Shan Zhai a Chinese Phenomenon Contact Information

Perspective Edward Tse Kevin Ma Yu Huang

Shan Zhai A Chinese Phenomenon Contact Information

Beijing Yu Huang Senior Associate +86-10-6563-8300 [email protected]

Greater China Dr. Edward Tse Senior Partner +86-10-6563-8300 +852-3650-6100 +86-21-2327-9800 [email protected]

Hong Kong/Shanghai Kevin Ma Principal +852-3650-6100 +86-21-2327-9800 [email protected]

Kate Li, a Booz & Company associate, also contributed to this Perspective.

Booz & Company EXECUTIVE Shan Zhai is becoming a widespread phenomenon in China. SUMMARY Originally used to describe a bandit stronghold outside government control, the term “Shan Zhai” today refers to businesses based on fake or pirated products. However, it does not stop there. Many businesses with humble Shan Zhai origins are now becoming formidable market disrupters and, in many cases, market leaders. The innovative nature of Chinese culture and the huge potential in the Chinese market create vast opportunities for Shan Zhai companies. The best of them are fast, flexible, innovative, and willing to take risks. As they achieve certain scale, they quickly move up the value chain and develop core competencies to differentiate themselves from the also-rans. The Shan Zhai phenomenon is not about low-cost fake products anymore; it is about how one type of Chinese company achieves success without following conventional wisdom and develops competitive advantage through innovation.

Booz & Company 1 What is Shan Ms Yang, a Beijing office worker, Perhaps the most impressive aspect shows off her new mobile phone of the phenomenon is the rise of Zhai? to her co-workers. It boasts all the a number of successful Shan Zhai features of a “typical” handset: companies. Often starting from touchscreen, camera, MP3 and video scratch, Shan Zhai businesses can players—but it offers a lot more evolve with astonishing speed to besides. Shake it, and its wallpaper challenge incumbent players in changes automatically. Dial in, and mature industries. Understanding lights on the sides flash in sync with how they function is important for the most popular ringtones. But foreign managers for two reasons: this is not a Nokia, a Motorola, or First, because they leave no room a Samsung. In fact, it has no brand for complacency—today’s backyard name at all and costs just 480 yuan imitator might tomorrow be eating (US$70), about a fifth the price of your lunch. Second, because the similar “branded” products. This is success or failure of Shan Zhai what is called a Shan Zhai model in businesses is predicated almost China. uniquely on their ability to disrupt the status quo by inventing new and The term Shan Zhai (山寨) is often ingenious business strategies widespread in China. Originally used tailored specifically to the local to refer to a bandit stronghold outside market. These can be illuminating for government control, it has today foreign managers looking for ways to become shorthand for fake or pirated improve their own business models. products, though it can also refer to anything improvised or homemade. Mobile phone maker Tianyu, for From mobile phones to digital example, whose knockoff handsets cameras, wine to medicine, New Year target trendy but value-conscious galas to movies, Chinese consumers buyers, has emerged from nowhere encounter Shan Zhai in almost every to become a major player in China. corner of their daily lives. Nokir and Not only did it take Tianyu just two Samsing Anycat mobiles, Pahetohic years to overtake top domestic player TVs, and Wetherm skin cream are Lenovo, but the company is now just a few examples. Shan Zhai was closing the gap on foreign giants such even the subject of a heated debate at as Nokia, Samsung, and Motorola this year’s National People’s Congress and moving aggressively into overseas held in Beijing in March, with some markets. BYD, a local battery and members deriding the vast number automotive manufacturer, is another of Shan Zhai goods as low-quality standout. After starting out making counterfeits, while others advocated half-price imitations of best-selling more tolerance given the benefits of Toyotas, the company has grown Shan Zhai to Chinese society. into one of China’s most successful automotive manufacturers and today

Often starting from scratch, Shan Zhai businesses can evolve with astonishing speed to challenge incumbent players.

