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The Chinese supply gameThe Chinese supply game

E-commerce eclipses commodity pricing as the issue to watch

Marc Brush

November 21, 2016

10 Min Read
The Chinese supply game

We begin this analysis of China’s supply chain with a story of price fixing. Citing the conflict between “China’s strong interest in its protectionist economic policies” and the “antitrust enforcement interests” of the United States, judge Peter Hall of the 2nd US Court of Appeals in New York recently overturned a $148 million verdict in a vitamin C price-fixing case dating back to 2001. Remember that one? When vitamin C out of China rose from $2.50 per kilogram to $15, US manufacturers filed suit and won the battle, but apparently not the war.

Sources for this story downplayed the relevance of this ruling as old news, but the matter warrants a second look. “This ruling suggests that the laws and culture of China can outweigh our antitrust laws,” says Scott Steinford of Trust Transparency Consulting. “It may not seem important, but in many cases, even outside our industry, this could be a very important decision. It could all but green-light the opportunity for collusion.”

Such is the path toward progress, forged in fits and starts. The legacy of cheap ingredients out of China at inferior levels of quality is changing, according to many sources, but never fast enough. Steinford’s expertise in CoQ10 illustrates the point. “Fifteen years ago, there were three Japanese manufacturers of CoQ10, and today that number is zero. Ninety percent of the market is Chinese. I don’t think there’s a problem there, but it is harder to have direct dialogue with China. The culture doesn’t support or promote it.” In an era of increasing demand for trust and transparency among consumers, that open dialogue throughout the value chain matters. “When commodity pricing prevails, science and education suffer the most, and that’s a shame,” says Steinford. “The industry does not grow with the commodity game, it grows through science and education.”

The new game

Dachao Zhang, Secretary General of China Health Care Association sees changes afoot. “It is correct to say that Chinese manufacturers have tended to focus on cheap bulk raw material for export, but we are seeing more of a shift to develop innovative ingredients with clinical trials,” says Zhang. “The economic growth in China has raised the costs of manufacture in recent years, so the ingredient exporters are losing profit and many are closing. Those that survive this change have shifted their attentions to proprietary ingredients with proven clinical trials.” If the domestic economy of China itself shifts away from the commodity model, perhaps that indicates lasting change that could benefit quality globally.

Some of the innovation that Zhang speaks of has less to do with the ingredients themselves and more to do with how they’re made. “There are a number of Chinese companies gaining in sophistication, especially with processes that enhance efficiency,” says Larry Kolb, President of TSI USA. “Glucosamine is a great example. We’ve invested in a new direct fermentation. We think traditional shellfish production—that game of high volumes, tight margins—is a process of the past. We’re moving toward cleaner, more efficient, patented processes in our Chinese facilities.” Kolb says such evolution is inevitable. “China is really leading the world in process technologies. When you’re in these commodities for this long, it’s a natural phenomenon to achieve these kinds of innovation.”

But that’s not all of the news out of TSI, as supply chain risks persist. To make sure upstream raw materials were not adulterated, TSI acquired its own 1,000-acre ginkgo plantation in China to grow its own leaves and ensure the feedstock is fully verified. “That’s really the only way to ensure a commonly adulterated botanical is not adulterated,” says Kolb. “Buying ground leaf through commerce is just too uncertain. There is still economic adulteration in China. The ginkgo crackdown last year was based on widespread adulteration that found its way into China’s domestic pharmaceutical market, with ripples into the US market. This impacted the whole botanical sector. Ginkgo was implicated in the New York Attorney General’s investigation, so it’s all tied together.”

Again, progress comes in fits and starts. Sources spoke to NBJ of longstanding concerns that still remain with Chinese supply of chondroitin sulfate, bilberry, and St. John’s wort.

Across the border

The big news in China of late has to be the growth in e-commerce—70% annually—as a selling channel for US brands. E-commerce is moving the market out to second- and third-tier cities where consumers don’t have access to stores or computers, but they do have phones. This is the way many US supplements have entered the market, as Chinese consumers continue to prefer foreign brands in higher-risk categories like milk powders, infant formula, and pet food. Merchants need authorizations to sell on the larger platforms, and this adds a further level of confidence for the online shopper.

Depending on definition and source, the domestic market for supplements in China sits around $25 billion, which pales in comparison to the levels of commerce happening on popular web storefronts like Alibaba Tmall. Alibaba has reported single-day sales across all product categories of $14.3 billion—more than ten times an average day for WalMart—and supplements are the second-best seller for cross-border commerce in China.

Entirely new industries have developed with the advance of e-commerce. The Financial Times reports that the “suitcase trade” of daigou—buyers on behalf of others—reached upwards of $7.5 billion in 2015. Driven by the craze for foreign-made products, the daigou phenomenon got so out of hand that leading Australian grocers like Coles and Wentworth imposed quantity limits on individual shoppers for infant formula. Sources also suggest that GNC effectively left the Chinese market due to pressure from this gray market of professional shoppers. Daigou can charge markups reaching 50% off the shelf with luxury goods and health products in the greatest demand.

