insight chinese retail 6 final

8/6/2019 Insight Chinese Retail 6 Final

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RETAIL OPPORTUNITIESIN CHINA

Travelling at high speed on a slippery road?


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ContentsPage

Retail opportunities in China .......................................................... 1

The retail environment .................................................................... 6

Food retailing ................................................................................. 11

Specialty retailing ........................................................................... 15

Conclusion ..................................................................................... 21

About the authors

Jacques Penhirin is a Partner and Tony Chan is a Manager

in OC&Cs Greater China office (Hong Kong and Shanghai) and

Kerstin Lehmann is a Partner in OC&Cs Dsseldorf office.


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Retail opportunities in China Travelling at high speed on a slippery road?

1

Deng Xiao Ping famously said: To Get Rich is Glorious. As China rapidly emerges

as a middle class society responding to the late leaders call, the country appears to

some to be a Shangri-La for retailers. With double-digit growth and huge untapped

potential, it is attracting interest from all over the world. Retailers, both local and

international, have been wasting no time in snapping up sites in towns and cities

across China to open new stores. Store portfolio size is impressive and some chainsalready have over a few thousand points of sale. Yet behind this rosy backdrop lies

a tough reality as intense competition becomes even more aggressive and costs run

ever higher. Inevitably, some will return from this gold rush empty-handed. This article

offers some advice on how to drive at high speed along the slippery road called China.

Retail opportunities in China


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China is still relatively poor on a per capita GDP basis, ranking below 100 othercountries in the world. Its average GDP per capita passed the US$2,000 mark in2006, but is still below that of Angola. But of course if you multiply that figure by1.3 billion, China is an economic giant and it is growing fast.

Chinas meteoric rise started in 1978 when Deng Xiao Ping introduced marketreforms to kick start the countrys stagnant Soviet-style centrally planned economy.These reforms have helped lift millions of people out of poverty and spearheadedeconomic development.

China overtook the United Kingdom as the fourth largest economy in the world in2005 and is slated to surpass Germany by the end of 2007. On the basis of adjus-ted Purchasing Power Parity, China is already the worlds second largest economy.China generated a record trade surplus of US$ 177.5 billion in 2006, pushing foreignreserves over the US$ 1trillion mark, making it the largest in the world. The pace ofthis growth, combined with the size of the country, makes China one of the mainglobal economic driving forces of the new century.

Historically, Chinas economic development has mainly been driven by fixedasset investment and exports. Fixed investments totalled US$1.41 trillion in 2006,up 24% on the previous year. Exports grew by 27% to reach US$ 970 billion,propelling China to become the worlds third largest trading nation (behind the USand Germany). GDP has been growing at over 10% for the past four years (2005:10.4%; 2006: 10.9%). The Chinese government realized that such voracious growth

would be hard to sustain in the future and that domestic consumption should be thegrowth engine in the next decade. The government therefore devised a number ofmeasures to simulate domestic consumption in the 11th Five-Year Plan (2006 10).

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2

A country in rapid transition

China is the worlds fourth largest economy

Source: IMF, National Bureau of Statistics

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 U.S. Japan Germany China U.K. France Italy

1.031.13 1.18

1.241.35

1.471.59

1.77

2.07

2.34

2.70

12.45

4.57

2.792.70

2.232.13

1.77

Chinas GDP Growth 19962006

(US$ trillion)GDP of the worlds largest economies

(US$ trillion)

CAGR 7806

9.8%


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This plan, which was reiterated in the recent 2007 National Peoples Congress, putsspecial emphasis on building a more dependable social safety net and a reliableand affordable healthcare system. The current insecure future caused by the existingpatchy social welfare and healthcare systems is believed to be one of the majorfactors that make the Chinese save rather than spend. Despite their relatively lowdisposable income, on average they save 24% of what they earn, which is muchhigher than the savings ratio of 2% in the US and 6% in Europe. Total savingsdeposits in China at the end of 2005 were US$ 1.75 trillion. This huge spendingpower will be unleashed when Chinese consumers become more confident aboutthe future, once better social security and healthcare services are in place.

Chinese consumers are relatively young and receptive tomodern concepts

The median age of the population is around 33, compared with 37 in the US and 39in the UK. People under 35 tend to be more open and relaxed than their parents,who experienced the turbulence of the Cultural Revolution in 1966-76. They are veryreceptive to new, modern concepts. In 1979 the Chinese government introduced aOne Child policy, which enforces a limit of one child per couple in urban areas.These little Kings and Queens became the focus of attention in their families andincreasingly found themselves the recipients of lavish gifts bestowed on them bytheir parents, two sets of grandparents and extended family members. Children andteenagers therefore constitute a fast-growing consumer target for FMCGcompanies.

Some critics argue that the One-Child Policy has significantly reduced the birth rate,risking rapid aging of the population and shortages in the labour market. The Chinesecould get old before they get rich. But two factors are likely to offset this: first, im-

provements in the quality of labour and second, an influx of surplus labour from theagricultural sector. Another factor is that Chinese consumers are getting rich at anunprecedented rate.


