Emerging Markets Insights

Despite the uncertainty surrounding the European debt crisis, geopolitical tensions in the Middle East, slowdowns in China and Brazil, and other external headwinds, multinational executives face aggressive 2012 emerging markets growth targets.  Frontier Strategy Group’s clients tell us that their 2012 targets are in line with 2011 performance, despite the fact that 2011 enjoyed more favorable tailwinds.

In the past, Western consumer products companies have been able to rely on higher-income consumers to drive growth.  These consumers often have tastes and preferences in line with those of Western consumers, and place a premium on the cachet of Western brands.  And, given the relatively early stage of market maturity, there was plenty of white space for first-movers to take advantage of.

Looking into the future, Western companies will face a new paradigm characterized by more competitors fighting for share of a decelerating premium market.  White space will shrink as more companies enter and expand in emerging markets in search of growth to offset the slowdown in the West.  Concurrently, growth of the premium segment in key markets such as China will plateau.  To achieve their targets in such an environment, executives will need to consider more innovative and aggressive strategies.

A new paradigm in emerging market customer dynamics

The changing dynamics of a softening and increasingly competitive premium market demand a new approach in how executives should think about emerging markets.   Aggregated across the BRICs, middle tier households (as measured by annual household income) will actually surpass lower-tier households in sheer quantity by 2014.  What this means is that the traditional market segmentation of the market pyramid will soon morph into what we like to refer to as the “Market Diamond”.  As executives are thinking about emerging markets, the Market Diamond represents the idea that the middle market will be so compelling that both local competitors and multinational companies cannot afford to ignore such a large market opportunity.

A race to the middle

The only way to fight the inevitable market squeeze (competition and lower growth at the top-end, and increased local competition from the bottom-end) is to prioritize product localization strategies and move down the diamond into this huge opportunity.  Growing into new market segments is not an easy task, and choosing the right strategies depends in part on executive tolerance for risk.

FSG has identified two key root challenges that are preventing companies and executives from implementing these eight middle market strategies: 1) corporate risk aversion, and 2) organizational misalignment.  To provide a framework for overcoming these challenges, FSG has defined eight steps that represent increasingly aggressive strategies for penetrating the middle market, and profiled the strategies and tactics leading companies have used to mitigate the risks associated with each strategy:

1. Redefine metrics of success
2. Operational efficiency
3. Adjusting price
4. Distribution strategy
5. Branding strategy
6. Adapting products
7. M&A
8. Reverse innovation

The best companies are acting now

Mounting evidence suggests that emerging market based companies will continue to develop new capabilities and increase in levels of sophistication.  Local competitors are increasingly following their current low-income customers into the middle market as those customers’ tastes and preferences evolve, and if multinationals fail to act now, they may find that they are arriving to the game too late.  As the world economy continues to globalize, sophisticated emerging market based companies are no longer anomalies, but are more frequently becoming the norm.  This trend illustrates that companies we now consider “local competitors”, might soon in the future become just “competitors”.

*Sam Osborn, Senior Analyst at Frontier  Strategy Group contributed to this piece.

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Companies are moving to more direct models in Saudi Arabia to capitalize on increasing public expenditure in priority sectors like education, healthcare, housing, and related infrastructure.

A local presence allows MNCs to be closer to customers and to leverage partners more effectively.

Drivers

Companies know their products better than distributors: Visiting local partners on an infrequent basis is not enough to imbue expertise in your product offering. There will always be a gap between realized and actual market potential without this knowledge.

Closer oversight of partners: Establishing a more direct presence allows companies to manage local partners closely and take advantage of special treatment due to the government’s mandate to prioritize companies with a local presence.

Business climate stability amid regional uncertainty: The Saudi market is growing in regional importance as companies de-prioritize business in less stable markets such as Egypt, Iran, Lebanon, Syria, and Tunisia.

Recognition of rising MNC competition: MNCs must get closer to customers due to the rapid expansion of foreign MNCs and regional conglomerates into the Saudi market.

