International -- Cover Story
HOW YOU CAN WIN IN CHINA (int'l edition)
The obstacles are huge, but surmountable
It's a frantic, cavernous place, filled with frazzled passengers trying to catch the next long-haul train to Shanghai and peasants disembarking from the far corners of China. Yet amid the mayhem around the Beijing West Railway Station is a sparkling IBM service center. The outlet, one of 40 IBM has set up around China in a venture with the Railways Ministry, is part of an aggressive strategy that has enabled IBM to vault to the top of China's booming personal-computer market after nearly a decade of frustration. It's the kind of success that heartens those who wondered if China would ever pay off for Western investors.
Encouraging, that is, until you talk to somebody such as Jean C. Monty, chief executive of Northern Telecom Ltd. Since agreeing to a sweeping, $130 million investment plan in 1993, Nortel has been anything but half-hearted in China. It built a giant factory making state-of-the-art digital switches, forged a raft of research and development tie-ups with government institutes, and secured a solid foothold in China's fast-growing $13 billion telecom-equipment market. The problem is Nortel is barely breaking even. All of its major rivals, such as Lucent Technologies, Alcatel, Ericsson, NEC, and Sie-mens, have built similar plants. Instead of the five competitors Monty expected in 1993, there are 12. "We all built capacity and killed the price levels," says Monty. "That's fundamental economics." He doesn't see the situation improving anytime soon.
VICTIMS. Why are some foreign executives so bearish on China while others rave? It's almost as though there are two Chinas--one the mother of all new markets, the other a maddening, bottomless money pit. In a way, there are. There is old China, where holdovers of the Communist Party's planning apparatus heap demands on multinationals, especially in politically important sectors such as autos, petrochemicals, and telecom equipment. Companies are shaken down by local officials, whipsawed by policy swings, railroaded into bad partnerships, and squeezed for technology. McDonnell Douglas, Peugeot, BellSouth, and Japanese retailer Yaohan have all been burned on big investments.
There are also political implications to the question of whether investing in China is worth all the effort. Particularly in the U.S., which posted a $39.5 billion trade deficit with China last year, the travails are prompting critics of the Clinton Administration's "constructive engagement" policy--and many executives--to question whether the high strategic importance attached to the China market is warranted. As more corporate investors return from China embittered by their losses, they could sour China-U.S. relations even further.
But before the critics write off China completely, they should realize that a new, market-driven China is emerging fast. Many consumer areas, from fast foods to laundry soap to shampoo, are now wide open. Even in some tightly guarded sectors, the barriers to entry are eroding as provincial authorities, rival ministries, and even the People's Liberation Army challenge the authority of control-minded Beijing bureaucrats. By tying up with more entrepreneurial players in the Chinese business scene, GTE Corp. has secured a foothold in telecom services and Ford Motor Co. a beachhead in autos. More barriers will tumble should China reach an accord to enter the World Trade Organization, which could happen in one or two years.
Some clear lessons are emerging on what divides the winners from the losers. The winners have become smarter about picking Chinese partners and increasingly are daring to go it alone. They have learned how to transfer enough technology to convince officials that they aren't there just to rip off China--without giving their crown jewels away to new competitors. Western companies have also learned that rather than making grandiose, multibillion-dollar promises in the Great Hall of the People, it's far better to fly below the radar screen of Beijing's state planners with modest but profitable projects that don't attract much attention at the national level.
The most basic lesson of all is that China is, slowly and fitfully, becoming more of a market economy. Gone are the days when investors focused only on getting in by hook or by crook and assumed big profits would be theirs because Chinese consumers would buy anything foreign and the government would manage the competition. That is all changing. More than ever, success or failure depends not on government policy but on bread-and-butter fundamentals including service, marketing, distribution, inventory management, and retaining good staff. The winners manage their business for profits, while many of the persistent money-losers in China simply have lousy business plans. "If a venture doesn't see a return in a few years, it won't see a profit," says Brian Wilson, director of Greater China at Andersen Consulting. "It'll be a matter of whether it's a fast or a slow death."
Whether the level of profitability is what companies expect is another question. A 1995 survey of multinationals by Andersen Consulting found that 64% said they were profitable in China the previous year. But half said their margins were lower than in other developing countries. Part of the problem is that while many investors demand returns of more than 20% in most emerging markets with murky legal and political systems, the Chinese think anything much more than 10% is gouging.
NOT JUST SODA. Veteran players have come to accept that the returns in China are way out of line with the risks. State companies' indifference toward paying bills and policies that promote overproduction drive down prices and make profits elusive. The survivors minimize losses by learning to avoid deadbeats and resisting pressure to expand too fast.
A growing number of companies is getting it right, and not just in soda pop and shampoo. China now is helping power growth in some of America's most strategic, leading-edge industries. Motorola Inc. had $3.4 billion in sales last year in Hong Kong and China, 12% of worldwide revenue. Skyrocketing PC sales in China are a big reason why Asia now accounts for 21% of Intel's revenue, compared with 11% just a year ago. "China is emerging as one of the great growth markets," says Intel China President James W. Jarrett.