3

The population structure in China

Source: National Bureau of Statistics

67>70

6069

5059

4049

3039

2029

1019

09

Age

group

Million % of total

88

148

190

241

168

213

138

5.4%

7.0%

11.8%

15.2%

19.2%

13.4%

17.0%

11.0%

Could the Chinese get

old before they get rich?


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4

Chinese consumers are getting rich fast

In 1981, China was one of the poorest countries in the world. The annual per capitadisposable income of the urban household was a mere US$60. Twenty-five yearslater, it had grown 25 times, reaching US$ 1,513. This rapid growth shows no signsof slowing down. In 2006, income growth in urban and rural areas compared to2005 was 12.1% and 10.2%, respectively (0.8 and 1.2 percentage points higherthan in the previous year). The emergence of a middle class defined as those withannual incomes of at least US$ 5,000 has been even more phenomenal. Thisgroup, which was virtually non-existent before 1990, is now estimated to be around50-60 million strong and is forecast to grow to 200 million by 2015.

Chinese consumers are well-equipped with white and brown goods


133Color TV

Mobile Telephone

Washing Machine

Refrigerator

Air Conditioner

DVD player

Oven

Computer

Stereo System

Durable consumer goods per hundred households, 2004 CAGR 99 04

111

96

90

70

63

42

33

3.6%

73.2%

1.0%

3.0%

23.3%

21%

28.0%

41.1%

7.5%28

Urban Chinese consumers are getting rich fast

Per capita disposable income of urban and rural household 19902006 (US$)


1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

1,600

1,400

1,200

1,000

800

600

400

200

CAGR 9006

13.7%

CAGR 9006

10.9%

Urban Rural


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Although the Chinese Middle Class are not rich by Western standards, they are never-theless well equipped with basic white and brown goods and are frequent buyers ofconsumer electronic devices such as mobile phones and DVD players. In 2004 thenumber of colour TVs per household reached 1.33, and mobile phones 1.11.

Uneven economic development

Economic development in China is very uneven. The gap in GDP per capita betweenthe richest province, Zhejiang, and the poorest, Guizhou, is six times. The richest

regions in China are concentrated around the Pearl River and the Yangtze Riverdeltas, along the coast in the East, and around the Bohai area. The poorer regionsare inland provinces in the southwest, northwest and centre. The top six richestregions (Shanghai, Beijing, Tianjin, Zhejiang, Guangdong and Jiangsu) account for36% of national GDP but only contain 19% of the population. In contrast, the sixpoorest provinces (Guizhou, Gansu, Guangxi, Yunnan, Sichuan, and Ningxia) onlycontribute 10% of national GDP with roughly the same total population as the topsix richest provinces.

It is not surprising that foreign retailers mainly targeted the coastal regions whenthey first entered China. However, capturing the full potential of the market requiresthem to go west and inland, and they will need to adapt their models to cater fordifferences in spending power and consumer preferences. Economic developmentin inland and western provinces is expected to speed up, because the government

is investing heavily in these regions in order to reduce regional differences in eco-nomic development.


5

Unequal GDP distribution, 2004

Source: China Statistics Year Book 2005, 1 US$=8.26 RMB; TDC survey 2002, OC&C analysis

Xinjiang

Qinghai

Sichuan

Tibet

Yunnan

Guizhou

Guanxi

Hunan

HubeiChong-qing

ShaanxiNingxia

Gansu Inner Mongolia

Shanxi

Henan

Hebei

Shandong

Iiangsu

Zhejiang

Anhui

Jiangxi

Fujian

Guang-dong

Hainan

LiaoningBeijing

Jilin

Tianjin

Heilonghang

GDP per capita > US$ 2,000

GDP per capita US$ 1,0002,000

GDP per capita < US$ 1,000

Shanghai


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6

The retail market in China is the third largest in the world (just behind the US andJapan). In 2006, total retail sales of US$ 983 billion were up 13.7% on the previousyear. Average annual growth has been 14% since 1991, inflation during the sameperiod was around 5% per year, and double-digit growth is expected to continue forthe next few years. Chinas retail market is already twice the size of all other Asiancountries together (excluding Japan), making it extremely attractive for internationalplayers.

The share of food in total retail sales has gradually shrunk from 49.4% in 1998 to47.5% in 2004, as a consequence of the growing affluence of Chinese consumers.Although modern foods such as dairy products, soft drinks and alcoholic drinkshave higher growth potential, traditional food (fresh and dry vegetables, fresh meat)

still accounts for the bulk of food sales. Tobacco and alcohol are dominated by localbrands due to strong local preferences and a lack of national brands. The largenumbers of people eating out present a very attractive market for fast food restaur-ants.

Non-food sales comprise 53% of total retail sales. The three largest categories areclothing (28% of non-food sales), disposable paper products (16%) and consumerelectronics (13%), while the top three fastest growing categories are householdproducts, telecom equipment and disposable paper products.