Frontier Strategy Group View

Companies should no longer expect to capture the full potential of the Saudi market if they are based elsewhere in the Gulf region.

MNCs are finding it easier and more necessary than ever to go direct or form joint ventures in Saudi Arabia. The commercial infrastructure improved significantly over the past decade, exemplified by Saudi Arabia’s #12 global ranking in the World Bank’s Ease of Doing Business Index.

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During the final weeks of 2011, Frontier Strategy Group spent a great deal of time speaking with emerging markets executives to understand their top priorities for 2012.  The chief concern for nearly every executive we spoke with largely boils down to, “How can I maintain growth in the face of market deceleration?”  Corporate expectations are roughly in line with the performance achieved in 2011, despite increasing external headwinds, uncertainty, and volatility.

As we began to unpackage and dig a bit deeper into these concerns, we identified four very common issue sets that we will address in our quarterly global business analysis and executive forums in 2012:

Responding to Local Competitors

• What are the most successful Western MNCs doing to counter the threat of local and emerging markets-based rivals?
• What are the most successful tactics for responding to price competition while preserving margins?
• How can multinationals best leverage their strengths and mitigate their weaknesses to beat local companies in the war for talent?

Streamlining the Strategic Planning Process

• How can I accelerate processes and ensure that time spent on strategic planning yields strong returns?
• What are the best mechanisms for collecting local market insight from my team?
• How can I more effectively make my case to the corporate center?

Walking the Channel Management Tightrope: Direct vs. Indirect

• What is the right balance between direct and indirect sales?
• How have leading companies managed the transition from indirect to direct, or vice versa?
• When is the right time to terminate a distributor relationship, and how can I minimize disruption through the transition?

Managing the M&A Lifecycle

• When is inorganic growth preferable to organic growth?
• What are the best (and worst) practices for identifying and screening potential targets?
• How can I more seamlessly integrate the new team and infuse my “corporate DNA?”

What do you think will be the most important challenge facing emerging markets executives in 2012?  Give us your feedback by clicking on this link.

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The criteria MNCs use to evaluate their distributors are designed to maximize the speed and breadth of initial market penetration, but over the long term incentive distributors to seek short-term gain rather than support their foreign partner in establishing a strong market presence.

Implications for MNCs:

• As a result of this evaluation process, most MNCs have developed distributor relationships that are optimal in the early stages of market entry, but over time become less useful
• However, many companies fail to upgrade and restructure these relationship to position themselves for long-term growth.

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Working with local partners has been a winning strategy for many MNCs interested in the Russian market. However, with increased concerns about FCPA and UK Bribery Act enforcement, MNCs are more than ever seeking to ensure their Russian partners are not engaging in any corrupt practices.

In theory, MNCs can protect themselves by conducting extensive due diligence on any potential partners, including compliance clauses in their contracts with their partners, and carefully monitoring for any suspicious activity.

In practice, however, “Some companies are so eager to enter the market, they rush into partnerships believing everything their Russian counterparts tell them. They allow themselves to be seduced by local partners,” says Tim Stanley, formerly with Control Risks and KPMG and now Frontier Strategy Group expert advisor and independent consultant with extensive experience in conducting integrity and operational due diligence for companies investing in Russia and throughout the CIS.

“There is often a huge gap between how foreign companies expect their local partners to work, and how their Russian counterparts actually operate on the ground. The gap may not become obvious for a while, especially if foreign company representatives only occasionally meet with their Russian partners,” points out Tim Stanley.

He adds that Russian firms may sometimes not share the details of how they get things done with their foreign partners, because they believe all that matters to the foreign company is good financial results. “Communicating to your partners the importance of ensuring compliance in all their actions is key,” says Mr. Stanley. “And doing so not just once, but on a continuous basis.”

