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21 February 2006| Member Edition

Interview

Making China your second home market: An interview

with the CEO of Danfoss
The head of the Danish industrial-controls company wants to make China one of its core markets.

William E. Hoover Jr.

2006 Number 1

Like many other global companies, Danfoss had been taking a slow boat to China. During the mid-1990s, the
company moved some of the manufacturing of its valves, compressors, and motion controls there to take
advantage of low wages. It was selling some of the output around the world and the rest locally, at high prices, to
business customers in the major coastal Chinese cities.

This approach was successful: after some ten years in China, Danfoss can boast profits, high growth rates, and
excellent relations with the Chinese authorities. Yet the company's CEO, Jørgen M. Clausen, who in 1996 took the
helm of his family's business (which had €2.2 billion in net sales in 2004), wondered if Danfoss was achieving its
full potential in China. Moreover, he doubted that the cautious approach would ensure a lasting and meaningful
role for the company in a market that over the next 40 years will probably overtake the United States as the
world's largest.

A company's long-term goals in China and the timing of the moves required to meet them are strategic issues
that chief executives all over the world are, or should be, pondering. For Danfoss, another dimension was
involved as well. Coming from a country with only 5.1 million inhabitants, the company was acutely aware that it
could achieve strong growth only through market leadership beyond its own borders.

Danfoss had used the opportunities that emerged from the reconstruction and integration of Europe's economies
after World War II to make much of the Continent its wider home market. But the company shared the fate of
most others by moving too slowly to challenge long-standing domestic incumbents in the United States, Japan,
and South Korea. Now, Clausen believes, there is a unique—but quickly closing—window of opportunity to
contend for market leadership in China, the next major market to open.

In an interview with Bill Hoover, a director in McKinsey's Copenhagen office, Clausen spoke about his company's
strategy to make China its "second home market," as well as the operational and organizational challenges
involved in that quest.

The Quarterly: What was Danfoss's China strategy in the 1990s?

Jørgen Clausen: We didn't really have a long-term strategy. We sell in more than 80 countries around the world
and have factories in about 20, and we thought of China as one of many markets, although its huge potential
naturally became clearer and clearer over time. Basically, we were gradually expanding our manufacturing
capacity in the country to take advantage of the labor rate differential. Some of the output was sold worldwide
and some of it was sold to big Chinese and multinational businesses in China's fast-growing coastal areas.

We had been fortunate in two ways. We were granted a business license for a wholly owned subsidiary in 1993
and didn't have to cope with one of those joint ventures that have proved cumbersome for many Western
companies. Also, one of our division presidents, who went to China to scout for a suitable industrial-development
park, found what turned out to be an ideal choice. We bought a piece of land in the development zone in Wuqing,
in the Tianjin municipality, and initially rented some manufacturing space there while we built our own factory. It
was ready in 1996, and we've expanded it four times since. It now houses seven product lines and 650
employees.

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The Quarterly: Why was Wuqing a wise choice?

Jørgen Clausen: It's about two hours outside of Beijing. There is plenty of labor available at attractive rates, while
at the same time Wuqing is still close enough to Beijing for expatriates who want to live in the capital so that
their children can go to international schools. We are also a relatively large company in a very small development
park, which means we get a lot of attention from the authorities. That wouldn't be the case today in the big zones
where the truly large multinationals are based. There, we would just be a tiny mouse.

The Quarterly: What about your manufacturing systems and product ranges? Were you adapting them to Chinese
conditions in the '90s?

Jørgen Clausen: No, we simply replicated our European production lines and even used our old suppliers, to begin
with. That meant we could hire local people and teach them to operate the machines. As a next step, we started
switching to local subsuppliers. So we had a strategy of not trying to do too many difficult things at the same
time.

This approach has served us well by assuring the same quality and productivity we achieve in Denmark or
Germany but at a much lower cost, because of the wage differential. So by the mid- to late-1990s, everything
was going well for us in China. We were growing and making a profit. I was out there regularly, and we were very
seriously and successfully lobbying local and national government officials. Even so, it would be fair to say that
China was moving up on our agenda but was still only one of many markets.

The Quarterly: In 2004 Danfoss dramatically shifted gears in China. The company now aims for growth of 50
percent a year and for a quadrupling of sales by 2008—steps toward eventually achieving market share similar to
the average 15 to 20 percent that Danfoss holds in Europe. How did this change come about?

Jørgen Clausen: There were two eye-opening events that made me start thinking about a long-term strategy for
China. First, I read an article in a newspaper one day about a big European manufacturer that was happy with its
40 percent growth in China until it discovered that the entire market for its product category was growing by 80
percent, which meant the company was actually losing market share. This made me wonder how successful we
really were in China and if we too were being fooled by growth rates that were vastly superior to the ones we
were getting in Europe.
The second event came when my wife and I indulged ourselves by making an old dream come true: we traveled
the ancient Silk Road from Almaty, in Kazakhstan, to Ürümqi, in China's western province of Xinjiang. We drove
for two days in a Land Cruiser through what struck me as quite backward areas until we reached the Chinese
border, where the president of our Chinese subsidiary waited for us in another Land Cruiser.

