China calling

Calgary-based software company Zi Corp. is trying to tap into one of the world's hottest mobile phone markets.

Trevor Sponagle, a 34-year-old Canadian expat, is folded into the back seat of one of Beijing's ubiquitous little red Xiali taxis. Despite his small, angular frame, his knees bump against the crude metal cage that surrounds the driver as the cab slowly makes its way through early-morning stop-and-go traffic. Although he's a little concerned about being late for a meeting with a customer in the city's northern Chaoyang district, Sponagle has learned to take it in stride. He's called Beijing home for seven years, first as an employee of the Canadian Embassy, and now as product marketing manager for Zi Corp. (TSX: ZIC), a Canadian software company with headquarters in Calgary.

To pass the time, Sponagle eagerly provides running commentary on Beijing's chaotic driving culture. At almost any hour of the day, cars clog even the widest boulevards and the seemingly well-engineered system of concentric ring roads emanating from the city's centre. To get anywhere requires a driver to aggressively win a series of close battles with other cars for precious lane real estate. (In fact, it's not uncommon to see five or six vehicles astride a four-lane road.) There is no deferential politeness or common courtesy here: it's every car for itself. When even a small gap opens up, several cars will rush to fill it. The winner is either bigger, faster or more belligerent with his horn. It's a culture rooted in how the citizens of Beijing have traditionally ridden bicycles — only now they're encased in heavy metal and glass.

The taxi lurches forward. A delivery van suddenly looms on its right and comes within inches of side-swiping a headlight as it cuts in front. The cabbie glowers. “Oh, he lost that time,” says Sponagle. As intimidating as it can be — especially turning left on a rainy night, headlights rushing in broadside — you cannot shy from the challenge or you won't get anywhere.

It's an attitude that also pervades business in China, where opportunities emerge and are either immediately seized or forgotten. Hesitation is defeat. And nowhere is this more evident than in the industry Sponagle and Zi know best: mobile phones, which are the ultimate status symbol of China's emerging consumer class.

Zi's software principally allows text to be entered into cellphones with both traditional and simplified Chinese characters used for both Mandarin and Cantonese, as well as Pinyin (phonetic spellings with roman letters). It has built an impressive expertise in the standardized pattern of strokes that form Chinese characters, and from that foundation the company is now designing predictive text-entry software for 41 different languages, including Japanese, Korean, European languages, even Hindi. But success in China remains crucial: of the roughly 100 handset designers and manufacturers around the world that have licensed Zi's software, more than a third are in China. In fact, the Chinese market accounts for over half the business of Zi, which Paradigm Capital analyst Barry Richards says is on track to post about $22 million in revenue this year — and which for the first time might make a small annual profit.

As the maker of China's leading text-entry software, Zi is in an enviable position to benefit from the largest mobile phone market in the world. More than 320 million people in China — 10 times Canada's total population — use mobile phones, and eight million more buy one each month. According to Sino Market Research in Beijing, domestic manufacturers account for some 45% of mobile phone retail sales. And what happens in the Chinese market will soon affect the global industry. Just as other electronics industries have witnessed, the strength of domestic economics could propel Chinese handset manufacturers like Ningbo Bird, Panda and TCL to international dominance. Engineering houses known as original design manufacturers (ODMs) have also emerged to build handsets to spec; more than 40% of Nokia's global handset sales are models designed in Beijing. And as China's ability grows to produce more mobile phones faster and less expensively, exporting will inevitably follow. Whether the brands are Chinese or not, manufacturers here will influence everything from semiconductor design to screen quality — along with what software is used to enter text.

Zi hopes to hitch a ride on this juggernaut. “Everyone [in China] wants a phone,” says Sponagle. “They will buy one before they invest in running water. It's just a matter of whether they have the cash.” But Zi faces new competition from the global leader in predictive text-entry software, Tegic Communications, and from Motorola's Lexicus division. Zi is counting on a competitive advantage: its inside knowledge of the Chinese market.

How did a small Calgary-based software company find itself in the midst of the most dynamic and important mobile phone market in the world? Part long-term planning, and part good fortune.

