A Dragon Not Ready to Fly

The Day Care Center, Silicon Hutong Plaza
Beijing

As the early sales results for the Christmas season begin to come in from the U.S., it’s pretty clear that consumer electronics (led by the iPod) was the category driving increases in sales. Eric Taub at The New York Times notes that consumers are shifting to digital products and flat panel TVs in droves.

In a year where most of the world’s consumer electronics manufacturers are high-fiving themselves for record-breaking results, China’s largest television manufacturer, Changhong, is declaring a huge first-time loss.

The details are ugly and not fully known. What the NYT will say is:

• Changhong says it’s rep owes Changhong US$468 million, an allegation rep Apex Digital president David Ji denied last year, saying they only took merchandise on consignment from Changhong and only took commissions, never owning title to the goods. Hmm.

• Changhong apparently appointed a single representative in the U.S., that only Changhong CEO Niu Runfeng was allowed to deal with. Hmmmm.

• Ji has allegedly been detained by Chinese police is Sichuan as part of an investigation.

There is a lot going on here. Changhong apparently would not invest in building TV sets with digital receivers in them as required in the U.S. of all television manufacturers. That automatically restricted the number of sets it could sell. Then they were hit by the new anti-dumping actions of the U.S. government, and Changhong sets probably got a lot less competitive with the big-box and discount retailers that were Apex/Changhong’s largest customers.

This is a huge fall from grace for Changhong and Apex, which together supplied the U.S. with 90% of the televisions made in China that were sold in North America. The companies won a Best of Show award at CES last year for a game product. Now the partnership is clearly in doubt.

Clearly, the anti-dumping ruling hurt, since the companies were bringing TVs in so cheap that it was pretty clear that they were being sold at less than cost. But to what end? Japanese companies have long sacrificed profits to build market share, but it seems that Changhong has tried, but failed, to take a page from that book.

As all of this unravels, a several lessons for aspiring Chinese multinationals are becoming apparent:

• Long term success for Chinese technology and electronics manufacturers in global markets will be directly tied to their corporate governance.

• Consistent investment in technology will be essential for all industries to compete in global markets. When people are buying flat screen TVs, trying to hawk big cathode-ray-tube based boxes makes you irrelevant, not inexpensive.

• Cheap products and dumping may build market share, but they don’t build mind share. Marketing, the construction of a brand, and the ability to understand and anticipate market directions in the major consuming markets worldwide will all be fundamentals, not extras. Look at BenQ.

The problem is, near-sighted approaches to globalization a la Changhong are the rule, not the exception in China. As the world’s begins to expect China to conform to global standards of corporate governance and business practices, running things “the old-fashioned way” will become untenable.

Wharton, Leader of Large Lemmings?

Editor’s Desk, Silicon Hutong Center, Beijing

The response of one Silicon Hutong reader to the Wharton piece:

“It’s actually pretty fabulous that Wharton can promote the guanxi route to China. I wholeheartedly applaud their efforts to encourage large US corporations to spend lots of money and efforts on the guanxi route to China. How else would a small company like mine be able to kick fellow foreign a*& in such a competitive market.”

Wharton’s Take on the IBM-Lenovo Deal: Out of Touch

In the Hutong, Hiding from the Snow

I like Wharton’s Knowledge website. There are some extremely smart people at Penn’s B-school and they usually have something brilliant and insightful to say about most things.

Which is probably why their article about the Lenovo deal, The IBM/Lenovo Deal: Victory for China was such a disappointment. Some concerns:

1. Wharton Does Not Understand Public Relations: Marshall Meyer (IMHO one of the giants in organizational theory) who is touted as having “studied Chinese companies and travelled extensively in China,” says “Public relations is a big component of Chinese Management and a lot of people will see [the IBM/Lenovo deal] as a victory for China.” Now, either the esteemed Dr. Meyer doesn’t know the difference between “face” and “public relations,” or he doesn’t know much about Chinese companies and the way they are run. Or both.

As someone with just a little bit of experience with Chinese companies and public relations will tell you, Chinese companies care about face. Full stop. But public relations? Most Chinese companies think P.R. stands for “press release” or “Payoff the Reporter.” Chinese companies and their executives are notoriously unsophisticated when it comes to any form of corporate communications, and that’s a distinction I’m genuinely shocked Dr. Meyer missed. As an organizational theorist, he should know that despite a widely accepted practice to the contrary elsewhere in the world, Chinese companies still insist on placing public relations beneath marketing and 23 levels removed from the C-suite.

