Scale of entry into foreign markets

After you have read this chapter you should be able to:

1 Explain the three basic decisions that firms contemplating foreign expansion must make: which markets to enter, when to enter those markets, and on what scale.

2 Compare and contrast the different modes that firms use to enter foreign markets. 3 Identify the factors that influence a firm’s choice of entry mode.

4 Recognize the pros and cons of acquisitions versus greenfield ventures as an entry strategy.

L E

A R

N IN

G O

B J E

C T

IV E

S

part 5 Competing in a Global Marketplace

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General Motors in China

Entering Foreign Markets

12 c h a p t e r

opening case

T he late 2000s were not kind to General Motors. Hurt by a deep recession in the United States, and plunging vehicle sales, GM capped off a decade where it had progressively lost market share to foreign rivals such as Toyota by entering Chapter 11 bankruptcy. Between 1980, when it dominated the U.S. market, and 2009, when it entered bankruptcy protection, GM saw its U.S. market share slip from 44 percent to just 19 percent. The troubled company emerged from bankruptcy a few months later a smaller enterprise with fewer brands, and yet going forward some believe that the new GM could be a much more profitable enterprise. One major reason for this optimism was the success of its joint ventures in China. GM entered China in 1997 with a $1.6 billion investment to establish a joint venture with the state-owned Shanghai Automotive Industry Corp. (SAIC) to build Buick sedans. At the time, the Chinese market was tiny (less than 400,000 cars were sold in 1996), but GM was attracted by the enormous potential in a country of over 1 billion people that was experiencing rapid eco- nomic growth. GM forecast that by the late 2000s some 3 million cars a year might be sold in China. While it explicitly recognized that it had much to learn about the Chinese market, and would probably lose money for years to come, GM executives believed that it was crucial for them to establish a beachhead and to team with SAIC (one of the early leaders in China’s emerging automobile industry) before its global rivals did. The decision to enter a joint venture was not a hard one. Not only did GM lack knowledge and connections in China, but also Chinese government regulations made it all but impossible for a for- eign automaker to go it alone in the country. While GM was not alone in investing in China—many of the world’s major auto- mobile companies entered into some kind of Chinese joint venture during this time period—it was among the largest investors. Only Volkswagen, whose man- agement shared GM’s view, made similar-sized investments. Other compa- nies adopted a more cautious approach, investing smaller amounts and setting more limited goals.

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By 2007 GM had expanded the range of its partnership with SAIC to in- clude vehicles sold under the names of Chevrolet, Cadillac, and Wuling. The two companies had also established the Pan-Asian Technical Automotive center to design cars and components not just for China but also for other Asian markets. At this point it was already clear that both the Chinese market and the joint venture were exceeding GM’s initial expectations. The venture was profitable, selling more than 900,000 cars and light trucks in 2007, an 18 percent increase over 2006 and placing it second only to Volkswagen in the market among foreign nameplates. Equally impressive, some 8 million cars and light trucks were sold in China in 2007, making China the second-largest car market in the world, ahead of Japan and behind the United States. Much of the venture’s success could be attributed to its strategy of de- signing vehicles explicitly for the Chinese market. For example, together with SAIC it produced a tiny minivan, the Wuling Sunshine. The van costs $3,700, has a 0.8-liter engine, a top speed of 60 mph, and weighs less than 1,000 kilograms—a far cry from the heavy SUVs GM was known for in the United States. For China, the vehicle was perfect, and some 460,000 were sold in 2007, making it the best seller in the light-truck sector. It is the future, however, that has people excited. In 2008 and 2009, while the U.S. and European automobile markets slumped, China’s market regis- tered strong growth. In 2009 some 13.8 million vehicles were sold in the country, surpassing the United States to become the largest automobile mar- ket in the world. GM and its local partners sold a record 1.8 million vehicles in 2009, a 67 percent increase over 2008. At this point, there were 40 cars for every 1,000 people in China, compared to 765 for every 1000 in the United States, suggesting that China could see rapid growth for years to come. • Sources: S. Schifferes, “Cracking China’s Car Market,” BBC News , May 17, 2007; N. Madden, “Led by Buick, Carmaker Learning Fine Points of Regional China Tastes,” Automotive News , September 15, 2008, pp. 186–90; and “GM Posts Record Sales in China,” Toronto Star , January 5, 2010, p. B4.

Introduction This chapter is concerned with two closely related topics: (1) the decision of which foreign markets to enter, when to enter them, and on what scale; and (2) the choice of entry mode. Any firm contemplating foreign expansion must first struggle with the issue of which foreign markets to enter and the timing and scale of entry. The choice of which markets to enter should be driven by an assessment of relative long-run growth and profit potential. The choice of mode for entering a foreign market is another major issue with which international businesses must wrestle. The various modes for serving foreign markets are exporting, licensing or franchising to host-country firms, establishing joint ven- tures with a host-country firm, setting up a new wholly owned subsidiary in a host

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Chapter Twelve Entering Foreign Markets 419

country to serve its market, or acquiring an established enterprise in the host nation to serve that market. Each of these options has advantages and disadvantages. The mag- nitude of the advantages and disadvantages associated with each entry mode is deter- mined by a number of factors, including transport costs, trade barriers, political risks, economic risks, business risks, costs, and firm strategy. The optimal entry mode varies by situation, depending on these factors. Thus, whereas some firms may best serve a given market by exporting, other firms may better serve the market by setting up a new wholly owned subsidiary or by acquiring an established enterprise. As discussed in the opening case, in 1997 GM decided to enter China on a sig- nificant scale. It’s choice of entry mode, a joint venture with Shanghai Automotive Industry Corp., was dictated by circumstances at the time (Chinese government regu- lations made a joint venture the only practical alternative). GM was attracted to the market by the promise of rapid future growth. The growth exceeded GM’s expecta- tions, and the company reaped the rewards of making the right strategic choice under considerable uncertainty. Although GM as a whole did not fair well in the late 2000s (it had to seek bankruptcy protection in 2009), its success in China was the glittering jewel in an otherwise dismal picture, demonstrating just how important it can be for a company to get its foreign market entry strategy right.

