Why U.S. Companies Tend to Struggle in China

With 1.37 billion people, China is an incredibly alluring market to U.S. companies. But there are more than a few issues that tend to crop up when they actually try to set up shop there. And it's not just information giants like Google (GOOGL 1.42%) (GOOG 1.43%) and Facebook (META 0.14%) that run into trouble -- it's consumer goods players like IMAX (IMAX 0.12%) too.

In this Industry Focus: Tech episode, host Dylan Lewis and Motley Fool contributor Danny Vena talk about a few of the biggest hurdles that non-Chinese companies are facing in the Chinese market today.

A full transcript follows the video.

This video was recorded on Jan. 26, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Jan. 26. We're talking about some of the interesting story lines in China. I'm your host, Dylan Lewis, and I have Fool.com's Danny Vena on Skype. Danny, how's it going?

Danny Vena: It's not too bad, Dylan. How are you?

Lewis: I'm doing OK. We're both caffeinated, we're both ready to roll. The tour that was just here at Fool HQ has left, so I'm a little bit less self-conscious about any mistakes I may make as we're taping the show, but it's good. And I plug that tour to say, listeners, if you're ever in the area, shoot us a note. We're always happy to have people come in and check out the show, even though I just said it makes me self-conscious. It keeps us on our A-game. That's what I like to think.

Vena: It keeps you on your toes.

Lewis: Exactly. Danny, today we're going to be talking about China, specifically looking at two different story lines and what each one shows about the dynamics between U.S. companies, the government, and domestic companies in the country. The inspiration for this show came from a couple of articles that you wrote, so it only really made sense to have you on.

Vena: I appreciate the opportunity. It's always fun to talk about these investments.

Lewis: Listeners, if you would like any of those pieces, just write in and we'll send them along. I think the case for why companies want to be in China is probably pretty clear at this point, but it's worth throwing a couple of data points out there. So, if there's any naysayers who are like, "Why are they interested in China?" give me a couple of stats here, Danny.

Vena: China has the largest population of any country on Earth, for starters. They have, at last count, an estimated 1.37 billion consumers there. That's a pretty large percentage of the global population that a lot of these companies want to tap into.

Lewis: And that's a population that's increasingly coming online, right?

Vena: It is. In fact, China has internet users that number, estimates vary, but somewhere between 700 million and 750 million internet users.

Lewis: And then, you also have the rising middle class in China. This is a mega-trend that we've seen over the last decade get a lot of press. Basically, you have a huge opportunity here. The problem is, particularly as an American company, you can't just port over your operations like you would for most countries. I think that's especially true if you're in the business of information, and that's really come to light in the last couple of years with some major companies, namely Google and Facebook, trying to get their way in or eventually having to leave due to issues and disagreements with the Chinese government.

Vena: That's true. Google was actually in China for a long time, and left the country voluntarily, they say, back in 2010. They cited several reasons for that. One of which was, they said they were no longer willing to censor the results that Chinese consumers saw on Google's internet site. So, when consumers got on there and they would search for things, there were a lot of things related to the Chinese government, the outside world, that China said, "We don't want searchers to see that." Another reason was that, while Google was in the country, they said they experienced a sophisticated hack of their servers. And one of the things that was targeted was the email accounts of some human rights activists. Google essentially said that was the last straw, and they ported over their search results to their Hong Kong operation, and that essentially banned them from the country.

Lewis: And rather than leave voluntarily, Facebook was actually banned back in 2009.

Vena: That's right. In fact, Facebook was actually in the country as well, and it turned out there were some activists in the country that decided to use Facebook as a coordination tool so they could get folks to and from anti-government protests. The government looked poorly on that, and they shut Facebook out. Instagram was similarly shut out of the country back in 2014.

Lewis: So, these two major companies have not had a presence in one of the world's largest economies. Some recent comments from some government officials, I think, were kind of coy in that they talked about how, "As the Chinese government, we're happy to have these businesses up and running in China. Of course, for them to come back, they'd have to be doing it under the right conditions." Right?