'I came away from our glimpse of Greater China with the feeling that there must be many opportunities that
we weren't addressing'

Once we'd crossed into China, I was struck by the good roads and the nice pavements lining them and, in
general, by how relatively modern and well organized things seemed to be in this very remote area, so far from
Beijing and Shanghai. In Ürümqi I peered through the window of a dressmaking factory and saw that it was
highly automated, which I was surprised to see in a remote area where labor must be very cheap. In a
department store, we mingled with ordinary Chinese shoppers and were surprised to find exclusive dresses and
$100 ties on offer. Something that particularly caught my eye was a refrigerator with inverters that control the
speed of the motor and thus save energy—a luxury category one wouldn't find even in a large Danish town.

Anecdotal as all this may be, I came away from our glimpse of Greater China with the feeling that there must be
many opportunities in the market that we were not addressing. So I went to my chairman and said, "We're
growing by around 35 percent in China and we're making good money, but are we doing enough?" He didn't know
the answer and neither did the board of our Chinese company. So we decided to find out by conducting an
exploratory review of all our product markets. This was more difficult than it might sound as there is little official
market data available in China.

The Quarterly: What did you find?

Jørgen Clausen: We found that we were just skimming the surface and capturing only a few percentage points'
share in most of our product markets. Our products addressed the high end of the market and some of the
middle, but not the low end, which in many cases we hadn't even known existed. This shortcoming was actually
not surprising, as we had simply taken our existing European product line to China. What stunned us was the size
of the low-end market. We concluded that if we could offer the right products, there was a potential to increase
our coverage by a factor of 10 and our profits by a factor of 30 in one segment of industrial-control devices—
somewhat less in other segments, but still by a very substantial amount. Collectively, this could give us a market
share of from 15 to 20 percent, roughly equal to our share in Europe.

What we then did was to identify areas where we needed to create new offerings. One was simple motor-speed
controls for commercial refrigeration units. While our products had all the bells and whistles and adhered to
European Union standards, they were too expensive and overengineered for most Chinese companies. These
companies in the low-end segment were mainly interested in two things: getting the energy-saving function at
the lowest possible price and getting a specially designed dust cover to protect the machinery.

The Quarterly: What was the thinking behind Danfoss's very ambitious strategic plan for China?

Jørgen Clausen: The plan was colored by our experiences in the US, Japanese, and South Korean markets, where
homegrown companies had already established themselves as market leaders by the time we moved in and so
held all the best cards. We have never been able to become big there, and we didn't want to miss the opportunity
once again. China may not be huge today, but in 15 years the Chinese market will be further advanced and ripe
for our products on a big scale.

So there was a sense of urgency that came into the strategic planning—a realization that we can move in
forcefully now while the window is still open or wait five years while others take the top positions and resign
ourselves to being one of many small players here too. This shift toward defining our aspirations in China by
market share rather than by growth rates, which are often from a very small base, also led us to the concept of
China as our "second home market," after Europe, which currently represents some 65 percent of our revenues
but where economic growth is slow.

By home market, we mean one where we want to be a market share leader, an aspiration that helps us set a goal
for ourselves. Maybe we cannot be number 1 in China, but maybe we can be number 2 or 3. We certainly don't
want to be number 17, because then we will be in trouble later on when the industry consolidates, and we won't
have the volumes needed to compete with local Chinese incumbents.

The Quarterly: What are the operational and organizational challenges of such a strategy?

Jørgen Clausen: It's a big step. We were already manufacturing high-end and middle-level products in China and
selling to big businesses in its top cities. We realized that now we have to develop some completely new products
at competitive prices—products with local components and manufactured with less capital-intensive techniques—
and to distribute them in maybe 40 urban areas across the country. To make all this happen, we need to expand
our Chinese staff from around 700 to perhaps 4,000 by 2008 and to develop a cadre of Chinese managers.

The Quarterly: How are you addressing the low-end gap in your product range? Is it possible to take a European
product and strip it down into a simpler, cheaper version?

Jørgen Clausen: No, I think a low-cost product must be designed from scratch, something our European
engineers can't easily do. They don't have the right mentality and would set excessively high standards for even
the smallest details, ending up with an overengineered and too expensive product. However, I think it is possible
to go the other way, by starting out with a simple version and improving its quality while still taking advantage of
China's low-cost base. That's why we plan to address this gap by acquiring Chinese companies, so that we can
draw on their products, distribution systems, and R&D.

For example, we just acquired a Chinese company that makes energy-saving inverters for specialized machinery.
This company is very successful in the low end of the market, while we already have products for the high end
and the middle.

The Quarterly: What will doing all these things in China mean for your company's product range and innovation
on a global level?

