DiligenceChina

Flattening Learning Curves: China Demystified

China business has just shifted again. It’s a little hard to tell because it was subtle, but the last few weeks have seen some powerful trends confirmed. US companies’ 06 China operations threw off 50% more profits than in the first half of 05. Starbucks is buying back their JVs and running their China stores independently. Wal-mart has unveiled plans to become the #1 foreign retailer in China.

US corporations, who have largely been waiting on the sidelines during the Great China Opening, are finally ready to start moving into this market.

The upshot is this:

International MNCs have officially learned to do business in China. The learning curve that is starting to flatten out. China is still hard and unpredictable, but now it’s possible. Expensive, bureaucratic, and slow – but that’s what legal departments are for. There are enough roads and wires and regulations in place for the US giants to execute their large-scale, integrated plans. The Americans are coming.

Chinese bureaucrats have officially learned to do business with the World. They have a good idea about what is possible, what is not possible, and what works. They know what they want their SOEs to do, what they won’t be able to do, and what they want in exchange for market access. Official China’s learning curve is flattening, or at least reaching the end of the steep ascent.

Private Chinese and ex-pat’s have learned where the opportunities in China really lie. While not always successful, they are a lot more savvy and sophisticated about how to attack the China market. They know that if they go with the flow, they will find tremendous opportunities. But anyone who bucks the trends or looks to get rich quick will get destroyed by the big forces in this environment.

A Status Quo Emerges

China has been “opening” its economy to the west since about 1976, when Deng Xiao Ping came to power for the second time. There are two basic rules about China’s opening that all China-watchers and economists need to take to heart:

1) China’s policy of economic opening is essentially a conservative attempt to safeguard the long-term security of the Party.
2) China’s intent was always to interact with the west as little as possible while securing maximum possible gain in terms of technology, knowledge, process and intellectual property.

It now seems that the Chinese bureaucracy and the multinational corporations have reached an accommodation. Westerners will get access to the market as long as they act to support the Bureaucracy. We’ve already seen them cooperate on unions, access to data, higher standards, and possibly, large amounts of grease to keep everyone’s wheels spinning. In exchange, the westerners get the Chinese middle class.

The Chinese get to hold on to manufacturing, but effectively back-off the notion of Chinese consumer branding. Chinese manufacturing, infrastructure and commodity businesses will continue to develop – probably under a kinder & gentler form of SOE scheme. But unless lightening really strikes in the mid-term auto export market, look for China Inc to quietly distance itself from the notion of big-global brands for everything from shampoo to luxury cars.

Private Chinese companies will still have to make due with the worst of both worlds – the higher operating standards and lack of capital access that private companies face, and less assistance and protection from a Chinese government committed to privatization and competition. Fat IPO and VC deals will fill the headlines and make everyone feel warm and fuzzy about how bright China’s future looks for entrepreneurial commerce, but the fact is that private China business is the big loser in the latest set of developments. Chinese brands haven’t really taken hold over the last 30 years – inside China or the export markets – and we’ll probably start hearing less and less about them. A couple of famous companies will emerge — maybe we already know them, or maybe they have yet to arrive. But the lion’s share of the Chinese domestic economy will be engaged in OEM manufacture for western companies or servicing international brands.

Implications for the future:

US companies have been waiting around for the waters to calm every since the time of Deng Xiao Ping’s big policy shifts of 1976. They don’t like cooperation and market building – they like to execute a specific plan for market leadership. Until now, China has been a scary and unfamiliar place. That all changed last week when Starbucks bought back it’s Beijing JVs and Wal-mart showed its national roll-out plan, complete with localized management team.

The impact will likely be a much more “US” style investment pattern in Chinese business entry. Large US-based MNCs will look for a high-profile toe-hold in Shanghai or Beijing, and then roll-out new stores or locations in a systematized, scheduled plan. Look for new energy in M&A and buy-out activity as US firms look to collect assets, brands and marketing territory.

Development in the second and third cities will explode as US giants begin strip-malling the region in waves radiating from the big business centers. Americans generally like to hit the high-activity areas first, and then fill in the gaps with integrated roll-outs targeting high-population centers nearby. It’s for logistics reasons – you can service more locations with fewer trucks if the routes are all connected.

You will also see more roll-ups, as US investors start scouring the landscape for under-utilized assets and inefficient competitors that they can consolidate. They like to buy small companies, take the brand and customer lists, shut the factory and centralize production and operations in an efficient, high-volume facility.

Hasn’t all of this been going on for years? Yes and no. There have been some roll-outs and a few M&As, but nothing like what we’re about to see. Up until now, the mantra has been “cultural sensitivity” and “cooperation”. If the American’s feel that the time has come to execute their grand China strategy, there will be a new wave of asset inflation and rising costs as the US corporate machines start running at full gear.

The new competition in China will be between the market-dominating US brands and the market-building Europeans. Europeans tend to get in early and try to slowly change the rules of the game in their favor. Americans like to wait until the regulatory and physical infrastructure is on the ground, and then move in force. There is still time for some Chinese private brands to emerge, but companies like Wal-mart and Best-Buy tend to be category-killers that discourage new competitors from entering the market.