2. Wharton Thinks Lenovo is the Only Chinese Company on the World Stage: This pains me, because I really respect the work Dr. Michael Useem has done on leadership. But when he says “It is untrodden ground for a Chinese company to make a sudden, big move to operate on the world stage,” I can’t let that pass. Other Chinese companies going boldly down that direction who have preceded Lenovo:
a. Haier opening a factory to build refrigerators in South Carolina.
b. Huawei and 3Com creating a joint venture to sell each other’s gear around the world
c. China Netcom’s purchase of Asian Global Crossing
d. The TCL/Thompson merger that brought the RCA brand to China
Not to mention the recent move by China Minmetals to purchase a major Canadian mining company. C’mon, Dr. Useem. If I were in your class and made such a blatantly inaccurate statement in a paper, you’d nail me for it, and rightfully so.

3. Wharton Thinks Guanxi is Worth Hundreds of Millions of Dollars to IBM: Dr. Useem is not finished with himself, as he goes on to note that “‘government relationships are key in China. IBM sees this as an alliance. Maybe the price wasn’t as good as it could have been’ but IBM gets a definite payoff in the form of ‘better relationships.'”

As anyone on the ground here understands clearly, IBM doesn’t need to forego hundreds of millions of dollars (or tens of millions, or even a few million) in order to enhance its standing with the Chinese government. A recent study my firm conducted for an entirely different I.T. client made clear that IBM’s government relations were outstanding, that no doors were closed to it, and that this had all been accomplished simply by operating in China as a good corporate citizen. If IBM knowingly left any money on the table in the name of “better relationships,” I think shareholders are entitled to an explanation of why they paid for something they already had.

There is a bigger issue here, and it concerns me deeply. Dr. Useem, and many other highly respected academics, seem to be laboring under the mistaken impression that government relationships, or guanxi in the local vernacular, are critical to the success of a business. Don’t get me wrong, building and maintaining good contacts with the government is important in China. But it is far, far less important than it was a decade ago, and it is certainly no determinant of success. The two generational changes in leadership that have taken place in China over the past 15 years have had a major effect on the way governments and foreign enterprises work together. Bureaucrats, regulators, and ministers are much more comfortable evaluating and working with business executives, and there are sufficient regulatory and procedural measures in place to ensure this takes place systematically enough of the time that you don’t need Hu Jintao’s help to get a business license.

Even if IBM didn’t have the kind of relationships that it has built over the years, it would not need to spend millions to build those relations. I’ve helped much smaller companies do very well for a lot less, and the cost is dropping all the time because the process is getting so much more straightforward.

3. Wharton Doesn’t Understand the Value of Brand: Professor Christian Terwiesch, a professor of operations management, can’t understand why Lenovo paid so much for “the number three company in the PC market.” Apparently Dr. Terwiesch is having a hard time comprehending that perhaps Lenovo (whose brand name, let’s face it, sounds more like a French economy car than a computer) saw some very real value in the IBM and Thinkpad brands. Certainly BusinessWeek and Interbrand recognize that the IBM brand alone is probably worth something on the order of $53 billion. For the privilege of using that brand for 5 years, Lenovo pays about $350 million a year. Some would call that a bargain, but only if they understood the value of a great brand to a company that lacks one.

There are other mistakes, mainly small ones (spelling the name of the infamous techno-gadfly Fang Xingdong as Fang Zingdong, etc), but what really jumps out is how much better the insights and analysis are when they come from Gartner and the Chinese, and how unplugged Wharton comes across when it comes to both China and Technology.

If I were a trustee or an alumnus at Wharton, I’d be very worried. This is a clear sign that Wharton is in deep danger of losing whatever relevance it has outside of the Boston-Washington corridor.

In the Hutong, Beneath the Departure Path of Runway 18R at PEK

Whenever I sit at a table with Hong Kong Chinese I consider to be my friends, the discussion always turns into a caustic debate: they insist Hong Kong people understand China better than anyone other than mainland Chinese. I insist that seven years after reunification, Hong Kong people still understand Great Britain better than they understand China.

Case in point: Air China’s public offering yesterday in Hong Kong was 83 times oversubscribed.

Why?

WHY??

Maybe Hong Kong investors enjoy a good gamble. (See Macao.) I think punters in the Special Administrative Region have actually convinced themselves that because China is booming, Air China will boom as well. Which speaks to my point. Andrew Chan, an analyst at Pacific Sun Investment Management, told Bloomberg “The strong demand is more driven by the market sentiment (sic) than the company’s fundamentals.”

Understatement of the year.

