I’ve been hearing from listeners that our last post cut out in the middle of the Podcast.  Sorry ’bout that!

Here is the re-post.  If you still find trouble, please email me at kkedl@technomicasia.com

Thanks!

Kent

I would like to begin this post with an apology … its been awhile since we checked in here on the China Business Blog and Podcast!  Thankfully, it seems we have not been forgotten as we’ve received many notes from loyal listeners asking how we are doing … if everything is ok.  I can assure you that, yes, things are just fine here in Shanghai, China … in fact, its because things are going so well that I just have not had the time to get these Podcasts recorded and posted.

We’ve been working on a series of discussions on mergers and acquisitions in China with Dr. Kim Woodard, one of the leaders of Technomic Asia’s M&A practice here in China, and we are continuing that today.  It is appropriate that one of the reasons we’ve been so busy lately is that we’ve seen a big upswing in M&A activity for clients here in China … lots of strategy development and target identification, the early stages of an M&A program.

Well, today, we are going to talk about a stage of the M&A process that, we believe, is unique in China – we call it “deal cultivation”.   Remember that we’ve been talking about the relatively “young” market for M&A in China … we are still in our first generation of doing deals here and there is not a lot of experience floating around.  Therefore, it is critical that we help bring the Chinese companies along in the process, helping them feel OK about it while, at the same time, doing what we call “discovery” – finding out as much about the target as we can ahead of the more formal legal and financial due diligence process.

I started today’s conversation with Kim by asking him about deal cultivation and why it is so critical in China…

Well … its been awhile since we’ve posted a Podcast.  Sorry ‘bout that!  I took the week of Chinese New Year off and tried to ignore my computer and email.  That was nice … but then I really paid for it coming back to work afterwards.  Now I have been able to dig out from everything and get back to our series of Podcasts on China M&A.

If you recall, I have been having a series of conversations about China mergers and acquisitions with Kim Woodard – a vice president here at Technomic Asia and one of the leaders of our M&A practice.  The theme we have been orbiting around is “reducing risk” … this is because the failure rate for China M&A deals is quite high.  We estimate that fully three quarters – that ‘s 75% for the CPAs in the crowd – of deals that reach the letter of intent stage fail to close.  So that means, for successful M&A, we need to focus on reducing risk at each stage of the process.

Today, we go back to the beginning and talk about, what we feel, is the most important stage in China M&A … target selection.  Here is a conversation that Kim and I had just this afternoon in our Shanghai office…

We are continuing our series on mergers and acquisitions in China through a conversation I have been having with Kim Woodard, a Vice President here at Technomic Asia and a specialist in China M&A.  In over 30 years of doing business in China, Kim has done deals both from within the corporate environment – with companies like John Deere and AMP – and as an outside advisor.  In the last part of this conversation we talked about the five key risk factors in doing a deal in China:

1. The acquiring company chooses the wrong target for the wrong reasons.

2. Failure to connect well and build trust with the shareholders, management, and other stakeholders of the target company.

3. Inability to bridge the valuation gap

4. The target company fails to meet due diligence expectations on financial documentation or on financial and commercial performance.

5. The C-suite in the acquiring company gets worried about post-acquisition performance.

Let’s get back into the conversation as we now turn to the best way to manage these risks …

One of our themes for 2010 here at the China Business Blog and Podcast is “acquisitions”.  A typical market sector in China is very fragmented and very crowded – there are many players working in their own local areas.  From automotive, to healthcare to consumer products … they are all this way.  Both foreign and local companies will be looking to strengthen their positions in these markets by acquiring smaller players, bringing products, brands and distribution together to gain scale and more power in the market.

In early 2009, the global economic crisis knocked the wind out of the M&A market all over the world, and here in China, it was no exception.  Transaction volume fell off significantly as companies hunkered down to wait out the storm.  Well, though for many individuals around the world, the storm is still blowing, for companies and investors here in China, it is prime time to move … they have motivation to grow and cash to invest.  The challenge, as we will explore today, is managing risk.

Here at Technomic Asia, we have strengthened our M&A practice to include end-to-end transaction services and have brought in to the Technomic family one of the preeminent deal guys in China, Dr. Kim Woodard.  When Kim joined us late last year, we started a Podcast series on M&A in China.  Today we are going to continue that series as Kim and I talk about managing risk in China M&A.  And we start off discussing a very shocking statistic …

OK… I am just going to put it out there: these last 10 years have kind of sucked.  Years from now, we are going to look back on the first decade of the new millennium and only the very strong among us are going to be able to avoid using a variety of four-letter words to describe it.  From the rise of terrorism to the meltdown in the global economy, these have been tough times.

Things didn’t start well, of course, with the futuristic “Y2K” problem. It was, for the most part, just IT consultants crying wolf.  But to so completely lack faith in our own technology so as to doubt its ability to handle a digit change in the thousands column does not speak well of our confidence or our technology.

But, for me, what started things off on the wrong foot was our inability to agree with simply what to call this decade.  The “Aughts”? The “O’s”?  The “Naughts”?  Given the current state of the average American’s bank account, “the Nils” sounds like it’s the most appropriate.  But c’mon, folks … if we can’t even name the stinking decade, how are we supposed to handle the real issues.  Frankly, I am a bit ashamed that we Americans couldn’t come up with the marketing slogan that we could all hold hands around.  We are a country that brought you such ditties as Hooters, Cabbage Patch Kids and the Pet Rock.  And we can’t name a decade?  How embarrassing!

However, contrary to the desperation much of the rest of the world is facing, China had a pretty good decade.  From a GDP of about $2,000 per person when 2000 started, China is projected to be over $6,500 per person heading into 2010.   And unlike other changing economies such as the former Soviet Union, China’s political infrastructure didn’t go through a meltdown in the face of such growth.  Certainly, there were many doomsayers predicting the imminent collapse of China, but so far, these people with their Nostradamus For Dummies guidebooks have been, thankfully, quite wrong.

The Chinese authorities are, certainly, giving themselves a big Attaboy for their performance in this past decade.  Not only has their growth been the best in the world, but they’ve landed some pretty big gigs to show it off including the Olympics and the Shanghai Expo.  Fair enough, let’s give China their due … but let’s also look forward to the next decade and make some guesses ourselves as to what we might expect.

Here at Technomic Asia, we are celebrating our 25^th year in China … that is, if I might say so, pretty impressive for a boutique consulting firm where many of our peer firms have burned out long ago.  However, if you would have asked any one of us when we first started in China in 1985 to predict what China would look like in 2010, there is NO WAY that any of us would have come close to envisioning what I can see out my window right now.  Back then, I had to bring in coffee from Hong Kong and now I have three Starbuck’s stores and seven knock-offs of the same within a 10 minute walk of my office.  So predicting the future in China is not a science; heck, its not even an art.  I would liken it to a pin-the-tail-on-the-donkey game played by at a birthday party of some cargo cult voodoo priestesses.   Yea, its that much of a crapshoot.

