On April 24, Best Buy, the largest electronics retailer in America, announced a plan to open seven to 12 new stores in China this year. In addition, Robert Willett, CEO of Best Buy International (a subsidiary of Best Buy), said that the company plans to add hundreds of new stores in China during the next five to 10 years.
Best Buy’s expansion is shaking up the electronics and appliance retailing industry in China. It currently has six stores in Shanghai and one in Beijing, plus another 170 outlets in China under its wholly owned subsidiary, Jiangsu Five Star Appliance. (Best Buy began with a 51% stake in Five Star three years ago and gradually increased its ownership. On February 15, it announced that it would purchase 100% of Five Star.) The challenge from Best Buy has not gone unnoticed by the two largest appliance and electronics chains in China, Gome Appliance and Suning Appliance. Even before Best Buy’s announcement, the appliance and electronics retail industry was in flux, and the two market leaders were already making dramatic changes to their operating models.
Gome and Suning pursue a sales model that is very different from the one used by Best Buy. For historic reasons, the two China retailers prefer a store-within-a-store sales method, in which manufacturers hire their own staff and use allotted retail space to sell their own products. Best Buy, by contrast, sells competing brands using its own sales staff.
But the game is changing. With the rising influence of e-commerce, and the entry of consumer-friendly Best Buy, with its helpful teams of well-informed sales people, it is increasingly essential for the two chain-store retailers to create more value for customers, in addition to providing low prices.
Shortly after Best Buy announced its ambitious expansion, Chen Xiao, chairman and president of Gome, which is the largest chain-store retailer of household appliances and consumer electronics in China, announced in the company’s annual report that the group would shift its emphasis away from expanding sales by opening new stores, to driving profitability growth by increasing the efficiency of each store.
In any case, the “big two” electronics retailers have not converted their dominance into handsome profit margins. Best Buy’s U.S. revenue in fiscal 2008 was US$40 billion, and its gross profit was US$9.5 billion, so its gross margin, which is the core indicator for the retail industry, approached 24%. By contrast, Gome’s nominal gross margin was only 9.8% and its adjusted gross profit margin, including income from suppliers, was only 17%, while Suning’s was just 18%.
At stake is a large — and growing — consumer market that was worth US$120 billion in China last year.
Rapid Expansion
In the late 1980s, with the collapse of China’s planned economy, the country’s leading household appliance and electronics manufacturers poured massive resources into sales and marketing. As a result, the manufacturers were forced to weather the high costs of building their sales networks. From 1993 to 2000 (before the rise of chain-store retailers), the average sales cost ratio (sales costs/revenue) of China’s major household appliance manufacturers rose from 2.9% to 10.6%.
However, with their advanced logistics systems and economies of scale, Gome and Suning began to take control of their relationships with the manufacturers. They squeezed much of the excess cost from their sales channels and passed the lower prices to consumers, which accelerated their expansion, especially in China’s biggest cities. Gome’s original founder, Huang Guangyu, also made many acquisitions to enlarge the chain’s sales network, and by the end of 2008, Gome had acquired 27 local chain-store retailers.
The large networks gave the retailers great leverage, and by 2005, financial magazine New Fortune summarized the strategies of the chain-store retailers as an ‘Analogous-Finance’ model, in which the manufacturers basically financed the expansion of the retailers. “Gome and Suning transact with consumers in cash, while the accounts payable provided by suppliers is as long as three to four months,” wrote the magazine. “This makes it possible for the retailers to expand their networks using the suppliers’ funds, and it enhances their bargaining power to prolong the accounts payable period even further.”
There is evidence to support this view. According to its 2008 annual report, Gome’s revenue was RMB 45.9 billion, while its accounts payable reached RMB 12.92 billion. Meanwhile Suning’s revenue was RMB 49.9 billion, while its accounts payable reached RMB 10.73 billion. Both retailers’ payables/revenue ratios exceeded 20%, and even soared to 51% for Gome in 2006. These figures are much higher than Best Buy’s 10.7% ratio.
The magazine attributed the unbalanced relationship to the monopoly power of the chain-store networks. Gome and Suning offer low prices to attract customers, but pass the costs to the manufacturers using various fees, such as charging the manufacturers a “slotting fee” to display their products. Gome’s 2008 Annual Report revealed that its income from suppliers consisted mostly of such fees charged to suppliers for promotional activities, management services, and display space leasing. The total was RMB 2.5 billion, which was nearly one billion more than the earnings before tax of the entire company. Suning’s related income in 2008 was RMB 1.4 billion, which contributed 48% of its earnings before tax. Best Buy, by contrast, earns its profit mainly through markups.
But with the period of rapid expansion nearing an end, and the retail chains concentrating instead on maximizing profit in each store, the high ratios of accounts payable/revenue are falling. Initially, the ratios might be related to a lack of financial resources for the rapid expansion, according to Sun Weimin, president of Suning. Viability in a certain location depends on creating widespread distribution in a short time, he said, “for example, because it requires at least seven or eight stores to maintain a profit in Beijing, Suning was forced to achieve this baseline as soon as possible.” After completing its countrywide expansion, and with an IPO in 2004, Suning is no longer thirsty for funds. In 2008, Suning even paid RMB 2 billion in advance to suppliers, in order to receive favorable price discounts. Gome, too, has been decreasing its ratio since the peak in 2006.
