The 6 Bullet Points Broken Down

BUSS4 2014: China Research Bullet 1 Overview

Relevant Business Concepts & Models

1. External environment: factors outside the control of the company that shape business decision-making and affect business performance.
2. PESTLE – A model to help identify and evaluate significant external influences
3. Emerging market: an economy and society undergoing rapid economic growth and industrialisation
4. Economic growth: an increase in the value of economic activity undertaken in an economy from sources such as investment, consumption and spending by government

Key Opportunities

• China is now the world’s 2nd largest economy and forecast to overtake the US in 2014 or 2015
• Still growing much faster than developed economies: target economic growth in 2014 is 7.5% although this is lower than previous decade
• Approaching 1 billion consumers as urbanisation progresses (world’s largest migration)
• Enlarged & increasingly affluent middle class
• Rapidly emerging market segments, particularly demand for consumer goods & services
• Massive public investment in infrastructure, but now looking to rebalance in favour of more consumption (% of GDP)
• Still a source of relatively low-cost and high quality supply despite rising wage costs

Key Threats

• Rising production costs, particularly as wages rise and industries and markets become more mature
• Time and cost to establish profitable market position – competitive position can deteriorate quickly
• Risks of loss of intellectual property
• Growing & intense local competition from firms with their own global ambitions
• Is competition fair in China? Govt protection and subsidy of domestic industries and firms + greater scrutiny of activities of foreign businesses
• China’s population is ageing quickly; many fewer younger people, restricting supply to workforce
• Much of China’s economic transformation has been financed through debt – is there a bubble?

Some Examples & Evidence (remember – there are many!)

• Air pollution is a major issue in China – killing over 1m per year - a focus for China Govt. who are investing heavily to move towards green energy
• China accounts for over 20% of global demand for luxury products
• China has become one of the most important markets for all global car manufacturers where Chinese consumers have demonstrated that they prefer foreign brands

Depends on Factors

• China is complex: individual sub-markets defined by vastly differing demographic, economic and cultural characteristics. Is the opportunity well defined to take account of this complexity?
• Targeting a product at emerging middle class? Depends on whom you define as middle class.
• Increasing numbers of affluent urban Chinese – but also much income inequality
• China needs to sustain high levels of economic growth to manage social unrest (e.g. unemployment)

Other Areas for Evaluation

• China is not the only fast-growing emerging market. Do some of the others present better opportunities and lower risks? (e.g. Indonesia, Malaysia, Vietnam, Turkey, Thailand)
• Is China too big an opportunity to ignore? Given the size of the Chinese economy, can global brands and leading multinationals afford NOT to be in China? Would shareholders expect it?
• Is it too late for foreign firms to take advantage of the biggest opportunities in China? Many of the most successful multinational firms in China first invested there decades ago and have taken a long-term approach to growth. New market entrants now face much stronger domestic competition and potentially a more hostile external environment.
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BUSS4 2014: China Research Bullet 2 Overview

Relevant Business Concepts & Models

1. Shareholder returns: profits (rewards) that earn a satisfactory return on investment (e.g. ROCE, ROI). Investments in China by multinationals will need to earn acceptable shareholder returns in long-run
2. Investment appraisal (BUSS3) – evaluating the potential returns (cash flows, profits) arising from an investment decision. Should take account of risk (e.g. use of discount factor in NPV calculations)
3. Diversification: strategic option in Ansoff’s Matrix (new markets, new products) often considered the most risky growth option. China could also be “market development” (existing product / new market)
4. State-Owned Enterprises: firms owned and operated under the control of the Chinese Govt.Re-shoring: the relocation of production & other operations which had previously been moved from an original location (e.g. moving production back to the US from China)

Key Risks

• Risk of loss: significant investment usually required to compete effectively in China – many foreign firms have sustained substantial losses
• Risk of IP transfer: Chinese firms may acquire IP illegally (e.g. counterfeit) or legally (through JVs) that can be used to compete against foreign firms
• Reputational risk: e.g. impact of being found to be acting unethically or breaching CSR standards
• Competitive risk: entering China exposes foreign firms to significant domestic competition

Risk Examples

• GSK: caught up in allegations of corruption in Chinese healthcare system
• Tesco: nine years of losses as it struggled to build scale – eventually forced to sell business into JV
• Nestle / Danone: accused of price-fixing in Chinese baby-milk market – highly damaging
• KFC – impact of quality problems and bird-flu has damaged a successful business in China
• Dyson: significant cost and time involved in taking action against Chinese firms who had stolen IP of Dyson Blade products

Key Rewards

• Revenue and profit growth: demand in many Chinese markets now world-leading. A source of faster growth compared with mature developed economies. Many multinationals are concerned that their businesses are too reliant on revenues from slow-growing, mature economies. Emerging markets (including China) offer the prospect of much faster growth.
• Source of high quality and low-cost supply: China is still the factory of the world with significant and highly flexible production facilities
• Base for further international expansion: able to learn much about successful market entry strategies for a broader range of emerging markets

