Chapter 1.7This is a featured page

Is China's strategy sustainable?


What we've seen in previous chapter is: 1. Chinese electronics firms benefit from ultra-cheap capital and they feast on research and brand investments from established rivals. These unfair advantages come on top of their: 2. perfectly legitimate low cost base, 3. a dedicated and almost unlimited labour force, and 4. the influx of investments and process technology from the West, Japan and other rich Asian nations.

In the absence of core technology and related learning, the question is if Chinese companies can remain competitive without breaking the rules, and if and how it may close the technology gap. The answer to that question determines the strategies of the established brands.

Before crying foul play, let’s not forget that Western companies also receive subsidies from governments and that this often determines where they invest. Israel in 2005 promised Intel a $525 million subsidy to expand its chip facility in Kiryat Gat which had been built there with another $600 million government injection granted in 1999. With more than $17 billion in the bank, Intel hardly needed the cash, but who says no to a cool billion?

Intel’s smaller rival AMD expands its chip factory in Dresden, encouraged by subsidies aimed to strengthen the weak eastern German economy.

STMicroelectronics has set up shop in Sicily for the same reason. Poland hands out subsidies to LG.Philips LCD to build a flat display assembly line. Without these subsidies, many of these factories would probably be built in Asia.
Government intervention will always influence and distort free trade, but there are different degrees of distortion. Being based in a high wage country will eventually erase the benefit of a subsidy, and eventually create a level playing field -- although arguably a job created with a subsidy does not deserve to be created in the first place. Definitely, the subsidy process is closely monitored in Europe and the United States, which is much harder in large parts of Asia. The pearls thrown to the electronics sectors by the governments of China, and to a lesser extent South Korea have certainly had a big influence, but it is hard to gauge by exactly how much.

More important is how China is positioned for the future, especially if the playing field becomes level under pressure of the WTO and China’s ambitions to be regarded as a market-oriented status.

First of all, China has become a production base that is no longer low cost and therefore low quality. Even premium products are now being assembled in Asia. Apple’s iPod music player, one of the most desired, high-margin gadgets of the moment, is being manufactured in China. Sony Ericsson’s red hot mobile phones come from a factory in Shanghai and Microsoft’s lastest Xbox 360 games console is made by three contract electronics manufacturers in the Pearl River delta.

Secondly, China has long surpassed the point where electronics companies can ignore the country, because the suppliers are all in the region. In the south and in the east have grown major manufacturing hubs for electronics goods which provide easy access to resistors, tubes, capacitors, inductors, crystals, connectors, power modules, Audio/video process modules and other components, whether from Chinese homegrown companies or Western suppliers. There are also abundant mold-making, plastic injection molding, and package factories. Higher value supplies such as semiconductors increasingly come from close-by countries Japan (18% of China's ICT imports), Taiwan (16 percent), South Korea (13 percent) and Malyasia (8 percent).

A country like India for instance does not yet have the infrastructure to be part of the global supply chain that delivers an iPod, made in Shanghai, at your doorstep within 4 working days. “India does not have a supply base,” says Peter Tan, Asia chief of contract manufacturer Flextronics. India does not even have enough skilled labour to fill hundreds of factories.

A risk, however, is China’s low cost base. “I think there will be a cost creep in China,” says Tan. “Already we are starting to see it in places like Shenzhen and Shanghai, where the increase in our labour costs is much higher than in other parts of the world where we operate, not to mention that China has one of the highest inflation rates globally. It is also becoming increasingly difficult to hire people to work in factories in China. It's a bit of an irony.”

With average GDP in China close to $6,000, and much higher earnings in the coastal areas, the consequence is that Flextronics is increasingly investing in Malaysia and even looking at Vietnam. Vietnam citizens earn less than half, while Malaysia GDP per capita is not yet $10,000. (CIA factbox)

In South Korea, with a much smaller labour pool, wages are already considerably higher than in China, but still well below (half of) European and American salaries. This does not only apply to workers but also to middle management. “That carries a lot of weight,” Van Splunter says.