2 Booz & Company also ranks as a global leader in car- battery technology and dual-mode drive-train systems. Future Cola, once labeled a cheap copycat of Coca- Cola, has grown to become the third- largest player in the local carbonated soft drinks market, right after Pepsi. Finally, QQ, originally a Shan Zhai version of ICQ, has now become China’s largest and most successful online instant-messaging platform, with nearly 380 million active users and more than 80 percent market share. These companies and others all form part of China’s so-called Shan Zhai economy.

Although each Shan Zhai company Why Does Shan is different, they often have common Nonetheless, understanding how the characteristics, such as tendencies to Zhai Matter? Shan Zhai culture works is important do the following: for companies operating in China, especially foreign companies. While • Focus on the domestic market (at cheap copycat-type operators are least initially) generally short-lived, some of the best Shan Zhai companies have quickly Proponents of Shan Zhai companies evolved to become disruptors in their • Target mostly mass consumers believe they bring both social and respective industries. economic benefits. By boosting the • Strive for very short cycle time on range of available products, Shan Three key questions are worth product introduction Zhai companies offer consumers probing: more choice at lower price points—an • Focus on cost (but often offer important advantage in the current • What environments would lower quality too) economic climate. In addition, encourage the emergence of Shan supporters say Shan Zhai products Zhai companies? • Tailor product features and can help break monopolies held by functions specifically to local makers of more expensive products • How can we identify those Shan requirements while simultaneously encouraging Zhai companies that will emerge grassroots innovation at home. as disruptors with sustainable Successful Shan Zhai companies Opponents, however, say Shan businesses, as opposed to the vast may begin as counterfeiters or pirates Zhai companies generate a flood majority that will fade away? but often evolve into legitimate of substandard products that often businesses with their own intellectual openly flout other companies’ IP • What are the implications for property (IP) portfolios. rights. Others argue that the Shan companies that compete with Shan Zhai culture fosters laziness and Zhai businesses, especially those ignorance and impairs creativity and from abroad? competitiveness.

Booz & Company 3 How did Shan The Shan Zhai phenomenon did not survive, they were forced to adopt evolve spontaneously—it emerged as a creative and pragmatic solutions, often Zhai culture result of both “soft” factors (Chinese by emulating the strategies of foreign emerge? culture, history, and the policymaking/ companies. Shan Zhai was part of regulatory context) and “hard” the answer. factors (market supply and demand) (see Exhibit 1). Chinese culture therefore provides a context for flexibility and creativity. Culture, History and Regulation: In fact, the salient quality of modern- Setting the Context day Chinese entrepreneurs, including Shan Zhai practitioners, is not their In terms of culture, Chinese people “me-tooism” but their willingness have a long history as “fearless to take chances and learn from experimenters”. Going back to the their experiences. “Let’s try it,” days of China’s ancient civilizations, they say. If an idea doesn’t work, evidence of Shan Zhai culture can they abandon it and try something be traced to Chinese classics such as else. Speed is critical. The ability to Journey to the West（《西游记》） experiment, replicate success and and The Story of Shui Hu（《水浒 move rapidly up the learning curve 传》）, stories that have influenced has given many Chinese companies the Chinese people for centuries. In an advantage over some slower- Journey to the West, for example, Sun moving foreign competitors. (See Wu Kong (孙悟空), the “Monkey China’s Five Surprises by Edward King”, demonstrates his fearlessness Tse, strategy+business, Winter 2005, and creativity in confronting provides more on challenges and fighting evil as he “fearless experimenters”). strives for justice against traditionally powerful authorities. In Shui Hu, the In terms of policy, the Chinese base where the heroes lived is called government has for years gradually Liang Shan Bo, a literal Shan relaxed the regulatory environment Zhai itself. in one industry after another. In the automotive sector, for instance, The mentality is also reflected in while authorities have tried to Chinese sayings such as “crossing the support growth at large stated- river by feeling the stones,” and in owned enterprises such as First recent times has been quickly adopted Auto Works (FAW) and Shanghai in Chinese business circles and even Automobile Industrial Corporation its major policymaking processes. (SAIC), nimble companies such as For example, when economic reform BYD and Chery have quickly grown was initiated on the Mainland into strong players. In the mobile about three decades ago, most local handset-manufacturing sector, enterprises started at a very low level, competition was for years stifled by with experience and resources far licensing requirements imposed by the inferior to those of the global majors. Ministry of Industry and Information Many, especially in the private sector, Technology (MII). However, the lifting lacked both the institutional support of this licensing barrier in October enjoyed by state-owned rivals and the 2007 allowed the newly legitimized economies of scale of large foreign Shan Zhai enterprises to bring new companies. Hard-pressed even to vitality to the industry.

