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In December 2012, Guan Shiyou, chairman of Shenyang Machine Tool Group, was honored by Chinese state media CCTV as one of its 2012 China Economic People of the Year. Guan received the award for taking control of a failing machine tool company and turning them around into a $2.8 billion giant. Or so it seems. Even as Guan received this award, his company was on the decline and would eventually fall into insolvency. In today's video, we profile the debt fueled fall of a Chinese machine tool giant. This video is brought to you by the Asianometry Patreon. Shenyang, once known as Mukden, is one of the larger metropolises in mainland China. The city proper hosts about 9 million people. As capital of the Liaoning Province, Shenyang is surrounded by satellite cities like Ansan and Fushan. The region is blessed with natural resources like coal and iron. During the warlord years of the early 1900s, Shenyang's local warlord, Zhang Zhuolin, father of Zhang Xuelang, the Xi' an incident guy, built several ammunition factories. This set the foundation for the city's heavy industry cluster. After the establishment of the People's Republic of China, the government continued this trend of manufacturing and heavy industry. In 1935, the Japanese company Mitsubishi set up a repair workshop in the Shenyang City area. After the PRC's founding, that workshop was nationalized and then rebuilt with Soviet aid into a large factory called Shenyang no.1 Machine Tool Works. China's machine tool industry was then in a difficult state. In 1949, the country's factories made only 16 types of tools and produced 1,582 units of those tools in total. So the Chinese government allocated resources to machine tools as part of its heavy industrial buildup. Output rose rapidly from those 1,582 units in 1949 to 28,000 in 1957. Meeting three quarters of domestic demand, Shenyang number one established itself as one of the country's better machine tool factories. In 1953, they produced, with Soviet aid, China's first domestically manufactured conventional lathe machine, the C620. The C620 was based on the Soviet Union's widely used one, a 62 screw cutting lathe. The thing won't win any beauty contests. Workers apparently dubbed it the Iron Pimple Scholar, but it was strikingly accurate. The horizontal lathe tool is memorialized in one of the PRC's two RMB banknotes, first printed in 1960. Throughout the 1960s, the factory developed other well liked machine tools like the CA6140 which gained a reputation for reliability and and ease of use. Together, Shenyang, along with Northeast China's other core machine tool SOEs were nicknamed the 18 ARHATs, a reference to the original followers of the Buddha. Then in the 1970s, Shenyang, like many of China's heavy industry enterprises, started to fall behind the rest of the world. Outside of China, the industry transitioned to machine tools controlled by computers. This new technology, called computer numerical control or CNC, relied on software and emerging IC based technologies like Intel's CPUs. The PRC had no access to those. While Chinese research institutes did develop certain CNC machine prototypes, none progressed to industrial production and later those institutes were privatized and dismantled, removing their R and D capabilities and causing brain drain. The Mao era planned economy did not impose profit and loss discipline on heavy industry. So the state took all profits and covered all losses. Growing output simply meant growing inputs, disincentivizing efficiency or technology improvement. The industry also suffered great losses of technological competence during the tumultuous days of the Cultural Revolution, which prioritized worker and peasant led innovation over foreigner knowledge. It was during this period that the company and others like it suffered a steady decline in its product tool quality. By the late 1970s, items produced by even China's top tier machine tool factories suffered scrap rates of 20 to 30%. In the late 1970s, China embarked on its economic reform and opening up in order to catch up with the rest of the world. Shenyang no.1 and other Chinese companies established partnerships with foreign companies to absorb and master their technologies. The government also funded multiple technology programs to develop CNC technology. In 1980, the Beijing machine Tool Research Institute struck a licensing agreement with Japan's Fanuc, one of the world's leading makers of NC controller modules alongside Siemens in Germany. These modules are critical to making these machine tools work. They are the brain and nervous system that interpret the design and dictate to the machine tool where to go and cut. Throughout the decade, Chinese companies struck over 18 partnerships with Japanese, German and American companies. Over 180 different technologies were brought in via license, technical cooperations and the purchase of sample machines for study. Unfortunately, this strategy of bringing in new technology and reverse engineering them, which one might refer to as bringism, did not work well with high end CNC modules. Chinese engineers can copy the