FORTUNE, May 27, 1996



The U.S. High-Tech Company is Doubling its Stake in What Could Become the World's Largest Electronics Market.




HINA IS IN TROUBLE. Its political system is unstable and plagued by corruption, its booming economy is perilously brittle. The people in charge show little respect for human rights or copyrights. It sells arms to global troublemakers and threatens the peace in its own neighborhood by lobbing missiles dangerously close to Taiwan. For all those drawbacks, however, China is proving irresistibly attractive to the world's most advanced technology companies. Northern Telecom and Philips now manufacture semiconductors in Shanghai, where Intel is building a $ 50 million chip assembly and testing plant. Sweden's Ericsson makes telephone switches in Nanjing; IBM puts together PCs in Shenzhen. But the Western investor with by far the most chips on the table is Motorola. When the U.S. high-tech giant (1995 revenues: $ 27 billion) finishes work sometime in 1998 on a $ 560 million semiconductor fabrication plant in Tianjin, it will have more than doubled the value of its stake in the People's Republic to nearly $ 1.2 billion.

   What's drawing Motorola and the rest of these all-stars is the prospect of an enormous shift in the high-tech world's center of gravity. Sometime in the early 21st century, many are betting, China will emerge as the world's largest consumer of electronics products--everything from PCs and TVs to microwave ovens and telephones. It may also become a major competitor for the electronics industry's Japanese, European, and American powers that be. Last summer, Intel CEO Andy Grove told a group of Fortune editors that he thought his biggest competition in ten years would come from China. Asked recently if he stood by that forecast, Grove replied, yes--"but probably in eight years." 

Really? The rival to future generations of the Pentium microprocessor originating in China? Skeptics will dismiss Grove's fear as proof that he really does live by his motto--"only the paranoid survive." After all, though China today is sometimes likened to Japan of a few decades ago, the comparison is hollow. Japan was a highly industrialized nation before World War II. China is a backward Third World economy, which, as it races to enter the age of the microchip and the infohighway, has barely begun driving into the age of the auto. 

   Even so, a healthy regard for the potential of this technological frontier seems more than warranted. Reason: the growing likelihood that China will eventually surpass the U.S. and Japan as a consumer of semiconductors and the electronic marvels they make possible. Already, a surprising number of China's 1.2 billion citizens have not only a hunger for the trappings of modern life but the money to buy them as well. A Gallup survey, conducted in 1994 and focused mostly on better-off urban areas, indicated that as many as 40% had color TV sets. With Beijing insisting on local production of such devices as a condition for selling in the PRC, China seems destined--at a minimum--to become a huge platform for making and shipping electronic goods elsewhere in Asia. C.D. Tam, head of Motorola's semiconductor products group in the Asia Pacific Region, flatly predicts that "by the year 2005 or 2010, China will have the world's largest electronics industry." 

   In the end, of course, China's place in the global high-tech hierarchy will depend on its ability to restructure its inefficient economy. But it also hinges in no small part on the size and nature of the investments made by the foreign powerhouses now hurrying into this promising but risky new territory--Motorola foremost among them. How's this for impact? By popularizing the cellular phone in China, where it is now a market leader, Motorola is helping the PRC leapfrog one particular stage of industrial evolution for which Western nations have had to pony u many billions of dollars--the need to tie every home and business together with copper wire. 

   At the moment, the U.S. company's 6,100 Chinese employees work mostly in a cluster of factories around the port city of Tianjin, 70 miles southeast of Beijing. There they make pagers and cell phones and pack semiconductors into housings, some for domestic use, others for export. But Motorola is also branching out into half a dozen joint ventures. 

   The boldest one is an alliance with a state-owned enterprise, Nanjing Panda Electronics, to produce a personal computer. The heart of the computer will be Motorola's Power PC chip, the major rival to Intel's Pentium. In a telling sign of East-West synergy, another joint venture will supply components for the cars that eventually roll off the line at a new factory being planned by an alliance between General Motors and one of China's biggest carmakers, Shanghai Automotive Industry. And finally, sometime in 1998, Motorola expects to open that $ 560 million plant to fabricate semiconductor wafers--a much more complex and delicate task than simply assembling these components into finished chips. (Historians and paranoids take note: When Motorola started assembling chips in South Korea 29 years ago, it was part of the catalyst that made Korea a force in the semiconductor business.) 

