Ingo Beyer von Morgenstern
January 11, 2006

Lenovo, TCL, and Huawei are well-known examples of Chinese high-technology companies that have established a global footprint. Beyond these headline-making brands, however, scores of high-tech companies - largely unknown outside China - are rapidly assuming market leadership within the mainland, while quietly building the capabilities to go global.

Chinese high-tech groups are growing at an impressive pace. Over the past three years, revenues of the largest 100 high-tech companies in China grew by 26 per cent per year, twice the overall market growth rate of 12 per cent and nearly four times the annual global rate of 7 per cent. Of these, nearly 20 medium and large-sized companies have grown at 50 per cent or more per year - a remarkable pace for companies of that scale.

The rise of Chinese companies comes at a challenging time for high-tech groups in the rest of the world. Slowing core markets and pressure from investors to grow earnings are forcing them to turn towards China. Depending on product category, 30 to 75 per cent of future growth in the global high-tech industry will come from emerging markets, with a significant portion expected to come from China.

In China, foreign high-tech companies find themselves up against a host of challenges: limited demand growth in high-end product segments, where they tend to compete and in which they are increasingly being attacked by Chinese players; severe pricing pressure; a tendency to over-invest, leading to excess capacity; high turnover of qualified local management talent; and difficulty managing joint venture partners.

Many foreign CEOs seem convinced they are doing the right thing. In addition to expatriate managers, they have local managers on the ground; they source components and manufacture inChina; and they visit China to check on the business three or four times a year.

While necessary, these actions will not be enough to win in China. By applying their tried-and-true products and business models in China, foreign high-tech companies are unlikely to earn the level of profits they earn elsewhere, not only from hardware, but also from after-sales parts, services and software. For example, in mature markets, printer makers earn as much from the sales of cartridges, ink, paper and services as they do from the printer itself. In China, this model does not work as well, since low-cost copycat cartridges are readily available and consumers would rather refill than purchase a new cartridge. Many local companies are available to provide maintenance services at a fraction of the price that a foreign group would charge.

A different set of dynamics is at work in China, requiring foreign high-tech companies to rethink how they compete. First, they will need a severe reduction in costs - about 30 to 50 per cent - to bring themselves in line with Chinese competitors. Many foreign players believe they are getting a good deal on components sourced in China, yet they often pay much more - typically 10 to 20 per cent - than local companies. Often, foreign companies in China rely on a single - and more expensive - overseas supplier for a particular component because the specifications cannot be met by suppliers in China. To reduce costs, these companies will need to design products that enable local Chinese suppliers to meet the required specifications.

But cutting costs is only part of the equation. Since many foreign high-tech groups may never be able to reach cost parity with their Chinese rivals, they will have to think of other ways to create value and compensate for their cost disadvantage. One way is to rethink their distribution system in China. In the US and Europe, consumer electronics goods are mostly distributed through large retail chains. But these channels do not have the same scale or reach in China.

To get around this problem, Sony distributes its notebook PCs through hundreds of stand-alone shops and sales counters in consumer electronics malls. Setting up its own distribution network has helped boost Sony's share of China's notebook PC market from just 1 per cent in 2002 to more than 8 per cent today. Foreign companies should also leverage their global brands and marketing muscle in China, especially given how brand-conscious Chinese consumers appear to be.

In a recent McKinsey survey of consumers in China, 55 per cent of respondents said they preferred a famous brand when buying consumer electronics.

Most foreign companies operate at the high end of the market, conceding the mid-range and low-end segments to Chinese competitors. But if they want to build large businesses on the mainland, they will have to figure out how to operate in these much bigger segments without eroding their brand image. Nokia and Motorola have succeeded in this, continuing to enjoy strong brands while occupying leading positions in China's mobile handset market with phones priced from Rmb400 to Rmb9,000 (Dollars 50 to Dollars 1,120).

Whatever strategy they pursue, the world's high-tech companies will need to think differently when doing business in China, or risk losing out on the biggest growth opportunity of the century.

Ingo Beyer von Morgenstern is a director in McKinsey & Company's Shanghai office and leads McKinsey's high-technology practice in Asia.

This article was originally published in the Financial Times.