module and maybe even its code, but cannot grok why it was done that way without decades of experience, intuition and trial and error. In early 1993, the Shenyang machine tool factory merged with other struggling factories in the area to form The Shenyang Machine Tool Co. The largest merger partner was the China Czechoslovakia Friendship Plant. It too was a nationalized former Mitsubishi repair workshop. As the name implies, the factory received technology aid from Communist Czechoslovakia to produce its radial drilling machines and jig borers. Other merger partners included the Liaoning Precision Instrument Plant and the Shenyang no.3 machine tool plant. All of Shenyang's factories were incredibly behind. Half their combined equipment were over 20 years old. Moreover, in 1994, China lifted import restrictions on foreign machine tools and CNC modules, cutting tariffs to 9.7% and 5% respectively. Imports surged, reaching $2 billion in 1994, and China became the world's second largest machine tool import destination. And the 18R hats suddenly found themselves on the back foot. The company's subsequent turnaround in the late 1990s was led by Guan Qiyou, born in 1964. Guan was born of Manchu descent in the Liaoning Province. He graduated from Tongji University in Shanghai with a degree in mechanical engineering, but decided to return to Shenyang rather than work in Shanghai. Apparently at his parents behest. He joined the China Czechoslovakia friendship factory in 1988 as an apprentice and technician in the lathe division. Guan is a charismatic leader, passionate but easygoing, with a touch of the direct self deprecating humor that China's northeasterners are known for. He soon became head of the factory CNC Machine Development Workshop, apparently because he had the balls to defy his team elders by calling out its bad design. When the wave of the foreign CNC imports hit soon afterwards, he pivoted the workshop to repair, which paid better. The factory nevertheless sank into its Financial Nadir. In 1996, its 22 bank accounts held just 5,000 RMB. Total salaries were not paid for half a year and dozens of their college educated employees left. In 1997, Guan, then only 33 years old, became general manager of the whole China Czechoslovakia Friendship Factory, a job that supposedly paid $72 USD a month. He reformed the factory by firing incompetent managers, tying pay to performance and hiring younger, hungrier workers. Shenyang updated its equipment and deeply cut its workforce. From 1993 to 2002, they went from 27,000 employees to just 11,000. This painful restructuring was funded by a $175 million loan from the World Bank. It was issued in 1995 to aid in Shenyang's industrial reform. China Development bank match with another massive $70 million loan to help raise more capital. Shenyang Machine Tool split into two. Its most favorable assets were hived off into a company retaining the original name, Shenyang Machine Tool Company having the best assets. The company was IPO'd on the Shenzhen Stock Exchange in 1996, but it was then made the subsidiary of a single larger entity called Shenyang Machine Tool Group. For the purposes of this video, it will be important to differentiate the larger group and the publicly traded subsidiary company which I shall call smtc. But unless otherwise specified, I refer to Shenyang as the whole group. The company's big break arrived in 2001 which when it took on the job of providing the CNC and boring machines to produce the Shanghai Maglev's 2,551 guideway beams. A guideway beam is the main steel or concrete beam containing the train's various levitation, guidance and propulsion components. Since misalignments can affect the train's stability, the beam must be made to exacting requirements. According to Xinhua, the Shanghai Maglev first went to some German companies which quoted them a two year turnaround time plus an installment time of six months. So the Maglev opened the job up to bidders. Guan personally led the factory's bid, pulling all nighters to produce a 32 page tender. Shenyang eventually won after three rounds. Then factory workers worked 13 hour days in 38 degree weather to deliver the eight machines in just six to eight months. The contract not only brought Shenyang badly needed revenue but also national attention. The press reported the China Czechoslovakia Friendship Factory's achievements with great pride, lionizing the factory workers for their efforts. The company would cite the 2001 Shanghai Maglev Project for many years afterwards as an example of what they can do and indeed he called a major step forward for China's native machine tool industry. Guan's efforts leading this successful project was key to his being appointed General Manager of the larger Shenyang Machine tool group in 2002. Shenyang generated revenues of 1.3 billion RMB, or about $150 million, good for 36th place in the world. The next major step in Shenyang machine tools growth was its 2004 acquisition of the German company Sheiss. Schiess is an iconic name. They were founded in 1866 by the famous German entrepreneur and engineer named Ernst Schiess. They started with steam engines and pipes, but