The Tech Dragon Stumbles

China's upstarts are finding life in the big leagues tougher than they reckoned

By Bruce Einhorn

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In recent years, the world has watched with a mixture of fascination and trepidation as Chinese technology companies making everything from semiconductors to cell phones have pushed their way onto the global stage. Investors have piled in, hoping to reap the rewards that would flow from betting on an Intel (INTC ) or Dell (DELL ) in the making. Potential rivals, meanwhile, have feared that the Chinese, like the Japanese and Koreans before them, might elbow their way into prominence worldwide.

From the looks of it, neither group has it quite right. For a host of Chinese tech companies trying to adjust to life in the major leagues, these are difficult days. Cell-phone makers TCL and Ningbo Bird have seen their share of the mainland market whittled down by global giants Nokia (NOK ) and Motorola (MOT ). Profit margins at telecom equipment makers Huawei Technologies and ZTE have shriveled. BOE Technology Group, the country's biggest maker of liquid-crystal displays used as screens for PCs and TVs, has dumped noncore assets to prop up earnings and is lobbying for a government bailout. Chipmakers Semiconductor Manufacturing International Corp. and Grace Semiconductor Manufacturing Corp., which once hoped to challenge the Taiwanese as world leaders, are limping. "Our greatest challenge is how to turn the company profitable," says Anne Chen, SMIC's Hong Kong representative.

Even computer maker Lenovo Group (LNVGY ), the highest-profile of China's up-and-comers, is struggling overseas. Lenovo's acquisition of IBM's (IBM ) PC division in 2005 led to predictions that it would morph into a powerhouse capable of challenging Dell Inc. and Hewlett-Packard Co. (HPQ ) Instead, even as Lenovo remains the leader in China, it is falling behind big competitors abroad. It gained share in the first quarter, but not enough to keep Taiwanese rival Acer Inc. from jumping ahead of it into the No. 3 position worldwide, industry watcher Gartner says. On Apr. 19, Lenovo said it was firing 1,400 people, or about 5% of its global workforce, with most of the cuts coming out of Europe and the U.S. It plans to fill some of those jobs with lower-cost employees in China. "We have more work to do," said Rory Read, president of Lenovo's Americas group. "We have strong competitors out there."

Some of the malaise afflicting China's tech majors can be chalked up to market forces in what are largely commodity industries. Makers of LCD panels moved into the business after 2004, the year the sector was at its most profitable. Since then, few players have made money. And SMIC's woes are partially the result of a downturn in the semiconductor industry. Although the Shanghai-based chipmaker on Apr. 27 said it posted a $9 million profit for the first quarter, without one-time financial gains SMIC would have finished $40 million in the red, brokerage Macquarie Research Equities estimates. For Lenovo, a price war at home has hammered margins, and its overseas effort has been hampered by logistical problems. While sales of consumer laptops are surging in Europe, for instance, Lenovo cant get enough machines into stores there.

The woes of China's tech hopefuls, though, aren't entirely the result of poor timing or management missteps. What was supposed to be a major advantage for Chinese tech companies—the backing they receive from Beijing—has in many cases turned into a liability. In exchange for preferential loans, tax breaks, and sweetheart property deals, Communist Party bosses often get to influence key business decisions.

Take SMIC. The chipmaker will soon operate plants in five cities across China. By contrast, SMIC's Taiwanese rivals, United Microelectronics Corp. (UMC ) and Taiwan Semiconductor Manufacturing Co. (TSM ), have built most of their factories in two science parks just a few hours' drive from one another in Taiwan, making it easier to manage the plants. So why has SMIC spread out so much? "Every [local] government wants to go into high tech," says Pranab Kumar Samar, an analyst in Hong Kong with Daiwa Institute of Research. That might make for good politics, but it's not exactly smart business.

Many Chinese companies are also paying the price of a government effort to spur the development of homegrown technologies. State-owned Datang Telecom Technology & Industry Group, for instance, has squandered hundreds of millions of dollars and almost a decade on a Chinese standard for so-called third-generation (3G) mobile telephony when it could have easily adopted one of the international standards already in use. This has also hobbled Huawei, ZTE, and the country's dozens of cellular handset makers. Chinese companies "don't have a [3G] market in which to cut their teeth," says Mark Natkin of Marbridge Consulting Ltd. in Beijing.

Meanwhile, competitors from other countries aren't standing still. Taiwanese, Korean, and Japanese LCD makers are pouring billions of dollars into more efficient plants, both at home and on the mainland. The Chinese lack both the technology and the cash to build such super-expensive factories. "It's very hard to catch up," says Byron Wu, director of China research for market tracker iSuppli Corp.

Don't count China's tech companies out yet, though. One sector that's thriving is the Internet. Search engine (BIDU ) continues to widen its lead over competitors Google (GOOG ) and Yahoo! (YHOO ) Tencent Holdings is the leader in instant messaging, and (NTES ) rules in online games. One thing they all have in common: no government backing. And in contrast to the likes of Lenovo and SMIC, theyre focused largely on the local market.

China's state-backed champions, meanwhile, still have plenty of potential. Remember that it took the Koreans and Japanese decades to work their way to global dominance. And the Chinese have a huge home base that gives them a chance to continue honing their skills for future forays into overseas markets. The payoff, however, may come later than China's boosters initially anticipated. There was a lot of excitement about Chinese technology companies," says Frank Lee, an analyst with Deutsche Bank (DB ) in Taipei, but Chinese policymakers "underestimated what it would take."

Bruce Einhorn is a correspondent in BusinessWeek's Hong Kong bureau.

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