Could China grow into a nation of shoppers? The country is better known around the world for its factory workers and exports. But to put China’s economic growth on a steadier glide path, especially in a global slowdown, the Chinese government wants to shift the drivers of the economy towards consumer demand at home.
By the looks of the glitzy shopping malls in Beijing and Shanghai, selling everything from Louis Vuitton luggage to Lenovo laptops, China is well on its way. Certainly, with 1.3 billion potential consumers, the future is bright for Chinese retailers. “In the next five to 10 years, the retail sector will go through dramatic growth,” says Wharton marketing professor John Zhang.
A quarter of a billion people have migrated from the countryside to the cities in the last 25 years, and rising incomes are spurring an expanding middle class. By 2025, that middle class is expected to number 612 million, or 76% of the population, up from 43% in 2006, according to the McKinsey Global Institute. Eventually, the bourgeoisie will be dropping an ever greater portion of their estimated $13,000 to $54,000 annual income (adjusted for purchasing power parity) in stores, says McKinsey. In a 2007 McKinsey & Co. survey of 6,000 Chinese, two-thirds of the respondents already count shopping as a favorite activity. Last year, the retail industry grew 17%, and is forecast to grow 13% to 14% this year even in the midst of a slowdown in the Chinese economy, says Matthew Moneyhon, managing partner at Ergo, a New York market research firm.
Yet, for all the potential, home-grown Chinese retailers are still in the early days of building a sector that matches the efficiencies of counterparts in developed economies. Today, Chinese retail chains account for only 10% of the entire retailing sector in China, with traditional mom-and-pops comprising most of the stores patronized by Chinese across the country, says Jeff Walters, principal at the Boston Consulting Group office in Beijing. “Even supermarkets that look modern from the outside are really pseudo-modern,” says Walters. “Decisions are still made locally; they still run as independent stores,” rather than as a part of a larger integrated operation.
Many of today’s large retailers started with a bang, growing rapidly, but now face new challenges at their next stage of growth. “In China, everything happens in a compressed time frame,” says Edwin Keh, a Wharton School lecturer and former chief operating officer of Wal-Mart Global Procurement. “China went from informal, unorganized marketplaces into shopping mall booms without much in between. There’s a degree of challenge in that.” Retailers’ challenges include transforming themselves from real estate operators to retail professionals, expanding to smaller cities, and managing the onslaught of e-commerce.
From Landlord to Retailer
Many of China’s largest home-grown retailers started essentially as landlords. Electronics purveyors Nanjing-based Suning Appliance Co. and Beijing-based Gome Electrical Appliances Holdings, for example, buy prime locations in major cities and rent floor space to sellers to set up their own mini-shops. The mini-shops are run by the suppliers’ employees, who make merchandising and pricing decisions on their products. The landlord-retailer, which has few in-store employees, takes a percentage of the suppliers’ sales, ranging from 5% for a strong international brand, to as high as 30% for an unknown domestic brand, says Jeongwen Chiang, chairman of the Marketing department at the China Europe International Business School (CEIBS) in Shanghai. “It’s reminiscent of the concession model of 19th century retailers in the U.S., where all the margins went to concession [the retailer], not concessionaire [the seller],” says Wharton professor of management Marshall W. Meyer.
The model is imported from other Asian countries, notes Wharton’s Zhang. During the early days of economic reform, Chinese state-owned department store managers went to Japan and Hong Kong to acquire know-how and brought back the store-within-a-store format, he says. According to Walters of the Boston Consulting Group: “It’s an easy transition from traditional to modern retail,” since stores within a store are similar to an old-fashioned bazaar.
The model facilitates go-go expansion. Because retail penetration is so low in China, “the easiest way to grow is to continue opening stores,” says Walters. “If I have five stores and I want 1,000 stores in five years, the landlord model is my first choice. Because the retailer shares the burden of running stores with the supplier, it can grow faster via new store openings.”
If retailers can grow through new store openings, they don’t have to worry about much else, say experts. “If you have a hot place for your store, you don’t have a reason to improve your operations,” notes Nephi Zhang, senior analyst of retail at IDC China in Beijing. As a result, “there are challenges retailers haven’t dealt with yet that will become more important over time,” Walters notes. They include the product management, pricing, marketing, customer service and analytical skills needed to increase traffic and basket size at each individual store to juice same-store sales.
Suning and Gome are now starting to build that capability, including installing data capture and analysis of customer demand. Says a speaks person offor Gome Electronic: “Compared with leading retailers in the world, Chinese retailers right now are still operating at the stage where they manage properties, suppliers and some of the products…. Gome has started a transformation to a new business model based on consumer-orientation and full-range consolidation on supply chain.”
