articles

Growth Strategies and Opportunities for Manufacturers and Industrial Distributors in Emerging Markets
February 2007ACG.org

For private equity investors and managers of portfolio companies owned by private equity firms, capturing cost savings and growing sales in emerging markets is a prerequisite for success. Companies that do not consider emerging markets are likely to miss significant growth opportunities. In addition, they may not realize the latent competition building in those markets until it is too late. So, exploring the possibilities in emerging markets is a must.

Given the limited and often contradictory information on the state of affairs in emerging markets and the limited internal expertise of manufacturers and distributors, how does a company quantify the potential opportunities for savings? How do decision-makers know if revenue growth is an option or a fantasy in specific emerging markets?

Rigid formulas designed to make these determinations rarely work. Successful companies, however, deploy frameworks for collecting and analyzing information. This article depicts one such framework, focusing specifically on the needs of industrial goods manufacturers and their distributors.

This framework recommends the following steps:

• Define demand
• Assess competition
• Determine brand strength and product positioning
• Analyze pricing structure
• Determine human resource options
• Outline logistics plans
• Build government relationships
• Assess supplier and service provider availability
• Implement an intellectual property protection plan
• Confirm labor compliance policies

Define Demand

Emerging markets are big and growing fast, but so what? While size and macroeconomic growth rates are necessary, that information alone is not sufficient for projecting revenue generation. One of the classic pitfalls of emerging market investing is acting on inaccurate information.

In places like China, where markets can double in just a few years and where the country has experienced greater than 10% compounded annual growth over the past 20 years, it is easy to forget that six-month-old news is often ancient history. If a company has not been on the ground in an emerging market, generating primary data over the past few months, the information on that market is probably distorted. Even supposed market experts often rely on old information, and, as a result, they provide advice that is off the mark.

The solution? Do your own research. Companies creating their own primary data can calibrate expectations around demand, including developing products that appeal to the idiosyncratic desires of the target market. During a recent study, Alaris Consulting learned that consumers were so enamored with a particular product offering that they were willing to pay 20% more than management projections. In addition, statistically significant primary data enables sales teams to project sales growth much more accurately.

Assess Competition

Many firms entering emerging markets underestimate the local competition in a number of areas. Indeed, local competitors often provide fierce competition and are adept at rapidly imitating product and service offerings. Local competitors also leverage their home-field advantage to garner government support and develop lower cost structures in all aspects of their business, including fixed asset acquisition and ongoing variable costs. And very often competitors will have a better operating knowledge in the sales, distribution, and sourcing areas.

Experience is another factor that affects competition. One key disadvantage of newcomers is their lack of experience. Incumbents have often been through many business cycles and have institutional and operations knowledge that enable them to avoid mistakes that newcomers make.

In terms of international competitors and large multi-national companies operating in emerging markets, there is a misconception that the first-movers have all the advantages. They may in some instances, but it is often common to find significant second-mover advantages. Many of these come simply because the first-movers have paved the way.

For example, the first-mover may have educated the market on the need for the service or product, establishing or expanding primary demand. Or perhaps the first-mover created a culture and management structure within its organization that is more suited to the past rather than the present. Finally, in immature regulatory environments, the permissible operating structures change quickly. While first entrants may have been limited in business scope, second-movers can often operate with much greater latitude.

Determine Brand Strength and Product Positioning

Unless companies are selling to international customers with whom they have pre-existing relationships or brand experiences, brands in emerging markets often mean nothing to customers. This is especially true for commoditized products; and in emerging markets, so many products are becoming just that.

Conversely, for certain products, such as highly engineered, high-tolerance or mission-crucial products, foreign expertise and experience can be a significant boost to branding efforts. The mere presence or pretense of “foreign” could connote high value or credibility. Consumers experience brands, and successful companies understand how to methodically define product positioning and implement a program to place the product effectively. Effective product placement requires a firm grasp of where a company’s products and those of its competitors reside in customers’ minds. In an emerging market, product placement is particularly tricky.

Successful examples of leveraging a brand position include implementing value-added services that local companies may not be capable of. Among these are: systems engineering, component integration, just-in-time (JIT) and just-in-sequence delivery, after-sales service, and reverse logistics. For industrial distributors in emerging markets’ hypercompetitive environments, product lifecycles are short. So rapid delivery and after-sales service can be critical advantages, especially in resolving supply shortages and equipment breakdowns.

Analyze Pricing Structure

Pricing in emerging markets can be difficult for a number of reasons.

