China: The Elusive Market For US Technology Companies

China ranks as the world’s largest country by population, second in annual GDP and is likely to rank second in terms of total Information Technology (IT) spending in 2013 at about 10% of global IT spending.  It is estimated by industry analysts that China will grow its IT spending by close to 10% per year over the next decade as IT spending only represents about 2% of its GDP which is less than half the level of more developed countries like the US.  While China represents a large and rapidly growing market for US technology companies, the path to success in this market has proven difficult and sometimes impossible due to indigenous suppliers, intellectual property protection and software piracy issues, pricing challenges and other unique market conditions.  China has also grown its own global technology powerhouses in certain industries like communications equipment and personal computers, materially impacting the competitive dynamics for traditional US and European players in not just the China market, but also the entire global technology market.  Finally, China has also developed its own Internet powerhouse companies that have made it difficult for leading US Internet and social media companies to succeed in China.   Is China “friend or foe” for US technology companies, and has history provided technology companies any lessons on sustainable business practices that can be applied to the Chinese market?

 

Over the past three decades there have been many failures and lackluster successes by US technology companies seeking to enter and profitably grow in the China market.  A high profile example was Google, who decided to exit the China market in 2010 after only about five years of formally entering the market with its own development center in China (and an earlier failed attempt to acquire local competitor Baidu).  Baidu’s market share only increased from the mid 40s to the mid 60s in the five years following Google’s entry, which was significantly higher than the 30%-35% share that Google was able to achieve during that period.   While Google pointed to censorship issues as the main driver to leaving the China market, it was also clearly the case that Baidu did a better job of understating the local market (e.g. Mandarin language searches, music downloads that “crossed” the line on piracy issues etc.) which contributed to Google not being a success in the search engine market in China as it was in other markets around the world. 

 

Google was not the only US Internet giant that failed to achieve its goals in China, as Yahoo and EBay entered and exited as well.  Both used acquisitions of Chinese-based companies as part of their respective entry strategies, but Yahoo could not effectively compete with Baidu in the search market while eBay lost out to Taobao.com (owned by Alibaba) in the online auction market.  In both cases, both eBay and Yahoo did not do a good job in understanding the local China market nuances for search and on-line auctions. Yahoo at least made a financially smart decision to exit the market and invest in competitor Alibaba, which took over its Internet operations.  It is estimated by some analysts that Yahoo’s investment in Alibaba is worth 50% or much more of Yahoo’s current market capitalization. 

 

In all the cases above, US Internet companies stopped their efforts in China within about a five-year period.  While the Internet may move a rapid pace of innovation, business success in China, especially in the technology sector, takes a much longer-term commitment.  Google’s former CEO, Eric Schmidt, initially stated that China had 5,000 years of history and Google would have 5,000 years of patience in China.  As it turned out, Google, eBay and Yahoo only had about 5 years of loss-making patience.  Unfortunately for US Internet companies, China continues to grow much faster than the US in on-line sales and is likely to surpass the US within the next couple of years as evident by China “crushing” the on-lines sales record on November 11th, 2013 as part of China’s annual “Single’s Day” national promotion.

 

The concern over protecting IP and pirating software has been an obstacle for US technology companies seeking to expand their sales business operations in China.  Taking legal action by US technology companies has often backfired.  For example, Cisco Systems’ first-ever corporate lawsuit on IP was against Chinese based Huawei in 2003, which allegedly copied Cisco manuals and software code.  Cisco dropped the lawsuit in 2004 after remedy actions by Huawei, but in my view the lawsuit cost Cisco more in reputational risk than any benefit from the lawsuit.  To this day, China represents less than 5% of Cisco’s total sales in China and the company often highlights China as being “unique” for Cisco when discussing its sub-par performance in the country.  Microsoft has faced software piracy issues around Windows for PCs in China since the company entered the market in 1992.   The issue of piracy in China is still an issue today for Microsoft as evidenced from its recent earnings call where it disclosed for the first time the performance of its Windows business with and without China (i.e. Windows is declining more rapidly in China than the rest of the world).  Microsoft is hoping to reduce piracy of software by selling cloud-based versions of its consumer software, thus, hopefully eliminating over time the availability of pirated software disks sold on the streets.