No industry better illustrates the rapidly changing rules of the game than information technology. Regarding the sector as strategic, Chinese planners in the 1980s and early 1990s limited imports of PCs and software and instead tried to promote homespun industries. But Chinese corporations and government agencies, the biggest computer buyers, preferred smuggled imports of the top U.S. brands to the overpriced, technologically backward PCs made by local manufacturers.
So Beijing eventually loosened the restraints, handing a golden opportunity to Intel and other U.S. high-tech companies. Microsoft Corp.'s Chinese version of Windows 95 is rapidly emerging as the dominant PC operating system. And the PC market, growing at a 40% annual clip and expected to reach 12 million units by 2000, is a stronghold of American brands.
IBM has raced to take advantage of this new openness and adopted a much smarter China strategy. In the early 1980s, the giant invested too heavily. Then it cut too far back, and stubbornly insisted on flogging its unpopular PS/2 systems. As a result, when the PC market started taking off, rivals AST Research Inc. and Compaq Computer Corp. zoomed ahead. Then, IBM moved its China headquarters from Hong Kong to Beijing, launched a range of cheaper PCs to replace the PS/2, and hiked China investments in everything from sophisticated manufacturing lines to world-class research labs.
PLENTY OF HELP. IBM also got serious about reaching customers through service centers, a big challenge for any foreign company in China. Thanks to its joint venture with the Railway Ministry, dubbed the Blue Express, IBM is setting up a national network of service centers, many of them in busy railway terminals. More important, the venture enables Big Blue to ship computer parts via the railroad around the country within 24 hours. Competitors must book cargo space weeks in advance. Plus, the ministry's staff of more than 300 computer engineers helps out in providing customer service on IBM products. Total IBM sales have risen 50% annually for the past three years, to more than $500 million, and plans call for tripling the number of service centers by yearend.
Other companies are learning to adapt to local conditions. As part of its ambitious China strategy, GE Capital had big plans for leasing everything from huge subway drills to bulldozers and cranes. But executives encountered the carnage of earlier leasing ventures by Japanese and European banks, which lost hundreds of millions when companies defaulted on payments and there was no way to repossess the equipment. The legal mechanism for protecting leased assets "doesn't exist in China," says Daniel H. Mudd, president of GE Capital Asia Pacific Ltd.
So it scaled back. GE Capital set up a joint venture with the Shanghai Municipal Construction Commission to lease construction equipment. Its employees drive cranes to construction sites and return them each evening to a depot. Instead of launching a credit card, GE Capital is taking the more cautious approach of providing consumer financing for purchases of appliances. Soon, GE Capital expects to land a license to set up China's first 100% foreign-owned finance company. "The flood is coming," says Mudd, "and we want to be ready for it."
Other investors are starting to test the limits of China's murky regulatory and legal systems. In telecommunications, where foreign operators aren't allowed to hold equity, GTE is investing $82 million to build China's first nationwide paging network. How? By forming a venture with Guangzhou Guangtong Resources Co., a business unit of the People's Liberation Army. In a deal brokered by former U.S. Secretary of State Henry Kissinger, GTE supplies the equipment and technological support and gets most of the revenues. The PLA brings a radio spectrum, which it controls, and a measure of political protection, especially against interference from the Ministry of Posts & Telecommunications. What's more, Guangzhou Guangtong employers can sell GTE's pagers out of military vans that drive or park even in the most crowded areas because they are immune from traffic laws. By 1999, GTE expects to have 250,000 customers.
Very clever, but still risky. Despite its huge outlay, GTE doesn't even have the right to audit the books of its partner. Also, outside its Guangzhou base, it has had a hard time getting business licenses from local authorities because connections tend to be done on the basis of personal relationships, not institutional ones. That means the venture couldn't legally sign leases, hire staff, or advertise. And GTE is at the mercy of local telecom operators to gain access to the telephone network.
GTE, however, is still committed to its partnership, while others have had to pull out of theirs. In 1994, BellSouth Corp., the Atlanta-based regional phone operator, tied up with Unicom Corp., one of China's new state-owned telecom operators. It has little to show for some $50 million in expenses. After signing an "agreement of principles" to build cellular-telephone systems in Tianjin and Beijing, BellSouth at its own expense worked up numerous plans, trained more than a dozen Unicom employees, and hosted visits by former Chief Executive Zhao Weichen and several other executives to the U.S. At one point, it had 20 American expatriates working in its Beijing office. Still, negotiations to actually close a deal dragged on.
Then, Zhao sent a letter demanding a $10 million cash advance within one week if negotiations were to proceed. BellSouth pulled the plug and trimmed its office to a skeleton staff. It hasn't recouped its money. As it turned out, BellSouth's chances may never have been very good: Unicom had dozens of similar "agreements" with other companies, only a few of which led to ventures. "They got taken to the cleaners," says a Western diplomat. "It was a classic case of coming in with a gold rush mentality." BellSouth declined to comment. Zhao has since left Unicom.