   Is this gamble paying off? Motorola's sales in the PRC and Hong Kong have shattered expectations, nearly doubling over two years to reach $ 3.2 billion in 1995--almost 12% of the corporation's worldwide revenues. The company declines to break down those figures by product line, but cellular phones account for a substantial chunk, and the potential market for these handy gadgets is enormous--three million new cellular phones a year until the end of the decade, according to a Chinese government estimate. P.Y. Lai, head of Motorola's China operations, divulges his predictions of future sales growth by pointing to--and through--the ceiling. 

   Ah, but what about profits? Lai is vague about details, but he denounces as "totally inaccurate" a Wall Street Journal report early last year maintaining that the company loses money on every cell phone it makes and sells in China. Price competition is brutal, Lai concedes, but, he insists, "we are making good profits in China." Motorola, moreover, gets income from the chips, pagers, and cell phones it exports from Tianjin. Whatever local operating profit might be, Lai says it all gets plowed back into the local market. 

   Anyway, as Motorolans are all quick to remind you, they're in this China game for the long haul. Former chairman Robert W. Galvin, the CEO largely responsible for turning Motorola from a smallish Illinois company that made radios and TVs into an international behemoth, first visited Beijing to set up a representative office ten years ago. Motorola started negotiating a deal for local operations in 1989, but its desire for 100% ownership proved a major sticking point. Some Chinese officials insisted that Motorola accept a joint venture, part-owned by Chinese--the usual arrangement for foreign investors. 

   Then, in the early hours of June 4, People's Liberation Army troops advanced on defiant student demonstrators camped out on Beijing's Tiananmen Square, killing hundreds of people as they shot their way toward the center of the capital. Reacting in horror, many foreign investors canceled deals, and some pulled out of China altogether. 

   Motorola, however, stayed the course. Negotiations were suspended for a few months until the U.S. government clarified its guidelines for investment. Then Galvin went back to the bargaining table, and he eventually got what he wanted from a government now eager to cajole big investors and restore international confidence. "We felt the best way to help the Chinese people was to continue dialogue and engage," says Tam, the semiconductor division boss who was a key player on the negotiating team. "Motorola believed it was a regrettable event but not the end of the world. China basically looked to us as a friend, and the time you need a friend most is when you're in hot water." 

   While Motorola's business plan from the start emphasized local production, the company still faced a major hurdle: the need to export a percentage of its goods to meet the standard government demand for offsetting the hard currency drain caused by importing components. But a shoddily assembled cellular phone isn't going to make it on the global market, even if the microchips inside are made in Japan or the U.S. How was it going to protect its brand name and uphold its reputation for quality if it used local engineers and assembly line workers who didn't have a clue about the company's standards for excellence? The solution was to quickly inculcate its new employees with a very alien corporate culture, at the core of which is an unwavering obsession with quality. 

   True believers at Motorola talk of quality as it is enshrined in the concepts of "Total Customer Satisfaction" and "Six Sigma" (that's fewer than four defects per million units, for the uninitiated among you). Slogans do extremely well in China, and sure enough, they took--buttressed by the kind of intensive training that Motorola's total control over its operations there made possible. Within six months after starting semiconductor assembly at one temporary facility, rookie Chinese line operators had achieved Six Sigma output quality, an achievement well above average. 

Motorola's first hit with Chinese consumers was the inexpensive paging device, a market Motorola more or less created (see box). But it is the cell phone that really solves problems in an unwired world, and the U.S. company played such an important role that "Motorola" became for a time the popular name for the device in northern China, as Kleenex is for tissue paper. 

   Motorola still has incredible brand equity in cellular and dominates the Chinese market for analog handsets, with an estimated 40% to 50% share. But an invasion of handset makers from Europe, Japan, and Hong Kong is hammering down margins. The price for a new cell phone, including a one-time fee for tapping into the system, ranges from $ 900 to $ 1,300 these days, in some cases half the price of a year ago. 

   Because prices are expected to continue sliding, the number of users should keep soaring. And many of the latecomers, be they Shanghai bankers or provincial entrepreneurs, are turning away from analog phones to the newer digital technology. Here Motorola is less dominant and is locked into fierce competition with Sweden's Ericsson and Finland's Nokia. But Motorola's new CDMA digital technology, which allows more calls to come through the base station, has been a success in Hong Kong and may tip the balance when it's introduced on the mainland sometime over the next year. 

   Even as the phone wars heat up, Motorola will soon find itself fighting in China on an equally contentious new front--the PC market. Here again, the name of the game is technological leapfrog. Because commercial mainframe computing never got very far in the Middle Kingdom, foreign PC makers enjoy a tremendous advantage over fledgling local brands. Unfortunately, for the time being, the main thing they seem to be battling for besides market share is the privilege of losing money. Compaq is leading in that respect, surging ahead to No. 1 last year at the cost of extending credit to deadbeat Chinese distributors, who have defaulted on $ 32 million they owe to the Texas PC maker. 