three years later they pivoted into machine tools specializing in very large scale machine tools like the world's largest Crankshaft Lathe in 1901 they contributed to the German war effort during World War I. They then extensively contributed to the Nazi war effort during World War II. So after the war the Allies ordered the company dismantled and banned them from making any more machine tools. The ban would not be lifted until 1952. The company is known for being accommodating, a philosophy that led it down a difficult path in the 1960s. The company was at its largest but was burdened with a scatter shop product lineup that spanned the gamut from 1,800 ton cranes to hoists to even car washes. This huge amount of custom work and special modifications meant that Shees consistently turned losses. Sheiss struggled to properly price its multi year heavy machinery projects and this worsened in the 1970s and 1980s with the energy crises and rapidly rising wages. The resulting persistent losses led the company to be sold and resold to multiple conglomerates. After an industry slump in the early 2000s, the company finally succumbed to its inefficiencies and declared bankruptcy in August 2004. Xi's managing director Rene Nitsch told the MM Maschenmarkt trade magazine in 2008 we actually lacked the imagination to see that something could be made of the company which was certainly an economic crisis, namely insolvency. We simply didn't have that vision back then. So to them, Shenyang Machine Tool Company looked like a white knight sweeping in to save the day. Shenyang allocated only $9.5 million for the purchase. General Manager Geng Hongchen told the China Daily, this is a very very cheap price. What we took was not only its permanent assets but also its famous brand name. We can take this shortcut to start our own high end product design and production through this acquisition. But it soon turned out that the price was cheap for a reason. In order to win the bid, Shenyang had to promise the government and the unions to retain jobs, maintain local production and and not just strip assets. And Shenyang really took substantive steps to put the German subsidiary back on its feet. They invested 30 million euros to renovate Xi's equipment and facilities. They hired back and even expanded the workforce with employment rising from 64 in 2004 to 369 by 2008. To address Xisa's long running struggles with high costs, the Shenyang transferred the manufacture of some large components deemed non core to China, reducing Shisa's tool Delivery time from 18 months to just 6. The two companies product lineups Shenyang made small to medium sized tools while Sheiss made huge ones were complementary. By leveraging Sheiss's sales network, Shenyang managed to grow its exports to $150 million. And in 2007, Chise's sales were said to have more than quadrupled to 50 million euro. In 2008, Shenyang envisioned cheese as their Germany based R and D hub, developing new, more advanced machine tool products in Germany and sending those designs to China where they can be manufactured more cheaply. But the company would struggle to implement this vision over the next few years for operational and financial reasons. One key sore point about Shenyang's machine tools was that they depended on imported CNC controller modules from Fanuc in Japan or Siemens in Germany. In 2006, the State Council of China listed high end NC machine tools as one of its 16 national science and technology major projects, putting it on the same level as spaceships. Money and tax rebates were offered for indigenous innovation. Later that year, Li Changcheng, one of China's most senior party leaders and a former worker in Shenyang's machinery Bureau, visited Shenyang Machine Tool Factory. As discussed in Lu Feng's book New Fire. Via Guan Shiyou's own recollections, the Li learned about the imported CNC modules and criticized Shenyang for their lack of progress over the years, saying, when I was at the Shenyang Bureau of Machinery, we were making these same broken down blocks of iron. You're still doing it now. This isn't the future. There's no prospect in this. Li then bluntly told Guan that Shenyang had to make its own CNC systems now. The previous year, Shenyang had struck a joint venture with an Italian CNC company called Fidia. The collaboration led Shenyang to announce in August 2009 a new domestic high level CNC product called Feiyang. Local Liaoning media declared it a breakthrough. I lean more towards it being rebadged. Fidia Technology Realizing a serious problem, Shenyang initiated in 2007 a separate R&D effort in Shanghai called NUT. The name NUT has a double meaning. First, it refers to the difficulty of the task at hand, that is a tough nut to crack, and second, it means fool in American slang. And that refers to how the Chinese developers felt like they were being treated during their prior collaboration with what I'm guessing was Fidia. Shenyang Machine Tool would dedicate years and pour immense amounts of money into not money that the company could scarcely afford. From 2001 to 2011, China's machine tool industry production grew 10 times over. The Chinese