The jig might be up. “There’s tremendous activity coming into the country for foreign-made supplements through cross-border trade,” says Kolb. “It was a boom for several countries—Australia, Japan, the US—but a legal gray area, and the Chinese government imposed further restrictions earlier this year that may bring this to a screeching halt.”

Indeed, free-trade zones, where commerce occurs without the intervention of customs authorities, came out in April, but supplements didn’t make the list. Taxes approaching 15% ensued, and some free-trade zones froze commerce overnight. A one-year grace period came to the rescue, but that ends in May 2017 with little suggestion of any extension, and many of the larger players in cross-border commerce have set up warehouses in Hong Kong to operate outside of Chinese jurisdiction. According to the Financial Times, Swisse estimates that its daigou shoppers have fallen from a high of 100,000 to 20,000 since the taxes and legal restrictions.

In addition, experts see stronger food safety laws coming online next year that will require foreign companies to obtain further certifications from the Chinese government in order to continue selling on cross-border commerce sites. “A lot of foreign companies choose to sell this way, and it’s not only Alibaba and jd.com,” says Zhang of the online channel. “But real success in China still comes from understanding the regulatory system. You have to get registration first to move any large volume of business from online to offline, and to invest in your marketing in China. Large companies are starting to do this—Schiff, Swisse, Blackmores—and they are seeing success.”

Changes on the regulatory front remain a challenge. Companies should expect two systems going forward. The blue hat registration, the China FDA’s version of premarket approval, will continue, to the great consternation of US manufacturers, with costs that can run as high as $150k for a single supplement and a timeline that can stretch to three years. E-commerce complicates the decision further. An investment in blue hat is really an investment in distribution inside China, a presence in market, but products on the shelf are expensive in comparison to Alibaba deals.

The Chinese government has announced a second path to market, with a new recording system—think notification—on common letter vitamins and minerals, but the actual process is still being developed. “I don’t see any big changes over the next 10 years,” says Zhang. “The Chinese government has started to loosen regulations on the vitamins and minerals side to adopt a new filing system, but the system of technical requirements still remains the same.”

Buying spree

Given the necessity and complexity of understanding Chinese regulations to achieve lasting success, is it any surprise to see China’s largest companies go on a buying spree for foreign brands? The buyer brings an essential toehold in a market less fraught with protectionist obstacles, and the brand brings quality—an ideal match.

“There has been lots of M&A activity in China over the past two years,” says Zhang, “with Chinese companies actively looking for Australian and US companies to acquire. I expect to see more deals very soon.” Few would argue with that summation. Financial wires lit up at press time with news of GNC in talks with potential Chinese acquirers. If the deal happens, it could hit $4 billion, with the list of suitors that includes Fosun Group, ZZ Capital, and Chinese pharmaceutical companies.

This would be the biggest deal since June of this year, when Xiwang Foodstuffs bought Iovate Health Sciences for $730 million to introduce popular sports nutrition brands to the Chinese consumer. In late 2015, Swisse also went to Hong Kong-based Biostime for $1.67 billion.

Feet on the ground

“More and more Chinese companies understand the nature of the business now,” says Zhang. “They have started to develop their own products with clinical trials. The large overseas manufacturers are not the only ones anymore. I do hear concerns that most of the clinical trials are not on Chinese populations, so this is an opportunity. Companies serious about the Chinese market should consider trials there, in country, with a Chinese demographic.” Smart companies might focus on digestion, as that growth market in the United States begins to catch wind in China. Companies beginning to focus their science on China include collagen players like Gelita and Rousselout as well as Dupont Danisco.

The future of supply in China begins to look more like US supply, with movement away from commodity pricing toward a stronger domestic base of science and proprietary ingredients. Might we see branded ingredients as well? Not as likely, say most of our sources, since “Brand China” does not instill the confidence of “Brand USA” and, more importantly, the practice of Traditional Chinese Medicine limits the appeal overseas. The likelihood of Chinese companies entering the US market is also less likely as the domestic market is so large, and TCM products have yet to catch in the US mainstream. “A change here will come from the spread of TCM culture in the U.S.,” says Zhang.

Here’s another tip for doing smart business with China in the years to come—drop the middleman. “Supply contracts are important,” says Steinford. “The pricing trends are likely to start reversing and, if more education and science do come into play, that passes along to the consumer. Supply contracts with distributors are almost useless—they have no control over supply, only perceived control. The only enforceable contract is between the ingredient manufacturer and the purchaser. That’s why contracts are not as utilized in China, but they should be.”

Most agree those prices will go up. The commodity game is losing favor inside the Chinese economy, and the world is waking up to the sustainability challenges in China. “There is greater expectation and pressure on environmental responsibility, and a recognition that addressing this in China impacts the entire world,” says Steinford. “China is beginning to mandate this, and that will impact pricing.”

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