Friday, August 24, 2007

August 2007 Early Indications: China's Changing Role in the Tech Sector

At base, technological change and globalization cannot be cleanly
distinguished, and thus will be interlinked for the foreseeable
future. The shipping container is arguably one of the five great
breakthroughs of the twentieth century. Cellular telephony's
revolution of participation, the impact of voice over IP on
international calling, offshore call centers and code factories, price
transparency, and many more facts of global life originated in a lab
or startup.

Given that China's rapid growth and wide impact have become
essentially synonymous with globalization, it makes sense to examine
the current state of the tech industry relative to this awakening
giant. Worldwide interest in the question has been on the upswing,
prompted by two developments: the acquisition by Lenovo of IBM's PC
operation, and Apple's reasonably prominent branding of the iPod's
Chinese manufacturing. More recently, the UK's Mail on Sunday
newspaper ran a critical story in June 2006 on the Chinese factories
from whence the devices originate. Since then, attention has been
focused on wages, working conditions, and the business models behind
the influx of Chinese-made devices and components. (A bibliography
appears at the end.)

James Fallows, who writes for The Atlantic Monthly, recently reported
from Shenzhen, the port city home to the contract manufacturing
factory linked to Apple. One theme that reappears throughout the
article is Fallows' amazement at the scale of Chinese activity:

-The port of Shenzhen and Hong Kong (only about 30 miles away)
dispatched 40 million cargo containers, or the equivalent of one per
second, in a calendar year. (The U.S. exports that return to China in
those containers consist primarily of scrap paper and scrap metal,
along with empty containers.)

-Shenzhen is a planned city that 25 years ago was a fishing town of
maybe 75,000 citizens. It is now bigger than New York, having grown
100-fold, or more, in 25 years.

-At the Foxconn manufacturing plant, a vast number of employees work
12-hour shifts turning out all manner of electronic goods: the precise
number is not made public or perhaps known, but estimates range
between 200,000 and 300,000 people, many of them young women from the
countryside who have migrated to the factory. The facility serves
150,000 lunches per day.

At the macro level, the impact of Chinese exports on the global
economy appear to be mostly anecdotal and probably overstated. In
selected markets, however, China's combination of low wages and
manufacturing scale has driven prices lower in much of the rest of the
world. A famous example is bicycles, but for our purpose, the low
prices of many advanced items -- including cell phones, laptop
computers, cameras, some medical devices, and electronics equipment in
general -- derive in part from China's impact on the industry. That
is, the availability of such items as Motorola Razrs for (apparently)
free and laptop computers for $500 and potentially $100 owes as much
to China's economics as it does to Dell's direct business model or
Moore's law.

The companies driving this transition are, for the most part, not
household names. The electronics manufacturing services (EMS)
industry, formerly known as contract manufacturing, is itself only
about ten to fifteen years old, but growing about 20% per year. In
the mid-1990s, Nokia, Cisco, Sony, and other major brands began
exiting the manufacturing business, leaving it in the hands of such
companies as Solectron, Flextronics, and Jabil.

The largest current EMS, Hon Hai Precision, is the parent of Foxconn.
It is expected to grow from $40 billion to $54 billion in revenues
this year after having grown 44% in 2006. The founder, Terry Gou, is
a native of Taiwan worth $10 billion, according to the Wall Street
Journal; he does not appear on Forbes Magazine's list of the world's
richest people, where he would rank in the top 65. Hon Hai, a
publicly traded company, is China's largest exporter.

As EMS companies seek to increase margins and avoid commoditization,
they take on more upfront work, moving toward becoming so-called
Original Design Manufacturers (ODM). A quick quiz: what do Quanta,
Compal, Inventec, Wistron, and Asustek do? According to Fallows, they
collectively account for 90% of global production of laptop computers;
at one factory, he saw machines from three different major brands
coming off the same assembly line. As a quick check of these
companies' websites illustrates, many laptops we might associate with
HP, Dell, or other major brands began life in one of these Asian
firms, which broadly speaking are higher in the food chain than EMS

The final step up the margin ladder is for a manufacturer to design,
make, and label its own offerings for market, as an Original Brand
Manufacturer (OBM). Brand is in fact a major story at Lenovo,
formerly the Chinese Legend PC firm, which bought the IBM business in
2005. The company's marketing is focusing heavily on sporting events,
with Olympic sponsorship at both the Turin and Beijing games.
Lenovo's story is fascinating: the CEO, Bill Amelio, is an American
with a Karate black belt hired away from Dell, while the chairman,
Yang Yuanqing, is Chinese. The company's ownership is split among
public shareholders (35%), the state-run Chinese Academy of Sciences
(the original investor in Legend at 27%), employees, IBM, and private
equity firms. Lenovo sells in 66 countries and recently announced
plans to open factories in India and Mexico, the better to shorten
supply chains and thus accelerate inventory flow.