Reward Examples

• Apple: reliant on Chinese suppliers to be able to supply global demand; increasing source of demand
• Yum! Brands: Now generates more than 50% of global revenues and 35% of profits from China
• Starbucks: by 2015 China will be Starbucks’ second largest market after the USA
• BMW: China now BMW’s largest market and aims to sell 2 million cars there in 2014
• JLR: China overtook the UK to become the JLR’s leading market in 2013
• P&G: revenue from China has grown 50% pa in last three years to almost $7 billion in 2013. One billion people currently use P&G products in China
• Samsung: revenue from China surged 80% to $25.7 billion in 2013

Depends on Factors
All investment in overseas markets carries a relatively high degree of risk (like any business investment). A trade-off between risk and reward.
Risk in China can be mitigated, to some extent, by the method of market entry (see research bullet 4).

Other Areas for Evaluation
The size and scale of China presents additional risks for a foreign firm wanting to invest there. Western firms have traditional targeted the more affluent Eastern seaboard and largest (Tier 1) cities.
Much has been learned already about how to manage risk in China, but the unpredictability of the political & legal environment there only adds to future risk.

BUSS4 2014: China Research Bullet 3 Overview

Relevant Business Concepts & Models

1. SWOT analysis: Model to assess strengths & weaknesses (internal to the firm), opportunities & threats (external to the firm) and help determine strategic direction and choice
2. Competitive advantage: factors within the control of the firm that may enable it to achieve sustainable advantage over competitors (e.g. brand awareness & aspiration, unit costs, distribution, quality)
3. Corporate objectives: targets the firm as a whole wishes to achieve; a measure to help to assess whether the results of strategic choice are successful or not
4. Value proposition: what distinguishes a business, brand or product in eyes of target customers
5. Localisation: changing elements of the marketing mix to make a product or service better suited to customer needs and wants in a new market

Success Factors

• Localisation: adapting the product to meet needs of Chinese customers
• Choosing a suitable joint venture partner(s)
• Scale – reaching a scale of operation that enables the business to operate efficiently
• Brand reputation – having brand values that Chinese customers aspire to (e.g. cars, luxury goods)
• Prepared to invest for the long-term – build scale; develop market understanding & accept initial losses in order to grow market share

Reasons for Failure

Loss / theft of critical intellectual property (IP)
Failure to localise and customise products and services to suit the domestic market
Not using local management & expertise
Underestimating domestic competition
Insufficient or improper market research
Inability to communicate with the local market in culturally appropriate and sensitive ways
Underestimating role of Chinese Govt. at every level of society including commerce

Successes in China

• Ikea (long-term perspective & localisation)
• Starbucks (used JVs to establish scale & localisation)
• KFC (owned rather than franchised;setup own distribution systems)
• Unilever (built brand awareness, localised product ranges)
• BMW, Honda & Toyota (successful JV partners & quickly established scale)
• JLR (luxury brand could be imported; invested in China factory)
• Wal-mart wholesale model (format suited Chinese middle class)
• IHG (one of the first hotel groups to enter China in 1984; successful JVs)

Failures / Disappointments in China

• Tesco (lacked scale and underestimated Chinese consumers)
• Revlon (wrong brand for Chinese market)
• M&S (poor market research & no localisation of products)
• Mattel (arrogantly thought Barbie would work without amendment)
• eBay (system did not allow for trading relationships between buyer & seller, Guangxi)
• Best-Buy (trading format did not work – no localisation)
• Wal-mart supermarket model (struggled to compete with domestic rivals with better local knowledge and product ranges)

Lessons Learned from analysts who have looked at success and failure in China

"Never assume what works for your existing markets will work for China. Success comes for those who stay relevant to the needs of the Chinese consumer." (Source: Millward Brown)
Multinational companies hoping to succeed in China can’t treat it as an interesting side bet any longer; they need to take China as seriously as they do their home market. (Source: McKinsey)

Underlying themes for evaluation of success or failure

How important is China to a business looking for growth? (relative to the alternatives)
Can the potential rewards justify the substantial risks – and how long to wait before those rewards arise?
What are the alternatives to China if a business (particularly a multinational) needs profitable growth?
Is it possible to compete effectively and fairly in China given the unpredictability of the Chinese Govt?
Is it too late to succeed in China, or can you learn from those who succeed or failed?
Which market entry strategy is best to mitigate risks? Note, this has changed, with many fewer JVs

