Podcast 73: Replacing China Myths with Facts – Part 4 China’s Overall Evolution

Hello, this is Jim Tompkins, CEO and President of Tompkins Associates and Tompkins International. I am pleased to be with you today as we do part four of our nine-part series on Replacing China Myths with Facts.

In the last two segments, we spoke with Steve Crandall on the overall evolution of China. Today we would like to focus on where China is going and the growth implications on Western firms.

To join me in this discussion, I am pleased to welcome back Steve Ganster, Executive Vice President of Technomic Asia and Tompkins International. Steve, welcome.

Steve Ganster

Jim, I’m happy to pick up where my colleague, Steve Crandall, left off in the last podcast.

Steve talked about China’s general evolution. I’d like to focus on where China is going, and specifically the growth implications for western firms.

To frame this discussion, let me first highlight a couple of important principles:

First, as we have already experienced, China’s pace of change can be dramatic and tough to keep up with. Frankly, we don’t expect this pace of change to abate much going forward. As we often say, China years are like dog years – one year there is like seven in the west. The key take-away here is that the shelf life of any growth strategy is probably only 2-3 years, so you need to constantly refresh it and validate your assumptions.

Second, it is critical to understand the quality of growth and not just its general vector. What I mean by this is that most markets are changing dramatically in terms of their segmentation and structure. For example, many markets now have 3 to 4 price/quality tiers. In some consumer products, we now have not only mass and premium product segments, but also masstige – a burgeoning segment evolving to serve the growing middle class. Similarly, in automotive components, multiple tiers have evolved to address the fragmenting vehicle market. These include genuine, branded, value, and even imitation product segments. You need to understand the shifts in these markets as they will directly affect your addressable market.

Jim Tompkins

Steve, this idea of quality growth and resultant addressable market is very interesting and seems important for western management to understand. Can you elaborate on this a bit?

Steve Ganster

Sure, Jim. And you’re right. Having a clear understanding of not only the current, but also the future, addressable markets is a critical requirement in the growth planning process. A subtle myth about China is that high growth equals attractive opportunity. One shouldn’t need a consultant to tell them that, say, luxury products, cars, or health care products, are growing rapidly in China. We can go back to the 1990s to see the fallacy of relying on high growth as an indicator of opportunity. Many firms during this Gold Rush period jumped into the market with the intent of riding this growth wave.

Unfortunately, many of them nearly drowned. Sure, volume growth accelerated rapidly, but value growth was much slower as a result of shifts within the markets, which caused changes in product mix and pricing. The result was that margins eroded significantly, and gradually, western firms could not be competitive in the broader market. This dynamic is still occurring.

Jim Tompkins

OK. Let’s assume management is on the ball and correctly anticipates the nature of their markets’ growth. How can they address this dynamic opportunity and expand their addressable market to capture a broader share of growth?

Steve Ganster

It really goes to the heart of exploiting growth opportunities in China. Once you sort out your addressable market (and again, remember these are markets where you can make money) you can then determine the right business model to employ.

Typically, if a company merely transplants its western business model to China, their addressable market will be limited to the very high end segments at best. Some of the highest growth market segments, as I mentioned, are geared more towards the middle market, where a western business model in its pure form can be too costly to compete effectively and generate decent margins. Often they will come up against local competitors in this middle market who have lower cost structures and a different, often more flexible way of looking at profitability and ROI.

Let me give some examples here in the fashion and automotive industries, which I cited previously. The China luxury market, including cosmetics, skin care, hand bags, jewelry, and the like, is now the 2nd largest in the world behind Japan, and growing in double digits. Most of the leading global players are already in China and are expanding rapidly; however, in order to tap into the full growth opportunity that China offers, many of these firms, like Gucci, Prada, LVMH, are aggressively localizing production and expanding their product portfolio into the middle market … sometimes even to the mass market, as exemplified by P&G and Olay in skin care.

Similarly, in the automotive components market, tier one parts suppliers are looking at alternative business models to expand into middle market segments. Because of the need to have lower costs in order to be competitive in these segments, companies are looking to acquire local Chinese firms for their lower cost production, mid-tier brands, and broader channel coverage.