Basic Entry Decisions A firm contemplating foreign expansion must make three basic decisions: which mar- kets to enter, when to enter those markets, and on what scale. 1

WHICH FOREIGN MARKETS? The world has more than 200 nation-states. They do not all hold the same profit potential for a firm contemplating foreign ex- pansion. Ultimately, the choice must be based on an assessment of a nation’s long-run profit potential. This potential is a function of several factors, many of which we have studied in earlier chapters. In Chapter 2, we looked in detail at the economic and political factors that influence the potential attractiveness of a foreign market. There we noted that the attractiveness of a country as a potential market for an interna- tional business depends on balancing the benefits, costs, and risks associated with doing business in that country. Chapter 2 also noted that the long-run economic benefits of doing business in a country are a func- tion of factors such as the size of the market (in terms of demographics), the present wealth (pur- chasing power) of consumers in that market, and the likely future wealth of consumers, which de- pends upon economic growth rates. While some markets are very large when measured by number of consumers (e.g., China, India, and Indonesia), one must also look at living standards and economic growth. On this basis, China and India, while rela- tively poor, are growing so rapidly that they are at- tractive targets for inward investment (hence GM’s decision to invest in China in 1997; see the opening case). Alternatively, weak growth in Indonesia im- plies that this populous nation is a far less attractive target for inward investment. As we saw in Chapter 2, likely future economic growth rates appear to be a function of a free market system and a country’s

LEARNING OBJECTIVE 1 Explain the three basic

decisions that firms contemplating foreign expansion must make:

which markets to enter, when to enter those

markets, and on what scale.

Another Per spect i ve

Thailand’s Homebuilder Enters Foreign Markets As a child in Thailand, Thongma Vijitpongpun helped his father sell soup to day laborers, balancing twin hampers on a shoulder pole and learning the first rule of good busi- ness: deliver quality at an affordable price. Today Thongma’s business, Pruksa Real Estate, uses mass-production tech- niques to build quality, affordable housing for low- and middle-income families. Pruksa’s process has been so successful—with recent annual revenues pegged at $569 million—that the company intends to expand to other Asian countries where the need for low-cost housing is great. First on Pruksa’s list are India, Vietnam, and the Maldives, with China, Indonesia, and the Philippines to fol- low. (Brian Mertens, “Biggest Thai Home Builder Moving Abroad to Expand Company,” Forbes.com, February 8, 2010, www.forbes.com)

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420 Part Five Competing in a Global Marketplace

capacity for growth (which may be greater in less developed nations). We also argued in Chapter 2 that the costs and risks associated with doing business in a foreign country are typically lower in economically advanced and politically stable democratic nations, and they are greater in less developed and politically unstable nations. The discussion in Chapter 2 suggests that, other things being equal, the benefit– cost–risk trade-off is likely to be most favorable in politically stable developed and developing nations that have free market systems, and where there is not a dramatic upsurge in either inflation rates or private-sector debt. The trade-off is likely to be least favorable in politically unstable developing nations that operate with a mixed or command economy or in developing nations where speculative financial bubbles have led to excess borrowing (see Chapter 2 for further details). Another important factor is the value an international business can create in a for- eign market. This depends on the suitability of its product offering to that market and the nature of indigenous competition. 2 If the international business can offer a prod- uct that has not been widely available in that market and that satisfies an unmet need, the value of that product to consumers is likely to be much greater than if the interna- tional business simply offers the same type of product that indigenous competitors and other foreign entrants are already offering. Greater value translates into an ability to charge higher prices and/or to build sales volume more rapidly. By considering such factors, a firm can rank countries in terms of their attractiveness and long-run profit potential. Preference is then given to entering markets that rank highly. For example, Tesco, the large British grocery chain, has been aggressively expanding its foreign op- erations in recent years, primarily by focusing on emerging markets that lack strong indigenous competitors (see the accompanying Management Focus). Similarly, when GM entered China in 1997 the indigenous competitors were small and lacked techno- logical know-how (see opening case).

TIMING OF ENTRY Once attractive markets have been identified, it is impor- tant to consider the timing of entry. We say that entry is early when an international business enters a foreign market before other foreign firms and late when it enters after other international businesses have already established themselves. The advan- tages frequently associated with entering a market early are commonly known as first- mover advantages. 3 One first-mover advantage is the ability to preempt rivals and capture demand by establishing a strong brand name. This desire has driven the rapid expansion by Tesco into developing nations (see the Management Focus). A second advantage is the ability to build sales volume in that country and ride down the experi- ence curve ahead of rivals, giving the early entrant a cost advantage over later entrants. One could argue that this factor motivated GM to enter the Chinese automobile mar- ket in 1997 when it was still tiny (it is now the world’s largest; see the opening case). This cost advantage may enable the early entrant to cut prices below that of later en- trants, thereby driving them out of the market. A third advantage is the ability of early entrants to create switching costs that tie customers into their products or services. Such switching costs make it difficult for later entrants to win business. There can also be disadvantages associated with entering a foreign market before other international businesses. These are often referred to as first-mover disadvan- tages. 4 These disadvantages may give rise to pioneering costs, costs that an early entrant has to bear that a later entrant can avoid. Pioneering costs arise when the busi- ness system in a foreign country is so different from that in a firm’s home market that the enterprise has to devote considerable effort, time, and expense to learning the rules of the game. Pioneering costs include the costs of business failure if the firm, due to its ignorance of the foreign environment, makes major mistakes. A certain liability is associated with being a foreigner, and this liability is greater for foreign firms that

Timing of Entry Entry is early when a firm

enters a foreign market before other foreign

firms and late when a firm enters after other

international businesses have established

themselves.

First-Mover Advantages

Advantages accruing to the first to enter a market.

First-Mover Disadvantages

Disadvantages associated with entering

a foreign market before other international

businesses.

Pioneering Costs Costs that an early

entrant has to bear that a later entrant can avoid,

such as the time and effort in learning the rules, failure due to ignorance, and the

liability of being a foreigner.