Lenovo's headquarters moved from Beijing to Raleigh, NC shortly after
the IBM transaction, but Amelio lives in Singapore. The culture of
the company is in flux as Chinese managers take courses in directness
and accountability and IBM, Legend, and Dell habits are sorted out.
The legacy IBM business, meanwhile, is being upgraded with investments
in IT, R&D (moved increasingly to China from the U.S.), and supply
chain. With 8.3% global market share, the company ranks #3 worldwide
in PC shipments, barely ahead of Acer and lagging HP (19.3) and Dell
(16.1). Competition is intense: Dell recently invested $16 billion in
one year in Chinese capacity, more than Lenovo's entire revenues.
Lenovo has responded by cutting costs, including laying off 1400
employees announced earlier this year, and by reinventing its channel
model outside China.

While the whole world is watching to see how Lenovo fares as China's
first global brand, another company from the other side of the ocean
is trying to create a hybrid Chinese-American firm. 3Com has had a
wild ride in its nearly 30 years of existence. After being co-founded
by Ethernet inventor Bob Metcalfe in 1979, the company sold a variety
of networking equipment including interface cards, and attempted
several consumer plays including USRobotics (modems) and its
subsidiary Palm Computing that were later spun out, as well as the
Kerbango Internet radio that never came to market and the Audrey
Internet appliance, which lasted less than a year.

In 2003 3Com formed a joint venture with Huawei, now an $8 billion
company of 62,000 employees that sells networking gear primarily to
telecom operators. Earlier this year, 3Com bought back Huawei's stake
for $882 million in the JV, now known as H3C. Total headcount in the
company is now heavily weighted toward Asia (5,000, mostly in China)
with about 1,200 employees still in the U.S. The company now enjoys a
similar R&D situation to Lenovo, in that engineers are about 1/5 as
expensive in China as in the U.S., so investment can go a lot farther.
3Com also will encounter some of the cultural issues that slowed
Lenovo after the IBM acquisition, but like Lenovo gained global scale
via a trans-Pacific deal.

So what's the overall picture? Software creation is generally a
non-issue, except domestically, where the Baidu search engine has had
some success and Lenovo has introduced some functionality specific to
the home market. Chinese firms have proven they can build electronics
to order, and build from original designs in certain segments.
Quality control and material provenance remain problematic. Lenovo
has proven it can sell lots of PCs in its home market and that
spending lots of money can build a brand. Unlike India, China has not
produced a generation of globally prominent managers and executives,
with the exception of Lenovo's Yanqing.

The dominant business model of China's role in the global technology
industry, however, is probably still represented by a man James
Fallows calls "Mr. China," an Irishman named Liam Casey. Casey runs
PCH China Solutions, a firm built up from Casey's personally-acquired
Rolodex of factory locations, contract outcomes, manufacturing
capabilities, roads, and many other factors. If someone needs a
widget built, Casey is likely to know who can build it, who has
capacity, who can supply appropriate materials, and how much it should
cost. For outsiders entering the country, as they are in droves, such
knowledge can be found only with informed intermediaries like Casey;
as Fallows notes, "foreigners don't know where to start or whom to
deal with in the chaos of small, indistinguishable firms."

The rapid growth, corruption, and lack of supply chain transparency
have led to predictable consequences, as when Mattel could not name
its suppliers of tainted toys until long after lead was discovered.
Pollution, the classic externality, is fast becoming a front-burner
issue, and could play a dramatic role in the Beijing Olympics.
Working conditions don't measure up to western standards, but at the
same time, China's industrialization has alleviated severe issues of
rural poverty. Furthermore, the process is probably safer and more
humane than what weavers experienced in Manchester, spinners
encountered in the Carolinas, or early auto workers persevered through
in Flint. To some extent, comparing historical examples of industrial
misery is an apples-and-oranges exercise, but it serves to remind us
that any judgment of these conditions is relative, and for better and
worse, Chinese factory workers are generally better off than they were
on a farm. The various winners and losers remain to be fully sorted
out, but China's emergence will continue to reshape many aspects of
the global order.

"Bold fusion; Face value," The Economist, Feb. 17, 2007, p. 74.

Steve Hamm and Dexter Roberts, "China's First Global Capitalist,"
Business Week, Dec. 11, 2006.

James Fallows, "China makes, the world takes," Atlantic Monthly,
July-August 2007, p. 48.

Jane Spencer, "Lenovo Looks to Expand Global Reach," Wall Street
Journal, July 27, 2007, p. B4.

Jason Dean, "The Forbidden City of Terry Gou," Wall Street Journal,
August 11, 2007, p. A1.

"The stark reality of iPod's Chinese factories," The Mail on Sunday,
August 18, 2006.

Bruce Einhorn, "The Tech dragon Stumbles," Business Week, May 17, 2007, p. 44.