economy was growing in every industrial sector, from appliances to automobiles to construction to xylophones. Thanks to the monstrous export boom in the wake of its entry to the World trade organization. In 2011, the machine tool market was worth about $40 billion. Mainland China was the world's largest consumer and producer of machine tools. Believing that the company had to first grow big before it can grow strong, Shenyang vastly expanded its production capacity to match. They were encouraged by policy. Shenyang benefited from a 2003 central government initiative called Revitalize Northeast China, which sought to modernize manufacturing and and revitalize aging SOEs like Shenyang with industrial parks and whatnot. The provincial, Liaoning and local city governments also pushed Shenyang to grow its top line as much as possible, their enthusiasm such that the reputable Kaixin magazine reported officials overstepping their bounds to make direct production and operation decisions for the company. So Shenyang massively scaled up through the decade to become China's largest machine tool company. In 2011, the whole group turned revenues of 18 billion RMB, or about 2.8 billion USD. Between 2002 and 2011, the company sold nearly 700,000 tools. The only other Chinese company of comparable size was another state owned enterprise called Dalian Machine Tool. The two were often pitted against each other. If Dalian did something, local officials went to Shenyang and asked them why they weren't doing it either. The festering problem with this expansion spree, however, was that many of those 700,000 tools sold were legacy low end products with little differentiation or profit. In just the 2011 year, Shenyang shipped 96,000 tool units, but only 31,000 of those had CNC at all. Some were based on designs 70 years old. In 2000, the company's net profit margin was just 0.75%. Ten years later, in 2011, Shenyang's net margin was a minuscule 0.56%, which is like kid lemonade stand status, nowhere near enough the bootstrap development of higher end, more profitable CNC products. And then loomed the dark question of what happens if the market turns. There were only so many people willing to buy these cheap low end machine tools. Wait, hey, didn't something financial crashy happen in 2008 anyway? After the global financial crisis, the Chinese government unveiled a 4 trillion RMB stimulus package. This spurred on machine tool growth for a couple more years. But by 2012, the stimulus investment boost had run its course and the economy shifted, with major consequences for the Chinese machine tool market. At the high end, Chinese machine tool customers in the electronic, medical device and automobile sectors demanded yet better performance that the domestic companies simply could not meet. And considering the catastrophic risk of failure, Chinese customers opted to not even consider an unproven alternative. So the Europeans and Japanese consolidated their hold on this part of the market. Shenyang Machine Tool realized that its hopes depended on fighting in the middle end of the market where it can compete with less sophisticated Taiwanese and Korean CNC enabled machine tool companies. Unfortunately, too much of its capacity were in the low end of the market, a sector that quickly descended into an economic civil war. Chinese machine tool companies, stuck with overbuilt capacity that they had no choice but to use, started price wars with no regards to profit or loss. We can look at SMTC, the publicly traded entity, to understand this trend. In 2011, the company showed its highest revenues and even turned a slight net positive operating cash flow, 28.8 million USD. But it never reached those revenues again. Net income stayed barely positive the next few years, but deteriorating operating cash flows showed the reality. The company's core operations were bleeding out. They had to shift upmarket. Shenyang acquired Sheiss because they wanted to supply the factories in China with advanced machine tools designed in Germany. It is why they invested so much money into the factory. But though they were able to stabilize the German business at a massive financial cost, Shenyang Group struggled to execute on its grander vision. The two companies did collaborate on new products, reviving a mid tier brand of machine tools called the Ashler Leben. Chinese workers were sent to Germany to learn in Shisa's factories. But unfortunately the desired cross pollination and synergies did not occur. The German government ended one joint research project due to concerns about the export of dual military use technologies back to China and the technologies and drawings that were allowed to be sent back. Engineers back home struggled to understand or execute at the right budget. Costs spiraled out of control and Xi started turning losses again. After 2011, she Shenyang injected 140 million euros into Sheiss since the 2004 takeover. Considering its own worsening financial distress, this was no longer feasible. It would have to look inwards for its own Turnaround product. In February 2014, after seven years of development, Shenyang unveiled its i5 series intelligent