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Chapter Twelve Entering Foreign Markets 421

Management FOCUS

Tesco’s International Growth Strategy

Tesco is the largest grocery retailer in the United Kingdom, with a 25 percent share of the local market. In its home market, the company’s strengths are reputed to come from strong competencies in marketing and store site selection, logistics and inventory management, and its own label product offerings. By the early 1990s, these competencies had already given the company a leading position in the United Kingdom. The company was generating strong free cash flows, and senior management had to decide how to use that cash. One strategy they settled on was overseas expansion. As they looked at international markets, they soon concluded the best opportunities were not in estab- lished markets, such as those in North America and Western Europe, where strong local competitors already existed, but in the emerging markets of Eastern Europe and Asia where there were few capable competitors but strong underlying growth trends. Tesco’s first international foray was into Hungary in 1994, when it acquired an initial 51 percent stake in Global, a 43-store, state-owned grocery chain. By 2004, Tesco was the market leader in Hungary, with some 60 stores and a 14 percent market share. In 1995, Tesco acquired 31 stores in Poland from Stavia; a year later it added 13 stores pur- chased from Kmart in the Czech Republic and Slovakia; and the following year it entered the Republic of Ireland. Tesco’s Asian expansion began in 1998 in Thailand when it purchased 75 percent of Lotus, a local food retailer with 13 stores. Building on that base, Tesco had 64 stores in Thailand by 2004. In 1999, the company entered South Korea when it partnered with Samsung to develop a chain of hypermarkets. This was followed by entry into Taiwan in 2000, Malaysia in 2002, and China in 2004. The move into China came after three years of careful research and dis- cussions with potential partners. Like many other Western companies, Tesco was attracted to the Chinese market by its large size and rapid growth. In the end, Tesco settled on a 50/50 joint venture with Hymall, a hypermarket chain that is controlled by Ting Hsin, a Taiwanese group, which had been operating in China for six years. Currently, Hymall has 25 stores in China, and it plans to open another 10 each year. Ting Hsin is a well-capitalized enterprise in its own right, and it will match Tesco’s investments, reducing the risks Tesco faces in China. As a result of these moves, by 2007 Tesco had more than 800 stores outside the United Kingdom, which generated £7.6 billion in annual revenues. In the United Kingdom, Tesco had some 1,900 stores, generating £30 billion. The

addition of international stores has helped to make Tesco the fourth-largest company in the global grocery market behind Walmart, Carrefour of France, and Ahold of Holland. Of the four, however, Tesco may be the most successful internationally. By 2005, all of its foreign ventures were making money. In explaining the company’s success, Tesco’s managers have detailed a number of important factors. First, the com- pany devotes considerable attention to transferring its core capabilities in retailing to its new ventures. At the same time, it does not send in an army of expatriate managers to run local operations, preferring to hire local managers and support them with a few operational experts from the United Kingdom. Second, the company believes that its partnering strategy in Asia has been a great asset. Tesco has teamed with good companies that have a deep under- standing of the markets in which they are participating but that lack Tesco’s financial strength and retailing capa- bilities. Consequently, both Tesco and its partners have brought useful assets to the venture, which have increased the probability of success. As the venture becomes estab- lished, Tesco has typically increased its ownership stake in its partner. Thus, under current plans, by 2011 Tesco will own 99 percent of Homeplus, its South Korean hypermarket chain. When the venture was established, Tesco owned 51 percent. Third, the company has focused on markets with good growth potential but that lack strong indigenous competitors, which provides Tesco with ripe ground for expansion. In 2006, Tesco took its international expansion strategy to the next level when it announced it would enter the crowded U.S. grocery market with its Tesco Express con- cept. Currently running in five countries, Tesco Express stores are smaller, high-quality neighborhood grocery out- lets that feature a large selection of prepared and healthy foods. Tesco will initially enter on the West Coast, investing some £250 million per year, with breakeven expected in the second year of operation. Although some question the wisdom of this move, others point out that in the United Kingdom Tesco has consistently outperformed the ASDA chain, which is owned by Walmart. Also, the Tesco Express format is not something found in the United States.

Sources: P. N. Child, “Taking Tesco Global,” The McKenzie Quarterly, no. 3 (2002); H. Keers, “Global Tesco Sets Out Its Stall in China,” Daily Telegraph, July 15, 2004, p. 31; K. Burgess, “Tesco Spends Pounds 140m on Chinese Partnership,” Financial Times, July 15, 2004, p. 22; J. McTaggart, “Industry Awaits Tesco Invasion,” Progressive Grocer , March 1, 2006, pp. 8–10; and Tesco’s annual reports, archived at www.tesco.com.

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422 Part Five Competing in a Global Marketplace

enter a national market early. 5 Research seems to confirm that the probability of sur- vival increases if an international business enters a national market after several other foreign firms have already done so. 6 The late entrant may benefit by observing and learning from the mistakes made by early entrants. Pioneering costs also include the costs of promoting and establishing a product offering, including the costs of educating customers. These can be significant when the product being promoted is unfamiliar to local consumers. In contrast, later entrants may be able to ride on an early entrant’s investments in learning and customer educa- tion by watching how the early entrant proceeded in the market, by avoiding costly mistakes made by the early entrant, and by exploiting the market potential created by the early entrant’s investments in customer education. For example, KFC introduced the Chinese to American-style fast food, but a later entrant, McDonald’s, has capital- ized on the market in China. An early entrant may be put at a severe disadvantage, relative to a later entrant, if regulations change in a way that diminishes the value of an early entrant’s investments. This is a serious risk in many developing nations where the rules that govern business practices are still evolving. Early entrants can find themselves at a disadvantage if a subsequent change in regulations invalidates prior assumptions about the best busi- ness model for operating in that country.