Suning is also expanding to take advantage of new opportunities, according to media reports. China Retail News noted in a report this month that the electronics and home appliances retailer opened 400 new outlets in 2011, including super flagship stores, Laox stores and boutiques. Suning plans to open another 400 outlets this year, China Retail News wrote, and quoted Jin Ming, president of Suning Appliances, who said the company would “establish five new major procurement and sales centers.”
From Shanghai to the Hinterland
As major Chinese retailers saturate China’s Tier I cities, includingBeijing, Shanghai and provincial capitals, growth will come from smaller markets, including other large provincial cities and county capitals – such as Jiangying City in Jiangsu province, Zengcheng City in Guangdong province, and Cixi City in Zhejiang province. With their populations numbering one million and over, even the smaller of these locales are still sizeable markets. When the top 10 Chinese retailers take only about 10% of total retail revenues in China, the search for new markets and economies of scale is the natural next step, says IDC’s Zhang. But that step is fraught with difficulties. “Compared with other countries’ retail markets, Chinese retailers are too small,” notes Zhang. “They can’t save costs on their supply chain. They need to get bigger, but it is very difficult in the Chinese market to grow.”
Specifically, the variation between consumer tastes and preferences across China, coupled with an underdeveloped infrastructure, means economies of scale are not easy to achieve. Consumers in smaller cities, for example, make less money than their Tier I cousins. They are more value conscious and less interested in brand names. Moreover, their tastes are specific to each locale. For instance, those in Hunan may crave hot peppers, and those in the Northeast, steamed breads over rice. Despite the challenges, Gome’s speaks personsays his company has found the right formula for these markets. “After our exploration and experiments in third- and fourth-tier markets, we have found a proper model to operate in those models,” he says.
Underdeveloped infrastructure and distribution networks in China are a significant hindrance. “There aren’t enough roads and trains and warehouses and organized infrastructure ready to help people expand into the West and North,” says Wharton’s Keh. Even different transportation regulations in different localities, governing truck size or road use during different times of the day, complicate logistics, according to Ergo’s Moneyhon. “Putting those regulatory pieces together in logistics is a challenge,” he says.
China’s fragmented mom-and-pop distribution industry also requires retailers laboriously to create new networks in every market they enter. In China, no national logistics company, such as Federal Express or UPS, serves all parts of the country. At best, domestic logistics companies may exist in individual big cities, but to transport goods between cities, “they might have to form an alliance,” says Chiang of CEIBS. In smaller cities, retailers may even have to find “a guy on a bike” to deliver packages, adds Keh.
Given these conditions, says Chiang, “You cannot use economies of scale to apply everything you learn from major cities to rural areas. “To some degree, you have to start from scratch and relearn the customer, realign the product line, strategy and supply chain.” For the most part, successful foreign retailers in China, including Wal-Mart, Carrefour, and Tesco, operate only in major cities. But those who do choose to make a big investment to conquer local infrastructure obstacles can win big. Louisville, Ky.-based Yum! Brands, which owns Pizza Hut, KFC and Taco Bell restaurants, for example, built its own national supply chain in China, betting that it will have decades of growth ahead with no competition. “It is not for the faint of heart,” says Keh. “Yum! invested in a cold and frozen storage supply chain, delivering frozen chicken to the back of nowhere,” and today, makes 40% of its profit from China.
From Bricks and Mortar to Cyberspace
Now, e-commerce is coming into China’s retail scene. With 40% broadband penetration nationwide and widespread smartphone use, China is ripe for a takeoff in online shopping, which could soon exceed the level in the U.S., says Wharton Marketing professor David Bell. In addition, e-commerce has the potential to catalyze change in both the landlord model of retailing and expansion to smaller cities.
E-commerce can also speed the evolving relationship between retail landlords and their store-within-a-store suppliers, where the latter are starting to balk at the terms they’re dealt. “Because e-commerce has come along as an alternative, traditional retailers may be forced to be a little kinder to tenants,” says CEIBS’s Chiang. Smaller suppliers see e-commerce as a way to sell products nationwide without having to give a cut to retailers. One of Chiang’s MBA students used to sell mobile handsets through traditional retailers who took a big chunk of his revenues. Now, he is selling his products through Taobao, China’s eBay-like site.
E-commerce can help retailers reach inland consumers in smaller markets. “There are a lot of people spread in the interior, who have no luxury to go to fancy supermalls,” says Chiang. “E-commerce can compensate somewhat and maybe take more and more share” from bricks and mortar shops. Gome aims to have Gome Online Mall account for 15% of the company’s total sales and 20% of China’s total online sales for home electronics in two to three years, according to company’s public statement.
Perhaps the biggest change e-commerce can bring to Chinese retailing is a greater orientation towards the consumer. “Consumers will not be satisfied in the same way they were before,” says IDC’s Zhang. “They will require from retailers lower prices and better services.”
As Chinese retailers learn how to serve customers better, and customers learn more about their prerogatives, China will start shifting into a consumer nation.