South Korea has responded by concentrating on higher value activities such as more advanced products, but compared with its Western rivals a higher proportion of production is still based in its home country because new products tend to be manufactured close to research and development centres -- proximity to R&D centres accelerates problem solving.

China and South Korea have enjoyed the advantages of two factors: relatively modern factories and strong sales growth. They compete with older rivals which own infrastructure at the end of its life – the write-off of tube factories has taken hundreds of millions of dollars/euros. Without sales growth, a company needs to dramatically improve efficiency ever year. Focus on cost control is not what created Intel, and its former CEO Craig Barrett said during the 2001 chip slump that “you don’t save your way out of a slowdown”. That was easy for him to say, because he had enough cash to keep investing in R&D, but for the generally low-margin electronics sector this is much harder, and cost cutting takes away focus on growth and chases away valuable staff.

The question is how slower growth will impact Chinese and other Asian companies? Already Samsung is feeling that it is hard to grow fast if you are a $55 billion a year company. Cost control was part of the reason China’s Lenovo took over IBM: it could save $200 million a year in component sourcing.
Western executives predict, or hope, that Samsung and LG will collapse once the growth slows down, or stops altogether.

Like the Japanese companies in the 1960s the Koreans started out as white box producers for established brands, and then invested in process technology, scale and quality. Samsung now leads globally in memory chips and monitors and is a global No. 2 in flat LCD displays and a leader in the chips that drive these displays, while LG owns 43 percent of the world’s top LCD panel maker LG.Philips LCD. The two Korean giants are now focused on becoming premier global brands, similar to what Japanese companies did in the 1970s, which may give their sales another boost. (Strategic Intent, Gary Hamel and Prahalad, 1989, Harvard Business Review).

Just like the Japanese felt the hot breath of the Koreans down their neck in the 1990s, the Koreans in their turn are now threatened by Chinese rivals trying to boost their technological expertise and build global brands. BenQ from Taiwan, formerly the consumer electronics activities of Acer, is the latest example of a brand making a successful jump to global recognition. Lenovo has bought instant recognition with the purchase of IBM’s personal computer business. Haier, TCL, TPV, Bird, Konka, Panda,Xoceco, Changhong, Huawei and ZTE may be next.

A strong global brand is the escape ladder from the rathole of low-margin entry-level products. Skyworth Digital Holdings Ltd, China's fourth biggest television maker and the only private enterprise among the leading Chinese TV makers, is trying to increase sales of more expensive models to boost its razor-thin margins. The effect is starting to show in the lucrative market segments where Chinese vendors were hardly seen until recently. “About 35 percent of all flat TVs are no-brands,” says Hans Kleis, European president for Sharp.

Components

Vital to the long-term success of the new players is access to key technologies, and specifically the components: semiconductors. (how much of the value of an electronics gadget is in the components, these days? 50 percent, 60 percent) China’s first, failed attempt was to pump $1 billion of government money into a $1.2 billion memory chip joint venture in Shanghai in 2000, with technology from NEC.

The so-called 900 project from Shanghai Hua Hong faltered due to ageing technology and a slump in world market prices for DRAM memory chips.
Ironically, China has now taken a cue from its rebel province Taiwan and changed its strategy to enter the market as a contract manufacturer.

This means a Chinese contract chip producer like SMIC takes a chip design from a client such as Texas Instruments, Samsung and Infineon, and manufactures the actual silicon die (a die is the integrated circuitry etched on silicon before it is packaged and becomes a chip). Instead of betting the farm on memory chips, which require the most advanced equipment, SMIC and others are making LCD driver chips and consumer electronics chips which can be produced competitively on older equipment.