The retail environment

Retail sales in China have been growing rapidly


1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

1,200

1,000

800

600

400

200

Retail sales value

Value (US$ billion)

Yoy growth rate

139 162184 240

304365

402430 457

501541

615677

766

865

983

35%

30%

25%

20%

15%

10%

5%

0%


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7

As Chinese consumers are becoming more affluent, share of non-food sales is growing

Source: Acess Asia, National Bureau of Statistics

27.9%Housewares

Telecoms equipment

Personal goods

Disposable paper products

Cosmetics

15.3%

14.1%

14.0%

12.6%

28.4%Clothing

Disposable paper products

Consumer electronics

Household cleaning products

Leisure products

16.0%

13.0%

10.0%

9.9%

Top 5 largest categories

% of non-food sales

Top 5 growing categories

CAGR 9804

13.5%Dairy

Soft drinks

Spreads

Frozen food

Alocohlic drinks

12.8%

12.6%

12.5%

12.5%

15.9%Fresh and dry vegetables

Alcoholic drinks

Fresh meat

Cereal products

Tobacco

15.6%

12.7%

12.4%

10.2%

Top 5 largest categories

% of food sales

Top 5 growing categories

CAGR 9804

Breakdown of retail market

(US$ billion)

50.6 52.5

49.4 47.5

Non-food

Food

1998 2004

438 766100%=


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8

Industry structure

Chinas retail industry is still in its infancy and the market is still highly fragmented. In2004, there were 18.7 million retail outlets (one for every 69 people). There may wellbe fewer today, but organized retailing (i.e. retail chains) currently accounts for justone sixth of total retail sales, significantly lower than the proportion in developedmarkets such as the US and Taiwan, where 80% of retail sales are generated byorganized retailing. However, this sector is developing rapidly. Its market share hasincreased from less than 5% in the early 1990s to 17% now. With the top 50 playersaccounting for less than 5% of the market (versus 30% in the US), there are clearlysubstantial opportunities for industry consolidation.

Chinas huge size offers great opportunities for expansion but at the same timecreates a logistics nightmare for retailers. Officially, there are 660 cities, 184 of whichhave a population of over 1 million. Chinese cities can be categorized into three tiersbased on population size and GDP per capita. There is no official definition fordefining these tiers. However, in general, tier one cities have a population of over 6million and a per capita GDP of over US$ 5,000. Tier 2 cities have population of atleast 1.5 million and a per capita GDP of US$ 2,000. The remaining cities belong totier 3. Tier 1 and tier 2 cities represent only one third of the market potential. Captur-ing the full potential in China will therefore require retailers to set up thousands ofdistribution points in hundreds of tier 3 cities.

Source: CLSA

USA Taiwan WesternEurope

Malaysia Brazil Thailand Indonesia China

Share of organized retailing in China is still low compared with other markets

Unorganized

Organized

Organized retailing share in selected markets, 2004

19%

30%

45%

60% 60%

70%83%

85%81%

70%

55%

40% 40%

30%

17%

15%


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9

Retail format development

The Chinese retail market first began to transform in the early 1980s. Within 10-15years, all modern formats had emerged, including department stores, conveniencestores, specialty stores, supermarkets and hypermarkets. Modern departmentstores, which first appeared in China in the early 1980s, were basically remodelledstate-owned department stores such as Wangfujing in Beijing and First Department

Store in Shanghai. In the early 1990s, local supermarket chains such as Hualianstarted to emerge and quickly expanded across the country. The mid-1990s saw thearrival of foreign hypermarkets with Carrefour as the first in 1995, followed a yearlater by Wal-Mart and Metro. Although 7-11 came to Shenzhen in 1991, the rapidgrowth of convenience stores only started to take off in the late 1990s, when theyproliferated in major cities such as Beijing, Shanghai and Guangzhou. By the late1990s, other retail formats, such as specialty chain stores, category killers, luxuryboutiques and DIY stores, all started to take root. By then, China had fully embracedthe world of modern retailing.

Modern formats, which are growing faster than traditional ones, are expected toaccount for 60% of retail sales by 2010, up from 55% today. The channel mix inmajor cities is already comparable to that of Western countries. In Shanghai, 70%

of retail sales are generated by modern format retailers. Hypermarkets have thehighest growth potential, with forecast annual growth rates of over 28% in the per-iod 2005-2008, followed by specialty stores (9.8%) and convenience stores (9.2%).The slowest growing segment department stores is still growing at 8%.

Tier 1 and tier 2 cities only represent one third of the market potential

Source: China Statistical Yearbook

Tier 2 High fliers (9 cities)

Big tier 2 cities

Tier 2 Rich cousins (9 cities)

Relatively rich, smaller tier 2 cities

Tier 2 modest neighbors (14 cities)

Other tier 2 cities

ChengduChhongqingFoshanHangzhouNanjingShenzhenShenyangTianjinWuhan

AnshanChangdeDaqingFuzhouGuiyangHaikouHefeiHuhehaote

HuizhouHuzhou

JiaxingJinhuaJiningLaiwuLanzhouLinxiLuoyangLuzhou

MianyangNanchang

NanningPutianQinzhouQuanzhouRizhaoShaoxingTaianWeifang

UrumqiXiangfan

XuzhouYangzhouYantaiYichangYiyangZaozhuangZhanjiangZhenjiang

ZhoushanZhuhai

Tier 3 Poor relatives (~600 cities)

