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 …

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.

Those who have been doing business in China for awhile are quite familiar with the differences between the State-Owned Enterprises (SOEs) and the Privately-Owned Enterprises (POEs).  For those of you not familiar with this distinction, let me break it down for you.  The POEs are just that, companies owned privately with little or no government involvement – they are often run by business-savvy executives with global business experience.  The SOEs, to put it succinctly, are seen as hulking, unprofitable behemoths chocked full of aging assets and run by 55 year old Party hacks in moth-eaten Mao suits and greasy comb-overs.  OK … maybe I am being a bit too hard on them, but the term “SOE” has been used as a pejorative descriptor more often that not.

After Liberation in 1949, the Chinese Communist Party brought all businesses under their control and POEs were, for all intents and purposes, completely eliminated in China (as was nearly all foreign investment when they were unceremoniously kicked out of China).  Through a series of disastrous events in the 50s through the 70s (the Great Leap Forward, the Cultural Revolution, etc.), the government proved that, not unlike their Soviet cousins, they were terrible CEOs – factories were inefficient, poorly run and churned out bad-quality junk that had no relationship to any market demands whatsoever.  That wasn’t as bad as it seemed because China retail and commercial trade was not yet standardized so bad products were also hard to purchase.  Go figure.

One of the many reforms that the Deng Xiao-ping administration started in the early 80s was captured under the Party phrase 民进国退 (min2 jin4 guo3 tui4): “POEs will advance; SOEs will retreat.”  What this meant, in effect, was that the Party wanted to get out of the business of being in business and started the long, mind-numbing, ulcer-inducing process of unwinding the complicated SOE culture … which included, for many people, guaranteed housing, education and healthcare.

Fast forward to the mid-2000s and you begin to see private Chinese companies really moving the market.  Thanks to China’s joining the WTO in the early part of this century, various sectors in the China market were opened to foreign investment, particularly retail and distribution/logistics.  This led to further (and more rapid) modernization of China’s business environment and it looked as if the SOEs were going to go the way of the dinosaur, only to be studied by business anthropologists who dug up their jerry-rigged balance sheets and padded expense accounts.

But don’t count the SOEs down for good … we see that there might be life in these old war horses yet, in part because the Chinese government and the Party (one in the same thing here) sees some advantages to keeping their fingers in the business world, particularly in areas that have remained the jurisdiction of the government such as automotive, oil & gas, media, etc.  Not to over-simplify things but these SOEs have two unique competitive advantages over their foreign competitors: first, the SOEs are not held to strict growth and profitability metrics and are encouraged by the State to get as big as possible, regardless of margin targets; and second, the government makes available an almost unlimited stock of growth capital through forced lending from the State-controlled banks.  Imagine if you, as a business executive, were told by your shareholders, “OK … here is the deal – we want you to grow this company.  Don’t worry about profits, just bring in the revenue … we have ways of dealing with the P&L.  And when you need money, just ask.  We’ve got plenty.”  Sounds like a dream scenario, right?

Well, it seems to be working and we are seeing a surge in some of these SOEs – in automotive, the so-called “Big Four” (First Auto Works, Shanghai Automotive, Dongfeng and Changan) are on a consolidation tear, encouraged by the government to acquire smaller, regional automotive companies, much like GM, Chrysler and Ford did in the early days of the U.S. auto industry.  The Chinese oil, gas and mining giants are actively looking outside of China for investment and, though they have been rebuffed by some foreign governments, are slowing expanding their global footprint.  Several of the larger SOE construction equipment companies are aggressively expanding, both inside and outside of China (as a side note, some say that this is why Carlyle’s acquisition attempt of construction giant XCMG did not go through last year … that the government wanted to maintain control in what they saw as a very strategic industry).  All of these SOEs – and many more besides – benefit from very easy capital lending requirements from State-run banks.

A recent article in the New York Times highlighted the pressures that Chinese banks are under to insure that they keep their lending capital accounts well-stocked and rumors are flying around China that the government is requiring China banks to raise their capital adequacy ratios.  Some might see this as a slowing down of lending.  However, I interpret it as just the opposite: the government wants the Chinese banks to keep good reserves of dry powder to be able to lend to those, predominantly, SOE companies that need growth capital.  It’s a “go slow to go fast” strategy if there ever was one.

All of this has led to private chats over dinners and drinks all over China that the government is trying to reverse their dictum of the 80s and say, rather, 国进民退 (guo3 jin4 min2 tui4): “SOEs will advance and POEs will retreat.”  While I seriously doubt we will ever see this in an official government document, the government’s practices are certainly encouraging this.  The SOEs are no longer run by Party hacks … their CEOs are often Western-business educated and understand very well both international commerce and the unique requirements of doing business in China.  They are dressed in Armani suits, have their hair styled and show up at the right parties, all the while maintaining their status in the Party-with-a-capital-P!

Just this past year, we’ve been involved in more competitive intelligence programs with our clients, helping them understand the ever-changing landscape around them.   It used to be that they were just interested in understanding their foreign competitors; however, more and more we see Chinese companies – and particularly SOEs – coming to the forefront of our clients’ concerns.  And given the competitive advantages these SOEs bring with them, everyone is very smart to be concerned about them.

So the question you need to answer is this – do you know your SOE competition?  Do you know who is backing them?  Who is running them?  Do you know what their growth strategies are and what their plans are to grow in the market?  Do you know what they think of you?!?  I can almost guarantee that they are no longer the lazy competitors you once knew.  You better understand them because they are a big threat, whether you know it or not.