Zi started in 1987 as Cancom Ventures, then became known as Multi-Corp., when it owned a small Edmonton secretarial college and an industrial equipment rental business. In 1993, board member Michael Lobsinger acquired control, became its CEO and chairman and sold off those businesses. With the proceeds, he bought, among other assets, the rights to a language translation technology developed in Asia. When efforts to develop a Chinese-English text translation software could not produce accurate enough results, the firm switched gears and began working on a Chinese character input system for personal computers and mobile phones. Licensing deals with manufacturers to bundle the software with computers didn't go very far, so the software was instead shrink-wrapped and sold separately, with limited success. Zi has also sold six technology licences to makers of television set-top boxes, which let consumers access the Internet and input text with a remote control.

But those markets pale in comparison to Zi's opportunity in mobile phones. The company first won licensing deals with high-end handset manufacturers Ericsson and Alcatel in 1998 and 1999, respectively. At the time, about a quarter of the 18 million cellular phones sold in China were made by Ericsson. Since then, the market has expanded exponentially, and so have the number of handset makers (see “Upwardly mobile,” page 36). While popular brand names like Nokia, Motorola, Samsung and Sony Ericsson still dominate the market, Chinese manufacturers can make many models, and take up as much as 50% of retail shelf space.

Linda Wu, who works out of Calgary as Zi's global marketing manager, tells a story about being in Cannes earlier this year for 3GSM World Congress, one of the world's largest mobile telecommunications conferences. She was in Zi's booth on the show floor when a representative from a Chinese handset manufacturer walked up and asked outright for a licensing agreement to sign. “It's now such a fast-moving market,” says Wu. “Everyone is looking to rush phones to market.”

Even so, most Chinese will not do business with just anyone. Zi's prominent local presence has been key to winning new business. “In North America, new customers are a little more trusting that you'll do what you say you're going to do,” says Mike Donnell, who took over as CEO in 2003 from Lobsinger, who remains chairman. “China has a little bit more of a skeptical culture, where being established and having a track record tends to make a big difference.”

But there's another reason Zi needs to be plugged into the local market: to keep tabs on the bureaucracies that govern how the Chinese language is used in electronic media. In a country so vast in size and population, there are many regional dialects and language variations besides the main division between the official Mandarin of Beijing in the north and the predominant Cantonese of the south. But for written Chinese, which consists of more than 50,000 characters (5,000 are commonly used), the government created a standard, simplified system of strokes, regardless of which dialect is spoken. To retain that consistency in the information age, four regulatory bodies now set and enforce a myriad of standards.

Navigating this red tape can be perilous, especially for a small, foreign company. Lobsinger was very active during the late 1990s, building relationships with industry insiders and government officials. (In the process, he recruited former Canadian ambassador to China Howard Balloch to his board of directors.) Zi was an integral part of the consultative process with scholars and industry experts that the language ministries used to set standards, testing methods and certification procedures. Getting certified early on helped Zi win business from foreign companies such as Ericsson and Alcatel. Keeping up with changing certification standards remains a sensitive topic in the industry; if phones aren't up to code, the authorities could yank them off the market.

Even with certified software, you just can't send the customer a CD. The software needs to be integrated into a handset's hardware and operating system, and that requires close and sometimes complex working relationships with Chinese phone manufacturers. That job is left to people like Sponagle and his boss, Ching Kam Wah, Zi's director of marketing development and sales in China. Both joined the company in 1999, just as it was switching from making software for PCs to software for mobile phones. Ching was raised in Hong Kong before moving to Edmonton with his family when he was 15. In 1989, he got a degree in electrical engineering from the University of Alberta. He returned to Hong Kong, eventually spending five years with Ericsson and another five with Lucent, mostly in mainland China.

Sponagle, on the other hand, is a world away from where he grew up: Sussex, N.B., population: 4,182. (“Not including the cows,” he says. “That would triple the population.”) After graduating Mount Allison University in Sackville, in 1996, he went to China to pursue language studies and then got a job at the Canadian Embassy in Beijing, helping companies do business there. He met Lobsinger and heard Zi needed marketing communications expertise for its fledgling mobile phone software business. “I think his words were, 'Jump on the train,'” says Sponagle, who is now fluent in Mandarin.

