Shanghai-based Baosteel is the biggest steel company in China. But that does not insulate it from the industry's problems. Baosteel faces the dual pressure of rising raw material costs and slowing demand from downstream clients. What's also looming over the company is the threat of industry overcapacity; according to some projections, it could be as much as 300 million tons annually. 

Baosteel Chairman Xu Le Jiang is aware of the issues. The 54-year-old Xu has spent nearly two decades at the public sector company. He knows the solution, too. The way out, he tells China Knowledge at Wharton in this interview, is to go beyond being an ordinary manufacturer and integrate in every possible way with customers — providing research at one end and logistics support at the other. 

For Baosteel, it matters more than other companies in the sector. First, Baosteel is expected to provide leadership for the industry. Second, its very size means that it will face the impact much more. Baosteel accounts for 5% of the industry's output but a whopping 20% of its profits. Its annual capacity is 43.83 million tons, and it had revenues of 288.2 billion yuan (US$45.03 billion) in 2012. 

Xu is confident but not complacent. "It's not just getting over a cold winter," he says. "The process of change will be painful." 

An edited transcript of the conversation appears below. 

China Knowledge at Wharton: How do you see the prospects of the steel industry in China? 

Xu Le Jiang: The winter has yet to come; we are now in autumn. Crude steel output in China for Q1 this year was 191.75 million tons, a historical high. The year-to-year growth was 9.1%, a figure much higher than the 2.5% in the corresponding quarter of 2012 and 3.1% for the whole year. 

However, the profit margins for middle-to-big steel companies are gradually declining month by month. Based on data from the China Steel Association, the profit for the industry dropped from 1,338 million yuan in January, to 998 million yuan in February, and then further to 267 million yuan in March and 153 million yuan in April. May data must be uglier than April, and June is even worse. I believe that more companies will disappear from the market. 

After 10 years of rapid growth, there has been a change in market dynamics. The industry has passed the demand-supply balance point. On the one hand, there is excess capacity. On the other, demand is clearly slowing down. [But] capacity expansion is near the end of the cycle. Running on a thin profit margin is something the industry must learn to live with. 

China Knowledge at Wharton: So what is the way out? 

Xu : The industry is at the crossroads. If we don't change our growth pattern in time, the pain will bottleneck downstream industries. This will be reflected in the entire economy. 

The only way out is to restructure our business model and pursue innovation-driven growth. The steel industry has yet to change from the old model which relies heavily on investing in production factors to expand scale of operations. The new model will have to depend on technology innovation and "service-oriented manufacturing." 

Service-oriented manufacturing means that manufacturing should cater to all ends of the Smiling Curve [a concept popularized by Stan Shih, founder of Taiwan's Acer Group. This includes design, market research, R&D, supply chain management, logistics and customized manufacturing.] Most steel companies today are still focused on basic manufacturing; they have not adapted to client demand. 

China Knowledge at Wharton: What challenges does Baosteel itself face today? 

Xu : Let me give you an example. Baosteel was the first company to produce high-grade pipeline steel in China. It was a high-margin product for us at the beginning of the century. However, competitors also improved their portfolio and we didn't have the supporting structure for overseas projects. So pipeline steel has dropped out of our best products list. 

When we compare ourselves with leading players in foreign markets, we find the gap is mainly in service-oriented manufacturing — to make customized products for clients. We have to transform ourselves and focus more on high-end products. 

Like the 4S stores [Sales, Spare parts, Service and Survey — information feedback]of the auto industry, steel companies have to get closer to clients. They have to get involved in the R&D processes of their customers and even their manufacturing and logistics needs. 

China Knowledge at Wharton: So what have you done at Baosteel? 

Xu : We are planning to offer expert, in-depth service and all-in-one solutions. Baosteel has laid the basic foundation for the transformation. For example, we have been involved in the R&D stage of some auto and home appliance companies; we have set up joint laboratories with them. We have also 50 logistics service centers to accommodate more clients. The goal is have 60 domestic and 10 overseas service centers. 

Recently, Baosteel has set up an electric trading center for steel with Bao Shan district government in Shanghai. The center not only sells Baosteel's products, but is also a third party platform for other steel companies, dealers and clients. 

In 2000, a subsidiary of Baosteel styled Oriental Steel started e-commerce in steel products. The company has obtained a license for third party payments. It plans to expand further downstream. Baosteel can also team up with its subsidiary Fortune Trust to provide finance-related services. Storage and logistics, and information consulting are all potential growth areas. 

China Knowledge at Wharton: Based on some projections, the excess capacity of the steel industry will reach 200 million to 300 million tons annually. The government has been unable to manage the problem. What do you think is the best way to address this issue? 

