China Tech News reports:

Guo Wei, president of Digital China, says that Digital China will push its business shift for each of its affiliates following the restructuring of its stake, and it will shift from a product seller to solutions provider in the next three to five years.

After last year’s Innovation Technology Week, Digital China announced plans to implement an operational structure for four virtual affiliates. Guo says that Digital China will spend three to five years completing the shift from products to services and it has already completed the first phase of shifting within the IT sector.

I’m not familiar with these “virtual affiliates”, but it’s interesting to see that Digital China is looking to move away from their very successful distribution business. A closer look at their numbers over the past few years explains why.

What Digital China does
Digital China (DC) is reckoned to be the top distributor and IT services provider in China. In April of 2004 (their fiscal year ends in March) they reorganized their operations into three groups:

- Distribution: consumer electronics, data projectors, PC servers, printers, peripherals, desktop computers, notebook computers

- Systems: divided into four categories of storage products, packaged software, UNIX servers, networking products

- Services: services: application software development, application integration, IT architecture and planning consulting, application development and operations outsourcing

DC has at least 17 subsidiaries, “platforms”, for different regions and provinces of China. This is a key factor in their market position, giving them on-the-ground access to China’s many different markets.

This doesn’t include their many joint ventures. They have invested in at least eight major entities including ERP software, distribution, and software companies.

The money is rolling in
The revenue began to really roll in as the reorganization was finalized in 2005 (data for the charts comes from Digital China’s annual reports):

Distribution showed strong revenue growth as the Chinese IT products markets expanded rapidly. Revenue growth was significantly slower, but still respectable, in systems and services.

Yeah, but how much of that money is going into the coffers?
The picture gets a little more interesting when looking at gross profits.

Gross profits for distribution surged after the reorganization, but hiccuped in 05/06 as DC experimented with different retailing models and expanded its distribution network. Nevertheless, profits continued to grow in line with revenue. DC now has something like 6000 channel partners across China.

Systems’ profits grew dramatically to just about match those of distribution. It’s channel network increased by 16% (with a particular emphasis on second and third tier cities) and the number of technical staff passed 200 in 2007. A broader reach and a larger staff showed immediate results.

The services group has pursued what they call their three core capabilities:

- A larger and centralized software development team based in Xi’an

- Develop IT outsourcing to provide facility, staff, and equipment to customers

- Switching focus from customized software development to application development of their own (and other’s) software platforms

The group has benefited from focusing on the finance, telecoms, and government sectors. They are the largest and most sophisticated organizational users of information technology in China.

Gross profits have steadily increased, but not at the dramatic rates of the distribution and systems groups.

If services produce the smallest profits, why does DC want to become a services firm?

Profit from services may be smaller than that of distribution, but the margin is fatter.

A gross profit margin of 4.79% is quite respectable for a distribution business. It could even be considered exceptional. But its prospects for growth are limited. The logic of the business is based on sales volume. In a highly competitive market with multiple layers of distribution there is simply no scope for big profits. DC is very good at this, but it clearly sees opportunities with its other groups for juicier profits.

The systems group sells higher-value (and higher margin) products that usually require some degree of planning and integration. By focusing on supporting channel partners’ sales in second and third-tier cities, DC has seen significant rises in all four product categories. Remarkably, turnover in the systems group services team increased 114% between 2006 and 2007.

It is the services group that has the highest profit margins. By bringing their software development teams under one roof in Xi’an, DC can better allocate resources to various projects. They have targeted the finance, telecom, and government sectors both for their software solutions and their outsourcing/maintenance services. The provision of these kinds of services is relatively immature in China. DC has established itself as the leader by serving the companies savvy enough to take advantage of them.

As other sectors of China’s economy embrace information technology they will need the kind of systems integration, support, and software that DC is already selling to finance, telecoms, and the government. As the services market expands, so will the opportunity for DC’s existing services group. DC has had a taste of the fat profit margins in services and it wants more.

And what will become of DC’s distribution empire? That’s unclear. There have been rumors over the past couple of years that DC would sell it, but that has yet to happen.

What’s the angle on the buyout for all this?
DC is in the process of being taken private by its primary shareholders and Guo Wei. It comes at an opportune time for the three to five year reorganization plan. That’s a long time in China. DC now has the luxury of time to play out the reorganization without the pressure of semi-annual reports and a share price to worry about.

Now they only have to make sure to keep China’s State-owned Assets Supervision and Administration Commission of the State Council (SASAC) happy.

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