4 Booz & Company Of course, many Shan Zhai companies Supply and Demand Dynamics markets, such as those in lower-tier operate in breach of, or at least on Drive Opportunities cities and the countryside—a logical the borderline of, China’s IP laws. choice given that more than 60 percent Foreign companies in particular Perhaps more important than the of China’s 1.3 billion people live continue to complain about poor “soft” factors detailed above, in rural areas. Although individual IP rights protection in China. Lack the emergence of the Shan Zhai incomes in these less developed of enforcement of patent legislation phenomenon has been driven by markets are lower, aggregate remains a key concern, as does the the supply and demand (ie, “hard”) consumer purchasing power can still inability of the Chinese court system characteristics of the Chinese market. be significant. In particular, younger (with a few notable exceptions) to deal rural consumers tend to follow urban with complicated technological issues. On the demand side, the rapidly consumption trends. Likewise, in Also, the lack of severe penalties evolving and still relatively immature more developed markets, lower- and for infringement does little to deter nature of China’s markets offers mass-market consumers often yield counterfeiting. Much more progress opportunities to exploit possibilities tremendous aggregate consumption is needed in China’s patent protection across a number of dimensions, power for many products and services. system before IP legislation can be including customer segments, enforced effectively. channels, and geographies. Shan Zhai Tianyu’s breakthrough in making companies often target less developed Shan Zhai handsets is a good example.

Exhibit 1 Key Factors for Shan Zhai Phenomena in China

“Fearless Experimenter” mindset is deeply rooted The relatively weak, inconsistent/non-transparent among the Chinese industry policy-making/regulation of certain Chinese regulators – Chinese started from very low base/often could only start from emulation – For example, the auto industry policy in past years “SOFT” CULTURE – “Experimentalism” mentality very common in POLICY – Also still poor IP protection etc FACTORS business world/even in major policy making – All these had given Shan Zhai folks room to – Long-rooted Shan Zhai culture in Chinese history play/grow

Rapidly evolving/still relatively immature nature of Industry incumbents’ irresponsiveness/negligence in Chinese market with opportunities of major discontinuities market changes often render opportunities for nimble existing in many industries locals to attack – Multi-segment (often very blurred segmentation) – Slow/irresponsive to market changes – Multi-channel – Inadequate understanding of China market – Multi-tier dynamics (esp. MNCs) “HARD” DEMAND SUPPLY FACTORS Especially the under-served rural market & very sizable Meanwhile the existence of tremendous supply low/mid-class offer abundant opportunities to Shan Zhai capacity in China enables Shan Zhai players to be players very flexible & efficient vendors – Substantial aggregate consumption power – Strong, often over-supplied manufacturing capacity – Price sensitive yet trend-following with very developed value chain or ecosystems existing in many sectors

