Key word: Evolution. In the next decade, western manufacturing leaders will experience a tectonic shift in the competitive environment. Threats abound - in home markets and in the emerging country markets that have provided recent growth. Circumstances require a change in the way companies conduct business. Those that thrive will be those that adapt. In the past, oversized reptiles died because they were clueless. Today, Blue Canyon Partners offers information that will help American businesses from treading the dinosaurs’ path.
Over the past decade, many western firms have identified and targeted China’s exciting, fast-growing markets. Most had already established manufacturing and sourcing operations in China, lured by the low-labor cost environment and its potential for delivering significant cost savings. Soon, a network of western firms emerged, with many traditional supplier/customer relationships transported into China. Over time, those firms turned their attention to selling to Chinese businesses and consumers, joined by other first-time participants in that country’s markets. Many of the western companies that established a presence in China were among the “early birds” – leaders in technology and design and offering product far beyond anything previously available to China’s customers.
Most of these companies found success in China. From a base of nearly zero, China became their company’s “growth story.” They expanded year-after-year at significant double-digit rates and, within a short time, achieved enough scale to move the needle in terms of both the top and bottom lines of their income statements. A common statement in earnings releases reads, “Our continuing success in China was a major factor driving the past quarter’s results.”
Customers reached by these western firms with their leading-edge products were the elite of China, a combination of western firms operating there that needed ingredients for their export-oriented manufacturing and the highest-end of China’s own society. Western firms operating in China carried their standards and expectations with them as, for the most part, their operations in China were oriented towards production to serve western customers. They expected their suppliers in China to be no different than their suppliers in developed country markets. In fact, in many instances, these suppliers were the exact same firms. The elite consumers in China quickly became aware of the best that western firms had to offer, and had the income levels necessary to buy those products. For these elite Chinese consumers, buying products that represented the best of the west proved a statement of stature in a country where that matters considerably.
The number of elite customers rapidly grew – from a miniscule fraction of the population, to a tiny fraction, to a usually still-small fraction of the population today. As the bell-shaped income curve shifted to the right at China’s growth rate, with its 1.3 billion people, even small shifts generated huge numbers of consumers at the higher-income levels. For the western firms, doing business in China was thus a natural extension of their activities, as customers were either familiar western firms or elite Chinese with preferences much like those of western consumers.
As western firms enjoyed the aforementioned growth over the past couple of decades, a new group of Chinese firms emerged, many from the state-run or local enterprises of prior years. As pointed out in 2007 (in “China Economics: Unraveling the Mystery of China’s Low Cost,” published by Blue Canyon Partners Inc.), these firms had access to the lowest cost labor pools available throughout China and, in fact, practiced “China economics” in a way that enabled them to achieve price points almost unimaginable to western firms. Many of these Chinese firms sold to their own customers at prices that were dismissed by western companies as either the result of government subsidies or a cultural belief that they could “lose money on every unit, but make it up on volume.” Their products – often characterized as low-quality knock-offs of similar western manufactured items – lacked the sophistication and refinement of the western brands.
In many instances, these Chinese firms also developed solid manufacturing competencies, and began to be “hired” on some basis by western firms to make products for them. This created a cycle that strengthened their manufacturing skills. The western firms they worked for served as the tutor. Further, through these relationships, they were also exposed to western technology and design on an ongoing basis. For example, Haier got its start manufacturing refrigerators for Germany’s Liebherr Group (and eventually borrowed its present name from the “herr” portion of that firm’s name in Chinese). In other instances, western firms were delighted to license technology and design to Chinese startups, often involving past-generation products. That’s how Geely entered the automotive industry. Its first car was based upon the design of the Daihatsu Charade seen all over Asia with local brand names.
NO LONGER A LAUGHING MATTER
Most western companies felt these new Chinese firms in no way represented a business threat. Products, especially in the early years, were viewed as primitive – even laughable – only interesting to the low-income Chinese that couldn’t in any way afford the quality embedded in western products. Such western companies comforted themselves with the knowledge that those Chinese consumers who had risen in the income distribution were clearly signaling their preference for the offerings of western firms, even though low-cost imitations were widely available. The prevailing belief was that it would be many generations before a Chinese firm could meet the standards, regulations and expectations of western consumers. Further, in many industries, it was argued that even the primitive offerings of these Chinese firms were the product of stolen western intellectual property, a practice that might work in China, but which couldn’t be exported elsewhere.
EASTERN THREAT TO WESTERN DOMINANCE
The emergence of Chinese firms poses two significant challenges to western firms. The first involves the new face othe global competitive environment. Previously, we have written about the emerging wave of Chinese competitors that are not only successful in China’s broad middle market but also gaining stature around the globe.