Jørgen Clausen: It's very important to be in China. For one thing, we can hire maybe ten engineers or
researchers there for the price of one in Europe. We have begun establishing R&D centers in China for
refrigeration, air-conditioning, and heating. These centers, in conjunction with local acquisitions, will help us
create a competitive range of products for the Chinese market, and they will also give our company a broader
portfolio in the rest of Asia and elsewhere.

It's a fairly big decision to establish an R&D center, because it requires its own little organization. But once a
center is in place, we can use it for many things with the help of modern communications technology. I was
visiting one of our R&D units in China recently and looked over the shoulder of an engineer. On her screen I
recognized a product I didn't think was being designed in China. Oh, yes, she explained, she was running the
project together with one guy in Germany, one in Slovakia, and one in Iowa.

The Quarterly: What about protecting your intellectual property in China? Have you found ways to do that?

Jørgen Clausen: A lot of companies copy our products, and we have now adopted a policy of going after them
systematically, especially the ones that export the copies from China to other countries. There was one case in
particular where we got inquiries from customers about a product that was supposedly ours and that was being
sold at a very low price. We investigated and found that it looked very much like ours, had a Danfoss label that
said it was made in Denmark, and came in a box that looked exactly like ours. We managed to locate the Chinese
company manufacturing the copies, documented our case well, and then went to the police. The police raided the
company, confiscated the goods, and the owner was sent to jail.

Meanwhile, the PR agent on our team encouraged Chinese newspapers to write articles in which we praised the
police and the judge. So it became a very positive story from the Chinese authorities' point of view. They are now
very happy to work with us. Our policy also acts as a deterrent. The copycats now realize that Danfoss will go
after them.

There have been some other cases that we brought to the attention of the Chinese government, which is taking
the intellectual-property issue more seriously now. Things will get better and better, I would say, but the issue
will always be around, just as it is in the West.

The Quarterly: Turning to organizational challenges, how do you develop and retain Chinese managerial talent?

Jørgen Clausen: It is very important to overcome cultural barriers. In Denmark, people are raised to speak
frankly and to disagree in public. The Chinese rarely disagree with a higher-ranking person and won't speak until
asked to do so. This is no good for us, because we need their help to find solutions to the challenges of growing
quickly in the Chinese market. So with the help of the Copenhagen School of Economics, we have designed a
three-month development program for Chinese and other Asian leadership talent. Psychologists in these
programs support the participants in their personal development and teach ways to bridge cultural differences.
This approach is working very well.
We also focus on sharing our corporate values, and I think that has helped our Chinese managers to adopt our
corporate culture very fast and to be loyal to us. We have very high retention, which is quite unusual in China. I
know of only three or four people in leading positions who have left the company.

The Quarterly: What role does the second-home-market concept play in the new China strategy?

Jørgen Clausen: It's only been a year since we launched this idea, and I can see that it's already made a huge
and positive difference in the attitude of our employees and customers in China. It adds to our credibility when I
tell Chinese government officials and customers that they shouldn't view us as a foreign company. "We are
Chinese, just like you," I say. "Only I am Danish. The technology you buy from us is from China, and you create
employment in China when you buy from us." They hadn't thought about it from that perspective before.

The Quarterly: What role do you as CEO play in this strategy?

Jørgen Clausen: I think the CEO's strong commitment to a high-speed strategy is crucial. I am chairman of our
Chinese company, and its president reports directly to me. The CEO plays a key role in developing good
relationships with the government, something that is crucial in China, and this role probably grows even more
important with a second-home-market strategy.

You simply have to invest a lot of time because you will only get results if you lobby systematically over a long
period. Just saying hello once or twice to the Chinese ambassador won't help a bit. I go over to China five times a
year, and some of these trips have as their prime purpose meetings with government officials. We have pictures
in our offices of me together with Chinese mayors and government ministers, and this kind of picture serves as a
stamp of approval in the eyes of our customers, who often cannot get that close to government leaders.

The Quarterly: How big a bet is Danfoss making on China? Is it a risky gamble?

Jørgen Clausen: Absolutely not. We are already making profits in China, and the government there financed
much of the over $100 million in investments that we plan to make. In fact, we have decided that we now want
to repatriate some profits—partly to see how that process works—and to finance further investments by
borrowing the money in China. So we can actually afford the bet we are making there, and not to have made it
would simply be another missed opportunity, like the United States, Japan, and South Korea.

The Quarterly: How important is speed? In what kinds of businesses is it still possible for multinationals to aspire
to market leadership in China?

Jørgen Clausen: I would say that in some markets—for example, PCs and white goods—it's already too late
because Chinese domestic players are very strong. Then there are markets, like the ones where Danfoss is
operating, that are maturing but where the game is far from over. But you cannot make a decision on China when
you're sitting behind a desk back home. You've got to get up from your chair, buy a ticket not just to Beijing and

Shanghai but to other parts of China as well, and see the opportunities and risks with your own eyes.

About the Author

Bill Hoover is a director in McKinsey's Copenhagen office.