Now, before I give a little insight into exactly why this is a bad investment (and on the eve of its London offering, no less), allow me to digress a moment:

When the wind is blowing in one direction, southbound departures out of Beijing International Airport curl in a graceful arc toward the Shahe navigational beacon in a way so that, from my third floor balcony, I can watch them from the time they are about 400 feet off the ground above the airport 4 kilometers away until they fly over northern Beijing.

When the wind blows the other way, those same departures lumber almost directly over the house at about 2500 feet. Some people would be bothered by that. As a semi-retired plane spotter, I love it.

So understand, I personally have a couple of very important reasons to be happy about the Air China IPO, not least of which is the better shape the company is in, the better shape the planes are in, and thus the safer I feel flying my hometown airline, and the safer I feel hearing them overhead. I have no airline clients, and I have no airline investments.

That said, Air China is another one of these state-owned enterprises that has gone to market before it was ready and at a bad time, hoping to catch investors who have China fever so bad they will miss the fundamentals. Except for a few very well run airlines that have turned their operations into high art, airline economics are awful, and being in China doesn’t change that.

• Fuel in China is preposterously expensive, and Chinese airlines pay more in their home airports than other airlines around the world because of a government-sanctioned monopoly. Now, China Aviation Oil Ltd. may or may not be affected by the misguided trading of its Singapore subsidiary, but as long as this monopoly stays in place, Air China’s fuel bills per seat-mile are going to be higher than other world airlines.

• Political pressure keeps ticket prices down even when aircraft are fully booked, meaning Air China can’t make money on high-demand routes.

• China was forced to eat two other airlines, Zhejiang Airlines and China Southwest – a year ago. It’s still digesting, and more important this underscores how the future strategy of the business is driven as much by politics as by commercial considerations.

• Air China’s fleet is ridiculously diversified in an era here most airlines are rationalizing theirs down to a single manufacturer and a handful of models. This increases the expense of training, operation, maintenence, etc. so much that the better run airlines only operate a handful of aircraft.
— Southwest only flies several models of only one aircraft type, the 737. Southwest is a well-run airline
— Singapore flies 3 types, the A340, the 777, and the 747. Singapore is a well-run airline.
— Virgin only flies the A340 and the 747. Virgin is a well-run airline.
— Air China operates nine distinct types of aircraft, including 4 models of 737, three models of the 747, the 757, two models of the 767, the 777, the Airbus A318, A320, A340, and the British Aerospace BAe-146.
Are their airlines that operate more types than Air China? Absolutely. But none of them are in good operational shape.

• China’s fleet problems are not likely to change soon, because aircraft purchases are as much driven by politics as they are by operational considerations. You can bet Air China will be operating the Boeing 7E7 and the Airbus A350 when those planes start flying, and will probably be forced to buy the A380 and the Boeing 747 Advanced as well.

• Even after consolidation, domestic competition remains cutthroat. Even though PRC airlines could raise prices, none are prepared to take the risk.

• International competition, on routes where Air China makes some good money in both passengers and cargo, is about to go way up.
— In passengers, China is opening up more slots to European, Asian, and American carriers. Even QANTAS is scheduled to begin direct Beijing-Sydney service. And Cathay Pacific, long denied entry into China because Hong Kong’s protectionist aparatchiks were backing Dragonair, is now being allowed into the market, turning it’s Hong Kong hub into the money-spinner it always should have been. Want to bet on an airline in China? Bet on Cathay Pacific or Dragonair.
— In cargo, Air China is moving too slowly with poor infrastructure on the ground. FedEx, UPS, DHL, and TNT, having built their businesses on high-value express shipments, will after the current round of international service agreements have enough belly space in aircraft coming into China that they can cream the better air-cargo shipments as well. And these companies offer something Air China cannot – not only tracking and delivery services and facilities on the ground around the world, but internal divisions that plan and manage global supply chains for clients. Air China, meantime, rents belly-space, leaving itself at the commoditized low-end of the business.

• Despite high-profile airport upgrades in Hong Kong, Guangzhou, Shanghai, and Beijing, most of the rest of China’s 119 commercial airports have facilities little different than what U.S. airports had in the early 1950s. This is the heart of Air China’s business, and it means that quick turnarounds are impossible (raising the capital cost per passenger flown), opportunities to grow to meet demand are less (airports can’t handle that many flights or large enough aircraft), and that because air travel in China is so uncomfortable at either end, the whole experience is miserable, keeping prices low and artificially restricting demand.

• The management are all bureaucrats, not businessmen. That needs to change. It should, but it won’t – not anytime soon.