But what the heck … its only my job to assess the China market and plan growth strategies for my clients, so I am going to go out on a limb here and introduce 5 themes for 2010 that I think will become even more important as the decade continues.   They are, in no particular order because they ALL are important and impact each other:

1. Growth

2. Distribution

3. Consolidation

4. Mergers & acquisitions

5. The emergence of China as a global power

As a year-end wrap up, I want to introduce each of these themes today and then we will re-visit them throughout 2010 and explore their progress (or lack thereof).  So let’s get to them …

The last decade has seen China grow in importance in companies’ global strategies … from just a blip on their radar screen at the turn of the century, China is now a major – if not THE major – strategic initiative for many companies.  And the reason?  Growth!  And its not just because, in 2009, China was the only market in the world to grow more than 8%.  The rumor perpetuated by politicians and angry journalists that China is ONLY a source of low-cost labor and a way for evil capitalists to export jobs from the U.S. is dead-wrong: China is a source of good-old top-line growth. In the midst of all the management theory bouncing around boardroom walls, it turns out that customers are important.  As a former sales manager of mine once told me, tongue firmly planted in-cheek, “Kent, I’ve done some research and have determined that 100% of our revenue comes from customers.  We better focus on them.”  And you know what?  China can be a great source of new customers for many companies.

We just completed the annual business survey for the American Chamber of Commerce in Shanghai and determined that over 60% of American companies were in China primarily to serve the China market … they were looking for growth!  As U.S. and European companies are emerging from the dark depths of economic depression in the past couple of months, I have increasingly had serious discussions with CEOs about ways to grow in China.  They have all said that they feel they have just scratched the surface of what they could – and should – do in China and they need to do more.

A sub-topic under our “Growth” theme for this year will be companies’ expansion into China’s Tier 2, 3 and 4 cities – its not only important to be in China but you have to expand across markets here as well.  Remember that a Tier 2 city in China can still have nearly 8 million people in it so we are not yet talking about selling into rural areas … this is still urban marketing.  But gone are the days when  company could just set up a sales office in Shanghai, Beijing or Guangzhou and hope to do enough throughout the country.  We see many companies today making significant efforts to expand their China footprints and throughout this year we’ll talk with some of these company leaders to find out what they are doing and how they are doing it.

Closely associated with the “Growth” theme is our second theme, “Distribution” … I guess this is overstating it but if you want to grow, you’ve got to actually get your products to market.  Companies who are already in China need to find a better way to get more products to more markets.   Companies are discovering that China is a VERY large and fragmented market and your route-to-customer in one region will not be the same as in another region.  We’ve said it before in these Podcasts but you will never – repeat, NEVER – find one distributor to represent you all over China.  I don’t care what industry you are in, it ain’t gonna happen.  Sure, your distributor will TELL you that they can do it, but they cannot, at least not as well as you need it done to realize the growth that you need.  You will need to take over that responsibility yourself, to find the right combination of distributors to reach the right markets.

In 2009, we did a lot of work for clients to assess the strength of their own distribution, typically benchmarking their operation against their competitions’ (both local and foreign).  And more often than not, we found huge gaps … geographies not covered, certain sectors totally missed and important customers under-served.  These clients are using 2010 to rebuild their distribution.  Sometimes they need to tear things down and then rebuild them … but more often than not, they just need to identify the gaps and start to fill them.

Not only do we need to address the people part of the distribution equation but we also need to consider the supply chain infrastructure.  From sourcing to manufacturing to transportation to warehousing and, finally, to distribution, foreign companies in China are reassessing how they handle their entire operation.  Growth without a firm distribution and supply chain foundation is impossible so 2010 will be the year when companies will start to get very serious about improving both.

The third theme that I think will be important in 2010 and beyond is “Consolidation”.  As I just said, China is a large and fragmented market and a key contributor to that fragmentation is purely the number of players involved in any particular sector.  For example, China has over 100 automotive OEMs … not just 100 brands but 100 distinct auto manufacturers (a long way from what we used to call the “Big Three” in the U.S. which is now, depending on how you count it, probably more accurately described as the “Big One-and-a-Half”).  In pharmaceuticals, there are over 3,000 manufacturers in China and over 10,000 pharma distributors.  Most of these are what China calls “sub-scale” which is a polite way of saying, in effect, that they are too small to survive very long on their own and really have no opportunity to grow very much.

The Chinese government is strongly supporting consolidation and are, in many cases, selecting key companies (often State-owned) to move to the top of the food chain in this Darwinian, survival-of-the-fittest process.  I did a Podcast recently on the Big Four automotive companies (including First Auto Works, Shanghai Automotive, Dongfeng and Changan) and how they are looking to acquire companies inside and outside of China to bring under their rapidly expanding umbrellas.  Look for some major automotive moves in 2010.  In pharma, the government is forcing the smaller distribution companies to merge with the larger ones, so much so that the rumor on the street is that there will be only one distributor per province in the end.  Personally, I don’t see how this can happen, at least in my lifetime, so while the end state is unknown, it is absolutely certain that consolidation will be the trend.

Foreign companies playing in China will want to play close attention to consolidation trends in their own industrial sectors.  The competitive landscape will change greatly as consolidation takes place … your competitors will be stronger, wealthier and have a larger geographical footprint.  In many cases, consolidation will result in a broader product portfolio, making it more difficult for you to compete with them toe-to-toe.

Our “Consolidation” theme leads us nicely to the fourth trend, “Mergers and Acquisitions”.  Not only will local companies grow through M&A but foreign companies are increasingly looking at growth by acquisition, particularly those who have been in China for awhile.  There are multinational companies who came into China through a joint venture many years ago but who are now, for all intents and purposes, operating as a wholly foreign-owned enterprise (or WOFE).  Once they did the deal, they started growing organically, adding products and distribution territories so that, over time, they have built quite a good presence.

However, they have gone about as far as they can go organically and, to speed up time-to-market and increase depth of market penetration, they are looking at acquisitions.  In the past couple of months, we have done some Podcasts on China M&A and will continue that again in the New Year.

