Edge Perspectives with John Hagel

BenQ and Siemens - Western Envy

One year ago, a high profile acquisition got me into trouble.  It seemed to directly contradict some broader themes that I have written about extensively.  A number of my clients and colleagues used the news of the acquisition to question whether these themes were valid. At the time, I was skeptical about the acquisition and recent events appear to justify this skepticism.

What was the acquisition?  It was BenQ’s acquisition of the mobile telephone equipment business from Siemens.

What were the themes it appeared to challenge? First, I have anticipated that all companies over time will unbundle into three much more focused business types – infrastructure management businesses, product innovation and commercialization businesses and customer relationship businesses.  Second, I have pointed to the success of a new generation of Chinese companies that are in fact growing very rapidly by pursuing business models focused on one of these three business types – their success stems from their focus and relentless efforts to get better faster by working with others. Third, I have made the case that at least two of these business types – infrastructure management businesses and customer relationship businesses - are highly scalable and can provide the foundation for rebundling strategies that leverage the benefits of focus as well as economies of scale and scope in order to generate significant economic value.

Well, the BenQ acquisition was certainly an exception to these patterns.  Based in Taiwan, BenQ is not very well known to the general public in Western countries, even though many people use their products on a daily basis.  The reason: BenQ makes mobile telephones, as well as a variety of other consumer electronics products, that are sold under the brand names of prominent Western companies.  It operates as a contract manufacturer making, and in many cases designing, consumer electronics products for other companies. So, in my terminology, BenQ had become very successful as a focused infrastructure management business, leveraging not only low wage rates in Asia but rapid incremental innovation to deliver increasingly sophisticated and reliable products in markets around the world. It has developed world class capabilities in terms of managing high volume, routine processing activities and designing products for manufacturability.

All well and good – very consistent with the broader themes I have described.  But the Siemens acquisition that took effect in October of 2005 came out of left field.  Now BenQ was diversifying from a focused behind the scenes manufacturer and designer into a full-fledged product innovation and commercialization company with its own brands and distribution operations in Western companies.  This was certainly contrary to the broader pattern of unbundling and rebundling that I have described. It also suggested that one major Chinese company was departing from the tight focus that had driven its early growth and success.

What was going on?  Well, from the beginning, this was an unusual acquisition.  It turns out Siemens was actually paying BenQ to take over its ailing mobile telephone business – it paid out 250 million euros to BenQ to support the venture and invested an additional 50 million euros in newly issues shares of BenQ as part of the transaction.  BenQ had already been a significant contract manufacturer for Siemens mobile telephones, so I guess the assumption was that, by combining the two elements of the business, BenQ would be able to overcome the financial difficulties that Siemens had experienced in the business.

If that was the assumption, it proved to be horribly wrong. Siemens’ payments to BenQ at the time of the acquisition pale in comparison to the 600 million euro losses sustained by BenQ’s mobile division since the acquisition. The Financial Times reported on September 29, 2006 that BenQ was pulling the plug on the former Siemens operation, as its Munich-based subsidiary filed for insolvency:

BenQ Corp in Taipei said it had decided not to put any more money into the business because if it had it might have threatened its own survival

Now, undoubtedly there were many factors contributing to BenQ’s difficulties following the acquisition.  Siemens' mobile telephone business was a relatively marginal player – it was number six in an industry where the top five handset companies account for 80% of the mobile telephone market. The mobile telephone business is an intensely competitive industry in which the increasingly concentrated service providers have growing bargaining power relative to equipment vendors.

But BenQ was venturing into a very different business type with different economics, skill requirements and even business cultures (not to mention national cultures).  In its efforts to master this new business type, it risked losing focus both in terms of management attention and financial resources. This was particularly unfortunate as competition was intensifying in its core business.

BenQ also apparently alienated many of its other customers.  In its contract manufacturing business, BenQ served many of the other major handset product companies but, as it forward integrated into selling its own handsets, BenQ found it more difficult to avoid being viewed as a potential competitor by its contract manufacturing customers.  As the International Herald Tribune reported on September 29, “. . . BenQ’s contract sales [of mobile telephones] have fallen to fewer than two million handsets a quarter, compared with five million per quarter last year.”

There’s a more fundamental issue here.  Many Chinese companies unfortunately suffer from something that I have described as Western envy. Despite enormous success in pioneering innovative business models and business practices, many entrepreneurial Chinese companies still have a sense of inferiority and want to look like larger Western companies with their own manufacturing, R&D and sales and marketing operations.  The irony is that, just as many Western companies are unbundling (in part offshoring and outsourcing to more focused Chinese companies), many Chinese executives are tempted to build more tightly bundled operations that mimic the model many Western companies are abandoning. About a year ago, I wrote about a similar cautionary tale provided by Moulin Global Eye Care, a Hong Kong company.

