Multinational Retailers’ Quest for Gold in China’s Tier 2 and Tier 3 Cities

Since China’s re-emergence onto the global economic stage initiated by Deng Xiaoping’s landmark Southern Tour in 1992, four Chinese cities have epitomized the nation’s unprecedented growth and development: Beijing, Shanghai, Guangzhou, and Shenzhen. For most foreign corporations, historically these so-called Tier 1 cities have been logical entry points into the Chinese market. Their uncontested dominance, however, appears to be waning amid an increasingly diverse urban landscape that is marked by the rise of numerous Tier 2 and Tier 3 cities, a trend that is expected to accelerate over the next two decades. Corporate leaders must grapple with the strategic reality of China’s urbanization and the sheer size and potential of these emerging urban centers.

Multinational retail corporations are at the forefront of the push into China’s Tier 2 and Tier 3 cities, locked in a race to deploy their brands on an unprecedented scale as they seek first-mover advantage and try to build lasting consumer loyalty. Today’s “gold-rush” mentality is rooted in undeniable opportunities tied to the secular trends in China’s urban and consumer development. Nevertheless, as retailers unwittingly pursue similar expansion strategies, they face execution challenges as well as tough decisions about how to balance the speed and depth of their expansion.

Unprecedented Urbanization

Urbanization is perhaps the single most inescapable reality of China’s current economic development. Among emerging markets, urbanization is certainly not unique to China; but where China stands out is in the sheer scale of its transformation. McKinsey speaks of “China’s urban billion” by 2030, predicting nearly 400 million new urban residents (an increase from 47% of the total population to more than 64%), exceeding the population of the United States.

Even more fundamental is the relatively diffuse nature of future urbanization, which motivates research analysts’ desires to tease out differences in urbanization potential through the categorization of cities into Tier 2, Tier 3, and beyond. For example, Jones Lang LaSalle has identified “China’s 40 rising urban stars,” a collection of 15 Tier 2 cities and 25 Tier 3 cities, representing largely provincial capitals. Specific categorization methodologies, however, do differ. For instance, McKinsey prefers a categorization into 22 city clusters based on industry structure, government policy, population characteristics, and consumer preferences. Bain, on the other hand, adopts the government’s potentially less useful classification into 330 Tier 2 cities.

Yet researchers fundamentally share the view, expressed by Euromonitor International, that “it is the rapid rise of ‘second-tier’ cities that is changing the urban landscape.” Indeed, the current four Tier 1 cities are likely to experience a decline in relative demographic and economic importance as future development and investment spread to a broader group of cities — over 200 of which exceed the one million population mark compared to 35 such cities in Europe, according to McKinsey.

The rapid growth of Tier 2 cities and beyond is driven by a variety of factors, including cheaper costs and deliberate government policies. While labor costs have historically been a dominant factor in attracting corporate investments, land costs are emerging as a new driver. Indeed, rising land costs are a growing push factor out of Tier 1 cities, encouraging businesses as well as individuals to “reverse migrate” to provincial capitals where economic opportunities are increasingly perceived to be more attainable. CBRE notes Beijing’s average housing prices rose 89% from 2006 to 2008, while prices in Guangzhou increased 69% during the same period. It is not surprising, then, that the Chinese media are filled with growing anecdotal evidence of Tier 1 city dwellers seeking economic refuge in Tier 2 cities, disillusioned with Tier 1 city housing prices so unaffordable that buying a house can equate to 50 years or more of salary for middle class workers.

Beyond cost drivers, the government (particularly at the local level) is a central actor in China’s Tier 2 urbanization, setting investment decisions and coordinating actions with state-owned enterprises. McKinsey observes that “today, the decisive actors in China’s urbanization are city governments themselves, [resulting in] very little evidence of conformity in the pattern of urbanization because of policies imposed from the center.” This has important implications for business leaders seeking to expand outside Tier 1 cities, particularly in terms of the need to adapt to local practices and urban characteristics.

The consumption implications of the demographic growth of Tier 2 and Tier 3 cities (along with the correlated rise in income levels) compel multinational retailers to forge ever deeper into China. McKinsey estimates that “the incremental growth alone in urban China’s consumption between 2008 and 2025 will amount to the creation of a new market the size of the German market in 2007.” The speed of the growth of China’s affluent and middle classes is staggering, even over shorter time frames. According to Bain, China is currently the world’s second largest luxury goods market (US$9.6 billion in sales in 2009, or 27.5 % of the world total) and is expected to grow by 52% over the next five years, becoming the world’s largest luxury market. Separately, McKinsey estimates that 75 million urban households will enter the middle class between 2008 and 2015 (defined as RMB50,000 –RMB120,000 [US$7,500 — US$18,000] in annual household income).

