Chinese car maker BYD is finding it tough to shift from imitation to innovation.

It used to take a cheeky sense of pride in copying, then beating much bigger rivals. Low costs and imitation made BYD one of China’s top five carmakers in an incredibly short space of time, even inviting a high-profile $232-million investment from Warren Buffett. Since its attempt to move up the value chain, however, the Shenzhen-based automaker, noted for its ‘shanzhai’ or copycat versions of better-known marques, has been having a rough time.

First applied to cheap imitations of brand name cell phones produced in southern China, the term ‘shanzhai’ has now come to denote an inexpensive – and often poor quality – copy. BYD’s efforts to drop the shanzhai label lay in tatters after a fatal accident in Shenzhen in May this year which saw a BYD E6 go up in flames after colliding with a Nissan sports car. The explosion of the E6 was particularly bad news given that it was BYD’s flagship car in the electric vehicle market.

Chinese automaker BYD once promoted itself as a global leader in e-vehicle technology and only three years ago made claims that it would be the biggest car company in the world by 2025. Company exports chief, Henry Li, was quoted earlier this year as saying BYD’s electric vehicle platform is “one of the most advanced in the world.” Despite this, the firm is now struggling to compete with other domestic Chinese car companies, let alone the international car brands it would face in developed markets.

BYD’s stock price has dropped 80% from its 2009 high, and 40% since April 2012, while the commercial release of its electric cars has been pushed further down the road.

Shifting Up a Gear

BYD’s problems are in many ways linked to its efforts to move upmarket, from imitation to innovation and higher-margin vehicles. Like many other Chinese low-end manufacturers, BYD has responded to rapidly rising costs by trying to develop a respected brand which will allow the firm to expand its margins, and market share. “You have to acquire capabilities to differentiate your brand, otherwise you’re going to be fighting a commodity battle at a low price point,” argues Bill Russo, a Senior Advisor at Booz & Co, a management consulting firm. “Chinese car companies are in a war of attrition and only the strong will survive.”

BYD began its operations in Shenzhen, producing cell phone batteries at 30% of the cost of competitors like Sony and Sanyo. Like many shanzhai operators, BYD at first largely eschewed machines in favor of an army of workers: as of 2011, the company had 178,000 employees in both its automotive and battery businesses. Ford Motor Company, by contrast, had 164,000 employees globally achieving five times the auto sales recorded by BYD.

Controversially, BYD in its earlier years was known for reverse engineering everything its competitors made, in an effort to learn the technology and see if they could figure out how to do the same thing cheaper. BYD’s bestselling car, the F3, is similar enough to the Toyota Corolla that it can use parts for the latter but sells at half the price. “A core competency of BYD is that they are more willing and more aggressive in copycatting some of the bestselling models globally,” says Teng Bingsheng, Associate Dean and Associate Professor of Strategic Management at the Cheung Kong Graduate School of Business (CKGSB). “You can call it a core competency because they have been very good at it.”

BYD didn’t, however, necessarily eat into the market share of the Toyotas it copied. BYD cars may look like Toyotas but on the road the F3 doesn’t match the performance of the car it imitates. “An automobile has some of the most complex engineering of any consumer product,” says Russo. “You can copy the hardware, but not the soft stuff. Two cars with the exact same hardware can perform completely differently on the road.”

Russo argues that this is why Toyota, unlike BYD’s competitors in the battery industry, has not bothered to take legal action against BYD. Learning from imitating your competitors is something done everywhere, particularly as countries develop their markets. But there it doesn’t have to be a negative for the company being copied. “In China, people buying Toyota Camrys are not cross-shopping with the F6 [another BYD imitation],” says Russo “There is some gray area here. It isn’t necessarily hurting the companies who are having their goods copied and it could improve their brand.”

Shanzhai Successes

BYD’s shanzhai-style imitations of Toyota didn’t take the company beyond the cut-throat, low-price segment of China’s auto market. There are, however, solid examples of shanzhai players taking market share from competitors they’ve copied, particularly in the handset market where shanzhai-style upstarts make phones for a low-income but trend-savvy market. Among the most notorious examples, the Shenzhen-manufactured GooApple handset looks uncannily like the iPhone 4 but runs Android 2.2 system, and retails at RMB 1,060 compared to the RMB 4,000-price tag of the iPhone 4.

Navigating its way upmarket out of the shanzhai space, phone maker Tianyu started out making cheap knockoffs of trendy handsets but has since invested heavily in 3G products. Tianyu’s cheap-chic approach helped it leapfrog Lenovo and nip at the heels of leading players like Nokia and Samsung in terms of handset sales. Selling under the K-Touch brand name, Tianyu showed its intent for export sales when it showed its Android handset at this year’s Mobile World Congress. “Today, Tianyu is a mainstream player virtually unrecognizable from its shanzhai beginning thanks largely to increased efforts in R&D and brand building,” says a Booz and Co. report titled ‘Shanzhai a Chinese Phenomenon’.

Other winners in the shanzhai economy include QQ, originally a shanzhai version of ICQ, which now commands 75% of China’s online instant-messaging market according to data for 2011 published by iResearch, a consultancy. Future Cola meanwhile has gone from copying Pepsi and Coca Cola (whose red-white packaging livery it most resembles) to become the third-largest player in the local carbonated soft drinks market, just behind Pepsi according to 2011 data published by Euromonitor.

A More Orthodox Approach

Forced by competition and rising costs to target higher-value and global markets, BYD has had to change the design of a number of its cars, including the F3, in order to avoid lawsuits overseas. “We are working to develop a unique brand identity as we grow to meet our customers’ demands,” says Sherry Li, a representative for the company. “We are very proud of our design evolutions.” But with the design changes, BYD lost market share and the F3 is now the 24th best seller inChina, down from first a few years earlier. In the first six months of 2012, sales of the F3 dropped 40%, a sales decline larger than any other car in the top 50.