The common theme in these situations is, how do I China-fy my business model to be competitive and to expand my addressable market? The secret to success here is to determine that right mix of the western way and the Chinese way. Those able to find this balance are thriving in China!

Jim Tompkins

Steve, this makes sense. What do you see as the major challenges for western management to take this approach?

Steve Ganster

To answer this, Jim, I am afraid I need to go to the well once again on one of the most important starting points to a China growth strategy, and that is to pursue strategy before structure. Anyone who has heard me speak on China has likely heard me expound on this axiom ad nauseum…but it is just so important and is still a challenge for management to think this way regarding China.

While we talk about the challenges of rapid and even uncontrollable growth, one of the upsides is the fluidity of the market. This means I can potentially be whatever I want to be, not limited by the shackles of my existing business model. Our counsel is to first objectively and without a narrow paradigm, look at the evolving opportunities in China…then determine the business model or structure to penetrate them. The best approach may stray from your core business model but could still be a close enough fit where you can pull it off.

Without the prejudice of structure or a rigidly defined business model, we could find opportunities up and down the value chain. For instance, we may be able to go downstream, because the customer base is not well developed. This could offer the opportunity to better shape the market and add more value to your offerings.

Conversely we could go upstream and establish a more competitive supply chain. A classic case in this regard is the automotive aftermarket in China, a market we are actively consulting in. Based on China’s explosive growth in sedans, the aftermarket is now expanding rapidly but chaotically. The market structure is inefficient, outdated and begging for change, but it also is a headache and challenge to deal with. In the chaos, there are huge opportunities for western companies to come in and shape the market at all levels.

One can take two courses of action here. The first is to do what you always do in terms of product portfolio, route to market, price positioning, etc. and play within your comfort zone. And you can be successful doing this, though perhaps limited in addressable market.

The other approach, for those with a greater growth appetite, is to take off the filter and look at the market with fresh eyes, unbiased by your existing business model. Find the opportunities first and then consider the way to go after them. You may find some unique opportunities as well as some creative ways to address them.

The key is in the planning approach, so changing management thinking in the planning process is the first step to success.

Jim Tompkins

Interesting stuff, Steve. As we are about out of time, any other thoughts you would like to share regarding China growth and how western companies can exploit it?

Steve Ganster

Let me raise one more topic, Jim, which is a big one and worthy of its own podcast, and that’s acquisition.

Given the rapid growth across many markets in China and the jockeying for position by competitors, an organic growth strategy may not be fast enough to get where management wants to go. Interestingly, we have heard many China-based managers lament the fact that their budgeted forecast of, say 20% annual growth, was rejected by corporate management as being too conservative! Growing through acquisition or alliance is thus becoming a more compelling or even necessary option for western firms.

However, the state of M&A in China is still embryonic, and the rules of the game are not so clear (such as in valuation) proper due diligence and legal approvals. Further, the track record for many western companies trying to do M&A in China has not been so good. By our estimates, more than two-thirds of all deals fail after a letter of intent is signed.

Again, as in growth strategy, one needs to China-fy the approach in pursuing acquisitions. Though they can be tough to establish and even tougher to manage, we encourage our clients to look at partnerships, including some very creative or out of the box options, to accelerate growth.

And as a last point to wrap up my comments: The rapid growth in China we’ve been experiencing will start to slow over the next 5-10 years as markets mature. This will make a high level of precision in the growth strategy planning process critical to success.

Competitive intensity, already high in many markets, will only get greater as both leading global players and domestic Chinese companies are all actively present and fighting for the same share. As I said at the beginning of our discussion today, growth planning is a very dynamic process in China so you can’t relax or get comfortable. One of my favorite expressions about China has never been truer…”In China, everything is possible but nothing is easy”.

Jim Tompkins

Thanks a lot, Steve, for being with us today and sharing your insights on the growth in China. Join me again in a couple of weeks when I welcome Michael Zakkour, a Principal with Technomic Asia and Tompkins International, where he will share with us his thoughts on understanding China sourcing. Speak to you again real soon. Bye now.