The year 2015, possibly even more than 2014, was another volatile year in China. Among the most notable events: the stock market crash and the devaluation of the RMB shortly before the summer. Since then, Western media has been rampant with doomsday prophecies and fears of global repercussions.
Nevertheless, many international companies have been getting on with business, especially those that are most experienced in China. Looking beyond the headlines, we believe there is something more interesting—and more significant—going on for international companies operating in China.
Against the backdrop of a slowing and changing economy, we are witnessing the transformation to a radically different business environment in China. The change is complex and varied, but it centers on the changing nature of customers and competitors. The consequent challenges posed to international companies are becoming more apparent and the need to adjust to the new business reality more necessary.
Therefore, what worked well for the last 20 years is no longer sufficient. Most companies will require fundamental changes in their business and operating models. While lower growth and margins demand a short-term solution, long-term challenges must also be addressed. This won’t be easy, as implementation must overcome the organizational and managerial inertia created by the success of the past 20 years.
China’s New Business Reality
In the cloud of dust thrown up by the economic transformation and financial volatility, the new business reality is not easy to understand. There are big differences between and within sectors and between and within regions. For example, GDP growth of northern provinces such as Liaoning and Shanxi nearly stagnated through 2015. Coastal provinces such as Jiangsu and Fujian hovered around the high single digits. Chongqing, a southwestern municipality, was in double digits.
All the same, it is possible to identify a set of new business realities that emerged over the past two to three years that define the day-to-day operations for many international companies in China:
The Indigenous Threat
The emergence of new Chinese competitors has the ability to disrupt the status quo. This does not mean they only become dangerous when they are able to compete head-to-head in product technology and performance. The impact starts long before. For instance, the participation of Chinese competitors in bidding processes, regardless of their chance of winning, pushes down prices. Due to their superior understanding of the customer or the market, they eat away at the lower end of segments traditionally dominated by international companies, winning with cheaper products, supported by faster services and better suited to local needs.
In addition, international companies shouldn’t underestimate the ability of Chinese companies to innovate. The most obvious example is China’s mobile Internet. Tencent’s WeChat seamlessly combines the social media functionality of Facebook and Twitter with chatting/texting convenience of WhatsApp, leaving its Western counterparts with cumbersome and dated applications. Mobile payments are leapfrogging debit and credit cards in China. Alibaba’s Alipay and Tencent’s WeChat Wallet are both in common use; soon, Chinese consumers will just leave their (physical) wallets at home. Both payment platforms are now linked to money market funds, Yu’ebao (Alipay) and Licaitong (WeChat Wallet), appealing to Chinese savers who enjoy checking their financial gains when they wake up each morning. The pace of change is intense and relentless as a growing range of integrated, simple services appears.
Innovation is entwined with an increasing depth and diffusion of entrepreneurism in China. New company registrations are surging, and many start-ups are thinking big. China has 100 million well-educated youngsters who are driven by the belief that they could be the next Jack Ma (founder of Alibaba) or Lei Jun (founder of Xiaomi). Shenzhen DJI, the world’s largest commercial drone maker, is a case in point. DJI’s 34-year-old CEO, Frank Wang, founded the company in 2006 when he was a graduate student. He pioneered systems and algorithms to distribute power among the rotors that stabilize the aircraft and its camera, and then packaged them in an inexpensive device ready to fly out of its box. The result: A Chinese company that was a first of its kind—and a new consumer category. Expect to see many other Chinese companies that both threaten existing industry structures and open up new spaces.
The Change Imperative
In a large country, international companies used to grow by “doing more of the same.” But with the onset of the new reality, this established model is now defunct. In fact, in many cases the established model has become a liability.
China’s burgeoning urbanization, for example, offered international companies hundreds of cities for expansion. Consumer goods companies have long been building out their route-to-market structures to reach smaller and smaller cities. However, few organized themselves effectively or formed new product development initiatives to address China’s rapidly changing consumer segments and future growth opportunities.
Meanwhile, many capital equipment suppliers in China’s construction sector, such as elevators and escalators manufacturers, remain focused on new equipment sales. Now that construction has slowed, they don’t have a business model ready to meet the service needs of the huge installed base.
With the right sales approach, Chinese buyers of industrial goods used to provide an easy source of demand. International companies typically focused on state-owned enterprises, which had an insatiable hunger for high-quality production machinery and manufacturing facilities. However, that hunger has turned to indigestion, and they have stopped buying. The consequence is that the sales forces that succeeded when sales depended on relationships are ineffective in meritocratic marketplaces. In the pharmaceutical industry, the government crackdown on corrupt sales practices spawned a new industry in retraining medical sales reps. Nevertheless, many international companies still find that their old sales forces, stuck in outmoded mindsets and practices, are not suited for their new purpose as they move into customer segments with very different demands.