Chinese executives appear particularly envious of the product brands owned by many Western companies.  Once again, this is ironic given the growing evidence of the general weakening of product-centric brands and the emergence of very different kinds of brands.  These new brands are much more compatible with the kinds of focused businesses that are being built by Chinese entrepreneurs.

BenQ’s stock price rose following the announcement of its decision not to pour any more money into the business it acquired from Siemens.  Hopefully, BenQ’s executives will heed this message from its investors and return to the focused strategies that led to its early success.

In the meantime, rather than viewing the BenQ acquisition as a troubling exception to a broader set of patterns that I see playing out on a global level, I can now point to it as an example of the deep challenges executives will encounter if they ignore these patterns.

Misconceptions About China

There is no China.  The sooner Western executives grasp this, the less likely they will be to make serious investment mistakes in this area.

Now, of course, there is a political entity known as China. It has embassies around the world and exercises significant political power domestically, moving vigilantly against any signs of political opposition. And, from an investment perspective, the central government of China has been a catalyst for, and general supporter of, the economic liberalization that has helped to transform the country over the past several decades. The central government also has control of some powerful economic levers like currency policy. But these basic facts also generate many misconceptions that can get executives into a lot of trouble.

Western views of an authoritarian central government in China that controls all activity in the country help to reinforce the misconception that there is a single China. There is no doubt that the central government is authoritarian, but it is easy to overstate the control it exercises throughout the country.

Andrew Browne’s article on the front page of the Wall Street Journal on September 15, 2006 helps to challenge this misconception.  Carrying the headline “Booming Municipalities Defy China’s Effort to Cool the Economy” (registration required), the article points out that:

Local governments are encouraging a frenzy of construction to boost their economies – even as China’s central government seeks to throttle back economic growth . . . .

More than a quarter century of economic overhauls has produced a striking contrast in China.  Politically, the Communist central government maintains a tight grip over the entire country: economically; it is losing control.

China’s leaders are caught in a trap as they cast around for ways to rein in investment.  The old administrative methods – ordering state banks to stop lending, restricting land sales, halting government approvals for major projects – aren’t working as well as before, partly because local governments are defying Beijing

It is ironic to find an article in the Wall Street Journal lamenting the diminished power of the central government to more effectively control investment.  The article darkly suggests that unrestrained investment by municipalities could lead to property bubbles and rapid escalation of inflation with ripple effects throughout the global economy.

There is no doubt legitimate concern about the efforts of municipalities to outdo each other in terms of elaborate and often uneconomic construction projects.  But the article misses a more fundamental point. 

Much of the economic growth of the country has been triggered by intense competition across municipal and provincial governments to attract private investment.  As I pointed out in an earlier blog, this is in sharp contrast to Europe and even the United States. In these regions, public policy discussions tend to emphasize the benefits of harmonization of economic policy. China has been pursuing a different approach. Economic policy diverges significantly across provincial and municipal boundaries, leading to very different trajectories of growth and rates of growth. This produces a rich environment of public policy competition, where local governments compete with each other to design more attractive economic policies to attract investment. In many cases, as illustrated by the example of Panyu’s emergence as a center of diamond polishing, the competition leads local governments to choose not to enforce burdensome regulations defined by the national government.

The result has been an increasingly complex tapestry of economic policies across China. This in turn has led to the emergence and evolution of highly diverse local business ecosystems that make regional centers like Beijing, Shanghai and Shenzhen quite different from each other in terms of business specialization, infrastructure capabilities and talent pools.  Adam Segal’s book on Digital Dragon remains one of the most insightful explorations of the business impact of this regional diversity in China's economic policy.  Although his particular focus is on the high tech industry, the dynamics he explores are playing out in such diverse industries as diamond polishing, motorcycles and textiles.

Recently, the newspapers have carried stories (registration required) about the high profile dismissal of Chen Liangyu from his post as Shanghai’s Communist Party secretary. The charges against Chen focus on corruption related to the mishandling of Shanghai’s $1.2 billion pension fund.  There has been much speculation that this dismissal represents an effort by China’s central government to assert greater control over provincial and local governments in terms of economic policy.  Shanghai certainly has been one of the most aggressive regions in attracting foreign investment and funding ambitious commercial real estate development, not coincidentally in part using funds from the city’s pension fund. If this is the motivation behind the corruption charges, it is unlikely to lead to a wholesale shift towards centralized control of economic policy but instead may lead to a re-balancing on the margin to slow the growing power of local governments in setting economic policy.

