Early Birds and China’s Mice

After  a brief summer hiatus, we are resuming our weekly postings.

This week’s article deals with a very interesting strategic issue of western companies entering a promising foreign market, only to find themselves later outsmarted and outcompeted by the local upstarts who have not only adopted their technologies and production techniques, but are also able to better compete and steal massive market share both home and abroad.  This is a perennial problem (remember Japanese cars and electronics couple of decades back?), which also has broad strategic implications for western companies with high labor costs.  There are two ways to deal with this problem: Western companies must foresee such a scenario and be ready to cede the market over the long-term once its commoditized. They need to focus on R & D and stay ahead of the curve by innovating, discovering new niches and attractive market segments, where a premium is placed on engineering, research, customer service, branding and top quality manufacturing.   Apple and Motorola Solutions are great examples of  such strategy. Apple uses Chinese manufacturing to assemble its products, but owns the customer experience, brand, design, research and development thus making it one of the most successful companies in history. Motorola Solutions also is very adept at staying on top of developing markets and technologies. It focuses on developing state-of-the-art products to solve complex problems in the fields of global healthcare, shipping and logistics, and public safety, all while divesting its mature and commoditized segments such as its Wi-Fi networks business.

Another way for Western companies to protect from domestic competitors abroad is to remain competitive in their  manufacturing processes, reduce labor costs and vastly improve productivity.  This means introducing robotics into manufacturing operations and reducing human labor costs.  Both of these techniques, I would imagine, will not be popular with organized labor .  Yet, union leaders must take a long hard look at the current competitive situation of the western companies and realize the dire predicament of such an inherent cost disadvantage. By refusing to adopt to the global market pricing (we do not necessarily need to match the labor costs offered by low cost emerging markets, but bridging the gap will help immensely), unions risk long-term erosion in favor of  the temporary bliss and comfort of the labor force who are clinging to the mirage of the current high wages and generous benefits. It is a strategy that is doomed for failure.  We have already witnessed the downfall of the U.S. garment industry, as well as TV manufacturing and furniture industries.

Thus unless western companies understand the broad strategic implications of the global balance shift towards the emerging dominance of leading emerging markets, they are doomed to be relegated to the status of also rans, and that would be a tragic outcome.   I hope you enjoy the article below and as always welcome your comments and suggestions.

Early Birds and China’s Mice

In the elite segments of China’s markets, western companies are threatened in terms of market share, sustained impressive growth rates and profit margins.

By George F. Brown, Jr. and David G. Hartman, Blue Canyon Partners, Inc.

Sept. 12, 2011

Over the past decade, many western firms have identified and targeted China’s exciting, fast-growing markets. Most of these firms had already established manufacturing and sourcing operations in China, lured there by the low labor cost environment and its potential for delivering significant cost savings. Soon, a network of western firms emerged, with many traditional supplier-customer relationships transported into China. Over time, those firms turned their attention to selling to Chinese businesses and consumers, joined by other first-time participants in that country’s markets. Many of the western companies that established a presence in China were among the “early birds” of western markets, leaders in technology and design, with product offerings far beyond anything previously available to China’s customers.Most of these companies found success in China. From a base of nearly zero, China became their company’s “growth story,” expanding year-after-year at significant double digit rates and within a short time achieving enough scale to move the needle in terms of both the top and bottom lines of their income statements. “Our continuing success in China was a major factor driving the past quarter’s results” remains a common statement in the earnings releases of many western companies.

The customers reached by these western firms with their leading-edge products were the elite of China, a combination of western firms operating there that needed ingredients for their export-oriented manufacturing and the highest-end of China’s own society. Western firms operating in China carried their standards and expectations with them, as for the most part, their operations in China were oriented towards production to serve western customers. They expected their suppliers in China to be no different than their suppliers in developed country markets — and in fact in many instances, these suppliers were the exact same firms.

The elite consumers in China quickly gained awareness of the best that western firms had to offer, and had the income levels necessary to buy those products. And for these elite Chinese consumers, buying products that represented the best that the west had to offer was a statement of their stature in a country where that matters considerably. The number of these elite customers grew very rapidly, from a miniscule fraction of the population, to a tiny fraction of the population, to a usually-still-small fraction of the population today. As the bell-shaped income curve shifted to the right at China’s growth rate, with its 1.3 billion people, even small shifts generated huge numbers of consumers at the higher-income levels. For the western firms, doing business in China was thus a natural extension of their activities elsewhere, as customers were either familiar western firms or elite Chinese with preferences much like those of western consumers.