China hopes the expertise in designing transistors on silicon may rub off on SMIC and other Chinese chip bakers. There is active collaboration with homegrown design houses, although these are still small. In the traditional Chinese carrot and stick approach, imported chips are slapped with a steep VAT tax while domestic chips are hardly taxed. SMIC also gets a 5 year tax holiday.

The bet is already paying off. In 2004, the Chinese foundries had total sales of over $1.9 billion and held about 12 percent of the worldwide pure-play foundry market. Just two years earlier, in 2002, the Chinese foundries had sales of $320 million and held only a 4 percent share of the worldwide IC foundry market (IC Insights).

Taiwan has done well by pioneering the made-to-order chip industry. It is home to TSMC and UMC, the world’s two biggest contract chip makers. TSMC has annual sales of over $8 billion, which puts it firmly in the global top 10 and its production equipment is now just as sophisticated as that of industry leader Intel. More importantly, it is also generating healthy profits and cash, despite the new competition from mainland China which is putting pressure on prices.

Contract chip making is becoming more important every year, because established chip makers balk at the investments needed for new production lines which turn into a liability when the sector goes through its usual cycle from peak to trough. Only the world’s top chip makers such as Intel and Samsung have high enough sales to fill the capacity of their new factories with the most advanced and most expensive equipment for the smallest and most energy efficient chips. The others, even with sales of many billions of dollars a year, will start off any new fab (industry lingo for a chip factory) with underutilized clean rooms. They have to pay interest on their multibillion dollar investment while only part of that investment is yielding revenues.

These companies are thrilled that China with its cheap capital is keen to do the heavy lifting, and they are happy to farm out part of the actual baking of chips as long as they can concentrate on the design of the electronic circuits. Jerry Sanders, co-founder and former chairman of Intel rival Advanced Micro Devices (AMD), once opined "Real men have fabs”. If that is true, turn to Asia for testosterone.

Keeping the Chinese tradition alive, SMIC does whatever it takes to win. The cat got out of the bag in 2005 when SMIC agreed to pay $175 million after being sued for systematically stealing TSMC's intellectual property by aggressively hiring former TSMC employees. SMIC would pay Taiwan Semiconductor Manufacturing Co. (TSMC) $30 million a year for five years and $25 million in the sixth year to settle a series of suits filed since 2003. SMIC is run by Taiwan-born tycoon Richard Chang.

Entering the chip industry as an efficient manufacturer of semiconductors that have been designed elsewhere sounds a lot like the cheap and efficient assembly lines which got the Chinese electronics industry off the ground.

It may yet pay off, but China still needs a lot more research and development to design leading-edge electronic circuits to create a corner it can defend.
The CEO of Applied Materials, the biggest supplier of semiconductor capital equipment, said in an Interview with Scott Hillis in Feb 2007, China's chip industry has failed to take off and that the latest wave of investment appeared to be heading to Singapore.

"In 2003-4 and the beginning 2005, there was a tremendous rush of Chinese semiconductor companies. There are a pile of companies in China. Since that time the Chinese semiconductor industry has really failed to accelerate. Maybe that's not even the right term. It's decelerated relative to the rest of the market. SMIC has not kept up, Wahung-NEC (?) decided on no 12" factory.

"What happens next? I think that's evidenced by what Hynix has done in Wuxi (where they have two fabs). I think the next phase of semiconductor indstury growth is going to be by IDMs (integrated device manufacturers). They have had a relatively slow start but they will inch forward the next few years in part as Taiwan and U.S. ease off technology licensing requirements."

"A number of major semiconductor companies are planning fabs for Singapore and I think this next wave is going to be in and around Singapore. Infineon is already moving and upgrading a fab and Chartered, Qimonda and Micron are looking. A lot of people are looking at Singapore for the next level of investment. If so, those investments have to play out before the next wave can take off."

