Key drivers and success factors for Chinese companies going abroad

Key drivers and success factors for Chinese companies going abroad Enrico Lanzavecchia Director Claire Zhong Manager China s Outbound Direct Investment (ODI) has been increasing sharply and is likely to continue this trend in the next year. ODI structure is concentrated in Asia and oriented towards natural resources, which may diversify in the future. From long term perspective, Chinese companies should consider three key drivers to go abroad: exploit market opportunity; accelerate technical and business skill evolution; improve the overall risk or opportunity profile. Although going abroad is a complex process, there are many lessons and experiences developed by other countries, and Chinese companies could learn to manage successfully this process by addressing critical issues. China s Outbound Direct Investment (ODI) increases sharply A consistent growth of current account surplus has accumulated huge assets either for foreign currency reserve or for outbound investment. Under the macro scenario that China growth model is changing and Chinese government has strongly supported Chinese companies to go abroad through series incentive policies, China s ODI has been increasing sharply, with narrowing gap between ODI and Foreign Direct Investment (FDI). Chinese Outbound Direct Investment increases sharply China current account surplus evolution CAGR 03-08 US$ billion 450 400 350 300 250 200 150 100 46 50 56% 426 372 253 161 69 0 2003 2004 2005 2006 2007 2008 China ODI, FDI and outbound M&A evolution US$ billion 100 80 60 % of outbound M&A vs. ODI 54 61 60 66 75 92 52 ODI FDI Outbound M&A CAGR 03-08 Sharp decrease due to financial crisis 12% 43 40 27 26 21 20 78% 12 12* 6 8 7 6 3 3** 3* 121% 0 2003 2004 2005 2006 2007 2008 1H2009 17% 45% 53% 39% 24% 5 22% * 1H2009 ODI data not include outbound investment for financial sectors; M&A data is from Merger Market database ** 2004 Outbound M&A data is calculated based on growth trends between 2003 and 2005 Source: Ministry of Commerce, Sate Administration of Foreign Exchange; Statistic Bureau, Value Partners analysis Nevertheless they still represent a much smaller fraction of GDP vs. other countries. By 2007, China s cumulative ODI is only 3% of GDP, while in the same period UK is 61.5%, France 54.7%, German 37.3% and USA 20.2%. Such a low ODI reflects that Chinese companies still rely heavily on domestic market as well as resources. Going forward, along with GDP growth and globalization of Chinese companies, there is a huge potential for an increase in Chinese ODI. 1

In terms of ODI geographical and industrial structure, Chinese companies used to go to closer new markets where they could leverage on established supply chain and familiarity with local markets. A shift to North America and Europe, though, indicates they are going to mature markets for new markets and business capabilities. Competing for natural resource has been consistently the main theme of China s ODI, conducted by huge State-owned enterprises (SOEs). Since 2006 Chinese financial institutions started to buy aggressively overseas assets thanks to the whole industry quick growth and huge funding capability after their spin off of Non Performing Loans (NPL) So far a large share of China S ODI flow has been concentrated geographically in Asia and oriented towards natural resources and commercial services ODI by regions ODI by industry sectors 10 10 10 10 10 10 10 10 10 10 2% 1% 2% 2% 1% 1% Asia 3% 5% 2% 3% 4% 6% 3% 4% Latin America* 9% 5% 3% 3% 4% 3% 6% Africa 3% 6% 3% 22% 19% 14% 8% 6% Europe 17% 6% North America 18% 36% 32% 48% Oceania 53% 26% 44% 33% Energy & mining Commercial service** Financial service Manuafcturing Other sectors 63% 61% 53% 55% 36% 43% 63% 48% 33% 4 14% 15% 2003 2004 2005 2006 2007 Possible over count % of Asia and LA, because companies report the first stop of investment (HK or Tax heaven) instead of destination 2003 2004 2005 2006 2007 *: Mostly to Cayman Iland or BVI **: including wholesale& retail trde, transport Source: MOFCOM, Value Partners analysis Analysis on outbound M&As of Chinese companies shows that, since 2005, 85% of the large deals are related to strategic reasons. Among the strategic outbound M&A deals, 7 are aimed at gaining natural resources and entering new markets. Up to now, important drivers for Chinese companies going abroad are entering new market and gaining access to natural resources US$ billion, Jan. 2005 - Aug. 2009 No. of outbound M&A with deal size over US$ 10 million 122 18 15% 104 37 Seems to show that Chinese companies tend to adopt defensive strategy in outbound M&As 10 85% 3 34 28% 21 17% 12 Deal Value Total Finance Strategic Access to resources Access to new markets Access to skill/tech. Access to product facilities 85.0 8.1 76.9 46.2 11.8 13.2 5.8 Top 3 countries (by Deal No.) Australia Australia Australia Indonesia Singapore UK Vietnam Top 3 sectors (by Deal No.) Media Telecom Consumer IT Source: Merger Markets, Value Partners analysis 2