machine tools at the Shanghai Machine Tool Exhibition. The name stood for Industry Information, Internet intelligence and integration i5. The effort grew out of their NUT R&D efforts in Shanghai. The NUT team finished fleshing out i5's architecture in late 2010. By June the following year, they had mounted it onto one of Shenyang's tools. Official write ups and media began beating the drum that the company had achieved a breakthrough. A cloud enabled remotely operable intelligent control system. So what specifically is i5 it is a CNC module platform with three a numerical control controller, servo drives and I O devices. The NC controller Brain runs a proprietary algorithm, was entirely software driven and runs on standard desktop Linux. I'm sure someone's heart just leapt for joy when I said that a big part of the system was its connection to the Internet. Users can connect to machines from anywhere online, review real time information or any alerts, alarms that might come up. A big part of this was Guan's thinking that a machine tool should be as easy to use as an iPhone. The i5 platform only worked with Shenyang's own machines. It was the only way they had to get it going, but a different approach than what Fanuc took many decades earlier. Upon its introduction they unveiled six i5 enabled machines positioned as its premium intelligent line. Chinese media positioned i5 as defeating foreigners grip on China's tool market and creating the smart factory of the future. In 2016, Shenyang reported that 20,000 i5 enabled machines had already been put into people's hands. China Daily wrote glowingly, the i5 broke the monopoly of companies such as Siemens and Fanuc over machine tool motion control systems and demonstrated that numerical controlled machine tools could have a Chinese brain Cloud networking enabled new aggressive business models, so Shenyang announced it would let customers rent the machines rather than buy them outright. The first user, a small consumer electronics producer, paid just 15 RMB an hour to get the tools into more people's hands. Shenyang announced it had partnered with local governments to set up two dozen smart manufacturing centers and inside industrial parks. It would enable something like sharing the first. The Jiahu Valley began operations in 2018. Guan embraced this change of business model saying from being a traditional manufacturer, Shenyang Machine Tool is transforming itself into an industrial service provider. It's a creative transition from selling tools to selling services. Now there is no doubt that i5 was a serious innovative product that caught the attention of competitors and users and that Shenyang's wild rental business model allowed rapid initial adoption with certain customers. It was at least serious enough to motivate Fanuc to cut prices on certain products 20 plus percent to retain customers. But the reality is that i5 had a long way to go in overturning the Fanuc Siemens duopoly. It lacked their rich product end user ecosystem. The Big Two had worked with clients on very demanding jobs for decades. There's just no way to shortcut that. The two benefited from a vast body of software applications, mature library functions for high end machining and a large pool of talent experienced in using their tools. Their modules also integrated with innovation every manufacturer's machine tools. While i5 was exclusive to Shenyang's, A Japanese analyst put it well when he told the Financial Times that entrants like i5 was like trying to sell a PC with a homemade operating system. The i5 product was not fully baked yet either. Kaixin magazine reported issues of software freezes, reliability problems and thermal issues. For instance, that first smart manufacturing center JAHU started with 400 operational machines, but hot weather in August caused all but 100 to malfunction. There were issues with the high end products too. The vast majority of i5 models were two or three axis tools, basically simple machine lathes or machining centers, middle to low end status. But at the high end, like five axis machines with two additional simultaneously moving rotary axes, the tools took longer to come out. It took until 2016 for Shenyang to announce their 5 axis competitor, the i5 M8. Few adopted them. The only way that i5 was going to work was through time and iteration, finding and fixing problems in the code and algorithms one by one. The customers were understandably unwilling to take on the financial and operational risk of being their vendor's R and D guinea pig. Thus partly why Shenyang financed customers with its rental business model. But that only exacerbated the company's already worsening working capital situation. To improve, they needed more tools in the market. But putting more tools in the market meant more precious cash out the door. By 2018, the Chinese machine tool industry had drastically pulled back. It peaked in 2011 when it was worth $40 billion. By 2018 that had declined 40% to just 23.4 billion. Few people needed these low to medium end machine tools. Years of loss has finally caused these heavily indebted Chinese machine tool companies to collapse. Shenyang's