Vena: Right. A government official was speaking at the Internet Governance Forum last month, and said that these companies were welcome to come back to China. We'd welcome them with open arms, as long as they abide by Chinese laws and regulations. Which, of course, can be onerous.

Lewis: And what exactly are those laws and regulations?

Vena: I have a list of them here. Some of them are pretty interesting. First of all, you know how there's a lot of anonymity on the internet? You can create a fake Facebook account; you don't need to use your real name on Twitter. That's not the case in China. In China, you have to sign up with your real name and provide verification of your identity in order to use social media sites. Similarly, with news programs that are on the internet, they're required to have editorial staff that have been pre-approved by government officials. Any time that there's an internet company in the country, they're required to first have their data servers on the ground in China. And in addition to that, they're required to keep all of the information gathered about Chinese citizens, that has to remain in the country, and they have to specifically ask for permission to transmit any of that information out of China. When we're talking about streaming companies -- and streaming is huge, you may recall that late in 2016, Netflix bowed out of its intentions to enter the Chinese market. And one of the reasons they cited was the government regulatory environment.

Lewis: What specifically about that is relevant to them, Danny?

Vena: Streaming companies are required to have no more than 30% of their content be from foreign sources. Again, the other same requirements, they have to keep the data in the country, a set of items that I just cited. But that's kind of tough for a company like Netflix, where if they're limited to 30% of their content being from foreign sources. That's not going to give them a lot of entry into that market.

Lewis: No, especially for a company that's focusing so much on original content, right?

Vena: Absolutely. And a couple of other items. The Chinese government has banned the use of VPNs, which is a virtual private network, something that internet users favored for getting around the Great Firewall, which was the things that the Chinese government used, essentially, to keep out foreign content. And finally, the companies in China that accept money from advertisers are required to verify the identity of those advertisers and their business credentials. So, there's a lot going on in China that we don't have to deal with here in the United States.

Lewis: Unpacking a lot of that and getting a sense of what these regulations are driving at, I think you clearly have some efforts there to maintain the government's control over what gets said, and what gets in and out of China. But you look at some of these -- that content one in particular seems like kind of a protectionist measure that's doing something to preserve local businesses. But I think one of the very interesting ones -- we've centered so much of this conversation on how regulations have impacted these U.S. firms. The reality is, these regulations have also had a pretty big impact on the digital ad market in China, specifically when you look at that bullet point about companies being required to verify the identity of advertisers. That came from a place where we were in this Wild West era of digital ad spend in China, and there were a lot of unseemly businesses getting really good placement on some paid posts and paid search results.

Vena: That's true. In 2016, Baidu, which is the search giant in China, sometimes called the Google of China, got itself into trouble because a 21-year-old student there died after receiving an experimental treatment that he found on Google search. Since then, Chinese officials have updated their advertising requirements, and they're really strict now on anything having to do with medical treatments, with prescriptions, unlicensed hospitals. There were a lot of fake medical groups on there, people who claimed to be support groups for people who were experiencing certain medical conditions when in fact, they were drug companies or even unlicensed experimental treatment companies who were trying to get users to buy their product.

Lewis: Earlier, you said "Google search" colloquially. I believe the actual search result was on a Baidu search result, correct? That cancer treatment?

Vena: Yes, absolutely. I'm sorry, I misspoke there.

Lewis: Which is a testament to Baidu's standing in China, given that that's the association you have there. These regulations went beyond just "We need to reshape how we're looking at this." There were also some fines that were levied. Not very big ones, but they were all targeted at the really big internet players in China.