SCALE OF ENTRY AND STRATEGIC COMMITMENTS Another issue that an international business needs to consider when contemplating market entry is the scale of entry. Entering a market on a large scale involves the commitment of sig- nificant resources and implies rapid entry. Consider the entry of the Dutch insurance company ING into the U.S. insurance market in 1999. ING had to spend several billion dollars to acquire its U.S. operations. Not all firms have the resources necessary to enter on a large scale, and even some large firms prefer to enter foreign markets on a small scale and then build slowly as they become more familiar with the market. The consequences of entering on a significant scale—entering rapidly—are associ- ated with the value of the resulting strategic commitments. 7 A strategic commitment has a long-term impact and is difficult to reverse. Deciding to enter a foreign market on a significant scale is a major strategic commitment. Strategic commitments, such as rapid large-scale market entry, can have an important influence on the nature of competition in a market. For example, by entering the U.S. financial services market on a significant scale, ING signaled its commitment to the market. Such a move has several effects. On the positive side, it makes it easier for the company to attract customers and distributors (such as insurance agents). The scale of entry gives both customers and distributors rea- sons for believing that ING will remain in the market for the long run. The scale of entry may also give other foreign institutions considering entry into the United States pause; now they would have to compete not only against indigenous institutions in the United States, but also against an aggressive and successful European institution. On the negative side, by committing itself heavily to the United States, ING would have fewer resources available to support expansion in other desirable markets, such as Japan. The commitment to the United States limits the company’s strategic flexibility. As suggested by the ING example, significant strategic commitments are neither un- ambiguously good nor bad. Rather, they tend to change the competitive playing field and unleash a number of changes, some of which may be desirable and some of which will not be. It is important for a firm to think through the implications of large-scale entry into a market and act accordingly. Of particular relevance is trying to identify how actual and potential competitors might react to large-scale entry into a market. Also, the large-scale entrant is more likely than the small-scale entrant to be able to capture first-mover advantages associated with demand preemption, scale economies, and switching costs.

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Chapter Twelve Entering Foreign Markets 423

The value of the commitments that flow from rapid large-scale entry into a foreign market must be balanced against the resulting risks and lack of flexibility associated with significant commitments. But strategic inflexibility can also have value. A famous example from military history illustrates the value of inflexibility. When Hernán Cortés landed in Mexico, he ordered his men to burn all but one of his ships. Cortés reasoned that by eliminating their only method of retreat, his men had no choice but to fight hard to win against the Aztecs—and ultimately they did. 8 Balanced against the value and risks of the commitments associated with large-scale entry are the benefits of a small-scale entry. Small-scale entry allows a firm to learn about a foreign market while limiting the firm’s exposure to that market. Small-scale entry is a way to gather information about a foreign market before deciding whether to enter on a significant scale and how best to enter. By giving the firm time to collect information, small-scale entry reduces the risks associated with a subsequent large-scale entry. But the lack of commitment associated with small-scale entry may make it more difficult for the small-scale entrant to build market share and to capture first-mover or early-mover advantages. The risk-averse firm that enters a foreign market on a small scale may limit its potential losses, but it may also miss the chance to capture first-mover advantages.

MARKET ENTRY SUMMARY There are no “right” decisions here, just deci- sions that are associated with different levels of risk and reward. Entering a large devel- oping nation such as China or India before most other international businesses in the firm’s industry, and entering on a large scale, will be associated with high levels of risk. In such cases, the liability of being foreign is increased by the absence of prior foreign entrants whose experience can be a useful guide. At the same time, the potential long- term rewards associated with such a strategy are great. The early large-scale entrant into a major developing nation may be able to capture significant first-mover advan- tages that will bolster its long-run position in that market. 9 This was what GM hoped to do when it entered China in 1997, and as of 2010 it seems as if GM has captured a significant first-mover, or at least early-mover, advantage (see the opening case). In contrast, entering developed nations such as Australia or Canada after other interna- tional businesses in the firm’s industry, and entering on a small scale to first learn more about those markets, will be associated with much lower levels of risk. However, the potential long-term rewards are also likely to be lower because the firm is essentially forgoing the opportunity to capture first-mover advantages and because the lack of commitment signaled by small-scale entry may limit its future growth potential. This section has been written largely from the perspective of a business based in a developed country considering entry into foreign markets. Christopher Bartlett and Sumantra Ghoshal have pointed out the ability that businesses based in developing nations have to enter foreign markets and become global players. 10 Although such firms tend to be late entrants into foreign markets, and although their resources may be limited, Bartlett and Ghoshal argue that such late movers can still succeed against well-established global competitors by pursuing appropriate strategies. In particular, Bartlett and Ghoshal argue that companies based in developing nations should use the entry of foreign multi- nationals as an opportunity to learn from these competitors by benchmarking their operations and performance against them. Furthermore, they suggest the local company may be able to find ways to differentiate itself from a foreign multinational, for example, by focusing on market niches that the multinational ignores or is unable to serve effec- tively if it has a standardized global product offering. Having improved its performance through learning and differentiated its product offering, the firm from a developing nation may then be able to pursue its own international expansion strategy. Even though the firm may be a late entrant into many countries, by benchmarking and then differenti- ating itself from early movers in global markets, the firm from the developing nation

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424 Part Five Competing in a Global Marketplace

Management FOCUS

The Jollibee Phenomenon—A Philippine Multinational

Jollibee is one of the Philippines’ phenomenal business suc- cess stories. Jollibee, which stands for “Jolly Bee,” began operations in 1975 as a two-branch ice cream parlor. It later expanded its menu to include hot sandwiches and other meals. Encouraged by early success, Jollibee Foods Corpora- tion was incorporated in 1978, with a network that had grown to seven outlets. In 1981, when Jollibee had 11 stores, McDonald’s began to open stores in Manila. Many observers thought Jollibee would have difficulty competing against McDonald’s. However, Jollibee saw this as an opportunity to learn from a very successful global competitor. Jollibee benchmarked its performance against that of McDonald’s and started to adopt operational systems similar to those used at McDonald’s to control its quality, cost, and service at the store level. This helped Jollibee to improve its performance. As it came to better understand McDonald’s business model, Jollibee began to look for a weakness in McDonald’s global strategy. Jollibee executives concluded that McDonald’s fare was too standardized for many locals, and that the local firm could gain share by tailoring its menu to local tastes. Jollibee’s hamburgers were set apart by a secret mix of spices blended into the ground beef to make the burgers sweeter than those produced by McDonald’s, appealing more to Philippine tastes. It also offered local fare including various rice dishes, pineapple burgers, and banana langka and peach mango pies for desserts. By pursuing