Our fifth and final theme is a bit trickier and I put it under the heading of “China as a growing global power” … however, this requires some unpacking.  Here on the China Business Blog and Podcast, we tend to avoid so-called “macro views” and, instead, dig deep into the specific strategies and tactics that companies are using to succeed in China.  We don’t talk much about the goings-on in Beijing, the ins and outs of political leadership.  Its that not this is NOT important – it is – but such palace intrigue can often be quite far away from the day-to-day issues that company management faces in China and, for most of us anyways, we have very little direct influence on the seats of power.  Besides, our daily experience is in the trench warfare of markets, not hanging out in the rare air of the Zhongnanhai leadership.  And my momma always told me to talk about what you know…

However, I think we are seeing an emerging power and even “attitude” from Beijing that warrants mentioning and awareness.  Basically put, the Beijing leadership has been making more unilateral decisions lately and is doing so quite confidently that the rest of the world will not punish or even censure them all that much.  Just a few days ago it was announced that China executed a British citizen for drug trafficking, despite the VERY loud protests from the West that China should take some time and think about it.  The view from Beijing since the execution is that this is an issue of their “judicial sovereignty” and that the rest of the world should butt-out.  In the many articles I have read on this, the journalist inevitably mentions that Britain is China’s third largest trading partner and hints that British authorities are trying to “keep lines of communication open”.  Which means that, although they will whine a bit, nothing is going to happen to China because of their actions.

I mention this, not to criticize either side for their behavior – and I am sure there is lots of criticism to go around – but rather to highlight that we are moving into some new territory here.  2009 was a heady year for China … the Olympics, the fastest growing economy in the world, huge cash reserves, significant investments in U.S. t-bills all added up to an administration that, frankly, thinks they are pretty bullet-proof.  You can be sure that, increasingly, the Chinese government will be making more unilateral decisions and will be less and less sensitive to the opinions of other international players.  How it plays out is anyone’s guess … but suffice it to say that this will be a factor, starting in 2010.

One word of caution here – just because things are happening in Beijing does not necessarily mean that there will be a direct impact on what you are doing in your local area.   All governments move along their own timelines … and some would say their own dimensions of reality … and these timelines are often best measured using carbon-dating methods, things move so slowly.  So please don’t assume that I am prophesying doom and gloom … this is just another data point you will need to include in the algorithms you use to understand what is happening in China.

So there you have it … my predictions for the future.  Radical and cutting edge?  Probably not, but I am very certain that we will see these themes come into play and interact with each other this coming year.  As for each of you and your companies – include these themes in your strategic planning.  Assume that your competition is moving in these directions and challenge yourself and your China management to be able to articulate, in detail, how you are going to handle all of these, both defensively and offensively.

One of my favorite quotes about the future is from Alan Kay, the American computer scientist, researcher and visionary, who said “The best way to predict the future is to invent it.”  It has been true for the past quarter century I have been in China and will be so for the next 25 years – China is a unique environment where you can, literally, create your own future.  And this is what we at Technomic Asia hope for you in 2010 and beyond which is why we end every Podcast with our motto: “In China, everything is possible but nothing is easy.”  We wish you all a very Happy New Year and we’ll see you next time on the China Business Blog and Podcast.

OK … we are on to Part 3 of our interview with the newest addition to the Technomic Asia team, Kim Woodard.  In this section, we get down into the nitty-gritty of doing deals in China.  Enjoy!

We are in the middle of a Podcast interview with Dr. Kim Woodard, the newest addition to the Technomic Asia team here in Shanghai.  Kim’s background includes setting up A.T. Kearney in the early days of China business and running his own boutique M&A consulting firm.  We brought Kim into Technomic to fill out our ability to provide end-to-end services for our clients doing deals in China.  While we saw a bit slow-down in 2009 for M&A in China (and, in fact, around the world), we see that things are really going to pick up in 2010 as companies are looking for aggressive growth opportunities.

In this Podcast, I talk with Kim about the practical do’s and don’ts of doing deals in China …

Unless you have been living in a hole or the dark side of the moon for the past year, your life has somehow been impacted by the global economic slowdown.  You, a friend or a family member have lost a job; your municipal budgets are being cut; heck, your OWN budget is being slashed.  It has not been a fun year, even here in China where things are still moving along at a pretty good clip.

Though there are signs that things are getting better, I am not convinced we are totally out of the woods yet.  But just because we have no guarantee of where things might be going, that doesn’t mean we can crawl back into our hole or retreat to the backside of the moon … no, we need to keep moving forward.

And at Technomic Asia, that is exactly what we are doing.  For many years, our consulting practice has been involved with foreign companies doing all kinds of alliances in China: from joint ventures to licensing to distribution to acquisitions, we have helped our clients put their alliance strategy together and then execute it.  Up until about a year ago, we had been seeing a real upturn in acquisitions in China: the government rules for acquiring companies were loosening up and foreign companies were looking to China for new growth opportunities.  Then the bottom fell out of the economy and companies put all that activity on hold.

However, as things settle around the globe, multinational companies are looking for ways to grow and China seems a very good place to look for that growth.  And one of the methods they are returning to is growth through acquisition.

To capture this wave, we have brought in a new team member to Technomic Asia: Dr. Kim Woodard.  Kim has had over 30 years of experience in China, first coming here in the 70s in the earliest stages of China’s opening to the West following Nixon’s “Ping Pong Diplomacy”.  Armed with a Ph.D. from Stanford, Kim was soon a respected leader of foreign companies’ earliest advances into China.  Kim helped establish A.T. Kearney’s China practice and then went on to help big names such as John Deere and AMP establish their China operations.

Most recently, Kim had his own firm, Javelin Investments, to assist Western multinationals with acquisitions in China.  We wanted to bring Kim in to Technomic Asia to give us the ability to provide a complete M&A advisory practice – from initial strategy development all the way through to negotiation, closing and integration.

Given the returning importance of M&A in China, I wanted to have a series of conversations with Kim about M&A and, in his experience, what makes for a successful acquisition in China.  Attached is the first in a series that we will roll out in the coming weeks.  I hope you enjoy it!

I’m speaking this week at the Sixth Annual GIC Mergers and Acquisition Summit, the title of my presentation is Deal Cultivation – Keys to Success in Making Acquisitions in China. The M&A process in China is much different than in the United States. Understanding this difference will reduce anxiety and frustration among US executives pursuing M & A strategies in China.

To give you a graphic representation think of the process as a ride on Disney’s Space Mountain, a long wait, followed by a plunge into the darkness of twisting turns, hair-raising screams, and emerging at the same place you started.

One of the reasons that the identification and relationship phase is so important is the high transaction costs in China, compared to the deal sizes available, so effective “discovery” is important before spending substantive dollars in due diligence. In China, acquisitions require more upfront target cultivation and pre-due diligence than is typically needed in the West.