Tier 1 Big Bosses

ChangzhouNingboDongguanSuzhouTaizhouWenzhouWuxiXiamenZhongshan

ChangchunChangshaDalianHarbinJinanKunmingQingdao

ShantouShijiazhuangTangshanXianZiboZhengzhouTaiyuan

BeijingGuangzhouShanghai

Poor relatives

Retail market

Percentage, value

Tier 3

Tier 2

Tier 1

Rich cousins

Modest neighbors

High fliers

Big Bosses

23

9

11

7

5

68


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10

FDI opens up to foreign retailers

Prior to 1992, Foreign Direct Investment by retail companies was prohibited.

In 1992, foreign retailers were allowed to form joint ventures with local companies innine coastal cities, but foreign ownership in these JVs was limited to 49%. In 1999,the foreign ownership cap was raised to 51% and the geographical coverage of theJVs extended to all provincial capitals. However, the regulations were not strictlyenforced and some retailers with more than a 51% stake notably Carrefour wereable to gain retail JV licenses from local governments. In 2003, the central govern-ment lifted restrictions on numbers of outlets and raised the maximum foreignownership ceiling to 65%. In late 2004, all restrictions on foreign participation werelifted in accordance with WTO rules. Local operators also need licenses to operatechain stores or operate beyond their own provinces. Some retailers are expandingtoo fast and operating without a license. If foreign operators attempt to acquire theselocal retailers, a lack of licenses is likely to be one of the key obstacles to a deal.

Modern trade is capturing a bigger share of the market

Source: Euromonitor; Acess Asia; Chinese Statistical Yearbook

China retail sales by format

(in %)

1998 2005 2008(F)

Traditional formats*

Convenience stores

Hypermarkets**

* Includes cooperatives, independent grocers,free markets, food specialists and other food and

non-food outlets

** Defined as a store with retail sales area of over

2,500 m2, with at least 35% of selling space

devoted to non-food product

CAGR 0508

7.4%

9.2%

9.8%

8.0%

8.1%

28.7%

Modern formats

23.2

11.0

17.61.8

46.1

0.3 1.6 2.721.7

10.0

19.8

2.3

44.6

21.4

9.8

20.5

2.4

43.2

Supermarkets

Specialty stores

Department stores


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11

Hypermarkets

Hypermarkets appear to be the winning food retailing format, having grown by 57%on average each year from 2000 to 2005, driven by the availability of hypermarketspace, which has increased at a CAGR of 36% for the past five years (much fasterthan growth in consumption).

According to a survey by AC Nielsen, hypermarkets tend to win on low price andwide product selection and are thus gaining share over supermarkets and neigh-bourhood stores. According to research by Planet Retail, the share of grocery salescaptured by hypermarkets rose from 3% in 2000 to 4.6% in 2004 and is expectedto grow to 5.5% in 2009.

Food retailing

Through fast expansion and high customer preference,

hypermarkets are gaining share over all other formats

Source: Planet Retail

% of total modern grocery sales

2000 2005 2009(E)

C-stores &forecourt stores

5.5%

Supermarkets &

neigborhood stores

Hypermarkets &Superstores

Note: Data relates to leading Chinese grocery retailers only

2.2%

4.6%

0.7%

1.5%

0.9%

2.8%

3.0%

0.3%

There is no dominant national player yet

Source: Literature search

* Include 33 Trust-Mart stores acquired by Wal-Mart in Feb 2007. The remaining 67 Trust-Mart stores will be acquired in the coming three years.

Wal-Mart

Carrefour

Century Mart

Hymall/Tesco

Auchan

No. of cities covered

36

35

16

14

9

No. of stores

101*

92

97

44

15

China has 184 citieswith population over

1 million


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12

Hypermarkets have penetrated into tier 1 and tier 2 cities, many of which are nowapproaching saturation point. Further growth there can only be supported by growthin GDP. However, there is still scope for growth, especially in tier 3 cities.

Due to Chinas size, there are no national hypermarket players. The closest is Wal-Mart with 101 stores (thanks to a major pending takeover in early 2007; see below)and Carrefour with 92 stores at the end of 2006. However, there are strong regionalplayers, such as Nonggongshang in the Shanghai area, Beijing Hualian in NorthernChina and CR Vanguard in Southern China. Most of these have ambitions todevelop only a regional presence.

Falling productivity

As tier 1 and some tier 2 cities become saturated and more stores are opening intier 3, where the potential is lower, the sales productivity of new hypermarkets isdeteriorating sharply. The average sales of hypermarkets which opened in 2005 are40% lower than those of hypermarkets which opened in 1998. In 2000, each hyper-market served around 100,000 people. This number dropped to around 24,000 in2004, due to a rapid increase in the number of stores and intense competition.Average sales in hypermarkets in China are 65-70% lower than their counterparts inWestern countries.