Vena: That's true, Dylan. The Chinese government has gradually been trying to seize control of the internet. Now, obviously, for a long time, they have already been able to effectively ban most of the content that comes in from foreign countries. What they were trying to do, like you mentioned earlier, the Wild West mentality that was going on on the internet, it was a free-for-all there. And the government decided to clamp down on that. Their regulations are pretty specific, in kind of a broad way. The say they're disallowing the spread of information of violence and terror, false rumors, fake news, pornography and other information that jeopardizes national security, public safety and social order. So, there are some pretty specific things, but then there's also those broad-based ones that they throw in there, so that if they want to, they can go, "This falls under here, so we're going to get you on that."

Lewis: And you look at these regulations, and I think the expectation when you think of a government that's kind of known for censorship and walling off itself from the world is, these are all control-oriented, that they are to preserve the status quo. But, looking specifically at the medical element here, with that really unfortunate episode with the cancer treatments and some of the other health forum things that you mentioned, some of these regulations are really good for consumers. These are things that needed to happen in order for the digital ad market to take the next step, and for people to be on the hook for what they're pushing people toward, in terms of treatments and in terms of information. There's a responsibility there that all of these platform businesses have.

Vena: Right. Honestly, if you look at some of the clampdowns that have been happening in the United States, and the European Union regarding companies like Facebook, and there have been clampdowns there. There's a lot of talk about fake news, they're trying to ban pornography, they're trying to keep terrorists from using them as communication tools. So, a lot of that is the same. But as you mentioned, there's also some protectionist measures there. China is known for favoring their hometown companies when it comes to regulations.

Lewis: And we're going to talk about that on the second half of the show. To wrap this part of the conversation, though, I would be surprised to see Facebook in particular in China anytime soon. Actually, news broke earlier this month that Wang-Li Moser, Facebook's liaison to Beijing, just stepped down. This is someone who had been putting in years of work, in addition to Mark Zuckerberg learning to speak the language and making all of these appearances in the country. They had done quite a bit on the policy side to try to work with the Chinese government and find some middle ground that they could eventually enter the country on everyone's terms. Her stepping down, to me, says that's probably not happening anytime soon.

Vena: Facebook is having enough trouble as it is in democracies, countries that allow free and open press, free exchange of ideas, anybody can say virtually anything that they want to on social media sites, and they're still having problems with terrorists using the platform to communicate, stories about fake news, issues that have come up recently having to do with the platform being cited as, people spending too much time there tend to be depressed. And if he's dealing with all of that in the rest of the world, I can't imagine how much trouble he would have in a country like China.

Lewis: There's a lot on Mark Zuckerberg's plate right now, safe to say. Danny, you hinted at some of the dynamics between foreign companies and maybe entrenched domestic companies getting a little support from the government. We're going to talk about that in the second half the show. That's another really interesting story line in China right now. 

Danny, big tech trouble in China is fairly well documented. I think it gets a lot of press. You told me, though, about the battle for the big screen in China. This is a story that I was kind of surprised to hear.

Vena: I was kind of surprised when I heard it. But if you step back and think about it for a moment, the propensity for the Chinese government to favor companies that originated in China is well documented, so it shouldn't be too much of a surprise if they should favor a hometown favorite. Now, you may have heard of IMAX. IMAX is one of the largest theater companies in the world. They create the giant premium big-screen format that a lot of folks go to movies and see their blockbusters on. IMAX already does business in China. They control about 68% of IMAX China. They spun off their Chinese screen business several years ago, in 2015. China is the second-largest market in the world in terms of box office, behind only the United States. It's also important to note that China has seen significant ticket sales growth over the last few years. Now, there's a company in China called the China Film Digital Giant Screen Company, which, if you were trying to do a really descriptive definition of what IMAX is, it would come out very similar to that.

Lewis: That company description almost sounds like a front. It's so vanilla in its description of what the company does that it practically sounds illegitimate. Not to say that it is. It's a very real giant screen company, and they are in the theater business. But, you know what I mean?

Vena: Oh, absolutely. That's why I mentioned it. Now, the government gave them a mandate to become the largest premium format brand in the country, and they believe they can overtake IMAX in ticket sales by 2019.