To appreciate this, one need only be reminded that in China the seeds of private investment and the concept of a merger were sown just 20 years ago. China is more akin to a college age individual as it is developing a comfort with markets and corporate business entities.

In this podcast, I’m interviewed by Albert Maruggi reporter for the Marketing Edge podcast about the M&A landscape as a preview to the GIC presentation this week in Shanghai.

| Get your Presentation Pack

Shanghai, China, June 21, 2009 – Steve Ganster, Executive Director of Technomic Asia, will highlight the opportunities and challenges of mergers and acquisitions in China at the GIC sixth annual Mergers and Acquisitions Summit held in Shanghai on June 25. Ganster says China’s business is good for M&A activity, however it is still a maturing market that requires a much different approach from what many US companies expect as they consider expansion through acquiring a stake in China companies.

“US companies need to modify their approach in making acquisitions in China putting a great deal more emphasis on cultivating relationships with target companies. Acquisitions are in an embryonic state in China, and the rules of the game are not well established. Much more energy needs to be spent in the discovery stage, getting to know the stakeholders and what they want from a deal. Local Chinese management often goes into the discussions not fully understanding what they want,” says Ganster.

“In the US, the emphasis is placed on financial statements in a relatively transparent process. In China, relationship is the key filter through which the deal must successfully pass.” Ganster added.

China’s companies are searching for natural resources and big name brands to beef up their portfolio or supply chain in anticipation of increasing growth. Since 2007, outbound investment has grown from $26.5 billion to $52.2 billion in 2008, according to Reuters.

One example of this activity is the recent intended acquisition by Sichuan Tengzhong Heavy Industrial Machinery, a private machinery maker, to purchase the Hummer brand from bankrupt General Motors.

The Mergers and Acquisition Summit will be held at the Crown Plaza Century Park, Shanghai June 25 and 26.

Editors & Bloggers Note: A soundbite from Steve Ganster is available with a description of the bite below.
Soundbite with Steve Ganster on China Mergers and Acquisitions
IN: After I’ve identified…
OUT: Can’t do that successfully in China
Length: :38

A full interview with Steve Ganster on the Merger and Acquisition topic is available on the China Business Podcast

About Technomic Asia

Technomic Asia (www.technomicasia.com), a division of Tompkins Associates, is a business strategy and supply chain consultancy with more than 25 years of experience helping clients plan and execute Asian growth and operational strategies. Technomic Asia assists companies in entering the Asian market or in expanding their business by providing critical market insight, an understanding of business potential, and assistance in designing the optimum strategy for success.

Media Contact: Albert Maruggi amaruggi@providentpartners.net
612-325-8126

China’s rapid development in the past 15 years can leave one feeling a bit dizzy.  My first time in Shanghai in the late 80s – in town for an escape from the small central China city where I was living and teaching – was heady enough.  There were only 10 taxis in the entire city and you had to get around on diesel fume-belching busses or by foot (and it was a battle between the aerobic benefits of walking and the heart-stopping inhalation of diesel exhaust).  Now its tough to step in the street here and avoid getting hit by a cab (unless, of course, it is raining or you are late to a meeting or you have two heavy boxes you are trying to schlep to a client … and then there are NO taxis to be found in the entire city.  Go figure).

So when China seems like its returning to the bad old days, it is a bit shocking, particularly when this return is signaled by increased regulation from the Party.  There have been a series of steps over the past year that, in hindsight, are heading in a direction that could be of concern to everyone who does business in China, local and foreigner alike.  Late last year we saw the government put extra restrictions on Carlyle, the financial investor, as they sought to buy out XCMG, one of China’s leading heavy equipment manufacturers.  Carlyle eventually let the deal die because the limitations were so onerous.  At the time, everyone clucked about “protectionist policies” but eventually chalked it up to China wanting to guard an industry that could figure into national defense (ala the U.S. blocking the Chinese oil giant CNOOC from investing in a U.S. offshore oil company a couple of years ago).

The next big restriction was for visas for foreign visitors wanting to enter China just before the Olympics last year.  Thousands of businesses were impacted by this and many Olympic events were sparsely attended because people just could not get here.  Again, apologists for China cited so-called “legitimate” reasons for this … in this case there were serious security concerns.  The reality was that China was playing a game of CYA – “Cover Your Anterior-region” – and was willing to go overboard on restrictions in order to insure that nothing happened while the spotlight was shining so brightly on them.  Sure, it bothered me too but I guess I understand erring on the side of caution – my own country’s Transportation Safety Administration recently busted my daughter on a routine check at an airport … she was relieved of a fingernail clipper, ostensibly because she might use it to hijack the airplane to Cuba (where she would need said clipper because you simply cannot buy them there).  In the immortal words of Fleetwood Mac: “Oh well.”

But then this year, things have been getting even more tight, it seems.  We started the silly season off with Coke being denied their acquisition of the large Chinese juice manufacturer, Huiyuan.  The government was oddly silent on the specific reasons for the denial.  There were some mumblings of avoiding “monopolistic” practices which, in a way, was legitimate as the merger would create a beverage company that would rule in two key categories: sodas and juices.  But many legitimately pointed out that China’s industries are ripe for consolidation and that, following pretty much any other economy as its developed, there are, as time goes on, going to be fewer but larger players in the market.  There is speculation – no none of it published, as far as I have seen – that the government is pushing Huiyuan to themselves become more acquisitive … to go out and start buying up smaller beverage companies to grow larger themselves, in effect creating a competitor to Coke.  Typical of China, the old adage is flipped on its head: “if you can’t join them, beat them.”

Just this last week, two things have happened to make me even more concerned.  The first was the release last Friday of the new Postal Law in China which everyone in the logistics and delivery sector has been anticipating like Christmas morning at the Bill and Melinda Gates household.  However, much to the chagrin of foreign delivery companies like FedEx, UPS and DHL, the law bans foreign companies from participating in domestic express delivery, citing the original 1986 Postal Law that limits domestic delivery of regular mail to the government-owned China Post.

1986?  In China in 1986 it took an entire day to mail a letter!  We had to, literally, make our own envelopes, painstakingly cutting out a template from paper and then using paste thoughtfully provided by the post office to glue them together.  Then you had to let them dry before stuffing them with your letter.  You ended up with glue all over, trying to cram a sticky mess in a drop box with fingers webbed like Aquaman.  And if you wanted to send a parcel in China, fuggitaboutit!  You had to purchase white cloth and make your own bag in which to put your items.  Seriously, I am not making this up.  Around the post office were stores selling fabric, needles and thread and you had to form your own sweatshop on the steps outside the post office to assemble your package for mailing.  I had flashbacks to 7th grade home-economics class, nearly failing for improper needle threading and insufficient stitch tightness.  Who knew that I was actually learning life skills that would come in handy some day??