this strategy, Jollibee maintained a leadership position over the global giant. By 2006, Jollibee had over 540 stores in the Philippines, a market share of more than 60 percent, and revenues in excess of $600 million. McDonald’s, in contrast, had about 250 stores. In the mid-1980s, Jollibee had gained enough confidence to expand internationally. Its initial ventures were into neighboring Asian countries such as Indonesia, where it pursued the strategy of localizing the menu to better match local tastes, thereby differentiating itself from McDonald’s. In 1987, Jollibee entered the Middle East, where a large contingent of expatriate Filipino workers provided a ready- made market for the company. The strategy of focusing on expatriates worked so well that in the late 1990s Jollibee decided to enter another foreign market where there was a large Filipino population—the United States. Between 1999 and 2004, Jollibee opened eight stores in the United States, all in California. Even though many believe the U.S. fast- food market is saturated, the stores have performed well. While the initial clientele was strongly biased toward the expatriate Filipino community, where Jollibee’s brand awareness is high, non-Filipinos increasingly are coming to the restaurant. In the San Francisco store, which has been open the longest, more than half the customers are now non-Filipino. Recently Jollibee has focused its attentions on two inter- national markets, mainland China and India. It has more than 100 stores in China, which operate under the Yonghe brand name (and serve Chinese style fast food). While it

Jollibee may be heading your way! Unlike many fast-food chains that have their roots within the United States, the Jollibee chain originated in the Philippines using McDonald’s as a role model.

(continued)

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Chapter Twelve Entering Foreign Markets 425

does not yet have a presence in India, the company is re- ported to be considering its options for entering that nation and is reported to be considering acquiring an Indian fast- food chain, although as with so many enterprises, Jollibee has slowed its expansion strategy in the wake of the 2008–2009 global financial crisis. Jollibee has a bright future as a niche player in a market that has historically been dominated by U.S. multinationals.

Sources: Christopher Bartlett and Sumantra Ghoshal, “Going Global: Lessons from Late Movers,” Harvard Business Review, March–April 2000, pp. 132–45; “Jollibee Battles Burger Giants in US Market,” Philippine Daily Inquirer, July 13, 2000; M. Ballon, “Jollibee Struggling to Expand in U.S.,” Los Angeles Times, September 16, 2002, p. C1; J. Hookway, “Burgers and Beer,” Far Eastern Economic Review, December 2003, pp. 72–74; S. E. Lockyer, “Coming to America,” Nation’s Restaurant News , February 14, 2005, pp. 33–35; Erik de la Cruz, “Jollibee to Open 120 New Stores This Year, Plans India,” Inquirer Money, July 5, 2006, www.business.inquirer.net; and www.jollibee.com.ph.

may still be able to build a strong international business presence. A good example of how this can work is given in the above Management Focus, which looks at how Jollibee, a Philippines-based fast-food chain, has started to build a global presence in a market dominated by U.S. multinationals such as McDonald’s and KFC.

Entry Modes Once a firm decides to enter a foreign market, the question arises as to the best mode of entry. Firms can use six different modes to enter foreign markets: exporting, turn- key projects, licensing, franchising, establishing joint ventures with a host-country firm, or setting up a new wholly owned subsidiary in the host country. Each entry mode has advantages and disadvantages. Managers need to consider these carefully when deciding which to use. 11

EXPORTING Many manufacturing firms begin their global expansion as export- ers and only later switch to another mode for serving a foreign market. We take a close look at the mechanics of exporting in the next chapter. Here we focus on the advan- tages and disadvantages of exporting as an entry mode.

Advantages Exporting has two distinct advantages. First, it avoids the often sub- stantial costs of establishing manufacturing operations in the host country. Second, exporting may help a firm achieve experience curve and location economies (see Chapter 11). By manufacturing the product in a centralized location and exporting it to other national markets, the firm may realize substantial scale economies from its global sales volume. This is how Sony came to dominate the global TV market, how Matsushita came to dominate the VCR market, how many Japanese automakers made inroads into the U.S. market, and how South Korean firms such as Samsung gained market share in computer memory chips.

Disadvantages Exporting has a number of drawbacks. First, exporting from the firm’s home base may not be appropriate if lower-cost locations for manufacturing the product can be found abroad (i.e., if the firm can realize location economies by mov- ing production elsewhere). Thus, particularly for firms pursuing global or transna- tional strategies, it may be preferable to manufacture where the mix of factor conditions is most favorable from a value creation perspective and to export to the rest of the world from that location. This is not so much an argument against exporting as an argument against exporting from the firm’s home country. Many U.S. electronics firms have moved some of their manufacturing to the Far East because of the avail- ability of low-cost, highly skilled labor there. They then export from that location to the rest of the world, including the United States. A second drawback to exporting is that high transport costs can make exporting uneconomical, particularly for bulk products. One way of getting around this is to

LEARNING OBJECTIVE 2 Compare and contrast the different modes that firms

use to enter foreign markets.

Exporting Sale of products produced in one country to residents of another country.

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426 Part Five Competing in a Global Marketplace

manufacture bulk products regionally. This strategy enables the firm to realize some economies from large-scale production and at the same time to limit its transport costs. For example, many multinational chemical firms manufacture their products region- ally, serving several countries from one facility.

Another drawback is that tariff barriers can make exporting uneconomical. Similarly, the threat of tariff barriers by the host-country government can make it very risky. A fourth drawback to ex- porting arises when a firm delegates its marketing, sales, and service in each country where it does business to another company. This is a common approach for manufacturing firms that are just be- ginning to expand internationally. The other com- pany may be a local agent, or it may be another multinational with extensive international distribu- tion operations. Local agents often carry the prod-

ucts of competing firms and so have divided loyalties. In such cases, the local agent may not do as good a job as the firm would if it managed its marketing itself. Similar problems can occur when another multinational takes on distribution. The way around such problems is to set up wholly owned subsidiaries in foreign nations to handle local marketing, sales, and service. By doing this, the firm can exer- cise tight control over marketing and sales in the country while reaping the cost ad- vantages of manufacturing the product in a single location, or a few choice locations.

