Argument

Why Buy the Hardware When China Is Getting the IP for Free?

IBM is sharing proprietary technology with Beijing in exchange for market access. Is it savvy or suicide?

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In Beijing in late March, IBM CEO Virginia Rometty announced that the company’s new strategy in China will be to share its technology to help build the country’s IT industry.

“If you’re a country, as China is, of 1.3 billion people, you would want an IT industry as well,” she told the crowd at the China Development Forum, a government-sponsored event. “I think some firms find that perhaps frightening. We, though, at IBM … find that to be a great opportunity.”

Rometty needs a great opportunity. As the CEO of IBM since 2012, she has spent her more than 30-year career at the company watching it slowly shed the hardware, heft, and influence that earned it the “Big Blue” moniker. Still, IBM is no pipsqueak: With a roughly $160 billion market capitalization and just under 380,000 employees, the firm remains a massive force in information technology. But today, 88 percent of the company’s revenues come from selling software and services to enterprises that put data to work for their business, with most of the remainder coming from selling the specialized hardware that lives at the hearts of the most advanced networks. Where once IBM could count on scale and presence for its competitive edge, the company now faces competition in nearly all its major businesses, often from small, specialized, and nimble upstarts. With a lackluster price-to-earnings (P/E) ratio hovering between 10 and 11 and a mediocre C+ rating from the financial news website TheStreet.com, investors do not see IBM’s future in the same way that they see, say, Oracle’s. Rometty needs to steady the boat. The company’s enterprises in China, Rometty seems to be saying, could be the company’s staysail.

But does China need IBM as much as the latter hopes it does? Leaving aside for a moment that China already has an IT industry — one that has produced global giants like Lenovo, Huawei, Baidu, and Alibaba — Rometty’s message gave an artful spin to an ugly reality: Gone are the halcyon days of the U.S. IT industry in China, when it could profit by selling leading-edge hardware and software to a country determined to leapfrog the world. China is now engaged in an unprecedented campaign of techno-nationalism that it justifies by pointing to Edward Snowden’s allegations of the American IT industry’s complicity in the National Security Agency’s (NSA’s) efforts to spy on China. Since coming to power in late 2012, Chinese President Xi Jinping has doubled down on his predecessors’ effort to compel local companies to buy from Chinese vendors. In doing so, he is giving local firms the scale to take on the industry giants in global markets.

The rise of China’s IT industry

That effort has born results, turning formerly midsized Chinese firms like IT hardware manufacturers Inspur and Suzhou PowerCore into major players in China and giving Lenovo and Huawei an opportunity to extend their dominance of domestic markets. Inspur now has $6 billion in annual revenues, and Huawei has reached $46 billion. Ironically, Lenovo’s annual revenue of $39 billion comes in no small part from buying pieces of IBM — which sold its PC division in 2005 and x86-based server division in 2014 in an effort to get out of what pundits were calling a “commoditized” business. For its part, Lenovo turned its IBM castoffs into a leading share of the global PC market, growing shipments 15 percent in the second quarter of 2014, far better than the global increase of 0.1 percent.

For non-Chinese IT companies, Xi’s buy locally, sell globally effort has led to major losses in a market that had been the major driver of global business growth. IBM was particularly hard hit: In October 2013, the company reported that its revenues in China had plunged 22 percent in the year’s third quarter. Big Blue had not recovered a year later; revenues were still more than 25 percent off October 2012’s peak.

Faced with the decline and potential loss of China as a market, IBM has reacted by shifting to a strategy of trading technology for access. Over the past six months, the company has signed a spate of deals to allow local Chinese rivals to sell IBM products and technologies themselves. Among other things, it has handed software and hardware blueprints to local vendors, allowing them to produce a version of the leading-edge IBM Power8 processor and build and sell servers that compete with similar IBM products. It is letting Chinese rival Inspur bundle IBM database software with the local company’s servers, and it looks ready to do similar deals with software rivals like Yonyou. In short, the company is giving rival businesses access to technologies that are, for IBM, its competitive advantage.

The exact value of what IBM is handing over to its local partners, or the capabilities of its partners to replicate what they are not being given, remains unclear. However, it seems that IBM is gambling that Chinese companies will not undercut Big Blue in its global markets — in which it earns 95 percent its revenues — in return for some access to China, which makes up just 5 percent of the company’s sales.

So is Rometty betting that the future value of the Chinese market to IBM will exceed the value of the rest of the world combined? If so, then it makes sense for the company to do anything possible to retain a foothold in China. But that seems very unlikely, and very unwise.

If you hold stock in IBM, you’ll probably have a long list of questions at the next shareholders’ meeting: How long can IBM count on retaining that access to China, and to what end? How much longer can IBM rely on winning sales in China by empowering local companies, and how long will it take before those companies realize they have what they need to shove IBM out the door? And how long then until those very same companies start competing and displacing IBM in emerging and high-growth markets around the world?

In return for access to a single — albeit huge — market, Rometty may well have sacrificed the company’s future.

A dangerous deal

Swapping technology for access to the Chinese market has always been a two-way gamble. Beijing risks that the global tech giants will end up dominating China’s market at the expense of nascent local players, with the upside that in the long run the transferred technology will help local firms improve and compete with global leaders. On the other side, global tech giants are betting that the technology they transfer will never be enough to turn local upstarts into true rivals.