As the performance of the new stores deteriorates, retailers become obsessed withtop-line growth. They open new stores in new cities where there is strong competi-tion, limited potential or greater complexity. This strategy further exacerbatesdeclining store performance, creating a vicious circle.

Intense competition has led to consolidation. At the end of February 2007 Wal-Martannounced the purchase of a 35% share in Trust-Mart, a Taiwan-based price-fighterhypermarket chain. Initially, Wal-Mart will buy 31 stores, and will acquire theremaining stores in the following three years. Hymall, another Taiwan based hyper-market operators in China with 31 stores, was acquired by Tesco in 2005. Localchains are up for sale with high price expectations but uncertain legal foundations.

As saturation happens in tier 1 and 2, sales productivity of hypermarkets are

going down and sale per store is low compared to Western countries

Source: OC&C Analysis

100

2005 average annual sales per hypermarket (Index 100=U.S.)Average sales per m2(Index 100=1998)

100

Opening years 1998

69

2002

59

2005

U.S.

94U.K.

85France

31China


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13

Hypermarket strategies

After twelve years of rapid growth, there is now less room for green-field entries.However, there are still opportunities to buy or to form joint ventures with existingregional players, which can be consolidated to build a national presence.Nevertheless investors need to bear with short-term fluctuations in profitability aswell as licensing and other operating issues. These local players typically have weakcash flow and poor management. This window of opportunity for buying into themarket may not last long, as consolidation is already underway (see above).

For existing players, the challenge is to develop a low-cost model that can be usedto expand profitably into tier 2 and 3 cities. There are two main ways to do this: youcan reduce investment costs and/or reduce operating costs.

More innovative methods include supplying fresh produce (high-growth) area thatdrives traffic to the stores, but few operators can make it profitable. Stores also facetough competition from wet markets, which offer unbeatable freshness, great varietyand very low prices. Outsourcing fresh produce to concessionaires, who can sourcelocal products, manage stock levels and be more flexible in pricing, is a low-invest-ment option. Above all, they understand the tastes of local customers and knowhow to sell to them.

Another way to save costs is by outsourcing logistics. China is notorious for its in-efficient supply chain and products need to pass through many layers of distributors

to reach consumers. However, although no single company has yet built a nationaldistribution network, there are many sizeable regional and local players whichprovide relatively reliable, efficient services at a competitive price.

As hypermarkets expand into lower potential areas, reducing operating costs isessential. Giving store managers accountability for cost control and then sharing thebenefits with them is a possible solution. If targets are reasonably set and incentivesare properly aligned, store managers will think of many creative ways to save costs.However, strict control mechanisms are needed.

Boosting top-line growth and margins is also important. International players havebetter skills in marketing, managing customer databases, launching loyaltyprogrammes and developing private labels, all of which help improve revenue andmargins. The challenge is to find and retain qualified middle managers to execute

such programmes.


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14

Supermarkets

Supermarkets have grown moderately in recent years. Sales per store have declinedsteadily due to market saturation and keen competition from other formats. Thenumber of supermarkets per household in China is three times that of Hong Kongand 17 times that of Taiwan. The sector is dominated by local players, the largest ofwhich is Lianhua with around 4,000 stores nationwide. Lianhua merged with Hualian(with 2,000 stores) two years ago to form the Bailian Group, but the two chainscontinued to operate under separate banners. The Shanghai-based Bailian Group,Chinas largest retailer, has an aggressive goal of opening 8,000 stores by the end of2008.

Supermarket strategies

Supermarkets are stuck between two rapidly growing formats: hypermarkets andconvenience stores. Their sales productivity is well below that of hypermarkets, dueto low traffic and limited offerings so they need to make a choice between movingupmarket to provide premium quality products and better services or moving downtowards hard discounters. There are still opportunities for new entrants to build ahard discount chain, but no one has done it successfully yet. Even Dia run byhypermarket giant Carrefour has yet to return a profit. The current hard discountermodel clearly needs to be refined further to gain wider acceptance in China. Lowmargins and low productivity is hardly a recipe for success.

Convenience Stores (CVS)

Growth drivers for convenience stores in the large cities are already in place. Theseinclude: a dense urban population, increasingly long working hours, a customer pre-ference for convenience, a large volume of foot traffic in business/shopping districts,high population density in city areas and a growing middle class plus high levels ofsnacking. However, saturation has already been reached in several cities. Forexample, Shanghai is already over-saturated with more than 4,000 stores. The CVSconcentration (measured as no. of CVS divided by GDP) in Shanghai is already fivetimes that of Hong Kong. Although CVS giant 7-11 received a license to open storesin Shanghai, it now appears to be focusing on the less saturated markets of Beijing,Tianjin and Hubei province first and avoid entering the Shanghai market. Quik, owned

by Lianhua, is the largest CVS chain in China with around 2,000 stores, many ofwhich are co-located with Lianhua supermarkets, acting as 24-hour outlets for thelarger stores. Quik recently sold its Guangzhou operations (110 stores) to 7-11.