   Though PC sales are tiny, the growth rate looks promising. Reliable statistics are hard to come by, but the best guess is that about one million machines were bought in China last year--up 50% from the year before. At least half of these were inexpensive domestic clones, or kits assembled in back-street shops, often built with pirated components and loaded with stolen software. Still, some studies suggest Chinese consumers would be willing to spend a year's salary on a PC, says Daniel Wong, China manager for AST, which is running neck and neck with Compaq for market leadership. The financial sacrifice is justified by Confucian values that stress the importance of education, and is bolstered by the state's one-child policy, which means whatever economic gains a poor family enjoys tend to get lavished on the single heir. China is not likely to remain computer illiterate for long. 



HE HIGH END of the PC market caters to commercial and academic users, as well as to nouveau riche entrepreneurs and Communist princelings who can afford to spend $ 1,800 to $ 2,400 for a foreign- branded machine. It's a status symbol but also a powerful tool that could radically change the way information flows in China. Flourishing interest in China's nascent Internet backbone is proving a driver of PC demand. That's occurring despite the chill that the government has put on the growth of this medium by decreeing that all Internet service subscribers must register with local state security bureaus. In the long run it's doubtful that Beijing's thought police have the manpower or the sophistication to muzzle the Internet. Insists maverick Hong Kong publisher Jimmy Lai: "They can pee on the Internet, but they can't control it." 

   Motorola has jumped into China's computer firmament through its joint venture with Panda, a large state enterprise that is diversifying from color televisions into high technology. Panda is trying to reinvent itself as the sort of musclebound and profitable conglomerate that Beijing's technocrats hope will lead China into the future. The inspirations here are the chaebol in South Korea and the keiretsu in Japan (see box). 

   The Panda venture is also a good example of how Motorola is melding tactics in China with broader strategic plans. As with the rest of the world, China's PC market has been all but locked up by the "Wintel" alliance of Microsoft's Windows operating system and Intel's Pentium chip. Microsoft CEO Bill Gates is determined to keep it that way, even though the franchise is expensive and pecked at by incorrigible software piracy. "The China market is less than 1% of our sales, and the amount of energy we put in is so disproportionate that it's pretty unbelievable," says Gates. But because China is also "one of the world's fastest-growing markets," Microsoft's billionaire founder intends to keep putting in the effort. 

   Now Motorola plans to challenge that dominance. The alternative to Wintel is Apple's Macintosh, which relies on Motorola's Power PC as its engine. The Mac is wildly successful in Japan but has yet to scratch the surface in China. Allied with Panda, Motorola hopes that the Power PC will get a second chance in China. Licensing rights to the Macintosh Operating System recently acquired by Motorola will give the joint venture the technology to design a PC with applications ideally suited for China's home and educational markets, says Kenneth Kin, who heads Motorola's computer division in Asia. 

   The Mac OS has superior capabilities for handling Chinese characters, and Motorola's Lexicus subsidiary has voice- and handwriting-recognition technology that surmounts the pain of typing keyboard codes for the 7,000 to 10,000 Chinese characters required for basic literacy. If the Panda venture works, China could become a base from which to assault the thriving PC markets in the rest of Asia. "If we succeed," says Kin, "we'll look at other countries in the region, especially emerging markets like India." 

   Even if the Panda venture doesn't thrive, Motorola should be able to prosper by selling chips to China and the region; it won't have much local domestic competition for a while. The domestic Chinese chip industry is chugging along--but hardly flying. Between 1992 and 1995, it tripled the annual value of its production of integrated circuits to $ 500 million, and it is likely to hit the $ 1.2 billion mark by the year 2000, according to Semiconductor Equipment and Materials International, a U.S. trade association. 



UT CHINA'S wafer production is still crude by global standards. A key to success in the business is imprinting ever smaller integrated circuits, or chips, in ever greater numbers on ever larger wafers of pure silicon. The Chinese right now can only etch lines about one micron in width (a micron is a fraction of the width of a human hair) and typically imprint them on wafers four to five inches in diameter. Elsewhere in the world, industry leaders like Motorola can make chips as small as 0.5 to 0.35 microns on eight-inch wafers. 