biggest domestic competitor and fellow Northeast machine tool star Dalian Machine Tool was amongst the first in line. In November 2017 they were ordered by the local court to enter reorganization so to pay back the 22.4 billion RMB or 3.3 billion USD they owned to creditors. But they then dragged their feet on their structuring plan for another 18 months. In 2018, the government issued an arrest warrant for Chairman Chen Yong Kai for orchestrating faked accounts receivable to show as collateral for the sale of $94 million of investment trust products. Chen was designated a Class A criminal. The company was eventually taken over by a state owned conglomerate called General Technology Corporation. This was not a one off other northeastern machine tool companies that Suffered from overcapacity were Gansu Xinghuo machine tool and Sichuan Changzhen machine tool. This was a systemic thing. Kwon later said in an interview that his mistake was using short term commercial bank loans for long term R and D investment. Even before the business environment worsened after 2011, the listed company STMC, was suffering from weak cash flows and a precarious debt situation. For every dollar of assets, they had $0.86 of liabilities. Worse yet, those liabilities were all short term bank debt guaranteed in part by the privately held Shenyang Machine Tool Group, the parent entity. There was so little room for error with the core business not producing enough cash to service the debt. So they had to keep borrowing from the bank to roll over older loans, leading to ever rising financial costs. Then after 2011, SMTC's operating cash flows went negative for seven straight years. At the same time, Shenyang was trying to develop i5. Between product development, factory renovations and trial and error costs, Guan estimated that Shenyang invested a total of 10 billion RMB, or 1.45 billion USD into the i5 project, all paid with bank debt. Then, after i5 finally hit the market in 2015, Shenyang plunged into the rental business model. That model burned working capital even faster. By 2015, end asset liability ratios had risen from 86% to 89%. Their debt situation worsened in 2016 when a steel company called Dongbei Special Steel defaulted on a billion dollars of bonds financing locked up. So in 2017, Shenyang found itself unable to roll over half a billion dollars of its debt. With some help from the local government, the listed company, smtc, executed a rabbit magic hat trick, selling a bunch of money losing businesses and liabilities to the parent company, Shenyang Machine Tool Group, for one rmb. This made a magical profit that prevented SMTC from being delisted, but only kicked the problems upstairs. Over the next two years, both the Shenyang Group and listed company sought some way out from underneath the crushing debt, pursuing debt equity swaps, disposals, deals for restructurings and a share sale. None worked out despite pledges of aid from government agencies like the Ministry of Industry, Ministry of Finance and Sasak, the agency that administers all of China's state owned enterprises, Shenyang could not be saved. In July 2019, Shenyang's 1,496 creditors went to court to chase repayment on their debts. The courts granted their request, ordering a restructuring that SMTC and its parent company took as an opportunity to refresh itself. In November 2019, Shenyang was formally taken over by Genertech, the state owned holding company that earlier took over Dalian subsidiary. Xi filed for bankruptcy too, burdened with a debt asset ratio of over 100%. It has been five to 10 years since that kerfuffle. And how is China's machine tool industry now? Shenyang had projected there to be 60,000 i5 machines in use by 2019. The actual number was about 25,000, with half of those being sitting in smart manufacturing centers hardly being used. Utilization was reported to be under 40%. Some have mused that the i5 might have done better in the Chinese market had it been released after the Sino American trade war. China's autarkic drive might have been better atmosphere for its growth. But the real problem, I say, was that i5 needed more money, time and resources to challenge one of the world's most formidable industries than what a heavily indebted 70 year old factory can afford. The state continues to reform Shenyang and Dalian. I5 may even still be around in some form or fashion, though its user base is certainly minuscule. In 2019, less than 205 Axis i5 machines were reported to be used by customers Today. Fanuc and Siemens still together hold 70 to 75% of the market in high end CNC controller modules in China, a rare critical spot amidst China's domestic technology policy push. Experts and analysts still expect Chinese companies to eventually make some inroads in into the higher end machine tool space, and that's sort of a safe call to make. There's a new generation of Chinese companies working on this, but the mistakes of Shenyang, Dalian and the other old guard machine tool companies are ones to remember. Alright everyone, that's it for tonight. Thanks for watching. Subscribe to the Channel, sign up for the Patreon and I'll see you guys next time.