BYD may have to wait some time to regain sales momentum as it moves from the shanzhai model in search of higher margins. BYD is following much the same path taken by another privately-owned Chinese carmaker Geely (lambasted by the global auto press for its Geely GE, a cheeky imitation of Rolls Royce’s iconic Phantom, among others), which has looked to foreign companies to bring in expertise. In 2007, the company opened a joint venture with Manganese Bronze Holdings, which manufactures London black taxis. The joint venture led to the development of the Englon, Geely’s mid-range model, and the company is in talks with the UK government to electrify the London taxi fleet. In 2009, Geely acquired Drivetrain Systems International, a global transmission developer, and finally in 2010, bought the Volvo brand from Ford, bringing access to global markets with it.

By slowly building capacity and knowhow, Geely has been able to gain high-value and high-margin customers. “It took the better part of 10 years to get where they are today, but it is paying off in terms of how their brands are performing,” says Russo.

BYD is slowly coming around to the same approach, in part by entering into a 50:50 partnership with Daimler-Mercedes. The partnership is mostly focused on electric vehicles, but according to BYD spokesperson Li, it is affecting other parts of the business as well. “BYD’s partnership with Daimler-Mercedes relocated over 100 engineers and quality professionals to BYD headquarters,” she says. “We have acknowledged many improvements in our design and production processes with the help of our partners.” Experts feel that more such partnerships will be the only way that BYD can catch up to its competitors.

“BYD [needs] partnerships so they can be technologically competitive,” says CKGSB’s Teng. “State-owned car companies have been doing this for 30 years, so they have an advantage in the mid- and high-level [market]. But even in the lower-end, companies are finding they need competitive advantages.”

The company is no longer claiming it will reach market-leading status in the next decade, but rather it is reaching “foreign-OEM brand quality”, according to Sherry Li. In other words, they are catching up with two of China’s ‘Big Four’ automakers, SAIC and FAW, and are still a long way off from the Japanese, Korean and American brands the firm once gleefully imitated.

This new modesty has turned into concrete business development. The company is developing its own drivetrain system, as well as mechanizing much of its production line, which, according to Chinese media reports, previously had error rates of 20-30%.

Electric Options

Unlike many other brands with a shanzhai past, BYD has an ace to play if it can retain a reputation for innovation in electric vehicles. BYD is a household name now, both within and outside of China, and much of that has to do with their electric vehicle business, even though it’s not been doing very well. “The company barely sells any electric vehicles, but it gives their company the aura of a high-tech company,” says Han Xiong, automotive editor at the Guangzhou-based Yangcheng Evening News and a popular blogger on China’s auto market.

This strong brand is an incredibly valuable asset to BYD. “Chinese companies need to develop capacities that improve the image of their brand,” says Russo. “The worst thing is to have technology that you can’t price.” But BYD “over-promised and under-delivered”, he adds.

Having come up with the concept for the world’s first mass-produced, plug-in hybrid vehicle (three years before the GM Volt), the F3DM–BYD’s fully electric car–came out in China two years behind schedule, and it still faces delays with its planned US release. The company and analysts are in disagreement as to how much of the delay was due to a shortage of related infrastructure, versus deficiencies in the engineering, and safety concerns.

Industry analysts were bullish about BYD because of its background in battery making, giving it a possible edge in the electric car business. In 2008 Warren Buffett took a 10% stake in BYD for $230 million, praising the firm’s battery technology and its role as a leading player in electric vehicles.

Proving a reputation for innovation may restore BYD’s fortunes. In the meantime, other one-time shanzhai operators may also be making the move from imitation to innovation. Booz and Co.’s ‘2012 China Innovation Survey: Innovation – China’s Next Advantage?’ shows that 45% of multinationals active in five sectors in China reported that Chinese peers were equally or more innovative than themselves. Chinese firms (38% compared to 30% of MNCs) are “need seekers” – firms that research their customers’ needs and design products accordingly. While 53% of Chinese firms said they’re collaborating with foreign partners on R&D another 40% said they’re pursuing their own R&D.

By tailoring products quickly to local needs and pockets – and then investing in R&D and marketing–the shanzhai path pursued by Tianyu and BYD is largely similar. However the future of that model is now uncertain as government leans on IPR infringers, through more aggressive prosecution of offenders, to encourage innovation. Competition in the domestic market and ambitions to export will force more Chinese manufacturers to make a choice similar to the one faced by BYD and Tianyu.

Nonetheless, there will be space for low-cost imitators in China’s vast lower-income markets. While labor costs have risen, the key factor in the success of the shanzhai model–China’s manufacturing capacity–remains intact. Shanzhai handset makers, for instance, are still churning out new models in Shenzhen, leveraging an ecosystem of 30,000 highly specialized companies which collaborate across the entire mobile phone value chain from design to sourcing, production and distribution.

Facing possibly the toughest period in its short history, BYD has a chance to redeem itself and emerge as a serious global player, if it can prove its abilities to innovate in electric vehicles. That will be difficult. Russo warns that, if anything, Chinese companies are at a disadvantage to foreign companies when developing electric vehicles because they lack the deep engineering experience that comes with decades in the business. “Whether or not BYD can develop feasible battery technology, that is the most critical issue here,” say Teng. “So far it has been much more difficult than expected.”

Shanzhai companies have boomed in China on the back of innovative cost-cutting and aggressive business models, but there is still a substantial need for outside experience for companies wanting to go global. Copying can bring you to the technological frontier, but pushing past it requires hard-won experience. It’s the sort of thing BYD needs a lot of, fast.

Photo courtesy: Flickr @jerryluo0520’s photostream