Convenience stores strategies

Chinese consumers are not yet willing to pay a big price premium for convenience.Convenience stores are used for quick snacking and top-up shopping for groceriesand daily necessities. Given the high rents in prime street locations, it is hard tomake a profit, even with a high-density store network. The key to profitability isdeveloping new sources of revenue such as providing services like bill payment anddistribution points for online companies. Franchising is the best model for a rapidroll-out to new cities, thanks to lower capital investment, low operating costs andpreferential tax arrangements. Instead of paying 17% in VAT, CVS franchisees with

annual revenue under RMB 1.8 million (US$233,000) only pay 4%. Creative account-ing and other means of tax avoidance further reduce the tax burden of franchiseesto virtually nil. Franchisees also keep costs low. It is not unusual to find the wholefamily of a franchisee working for the store.


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15

Apparel

In 2005, US$ 61 billion worth of apparel was sold in China, approximately one-thirdof the size of the US market and 50% larger than in France. Datamonitor predictsthat annual growth will be 6% for the next five years.

Specialty retailing

Climate variation across China is significant

Source: China Statistics Year Book 2005

30

Average temperature, 2004 (in C)

25

20

15

10

5

0

-5

-10

-15

-20

Jan May Jul Sep NovFeb Apr Jun Aug Oct DecMar

Guangzhou (South of China)

Shanghai (East of China)

Beijing (North of China)

Harbin (Northeast of China)

Temperature difference across China:

29,4C in Winter 5,5C in Summer

China Apparel market is already sizable and is one of the fastest growing in the world

Source: Datamonitor, Yano research institute; Asian textile; German textile retail association; Government reports

* Others include underwear, night wear, knitwear, socks, tights and clothing accessories

US

World Apparel retail industry, 2005

(US$ billion)

183

Japan

85

China

61

France

41

India

18

S. Korea

12

2002

China Apparel retail industry, 2000-2010 (forecast)

(US$ billion)

43

Others*

Childrenswaer

Menswear

Womenswear

03

48

04

57

05

61

06E

66

07E

70

08E

74

09E

78

10E

82

24

14

42

26

15

53

31

17

63

34

18

63

37

19

73

20

39

7

4

41

21

8

4

2224

44 44

8

4 9

5CAGR

=12.4%

CAGR

= 6.1%

1/3 of US market 50% larger than France 3.5 times of India


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16

Consumer preferences vary widely across China. People in Guangdong provincetend to be influenced by the fashion trends of Hong Kong. They like casual clothes,whereas consumers are more formal in the North.

There are also huge variations in climate. The difference in winter temperaturesbetween the north and the south is close to 30 C. Such differences affect the typeand style of apparel sold in different parts of the country.

The casual wear market in China is dominated by Hong Kong and Mainland Chinesebrands with a large store base. For example, Baleno, a Hong Kong brand, has morethan 3,000 sales outlets across China and Jeanswest, another Hong Kong brand,has around 1,300 stores. However, revenue per store is small. Balenos annual salesper store were around US$90,000 in 2005. Other brands such as Jeanwest andBossini do slightly better but revenue per store is still below US$100,000 per year.

Undeterred by low sales per store, large international players continue to enter themarket. At the end of 2006, Uniqlo had opened eight stores and Zara had twostores in China. Other big names such as C&A and H&M plan to open their firststores in 2007.

There are a number of challenges retailers need to overcome in order to capture themarket potential in China. First of all, brand building is difficult and costly.Consumers have limited knowledge of brands in general. This can be explained bythe proliferation of local brands and the fact that brand loyalty is low. Rising media

costs also add a further challenge to brand building.

A New Game

The total advertising spend in China has grown at a rate of 25% per year for thepast seven years. Even if a retailer successfully builds up a brand, counterfeitersoften move in and take a substantial slice of the business. Although the governmenthas stepped up efforts to clamp down on counterfeit operations in recent years, thisremains a big problem for many companies with losses estimated at approximately20% of total sales revenues for multinational companies operating in China.Successful brands may sometimes avoid counterfeit, but they seldom escape thecopycats. Chinese companies are swift imitators. Popular concepts and styles areusually copied within months, if not within weeks or days.

Extensive preparation is needed to position products and services strategically.Customer segmentation is the way retailers usually tailor offers to the requirementsof Chinese consumers. However, these are becoming increasingly sophisticated inlarge cities, creating a need for finer segmentation. In addition, psycho-behaviouralsegmentation requires robust, quantifiable market research.

Finding the right retail location at the right price is another challenge. Although retaildevelopments have been sprouting up in cities all over China, rental cost keepsgoing up. Today, rental costs in prime retail areas are comparable to internationallevel. For example, the cost of prime retail locations on Beijing Road in Guangzhouis now comparable to similar location in Shinjuku, Tokyo. As prime retail locationsbecome scarce, retailers are forced to look for secondary locations for expansion.Local brands are catching up with international brands. According to our recent sur-

vey, the store productivity gap between international and local brands has narrowedto 6%. The years of land grabbing are over. The time has come for sophisticatedmonitoring of consumer demand and store execution.