In conjunction with the growth of the middle class in demographic terms, what excites foreign retailers is the emerging shift toward consumerism as a way of life, offering a potential windfall to retailers able to tap into new consumer trends. David Hand, a retail analyst at Jones Lang LaSalle in Beijing, articulates this bullish view to the newspaper The National: “The Chinese love shopping, they love brands, and they love international products, even though the average income is low. New shoppers are born every day. We won’t run out of them.”

However, the uneven geographic distribution of middle-class consumption presents challenges for retailers. McKinsey estimates that 25 of the 100 top Chinese cities will see consumption double between 2008 and 2015, while the other cities will grow more slowly. Broadly speaking, many Tier 2 and Tier 3 cities have been growing substantially more rapidly than Tier 1 cities (up to 5% faster, according to Jones Lang LaSalle), signaling a catch-up effect. Illustrating this trend, Ogilvy Discovery estimates that the top eight Chinese cities will account for only 33% of affluent households (defined as more than RMB80,000, or US$12,000 in income) in 2012, a dramatic drop from 70% in 2003.

As a result, multinational retailers are tracking the spread of China’s growing affluent and middle classes into increasingly unexpected geographies. Louis Vuitton, one of the longest-established international luxury brands in China, recently opened a store in Hohhot, the provincial capital of Inner Mongolia, an area that is undergoing a mining boom. Perhaps even more surprisingly, Louis Vuitton also has a presence in Urumqi, the capital of Xinjiang, China’s western-most province. These two stores rank among 24 Louis Vuitton stores located across Tier 2 and Tier 3 cities, outnumbering the brand’s nine Tier 1 city stores by nearly three to one.

In addition to the pull effect from rising consumption across China’s dispersed urban centers, multinational retailers’ expansion away from Tier 1 cities increasingly reflects the tough competitive environment in Tier 1 markets, including signs of market saturation, high costs of retail space, competition for attractive locations, and high costs of advertising.

Multinational Retailers’ Expansion Strategies

As multinationals increasingly turn to Tier 2 cities and beyond, multinational retailers typically rely on a number of core expansion strategies. Multinational corporations included in our study comprise retail and retail-focused companies, such as luxury brand Coach, education company English First (EF), and mall developer Ivanhoe Cambridge. These corporations have implemented geographic expansion strategies that share a common pragmatism to cater to the realities of the Chinese market. As they make strategic decisions regarding geographic reach within China, multinationals are also reassessing their entry modes, reducing reliance on franchising and licensing in favor of greater control over local operations. Being closer to the ground means multinationals must learn to work increasingly with local partners and, perhaps most importantly, with local governments across a wide array of jurisdictions.

In expanding its geographic reach in China, Coach, a U.S.-based luxury retailer, initially focused on creating brand equity and goodwill in affluent Tier 1 cities. The company is now actively leveraging these footholds in support of its foray into Tier 2 cities. This corresponds to a move from what Harvard Business School Professor John Quelch and China Europe International Business School researcher Maria Ibanez Gabilondo refer to as a “beachhead” strategy to a “disperse” strategy in an article published in the South China Morning Post.

Concretely, by establishing a recognizable brand in its core markets, Coach has been able to take advantage of halo effects, which facilitate the spread of brand awareness from established markets into new, neighboring markets. As such, Coach built stores in a sequential manner that simultaneously expanded the company’s reach and fortified the brand, moving to newer markets such as Chongqing only after core markets were firmly established in Beijing and Shanghai. Of Coach’s 28 stores currently in operation in China, 12 are located in Tier 1 cities and 16 in Tier 2 cities or beyond, with many of the latter stores representing recent openings. The company opened 13 new locations in fiscal year 2010, representing a square-footage increase of 50%. Going forward, Coach plans to continue to grow its footprint aggressively, adding 30 new locations in fiscal year 2011, representing an overall square-footage increase of 60%. This expansion includes opening flagship stores in new cities in order to launch the brand’s presence in provincial markets, despite the lower profitability of flagship stores.

EF, a leading provider of English language and cultural training to young professionals, has also utilized a “beachhead” strategy, first establishing a proven service model and brand presence in Tier 1 cities. Now, it is beginning to expand outward with a plan to enter several Tier 2 cities, leveraging cluster effects around existing strongholds to drive synergies on management overhead and marketing. However, Peter Winn, president of EF China, notes that expansion in Tier 2 markets hardly precludes continued growth in Tier 1 cities. In fact, he believes that “primary cities still have huge potential to develop.”