This new reality is here to stay, so it is important to address the long-term challenges that come with lower growth and lower margins.
A New Approach for a New Reality
Based on our advisory work over the last three years, our ongoing research into China’s transformation and implications for international companies and a recent set of interviews with more than 60 China country managers, we identified four key initiatives for international companies to remain competitive in the new reality:
Refocusing Marketing & Sales: International companies need to identify the new growth opportunities that China’s economic transformation is generating. B2B companies could consider shifting their sales resources toward higher growth sectors, whether dominated by state-owned (e.g., aeronautics, transportation, automation) or privately owned customers (e.g., life sciences, food and beverage). Companies may want to consider offsetting the slowdown in new product sales with new revenue streams derived from the existing stock (e.g., maintenance services, aftermarket parts). In elevators and escalators, Shenyang Brilliant and other players have already increased the service share in total revenues to 20%, double over the past few years (see Chart 2). In property, developers such as Soho China managed to sustain revenues by switching their focus from build-to-sell to build-to-rent (see Chart 3). Companies can also look again at how they segment their markets, seeking to identify emerging segments with distinct needs. In food and beverage, new products, targeting young consumers with trendy propositions, have turned into hero products. A good example is Uni-President’s Classmate Xiaoming ready-to-drink tea, which contributed RMB 1 billion in revenues in 2015, targeting schoolchildren with its “Seriously Funny, Inconspicuously Cool” tagline (see Chart 4).
Localizing Operations: Probably the most important initiative—and the most difficult one—is the need to become more “Chinese” and more “local.” This becomes particularly urgent once Chinese competitors, with their speed and flexibility, start disrupting the status quo. However, even without strong Chinese competitors, localization contributes to an international company’s competitiveness in China. Being local means moving core operations and decision-making processes (including product development and services) to China. In a market where local customers are developing their own distinct needs, this allows international companies to make decisions closer to their customers, developing solutions that meet their needs and delivering at a speed that matches the pace of the market. Localization doesn’t mean, however, forfeiting global standards.
Overhauling Operating Models: Slowing sales and rising costs mean that profitability is no longer a given as it was previously. For companies fixated on the top line for the last 20 years, this will require a drastic shift in mentality. Not easy, by any means. This is not just about increasing automation or running internal operational excellence programs. Companies need to look at whether their operating models are still fit for the purpose. For many companies, current operating models may be a result of piecemeal decisions accumulated over a long period of expansion. Their organizational structures are overly complex; operating practices lack cohesion and product portfolios are bloated. These will need overhauling to boost performance, improve profitability and see them through the period ahead. For instance, where product portfolios suffered from proliferation, with thousands of SKUs catering to all customers in all circumstances, companies may consider portfolio optimization, using a critical analysis of product-by-product profit contribution.
Acquiring & Divesting: Slower economic growth both increases the pressure to consolidate and generates more acquisition opportunities. In most sectors the choice is between investment and growth on one side and divestment on the other. International and Chinese companies alike are now accepting this reality and are acting to avoid the default choice, which is a slow death. Stronger Chinese companies that were not for sale are coming into play, as the difficulties increase with going public. Meanwhile, international companies will continue to pursue “B brand” strategies through local acquisitions to participate in mid-market segments. We are seeing more reasonable valuations, partly due to the economic slowdown and drop in stock market multiples, and partly due to weakening confidence and narrowing of exit options. Thus, we expect the trend for greater M&A activity that heated up through 2015 to continue into 2016. Selected sectors we expect to be particularly active: automotive components, healthcare, energy/chemicals, technology, consumer goods and services.
Overcoming the Inertia
Despite the importance of these four initiatives, they are not easy to implement. Support needs to be secured from headquarters for the investment budgets needed to grow and for the devolution of power to China, so decision-making chains are sufficiently short and responsive. Where international companies have 20-year histories of operating in China, business practices are stubbornly resistant to change. The old guard may find it difficult to develop the new capabilities required of them. Some hard decisions will have to be made, perhaps related to the rationalization of manufacturing footprints or the optimization of product portfolios.
Although there are challenges ahead, there is considerable cause for optimism. By adjusting their business and operating models to China’s new reality, international companies will remain competitive in what is one of the world’s fastest-growing major economies. New growth opportunities continue to emerge, and international companies are often well placed, if not best placed, to exploit them.
Jan Borgonjon, President, InterChina Consulting
James Sinclair, Managing Partner, InterChina Consulting
Simon Zhang, Managing Director (Strategy Practice), InterChina Consulting