   When its Tianjin plant is finished, Motorola will set a new standard for Chinese chipmaking by fabricating 0.8 micron chips on eight-inch wafers. Because the company owns the operation outright, it does not have to let the Chinese share in this advanced technology. Still, while no trade secrets will be officially passed along to the local competition, it will be difficult to keep the Chinese engineers employed on the site by Motorola from picking up on-the-job expertise that might be useful to rivals. The company is not worried, however. "They're very far behind," says Lai, a former Intel executive. "If we were to let them catch up, it would be because we were slipping. So we keep saying, 'Don't be complacent--a little bit of paranoia is good.' " 

   Some U.S. suppliers to the semiconductor industry may feel more threatened than Motorola itself. Finding local suppliers that meet quality standards and just-in-time delivery expectations isn't an easy task in China. To succeed in wafer fabrication, Motorola is counting on more of its traditional suppliers' coming in and helping build an industrial infrastructure. Will they? "We've got real concerns about our intellectual property rights," says David Ferran, CEO of San Diego-based Tylan General, a $ 50 million maker of testing devices for semiconductor production. "But we'll follow. Wherever you see a Motorola wafer fab, you'll see a Tylan General service center within 50 miles." 

   Motorola's more pressing problem may be convincing shareholders that investing an additional half a billion dollars in a developing nation plagued by widespread corruption, social dislocation, a patchy legal structure, and an opaque political process is a great idea. It's even harder to sell at a time when the semiconductor industry has a lot of capacity, and there are persistent fears that the growth of the PC business, a crucial customer for chips, is slowing down. Already, the global capital-spending budget is being scaled back in Motorola's semiconductor division, and plans for a new chip plant outside Richmond, Virginia, have been pushed back a year. 

   Motorola's share price has been shaky, recently trading at around $ 60, a drop of about 20% from six months ago. Over the same period, Morgan Stanley's HiTech index, a composite of 35 high-technology stocks, has risen about 6%. Part of the decline in Motorola's price can be explained by the uncertainty over whether Motorola's new CDMA cell phone technology will be a winner and by the slowdown in U.S. semiconductor and cell phone sales. But the Tianjin wafer fab has also come under close scrutiny by investors. "It's viewed as a risky proposition with the current state of semiconductors," notes Susan Kalla, a Motorola watcher at SoundView Financial Group of Stamford, Connecticut. 

   Whatever Wall Street's doubts may be, on the other side of the world is a group that's clearly enthusiastic about Motorola's investment--Chinese workers. Entry-level jobs on the assembly line pay a competitive $ 125 a month. Motorola sweetens the deal with an innovative home-ownership policy aimed at retaining the workers it trains. The company is building 400 units of housing in Tianjin and another 180 units for its 800 employees in research, sales, and administration in Beijing. All an employee has to do is scrape together a 30% down payment for a condo that will cost some 17 times a line operator's annual base salary, ten times an engineer's. Layoffs, of course, are never easy in a country where the concept of the "iron rice bowl"--cradle-to-grave welfare benefits and lifetime employment--is still strong. How would Motorola lay off and move out an unproductive engineer already comfortably ensconced in a home? After all attempts to retrain the deadbeat had been exhausted, the company insists it would nullify the mortgage, compensate the engineer and his family for paid-in principal, and show them the door. 

   Other kinds of firing, of course, may yet test Motorola's ability to stay the course in China. When CEO Gary L. Tooker paid his most recent visit to China in March--nearly seven years after the Tiananmen Square slaughter--Beijing's hard-liners were again terrifying people with their troops. This time they were firing missiles precariously close to Taiwanese ports, in a game of intimidation and brinkmanship that seemed to defy rational explanation. At the peak of the saber-rattling, an unruffled Tooker met with President Jiang Zemin for a relationship-building session, practicing Motorola's own private diplomacy. 

   President Jiang, hand-picked to succeed ailing patriarch Deng Xiaoping, is a Soviet-trained electrical engineer who understands the critical importance of technology to China's future prosperity. Many China watchers conclude his power base is weak, however, and that he may not have the personal authority to keep factional infighting at bay when Deng finally dies. Should Beijing's commitment to economic reforms erode--or in the worst case, collapse--few companies would lose more than Motorola. 

   But that comes with the territory in the People's Republic--the greater the engagement, the greater the risk. Certainly CEO Tooker sounds unwavering in his belief that China deserves the large place it now holds in Motorola's future. "I think people who have invested in Motorola over the years understand that we maybe have a longer-term view than some of our competitors," he says. "But we think that it's a balanced view, and they understand and respect it." And so they may--provided, of course, those big bets eventually pay off.