TIGHT LIPS. The hazards of partnerships are driving some of the more experienced foreign players to push for more control over their enterprises. Procter & Gamble Co. used joint-venture partners to help get it started and establish its strong market position in shampoo and laundry detergent. Yet the massive new shampoo factory it is building in the northern city of Tianjin, which will be its biggest in the country, is its first wholly owned operation in China. P&G is tight-lipped on its sales, but consultants say it may lead the market in both detergents and shampoo. Prospects weren't always so rosy. In P&G's first big manufacturing joint venture, set up in Guangzhou in 1988, the company had to deal with two different partners, one from Hong Kong and one from China. It also wrestled with distribution problems, excess inventory, and deadbeat customers. "P&G built a palace of a factory, but within two years, receivables had gone through the roof," says an executive formerly involved with the venture. "It needed really serious attention." So P&G now offers discounts to store owners who paid for shipments within seven days. It also pays stores to ensure prominent displays of its shampoo, detergent, toothpaste, and sanitary pads.
As they gain confidence, a growing number of companies is investing without local partners, something virtually impossible not long ago. After long analysis, adhesive maker Avery-Dennison Corp. figured a partner wouldn't help even its maiden venture, so it set up its own factory near Shanghai. The move to wholly owned ventures "is growing much faster than most people realize," says foreign-investment expert Wilfried Vanhonacker at the Hong Kong University of Science & Technology.
HEAVY HAND. Nestle bought out local partners in two ventures and upped its share in two others as part of a strategy of taking control. The China operations aren't breaking even yet, but they're growing rapidly. After opening five mainland factories last year, Nestle expects China sales of instant coffee, condensed milk, ice cream, and other foods will double in 1997 for the second year in a row, to about $250 million.
In some sectors, though, eluding Beijing's heavy hand remains tough. Investors in autos, telecoms, chemicals, and other "pillar" industries will likely remain plagued by poor partners and meddlesome bureaucrats until government policies change. "If anything, the problems in these areas are getting worse," says Greg Mastel, a Washington-based China consultant with the Economic Strategy Institute. "Even companies that have been established a long time in China are feeling new pressure."
Take Volkswagen, one of the most successful foreign investors in China. Its joint venture with Shanghai Automotive Industry Corp. has been making money on its Santana sedans since a year after opening in 1986. But things have gone very wrong at VW's second joint-venture plant. VW had a partner forced upon it, First Auto Works, in the northeastern Rust Belt city of Changchun. Authorities dictated the factory have a massive 150,000-unit capacity to roll out the Jetta. As a result, production is less than one-third of capacity. The two sides have quarreled over everything from distribution rights to accounting. While VW enjoyed healthy margins with the Santana, Beijing set the price of Jettas at $16,750, not enough given the small production runs and high content of imported parts. VW says the venture has lost at least $100 million. The partner, using its own accounting, insists it's breaking even.
Other carmakers haven't fared much better. With the industry glutted with overproduction, Peugeot is writing off its 22% stake in a now idle passenger-car venture in Guangdong province that was plagued by unpopular models and clashes with the government. In the southern city of Wuhan, Citron struggles with its massive new factory because of slumping demand. A deal Mercedes-Benz struck in 1995 to produce minivans hasn't been finalized.
Perhaps the savviest car deal is one that apparently slipped through the cracks. After losing out to General Motors Corp. in the bidding to build a $1 billion car plant in Shanghai, Ford quietly bought shares in publicly traded Jiangling Motor. Now, though Ford's investment is not part of any state plan, it is spending $55 million to up its stake from 20% to 30%, and Jiangling is starting to make high-end minibuses based on the Ford Transit. Plans call for initial output of just 20,000 units annually, rising to 60,000 sometime in the next decade.
Such evidence that Beijing's state planners are starting to lose their grip is one reason why, despite their complaints, few deep-pocketed multinationals caught in the tougher situations are likely to cut back. Take the telecom equipment suppliers like Nortel, Lucent Technologies, and Alcatel. They believe the alternative--ceding the world's biggest future telecom market--is worse than pushing on. And they figure as the bureaucrats lose power, they will have more opportunities to recoup. Even if they only break even now on phone lines, they still hope to make big returns by landing follow-on orders and selling upgraded software. Such determination explains why investment continues to pour into China.
The best chance for these and other companies to make money eventually is China's commitment to greater reform. President Jiang Zemin's government is determined to tackle the staggering problem of China's money-losing state sector and win entry into the WTO. Officials are weighing a range of domestic reforms that could include privatization of state-owned factories, deregulation of more financial services, and an end to state control of imports and exports. Such changes could open huge new opportunities for foreign investors.
Companies that need high returns fast probably should opt out of the China game. But as the old China gives way to the new, successes will multiply. The winners will not be those who try endlessly to figure out what Beijing expects from them. Instead, the winners will be those with more smarts, creativity, and endurance.By Mark L.Clifford in Guangzhou, with Dexter Roberts in Beijing, Pete Engardio in New York, and bureau reportsReturn to top