In many emerging markets, per capita incomes are often well below $5000 per annum, so customers are price-sensitive. Depending upon the specific market and the level of competition, companies must be willing to accept price points that can be significantly lower than those in developed markets. One problem is that in some cases, companies are forced to maintain a global price consistency. Otherwise, the emerging market price becomes the global price and margins erode everywhere. Indeed, an inability to lower prices gives local competitors time to develop competencies to counter a newcomer’s product offering at a lower price.

To deal with this problem, successful companies may develop bifurcated pricing and product differentiation, such as second-tier brands. They offer some customers a Camry and some customers a Lexus. This offering of second-tier products may require reengineering the products, simplifying or altering the product to suit market demand, or localizing sources of supply.

Cost of capital is another factor affecting pricing. To set their cost of capital and company benchmarks, many foreign entrants use gross profit margin requirements that are driven by global prices. In many emerging markets, the cost of capital can be markedly lower than in places such as the United States. As a result, local companies are willing to play a different game than the global competitors are. An inability to understand or act upon the pricing models of competitors is a common mistake in emerging markets.

Moreover, it is also very common for local competitors to fall victim to hubris, believing that double-digit growth of the past few years means that the future is also bright. These local companies often have a field of dreams mentality—“if I build it, they will come.” Such a mindset leads to overcapacity and a race to the bottom until markets consolidate. This set of events is not unique. At the turn of the 20 th century, the US, then one of the great emerging markets, had more than 100 auto companies. Only three survived. In many industries in emerging markets, the industry life cycles are in their infancy and we are rapidly approaching a period of creative destruction.

Determine Human Resource Options

Success requires a team on the ground to market, sell and source or manufacture the products. Despite huge populations in emerging markets, finding qualified employees is often a monumental challenge. Many emerging countries experience rapid growth and as a result, competition for talent becomes fierce. Local hires and/or experienced expatriate managers can help with launching operations quickly, but local talent levels can be hard to evaluate, and the pool of proven managers is shallow. In addition, attracting and retaining top managers as companies move to less desirable, second and third-tier markets requires even more creative HR solutions. Emerging markets have historically lacked executive search firms, yet this situation should improve as headhunters are flooding in to meet demand.

Once companies hire talented managers, they must have strategies to retain them, as these managers will inevitably be coveted by recruiters. For example, it has been estimated that 30 percent to 40 percent of senior managers at multinationals in China switch jobs every year, and their average salary increased by 14 percent annually from 2000 to 2004.

When hiring locals, companies should seriously consider not only pay, but also training, career-development opportunities, and global rotational programs. These types of features can set companies apart from competitors that rely solely on bidding wars to attract talented employees.

Outline Logistics Plans

Transporting goods is another major issue. Undeveloped infrastructure, regionally fragmented service providers, poor handling of goods, and inefficiencies abound when trying to transport goods in emerging markets. The primary advantage of low cost countries—low labor costs—can be quickly eroded by logistics costs that are often double to triple those in developed markets. Planning ahead for logistics, both in terms of distribution costs and timing, should be a priority of any company considering entry into an emerging market. This is especially true in less developed, inland regions where delivery times can be particularly unreliable.

Few end-to-end logistics providers exist for emerging markets. For companies that have known only the relative efficiencies of developed markets, emerging markets present new challenges. But there is help in the offing. In certain markets, such as China recently, de-regulation of the logistics sector has allowed foreign companies to enter the market, and that should bring best practices to an industry desperately in need of such services.

Build Government Relationships

Depending on the instability and frequency of regulatory changes in an emerging market, a strategy for building government relationships and staying on top of regulatory changes is crucial to anticipating and dealing with rapid changes in the business operating environment. This is especially true for foreign entrants who have never confronted highly regulated and controlled markets.

Large companies are often vulnerable to the backlash stemming from economic nationalism. This backlash can be severe when companies operate in strategically sensitive industries or in industries where government leaders have put an emphasis on building national brands. For such markets, it is critical for senior level executives to commit to building strong relationships with government and regulatory bodies.

Assess Supplier and Service Provider Availability

Managing suppliers and service providers in emerging markets presents new challenges to companies separated by both distance and business practices from the home office infrastructure and personnel. For such companies, establishing an in-country presence is the most effective way to manage suppliers on a day-to-day basis. Systematic auditing, re-bidding, and use of established procedures are some of the ways that companies can ensure that the suppliers are providing competitive prices and consistent quality.