Sponagle admits that one benefit of being in China is that he's quite removed from the day-to-day stock watching and other distractions of a public company. Zi has frequently flirted with controversy, including a whiff of scandal with associates of Alberta Premier Ralph Klein back in its Multi-Corp. days, and a patent infringement lawsuit initiated by competitor Tegic Communications. (Zi lost, but the court ruled its subsequent design changes worked around the problem, and the two companies settled out of court in 2002.) More recently, when the U.S. Securities and Exchange Commission froze the assets of Lancer group, a hedge fund investment management firm that was supposedly a 10% shareholder of Zi, it discovered that Lancer in fact owned 49.1% of Zi's shares, which were trading recently at $3.60. Lancer is now in the hands of a court-appointed receiver while it faces securities fraud allegations, but Zi has let Lancer appoint a board member, which it did in August.

Far away from those goings-on, Sponagle and Ching have their hands full looking after the ultra-hot China market, while jetting off to meet clients in Taiwan, Singapore and Korea. They operate out of a sparsely decorated office in Beijing's Chaoyang district with eight other employees (another eight are in Hong Kong) who spend most of their time staring at computers or meeting customers. Many of those customers in Asia are ODMs — engineering houses that develop products for other firms to stick their brands on. The wave of these companies began in South Korea and Taiwan a few years ago as spinoffs from major manufacturers like Samsung and LG, to sell their expertise to the booming China market. Now there are close to 20 major ODMs and more than 300 smaller design houses. They cater to manufacturers desperate to keep up with the some 400 new models slated for release this year.

The market is awash with different brands and styles; many have only the slightest differences (reverse-engineering is common). Chinese consumers treat handsets more as fashion accessories than appliances, and that is driving demand for increasingly sophisticated features, like multimedia. A model might last six months on the market, and price competition is fierce. ODMs can operate more cheaply and quickly than most manufacturers, adding new features at a brisk pace.

Text input, of course, is one of those features. Zi partners with ODMs to get the software integrated into the handset modules; licensing agreements are structured so Zi gets a royalty for every handset shipped. One such partner, which signed with Zi in early 2003, is NGT China, a division of NewGen Telecom in Korea, which designs phones mostly for Japanese giant NEC. “We have tried to look into a lot of local companies,” says David Yang, NGT's vice-president and general manager, “but we found it is very difficult to get money from local clients.” Indeed, big inventories are rumoured to be a serious problem for many smaller manufacturers.

There is, however, plenty of price competition among ODMs, too; handset designs cost a quarter of what they were two years ago. As margins continue to shrink, consolidation in the sector is inevitable — indeed, some component manufacturers are already bowing out. For now, Ching says Zi has to resist pricing pressure on its own product. “Customers will say, 'We need to lower our bottom line. It has to be cheaper,'” he explains. “There is always some regional player coming out with a product 10 times cheaper than you are, and selling to the same customers.”

The domestic competition is also driving manufacturers to look abroad for growth and profits — something Zi can help them achieve. Huawei Technologies Co. Ltd., for instance, is a major telecom infrastructure player in China. Huawei began making handsets only last year for the express purpose of supporting its network equipment sales — especially the coming 3G market. Already, foreign sales are about equal to the domestic market and will surpass it next year, on the back of packaging them with infrastructure deals to eastern Europe, Russia, east Asia and Africa. But says Su Liqing, the vice-chief of Huawei's Beijing Research Centre, the next strategy will be to sell handsets, separate from network equipment shipments, under Huawei's brand worldwide.

Zi has been fortunate to learn from the China mobile phone market as it's grown. Even the experience of making the complex Chinese language work on such small devices has influenced its approach to other languages. “There are 20,000 characters and you have 12 keys,” says Sponagle. “You don't want to press too many keys, and you don't want to think too much. So we had to start out that way, and when we transfer that over to other languages, the result is a bit different from our competitors: less key presses, less thinking, and we give you as much as possible — prediction, learning. We did the hard one first and it made us think a bit.”

Back in traffic after Sponagle's meeting in the Chaoyang district, his taxi lurches ahead. A yellow Japanese compact drifts in from the left but abruptly hits its brakes and swerves back out of the way of the red Xiali. “See? He won that time,” says Sponagle, his eyes scanning for the next opening.