As western firms enjoyed the growth described above over the past couple of decades, a new group of Chinese firms emerged, many from the state-run or local enterprises of prior years. These firms had access to the lowest cost labor pools that were available throughout China, and in fact practiced “China economics” in a way that enabled them to achieve price points almost unimaginable to western firms. Many of these Chinese firms sold to their own customers at prices that were dismissed by western companies as either the result of government subsidies or a cultural belief that they could “lose money on every unit, but make it up on volume”. Their products lacked the sophistication and refinement of the western brands, often characterized as low-quality knock-offs of similar products manufactured by western companies.

In many instances, these Chinese firms also developed solid manufacturing competencies, and began to be “hired” on some basis by western firms to make products for them, creating a cycle in which they strengthened their manufacturing skills under the tutelage of the western firms for which they were working. Furthermore, through these relationships, they were also exposed to western technology and design on an ongoing basis. Haier, for example, got its start manufacturing refrigerators for Germany’s Liebherr Group (and eventually borrowed its present name from the ‘herr’ portion of that firm’s name in Chinese). In other instances, western firms were delighted to license technology and design to Chinese startups, often that of past-generation products. Geely entered the automotive industry in such a manner, with its first car based upon the design of the Daihatsu Charade seen all over Asia with local brand names.

Most western firms dismissed these new Chinese firms as in any way representing a threat to their business. Their products, especially in the early years, were viewed as primitive and often laughable, only interesting to the low-income Chinese that couldn’t in any way afford the quality embedded in western products. And such western companies comforted themselves with the knowledge that those Chinese consumers who had risen in the income distribution were clearly signaling their preference for the offerings of western firms, even though these low-cost imitations were widely available. In terms of western markets, it was widely believed that it would be many generations before a Chinese firm could meet the standards, regulations, and expectations of western consumers. And furthermore, in many industries, it was argued that even the primitive offerings of these Chinese firms were the product of stolen western intellectual property, a practice that might work in China, but which couldn’t be exported elsewhere.

The emergence of the Chinese firms described above poses two significant challenges to western firms. The first of the challenges involves the new face of the global competitive environment. In an article onIndustryWeek, we have written about the emerging wave of Chinese competitors that are not only being successful in China’s broad middle market, but also gaining stature around the globe. We have labeled the emerging global competitors from China as Second Mouse firms, drawing upon the saying “The early bird gets the worm, but the second mouse gets the cheese” and reflecting the fast-learner and fast-follower capabilities of these firms. There are many such Second Mouse firms around — Huawei in telecommunications equipment, Haier in appliances, Sany in construction equipment, Mindray in medical equipment, Geely in autos, among many other examples. All of these firms got their start in China, learning from western firms, showcasing strong manufacturing and economic competencies, and establishing a strong position serving those Chinese consumers below the points on the income distribution where western products were an option.

Our characterization of these companies as Second Mouse firms doesn’t just reflect their ability to learn from and follow the leaders from the west. They were also genuinely second in the race, faster than the many other Chinese contenders who started up at the same time and with the same roots. They grew to significant scale in China’s markets, and evolved from their early position as contract manufacturers to become legitimate firms. But for many years, their focus remained centered on the middle markets of China, and over time they evolved products that were “almost as good at an incredible price point,” a considerable improvement over the early knock-offs belittled by the western firms in their industries. In part, their ability to achieve nearly-comparable products was due to their mastery of “China economics,” but a significant factor reflected important elements of China’s business culture, including an ability to think far outside of the box, processes that allowed progress at “China speed,” insights about what actually mattered to customers in their target market and a willingness to engineer unnecessary features out of the product and out of the cost structure, and service competencies that redefined relationships with customers and allowed the substitution of low-cost labor for high-cost product elements and business processes.

These Second Mouse firms are no longer constrained to China’s markets. As the examples cited above suggest, they are now significant global players. Some, like Huawei and Haier, are among the leaders in their industries, having surpassed well-established western firms in terms of sales and global market share. The transition of these firms into global markets has been gradual, with most of them first venturing into other developing markets in Asia, then into developing markets elsewhere, and only recently into the developed country markets of North America, Europe, and Japan. In many industries, these Second Mouse firms haven’t yet arrived in the developed markets of the west, allowing western firms to continue to embrace the fiction that they aren’t serious global competitors. But it is more likely just a matter of time until they arrive and become the most serious competitors of the coming decade.