BUSS4 2014: China Research Bullet 4 Overview

Relevant Business Concepts & Models

1. Joint venture (“JV”): an enterprise in which two or more firms invest jointly and share the risks and rewards (not always 50:50). Contractual details are set out in the JV agreement – a complex document
2. Local production: setting up manufacturing or other production capacity in China
3. WOFE: wholly-owned foreign enterprise; a business entirely under the control of shareholders
4. Direct exporting / distribution: selling products and services directly to customers or distributors in the target market (note: have to consider impact of tariff and other import barriers)

Option: Local production (e.g. factory in China)
Advs: Flexible & many options; closer to end-user/customer; faster delivery time
Disadvs: requires investment; higher operating costs; danger of technology transfer (IP)

Examples:
Samsung investing $7bn in factory to make memory chips for its product range
P&G: In 2012 announced plans for 20 new manufacturing units in Brazil, China and Eastern Europe by 2015 – including $1bn into China

Option: Direct exporting into & direct distribution
Advs: Best way to protect IP; lower operating costs; easier to exit / stop
Disadvs: May face import restrictions (e.g. tariffs & quotas); selling costs higher

Examples:
Brompton Bikes: 80% of sales are exports; now retails through an exclusive retail outlet in Shanghai
Tyrrells Crisps: targeted 60% export revenue growth by agreeing distribution deal with Chinese food importer in 2011

Joint Ventures

Key advantages:

• Shared risk and investment
• Partner should provide some benefits (e.g. local market insight, distribution, facilities)
• May help gain Govt. approval for market entry

Key disadvantages:

• Technology (IP) could be at risk
• More difficult to exit particularly if relationships with partner become strained
• Risk JV simply helps create a domestic competitor

Why joint ventures were popular initially
Helped make foreign firms make sense of a complex market
Combined foreign capital/know-how/brands with local capacity
Perceived by foreign firms as a way to reduce risk
Often required by Chinese government in some protected industries (e.g. motor vehicles, transportation projects, green energy)

Issues relating to joint ventures in China now
China has changed: now has plenty of investment capital and strong domestic businesses
Track record of technology transfer and corrupt practices
Many examples of JVs in China which did not work out as planned & proved costly to exit for the foreign firm
If you are serious about investing in China, try to keep control by owning the business

Examples of successful JVs in China
JLR & Chery Automobile (including new production plan and R&D facility
BP and PetroChina – JV in petrol retailing
Ford – built market leadership position in China through two success JVs
InterContinental Hotels Group (IHG) – JVs with property developers to build 400+ hotels

Examples of Where JVs in China went wrong
Danone: high-profile JV in 1996 with Chinese soft drinks maker Wahaha turned into a bitter commercial dispute
HSBC – invested in stakes in several Chinese financial institutions; now looking to exit those investments
Lufthansa (Germany) exited JV with Jade Cargo in 2012 after heavy losses – excess capacity blamed

Depends on Factors
The failure rate of joint ventures in China is high, and joint ventures in China have achieved a reputation for being difficult to manage.
In some sectors, JVs are the only way into China: Chinese law requires a foreign company to have
minority ownership of enterprises operating in certain industries

Other Areas for Evaluation
In China, as in any foreign market, it is difficult to succeed alone. Business practices, language, culture,legal environment, and other obstacles make success in China elusive = an argument for using JVs
Business relationships in China are complex (link to Guangxi and corruption), and disagreements between partners are common.

BUSS4 2014: China Research Bullet 5 Overview

Relevant Business Concepts & Models

1. CSR: corporate social responsibility: the impact a business has on society through its activities
2. Ethics: how a business chooses to operate; its practices, processes and culture
3. Corruption: the abuse of entrusted power for private financial or non-financial gain
4. Guangxi: the Chinese model of “relationships” which influences how business is conducted.

CSR / Ethical Issues

Guanxi - or inter-personal relationships or social networks are an important part of how business is done. However, there is a fine line between corruption and money spent on developing guanxi.
Corruption is rife at all levels of Chinese society, particularly in government
The Chinese leadership recently announced a crackdown on corruption
The working practices of suppliers to foreign firms have come under increasing scrutiny, partly as a result of scandals like Foxconn (see below)

Environmental Issues

Remember that China is the most populous country on earth, and the impact of population growth on the environment is significant, even in remote rural areas. The cumulative impact of rapid growth in the consumption of 1.3bn people is tremendous.
China has a significant and growing problem with air and other pollution. China is the world’s biggest producer of CO2. Respiratory and heart diseases related to air pollution are the leading cause of death in China.
Water scarcity has become a major issue as the process of urbanisation and industrialisation has taken hold

Some Examples & Evidence

• President Xi Jinping’s campaign against corruption is extended from March 2014 making it one of the broadest in China’s modern history, snaring dozens of businessmen and government officials
• Diageo – impacted by crackdown on corruption: new rules over gift-giving and spending by Chinese officials dented sales in the country by 66% in 2013
• Foxconn - Taiwan-owned company operating in China (supplier to Apple & other global electronics brands) exposed to have unsafe working conditions, forced labour, overcrowded dormitories and did not pay a living wage. [Apple & others responded by introducing supply audits & reporting)
• Nestle & Danone - investigated (along with others) into alleged price-fixing. China is the world’s largest market for baby formula.
• Rolls Royce - 2013, SFO launches investigation into potential corruption & bribery in China
• JP Morgan - still under investigation in the US for allegedly hiring children of elite Chinese bureaucrats in return for access to the market
• Water pollution: About 40% of the water in the country's river systems has a quality index of 3 or worse, meaning that it is unfit for human consumption.