We have labeled the emerging global competitors from China as “Second Mouse” firms (the label draws upon the saying “The early bird gets the worm, but the second mouse gets the cheese”) and reflects the fast-learner and fast-follower capabilities of these firms. Many “Second Mouse” firms exist. The characterization doesn’t just reflect their ability to learn from and follow the leaders from the west. These firms were also genuinely second in the race, faster than the many other Chinese contenders who started up at the same time and with the same roots. They grew to significant scale in China’s markets, and evolved from their early position as contract manufacturers to become legitimate firms. For many years, their focus remained centered on the middle markets of China. However, over time, they evolved products that were “almost as good” and at “an incredible price point,” a considerable improvement over the early knock-offs belittled by western firms. In part, their ability to achieve nearly-comparable products was due to their mastery of “Chinaeconomics.” At the same time, a significant factor reflected important elements of China’s business culture, including:
- An ability to think far outside of the box;
- Processes that allowed progress at “China speed”;
- Insights about what actually mattered to customers in their target market;
- A willingness to engineer unnecessary features out of the product and out of the cost structure;
- Service competencies that redefined relationships with customers and allowed the substitution of low-cost labor for high-cost product elements and business processes.
“Second Mouse” firms are no longer constrained to China’s markets; they are now significant global players. Some, like Huawei and Haier, are among the leaders in their industries (telecommunications and appliances, respectively). Indeed, they’ve surpassed well-established western firms in terms of sales and global market share. The transition of these firms into global markets has been gradual, with most of them first venturing into other developing markets in Asia, then into developing markets elsewhere, and only recently into the developed country markets of North America, Europe and Japan. In many industries, these “Second Mouse” firms haven’t yet arrived in the developed markets of the west, allowing western firms to continue to embrace the fiction that they aren’t serious global competitors. But it is more likely just a matter of time until they arrive and become the most serious competitors of the coming decade.
The second challenge facing western firms reflects the difficulty they face competing with “Second Mouse” rivals. They didn’t realize that the strategy that carried them into China’s markets was, for them, a mouse trap. By entering – and subsequently prospering in – the high-end of China’s markets, western technology and design leaders (with their advanced products and high price points) created a self-imposed conundrum: To later enter the broad middle market, where almost-as-good products at very attractive prices are prerequisite to success, they would have to take actions that would threaten their income and profit streams from the elite market segments and from their China operations oriented towards serving western customers. Doing so would disrupt the steady growth expected from these firms’ China operations. Since the elite segments of the China market were initially the fastest growing parts of the market (in percentage terms), growth rates in sales were impressive indeed. Naturally, most of these western firms remain focused on the elite segments of China’s markets, earning solid margins and continuing to grow at reasonable rates, but without an ability to expand into the broad middle markets of China without compromising their position – and their profits – in China’s elite market segments.
As a result, the broad middle markets of China remain the territory of the Chinese “Second Mouse” firms. Fortunately for these firms – and unfortunately for their western competitors – those markets represents the next decade’s greatest growth area. Any firm seeking leadership positions by 2020 must acquire a meaningful share of the broad middle markets of China(as well as India and Brazil – think BRIC). Ceding these markets to “Second Mouse” firms most likely hands over global leadership. It also enhances the abilities of “Second Mouse” firms to compete in the west, both as a result of the earnings from emerging markets and from their continued access to the world’s best laboratories. From such settings, the upstarts will develop products that will not only compete but win in the global environment.
Evidence is already plentiful. Read press releases that describe “Second Mouse” investments and acquisitions for verification.
LOOMING DARK CLOUDS
Even in the elite segments of China’s markets, future trends threaten western companies in terms of market share and sustained impressive growth rates and profit margins. As China’s income distribution continues shifting, new entrants into the elite segment will face a choice between western brands and those almost-as-good products with their “great price point” from the “Second Mouse” companies, an option much different from the earlier choice between western brands and laughable knock-offs.
Strategic implications of these two challenges are clear. Future growth requires western companies to develop the ability to compete in the broad middle segments of emerging markets like China. Any future competitive success, in even traditional western markets, will require responses to new “Second Mouse” competitors that will quickly offer western customers almost-as-good products at highly attractive price points – a value proposition likely to find as many takers in the west as it did in China and other developing country markets. Skeptics should note that western firms like Southwest Airlines and Vizio generated great success using what is basically a “Second Mouse” business model.
George F, Brown Jr. is chief executive officer of Blue Canyon Partners, Inc., a strategy consulting firm. With Atlee Valentine Pope, he co-authored “CoDestiny: Overcome Your Growth Challenges by Helping Your Customers Overcome Theirs. David G. Hartman is Blue Canyon Partners’ China practice director. For more than 20 years, he has actively participated in China markets.