RETAIL OPPORTUNITIES

IN CHINA
Travelling at high speed on a slippery road?
Contents
Page

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&C’s Greater China office (Hong Kong and Shanghai) and
Kerstin Lehmann is a Partner in OC&C’s Düsseldorf office.
 Retail opportunities in China – Travelling at high speed on a slippery road?

Retail opportunities in China

Deng Xiao Ping famously said: “To Get Rich is Glorious.” As China rapidly emerges
as a middle class society responding to the late leader’s 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 chains
already 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.

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A country in rapid transition

China is still relatively poor on a per capita GDP basis, ranking below 100 other
countries in the world. Its average GDP per capita passed the US$2,000 mark in
2006, but is still below that of Angola. But of course if you multiply that figure by
1.3 billion, China is an economic giant and it is growing fast.

China’s meteoric rise started in 1978 when Deng Xiao Ping introduced market
reforms to kick start the country’s stagnant Soviet-style centrally planned economy.
These reforms have helped lift millions of people out of poverty and spearheaded
economic development.

China overtook the United Kingdom as the fourth largest economy in the world in
2005 and is slated to surpass Germany by the end of 2007. On the basis of adjus-
ted Purchasing Power Parity, China is already the world’s second largest economy.
China generated a record trade surplus of US$ 177.5 billion in 2006, pushing foreign
reserves over the US$ 1 trillion mark, making it the largest in the world. The pace of
this growth, combined with the size of the country, makes China one of the main
global economic driving forces of the new century.

China is the world’s fourth largest economy

China’s GDP Growth 1996 –2006 GDP of the world’s largest economies
(US$ trillion) (US$ trillion)
12.45
4.57

2.79
2.70 2.70
CAGR 78 – 06
9.8 % 2.34
2.23
2.07 2.13

1.77 1.77
1.59
1.47
1.35
1.18 1.24
1.13
1.03

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

Source: IMF, National Bureau of Statistics

Historically, China’s economic development has mainly been driven by fixed

asset 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 world’s third largest trading nation (behind the US
and 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 the
growth engine in the next decade. The government therefore devised a number of
measures to simulate domestic consumption in the 11th Five-Year Plan (2006 – 10).

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

This plan, which was reiterated in the recent 2007 National People’s Congress, puts
special emphasis on building a more dependable social safety net and a reliable
and affordable healthcare system. The current insecure future caused by the existing
patchy social welfare and healthcare systems is believed to be one of the major
factors that make the Chinese save rather than spend. Despite their relatively low
disposable income, on average they save 24 % of what they earn, which is much
higher than the savings ratio of 2% in the US and 6% in Europe. Total savings
deposits in China at the end of 2005 were US$ 1.75 trillion. This huge spending
power will be unleashed when Chinese consumers become more confident about
the future, once better social security and healthcare services are in place.

Chinese consumers are relatively young and receptive to

modern concepts
The median age of the population is around 33, compared with 37 in the US and 39
in 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 very
receptive to new, modern concepts. In 1979 the Chinese government introduced a Could the Chinese get
“One 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 and old before they get rich?
increasingly found themselves the recipients of lavish gifts bestowed on them by
their parents, two sets of grandparents and extended family members. Children and
teenagers therefore constitute a fast-growing consumer target for FMCG
companies.

The population structure in China

Million % of total

>70 67 5.4%

60–69 88 7.0%

50–59 148 11.8%

Age group

40–49 190 15.2%

30–39 241 19.2%

20–29 168 13.4%

10–19 213 17.0%

0–9 138 11.0%

Source: National Bureau of Statistics

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 Chinese
could 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 the
agricultural sector. Another factor is that Chinese consumers are getting rich at an
unprecedented rate.

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Chinese consumers are getting rich fast

In 1981, China was one of the poorest countries in the world. The annual per capita
disposable income of the urban household was a mere US$60. Twenty-five years
later, it had grown 25 times, reaching US$ 1,513. This rapid growth shows no signs
of slowing down. In 2006, income growth in urban and rural areas compared to
2005 was 12.1 % and 10.2 %, respectively (0.8 and 1.2 percentage points higher
than in the previous year). The emergence of a middle class – defined as those with
annual incomes of at least US$ 5,000 – has been even more phenomenal. This
group, which was virtually non-existent before 1990, is now estimated to be around
50-60 million strong and is forecast to grow to 200 million by 2015.

