minority ownership doesn’t limit one’s exposure to a foreign venture’s downside, there’s no reason not to seek control over it, especially when global market conditions are as uncertain as they are today. Unless, of course, one needs outside help. In that case, a company might find it more prudent to cut and run for whatever shelter remains within U.S. shores.

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