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Apparel stores strategies

Given the low level of sales per store, an apparel retailer needs to build a vast net-work of outlets to achieve sufficient volume to justify the cost of advertising in thenational media. There are three main strategies for building a retail network in China.

The first is the city-by-city approach: building up critical mass in one city beforeexpanding to others. For example, Uniqlo started in Shanghai and built up sevenstores there before expanding to Hangzhou. There are a number of advantages tothis approach. A retailer can do in-depth research and focus resources on the mostattractive city while saving on the prohibitive cost of national advertising and large-scale investments in logistics.

The second is a regional cluster approach, rolling out stores in different tiers of citiesin the same region first before moving out to other regions. Several mass apparelretailers from Hong Kong such as Baleno, Giordano and Bossini used this approachinitially. Retailers can benefit in a number of ways. They can develop a more efficientregional logistics network and they can take advantage of cultural similarities amongconsumers in the same region to develop their product offerings.

The third is a tier-by-tier approach, which involves opening stores in tier 1 cities(Beijing, Shanghai and Guangzhou) first. After penetration has reached a certain level,retailers then roll out stores to tier 2 cities. Advantages include capturing the coun-trys most affluent customers quickly and buildings a solid financial and branding

foundation for further expansion. Mangos strategy is an example of this approach. Franchise frenzy

In addition to directly owned sales out-lets, franchising presents an attractiveoption for expanding geographically,but strong controls are needed. Thisapproach is widespread in China. Over5400 stores of the leading five apparelretailers in China (84%) are franchised.Under such a scheme, authorizeddealers open individual stores underthe retail brand. Typically all brandedproducts are then sold exclusivelythrough franchised and directlymanaged stores. The brand franchiseralso plays the role of distributor,supplying products to franchised stores.

Testing business models and formats be-fore national rollout is critical. There is noOne Size Fits All in China. People indifferent cities prefer shopping in differ-ent formats for apparel. Even within thesame city, running a standalone storeversus a counter of similar size in a de-partment store has different economics.Therefore, it is advisable to test the

format first before entering a new city.Setting up counters within departmentstores is a prudent way to test themarket before expanding into new cities.

Franchise stores are very common in China

Source: Company annual reports; literature search

# of stores, 2006

84% are

franchised stores

Baleno

Jeans West

Giordano

Bossini

Esprit

Franchise stores

Directly managed stores

1,285

Total

3,143

714

675

628

6,445

804 481

2993 150

594 120

500 175

539 89

Grand total


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Department stores

In early 1990s, the department store was the main focus of retail development inChina. With backing from local governments, domestic companies flocked to buildstores in cities across China. The size of its department store was once seen as ameasure of economic success by the inhabitants of local towns. However, thesestores were poorly run and did not have the right product mix, price range, servicelevel or any special shopping experience to offer to consumers. As a result, manylost money or scarcely generated any profit from retailing (they made their moneyfrom real-estate transactions). The tide turned during the Asian Crisis in 1997,when many poorly performing department stores closed down. However, somesurvived in prime locations and the legacy of good locations has become asustainable advantage for these stores.

There were signs of revival in late 1990s, along with strong retail growth in generaland successful reform of state-owned enterprise (SOE) department stores to drawback customers. The arrival of international department stores also added new lifeto the sector.

In 2003, total sales of department stores in China were around US$58 billion,representing a CAGR of 8.7% since 1999. The number of department stores grewfrom 1600 stores in 1999 to about 2200 in 2004. Results from a consumer surveyconducted by Euromonitor showed that department stores are still the preferredretail format for customers for non-food products such as clothing, cosmetics and

furniture. Department stores accounted for nearly half of total retail sales of clothingand footwear in China.

However, competition from hypermarkets and specialty stores pose a growing threatto department stores, especially in household goods and home appliances.

Source: Euromonitor

Department stores remain a key channel for apparel and footwear

Retail distribution of Chinese clothing retailers core products in 2003

FootwearMens wear Womenswear

Childrenswear

Fashionaccessories

Others

Department stores

45%

Grocery retailers

Specialists

49%

35%

50%45%

39%

40%

45%20% 32%

8%

15%

12%

18%

7%

13%2%

9%

5%

11%


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Concession-based sales

Department stores in China are quite different from those in Europe and the US,typically occupying the best shopping locations. They are also powerful landlords.Roughly 80% of their floor space is concession-based, providing 85% of sales.Each concessionaire occupies a 50-100 m2 booth and there are usually 50-80brands within a store. The owner charges the concessionaires 15-30% of theirturnover (depending on the store location and floor) as commission. Mostdepartment stores offer a one-year contract to concessionaires, but some evaluatetenants as frequently as every quarter and poor performers are asked to leave. Ingeneral, department stores in China lack concept or marketing skills.

International department stores started to enter the Chinese market in the early1990s. Parkson from Malaysia and Pacific from Taiwan were the pioneers. Parkson,which entered China in 1994, is the largest MNC department store chain in Chinawith 38 stores. Pacific Department Store currently has nine stores. MNC departmentstores, which are typically better managed, have a more appealing shoppingenvironment and a better brand mix compared to their SOE counterparts. They areexpanding rapidly. Parkson, for example, has aggressive plans to expand to 100stores after a successful IPO in Hong Kong. Other Asian and western players arerumoured to enter the market soon.