Urban Chinese consumers are getting rich fast

Per capita disposable income of urban and rural household 1990–2006 (US$) Urban Rural

1,600

1,400

1,200 CAGR 90–06

13.7%
1,000

800

600 CAGR 90–06

10.9%
400

200

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

Source: National Bureau of Statistics

Chinese consumers are well-equipped with white and brown goods

Durable consumer goods per hundred households, 2004 CAGR 99 –04
Color TV 133 3.6%

Mobile Telephone 111 73.2%

Washing Machine 96 1.0%

Refrigerator 90 3.0%

Air Conditioner 70 23.3%

DVD player 63 21%

Oven 42 28.0%

Computer 33 41.1%

Stereo System 28 7.5%

Source: National Bureau of Statistics

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

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 of
consumer electronic devices such as mobile phones and DVD players. In 2004 the
number 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 between
the richest province, Zhejiang, and the poorest, Guizhou, is six times. The richest
regions in China are concentrated around the Pearl River and the Yangtze River
deltas, along the coast in the East, and around the Bohai area. The poorer regions
are inland provinces in the southwest, northwest and centre. The top six richest
regions (Shanghai, Beijing, Tianjin, Zhejiang, Guangdong and Jiangsu) account for
36% of national GDP but only contain 19% of the population. In contrast, the six
poorest provinces (Guizhou, Gansu, Guangxi, Yunnan, Sichuan, and Ningxia) only
contribute 10% of national GDP with roughly the same total population as the top
six richest provinces.

It is not surprising that foreign retailers mainly targeted the coastal regions when
they first entered China. However, capturing the full potential of the market requires
them to go west and inland, and they will need to adapt their models to cater for
differences in spending power and consumer preferences. Economic development
in 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.

Unequal GDP distribution, 2004

Heilonghang

Jilin
Xinjiang
Liaoning
Gansu Beijing
Inner Mongolia
Tianjin
Hebei
Shanxi
Qinghai Shandong

Ningxia
Shaanxi Henan Iiangsu
Tibet
Shanghai
Chong-qing Anhui
Hubei
Sichuan
Zhejiang
Jiangxi

Guizhou Hunan
Fujian
GDP per capita > US$ 2,000 Yunnan
GDP per capita US$ 1,000–2,000
Guanxi Guang-dong
GDP per capita < US$ 1,000

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

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The retail environment

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

Retail sales in China have been growing rapidly

Retail sales value Yoy growth rate

Value (US$ billion)

35%
1,200

983
30%
1,000
865
766 25%
800 677
615 20%
541
600 501
430 457
402 15%
365
400 304
240 10%
162 184
139
200 5%

0%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Source: National Bureau of Statistics

The share of food in total retail sales has gradually shrunk from 49.4 % in 1998 to
47.5 % in 2004, as a consequence of the growing affluence of Chinese consumers.
Although modern foods such as dairy products, soft drinks and alcoholic drinks
have 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 local
brands due to strong local preferences and a lack of national brands. The large
numbers 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 are
clothing (28 % of non-food sales), disposable paper products (16 %) and consumer
electronics (13 %), while the top three fastest growing categories are household
products, telecom equipment and disposable paper products.

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

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

Breakdown of retail market Top 5 largest categories Top 5 growing categories

(US$ billion) % of non-food sales CAGR 98–04

100%= 438 766

Clothing 28.4% Housewares 27.9%
Disposable paper products 16.0% Telecoms equipment 15.3%
Consumer electronics 13.0% Personal goods 14.1%
Household cleaning products 10.0% Disposable paper products 14.0%
Non-food 50.6 52.5
Leisure products 9.9% Cosmetics 12.6%

Top 5 largest categories Top 5 growing categories

% of food sales CAGR 98–04

Fresh and dry vegetables 15.9% Dairy 13.5%

Food 49.4 47.5
Alcoholic drinks 15.6% Soft drinks 12.8%
Fresh meat 12.7% Spreads 12.6%
Cereal products 12.4% Frozen food 12.5%
Tobacco 10.2% Alocohlic drinks 12.5%
1998 2004

Source: Acess Asia, National Bureau of Statistics

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Industry structure
China’s retail industry is still in its infancy and the market is still highly fragmented. In
2004, there were 18.7 million retail outlets (one for every 69 people). There may well
be fewer today, but organized retailing (i.e. retail chains) currently accounts for just
one sixth of total retail sales, significantly lower than the proportion in developed
markets such as the US and Taiwan, where 80 % of retail sales are generated by
organized retailing. However, this sector is developing rapidly. Its market share has
increased from less than 5% in the early 1990s to 17% now. With the top 50 players
accounting for less than 5 % of the market (versus 30 % in the US), there are clearly
substantial opportunities for industry consolidation.