Mr. Stanley offers a few other tips for foreign companies working with local partners in Russia:

When evaluating potential partners: know who runs the company, and who actually owns it

Who legally owns the company and who runs it can differ greatly in Russia, and MNCs should see any inconsistencies in the ownership and management structures of potential partners as a red flag. Some Russian companies have immensely complicated ownership structures, sometimes for legitimate reasons but often created with the purpose of tax evasion and other illegal practices. The real owners may present operational, reputational and political risks significantly different from those which an unwitting investor or business partner may be aware of when negotiating with local management.

Reputational due diligence is extremely effective in Russia

Often in Russia, word of mouth can give you a better perspective on a potential partner than a review of their financials. Get a second or third opinion on a potential partner, learn about their reputation and the experiences other companies – especially Western ones – have had working with them. If the company has a local track record of legal disputes, or a reputation for using aggressive business tactics or for cutting corners, then chances are, you will hear about it.

Due diligence does not end with a signed contract

Over time a company’s profile will change as business activities adapt and develop.  A company’s compliance profile – and thus potential vulnerability – will change in step with the changing nature of the company, with some risks becoming more prevalent and others diminishing.  A clean bill of health during the pre-transaction due diligence is a necessary, but not sufficient condition for compliance purposes, and foreign investors need to invest in promoting a culture of integrity and compliance in their dealings with local companies. This can be achieved by embedding compliance throughout the company’s operational activities, and through regular communication and training.

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Luxury jewelry retailer Tiffany & Co. recently released its second quarterly results, notching a better than expected 33% boost in profits, driven by demand in international markets.  In terms of growth, Tiffany cited a 46% increase in sales to distributors in emerging markets.

FSG has found that one of the keys to success for high growth companies in emerging markets is taking a “tough love” approach with their distributors.

In terms of “love,” our benchmarking research has found that high growth companies are selling more than 50% of both revenues and volumes through distributors, compared to less than 38% and 36% respectively at average growth companies. High growth companies are also investing significantly more resources in managing their distribution relationships.  Measured in terms of full-time equivalents (FTEs), high growth companies are dedicating about five times more resource than low growth companies.  We have also found that senior executives at high growth companies are investing substantially more time personally working with distributors than their peers at low growth companies.

In terms of “tough,” high growth companies are much more likely to terminate relationships with distributors.  We found that the average tenure for distributors for high growth companies is about 7 years, compared to over 10 years at average growth companies.  When we asked companies what percentage of their relationships they have terminated in just the past 2 years, high growth companies told us that on average they had ended 17% of their partnerships, compared with 7% at average growth companies.

Although it may seem counterintuitive, it turns out that despite the significant extra investments that high growth companies are making as part of this tough love approach, their channels are much more profitable than those of low growth companies.  Simply put, growing the size of the profit pie means that the distributors’ appetite can be satisfied with a smaller piece.

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Cisco Systems is reinventing itself.  The company is currently making headlines for slashing costs, announcing plans to lay off 6,500 employees, and selling off non-core product lines such as Flip video recorders and television set-top boxes.  Behind the scenes, however, Cisco is making strategic moves designed to accelerate the company’s growth and profitability.  A revamping of the channel strategy stands out as a key priority, with the company opting to “go deep” with a select number of preferred channel partners and reduce confusion by doubling down on five key product categories (versus 30 previously).

Incentives (especially non-monetary incentives) for channel partners are certainly something that Cisco will be evaluating. Non-monetary incentives in particular are playing an important role for vendors, as they are seen as a strategy for protecting margins and preventing damaging price competition.  However, many vendors also believe that non-monetary incentives yield greater returns in enhancing performance since they represent specific investments in distributors’ capabilities.  Cash payouts, on the other hand, may or may not be properly re-invested by the distributor in their business.

However, FSG’s research has discovered that not all non-monetary incentives are created equal.  We have identified two distinct types of non-monetary incentives: 1) Integrating, and 2) Value Transfer. High growth companies are much more likely to turn to Integrating Incentives.  These are non-monetary incentives that provide the vendor with increased visibility into and control over the operations of their distributors.  These Integrating Incentives can act as a sort of Trojan Horse for vendors seeking to gain increased control over distributors in a way that does not cause their partners to put up defensive barriers.