Source: Booz & Company analysis

Booz & Company 5 The company started out by focusing (for large Chinese state-owned technology into China’s first electric on previously neglected low-end enterprises) hybrid car. The company is now handset users in China’s overlooked working on an all-electric vehicle that Tier 3 and Tier 4 cities, aggressively One example is the car rental industry. BYD claims can travel 300 kilometers rolling out a channel strategy (again, Hertz, the world’s largest car rental on a single charge. one overlooked by majors such as company, entered China as early Motorola and Nokia) targeting as 2002. But despite its first-mover Another major supply-side advantage “last-mile” sales. This involved advantage and years of industry is China’s imposing manufacturing development of a streamlined experience, Hertz’s Chinese operations capacity and capabilities. Most Shan distribution model that offered were slow to develop, as were those Zhai mobile phones, for example, products mostly at points of sale at of Avis, the number two global brand. are developed in Shenzhen, where a retail chain stores or supermarket One reason was that both companies well-developed ecosystem has evolved. electronics counters and paid generous tried to apply their US operating Clustered within a few kilometers of sales commissions directly to retail models to China, a strategy that left Shenzhen’s Hua Qiang Bei Road, more sales forces. A critical turning point the door open for a domestic player, than 27 large markets sell all kinds of came when Taiwan’s cell phone chip eHi Car Rental, to develop its own, electronic goods, ranging from basic solution company MediaTek launched localized business model. Realizing components to complete handsets. In a new chip solution that featured that the Hertz/Avis self-drive approach fact, in Shenzhen today there are over all-in-one functionality. Taking neither suited the needs of busy and 30,000 companies collaborating across advantage of MediaTek’s simple, often stressed local executives nor the entire mobile phone value chain, integrated motherboard and easily worked well in China’s heavy traffic including design/product solutions, changeable user interface, Tianyu then and rapidly-evolving road systems, sourcing, assembly/production, focused its efforts on developing and eHi began offering chauffeur-driven testing, packaging, distribution, and adding popular features, building on services—a move that turned out to after-sales services. Over the past its in-depth understanding of local be both profitable and viable. As several years, this critical mass of customer needs and its ability to reach a result, eHi has grown quickly to businesses has morphed into a virtual them effectively. become China’s only profitable large organization. This means that for Shan car-rental company. Zhai companies, just one or a few Meanwhile, on the supply side, the firms (such as MediaTek) perform the often slow and occasionally negligent BYD’s breakthrough as a major majority of chipset-level R&D, the responsiveness of industry incumbents Chinese vehicle manufacturer in an costs of which are then shared among in reacting to market changes has industry formerly dominated by large a large number of manufacturers. For created opportunities for nimble state-owned enterprises is another companies such as Nokia or Motorola, local competitors. Typical mistakes good example of Shan Zhai in action. however, each business must pay for include these: BYD started its car business by making its own R&D and recoup its costs copies of Toyotas. However, just as through large volume sales. As a • Failure to respond quickly to many local vehicle manufacturers result, R&D costs for each Shan Zhai evolving markets or adapt to began focusing on cutting costs and mobile phone chip are normally $8 changing consumer preferences developing smaller cars in response to $10 cheaper than for a traditional to a deteriorating economy, BYD mobile chip. While Nokia or Motorola • Inadequate understanding of chose instead to develop its own must sell nearly a million units to local market dynamics (for technology. After making a significant break even, a Shan Zhai company foreign companies) or a persistent breakthrough in car battery design, can reach breakeven on sales of just reluctance to implement change the company incorporated its new 10,000 phones.

6 Booz & Company How to tell While many Shan Zhai companies are 4. Most important, an creating an short-lived, some go on to become “experiment-learn-adapt” the Disruptors very successful. These winners often virtuous cycle from the share similar traits, particularly three kinds (see Exhibit 2, page 8): • Scaling up quickly while Also-Rans simultaneously creating barriers An ability to break into a market to entry and developing strategic and establish a significant position core competences. A common quickly. They do this by: modus operandi involves targeting lower-end mass segments in order • Developing an in-depth to build scale and market share via understanding of local needs, large-volume sales, then raising then moving quickly to capture entry barriers by developing further emerging opportunities overlooked advantages in areas such as cost or underserved by incumbents. control, pricing, and supply chain stickiness, or by building cohesive • Developing a very responsive and ecosystems with industry partners. resilient business model, often featuring: An ability to upgrade core capabilities and migrate up the value chain 1. Rapid/frequent launches of new products and services that fit well • Upgrading core capabilities. with the latest market trends or After starting out as copycats, consumer preferences successful Shan Zhai proponents 2. Very flexible and localized acquire key know-how, especially operations that are both low-cost in R&D and new product design, and resilient and then begin developing value- 3. Innovative channel/sales added services or differentiated strategies that maximize reach to products to solidify or expand their target customers customer base.