Ever since the beginning of modern China’s opening to the outside world in the late 1970s, Beijing has insisted that foreign firms in many industries transfer technology to local Chinese enterprises as a prerequisite to market access. In the IT industry, initial concerns about creating rivals died quickly; the handful of Chinese companies that existed were not ready to exploit the technology. Local customers preferred foreign market leaders over local competitors, and Chinese enterprises were unable to deliver the mix of quality, features, and after-sales service necessary to beat the global giants. While domestic companies lived on the low-margin business that the global players could not afford to service, foreign IT firms flourished in China.

Today, though, that gamble is increasingly looking like a sucker’s bet loaded in China’s favor. The market dynamics of the 1980s and 1990s, when a company could transfer technology to relatively primitive Chinese enterprises and still remain dominant in the country and beyond, have evaporated. The local players left standing after a Darwinian consolidation process are focused, hungry, and ready to use foreign technology to vault them into global leadership.

China now has an information technology industry that is equipped to match — and beat — the global leaders. It has set up sales organizations that are tightly integrated with product development, allowing them to deliver customer-requested product improvements faster than global leaders, which often cannot be bothered to make a product change for a single customer. For example, Huawei designed suitcase-portable cellular base stations for the charitable arm of the British telecommunications company Vodafone, which wanted a way to quickly re-establish phone service in disaster-stricken regions. Chinese firms have established vast research-and-development organizations — Huawei spends a whopping 14 percent of revenues on R&D, far higher than the industry standard, and has more than 1,000 researchers at its Silicon Valley facility alone. Inspur and Lenovo each have a half-dozen research centers around the world and spend a growing portion of revenues on R&D. These investments and others like them have allowed China’s top technology firms to imitate the innovations of global leaders more quickly than ever, narrowing the window in which global leaders can exploit their technology advantage.

And Chinese IT firms are doing this while pursuing a strategy to pick off international markets until they have turned the tables on global leaders. Huawei has made deep inroads into Africa and India; electronics giant TCL is building factories in Brazil to support both Latin American markets and global production; and upstart software developer Kingdee is fighting American enterprise-software giants in Southeast Asia. And they are doing it all with the support of a government determined to forge international champions, aiding them not only with an umbrella of soft protectionism, but also with export credits that enable Chinese players to sell in developing markets under the most attractive terms available.

If that sounds fanciful, look at a list of global market leaders for servers, smartphones, and the sophisticated networking gear that forms the backbone of telecommunications networks. At or near the top are Chinese companies that were born of technology transferred from the West.

Which brings us back to IBM.

The R&D race

With a few notable exceptions, most Chinese IT firms have lacked innovation — the wherewithal to create new, useful, and relevant advances in products and processes ahead of the competition, and a vital component of market leadership. Innovation delivers to the manufacturer valuable cachet, the perception that its products are the most advanced and, by implication, the best. That perception drives demand and allows companies to charge higher prices, driving the profits that help fuel R&D and the public relations that solidify and enhance market leadership. What Chinese companies need to learn today is how to leap that last gap.

For companies like Inspur and Suzhou PowerCore, IBM’s technology sharing may be the bridge across that gap, the extra ingredient that will enable them to take on Big Blue — first in emerging economies where price will be more important than brand and then, as those companies build scale and master the challenges of international markets, in more lucrative developed markets.

Granted, technology transfer does not always spell doom for the originators of that technology. Global technology companies adept at creating a constant stream of innovations that are essential to the success of important sectors of the Chinese economy have made themselves irreplaceable. Government fuming and anti-monopoly laws notwithstanding, IT companies like Intel, Qualcomm, Apple, General Electric, United Technologies, and at least a dozen others have pursued this strategy to forge lasting success in the Chinese marketplace. Knowing that their current technology would be eventually reverse-engineered, they still innovated quick enough to propel the market forward faster than their Chinese competitors.

Thus each knows that it is only as good as its pipeline of innovations. IBM, for its part, is doubtless aware that any control over its intellectual property in China is tenuous at best and that long-term success in China depends on milking its stream of patents. But, as leadership and innovation expert Steve Denning has noted, IBM’s shift in focus away from innovation and toward earnings under Rometty’s predecessor compelled the company to make deep cuts in R&D. With the support of institutional shareholders, Rometty has continued the trend.

In 2014, the company cut 12 percent from its R&D budget, spending less on innovation than it had per year in over a decade. The cuts this year look to be even deeper. The results are hurting business: The company’s bid on the CIA’s new cloud-based information systems was rejected as technically inferior. In the best of times, turning patents into marketable innovations is a brutal process, and there are no guarantees of market success. (Xerox PARC, anyone?) At IBM, these are far from the best of times.

Cutting investment in innovation while potential rivals are doubling down on R&D suggests that IBM’s leadership remains more focused on shareholders than on innovation. Rometty must demonstrate either that IBM can deliver a stream of innovations that will make the emergence of technology transfer-enabled competitors irrelevant, or that China is worth more than the rest of the world combined. Otherwise, Rometty may be sacrificing the long-term viability of her company for a short-term opportunity in China.

Photo credit: TOBIAS SCHWARZ/AFP/Getty Images

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