"Companies outside of China cannot move their most advanced processes into China and fabs are always the most advanced process because you're going to spend $3 billion and if you can't put your most advanced factory there it really doesn't make any sense to put a factory there. "

Labor is a relatively low cost part of wafer fabs but don't kid yourselves here, 70 percent of wafer fabs are built in Asia, 85 percent are outside the U.S., and a very small part of the equipment we sell is actually to U.S. companies in the U.S.

In cases where AMD is going to get very good incentive package, that will help neutralize the cost differential in New York.

One of the trade discussions between the U.S. and China is that you want trade to be more balanced but on high tech stuff you have all these limitations.

Despite the cheating, stealing and cheap capital, China’s electronics businesses are still very poorly performing companies.

It is clear to all, including the Chinese, that a business model based on competitively priced hardware will never bring healthy profits. The golden days of consumer electronics are over, and the current era of overcapacity and all-out, anything-goes competition has already forced giant companies to throw in the towel. Alcatel sold its mobile phone business to TCL, Thomson flogged its TV business and IBM gave up its PC activities.

Chris Deering at Sony predicts that “if this continues for another five years there will be victims”, suggesting even a behemoth and clear industry leader like Sony is at risk.

But that is not before they will show at least one more good fight. What is important to note is that the reason of being for most consumer electronics companies is, well, consumer electronics. Unless you are IBM and more than half of your business is in computer services and consultancy which has nothing to do with PCs, you need to cling on to your electronics business with your fingernails or become a footnote in the history books. There will not be much left of Sony, Matsushita, Samsung, LG, Sharp, Dell, Sanyo and even H-P, without electronics activities.

The sheer size of the electronics industry is another very powerful argument to hang in there. Why leave an industry with annual revenues of $1.2 trillion to the Chinese? Akihiro Matsubara, Sony’s European manager for Vaio computers and networked products like Walkman, sums it up perfectly: “Why stay in it? “Because it’s a big market. Because it’s there.”

The consumer electronics industry is also like the car industry, or the airline sector, or even big club sports. It has visibility and sex appeal, and there will always be someone around who is brave, or ignorant, enough to believe he can make it work. Just listen to Yang Yuanqing, the chairman of Lenovo: “In five years I want this to be a very famous PC brand, with may be double the growth of the industry (over that period). I want to have a very healthy profit margin and maybe some other businesses beyond PCs, worldwide.” (FT, Nov 10, 2005)

Finally, there is widespread confidence that higher profits can be achieved if electronics companies play their cards well. Sharp president President Katsuhiko Machida says he has a mid-term target, by 2007, to achieve a 10 percent return on equity. He points out that his company’s 2004/2005 operating profit was already 5.9 percent, compared with an average of less than 3 percent for the top 10 Japanese electronics makers. (IFA 2005)

Matsushita’s Fumio Ohtsubo says he aims for an operating margin of at least 5 percent for the consumer electronics and computer activities in fiscal 2005/2006 and reckons this is easily achievable, and is aiming for more. (IFA 2005) (It includes its plasma production)

Philips aims for at least 4 to 4.5 percent operating margins for its consumer electronics business and believes it can achieve this with negative working capital and hardly any assets, suggesting an phenomenal return on capital. Samsung aims for industry average profit margins of high single digits (including the printer business which adds a few points; David Steel) and even China’s Skyworth aims for 5 percent operating profit margins.

If it were only one company to sound so irrationally exuberant at a time of crisis, it could be easily dismissed. But with so many companies doing their rain dance, it deserves a much closer look. In the next part of this book, I will investigate how companies expect to achieve their ambitious targets, and if these are realistic.

Go to Part 2 here





gadgethell
gadgethell 		Latest page update: made by gadgethell , Apr 10 2007, 8:30 AM EDT (about this update About This Update gadgethell Edited by gadgethell

5 words added

view changes
- complete history)
Keyword tags: None (edit keyword tags)
More Info: links to this page

Threads for this page

Anonymous  (Get credit for your thread)

There are no threads for this page.  Be the first to start a new thread.