Xu : I think that environment protection can be used to manage the overcapacity issue. Some companies have started to address this. For example, the Shougang Group [a Beijing-based steel conglomerate] moved out of Beijing for the Olympic Games, and Pu Gang, one of our subsidiaries, went to a new site before Expo 2010 in Shanghai. We have taken the initiative to cut output in Shanghai; this is a major part of Baosteel's next stage. 

Last July, the Shanghai municipal government signed an agreement with Baosteel under which we will reduce output of iron by 5.8 million tons and steel by 6.6 million tons in Shanghai between 2012 and 2017. This relates mainly to our Wusong and Luojing plants in Baoshan district in Shanghai. After the plants move out, we are looking at creating a new business model in Luojing. This may move further into the steel industry chain, or we might set up an information center for communication and cloud services, or we might experiment with new material and energy projects. 

By restructuring the manufacturing in Shanghai, we not only want to realize the "two deltas-one edge" strategic layout, but we will also extend the value chain, improve the ratio of high-end products and manufacturing capabilities, build an advanced base for plain carbon steel products, and set up an R&D center, a talent training center, as well as other service facilities. 

China Knowledge at Wharton: Could you talk more on your two deltas-one edge strategic layout? 

Xu : The two deltas refers to the fact that Baosteel itself is based in Shanghai, the Yangtze delta region, and the Zanjiang plant is in Guangdong province, the Pearl River Delta region. One edge refers to the resource-rich northwestern China where we are building a steel base by restructuring our subsidiary Ba Yi Steel in Xin Jiang autonomous region. 

China Knowledge at Wharton: I have heard that Baosteel is investing in a high-end steel plant in Zhanjiang in Guangdong province in south China. How can you ensure that the Zhanjiang project will be competitive when there is excess capacity? 

Xu : We have repeatedly verified the feasibility of the Zhanjiang project and optimized the product portfolio. Zhanjiang will have an annual output of 10 million tons of steel and will mainly focus on carbon steel plates and other high-end products. It will serve the sophisticated southern China market. 

China Knowledge at Wharton: What apart from Zhanjiang are your new investment plans? 

Xu : Our future investment will be targeted at our regional structure and product portfolio. We will not be increasing capacity, but will strengthen our R&D in high-end products. 

At present, Baosteel has a new strategy to transform itself from "steel to material, manufacturing to service, China to global". We will develop new steel materials and replace existing products with higher-performance items. At the same time, we will introduce non-steel materials for the automobile sector and other clients. 

From pure-steel manufacturing to a dual focus on both production and service is the inevitable choice for future steelmakers. From China to global not only refers to expansion geographically, but also to a widening of our vision. 

In addition to this, we have implemented a manage-the-environment strategy, which is an innovative model integrating environment protection, into our business and building up a green value chain. 

In short, for steel companies like Baosteel, the opportunity in the domestic market will come mainly from the low-carbon economy. Baosteel has started exploring environment management. We believe these measures will make us a top player in the market. 

China Knowledge at Wharton: What has Baosteel done to get to the global market? 

Xu : In global markets, the potential is not just in the export of products and investment in energy industries; we have also to take an active role in R&D. We will look at joint ventures. Our future steps will be different from the ones we took 10 years ago. 

The globalization efforts of steel companies can be divided into three categories. The first is product export. The middle stage is to invest in manufacturing plants overseas and tap foreign clients. For example, we have bought into a resource company in Australia to jointly explore iron ore deposits. We have also started some steel factories overseas. But the most advanced form is R&D cooperation. 

We have jointly set up a Baosteel-Australian R&D Center with four Australian universities. This is not just on steel, but also for energy, new materials and green technologies. I have got in touch with R&D institutions in Sweden, Finland and other countries in Europe. 

In addition, globalization not only refers to Chinese companies going out, but also foreign capital coming in. At present, foreign capital has yet to come into China's steel industry. However, I personally think that the restrictions will be gradually removed. 

China Knowledge at Wharton: What is your approach to M&A? 

Xu : We will take the initiative, but will do it selectively. It will depend on whether the targets fit our layout strategy (two deltas, one edge), whether they are the leading players in that region, and whether they are globalized to some extent. Other factors are whether they can improve our market share, benefit our technology upgradation and help us strengthen our industry impact.

We have successively acquired Ba Yi Steel in northwestern China, restructured some steel companies in Guangdong province, bought into Ning Bo Steel in Zhejiang province, and also acquired De Sheng Stainless Steel inFujian province. We have therefore completed the first phase of our plans domestically.