Depends on Factors
Important to understand that Chinese society itself has changed significantly in recent decades & the pace of change is quickening. Therefore, the relationship between business and society in China will inevitably change.
Chinese people are increasingly concerned about income inequality and sustainability; the pace & scale of urbanisation and resulting impact on environment (pollution) has made these major social issues
In China, the concept of trust is crucial; can foreign firms operate in way in which that trust can be built and maintained?

Other Areas for Evaluation
China is still an emerging market (a clue in the word!) Business ethics and CSR in China are a work in progress and while they still have a way to go, Chinese companies are moving fast.
As supply chains become more complex and widespread, many international companies are adopting a more integrated approach to their corporate responsibility, integrity, ethics and compliance policies.
The costs of non-compliance with corruption & bribery regulations around the world are significant. Investment exposure to China & other markets increases the risk of non-compliance.

BUSS4 2014: China Research Bullet 6 Overview

Relevant Business Concepts & Models

1. PESTLE model: changes in the external environment: political, economic, social, technological, legal and ethical/environmental. The competitive environment is often added to the model
2. Porter’s Five Forces: a model that helps analyse the nature of competition in a market
3. Contingency planning: a key part of risk management, particularly for firms operating in markets and countries with unpredictable external environments

Key Developments to Consider (structure these around the PESTLE model)

• Political: China needs greater openness in order to sustain economic growth; but still committed to protection & support of domestic firms and markets. Still a communist country!
• Economic: A rebalanced China is a slower-growing China; greater focus on consumption & less reliance on infrastructure investment. China now also looking to expand its investment outside of domestic markets. A move to floating exchange rates might impact the competitiveness of Chinese businesses
• Social: Increasingly urbanised population and growing older – significant demographic changes have already taken place. The long-term costs of these changes are only just becoming a serious issue. China is losing the advantage of its demographic dividend (millions of cheap, young workers).
• Technological: China now has capability & resources to compete globally in technological change. Significant increase in investment in R&D (see below) will drive innovation by Chinese firms
• Legal & regulatory: More mature economy & society implies greater legal & regulatory control. Will this make China a better / easier place to do business?
• Ethical: Anti-corruption drive is the key focus – but are foreign firms being targeted unfairly?
• Environmental: Pollution is the key concern – China responding with significant investment. A much closer scrutiny of the environmental impact of business activity is inevitable.
• Competitive environment: Domestic firms in China increasingly able to compete against foreign businesses both in China and in international markets

Examples of Increasing Domestic Competition facing Foreign Firms (Home and Abroad)

• 95 Chinese firms were listed in the Forbes Global 500 World’s Largest Businesses 2013
• Sinopec – one of the world’s leading energy businesses
• Hauwei – world’s largest telecoms-equipment-maker; diversifying into consumer electronics
• Lenovo – world’s largest manufacturer of personal computers; moving into smartphones & tablets
• Haier – world’s largest manufacturer of white-goods (e.g. fridges, freezers)
• Alibaba – world’s leading (by revenue) e-commerce business

R&D spending in China: estimated at $284 billion in 2013, up 22% from 2012. China likely to surpass Europe in terms of R&D spending by 2018 and exceed the U.S. by 2022.

Increasing amount of investment by Chinese firms in outbound M&A: Chinese acquisitions of overseas companies hit a record high in 2013

Depends on Factors

Perhaps unlike any other country, China has undergone a remarkable transformation in recent decades – affecting every aspect of the PESTLE model. Businesses wanting to trade with or invest in China should expect the pace and scale of that transformation to continue.

China is becoming much more closely integrated into the global economy, particularly through its overseas investments and increasing competitive strengths of domestic firms.

Other Areas for Evaluation
The West has long viewed China as a source of low-cost, good quality supply. Things are changing rapidly. Increasingly, China's own technology companies are challenging market leaders and setting trends in telecoms, mobile devices and online services.
For a variety of reasons, the Chinese Govt. needs to sustain a reasonably high level of economic growth in the coming years. It is unlikely to be able to do this without taking further steps to “open-up” China (e.g. trade liberalisation”) and continue to encourage inward foreign direct investment (“FDI”)