If the ODI structure of Japan and Korea is compared to China, what results is that Japan has shifted away from Asia and invests more in North America, Europe and Latin America, and nearly 8 of ODI has been devoted to finance and manufacturing sectors. Korea also invests a lot in Middle East and Latin America, and sector structure is more focus on manufacturing, trade and mining. Referring to this, it is expected that China s ODI is likely to diversify more in regions and sector structure. Three key drivers to go abroad for Chinese companies Exploit market opportunity Chinese companies are sustaining relatively favorable economic performance despite the financial crisis. Despite a negative economy growth of developed countries and regions e.g. USA and European countries China is expected to keep ~8% GDP growth rate. According to a forecast by the International Monetary Fund (IMF), China s contribution to the rate of global economic growth will increase from 29.9% in 2008 to 46.4% in 2009. Affected by the recent economic downturn, stock market capitalizations of developed countries have been reduced over 15% compared to pre-crisis ones, and the same reduction happened for bank credit amounts. Foreign companies have difficulties in financing from both capital market and bank loans, leading to strong needs in capital injection. Besides, foreign companies are interested to cooperate with Chinese ones, mainly due to their interests of China markets. As commented by Dr. Tadao Kasahara, CEO of MSK, on Suntech s acquisition of MSK, one of Japan s largest photovoltaic (PV) manufacturers: As a subsidiary of Suntech, MSK will be able to access Suntech s support in terms of PV cell/module and cost competitiveness, financial resources, and channels, as well as have the possibility of pioneering BIPV applications in the Chinese market. Generally speaking, foreign markets are attractive, also considering that their consumption expenditure levels are much higher than China one. If evaluated by absolute number of consumption expenditure, Chinese purchase capability per capita is significantly lower than developed countries. According to UN statistics, in 2008 China household consumption expenditure per capita has been US$ 1,030, while in the same period USA expenditure has been US$ 32,564 and Japan US$ 21,747. Even taking into account that Chinese first and second tier cities have higher expenditure than average, there is still a big gap with developed countries, which presents big market potential, both in terms of market size and margin, to Chinese companies. Accelerate technical/business skill evolution Taking intellectual property numbers of main industries as hint of technology development level, China has still a long way to go to catch up with developed countries. In 2007, for example, the number of effective patents per 100,000 inhabitants for China mainland is 22, while Korea 1,170, Japan 968, and USA 593. Large Chinese companies have committed, in fact, significant technology investment abroad. For example, Huawei has established its R&D centres in Silicon Valley, USA, and in Banglore, India, besides hiring thousands of local talents in those centres which play a key role in helping Huawei keep abreast of the cutting-edge overseas technologies and product development. Such strategy has allowed the company to minimize the time to catch up with competitors and fully seize the rapidly changing opportunities in the international markets Some Chinese SMEs have leveraged overseas technology investment to upgrade their market positioning. Pearl River Piano acquired, for instance, R&D centre of Rudisheimer, obtaining its technology in piano manufacturing and gaining 4 market share of USA s vertical pianos segment. It acquired later the R&D centre of Herman Miller in the USA and further expanded its market share by leveraging its techniques in Baby Grand Pianos, a piano design in line with modern American furniture styles. For most Chinese enterprises, expanding in the global value chain is a shortcut to acquire complementary business skills. They could obtain overseas R&D centre, and leverage on the local high-tech incubator to accelerate innovation, or develop a global brand to enhance the anti-risk capability and profitability, or leverage on a local network to penetrate effectively in local market, or acquire talents, gaining local expertise, which are crucial for Chinese enterprises to build up global competitiveness. 3

