U.S. Companies: Beware in China

We've known for years that China isn't the most honest trade partner. It subsidizes industries it wants to own, manipulates its currency, and doesn't care about borrowing intellectual property when it sees fit. But recent hacking of U.S. companies and the U.S. government has brought to the forefront one of the great challenges for U.S. companies in China: how to control increasingly important intellectual property in today's connected world.

Most major companies do some business with China; many even outsource a large amount of production. Can they really expect China to keep trade secrets a secret when they're stealing them from across the ocean? It's a challenge that may define how companies view China in the future.

Exposing secrets to China
The challenge for companies has become leveraging inexpensive labor in China without exposing all of their secrets to workers there. Companies take a variety of strategies to mitigate the danger of losing control of IP.

For a company such as Apple (NASDAQ: AAPL  ) , which has most of its products manufactured in China, you do this by developing and producing different parts of a product around the world. The software is developed in the U.S. while displays and chips are made by suppliers around Asia and shipped to Foxconn for final assembly. This makes it harder for a single manufacturer to copy Apple's products, particularly the software that makes everything work smoothly.

3M (NYSE: MMM  ) takes a slightly different approach. It chooses to manufacture highly sensitive technology in the U.S. The two largest manufacturing plants 3M owns are within about an hour's drive of headquarters in St. Paul, Minn., keeping sensitive IP close to home. When manufacturing is complete for a product, such as the films that go into Apple's products, the converting (cutting the film into phone-shaped pieces) may take place in Asia but the sensitive technology has stayed close to home.

But even these methods don't always work. American Superconductor (NASDAQ: AMSC  ) was nearly put out of business when Chinese manufacturing partner Sinovel stole proprietary software the company used to control wind turbines. The manufacturer paid (or promised to pay) a disgruntled employee for the code and cut ties with the company despite contractual obligations. In this case, the Chinese court system hasn't backed up American Superconductor despite the fact the man who sold the IP is in jail and Sinovel clearly breached contracts. What recourse does a company have even when all possible protections are done?

More reason to come home
I think the recent hacking attacks give U.S. companies even more reason to bring manufacturing back home. Even though attacks happened to U.S. companies and originated in China, the ocean between us at least makes it harder to copy products or steal technology. The fallout from hacking may not be felt overnight, but it is a piece of China's strategy to dominate increasingly complex industries once owned by U.S. companies. When the government of China is involved with hacking as well as funding industries, you can tell it's a concerted effort to pick industries China wants to own, which should worry U.S. companies.

The U.S. used to control the PC business until it started outsourcing manufacturing to China and other Asian nations. Over two decades, engineers became increasingly capable at building computers and today they own the industry. In 2001, four U.S. companies and one Japanese company were the top five computer makers by market share; today three of five are Asian companies. That's a huge shift in a giant industry over just 11 years.  

Smartphones are trending in the same direction. Manufacturing already occurs in China and it's only a matter of time before a serious brand emerges to challenge today's leaders. Apple taught Samsung how to build today's smartphones and rumors have circulated that supplier Foxconn has its sights on its own smartphone.

Hacking isn't a silver bullet against U.S. companies, but it's a piece of the picture. Teach a few bright people how to build smartphones here, steal a little software code there, and suddenly a new competitor is born.

China shooting itself in the foot
The crazy part of the hacking reports is that China has more to lose than we do. Its economy relies on exports to survive and if U.S. companies began pulling out, it could be devastating. China isn't at the point where it can export its own products. It currently relies on U.S. companies to provide brands and technology while leveraging cheap Chinese labor, and it doesn't have a consumer-driven economy.

Over time, that will change, but China has a long way to go before it has a consumption or locally developed export economy. Whether it's hacking or IP theft, the country has to keep its eye on how far it pushes U.S. companies, which are already dealing with higher labor costs and could bring production home to the U.S.

China isn't the only problem
None of this is to say that China is the only problem. Facebook (NASDAQ: FB  ) , Apple, Microsoft (NASDAQ: MSFT  ) , and Twitter have all been hacked very recently and it doesn't appear to be coming from China. Eastern Europe and Russia, which are known to have some of the most sophisticated hackers, seem to be the source of recent problems. Microsoft has been fighting Chinese copyright infringement for decades so it already understands what a challenge these new markets present. For Facebook, the stakes are extremely high given the information people put on their site. A hack from anywhere in the world could render the company untrustworthy, sending users fleeing the site. 

The difference between Chinese hacking and the recent tech hacking is that these countries don't make a lot of the products we buy so stealing IP wouldn't have the same impact. China could take the IP and leverage an already existing manufacturing infrastructure to build industries that compete directly with U.S. companies.

Buyer beware
With IP in danger, labor costs rising, and local competitors popping up, I think we'll see increased scrutiny by U.S. companies doing business in China. We won't see a wholesale move back home, but a trickle will take place. If hacking from China continues, the discussions in boardrooms across the U.S. will take a more serious tone, particularly in high-tech industries.

U.S. companies have a lot to lose and a slightly lower margin may be a small price to pay if your whole business is under attack.

One of the biggest outsourcers to China

There's no doubt that Apple is at the center of technology's largest revolution ever, but it has done so by leveraging Chinese manufacturing and teaching competitors like Samsung how to build great devices. Now, there is a debate raging as to whether Apple remains a buy. The Motley Fool's senior technology analyst and managing bureau chief, Eric Bleeker, is prepared to fill you in on both reasons to buy and reasons to sell Apple, and what opportunities are left for the company (and more importantly, your portfolio) going forward. To get instant access to his latest thinking on Apple, simply click here now.

 


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