• If you think Air China is such a hot stock, look at the past performance of China Southern and China Eastern. Zzzzzz. These airlines have been listed in New York for a decade and they’ve gone nowhere, because analysts recognize the fundamental issues in the market.

Whenever anyone talks about the Chinese commercial aviation market, they get drunk on the potential of the place. And there IS a lot of potential. Air China’s issues as a business, however, are fundamental. They must be changed – and the problems in the local industry environment must be changed – before this can be a good investment for an average punter.

UPS Success Depends on Breaking China Customs/China Post Axis

Somewhere on Second Ring Road East

Kudos to UPS for making the decision to buy out Sinotrans’ share of their joint venture. Sinotrans is living proof that you can’t have multiple, competitive joint ventures with the same local partner and expect all of them to be equally successful. DHL was first into China and first in with Sinotrans, and as a result got the best people and most attention. Add that to DHL’s tightly focused and very aggressive push into the market, and you get a formula for success.

Just as an aside, TNT is another company in UPS’ position. They too have a Sinotrans JV that has been going nowhere. TNT needs to swap out of its partnership as well if it plans to be competitive.

None of this suggests that UPS’ troubles are over in the market. Now they will have Sinotrans as an enemy rather than a lead weight, which might redound to DHL’s favor. The other problem is the one they all face: China Post is allegedly in cahoots with the Customs Service to delay clearance of all non-document express parcels coming into China using anything but Express Mail in a fairly brazen attempt to damage the prospects of UPS, DHL, TNT, and FedEx. Until they can get over this workaround, UPS will be unable to compete effectively in China. Without a strong local partner, UPS needs to build a powerful constituency in China and ally themselves with their rivals to end the customs nonsense, or they will find their business in the PRC unsustainable. Remember where you heard it first.

China’s Tech Firms and Africa

The Silicon Hutong Desk, Starbucks @ China World Tower 2, Beijing

A great article in the Economist on 25 November (“A New Scramble: Booming Chinese interest in Africa is not just about oil”) concisely documents the strategic raw materials relationship that China is building with Africa. Shades of 1964 indeed, but instead of Simbas and Stalinists, this time China is dealing with any odious dictator or pariah with oil or mineral reserves that the country needs. Zambia and Gabon are about to join a rogue’s list that includes Zimbabwe, Angola, and Sudan as countries that China is courting mostly because nobody else wants to do business there.

It’s a fantastic opportunity for China, created in no small part by NGOs and activist shareholders who won’t let global companies break bread, much less do business, with these nations.

Huawei, never concerned by such niceties as consumer perceptions, shareholder activism, or ethical corporate behavior, has staked claims in markets like Sudan and Zimbabwe where Lucent and Nortel hesitate to tread. They are the largest and most visible, but they won’t be the last.

In fact, Africa is an opportunity for many of China’s tech firms, at least on the surface. ZTE and Bird can sell low-cost mobile handsets. Lenovo can sell low-cost computers. AVIC can sell low-cost airliners. Etcetera ad nauseam.

There will be two key issues for tech firms venturing into Africa. First is getting paid: these countries are rated poor credit risks for a very good reason. PRC tech firms that venture into Africa should think about doing so on COD terms. Period. Normally I would suggest getting guarantees from the PRC government, but I’m not sure the PRC government would pay that much quicker.

The second issue is appropriateness. Even though China is a developing country and has vast regions of very poor people, the circumstances in Africa make China look like Northwest Europe. Products that are developed and priced specifically for the market are essential. One indicator of how radical products need to be modified for Africa comes from the Economist’s quarterly technology review (“Human Powered Health Care”, Economist, December 2, 2004). Anyone for PCs powered by hand-cranked generators? China will find the kind of challenges in Africa that rival those American adn European firms encounter in the PRC. Good luck, boys.

Nok Nok…Anybody Home? More Empty Offices in the Glass House in Espoo

In the Hutong, Looking Toward the West
The executive suite in the Glass House is starting to look like the Bush Cabinet: the first team leaves, the second team is left to carry the can. Here’s the Reuters story filed late Friday.

Nokia is a walking corpse. You heard it on the Silicon Hutong over a year ago. Now that chunks are starting to fall off the cadaver, will people start believing? Mobile networks Chief Sari Baldauf and senior staffer Jukka Bergqvist, also of the networking unit, join Matti Alahuhta, the company’s head of strategy.

Nokia is spinning this as natural progression. But wait…Matti and Sari were supposedly leading the pack for CEO Jormo Ollila’s job when he steps down in 2006. Leave on the verge of possibly getting The Big Chair? Stretches credulity a bit.