Booz & Company 7 Exhibit 2 Growth Pattern of Successful Shan Zhai Companies

AMOUNT OF FDI UTILIZED IN CHINA (2000–2008)

US$ Billion 1,000 92.4 900 82.7 800 +11% 69.5 700 60.6 60.3 600 52.7 53.5 500 46.9 40.7 400

300

200

100

0 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Booz & Company analysis

8 Booz & Company • Moving up the value chain, • That said, the very best Shan within a year, Tianyu created a wide upgrading their brand image, Zhai players are constantly spectrum of product choice for its and actually moving away from looking for the next “blue ocean” channel partners and ultimately their Shan Zhai beginnings. Some opportunity—one that can offer its customers. Crucially, its nimble have even emerged as industry new growth before their current and efficient team, together with a trendsetters, leading a new wave of market comes to the end of its distributor network motivated by a product or technology development. life cycle. proper profit-sharing scheme, allowed costs to be effectively managed. The Investment in the future: In Tianyu’s case, the company’s resulting high sales volumes led to first move was to target lower- rapidly growing market share, and • Many Shan Zhai companies target end customers by leveraging the the company soon became China’s markets that have reached maturity simplified but disruptive MediaTek top domestic handset manufacturer, on the S-curve, after which basic technology platform to offer whose sales are now closing in on entry barriers are lower, market value-for-money handsets with market leaders Nokia, Samsung, demand has grown to allow more practical but trendsetting features. and Motorola. But Tianyu hasn’t participants, and they are able to In addition, it developed a very stopped there. The company has now apply their “disruptive” tactics to responsive operation capable of started investing in 3G products, attack incumbents. fast turnarounds. Launching more aiming at the next phase of China’s than a hundred tailored models telecom development. Following a

The very best Shan Zhai players are constantly looking for the next “blue ocean” opportunity.

Booz & Company 9 recent agreement with Qualcomm, a even topple incumbent industry manufacturing system featuring low leading developer of CDMA wireless leaders that had generally focused fixed investment and high labor technologies, Tianyu will soon be able on incremental improvements and content that leveraged China’s still to develop, manufacture, and sell its sustaining established business low labor costs. In addition, it popular K-Touch range on a platform territories. This template has been developed a unique backward-vertical compatible with China’s upcoming boosted by the fearless experimenter integration model by streamlining its 3G networks. Today, Tianyu is mind-set, which has further propelled production line and developing key a mainstream player virtually already nimble Shan Zhai companies high-cost parts (including chassis, air- unrecognizable from its to become ever more responsive and conditioning, and engine) in-house. Shan Zhai beginnings, thanks largely adaptable to market changes. In 2006, BYD’s sales reached some to increased efforts in R&D and 60,000 units, up from just 11,000 brand building. BYD is another example of a Shan in 2005. By expanding market reach Zhai imitator that was transformed and continuing to leverage scale to There are more than a few similarities after applying a similar migration cut costs, the company has seen sales between these various Shan Zhai pattern. BYD was originally mushroom further. In 2008, it sold a success stories and what Harvard known for churning out copies of remarkable 200,000 cars, while in the Business School Professor Clayton Toyota cars—particularly its F3 first two months of 2009, sales grew a Christensen has described as the model, a half-price Toyota Corolla further 140 percent year-on-year. The “innovator’s dilemma”: New entrants imitation that became profitable company is now targeting 2009 sales such as Tianyu have adopted a within just three months of product of 400,000 cars, doubling turnover in disruptive business model (MediaTek launch. In order to minimize costs, a single year. in Tianyu’s case) to attack and BYD deployed a semiautomatic

Today, Tianyu is a mainstream player virtually unrecognizable from its Shan Zhai beginnings, thanks largely to increased efforts in R&D and brand building.