Anyway, I digress …  This new and unimproved interpretation of the Postal Law is going to be a serious setback to the entire postal system in China.  Plainly speaking, the foreign delivery companies have, for the most part, cracked the code in express delivery in their home markets.  Pretty much anywhere in Europe or North America, if I want something delivered by 10 a.m. tomorrow morning, its going to get there.  I might have to take out a second mortgage on my house to do it, but dang-it, its going to get done!  Now, I don’t for a minute think that any express delivery company would be able to quickly transplant their system in China … China is too big and too complex to do that simply.  But the China postal system could certainly use some external influence and best practices … mailing a letter by regular post is a hit-or-miss thing these days.  The Chinese authorities cited security reasons for keeping the foreigners out … I guess news of the express-delivered anthrax a couple of years ago in the U.S. freaked some people out here.  But seriously, can the Chinese postal system do any better??  I guess in one way they can – with such a dismal delivery rate for their mail the insidious package can’t do any damage if it never reaches the intended receiver.  Let’s hear it for incompetence!

The last indicator that something’s up is the rumor – at this point unsubstantiated – that China is going to once again be very restrictive in issuing visas this summer and into the fall.  This year marks two very important anniversaries in China: the 20 years this June since the Tiananmen Square movement and 60 years this October since the founding of the People’s Republic.  Like with the Olympics last year, China wants to keep out anyone who might make a placard and march on the streets, shouting their support of any one of a number of banned issues.  Hong Kong’s South China Morning Post published a story last Thursday saying that Beijing has said that all “F” business visas issued after April 15th will expire on September 15th.  An F visa is for short-term stays of less than 6 months.  The paper quoted several China visa agents who said that applications for F visas beyond September 15th would be put on hold until there were more clarifications from the government (who, like any government, avoids clarity like the plague).  Again, there have been no confirmed announcements of this, just newspaper articles … so let’s not wig out until we have to.

But shy of wigging out, I think there is some indication for concern here. There is DEFINITELY a protectionist wind blowing in China and with it could come a storm that could hit us all.  There are two sides of this coin here:

First, remember that Chinese regulations are often published but never – or are selectively – enforced (on a side note, the converse is also true … China has been known to enforce rules for which they do not allow the publishing of the official law … I have heard stories of people being prosecuted for breaking a law and were refused the request to actually read the law on the basis that the law was a state secret).  What this means is that there are varying levels of sensitivity in China – if you are a big company and are doing big things in China, the light shines more brightly on you and you have to take more care to cover your bases.  All the big Fortune 500 companies working in China spend squillions of dollars each year in lobbying efforts in Beijing and in the various localities in which they do business.  This is just good business practice (hey, they even do it in Washington!).

But for many companies, they work hard at doing a series of smaller things in order to stay below that radar and to not attract attention.  In any M&A deal we do in China, one of the biggest commercial due diligence questions to probe is how the regulating authorities will treat the new entity once it has foreign ownership.  Chinese companies can get away with things that foreign companies cannot, simply because they are foreign companies (and, contrary to popular practice, having local staff often does not protect you … the spotlight is just brighter on you when you are a foreign company).  So the lesson here is to explore all the possible regulatory implications of what you are doing in China … not just the laws on the books but to talk to all the authorities who touch your business to get their read on what might actually be enforced.  Your business leaders here – your general managers and CEOs – should be spending a large amount of their time schmoozing with the authorities here.  If they are not, you are exposed.

The second thing to remember is, simply, that China is different – it is a one-Party system and that Party is primarily concerned with maintaining their singular hold on power. On a global scale, it is not the riskiest place to do business – that honor is held with dictatorial grip by some southeast and African nations.  But it is comparatively riskier than doing business in the West.  Walk the streets of Shanghai and you can often forget that – the signs for Western products and services make it seem like New York with a really big Chinatown.  But its not.  China is different from other markets.

And, truthfully speaking, I often forget this.  Therefore, I have made myself a May Day resolution (my New Years resolutions having drowned in the Ocean of Poor Self Discipline long ago) – I resolve to be more observant of some of the macro-regulatory moves here and to not be so flip and dismissive of them when they do happen.  I firmly believe that China is moving towards more openness … my last quarter century hanging around here is proof of that.  However, these changes progress at glacial speed with short-term freezes and retreats in the midst of forward movement.  Whether what we have been seeing recently is such a momentary freeze or the tip of a larger iceberg remains to be seen.

Download this podcast
Download audio file (20090203_how_to_mess_up_a_deal.mp3)

Full transcript of today’s podcast:

In a recent podcast, I talked about how we at Technomic Asia think that many sectors in China today are in a “pre-consolidation” phase where, we believe, that we are going to see a lot of the smaller companies in many industries falling away and the bigger ones getting bigger. I talked about the potential for some interesting acquisition plays in 2009 for the right company to come in and lead this consolidation. We’ve had some really good response to this podcast and some good questions so I thought I would continue the topic this week.

I was in a meeting a couple of weeks ago with a client of ours, a foreign consumer products company that is looking to acquire a local company here in China. One of my senior managers and I were talking with their division president from their overseas headquarters and their China GM in charge of this division, along with various other financial and legal reps on their deal team. We were talking about the M&A process in China – what to do, the pitfalls, how long it takes, etc.

The Big-Big Boss asked me the question that EVERYONE asks in this situation: “What are the chances of success for doing a deal in China?” Not able to resist a chance to be smarmy, I responded, “Well, if you do it right, you’ll probably see over a 60% hit rate. But if you want to mess it up – and most seem to be wanting to do that – the rate is closer to 25%.”

Thankfully, the Big-Big Boss got the distinction and my lame attempt at injecting humor in a very serious question. Then, better than any straight-man in a comedy team, asked me the next question, a great set up: “So, Kent, how would we really mess this one up?”

So in this week’s podcast, I am going to tell you, verbatim, what I told this deal team and am titling it, “China M&A: How to mess up a deal, possibly wrecking both your company and your career.” OK, I didn’t quite respond with that level of sarcasm, but you get the idea…

So, here, in order of importance, are the 4 steps to doing a bad deal in China:

#1: Make no attempt to understand the market environment in which you are acquiring a company.

You are thinking to yourself, “Oh, this is going to be a good podcast, starting out stating the obvious like that.” But you’d be surprised at how many companies come to China to acquire a company and they don’t really understand the market environment in which the targets live and work. We were contacted recently by the CEO of a company who wanted to look for acquisition targets making a certain kind of product. There are, conservatively, about 500 companies doing this type of product in China. I asked him what applications were most attractive; what types of distribution they needed to have; did they need R&D; how about certifications? There was a pregnant pause and the CEO said, “I don’t know, they just need to make the product.”

