China Business Blog and Podcast

Signs: Observing the pre-consolidation stage in China

Download this podcast

Audio clip: Adobe Flash Player (version 9 or above) is required to play this audio clip. Download the latest version here. You also need to have JavaScript enabled in your browser.

Quick quiz — what’s the most difficult job these days? Besides the one the new president of the United States will take on, I would vote for “business journalist.” It’s tough enough these days reporting on what just happened in the global business arena. Can anyone still say, exactly, what deferred securities are and who really owns them? But try to report on what might happen tomorrow … next year … over the next TEN years? Fugitaboudit!

But that’s one of the secrets of success, isn’t it? To be able to see what’s coming before it gets here. And to do that, you have to learn to read the signs…

Warren Buffet is called the Oracle of Omaha for his supposed ability to peer into the future. He avoided the tech bubble, he avoided (I understand) the major tragedies of the recent housing crisis and is starting to invest more in this down market. Alan Greenspan, former chairman of the U.S. Federal Reserve, was also called The Oracle and was, by current accounts, tough to argue with during the go-go years of the banking boom. But now, he is not looking too Oracle-like.

China could benefit from an oracle or two these days — is China, quote-unquote “de-coupled” enough from the global economy (particularly the U.S.) to weather this storm? Can China safely transition from an economy based on infrastructure building and exporting to a more mature, domestic consumption and global investment platform? Don’t ask me. I’m just a consultant!

Seriously, when I first came to China in the ’80s, if you would have shown me a picture of downtown Shanghai and said, “In a mere 25 years, you are going to look out your window everyday and see THIS,” I would have said you were, as my British friends say, “barking mad!” I would NEVER have predicted this; and neither would anyone else, at the time.

So all we can do is sit here and look at the signs — read the tea leaves, as it were and, based on our imperfect interpretations of the past and our too-sketchy view of the present, we predict the future. Sounds like a good gig if you can get it, isn’t it? Hey, welcome to life in China, baby!

But I think there are some signs that are quite clear that are telling us what stage we are at in China’s growth — and one of the defining features of this stage is what I call “pre-consolidation,” meaning, generally, that many industrial sectors in China are still very diverse, fragmented and messy but are in the process of becoming more aligned and streamlined. Instead of trying to further describe this stage, I would like to look at four “signs” that define what I am calling “pre-consolidation” and signal that we might be coming to a crossroads.

First of all, the biggest sign — and the easiest to recognize — is simply the number of players in many market sectors in China. One of the features of a more mature economy is that there have emerged several large players in a particular sector and other players have either fallen away or have been gobbled up (and that’s how the big players got that way, growth by acquisition). The auto industry is a good example — in the early 1900s, there were dozens and dozens of car companies in the U.S.; today, there are only three (and if the talks GM is reportedly having with Chrysler come to fruition, there will only be two!). China is on the other end of this spectrum. There are over 54 different car companies operating in China and well over 100 brands. Given time, consolidation will happen, but for now, China is in the “pre-consolidation” stage.

Car companies is one thing, but what about the rest of the China market structure? Could other sectors be described as being in a “pre-consolidation” stage? I think they do. In the past couple of months, we have done programs in medical devices, off-road equipment, vehicle components, stationary, aerospace — and ALL of them have MANY times the number of players in them than do similar sectors in North American and Europe. There are over 500 tire manufacturers in China, each of them making a variety of tires from smaller ones for lawnmowers to larger ones for road construction equipment. Most of them are doing less than $5 million per year in revenues.

I was talking to the product manager of motor graders at Caterpillar the other day and he said that, in China, there are 15 serious competitors — in the West, there are only 2 or 3 others, besides them. And several of these China competitors are only making 30 units per year! “That is tough to compete against,” he said. No kidding.

