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Ricky Wong for Asiaweek.

Suddenly, Profits Matter
A Chinese disk drive maker learns new rules

For the last two decades, the business of state-owned enterprises in China has been all about more sales, bigger market share, faster growth, bolder expansion. That makes the situation for Great Wall Technology, the nation's second best-known high-tech manufacturer after Legend Computer, something of a problem. Great Wall has been selling both disk drives and personal computers for more than a decade. The company's sales exploded in the 90s as it supplied a growing list of name-brand computer and disk-drive companies with low-cost product. But suddenly, size matters less than it used to. The true measure of success in post-WTO China will be survival, and that means SOEs like Great Wall had better change their mindset to quality over quantity.

The problem is apparent from just-released half-year financial results. Year-on-year profits fell 20% to $30.3 million in the period even though sales increased 9.6%. Earnings per share declined 37% and would have fallen much more steeply without a one-off gain. Blame the marketplace. Increasingly, the profit margins of disk-drive makers are being squeezed by a growing global supply of cheap units. Disk drives and related components account for about 43% of Great Wall's sales. That is better than four years ago when disk-drive parts made up fully 80% of revenues, but it is still a big proportion. However, because the company has expanded into manufacturing personal computers for itself and, through a joint venture, IBM, Great Wall is more multidimensional than before. Now, PC sales account for one-third of the company's turnover. The remaining one-quarter of sales comes from an assortment of PC peripherals like monitors, power supplies and modems.

For most companies, the response to long-term declining profitability of a key product would be obvious: Stop making that product. But remember that China's SOEs are better at expanding into new markets than shedding old ones. To their credit, Great Wall's managers have devised a comprehensive strategy to remake the company in the image of a cutting-edge Western technology producer by focusing on optical networking equipment. The time is right for such a change because some of the hottest names in global technology are looking for optical parts suppliers, companies such as Nortel, JDS Uniphase and Corning that are challenging the hegemony of Cisco Systems in networking equipment. At 25% to 30%, the margins on parts for such equipment are many times better than on disk drives, and though Great Wall is diving into a highly competitive market, its instincts — and quickness — are good signs.

But the transition won't be easy. Belle Chan, a technology analyst at Salomon Smith Barney in Hong Kong, says Great Wall's management has traditionally been more reactive than proactive, at least compared to Legend, the No. 1 computer maker in China by a wide margin. She notes: "However, Great Wall has been able to sell itself well." The company is talking about a two-pronged strategy to take advantage of the expected strong growth in Internet access and activity in China. It has begun procucing some optical networking equipment and expects sales of $15 million this year rising to nearly $100 million by 2002.

Part two of the plan is to become an Internet access provider for Chinese seeking the kind of broadband connection that allows for fast downloading of large quantities of information like music or movies. Initially, Great Wall said it would spend $640 million over the next three years to roll out a broadband fiber-optic network. The company projects that it will have 1 million broadband customers by the end of next year rising to 5 million by the end of 2003. That's ridiculous, say many analysts, who note that the U.S. today has only 4 million broadband customers. One of the constraints on Great Wall's growth in China will undoubtedly be price: Broadband connections are expected to cost about $60 for installation and then $12 per month, amounts that are out of reach for the vast majority of mainlanders.

"Great Wall has pushed its Internet story but it isn't very credible yet," says Mark Siford, technology analyst at Deutsche Bank in Hong Kong. "There is a lot of hype, and while [Great Wall] may have dreams and aspirations, the reality is they aren't about to become a serious broadband player." Investors seem to agree. From its IPO price on the Hong Kong stock market a year ago of HK$3.15 (40 cents), shares surged past HK$9 last year before falling with other tech stocks below HK$6 in March. The price has recently been stuck near HK$4.50 a share.

Perhaps Great Wall realizes it is over-reaching. The company recently announced plans to cut by 43% its planned spending on a broadband network by the end of 2002. That's a good sign. Most investors never bought into the company's huge prospective investment in a project with dubious potential for returns. Chinese SOEs aren't known for responding to investor sentiment so directly. Still, Merrill Lynch last week downgraded its earnings estimates for the company going forward to 2001. It seems Great Wall may be retreating from a bigger-is-better ethic, but whether it can truly focus on the quality of its earnings going forward is still open to question.

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