No. Wrong answer. Successful China M&A starts with a deep understanding of the market and a VERY detailed checklist of the criteria of an attractive candidate, the criteria that makes the target attractive in THIS market. If the market I am working in has a particularly fragmented distribution structure and several key customer segments, then I am going to want to look at the targets that have both solid distribution and a really good sales team into those customers. It sounds really simple, but again, you’d be surprised at how many companies overlook this when coming into China.

You are going to want to pay particular attention to the requirements for distribution in China. Too often, we see foreign companies come here with what they think is a “great product” but since they don’t understand the often-fragmented distribution chains here, they don’t really know how to get it to market. I would say that nearly all of the acquisitions we do here put “effective distribution” very high on the list of criteria for assessing targets. Distribution is the one thing that takes a long time to build in China and tends to be regionally fragmented. If you can come in and buy that distribution and start to run your own products in parallel with the target’s, then that can be a “win” all around.

So though it might seem obvious, get a shopping list together before you head into an M&A program. Deep dive the market to understand what products are out there, what customers want, and how the competition is getting product to market. Only then will you be able to determine the list of criteria that makes for an attractive target. We typically spend the first part of a project developing and refining that list – it might seem tedious at first, but if you have a good criteria list, then it makes the rest go much faster.

#2: The second way to mess up a deal in China is to go after the first company you find.

A good M&A process – like a good sales process – starts with a good pipeline. If you have a number of prospects in your sales pipeline, you are going to be able to work all of them at the same time. The right ones will close and some will fall away. If you have only one deal in your pipeline, you are going to kill yourself to close it, even if it is not closeable.

The same goes for M&A – if you only have one company you are considering, and if you REALLY want to do a deal, you are going to do whatever you can to make that deal work, even if it is the wrong deal. You should arrive at your acquisition targets through a rigorous process of elimination, starting with that criteria list I talked about. Take that list and find as MANY companies in China as you can that come anywhere near fitting that list. Then start doing commercial due diligence on them, all at the same time. Get as much information as you possibly can about all of them, and then you can compare this information and benchmark them against each other.

“How many” companies should I consider, you ask? It might seem like an unanswerable question, but those are my favorite kinds! In truth, I think you need to have at least 10 companies on your “Long List” – this is the list of companies that somehow operate in this market and on which you have a certain high level of intelligence (and in some cases, we’ve had as many as 30). Then I think you need to have at least 2-3 on your “short list” … these are companies that you have researched very deeply and know a LOT about them. You know their commercial practices (distribution, pricing, bribes, etc.), manufacturing (processes, costs, suppliers, etc.) and their management (who they are, where are they from, what is their reputation, who really owns the company).

Your short listed companies should have also indicated a level of interest in doing a deal with a foreign company. We’ll talk below about HOW to approach them but, for now, hear what I am saying: You should have at least 2-3 companies that fit your criteria and who have shown an interest in doing a deal. Certainly, you will prefer one over the others, but at least you’ll have back-ups. If you have only one option, you are, essentially, going into a deal and are trying to “marry your first date”. You could be in trouble. You NEED options and it is your responsibility to go find them.

#3: Ignore the importance of relationships in China

The 3rd way to mess up a deal in China is related to the first … and that is to ignore the importance of relationships in China when starting deal discussions. The Western way to get a deal started is often to have the CEO of one company call the CEO of another company and they start talking. Sure, sometimes intermediaries like brokers or investment banks are used, but direct is a valid approach as well and is often preferred. At least in U.S. business culture, “directness” and “openness” is valued and boss-to-boss communication is often the best way to do that.

Too often, we see foreign companies use this same method in China, going directly to a potential acquisition target and start discussions, saying too much, too soon, before they have done any kind of due diligence on the target. They even rely on the target to tell them about the target’s business and the market. But in China, where standards of accounting and business practices are still in their early stages, you cannot rely on a target to either really understand their market or their company the way YOU need to understand them. And in Chinese business culture, going through intermediaries is often preferred so that both sides can explore things slowly without having to confront the principals directly and risk either side losing face.

The consumer products company I was talking about in the introduction to this podcast fell into this trap. They are a large, well-known global company with a very large group of super-smart MBAs in their deal team. When they want to do a deal, they send these Men (and Women) in Black who do a deal the way they are used to doing a deal … approach the target, sign an NDA, validate the target’s financials and go from there. Well, they basically did that here in China … before getting ANY market intelligence on the target, they approached one of the biggest players in the China market and started talking about ways they could cooperate. The target was, of course, VERY interested in this large, well-known company that wanted to do a deal with them, but they were a bit befuddled as to how to properly respond. So they did the only thing they knew how to do and they pulled out all the stops to show what a good acquisition target they could be and why a VERY high price would be justified. After many months, LOTS of documents being passed back and forth (including letters of intent that discussed possible valuations) not to mention untold dollars spent on the deal team’s resources, the Western company’s senior management suddenly realized that what they were hearing from the target did not seem to make sense in the market and that they had no objective view of the target or the market.

That’s when they called us, to come in and do the due diligence on the target – which is fine! We love doing this and we are VERY good at what we do. And in this case, we found out that there were some huge problems with the target: they had been losing market share rapidly, their management was clueless and many of their distributors were angry and in danger of jumping ship (none of this information, of course, was included in the presentations that the target did when our client approached them directly … then everything was hunky dory and getting even hunkier and dorier!). This is NOT an uncommon finding in China; however, since our client had already had very deep discussions with the target – including discussing deal structures and valuations – there was no room to move with this new information.

If our client would have done the commercial due diligence FIRST, before ever approaching the target, then they would have been MUCH better prepared to discuss the details of a deal and would have had tons of objective market intelligence to challenge the target with.

We did a program like this a few months ago, for a large high-tech company where we had 9 China targets on the “long list” and on whom we did a pretty deep level of due diligence. Two companies came out of that effort as the leading targets – we knew who they were, their ownership, their advantages in the market, their warts. Everything! We also were able to get a high level of confidence from the target’s ownership that they were interested in talking to a foreign company about potential hook-ups.

The key here, is that we were able to get all of this information ANONYMOUSLY … none of the 9 companies knew who our client was. Now, we were able to put our client in a VERY strong position where they know a lot more about the targets than the targets know about them. We can make the introductions and continue to act as a “middle-man” of sorts to facilitate the communication. Our client is able to keep the conversation going with several of the targets at once, only committing themselves once they absolutely have to (usually around the time that they need to sign an LOI).