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

Organized retailing share in selected markets, 2004

Unorganized 15%
19%
30%
45%
60% 60%
70%
83%

85%
81%
70%

55%
40% 40%
30%
Organized 17%

USA Taiwan Western Malaysia Brazil Thailand Indonesia China

Europe

Source: CLSA

China’s huge size offers great opportunities for expansion but at the same time
creates a logistics nightmare for retailers. Officially, there are 660 cities, 184 of which
have a population of over 1 million. Chinese cities can be categorized into three tiers
based on population size and GDP per capita. There is no official definition for
defining these tiers. However, in general, tier one cities have a population of over 6
million and a per capita GDP of over US$ 5,000. Tier 2 cities have population of at
least 1.5 million and a per capita GDP of US$ 2,000. The remaining cities belong to
tier 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 of
distribution points in hundreds of tier 3 cities.

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

Tier 1 and tier 2 cities only represent one third of the market potential
Retail market
Percentage, value

Tier 1 “Big Bosses” Beijing

Guangzhou Tier 1
Shanghai Big Bosses 9

Tier 2 “High fliers” (9 cities) High fliers 11

• Big tier 2 cities 23
Chengdu Changzhou Modest neighbors 7
Chhongqing Ningbo Changchun Shantou
Foshan Dongguan Changsha Shijiazhuang Rich cousins 5
Hangzhou Suzhou Dalian Tangshan
Tier 2 “Rich cousins” (9 cities) Nanjing Taizhou Harbin Xi’an Tier 2
Shenzhen Wenzhou Jinan Zibo
• Relatively rich, smaller tier 2 cities Shenyang Wuxi Kunming Zhengzhou
Tianjin Xiamen Qingdao Taiyuan
Wuhan Zhongshan

Tier 2 “modest neighbors” (14 cities)

• Other tier 2 cities Poor relatives 68

Anshan Jiaxing Nanning Xuzhou
Changde Jinhua Putian Yangzhou
Daqing Jining Qinzhou Yantai
Fuzhou Laiwu Quanzhou Yichang
Guiyang Lanzhou Rizhao Yiyang
Tier 3 “Poor relatives” (~600 cities) Haikou Linxi Shaoxing Zaozhuang
Tier 3
Hefei Luoyang Taian Zhanjiang
Huhehaote Luzhou Weifang Zhenjiang
Huizhou Mianyang Urumqi Zhoushan
Huzhou Nanchang Xiangfan Zhuhai

Source: China Statistical Yearbook

Retail format development

The Chinese retail market first began to transform in the early 1980s. Within 10-15
years, all modern formats had emerged, including department stores, convenience
stores, specialty stores, supermarkets and hypermarkets. Modern department
stores, which first appeared in China in the early 1980s, were basically remodelled
state-owned department stores such as Wangfujing in Beijing and First Department
Store in Shanghai. In the early 1990s, local supermarket chains such as Hualian
started to emerge and quickly expanded across the country. The mid-1990s saw the
arrival of foreign hypermarkets with Carrefour as the first in 1995, followed a year
later by Wal-Mart and Metro. Although 7-11 came to Shenzhen in 1991, the rapid
growth of convenience stores only started to take off in the late 1990s, when they
proliferated in major cities such as Beijing, Shanghai and Guangzhou. By the late
1990s, other retail formats, such as specialty chain stores, category killers, luxury
boutiques and DIY stores, all started to take root. By then, China had fully embraced
the world of modern retailing.

Modern formats, which are growing faster than traditional ones, are expected to
account for 60% of retail sales by 2010, up from 55 % today. The channel mix in
major cities is already comparable to that of Western countries. In Shanghai, 70%
of retail sales are generated by modern format retailers. Hypermarkets have the
highest 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 %.