SOE department stores are usually old-fashioned, relying heavily on concessionairesales and focusing on short-term profitability, resulting in poor floor planning and achaotic tenant mix. Although they still have a positive image among olderconsumers, they find it increasingly difficult to attract young consumers due to theirtired store image. However, SOE department stores do have one advantage theirlocations. They usually occupy prime locations in shopping districts and thereforecan charge their tenants very high rents.

Department store strategies

Department stores are primarily a real-estate game. The key is to secure primelocations in shopping districts. It is now difficult to find such locations in tier 1 citiesbut not impossible, as some major cities are undergoing city centre redevelopment.However, opportunities are still abundant in secondary cities where numerous retaildevelopment projects are underway, with developers eager to find anchored tenantswith strong brands to boost the value of their projects.

So far, there is no national department store chain. Local players are mainly city orregionally focused. International players such as Parkson are far from achievingnational coverage. A national chain would command huge economies of scale, bothin operations and in branding.

Unlike other modern retail formats, department stores have so far experienced lesscompetition from international players. Given that department stores in China relymainly on sales from cosmetics and textile concessionaires, their skills are mainly intenant management and contract negotiation. They are more like shopping malloperators than retailers. This model works well in the short term and has providedmany advantages, such as low inventory risk and capital requirements. However,whether this model can be sustainable in the long term when competition heats upremains uncertain.

The value that international players can bring to the table is marketing skills as wellas an ability to manage the brand and product mix. They also provide better custo-mer service, plus an enhanced shopping experience. These will become sustainableadvantages in the long term.

International players

provide better customer

service, plus an enhancedshopping experience.


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Other specialist formats

Apart from the formats described above, there are many other specialist formats inChina. The following have been growing rapidly in recent few years and have startedto attract attention from international players:

DIY stores

Over 40,000 DIY related retail and wholesale companies have opened up since thebeginning of the 1990s. DIY sales grew from US$ 3.5 billion in 1996 to US$ 5.8billion in 2002. This attracted the interest of many foreign retailers such as Komeri ofJapan, B&Q of the UK, and Leroy Merlin of France, all of which have establishedsizable store networks in China. Home Depot a late arrival is catching up byacquiring a local chain of 12 stores in December 2006.

Sports shops

With more leisure time, Chinese consumers are increasingly interested in sportingactivities and watching sports on TV. Multi-brand multiples have a limited presencein China. Mono-brand stores are the dominant format because customers treatbranded sportswear as a fashion item rather than a functional product, thus they aremore effectively served through mono-brand stores. In addition, mono-brand storeshave more space for expansion because shopping mall operators prefer mono-brand shops in order to have more shops and brands in their shopping malls.

Foreign brands dominate the market. The largest sports retailer, Nike, currently has2,196 stores in China and is opening on average of 1.5 stores a day. Adidas is notfar behind with 1,535 stores. Following Chinas successful bid for the 2008 OlympicGames, sales of sports goods retailers are expected to remain strong for the nextfew years.

Shopping malls

Numerous new shopping malls have been built in recent years. China is how hometo seven of the top 20 largest shopping malls in the world. The largest of these,which has a total area of 9.6 million square feet, is located in Dongguan, a townnorth of Shenzhen, close to Hong Kong. Chinese shopping malls are usually part ofmuch larger mixed-use residential, office and entertainment complexes. Manyremain showpiece malls, devoid of crowds of shoppers and sales, while others areexperiencing strong growth because they are better designed and managed. Thekey factors separating the successful malls from the unsuccessful ones are location,transportation network and tenant mix.

These new formats are expected to gain importance in the next wave of retaildevelopment in China. OC&C has detailed research on all these formats which arepublished in separate folders.


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Retail in China undoubtedly represents an attractive market for local andinternational firms alike, but the market conditions are getting tougher. Seizing thisenormous opportunity not only requires an appropriate strategy but also faultlessexecution, perseverance and audacity. It is still not too late for new entrants, but theprice will not be cheap. Statistics indicate that 70% of the worlds top 50 retailershave entered China, but they currently occupy only around 8% of the market.

The key challenge is to find the right entry vehicle. For players who have alreadymade inroads, driving at high speed along this slippery road as the nationaleconomy continues to grow requires refining the business model to tackle bothformat and human resource challenges. This Shangri-La for retailers is not a myth it is there somewhere in China for those who can find the right path to it.

Fortune favours the Bold Alexander the Great

Conclusion


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Retail practice

The retail industry is one of OC&Cs strongest areas of expertise.Internationally OC&C is recognized as one of the leading providers ofboard-level advice on strategy and performance improvement to majorretail groups. We have experience in most parts of the world and inalmost every product and service category.

As well as extensive experience in retail strategy development and

strategic due diligence, our work extends into operational andimplementation issues such as new format development, buying andsupply chain effectiveness, range and category management, retailbrand development and managing costs.


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