If our consumer products client had done this, knowing what they know now, they might not have approached their target at all. But like my point earlier, they had NO back-up plans … they didn’t have a short list … so there was no where to go from here. It is really too bad because our client wasted a LOT of time, effort and money to get to a point of no return and they had to start at zero again.

#4: Relying too much on financial wizardry

The fourth and final way to mess up a deal in China is to assume that the value you create is going to be done through balance sheet re-engineering and NOT through improving the commercial practices of the target. In the West, the heroes of the M&A deal teams are the financial wizards, the quant jocks who can read a dense balance sheet like a primary school textbook and then apply complicated techniques to squeeze more value out of it. A Private Equity firm we work with did just this with a recent acquisition of a $25 million company, finding an extra $1 million in EBITDA that the original owners did not have the experience to locate. I am not naïve here … of course this is not the ONLY value that is created from M&A in the West, but it is a key goal for many acquiring firms, be they strategic or financial.

But in China, this does not work so well; rather, value in an acquisition is created by helping the target become a better player in the market. To a great extent, this starts with very often not having an accurate balance sheet at all … remember, you ask a Chinese company to show you their books and they will often say, “sure, which ones?”. This even applies to the larger, publicly traded companies – we found this to be very true in the due diligence we did on this consumer products company – there was a broad discrepancy between their stated sales and the actual tax receipts that could be associated directly to those sales.

No, foreign companies who acquire Chinese companies need to be thinking, first and foremost, of creating value by upgrading the target’s commercial practices, working with them to find the right products, at the right prices going to the right customers through the right channels. For the consumer products company, we identified big gaps in the target’s distributor management processes that were contributing to their loss of market share. Our client is quite well known for how they manage distributors and, though their practices would need some “China-fying” we identified several key areas where value could quickly be created.

With our high-tech client – the one with the 9-company long list – it was a different situation. The targets had very good channel and distribution practices (this was one of the key criteria for selecting them); however, what all of them lacked was a solid foundation in R&D, an area in which our client is a global leader in their sector. We identified areas where upgrading the targets’ R&D capabilities could reap great rewards in the market, by promoting Western technology at a China price.

The value created is, of course, very different in each situation – but the fact remains that, more often than not, this value is going to be in the commercial area and NOT in reorganizing the balance sheet.

So…if you really want to mess up a deal and risk destroying both your company and your career, I just gave you the roadmap! I am assuming, of course, that this is NOT the case. So what should you do?

Well, if you already have a target identified, sit with your deal team and assess what you do or do not know about the China market situation (point #1 above) and what other possible targets might be out there (my point #2). If you are in talks with a target and find that things have stalled, a good way to shake things up is to start talking to another target: it provides you with some perspective and signals to the first target that you have options!

If you are just considering growth in China via acquisition, then you have the freedom to start things off correctly. Walk through points #1 and #2 by fully understanding the market and all of your options. Then you can find a way to approach these targets in an IN-direct fashion and find ways where you can add value by improving their commercial practices. Trust me, when you reach the point of pulling the trigger on a deal, you will be MUCH more confident if you’ve first eliminated most of the ways that you could possibly mess it up.

Thanks again for spending time with us. Remember our motto – and it particularly applies to M&A in China – “In China, everything is possible but nothing is easy.” We’ll see you next time on the China Business Blog and Podcast.

Download this podcast
Download audio file (20081029_signs.mp3)

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!”

Download this podcast
Download audio file (20080828_forming_alliances.mp3)

The following is a full transcript of today’s podcast:

KENT KEDL: Newsflash. The U.S. economy stinks. Now I know I do not have the academic credentials to make an educated pronouncement about this – then again, a Master’s degree in Chinese philosophy qualifies me for very little – however, I think it is safe to say it is true. The Republicans thinks it is too many taxes, the Democrats think it is too much outsourcing, and Phil Graham thinks its all in our heads. No matter the cause, the fact remains that the U.S. economy is deep in the doldrums and there does not seem to be much hope that it will get out any time soon.

This was really brought home to me when I was back in the U.S. a few weeks ago for an all-too-brief summer holiday. I try to get back to the U.S. several times a year to visit family and clients, and it is always an education. No matter how informed I try to be here about what is going on back home, simply reading news stories does not give one the full picture, particularly the current status of emotions in the U.S. business community.

So it is from these conversations with U.S. clients and friends that I reached this conclusion: the U.S. economy stinks. More to the point, the many people I talked to seemed to question whether or not the U.S. economy was worth investing in as a stand-alone investment. There was not a lot of faith that we would be getting back to the hey-days of the U.S. economy where growth was easy, foreign competition was very low and return on investment nearly guaranteed.

Notice I qualified that last statement by saying that I heard people questioning the U.S. as a stand-alone investment. This is a key point – certainly, U.S. businesses are not giving up on their domestic markets completely; however, they are considering how their domestic and international strategies can work together. And this is where I heard some rumblings of optimism among U.S. businesses, that there were some investment opportunities outside of their domestic markets which, if successful, could help grow their domestic business.

One of the key investments we see companies making overseas is some form of equity alliance with a foreign company – be it joint-venture, acquisition, merger, etc. Here in China, over the past year, we have seen our M&A practice jump to a new level as Western firms interested in the China growth opportunities are looking for good companies to align with.

But when times are tough in domestic markets, this puts even more pressure on a foreign alliance to work the first time – there is no margin for error when sales are down and capital markets are tight. Over the past few years of these podcasts, we have addressed the subject of China alliances from various angles. Today, I’d like to update that perspective and talk a little about what makes China a unique environment for alliances. This is not meant to be an exhaustive list; rather, I want to point out what makes China alliances unique and identify potential potholes in the road ahead.

One of the biggest challenges to doing good alliance deals in China (or anywhere, for that matter) is finding good alliance targets. In other podcasts, I have talked about the all-too-common mistake we see foreign companies make here by being too opportunistic in selecting their alliance partners. A common pitfall is finding a partner at a trade show – what I have called the “industrial single’s bar” – and, after a few drinks and an exchange of product literature, both sides are ready to do a deal. I won’t harp on the fact, again, that it is CRUCIAL for you to “date around”, to assess multiple alliance opportunities and benchmark them against each other and against the strategy you have in mind for China.

But when you find these companies, they will, generally, share some similarities. Assuming they are a private company (and not State-owned, a whole ‘nuther can of worms here!), it is almost guaranteed that they will be a “first generation” owner, meaning that the founder of the company is likely to be the owner or at least one of the owners. In more developed and older economies such as the U.S. and Europe, good targets can be found among second- or third-generation owners. The kids or grandkids of the founder have run the business for awhile, have made some money but have lost the original emotional attachment to the business and, in many cases, are looking for an exit strategy.