Lewis: And you have to imagine that a company that gets a government mandate from a government that is notoriously involved in the commerce in its country is probably going to be well on its path to achieving that.

Vena: That's not a bad assumption. And what they're doing to achieve that is pretty interesting. In fact, the chairman's quote was, "Our top priority is expansion, not profitability."

Lewis: That's kind of taking a page from Jeff Bezos right there.

Vena: That sounds pretty familiar, doesn't it? So, this company, the China Film Digital Giant Screen Company, they allow theater owners to keep a larger percentage of the ticket revenue than IMAX does. IMAX has several different ways that they deal with theater owners. Because putting in an IMAX system is a large cash outlay, big amount of capital up front, they will either let the theater owners pay for the system up front, or they have what they call a joint revenue-sharing arrangement, which is, they say, "We'll front you the theater, we'll put the projection system into your theater, and you can pay us back over time with a percentage of your ticket sales." This Chinese company charges just a flat fee for installation that's significantly lower than what the theater owner would pay for an IMAX system. But then, you get what you pay for.

Lewis: Danny, you follow IMAX quite a bit. Is this something that has you a little bit worried? You talked about how China is the world's second-largest market for the box-office behind only the United States, and they have a fairly major stake in IMAX China. Is this something that concerns you at all as an investor?

Vena: I would be foolish not to be concerned about it. So far, someone making a statement like that, in and of itself, is not enough to make me sell my IMAX shares. I am holding my shares. But, that's something that bears watching, because the Chinese government basically can do what it wants. It's their country. And If they wanted to promote this other company ahead of IMAX, if they wanted to tell their consumers that this is the big bad Western devil, it could cause problems. And the people going to see the movies might think twice about going against something that has tacit government approval.

Lewis: Yeah. And operationally, it can be a little bit easier to get favorable financing if you are the hometown team, so to speak.

Vena: Right. So, I'm not concerned about it yet, but I'm definitely watching it.

Lewis: I think this example is worth highlighting because, we think about these super-big multinationals that we read about all the time. This is an instance of a fairly big company, IMAX, in a market that matters quite a bit to them, but not necessarily one where you think that the Chinese government would be heavily involved. This is a story line that really caught me off guard, and kind of a good reminder that the Chinese government can really decide to support any business that they'd like to.

Vena: Right. Just to put this into perspective, it's a pretty sizable chunk of IMAX's box office. If you do a comparison, IMAX's domestic box office in its most recent quarter was $80 million in box office. The Greater China box office was $60 million, which was about 27% of the company's box office totals. Even if the state-backed China Film Digital Giant Screen Company was able to make small inroads there, it could definitely cost IMAX in terms of box office.

Lewis: That's probably a good thing to wrap on there. Listeners, just keep a heads out for this if you enjoyed this conversation, I'm planning on having Danny back on at some point in the future to talk about some Chinese companies he's been watching. He follows a lot of the tech companies in that space. And that's companies that are based in China and have the benefit of the Chinese government giving them help every now and then. So, look out for that. Anything else before I let you go, Danny?

Vena: No. I rib you a lot about the weather in sunny San Diego, and it is supposed to be 70 today, but I thought I would throw you a bone here. The last few mornings, when I've been out walking the dog at about 05:15, the temperature out there's been about 42 degrees. So, it's not always sunny in San Diego.

Lewis: You know, we might hit a high of that today. We'll see. [laughs] But, you know what? Whatever, I'm going snowboarding this weekend, so I have that going on for me.

Vena: Cool.

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions or if you just want to reach out and say hey, shoot us an email over at [email protected], or tweet us @MFIndustryFocus. If you're going snowboarding this weekend, shoot us a picture of you doing that. Our producer, Austin Morgan, is an avid snowboarder, might be planning on going next week. And of course, if you're looking for more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Danny Vena, I'm Dylan Lewis. Thanks for listening and Fool on!