TURNKEY PROJECTS Firms that specialize in the design, construction, and start-up of turnkey plants are common in some industries. In a turnkey project, the contractor agrees to handle every detail of the project for a foreign client, including the training of operating personnel. At completion of the contract, the foreign client is handed the “key” to a plant that is ready for full operation—hence, the term turnkey. This is a means of exporting process technology to other countries. Turnkey projects are most common in the chemical, pharmaceutical, petroleum refining, and metal re- fining industries, all of which use complex, expensive production technologies.

Advantages The know-how required to assemble and run a technologically com- plex process, such as refining petroleum or steel, is a valuable asset. Turnkey projects are a way of earning great economic returns from that asset. The strategy is particu- larly useful where FDI is limited by host-government regulations. For example, the governments of many oil-rich countries have set out to build their own petroleum refining industries, so they restrict FDI in their oil and refining sectors. But because many of these countries lack petroleum-refining technology, they gain it by entering into turnkey projects with foreign firms that have the technology. Such deals are often attractive to the selling firm because without them, they would have no way to earn a return on their valuable know-how in that country. A turnkey strategy can also be less risky than conventional FDI. In a country with unstable political and economic envi- ronments, a longer-term investment might expose the firm to unacceptable political and/or economic risks (e.g., the risk of nationalization or of economic collapse).

Disadvantages Three main drawbacks are associated with a turnkey strategy. First, the firm that enters into a turnkey deal will have no long-term interest in the foreign country. This can be a disadvantage if that country subsequently proves to be

Another Per spect i ve

Saudi Arabia to Export Phosphate In an effort to curb its reliance on oil as the country’s primary export commodity, the kingdom of Saudi Arabia has taken steps to develop and market a number of its other natural resources, including phosphate, gold, and bauxite, the main source of aluminum. Phosphate is important in the manufac- ture of many commercial fertilizers. As the world population continues to grow, the global food crisis deepens, leading economists to emphasize the need to optimize crop yields. Thus, fertilizer stands to become an important commodity. According to the Saudi Ports Authority, plans are under way to export phosphates from the port of Ras al-Zour. (“Saudis to Start Exporting Phosphates in Dec—Paper,” Reuters.com, January 27, 2010, www.reuters.com)

Turnkey Project A project in which a

firm agrees to set up an operating plant for a

foreign client and hand over the “key” when the plant is fully operational.

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Chapter Twelve Entering Foreign Markets 427

a major market for the output of the process that has been exported. One way around this is to take a minority equity interest in the operation. Second, the firm that enters into a turnkey project with a foreign enterprise may inadvertently create a competitor. For example, many of the Western firms that sold oil-refining technology to firms in Saudi Arabia, Kuwait, and other Gulf states now find themselves competing with these firms in the world oil market. Third, if the firm’s process technology is a source of competitive advantage, then selling this technology through a turnkey project is also selling competitive advantage to potential and/or actual competitors.

LICENSING A licensing agreement is an arrangement whereby a licensor grants the rights to intangible property to another entity (the licensee) for a specified period, and in return, the licensor receives a royalty fee from the licensee. 12 Intangible property includes patents, inventions, formulas, processes, designs, copyrights, and trademarks. For example, to enter the Japanese market, Xerox, inventor of the photocopier, estab- lished a joint venture with Fuji Photo that is known as Fuji–Xerox. Xerox then licensed its xerographic know-how to Fuji–Xerox. In return, Fuji–Xerox paid Xerox a royalty fee equal to 5 percent of the net sales revenue that Fuji–Xerox earned from the sales of photocopiers based on Xerox’s patented know-how. In the Fuji–Xerox case, the license was originally granted for 10 years, and it has been renegotiated and extended several times since. The licensing agreement between Xerox and Fuji–Xerox also limited Fuji– Xerox’s direct sales to the Asian Pacific region (although Fuji–Xerox does supply Xerox with photocopiers that are sold in North America under the Xerox label). 13

Advantages In the typical international licensing deal, the licensee puts up most of the capital necessary to get the overseas operation going. Thus, a primary advantage of licensing is that the firm does not have to bear the development costs and risks as- sociated with opening a foreign market. Licensing is very attractive for firms lacking the capital to develop operations overseas. In addition, licensing can be attractive when a firm is unwilling to commit substantial financial resources to an unfamiliar or politically volatile foreign market. Licensing is also often used when a firm wishes to participate in a foreign market but is prohibited from doing so by barriers to invest- ment. This was one of the original reasons for the formation of the Fuji–Xerox joint venture in 1962. Xerox wanted to participate in the Japanese market but was prohib- ited from setting up a wholly owned subsidiary by the Japanese government. So Xerox set up the joint venture with Fuji and then licensed its know-how to the joint venture. Finally, licensing is frequently used when a firm possesses some intangible property that might have business applications, but it does not want to develop those applica- tions itself. For example, Bell Laboratories at AT&I originally invented the transistor circuit in the 1950s, but AT&I decided it did not want to produce transistors, so it licensed the technology to a number of other companies, such as Texas Instruments. Similarly, Coca-Cola has licensed its famous trademark to clothing manufacturers, which have incorporated the design into clothing.

Disadvantages Licensing has three serious drawbacks. First, it does not give a firm the tight control over manufacturing, marketing, and strategy that is required for realizing experience curve and location economies. Licensing typically involves each licensee setting up its own production operations. This severely limits the firm’s ability to realize experience curve and location economies by producing its product in a cen- tralized location. When these economies are important, licensing may not be the best way to expand overseas. Second, competing in a global market may require a firm to coordinate strategic moves across countries by using profits earned in one country to support competitive

Licensing Occurs when a firm (the licensor) licenses the rights to produce its product, its production processes, or its brand name or trademark to another firm (the licensee); in return, the licensor collects a royalty fee from the licensee.

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428 Part Five Competing in a Global Marketplace

attacks in another. By its very nature, licensing limits a firm’s ability to do this. A licensee is unlikely to allow a multinational firm to use its profits (beyond those due in the form of royalty payments) to support a dif- ferent licensee operating in another country.