As always, though, politics in China are complicated. This high profile dismissal could have other motivations.  It is true that the central government has a penchant for using corruption probes and charges selectively to discipline party and government officials. But in this case, it is not entirely clear what the focus of discipline is. The charges against Chen may represent jockeying for political position within China’s Politburo in anticipation of a meeting of party leaders next year.  Chen has been a member of the Politburo and widely viewed as a protégé of former President Jiang Zemin, now officially retired but continuing to exercise influence.

However the Shanghai saga plays out, Western executives need to move away from a view of China as a single economy or country and craft much more nuanced business strategies designed to tap into the increasingly diverse ecosystems and markets emerging regionally within China. It is no longer (if it ever was) sufficient for companies to have a “China strategy” – they need to define a Shanghai strategy, Shenzhen strategy, etc.

But this is not the only dimension where nuanced strategies are required.  Generalizations about China can get Western executives into trouble in other ways as well. 

I have written before about the need to differentiate three Chinas.  In this context, the second China refers to the massive state-owned enterprises (SOEs) that still dominate the economic landscape in terms of employment and production statistics.  Many of these SOEs are now being privatized (at least in part) in terms of ownership structures, but they retain the cultures and work practices of large, bureaucratic entities.

In sharp contrast, the third China consists of smaller, entrepreneurial companies that have emerged on the periphery (literally, in the sense of coastal regions, as well as figuratively).  These companies were the focus in part of my recent book, The Only Sustainable Edge. They represent an innovative group of companies that are reshaping global industries as varied as textiles, consumer electronics and motorcycles.

When most Western executives go to China, they tend to meet with counterparts in the second China and these meetings become their frame of reference for thinking about the capabilities and potential of Chinese business.  They rarely even become aware of the companies comprising the third China and completely miss the strategic challenges and opportunities created by these much less visible companies.

A prominent article in the September 18, 2006 issue of Fortune provides just one example of this misconception. Written by Alex Taylor, III, the article entitled “A Tale of Two Cities” contrasted the performance of a plant opened by Tenneco, a maker of auto parts, in Shanghai in 1998 with another plant owned by Tenneco in Litchfield, Michigan. These two plants make the same product for the same company, so they appear to be particularly useful to compare performance across two countries.

The conclusion, written in sweeping terms, is very comforting for Western executives:

China can be scary. . . .  For many people in high-wage countries like the U.S., Pu exemplifies the China threat – a hard worker making a tenth of U.S. wages.  Who can compete with that? . . . There is no question that, thanks to the labor of tens of millions of people like Pu, China has become a genuinely fearsome economic competitor.

Although wages in Shanghai are rising sharply, labor is still comparatively cheap.  But that is an advantage that goes only so far. Consider: At Tenneco’s plant in Shanghai, labor represents just 1% of production costs; at its Michigan plan the figure is 12%.  It is Michigan, however, that wins hands down in terms of profit, reporting gross operating margins that are a third higher.  The death of U.S. manufacturing has been greatly exaggerated.

Phew! Don’t be scared – we still can beat them in head to head competition. Dig deeper into the story and the article mentions one interesting fact but doesn’t really develop its significance.  Tenneco’s Shanghai operation is actually a joint venture with a state-owned company, Shanghai Tractor & Engine Co., a subsidiary of automaker Shanghai Automotive. So, we are comparing the performance of a state-owned company in China (albeit in a joint venture with a Western company) with a the domestic facility of a U.S. manufacturing company. The challenges faced in the Shanghai operation that limit its performance – resistance of workers to change, friction between workers and supervisors, high turnover of workers, difficulty in firing troublesome workers (meaning the good ones get hired away and the low productivity ones stay forever), primitive tools – are all classic symptoms of the low productivity state-owned enterprises in the second China.

There is no indication of any awareness of a completely different set of companies operating in China – the private, entrepreneurial companies of the third China where worker productivity is world class, where rapid incremental innovation is a foundation and where value is amplified by sophisticated networks of companies with complementary capabilities. If we generalize from the experience of state-owned enterprises in China, we build misconceptions that lead to complacency. 

Look to the edge in China – operating below the radar screen of many Western companies, the entrepreneurial companies of the third China are pioneering sophisticated management techniques that make them formidable competitors – or potentially helpful allies – in global markets. Combine this with a clearer view of the diverse ecosystems evolving in China and Western executives may finally discover ways to harness the enormous economic potential emerging in this part of the world. In fact, it is the complex interplay between these entrepreneurial companies and the diverse ecosystems reshaping the business landscape in China that makes these companies such formidable players in global markets.

Just keep reminding yourself – there is no China. It will help to keep you out of trouble and make you more alert to the developments that are reshaping both the domestic Chinese economy and, increasingly, the global economy.