Chinese companies could strengthen their skills portfolio through overseas investment Assessment of Chinese companies positioning along global value chain Industry R&D Raw material Manufacture Brand Distribution Customer services Home appliances Lack of highend product Improved sharply, while industrial crafts gap still exists Own brand and OEM coexist, Lack in player Some enterprises has set up his own outbound Plastics Imitation Limited investment in R&D Large production capacity and low price Mostly own brand Lack in player Mostly wholesale Clothing Mainly imitate Lack in design and innovation The raw for need to be imported Large production capacity and low price Mainly OEM Lack of own brands especially in high-end market Few players set up their own network Consumer goods- Electrics Improving rapidly while know-how is limited Large production capacity and low price Mainly OEM Lack of brand Few players set up their own network Toys and children's Weak design capability in high-end The raw for need to be imported Overcapacity in traditional while lack in high-end ones Mainly OEM Lack of own brand Few players set up their own network Source: Industry research, Value Partners analysis Exploit market opportunity Although China is the largest country in population and is growing fast, in many leading industries the Chinese market still accounts for a limited share of global demand and will do also for the near future. For example, China market value as % of global market are lower than for banking, construction, chemical and telecom industries. In many industries, domestic market hides significant temporary ups and downs, and companies, that have diversified their business abroad, could have the opportunity to offset the downturn impacts. Considering several industry sectors already face the risk of short-term saturation or slow down, it is important for companies not to over bet on local market. 4

Chinese companies could strengthen their skills portfolio through overseas investment %, growth rate Growth of Auto industry 4 2 Growth of chemical industry 2 China world 2001 2003 2005 2007-2 -4 Growth of construction industry 3 2004 2005 2006 2007 Growth of consumer good* industry 2 2 2001 2003 2005 2007 2009 2011 2013 * Consumer good without food market value Source: Global Insight's Global Construction Outlook 2008, Datamonitor, Euromonitor, EIU; Value Partners analysis - 2002 2004 2006 2008 Lessons and experiences developed by other countries For Chinese companies, going abroad seems to be a complicated process due to their lack of international experiences. A study on Chinese failed cases for going abroad suggests that Chinese companies have some key weaknesses. For example, they have limited knowledge of international markets, including market situation, regulations and customer. Besides, there is also limited availability of managers who can operate in international context, with language proficiency, foreign culture understanding and social network. Last but not least, they seem to lack systematic process, e.g. in strategy definition, roadmap development and execution process. Referring to developed countries experiences, Chinese companies could well prepare for some unavoidable issues: culture clash: generally speaking, English proficiency is limited for Chinese, and Chinese vague communication style is different from the direct style of western business practices. Besides, Chinese mix work and life attitude has big gap with European work and life balance attitude; higher uncertainty in global context: quick change in global social, environmental, technology and business trends could lead to systematic risks, e.g. financial crisis, regional conflicts; lack of availability of many professional managers who have solid overseas business experiences and local background; stronger social tension: needing to manage multi-national environment in house, while externally needing to deal with local government, communities, partners, etc. Developed countries have accumulated many overseas investment experiences to tackle these basic problems, which could be valuable references for Chinese companies. First of all, building dedicated team that focus on international expansion, including recruiting local professional managers with international business experiences, asking help from third-party professionals e.g. consulting firm, lawyers, PR agencies, lobbying firms, and training on culture difference management and international communication. Besides, it is critical to develop effective international governance model. For example, by choosing an appropriate governance model according to the target country s ecosystem, e.g. cautious in shareholding investment in emerging countries due to high risks of partner default, and being flexible for transition period, for instance. 5