10 Booz & Company As impressive as this is, it is just is still awaiting Chinese government addition, the company managed to the start of the BYD dream. Since approval) is a further indicator of the develop a vast sales and distribution the company began manufacturing company’s potential. Today, therefore, network in rural areas, partly by cars about five years ago, it has BYD is well on its way to becoming a leveraging the resources of its parent invested in and built a layered and major-league player and innovator in company, Wahaha Group. More integrated R&D organization, the automotive market. important, it launched an aggressive quickly transforming technology but very focused marketing campaign and experience into reality. It has A final example of aShan Zhai to build a brand image as “the also invested huge amounts in success story is Future Cola. Its Chinese people’s own cola.” By 2006, talent development. One of BYD’s humble beginnings saw it launching Future Cola had grown into the third- most significant achievements has a product that copied Coca-Cola’s largest player in China’s carbonated been its grasp of core technology packaging design but whose flavor soft drinks market, with a particularly and manufacturing know-how in was tailored for the Chinese palate. strong position in rural areas. In an car battery and dual-mode drive- Unlike Coca-Cola, which began effort to expand market share further, train systems. If its efforts in these largely by targeting major cities, Future Cola now has plans to branch areas prove as successful as the Future Cola sought out overlooked into Tier 1 and 2 markets in major company currently claims, BYD consumers in rural areas. It imported cities, in direct competition with will have created a key platform to state-of-the-art equipment and Coca-Cola and Pepsi. tackle the lucrative new-energy auto quickly localized production facilities, market. Warren Buffett’s proposed allowing it to offer products at investment in the company (which significantly lower price points. In

Booz & Company 11 Study the Shan Foreign and local companies alike are destructors” and game changers. often frustrated by China’s Shan Zhai Do not just react to market change; Zhai as they phenomenon. Shan Zhai companies’ change the market. study you modus operandi usually involves such careful study and adaptation of • Get out of your comfort zone. an existing business model that they Learn from the Shan Zhai players are perceived to be taking something and become a fearless experimenter belonging to an incumbent whether —you will find opportunities that they are acting in breach of its IP would otherwise never occur to you. rights or not. At the same time, Shan Zhai companies can offer instructive Companies that are able to work insights into how local markets successfully in China must first work and in particular how existing develop a clear understanding of strategies can be adapted to work its complex markets, appreciate the more efficiently in a Chinese context. diversity of the local customer base, This is especially true for foreign and come to terms with relatively companies, which are often unfamiliar poor IP rights protection. Those with China’s sometimes unusual who can come to terms with the operating environment. subtleties of China’s multi-tier customer segments, understand their Key takeaways include these: tastes and preferences, and create distinctive products that meet local • Underestimate low-cost competitors needs will benefit from theShan at your peril. With the right Zhai mind-set when serving China’s business model and strategy, some emerging breed of consumers. On one Shan Zhai companies can and do hand, Shan Zhai companies can be evolve into major-league players. formidable competitors. On the other hand, they could become potential • Always drive change instead business partners or even acquisition of being driven by change. candidates. The key is to keep an open Companies need to be “constructive and humble mind.

Get out of your comfort zone. Learn from the Shan Zhai players. Become a fearless experimenter.

12 Booz & Company About the Authors

Dr. Edward Tse is Booz & Company’s managing partner for Greater China, specializing in definition and implementation of business strategies, organizational effectiveness, and corporate transformation. He has assisted several hundred companies— headquartered both within and outside China—on all aspects of business related to China and its integration with the rest of the world.

Kevin Ma is a principal with Booz & Company in Greater China. He has extensive experience with multinational corporations and Chinese companies in the travel and tourism and high-tech industries in the Asia Pacific region, with a focus on Greater China.

Yu Huang is a senior associate with Booz & Company based in Beijing. He has over 10 years experience in consulting, financial services and high tech industries. His specialties are corporate strategy and project management.

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