While some research has focused on corporations that have made use of a “beachhead” approach, other corporations use different expansion methods that align with their corporate strategies. For instance, Quelch and Gabilondo identified fast-food retailers such as KFC and McDonalds, which use a “penetrate” strategy that focuses on expanding quickly and comprehensively throughout China. This strategy allows the fast-food retailers to generate a first-mover and low-cost competitive advantage through scale. Quelch and Gabilondo also cite retailers, such as Ermenegildo Zegna, that may already have channels in place across the country from their manufacturing processes and directly adopt a “disperse” strategy to leverage this network. Lastly, the researchers identify multinational retailers that decide to expand extensively within Tier 1 cities and not look outward toward Tier 2 cities for growth. Starbucks, for example, has executed a “focus” strategy that centers its expansion on deepening market penetration in Tier 1 cities, perhaps recognizing that Tier 2 markets may not be ready to adopt its products.

As they pursue their latest expansion round into Tier 2 cities, retailers have also learned from past missteps in China, such as the problematic experiences of brands that relied on licensing agreements early on and encountered brand dilution and intellectual property issues. Accordingly, multinationals are reassessing their entry modes and opting for greater control over local operations. Polo Ralph Lauren, for instance, acquired its Southeast Asia license from Dickson Concepts International in 2010. Also in 2010, Burberry and Longchamp planned to regain control over their Chinese operations, with Burberry buying back its network of 50 stores in 30 Chinese cities from its franchisee and Longchamp buying out its Chinese distributor. Managers at EF China and Coach are also demonstrating their commitment to reduce reliance on franchising and licensing to further their development objectives. According to EF China president Peter Winn, “Providing service quality in China is difficult to control even internally, let alone through franchises. Our customers are high end and demanding, and it is difficult to find good franchise partners. Ultimately we will plan to run our own businesses.” 

Similarly, Coach initially entered the China market in 2003 through several licensee agreements, but later found the profit opportunity too striking to license away. In 2009, the company bought back all of its locally managed retail outlets. Direct control of its China operations is central to Coach’s current strategy of pushing further into China. However, direct control also requires greater responsibility and management attention. Speaking to the unique needs of the market, the company has partnered with local market research groups to determine the right product mix for its customers in China. For example, Chinese consumers seem to prefer conspicuous brand markings in apparel and accessories products, leading management to tailor different products for the local market.

The question of whether, and how, to link up with a local partner — one that not only understands the Chinese market, but also has the necessary local connections to an area’s business leaders and government — is equally integral to a multinational’s success in Tier 2 cities. Given the juxtaposition of China’s relationship-based business culture (i.e., guanxi) with the complex approval process for any retail project, multinational corporations emphasize the importance of securing local partners in targeted Tier 2 or Tier 3 cities.  

This is particularly evident in the retail mall development industry. As Guy Poulin, a senior executive at Ivanhoe Cambridge, a mall developer and investor active in China, has noted: “If you don’t have a partner, forget the site. The site will not make sense if you don’t have a partner. And your partner has to be local. If he’s not local, he’d better be a well-connected Asian partner. Otherwise you will not be able to develop anything.” The partner is, therefore, considered as important — if not more so — than the specifics of a particular development opportunity. Expanding multinationals also perceive the long-term importance of these local relationships, since a good partner can work with the multinational through multiple projects.

The overarching partner and guide it seems, however, is the government. A prominent Shanghai-based private equity investor affirmed that, above all, investors must heed the motto “follow the government” if they want to succeed in China, while Poulin confirmed that this is “the first rule here [in China].” The Chinese central government and the local governments, to an even larger extent, play an essential role in guiding the direction of urban development. At the macro level, the central government’s emphasis on maintaining a “harmonious society” drives the country’s push for economic development in the form of sustained rapid GDP growth. These fundamental tenets are woven into the central government’s five-year planning process, which sets specific urbanization priorities, signaling to businesses and multinationals which cities have the potential to undergo transformative development.

The explosive yet concentrated growth of the high technology industry in Tianjin stands as a prime example of such a governmental directive (spurred by the 11th five-year plan, spanning 2006 to 2010), which repositioned Tianjin as the “economic center of north China.” On the other hand, as noted earlier, city governments retain even greater influence over urbanization at a local level, given the highly decentralized nature of China’s administrative structure. Inevitably, multinationals must navigate carefully through the government’s influence over business affairs, with one source at a retail development firm citing concerns that “the government is doing everything it can to limit the entrance of foreigners in the shopping center business.”