In my next post, we will take a closer look at the “tough love” approach that high growth companies are taking in managing their relationships with channel partners.

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Philip Morris International (PMI) recently reported its second-quarter results. PMI attributed declining performance in the EMEA region due to unfavorable terms with its local distributor. In my previous blog post I highlighted the top three takeaways from Frontier Strategy Group’s recent survey aimed at understanding the channel management secrets of high growth companies.  In this post, I’d like to take a deeper dive into how leading companies are segmenting their distributors and assigning territories.

Our analysis shows that many of the most successful companies are looking beyond geography when defining distributors’ territories. In fact, nearly 60% of high growth companies are using ‘Size of Customer’ or ‘Type of Customer’ as the key criteria for defining distributor territories.  Meanwhile, only 32% of low growth companies are using these advanced criteria.

Providing customers with access to a broad product portfolio through a single distributor is also correlated with higher growth.  More than 95% of high growth companies’ distributors carry multiple product lines. In contrast, about 20% of average growth companies limit their distributors to a single product line.

We found these characteristics to be true across emerging market regions and industries, with one notable exception – the healthcare industry. Geography remains the dominant criteria across high, average, and low growth healthcare companies.  This is not surprising given that purchases of healthcare products in emerging markets are most often driven by government bodies overseeing procurement for a particular territory.

In my next post, we will explore the incentives, and specifically non-monetary incentives that are most likely to be used by high growth companies.

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For the vast majority of MNCs, working with third-party distributors, dealers, and other types of channel partners is a fact of life in emerging markets. These local partners bring to bear their knowledge of the local market, relationships with customers, and a range of other capabilities that MNCs hope will offer a “plug and play” solution for rapidly scaling operations.  These benefits do not come without costs, however.  Many of the executives that Frontier Strategy Group works with report their fair share of headaches when it comes to managing the third parties that stand between them and their end customers; whether it is an over-zealous entrepreneur that is not willing to adhere to corporate strategies and policies, or an under-performing partner that can’t or won’t make the right investments to hit aggressive targets.

To shed some light on this challenging topic, Frontier Strategy Group recently conducted a comprehensive survey of our client executives.  We asked a range of questions designed to uncover how MNCs are evaluating, managing and incentivizing their channel partners.  The analysis we performed is designed to help senior executives benchmark their approach to channel management against that of their industry and regional peers.

We also uncovered some thought-provoking differences between the management approach taken by high-growth companies versus average and low-growth companies that we hope will challenge the status quo:

1) Do not default to geography as the criteria used to define distributors’ territories

• Although the status quo is to segment distributors by geography (57% of all companies), high-growth companies are roughly twice as likely as low-growth companies to assign territories based on type or size of customers

2) Use non-monetary incentives to gain increased visibility into, and control over, distributors

• 87% of companies use non-monetary incentives to reward distributor performance, but there is a stark contrast between the types of incentives used by high-growth companies (“Integrating” Incentives) and those used by average and low-growth companies (“Value Transfer” Incentives)
• Integrating Incentives, such as providing business consulting or CRM platforms to distributors, add value for both parties and provide vendors with the ability to streamline distributor operations
• Value Transfers, such as allowing the use of the vendor’s corporate logo, represent a one-time and one-way transfer of value from vendor to distributor, with little or no long-term ROI for the vendor

3) Invest in the best, walk away from the rest

• High-growth companies are highly reliant on their distributors in emerging markets, sending on average more than 50% of both volumes and revenues through their distributors
• These high-growth companies are investing significantly more resources in managing distributors – an average of 53 full-time equivalents (FTEs) per region, versus only 11 FTEs at low-growth companies
• However, high-growth companies replace a significantly higher percentage of their distributors (on average, 17% in the past two years versus 7% at average growth companies) and report shorter average partnership lifecycles

Over the next few weeks we will explore each of these recommendations in more depth here on the blog.

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