A third problem with licensing is one that we encountered in Chapter 7 when we reviewed the economic theory of FDI. This is the risk associated with licensing technological know-how to foreign companies. Technological know-how constitutes the basis of many multinational firms’ competitive ad- vantage. Most firms wish to maintain control over how their know-how is used, and a firm can quickly lose control over its technology by licensing it. Many firms have made the mistake of thinking they could maintain control over their know-how within the framework of a licensing agreement. RCA Corpora-

tion, for example, once licensed its color TV technology to Japanese firms including Matsushita and Sony. The Japanese firms quickly assimilated the technology, improved on it, and used it to enter the U.S. market, taking substantial market share away from RCA. There are ways of reducing this risk. One way is by entering into a cross-licensing agreement with a foreign firm. Under a cross-licensing agreement, a firm might license some valuable intangible property to a foreign partner, but in addition to a royalty payment, the firm might also request that the foreign partner license some of its valuable know-how to the firm. Such agreements are believed to reduce the risks associated with licensing technological know-how, since the licensee realizes that if it violates the licensing contract (by using the knowledge obtained to compete directly with the licensor), the licensor can do the same to it. Cross-licensing agreements enable firms to hold each other hostage, which reduces the probability that they will behave opportunistically toward each other. 14 Such cross-licensing agreements are increasingly common in high-technology industries. For example, the U.S. biotech- nology firm Amgen licensed one of its key drugs, Nuprogene, to Kirin, the Japanese pharmaceutical company. The license gives Kirin the right to sell Nuprogene in Japan. In return, Amgen receives a royalty payment and, through a licensing agreement, gained the right to sell some of Kirin’s products in the United States. Another way of reducing the risk associated with licensing is to follow the Fuji–Xerox model and link an agreement to license know-how with the formation of a joint ven- ture in which the licensor and licensee take important equity stakes. Such an approach aligns the interests of licensor and licensee because both have a stake in ensuring that the venture is successful. Thus, the risk that Fuji Photo might appropriate Xerox’s technological know-how and then compete directly against Xerox in the global photo- copier market was reduced by the establishment of a joint venture in which both Xerox and Fuji Photo had an important stake.

FRANCHISING Franchising is similar to licensing, although franchising tends to involve longer-term commitments than licensing. Franchising is basically a special- ized form of licensing in which the franchiser not only sells intangible property (nor- mally a trademark) to the franchisee, but also insists that the franchisee agree to abide by strict rules as to how it does business. The franchiser will also often assist the fran- chisee to run the business on an ongoing basis. As with licensing, the franchiser typi- cally receives a royalty payment, which amounts to some percentage of the franchisee’s

At the completion of the contract, the foreign client is handed the “key” to a plant that is ready for full operation.

Franchising A specialized form of

licensing in which the franchiser sells

intangible property to the franchisee and insists on

rules to conduct the business.

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Chapter Twelve Entering Foreign Markets 429

revenues. Whereas licensing is pursued primarily by manufacturing firms, franchising is employed primarily by service firms. 15 McDonald’s is a good example of a firm that has grown by using a franchising strategy. McDonald’s strict rules as to how franchi- sees should operate a restaurant extend to control over the menu, cooking methods, staffing policies, and design and location. McDonald’s also organizes the supply chain for its franchisees and provides management training and financial assistance. 16

Advantages The advantages of franchising as an entry mode are very similar to those of licensing. The firm is relieved of many of the costs and risks of opening a foreign market on its own. Instead, the franchisee typically assumes those costs and risks. This creates a good incentive for the franchisee to build a profitable operation as quickly as possible. Thus, using a franchising strategy, a service firm can build a global presence quickly and at a relatively low cost and risk, as McDonald’s has.

Disadvantages The disadvantages are less pronounced than in the case of licens- ing. Since franchising is often used by service companies, there is no reason to con- sider the need for coordination of manufacturing to achieve experience curve and location economies. But franchising may inhibit the firm’s ability to take profits out of one country to support competitive attacks in another. A more significant disadvan- tage of franchising is quality control. The foundation of franchising arrangements is that the firm’s brand name conveys a message to consumers about the quality of the firm’s product. Thus, a business traveler checking in at a Four Seasons hotel in Hong Kong can reasonably expect the same quality of room, food, and service that she would receive in New York. The Four Seasons name is supposed to guarantee consistent product quality. This presents a problem in that foreign franchisees may not be as concerned about quality as they are supposed to be, and the result of poor quality can extend beyond lost sales in a particular foreign market to a decline in the firm’s world- wide reputation. For example, if the business traveler has a bad experience at the Four Seasons in Hong Kong, she may never go to another Four Seasons hotel and may urge her colleagues to do likewise. The geographical distance of the firm from its foreign franchisees can make poor quality difficult to detect. In addition, the sheer numbers of franchisees—in the case of McDonald’s, tens of thousands—can make quality control difficult. Due to these factors, quality problems may persist. One way around this disadvantage is to set up a subsidiary in each country in which the firm expands. The subsidiary might be wholly owned by the company or a joint venture with a foreign company. The subsidiary assumes the rights and obligations to establish franchises throughout the particular country or region. McDonald’s, for example, establishes a master franchisee in many countries. Typically, this master fran- chisee is a joint venture between McDonald’s and a local firm. The proximity and the smaller number of franchises to oversee reduce the quality control challenge. In addi- tion, because the subsidiary (or master franchisee) is at least partly owned by the firm, the firm can place its own managers in the subsidiary to help ensure that it is doing a good job of monitoring the franchises. This organizational arrangement has proven very satisfactory for McDonald’s, KFC, and others.

JOINT VENTURES A joint venture entails establishing a firm that is jointly owned by two or more otherwise independent firms. Fuji–Xerox, for example, was set up as a joint venture between Xerox and Fuji Photo. Establishing a joint venture with a foreign firm has long been a popular mode for entering a new market. As we saw in the opening case, General Motors used a joint-venture strategy to enter the Chinese automobile market. The most typical joint venture is a 50/50 venture, in which each of the two parties holds a 50 percent ownership stake and contributes a team of managers

Joint Venture Establishing a firm that is jointly owned by two or more otherwise independent firms.