Expansion Risks

Unfortunately, as multinationals race to deepen their reach into China’s Tier 2 and Tier 3 cities, they also encounter a profound execution challenge. With alluring growth figures and promising charts touting deep pools of untapped market potential, it is easy to understand why so many multinationals have flocked to dive into the Chinese market. Yet, the realities of expansion are more complex, particularly when expanding beyond the comparatively more internationalized Tier 1 cities to the newly emerging Tier 2 centers. As Poulin observed, “foreign investors first perceive it shouldn’t be that difficult to succeed in China. The retail business is booming and local governments are looking for international developers, especially in second and third tier cities, so everything should be fine. Unfortunately, that is not the case, and the reality is sometimes brutal.”

In hindsight, it is easy to point to some brands that have entered China’s Tier 2 cities and failed for a myriad of reasons, including improper timing (too early), insufficient control over management and franchising agreements, and ineffective local partner relationships. In 1999, British-based Kingfisher Group entered China by rolling out B&Q China, a furniture-maker and seller, modeled on Kingfisher’s successful B&Q megastores in Europe, with the aim of capitalizing on the nation’s housing boom. Encouraged by promising financial indicators, Kingfisher quickly tried to expand its depth and breadth of stores. In 2007, however, the housing market reversed course as the Chinese government tightened lending criteria, causing B&Q China to recognize a £60 million (US$93 million) loss in fiscal year 2008-2009. As yearly growth upwards of 40% was replaced by declines of at least 15%, the retailer was forced to scale back dramatically and restructure its store footprint. As of early 2010, B&Q China had 43 outlets in operation, down one third from 63 at its peak.

In addition, mall-based retailers face the challenge of identifying suitable locations among numerous mall projects of widely varying quality and viability. Mall industry experts point to developers’ lack of accountability and misaligned profit incentives, as residential-focused developers often develop malls for mixed-use projects primarily as a way to acquire land from local governments on more favorable terms. This mismatch of interests has resulted in a number of high-profile mall failures, such as New South China Mall, located in Dongguan, a large industrial city in the Pearl River Delta. Built in 2005, during the boom years, this development aspired to be the world’s largest mall, holding over 1,500 stores in a lavish setting, including a mock Venetian canal, an indoor roller coaster, and a replica of the Arc de Triomphe. However, as of late 2009, approximately 99% of its stores stood empty.

Dick Groves, a Hong Kong-based retail development consultant, lists the many factors that combine to drive mall failures: “Preoccupation with residential development, failure to understand the complexities of retail development, hubris and gigantism, inappropriate designs based on Hong Kong and Taiwan malls, no accountability for capital, pressure to support GDP growth targets, and a corrupted system for securing sites.” Most importantly, he believes that mall failures are destined to continue because “the retail chain-store industry in China is years away from having the critical mass to fill megamalls, but developers don’t understand that bigger is not better, that they need to account for smaller numbers of stores,” particularly in Tier 2 cities. Even as professional mall developers such as CapitaLand, Swire, and Ivanhoe Cambridge build viable mall projects in Tier 2 cities, “the pace of change is very slow because easy credit continues to support poorly conceived projects,” says Groves.

The continued lack of quality mall space remains a core area of concern for retailers seeking expansion across China. In a retail game where location is key, prominent international chain stores such as Zara, H&M, and Uniqlo enjoy prime spots at attractive rates as anchor tenants, giving them a competitive edge. In contrast, Groves believes that current mall designs, often characterized by too many levels and poorly planned circulation, pose the greatest challenge to less prominent retail chains because “lesser brands are having to look at inferior shopping spaces” deeper and higher in commercial centers where business prospects are low.

In this context, today’s retail entrants face high execution hurdles and run the risk of repeating past failures, but on a much grander scale given the larger and faster scale of expansion and capital expenditure. For example, Coach, in its Q4 2010 corporate earnings conference call, cited China as its “largest geographic opportunity.” To that end, the company is rapidly investing funds to more than double retail sales, targeting US$250 million by fiscal year 2012, up from US$100 million in fiscal year 2010.

In addition, beyond the financial risk of suffering from underperforming stores, brands run the risk of longer-term damage to their image in these new markets if they mismanage their entry strategies and execution. We believe that while the blank-slate consumer markets of Tier 2 and Tier 3 cities are a tremendous opportunity for first-movers to establish a sustained lead over their global competitors, their newness also creates room for major missteps by brands overreaching into unknown territory. It remains to be seen whether a track record of successful entry into Tier 1 cities will be a good predictor of success in Tier 2 and Tier 3 cities over the next few years. Multinational retailers rushing to tap the gold mines of China’s Tier 2 and Tier 3 consumer markets certainly promise to offer revealing lessons on how to build strategic advantage in rapidly urbanizing markets. Meanwhile, these retailers’ successes — or failures — will also illuminate the true appetite for global brands among China’s burgeoning middle class.

This article was written by Stephane Lesaffre and Amy Wang, members of the Lauder Class of 2012.

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