Implement Intellectual Property Protection Plan

Companies that operate with, control, and depend upon proprietary product information or technologies and who transfer sensitive technologies to emerging markets must be vigilant. They need to define the technology risks presented by transferring this technology to emerging markets where IP regulations are still immature or irregularly enforced.

Because of weak IP laws and high turnover rates, an employee one day can easily become a competitor the next. Companies should assess which products, trademarks, copyrights, and patents need to be registered with local authorities. They should consider filing defensive registrations for products that may not ever enter the market to prevent others from registering or using them. Companies may arrive in emerging markets only to find that their brand names and trademarks have already been registered, and the owner is waiting to collect a transfer fee. In addition to the marks used in the home country, IP protection for local language and similar-sounding marks should be considered.

If companies are collaborating with local partners or agents, contracts should be extremely clear on IP rights. The absence of specific references to IP in a contract is a common problem when business relationships go sour. Preventive anti-counterfeiting technology such as “smart” chips, molded parts, specialized inks, and holograms can be used on products to differentiate the real goods from counterfeit goods.

Confirm Labor Compliance Policies

Because working conditions in emerging markets may differ from those in home markets, companies should establish standards for suppliers and staff on the ground in emerging markets. High visibility companies are especially vulnerable to public relations fiascos such as accusations of sweatshop labor practices or environmental degradation. Successful firms engage third-party auditing vendors that can ensure compliance and protect the firm in the case of infractions.

Comparison of Selected Market Conditions: US and BRIC

U.S.	Brazil	Russia	India	China
Demographics
US: pop. = 300M Slow population growth Largely urban, racially diverse	Population: 185 M Working age population rising to over 66% in 2015 Ethnically diverse from African, European, and indigenous origins	Population: 145 M Predominantly urban population Severe population decline - working age population rapidly declines after a peak of 68% in 2010	Population: 1.1 bn Rapidly growing, working age population peaks in 2025 at 65% 40% younger than 15 years old Religion, caste, and language are major determinants of social and political organization	Population: 1.3 bn Rising life expectancy & aging population Rapid urbanization 250M above $3.5K considered Middle Income (MI) MI will double in size in 15 years
Infrastructure / Logistics
Highly developed infrastructure; urban areas saturated Ports face challenges in handling imports from Asia	Bottlenecks at ports, power shortages, crumbling roads	European region has decent logistics networks Trans-Ural Russia is not well developed	Roads in poor condition Ports and airports underdeveloped “Golden quadrilateral project (country's largest express highway)” to finish by Jan 2007	Road network well developed Port facilities excellent Rail networks insufficient to support both freight and passenger traffic
Supplier Base
Companies use national and international suppliers Firms outsource and move manufacturing and services offshore instead of integrating vertically	Suppliers are available in Mercosur region	Local suppliers reliable only for simple components	Suppliers are available, but quality and dependability vary greatly Suppliers of steel products are strong due to raw material availability	Many suppliers have strong manufacturing capabilities Few vendors have most advanced / highest tolerance technical abilities
Labor Market for Managers
Large and varied pool of well-trained management talent exists	Large pool of management talent has varying degrees of proficiency in English Both local and expatriate managers hold senior management positions	Large pool of management talent has varying degrees of proficiency in English	Highly liquid pool of English-speaking management talent fueled by business and technical schools Local hires are preferred over expatriates	Small market for experienced managers, especially in inland regions Many senior and middle managers are not fluent in English Large number of managers are expatriates Members of Chinese Diaspora have returned to work
Labor Market for Workers
Level of unionization varies among industries	Trade unions are strong and pragmatic; companies can sign agreements with them	Trade unions are present, but their influence is declining except in certain sectors, such as mining and railways	Trade union movement is active and volatile, although becoming less important Trade unions have strong political connections	Workers can join govt-controlled All China Federation of Trade Unions No history of widespread strikes, but recent strikes have occurred at Taiwanese and HK- owned facilities

Conclusion

Emerging markets offer a tremendous opportunity for manufacturers and distributors, but seizing those opportunities is no easy task. Proven strategies that lead to success are needed. Successful strategies in emerging markets are driven by a company’s ability to adapt its business model to fit demand characteristics. At the same time, the company must retain core business values that have enabled the company to be successful in developed markets. In short, remember your roots and adapt to change.

Alaris Consulting, an Allied Capital portfolio company, provides operational and strategic services to private equity firms and middle market companies. Bob Forbes is a Partner in Alaris’ Chicago office and an ACG member. Francis Bassolino is a Partner and Sean Leow is an Associate in Alaris’ Shanghai office.

By Francis Bassolino, Bob Forbes and Sean Leow