Furthermore, it is necessary to conduct a down to earth planning to fully understand local context and possible changing factors and to reduce setback risks. Based on that, it is advisable not only to prepare a contingency plan after considering thoroughly all the possible risks in strategy, social environment, and economy but also to have a proper exit plan. Being committed to develop local network is also important, for example, by hiring a key relation contact person who could migrate effectively in local business community and apply PR approach to promote company s commitments and contribute to local community. Chinese companies have many possibilities between the spectrum of resisting overseas investment and duplicating domestic models. The first approach could be to form alliance with peers or strong players to share resources and risks. For example, large SOE could build partnerships with other giant players in some negotiations, so to avoid internal competition and to get lower price. SMEs could form consortium with other SMEs, or work with large players as their suppliers, service providers, or partners. In addition, firms starting investment from the easiest point to build up competency step by step could be a viable way. Target areas might be the ones where the company has already done business before, or even the regions where many Chinese communities exist. The firms could set up JV with local partner, leveraging their local resources and learning local market and culture. It is important to focus on a niche market in which the company has its core know how, i.e. identifying those markets that have good return and less competitions, avoiding to compete in the mass market. its own unique know how should be strengthened and differentiated and services should be provided to local customers. Concerning organization and HR, it is best to build through practices. Organization formats could go through sales agent-sales subsidiary-manufacturing facility-full operation, with right governance structure. Chinese talents should be trained on job, and local talents should be motivated from a long-term perspective. It is also essential to adapt to local game rules i.e. changing mindset, not always distinguishing we vs. they, and to build business models that are win-win for both parties, e.g. maintaining certain levels of local employment, instead of just acquiring small expert team while firing all manufacturing labours. Last but not least, assessing critical issues in each step of going abroad could be a good approach to structure the solutions. Focusing on four steps in particular, the main critical issues could be: defining the objective: - what is the main investment target for market, technology, skills, or profits? - what is the minimum target? - what is the timeframe for the target? - how much funding is needed, considering both the whole investment cycle and the contingency scenario? - what are the main risks and how to reduce or migrate them? preparing to go: - what are the top three criteria to evaluate targets and investment results? - who are the right persons to be involved in a dedicated international expansion team? - what external resources could be leveraged on, in order to understand the feasibility and the risks of targets, and also to grant support so to make things happen? manage the process: - which is the appropriate governance model? - how is it possible to communicate proactively with all the stakeholders? - how a positive image of the company could be promoted and how branding could be established in local communities 6

integrate effectively: - what is the integration blueprint, with specific milestones, timelines, and key actions? - which are the integration plan and the governance structure during the transition period? - what is the new business model and how to implement it? - who should be appointed in the board? - how company culture can be quicky integrated and communication efficiency improved? About Value Partners Value Partners Management Consulting has been present in China since 2005, and has long term commitment to China market and its sustainable economy growth. Our 40 professionals based in Beijing, Shanghai and Hong Kong offices has supported local companies and international companies who considering to grow in China market with our solid experiences. Value Partners provides comprehensive consulting services, ranging from Strategy to Organization, and from Operation Improvement and International development to Technology support. We have assisted many multi-national companies successfully develop China business, providing Strategy development, M&A, local support and sourcing consulting. In the past years, we have supported operation of Luxury and FMCG companies, as well as Energy and Environmental areas. Value Partners has strong global functional practices, particularly in TMT (Telecom, Media, Technology) and Financial Institutions. In China we have successfully supported international banks and Financial Groups to develop China market entry strategy and M&A, and we also help top Telecom Operators to define channel strategy and improve operation. Nowadays Value Partners are working with more and more China local financial institutions and telecom industry players in strategy definition, organization optimization and operation improvement areas. Founded in 1993, Value Partners is a global management consulting firm that works with multinational corporations and high-potential entrepreneurial businesses to identify and pursue value enhancement initiatives across innovation, international expansion, and operational effectiveness. It comprises two sister companies: Value Partners Management Consulting and Value Team IT Consulting and Solutions. With 15 offices across Europe, Asia, South America and MENA, Value Partners expertise spans corporate strategy and financial business planning, cost transformation and organizational development, commercial planning, technology decisions, and change management. Its 3,000 professionals from 25 nations, combine methodological approach and analytical frameworks with hands-on attitude and practical industry experience developed in executive capacity within their sectors of focus: media, telecoms and IT, luxury goods, financial services, energy, manufacturing and hi-tech. For more information on the issues raised in this note please contact claire.zhong@valuepartners.com or enrico.lanzavecchia@valuepartners. com or one of our offices below. Find all the contacts details on www. valuepartners.com Milan Rome London Munich Helsinki Istanbul Dubai São Paulo Rio de Janeiro Buenos Aires Mumbai Shanghai Beijing Hong Kong Singapore 7