The interesting thing about many of these markets is that the “sweet spot” is pretty big — many of these manufacturers are making products that are “good enough.” It is a clear issue of over-supply in the “good enough” sector. Companies like Caterpillar, of course, are not competing in this “good enough” sector but rather are working to pull the market up to the premium end. But for now, “good enough” is pretty strong and it is a VERY populated section of the market. There are too many players offering too-similar a product with an value proposition that is difficult (if not impossible) to differentiate. Something’s gotta give…

A second sign that China is in a “pre-consolidation” stage is its fragmented distribution channels. Historically, China has developed regionally where personal relationships (you’ve probably heard the Chinese term guanxi) built over generations have made their way into business relationships. And these personal relations are, by definition, geographically specific. If I grew up in Beijing and so did my parents, then our relationships are strongest there … and if I have a business, I am going to rely on these relationships to help me start and grow. If I need sources of supply, I am going to look to my immediate network; my customers are probably near me as well; and I certainly rely on the good graces of the local governing authorities to smooth my road for me. Historically, in China, all distribution (like politics) is local.

Although the mass of China’s national economy has increased, some regions have grown more quickly than others. Starting in the south in the 80s, it moved to East China — Shanghai, Suzhou, Nanjing, Hangzhou, Ningbo, Wenzhou — in the 90s. And today, some think that the north, particularly Tianjin, is going to be the next growth frontier. For foreign companies wanting to penetrate the China market, they typically have had to contract with different distributors to be successful in different markets (if you are listening to this Podcast and are wondering why your Hong Kong-based distributor is not able to get outside of Guangdong province, there’s your answer — go find other distributors in other areas!).
In part, this is why the Chinese economy can support so many players, because there really isn’t one “national” economy here; rather, there are a series of smaller, regional economies with their bigger and smaller players.

But things are changing…transportation in China is improving drastically, and it is now possible to get products from one part of China to the other relatively quickly. Business people, too, are widening their spheres of influence and are beginning to make cross-regional guanxi work for them. They are partnering with others and, in effect, consolidating distribution. Distribution is still very fragmented, compared to the U.S. but we are starting to see some changes. The automotive sector is seeing some consolidation as dealers are starting to gather under nation wide dealer groups. The smaller dealers — those not able to perform a wide range of services — are closing their doors as they are unable to survive just selling new cars.

Think of your own industry sector and the China distribution map (and if you don’t know it, go find out!). Are there distributors moving from one region to the next? Have any of the smaller distributors died out or gotten snapped up by larger ones? Are you seeing the establishment of distribution centers to be able to stock regionally for faster customer service? If so, you are seeing signs of “pre-consolidation.”

The third sign that we are in a pre-consolidation stage in China is that the expectations of customers are slowly beginning to rise. I mentioned before that, often, “good enough” has been good enough here. Starting with consumers in China, they are the first generation of Chinese with enough disposable income and enough choices to make consuming interesting. But they have not been, on the whole, as picky as their counterparts in the more developed West and a lot of junk still sells. But this is changing…there are now MANY choices in markets here and consumers are getting good at making choices. Many are looking beyond “good enough” and are differentiating good-better-best.

Manufacturers, too, are considering product quality a must-have and not just a nice-to-have. They are more concerned with the quality of the components and raw materials that go into their products and are demanding quality. As they push on their suppliers, some of them will rise to the challenge and will improve, thus differentiating themselves from the hundreds of others. Some will, inevitably, fall off.

We see this beginning to happen, particularly, in the medical sectors in China. There has always been, certainly, an acceptable level of quality — when you are messing around with people’s lives, you pay attention to quality. However, “good enough” is no longer good enough for many mid- and upper-tier hospitals and their patients, and the medical device manufacturers selling to them are improving and streamlining their supply chains to make sure they are getting better quality products at competitive prices.

Finally, rising costs are a sign indicating that we are in a pre-consolidation stage in China. Historically, China has been THE (or one of THE) lowest cost markets in the world. However, just in the past year and a half we have seen a sharp rise in a number of costs. Labor rates have risen about 12% in the last year, on average, and have included a more restrictive employment law that adds costs for employers. Tax rebates for exporters have gone down, which means that the lower margin exporters are getting squeezed even more. The increase in raw material costs — particularly steel — has had a global impact and China has not been immune as costs have risen dramatically. Rising oil costs have hit the logistics sector particularly hard and so now the total landed cost of many goods exported from China is becoming less competitive with locally-made products.