 

Cisco’s problems in China have intensified recently as the company’s orders from China fell 18% in its recent October 2013 quarter. Cisco is likely feeling the backlash of Huawei’s years of struggle and ultimate failure in building a US business, which was exacerbated by recent press reports on spying by the US National Security Agency. Other large US technology companies like IBM and HP also reported recent weakness in China and Qualcomm has made public comments that U.S. restrictions on Chinese companies and revelations about surveillance by the NSA are impacting its business in China.  As a result of these and other recent data points, there is now a growing view on Wall Street that US tech firms are seeing slowing sales in China due to the NSA spying claims. It is interesting, however, that Franco-American company Alcatel-Lucent announced the day after Cisco report its poor China results that it had won the largest market share in China Mobile’s network for Enhanced Packet Core (EPC) technology among all vendors (including Chinese based vendors). Alcatel-Lucent sells in China through a joint venture established in 1984. Perhaps Alcatel-Lucent is not feeling the same issues as other large US technology firms because it is technically a French company, but it’s long standing JV and the relationships established by this JV in China also has likely played a role in its ability to so far overcome the political backlash that other large US technology companies have experienced.

 

While China based Internet companies like Baidu (search engine), Alibaba (e-commerce) and Tencent (social media and gaming), have generally become dominant in their home market, China based IT centric companies Huawei and Lenovo have established global businesses which have led to weakening fundamentals for Western suppliers of communications equipment and personal computers.  Huawei generated sales of $35.4 billion in 2012 and is now comparable in size to Western leaders Ericsson and Cisco.  The dramatic success of Huawei over the past fifteen years contributed to the bankruptcy of Nortel, the failed mergers of Alcatel with Lucent and Nokia with Siemens, and the lackluster stock performance of Ericsson and Cisco.  Lenovo became the world’s largest supplier of personal computers in 2Q13 with both IDC and Gartner estimating their market share at 16.7% surpassing both HP and Dell for the first time.  In 2009, Lenovo ranked fourth in the world in PC shipments with about 7% share.  While HP and Dell continue to suffer from the fundamental shift from PCs to tablets and smartphones, the loss of market share to Lenovo over the past few years intensified this fundamental issue for both companies and was likely a contributing factor to Dell deciding to go private through an LBO to realign the company and pursue a more Enterprise IT and Services strategy.

 

While US Internet companies and global IT equipment suppliers such as Microsoft, Cisco, HP and others have had either difficulties succeeding in the China market, or face significant competitive pressures from China based IT global competitors such as Huawei and Lenovo, there are examples of US technology companies that have succeeded in selling in China and competing globally against Chinese based competitors over an extended period of time and who so far, have not publicly acknowledged any political pressure on their respective businesses.  Two such companies are Apple and Corning.  Apple currently generates about 15% of total sales from Greater China and its operating margin in China is generally comparable with other regions.  This level of success has been achieved with Apple not yet selling iPhones to China Mobile, the largest mobile operator in the world based on subscribers.  Apple has also been vocal and active on improving working conditions in China among its supply chain companies including conducting annual audits on its suppliers; thus, thus likely helping its reputation in the country.  Corning has been in China for 25 years and competes effectively in catalytic converter substrates, LCD glass display and fiber optic cable.  The Greater China Region represents 26% of Corning total sales and is the company’s largest country by annual sales.  Corning attributes it success in China to having a very long-term perspective, developing relationships with key leaders at the local and national level on important issues such as IP protection, investing in local manufacturing and developing extra checks and balances on potential IP protection issues. 

 

While there is no magic formula for succeeding in the China market as a technology company, there are some common threads among companies that have shown success in the market.  These include, truly showing (not saying) a long-term commitment to the country, developing key relationships (including JVs) at the local and national level to help support a fair playing field and protection of IP, local manufacturing through long lived assets and R&D, understanding the risks of reputational damage when taking legal or other public action against a local company and enacting unique processes to help ensure IP is maintained.  Having products or a distribution of products that make pirating or copying of your products difficult, is also a big plus.

 

Note: The above article first appeared in the November 2013 issue of “The Cornerstone Journal of Sustainable Finance & BankingSM