Western firms face a second challenge, one that reflects the difficulty they will face in terms of getting to the point where they can compete with Second Mouse competitors. What western firms didn’t recognize was that in their strategy for entering into China’s markets, they fell into the “first mouse trap.” By entering the high-end of China’s markets and prospering there, these western technology and design leaders, with their advanced products and high price points, had created a conundrum for themselves. To later enter the broad middle market, where almost-as-good products at very attractive prices are prerequisite to success, they would have to take actions that would threaten their income and profit streams from the elite market segments and from their China operations oriented towards serving western customers. And doing so would disrupt the steady growth expected from these firms’ China operations.

Since the elite segments of the China market were initially the fastest growing parts of the market (in percentage terms), growth rates in sales were impressive indeed. Naturally, most of these western firms remain focused on the elite segments of China’s markets, earning solid margins and continuing to grow at reasonable rates, but without an ability to expand into the broad middle markets of China without compromising their position — and their profits — in China’s elite market segments.

As a result, the broad middle markets of China remain the territory of the Chinese Second Mouse firms. Fortunately for the Second Mouse firms and unfortunately for their western competitors, those markets are where most of the growth of the next decade will be found. It will be hard for any firm to be among the global market leaders in 2020 unless they have a meaningful share of the broad middle markets of China (and India, Brazil, etc.). Ceding these markets to the Second Mouse firms not only most likely hands over global leadership to them, but also enhances their abilities of the Second Mouse firms to compete in the west, both as a result of the earnings from emerging markets and from their continued access to the world’s best laboratory from which to evolve products that can compete and win around the globe.

Evidence of this is already plentiful, as a quick reading of press releases describing Second Mouse investments and acquisitions in the west will verify. And even in the elite segments of China’s markets, the future will begin to threaten the western companies in terms of market share and sustained impressive growth rates and profit margins. As China’s income distribution continues to shift, the new entrants into the elite segment will face a choice between western brands and those “almost as good products at a great price point” from the Second Mouse companies, an option much different from the earlier choice between western brands and laughable knock-offs.

The strategic implications of these two challenges are clear. Future growth will require western companies to develop the ability to compete in the broad middle segments of emerging markets like China. And future competitive success in even traditional western markets will require responses to new Second Mouse competitors that will quickly offer western customers “almost as good” products at highly attractive price points — a value proposition likely to find as many takers in the west as it did in China and other developing country markets. Those that are skeptical of this should reflect on western firms like Southwest Airlines and Vizio that generated great success using what is basically a Second Mouse business model.

For most firms in most industries, while this challenge is on the way, there is still time to shape a response to these challenges. We believe that an effective response will require western businesses to evolve, blending what they already do well with the competencies that characterize Chinese Second Mouse firms. It will no longer be enough to be an “early bird” leading the way with innovative technology and design. The growth markets of the future will place a much more significant premium on price, with the competitive winners far more likely to be those with “almost-as-good products at a great price point” than those with state-of-the-art technology. This prescription is very different from the mantra that most western companies have repeated over the years: “We must step up our innovation capabilities in order to maintain our lead on the Chinese competitors.” The global leaders of the future will have to figure out how to blend both competencies, sustaining leadership over the full technology life cycle.

To accomplish that, most western firms will have to bring what the Chinese do so well into their own firm’s cultures, most likely through acquisition of companies from developing markets like China. Doing so will require a different perspective on acquisition strategy and about what is to be accomplished in the integration process. Acquisition priorities must be refocused on strong Second Mouse companies, and integration priorities must emphasize not just retaining, but fully assimilating, the core competencies that these acquired firms can bring to the firm that acquires them. The task ahead is monumental, but it is one that must be tackled by western firms aspiring to sustained global leadership.

George F. Brown, Jr. is CEO of Blue Canyon Partners, Inc., a strategy consulting firm. David G. Hartman is Blue Canyon Partners’ China Practice Director and has been an active participant in China’s markets for over twenty years. He has previously served on the faculty of Harvard University and as executive director of the National Bureau of Economic Research.