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Modern trade is capturing a bigger share of the market

China retail sales by format CAGR 05–08

(in %)

43.2 Modern formats

7.4%

44.6
2.4
9.2%
Traditional formats* 46.1 2.3 20.5
9.8%
19.8 * Includes cooperatives, independent grocers,
Convenience stores 1.8 free markets, food specialists and other food and
9.8 8.0%
Specialty stores 17.6 non-food outlets
10.0
Department stores 11.0 8.1%
21.4 ** Defined as a store with retail sales area of over
Supermarkets 21.7 2,500 m2, with at least 35% of selling space
23.2 0.3 1.6 2.7
Hypermarkets** 28.7% devoted to non-food product

1998 2005 2008(F)

Source: Euromonitor; Acess Asia; Chinese Statistical Yearbook

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 in
nine 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 the
JVs extended to all provincial capitals. However, the regulations were not strictly
enforced and some retailers with more than a 51 % stake – notably Carrefour – were
able to gain retail JV licenses from local governments. In 2003, the central govern-
ment lifted restrictions on numbers of outlets and raised the maximum foreign
ownership ceiling to 65 %. In late 2004, all restrictions on foreign participation were
lifted in accordance with WTO rules. Local operators also need licenses to operate
chain stores or operate beyond their own provinces. Some retailers are expanding
too fast and operating without a license. If foreign operators attempt to acquire these
local retailers, a lack of licenses is likely to be one of the key obstacles to a deal.

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

Food retailing
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 hypermarket
space, which has increased at a CAGR of 36 % for the past five years (much faster
than growth in consumption).

According to a survey by AC Nielsen, hypermarkets tend to win on low price and

wide product selection and are thus gaining share over supermarkets and neigh-
bourhood stores. According to research by Planet Retail, the share of grocery sales
captured by hypermarkets rose from 3 % in 2000 to 4.6 % in 2004 and is expected
to grow to 5.5% in 2009.

Through fast expansion and high customer preference,

hypermarkets are gaining share over all other formats
% of total modern grocery sales

0.9%
0.7%
C-stores & 0.3%
1.5%
forecourt stores 2.2%

2.8%
Supermarkets &
neigborhood stores
5.5%
4.6%
Hypermarkets & 3.0%
Superstores

2000 2005 2009(E)

Source: Planet Retail Note: Data relates to leading Chinese grocery retailers only

There is no dominant national player yet

No. of cities covered No. of stores

Wal-Mart 36 101*

Carrefour 35 92

Century Mart 16 97

Hymall/Tesco 14 44

Auchan 9 15
China has 184 cities
with population over
1 million

* 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.

Source: Literature search

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

Due to China’s 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 regional
players, such as Nonggongshang in the Shanghai area, Beijing Hualian in Northern
China and CR Vanguard in Southern China. Most of these have ambitions to
develop only a regional presence.

Falling productivity

As tier 1 and some tier 2 cities become saturated and more stores are opening in
tier 3, where the potential is lower, the sales productivity of new hypermarkets is
deteriorating sharply. The average sales of hypermarkets which opened in 2005 are
40 % 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 in
2004, 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 in
Western countries.

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

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

100

U.S. 100

69
59 U.K. 94

France 85

China 31

Opening years 1998 2002 2005

Source: OC&C Analysis

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

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

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

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 existing
regional players, which can be consolidated to build a national presence.
Nevertheless investors need to bear with short-term fluctuations in profitability as
well as licensing and other operating issues. These local players typically have weak
cash flow and poor management. This window of opportunity for buying into the
market 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 used
to expand profitably into tier 2 and 3 cities. There are two main ways to do this: you
can reduce investment costs and/or reduce operating costs.

More innovative methods include supplying fresh produce – (high-growth) area that
drives traffic to the stores, but few operators can make it profitable. Stores also face
tough competition from wet markets, which offer unbeatable freshness, great variety
and very low prices. Outsourcing fresh produce to concessionaires, who can source
local 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 know
how 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 national
distribution network, there are many sizeable regional and local players which
provide relatively reliable, efficient services at a competitive price.

As hypermarkets expand into lower potential areas, reducing operating costs is

essential. Giving store managers accountability for cost control and then sharing the
benefits with them is a possible solution. If targets are reasonably set and incentives
are 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 have
better skills in marketing, managing customer databases, launching loyalty
programmes and developing private labels, all of which help improve revenue and
margins. The challenge is to find and retain qualified middle managers to execute
such programmes.

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Supermarkets
Supermarkets have grown moderately in recent years. Sales per store have declined
steadily due to market saturation and keen competition from other formats. The
number of supermarkets per household in China is three times that of Hong Kong
and 17 times that of Taiwan. The sector is dominated by local players, the largest of
which 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 chains
continued to operate under separate banners. The Shanghai-based Bailian Group,
China’s largest retailer, has an aggressive goal of opening 8,000 stores by the end of
2008.