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430 Part Five Competing in a Global Marketplace

to share operating control. This was the case with the Fuji–Xerox joint venture until 2001; it is now a 25/75 venture with Xerox holding 25 percent. The GM SAIC ven- ture in China was a 50/50 venture until 2010, when it became a 51/49 venture, with SAIC holding the 51 percent stake. Some firms, however, have sought joint ventures in which they have a majority share and thus tighter control. 17

Advantages Joint ventures have a number of advantages. First, a firm benefits from a local partner’s knowledge of the host country’s competitive conditions, culture, language, political systems, and business systems (this was one reason GM entered into a joint venture with SAIC in China; see the opening case). Thus, for many U.S. firms, joint ventures have involved the U.S. company providing technological know- how and products and the local partner providing the marketing expertise and the lo- cal knowledge necessary for competing in that country. Second, when the development costs and/or risks of opening a foreign market are high, a firm might gain by sharing these costs and or risks with a local partner. Third, in many countries, political consid- erations make joint ventures the only feasible entry mode (again, as was the case with GM’s joint venture with SAIC). Research suggests joint ventures with local partners face a low risk of being subject to nationalization or other forms of adverse govern- ment interference. 18 This appears to be because local equity partners, who may have some influence on host-government policy, have a vested interest in speaking out against nationalization or government interference.

Disadvantages Despite these advantages, joint ventures have major disadvan- tages. First, as with licensing, a firm that enters into a joint venture risks giving control of its technology to its partner. Thus, a proposed joint venture in 2002 between Boeing and Mitsubishi Heavy Industries to build a new wide-body jet (the 787), raised fears that Boeing might unwittingly give away its commercial airline technology to the Japanese. However, joint-venture agreements can be constructed to minimize this risk. One option is to hold majority ownership in the venture. This allows the dominant partner to exercise greater control over its technology. But it can be difficult to find a foreign partner willing to settle for minority ownership. Another option is to “wall off ” from a partner technology that is central to the core competence of the firm, while sharing other technology. A second disadvantage is that a joint venture does not give a firm the tight control over subsidiaries that it might need to realize experience curve or location economies. Nor does it give a firm the tight control over a foreign subsidiary that it might need for engaging in coordinated global attacks against its rivals. Consider the entry of Texas Instruments (TI) into the Japanese semiconductor market. When TI established semiconductor facilities in Japan, it did so for the dual purpose of checking Japanese manufacturers’ market share and limiting their cash available for invading TI’s global market. In other words, TI was engaging in global strategic coordination. To im- plement this strategy, TI’s subsidiary in Japan had to be prepared to take instructions from corporate headquarters regarding competitive strategy. The strategy also re- quired the Japanese subsidiary to run at a loss if necessary. Few if any potential joint- venture partners would have been willing to accept such conditions, since it would have necessitated a willingness to accept a negative return on investment. Indeed, many joint ventures establish a degree of autonomy that would make such direct con- trol over strategic decisions all but impossible to establish. 19 Thus, to implement this strategy, TI set up a wholly owned subsidiary in Japan. A third disadvantage with joint ventures is that the shared ownership arrangement can lead to conflicts and battles for control between the investing firms if their goals and objectives change or if they take different views as to what the strategy should be.

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Chapter Twelve Entering Foreign Markets 431

This was apparently not a problem with the Fuji–Xerox joint venture. According to Yotaro Kobayashi, currently the chairman of Fuji–Xerox, a primary reason is that both Xerox and Fuji Photo adopted an arm’s-length relationship with Fuji–Xerox, giving the venture’s management considerable freedom to determine its own strategy. 20 However, much research indicates that conflicts of interest over strategy and goals often arise in joint ventures. These conflicts tend to be greater when the venture is between firms of different nationalities, and they often end in the dissolution of the venture. 21 Such conflicts tend to be triggered by shifts in the relative bargaining power of venture partners. For example, in the case of ventures between a foreign firm and a local firm, as a foreign partner’s knowledge about local market conditions increases, it depends less on the expertise of a local partner. This increases the bargaining power of the foreign partner and ultimately leads to conflicts over control of the venture’s strat- egy and goals. 22 Some firms have sought to limit such problems by entering into joint ventures in which one partner has a controlling interest.

WHOLLY OWNED SUBSIDIARIES In a wholly owned subsidiary, the firm owns 100 percent of the stock. Establishing a wholly owned subsidiary in a for- eign market can be done two ways. The firm either can set up a new operation in that country, often referred to as a greenfield venture, or it can acquire an established firm in the host nation and use that firm to promote its products. 23 For example, ING’s strategy for entering the U.S. insurance market was to acquire established U.S. enter- prises, rather than try to build an operation from the ground floor.

Advantages There are several clear advantages of wholly owned subsidiaries. First, when a firm’s competitive advantage is based on technological competence, a wholly owned subsidiary will often be the preferred entry mode because it reduces the risk of losing control over that competence. (See Chapter 7 for more details.) Many high-tech firms prefer this entry mode for overseas expansion (e.g., firms in the semi- conductor, electronics, and pharmaceutical industries). Second, a wholly owned subsid- iary gives a firm tight control over operations in different countries. This is necessary for engaging in global strategic coordination (i.e., using profits from one country to support competitive attacks in another). Third, a wholly owned subsidiary may be required if a firm is trying to realize loca- tion and experience curve economies (as firms pursuing global and transnational strat- egies try to do). As we saw in Chapter 11, when cost pressures are intense, it may pay a firm to configure its value chain in such a way that the value added at each stage is maximized. Thus, a national subsidiary may specialize in manufacturing only part of the product line or certain components of the end product, exchanging parts and products with other subsidiaries in the firm’s global system. Establishing such a global production system requires a high degree of control over the operations of each affili- ate. The various operations must be prepared to accept centrally determined decisions as to how they will produce, how much they will produce, and how their output will be priced for transfer to the next operation. Because licensees or joint-venture partners are unlikely to accept such a subservient role, establishing wholly owned subsidiaries may be necessary. Finally, establishing a wholly owed subsidiary gives the firm a 100 percent share in the profits generated in a foreign market.

Disadvantages Establishing a wholly owned subsidiary is generally the most costly method of serving a foreign market from a capital investment standpoint. Firms doing this must bear the full capital costs and risks of setting up overseas op- erations. The risks associated with learning to do business in a new culture are less if the firm acquires an established host-country enterprise. However, acquisitions raise