Ingo Beyer von Morgenstern and Xiaoyu Xia
June 27, 2006

"If you can't beat them, acquire them." This has become the mantra favored of late by multinational high-tech firms in China as they face fierce competition from Chinese firms. Our research into 1,000 Chinese high-tech firms shows them to be growing on average three times as fast as multinationals. So what are multinationals doing wrong?

By sticking too rigidly to product specifications for developed markets, and high prices, multinationals in many sectors have squeezed themselves into the thin, high-end market in China. To succeed in China, these firms would do better to focus on the faster-growing mid-range segment of the Chinese high-tech market, where products cost an average of 20 percent to 30 percent less than their high-end counterparts.

Take electrical equipment, a $60 billion industry comprising sectors such as automation and power generation. While multinationals focused almost exclusively on the high end of the market, mid-range Chinese players - led by emerging contenders such as Chint, a maker of low voltage electronics, and Shanghai Electric, maker of power generation products - have expanded their share of the overall market to 65 percent from 55 percent over the past five years. This segment is growing almost twice as fast as the market for electrical equipment as a whole. As a result, multinationals as a group saw their share of the market drop to 35 percent from 45 percent since 2001.

Local firms such as auto-electronics-maker Hangsheng Electronics or medical-equipment-maker Shinva may not yet be household names, but such enterprises are sweeping to dominance in their industries. By 2010, we estimate Chinese companies will hold as much as 80 percent (worth about $260 billion) of China's high-tech market, up from 67 percent in 2004.

Some multinationals have responded to the erosion of their market share by buying into the new breed of mid-range Chinese winners in order to quickly build up a competitive mid-range product line for the Chinese market.

The multinational out shopping faces a number of obstacles in its path. First, there's the question of what they should be looking for. Simply spotting a suitable company is a challenge in a market characterized by a lack of transparency. Local firms with a revenue of $30-100 million and around 500-1,500 employees are potentially attractive buys. Mid-range Chinese companies usually do not compete in the same high end segment as the multinational acquirer, and have more narrowly focused products, making it easier for a multinational to plug gaps in its product portfolio without buying a firm with an overlapping product line.

But when a multinational tries to buy a local company, it may find Chinese competitors, which have been fiercely battling each other for survival, close ranks against a perceived foreign threat. The local companies may enlist the support of government officials to require foreign players to find a local partner before bidding for a project, or to require a certain amount of locally made components. Thus, gaining government backing for a deal is a vital prerequisite.

Chinese companies can also squeeze foreign competitors out by pushing down prices. Chinese companies are used to operating on very thin margins: last year, the top 1,000 electronics firms in China earned an average net margin of only 2.5 percent.

Nonetheless some foreign companies are overcoming these hurdles. For example, one multinational maker of industrial electronics last year bought a Chinese company with a 30 percent share of the mid-range segment and 25 percent annual growth. To ensure that customers and employees didn't flee post-merger, the acquirer enticed key management to stay put by allowing the Chinese firm to maintain day-to-day management control. While it's too early to judge the outcome of the deal, initial signs look positive: in the first quarter of this year, sales increased by over 60 percent.

That is a trend which other multinationals can be expected to follow. China is becoming an increasingly competitive market, and the route to success for foreign companies will lie in eschewing their past preference for the high-end in favor of carving out stronger positions in mid-range products.

Mr. Beyer von Morgenstern is a director in McKinsey & Co.'s Shanghai office and leader of McKinsey's high-tech practice in Asia. Mr. Xia is an associate principal in McKinsey's Beijing office.

This article was originally published in the Wall Street Journal Asia..