According to Sun, the retail prices of household appliances are mostly determined by suppliers, not retailers. The suppliers and the retailers make a deal on the basic supply prices and the gross margin for the retailers, but in the actual operation, the price is not fixed. For example, the suppliers may lower the prices of certain products (even below the production prices), so they have to compensate the chain-store retailers. However, in accordance with accounting standards, the compensation income can’t be included in the gross margin; it can only be listed as “other income.”
Why not simply improve gross margins, like Best Buy has done? Sun notes that although basic prices and the accounts payable period are negotiated by the headquarters, due to the intense price wars, the nationwide branches of the suppliers take considerable responsibility for the local markets, and are granted price autonomy in order to compete. Under such circumstances, plans change, and so do prices.
Suning has begun to simplify its price structure in order to reduce its transaction costs with suppliers, and its profit structure is gradually shifting toward standard markups. Suning’s nominal gross profit margin rose from 11.2% in 2007 to 14.5% in 2008, while its percentage of “other income” dropped from 3.76% to 3.19%.
Store-within-a-Store
Even with the products they sell through Gome and Suning, the manufacturers are not willing to cede control. They prefer the store-within-a-store concept, which means that salesmen employed by different brands compete with each other as they promote the same products in the same retail store.
The presence of stores-within-a-store often indicates the strength of retailers, rather than manufacturers, according to a detailed study titled “Store-Within-a-Store”, written by Kinshuk Jerath of the Tepper School of Business at Carnegie Mellon University, and Wharton marketing professor Z. John Zhang.
“The presence of a manufacturer’s store within a retailer’s store could suggest the weakness of the retailer or the dominance of the manufacturer, as the manufacturer has autonomy in the space owned by the retailer,” write the authors. “However, our analysis shows that the store-within-a-store arrangement can, in fact, be a sign of the retailer’s strength … one would expect to see the store-within-a-store arrangement only in the stores of power retailers, as is commonly the case.”
In the author’s model, the retailer could have avoided the store-within-a-store arrangement altogether if it could credibly commit to the prices and service levels that the manufacturers could deliver through the store-within-a-store arrangement. “However,” they write, “any such commitments would not have been credible to the manufacturers.”
But in China, paradoxically, the store-within-a-store model often results in an inferior customer experience, in which it is often hard to get knowledgeable advice about products. From a consumer perspective, the contrast between Best Buy and its two competitors could not be more pronounced. Best Buy is staffed by friendly and knowledgeable sales people who wear bright uniforms, and its stores are quiet, clean and well designed, and offer vast selections of competing products. Most other appliance retail stores in China, on the other hand, are dirty, noisy, and chaotic, and are staffed by unkempt and often discourteous sales staff, who often know little about the products they are selling. In addition, because many use the store-within-a-store sales model, the staff “push” particular brands, while denigrating the competition. Aside from creating an unwelcome street market atmosphere, this setup makes it hard for consumers to make informed decisions.
For example, Lucy Xu, who works for a financial service company, tried to purchase appliances for her new house, but she was not able to get sufficient information from the sales teams, receiving only competing discounts. “My most important concern is to purchase the most appropriate products, not the cheapest,” Xu said. Nor is she satisfied with the overall setup. “If I want to buy a TV, it makes me sick that I must walk around all the related brands,” she says.
More Attention to Customers
In any case, Gome and Suning are now paying more attention to their customers. Aside from the growing threat from Best Buy, the rise of e-commerce has appealed to China’s price-sensitive consumers, forcing the chain-store retailers to seek other comparative advantages. For example, 360buy Jingdong Mall, the largest B2C on-line retailer in China, posted revenue in 2008 of RMB 1.4 billion, and its goal for 2009 is RMB 4 billion.
Chen Xiao, chairman and president of Gome, wrote in the company’s annual report that “our vision includes overall care for the consumer experience, both in the store and afterwards.” In 2008, Gome continued to promote services such as its membership system, home appliance repair, extended warranty service, call center, and after-sales services, all of which were designed to enhance customer satisfaction. In 2009, Suning plans to employ more Suning staff to provide professional, neutral recommendations for consumers.
Suning is also trying to create a new supplier model. In March 2008, Suning signed a cooperation agreement with Whirlpool and was appointed the exclusive strategic partner for Whirlpool’s air-conditioning products in China. Suning directs the sales, branding and after-sales service, while Whirlpool focuses on manufacturing and developing new products based on suggestions from Suning. In December 2008, the two companies expanded their cooperation to include water heaters. “Our idea is to simplify the cooperation model with suppliers,” said Sun. “The manufacturers are responsible for quality and quantity, while we take charge of the rest.”
However, it is still uncertain whether leading suppliers, who have so far preferred to control their own fates, will accept a similar model of cooperation. Suning previously tried to persuade manufacturers to cancel the direct-sales-person system in these store-in-stores but failed, as the manufacturers still wish to retain influence over end-users, despite the high expenditures.
Even aside from Best Buy and the “big two” retailers, a number of other sales experiments are underway. China has a wide diversity of household appliance sales channels, including supermarkets, department stores, chain stores and exclusive shops, many of them tiny. A study in 2008 showed the domestic market for household appliances and consumer electronic products was RMB 792 billion, while the total revenue of Gome and Suning was only about RMB 100 billion. In addition, most Gome and Suning stores are located in first- and second-tier cities. In the rapidly changing marketplace of appliances and consumer electronics, it remains to be seen which approach will ultimately prove the most efficient and successful.