Not so in China where modern business is still measured in years, not decades (or even centuries). Private businesses were allowed here starting in the late 80s and did not start becoming popular until the mid 90s, so we are still very much in our first generation of founder/owners. These are people who have put their very lives into their businesses, risking a LOT to do so. Many of them could have settled for a well-connected job in a State-owned company but they didn’t. Many of them gutted it out and became successful as a result.
So, psychologically speaking, these owners are in a unique place when someone approaches them about a possible alliance. In the first place, they are not actively looking to sell their companies nor are they even interested in capital investment. If they are good (and typically we are only targeting the good ones), then they are fully confident in their ability to continue to grow their company and be successful, without having to give anything away or ask for anything.

I have told this story before, so forgive me if you’ve heard it, but its like my oldest daughter (now 15) when she went to her first day of preschool here in Shanghai when she was 4 years old. A very confident and outgoing child, she walked in the front door of the school, put down her book bag and called out, “OK, I’m here … you can all play with me now!!” In the same way – and unfortunately – many foreign companies think that, because they are foreign, everyone here is just DYING to work with them. They can just show up and everyone will come running.

Owners of Chinese private companies want to know what the foreign partner brings to the table. Before starting a program, we work with our clients to define, very specifically, just what they could bring to the Chinese partner. Chinese companies are often looking for access to foreign markets (particularly big-name customers) and access to brand or technology. Many of these companies know that, to be a legitimate global player, they cannot copy technology or rip off trademarks. This – oftentimes more than money – is what the foreign partner can bring to the Chinese side and make a potential alliance very attractive to both.

A desire of many Chinese companies is also to go international and this can be a key motivation for them to do a deal with a foreign company. If the foreign company has access to good channels and customers then, often, they can work with the Chinese company to expand their product portfolio by either providing a broader range of products or more price, quality and brand tiers. However, before you go offering this to a Chinese company, you must think VERY carefully about how that will impact your current business and how to avoid diluting revenues and margins with additional – often lower cost – products.

Another characteristic of first-generation owners is that their objectivity in valuations can be a bit skewed. If you have just invested your heart, soul and savings account into a business and have succeeded, you are not going to be satisfied with more “objective” calculations such as multiples of earnings or discounted cash flows. The cold, objective, CPA-driven valuations that many Western companies take can really be a turn-off to a Chinese company. When we approach the topic of valuations with a Chinese alliance target, we do it very carefully and slowly, helping them see just how the foreign company is looking at the deal as well as the final numbers.

Very often, I will represent the foreigner’s perspective and will say to the Chinese partner “You know, we foreigners have our own way of looking at things and the board of directors for Company X is no different. This is how they will be doing their valuations…” and I launch into a description of the criteria and methods our client will use. But then I continue, “However, we all know that there are many more issues that need to be taken into account when evaluating your company and we want to make sure we are able to capture all of them.” Then we start to have the conversation about the assets – tangible and intangible – that the Chinese partner brings to the deal and start drilling down into the details of just how valuable they really are.

For example, we just went through this with a Chinese company that a client of ours is considering doing an alliance deal with. The Chinese company, though small, has captured some very big customers, in particular the largest Chinese company in this industry, a Big Name. The Chinese target is, rightfully, proud that they are a supplier to this Big Name and they point to this as being a reason that they are such a valuable partner. However, when we started digging down into the actual metrics of this relationship, the picture changed – we discovered that the business the target was doing with the Big Name was barely break even and, in fact, had prevented them from serving other, potentially more profitable, companies in a similar space.

After some time – and it did take some time – the owner of the target company started to see that maybe this Big Name was not such a big deal after all. In fact, this started a very good discussion about how, with our client’s participation, they could both go after even bigger names and could demand the kind of premium that would result in a sustainable, profitable business. And, in addition, we were able to get to a much more reasonable and agreeable approach to valuation.

Finally, these first generation owners – while very “modern” by Chinese standards – are still often very traditional in that relationships are of central importance to them. All of them, without exception, cultivated good relationships to get them where they are today. And I am NOT saying that they succeeded only BECAUSE of key connections which, to foreign ears, implies some form of under-the-table dealings. In some cases, this is true, but that is fairly easy to discover in a rigorous course of commercial due diligence. No, successful Chinese companies got that way because they sought out and nurtured relationships all along their value chain – from suppliers, to customers, to regulators and even competitors. They work very hard on getting and maintaining these relationships.

In the same way, they are going to judge the value of a potential partnership on the basis of the type of relationship that they are going to be able to build with you. You might dazzle them with your company’s success and the animated PowerPoint slide show about how you are going to dominate the market might be kind of cool, but they will follow through with an alliance ONLY if they trust you. There is no set path to developing these relationships – suffice it to say that everything you do, every word you say has an impact. If you are truthful and fair in the due diligence and the negotiation process, then chances are you will be able to continue that going forward. If you are cheap and are trying to “win”, then you can just give up now – because even if you “win” the deal, you are going to loose the business eventually.

A very practical way to show the importance of this relationship is to clearly identify the role of the owner going forward. The fear of every business person is to go from owner to employee. And, even though the org chart might say “employee”, no former-owner should be made to feel that way. In China, it is appropriate to just “hang-out” … spending an afternoon having a conversation. I would recommend that the role of the owner be a topic for several of these sessions. You are not going to solve it in one sitting, but if you keep returning to it and talk about it over time, you will show that you are serious about it and you will get to a conclusion that feels right to everyone.

A Chinese friend of mine asked me yesterday what I thought of the U.S. economy and what the chances were of recovery. “I don’t know,” I told him, “I don’t think anyone knows. We are such a new territory here – while the U.S. has certainly seen some down economic times in its history, never before has much of the rest of the world been as strong. This is certainly a threat in that, if they U.S. cannot bounce back or find their feet, then other global economies will come in and fill the vacuum (and one might argue that this has already happened in the manufacturing sector, particularly for commodity goods). However – and I hate to sound like a bad fortune cookie here – with every threat comes and opportunity, and a well-planned alliance in China could be just that opportunity.

Thanks for listening to the China Business Podcast. Remember, in China, everything is possible but nothing is easy. We’ll see you next time.

Steve’s session is titled “M&A Opportunities and Challenges in China,” and he’ll address:

• Recent developments in M&A in China
• Review of the process and its differences from the West
• Finding good prospects
• Pitfalls in due diligence
• Key principles of success

The conference site has more info about the conference topics.