In a developing market where costs are low and price is King, nearly anyone can compete. Provided the capital costs are controllable, the barriers to entry in many industries have been quite low, so tons of companies have rushed in. But as input costs rise, the winners are those that are able to maintain (or even increase) their sales price to balance costs, maintaining or increasing margins. Those who can’t either learn to survive on lower margins — which, for many Chinese companies were already quite low — or go out of business. And we are getting early indications that this is happening. Many low-value manufacturers in southern China have reportedly gone out of business in the last year because of this caustic cocktail of price increases.

So this is what I am calling a “pre-consolidation” stage in China and am defining it by the signs in the market — a situation where there are too many players, going to market through a fragmented-yet-slowly-streamlining distribution chain reaching customers for whom “good enough” is good enough but not for long, all the while navigating the rough waters of rising prices. I don’t think I am going to win a Nobel prize for economics any time soon, but there it is.

Well “so what,” you are asking yourselves, “Interesting observations, Kent, but how does it affect me, the international business person and my dealings with China.” Well I am glad you asked that question … because this Podcast needed a couple more minutes to be long enough!

Seriously, I think this “pre-consolidation” stages has HUGE potential to impact foreign business. And the advantage is that, if I am right and this is still in the “pre” stages, planning our strategy now helps to insure that we are ready when it really DOES happen. Overall I see a couple of things that all foreign businesses should be thinking about to take advantage of “pre-consolidation” in China…

First, understand that the needs of your customers are changing. If you have been selling into China for awhile, don’t rely on your past knowledge of what your customers want. Ask them again. We have done an inordinately large number of “Voice of Customer” programs this year simply for this reason — our clients want to find out what customers are thinking now, not what they thought 5 years ago when “good enough” was good enough. What kind of “better” product are they looking for? How do they define “better”? What does “best” mean to them — what features and functions define “best”? What price premiums are they willing to pay for “better” and “best”? Unless you know the answers to these questions, the consolidating market is going to pass you by and you won’t know what hit you (or even why).

Secondly, competition is going to become more intense. In order to survive — yet alone thrive — competition is going to start going beyond their normal bounds, expanding into new territories with new distribution, coming out with new products, new pricing. You are likely going to start seeing new competitors in some of your regional markets — they are not new in an absolute sense in that they have been around for awhile, are strong in other regional markets and are expanding their spheres of influence. You might start seeing several of your competitors band together in order to attack a market segment or customer grouping. If you have not been gathering intelligence on your competitors to this point, now is a good time to start. Find out what they are doing now and what they are planning on doing in the coming 18-24 months.

Finally, the “pre-consolidation” stage in China could represent an opportunity for you to grow exponentially, through acquisition. This is how the big companies in the West got big — they didn’t so much grow their markets as they ate their competition! We have done several growth strategy projects recently where growth-by-acquisition was a viable strategy and we found some attractive targets where acquisition was possible. However, rather than finding just the ONE good target, in several cases, we found a couple of smaller targets where we could see a step-by-step move to acquire them in quick succession. Are there risks to this? Sure…big ones. Is it easy? Heck no…smaller deals are just as much of a pain as big ones. But the goal here is not just to get into the market, the goal is to be a catalyst to consolidate the market…to own some major real estate in the market and to establish ourselves as the no-B.S. market leader. We planned the acquisition path to work, even if we could not eventually get them all…but our ultimate goal is to do so.

Now, I realize that there are going to be a LOT of people who will have a LOT of arguments as to why we are not in a pre-consolidation stage or why consolidation won’t happen or that it will happen in such-and-such a way. Most people — most sane people — would say that, in any case, the risks are just too high to lead consolidation. The chances of failure are VERY high; it is too risky to rely on consistent market trajectories in China; and besides, the global capital market are in such a mess now that consolidation is going to take its time, if it even ever happens.

And to those people, I would say, “You may be right.” Certainly, the history of market development in the West has many examples of companies that were trampled under the wheels of changing market sectors. But there were always those that were not quite sane — the Fords, the Welch’s, the Gates’s — that thought differently. They were sitting in an era of “pre-consolidation” and thought, “you know, maybe if I did something different…” and look what happened.

So I would quote the philosopher Billy Joel and say, in this era of pre-consolidation in China, “You may be right. I may be crazy. But it just may be a lunatic you’re looking for!”

This entry was posted on Wednesday, October 29th, 2008 at 11:24 am and is filed under China, M&A, podcast. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.