Supermarket strategies

Supermarkets are stuck between two rapidly growing formats: hypermarkets and
convenience stores. Their sales productivity is well below that of hypermarkets, due
to low traffic and limited offerings so they need to make a choice between moving
upmarket to provide premium quality products and better services or moving down
towards hard discounters. There are still opportunities for new entrants to build a
hard discount chain, but no one has done it successfully yet. Even Dia – run by
hypermarket giant Carrefour – has yet to return a profit. The current hard discounter
model clearly needs to be refined further to gain wider acceptance in China. Low
margins 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. These
include: 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 of
‘snacking’. However, saturation has already been reached in several cities. For
example, Shanghai is already over-saturated with more than 4,000 stores. The CVS
concentration (measured as no. of CVS divided by GDP) in Shanghai is already five
times that of Hong Kong. Although CVS giant 7-11 received a license to open stores
in 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 of
which are co-located with Lianhua supermarkets, acting as 24-hour outlets for the
larger 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 groceries
and daily necessities. Given the high rents in prime street locations, it is hard to
make a profit, even with a high-density store network. The key to profitability is
developing new sources of revenue such as providing services like bill payment and
distribution points for online companies. Franchising is the best model for a rapid
roll-out to new cities, thanks to lower capital investment, low operating costs and
preferential 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 franchisees
to virtually nil. Franchisees also keep costs low. It is not unusual to find the whole
family of a franchisee working for the store.

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

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

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

China Apparel retail industry, 2000-2010 (forecast) World Apparel retail industry, 2005
(US$ billion) (US$ billion)

183 • 1/3 of US market

CAGR • 50% larger than France
= 6.1% • 3.5 times of India
82
85
Others* 78 5
CAGR 74
70 4 9
=12.4% 4
66 4 8
61 3 8
57 7 61
Children’s 3 7
48 24
waer 3 6 22
43 3 6 21
20
2 5 19
Men’s 4 18 41
wear 17
15
14
Women’s
wear 41 44 44
37 39 18
31 34
26 12
24

2002 ‘03 04 05 06E 07E 08E 09E 10E US Japan China France India S. Korea

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

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

Climate variation across China is significant Guangzhou (South of China)

Shanghai (East of China)
Average temperature, 2004 (in °C) Beijing (North of China)
Harbin (Northeast of China)

30

25

20

15

10

0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

-5
Temperature difference across China:
-10
• 29,4 °C in Winter • 5,5 °C in Summer
-15

-20

Source: China Statistics Year Book 2005

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Consumer preferences vary widely across China. People in Guangdong province

tend 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 temperatures
between the north and the south is close to 30º C. Such differences affect the type
and style of apparel sold in different parts of the country.

The casual wear market in China is dominated by Hong Kong and Mainland Chinese
brands with a large store base. For example, Baleno, a Hong Kong brand, has more
than 3,000 sales outlets across China and Jeanswest, another Hong Kong brand,
has around 1,300 stores. However, revenue per store is small. Baleno’s annual sales
per store were around US$90,000 in 2005. Other brands such as Jeanwest and
Bossini 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 the
market. At the end of 2006, Uniqlo had opened eight stores and Zara had two
stores in China. Other big names such as C&A and H&M plan to open their first
stores in 2007.

There are a number of challenges retailers need to overcome in order to capture the
market potential in China. First of all, brand building is difficult and costly.
Consumers have limited knowledge of brands in general. This can be explained by
the 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 the
past seven years. Even if a retailer successfully builds up a brand, counterfeiters
often move in and take a substantial slice of the business. Although the government
has stepped up efforts to clamp down on counterfeit operations in recent years, this
remains a big problem for many companies with losses estimated at approximately
20 % of total sales revenues for multinational companies operating in China.
Successful brands may sometimes avoid counterfeit, but they seldom escape the
‘copycats’. Chinese companies are swift imitators. Popular concepts and styles are
usually 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 requirements
of Chinese consumers. However, these are becoming increasingly sophisticated in
large cities, creating a need for finer segmentation. In addition, psycho-behavioural
segmentation requires robust, quantifiable market research.

Finding the right retail location at the right price is another challenge. Although retail
developments have been sprouting up in cities all over China, rental cost keeps
going up. Today, rental costs in prime retail areas are comparable to international
level. For example, the cost of prime retail locations on Beijing Road in Guangzhou
is now comparable to similar location in Shinjuku, Tokyo. As prime retail locations
become 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 narrowed
to 6 %. The years of land grabbing are over. The time has come for sophisticated
monitoring of consumer demand and store execution.

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

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 the
national 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 before
expanding to others. For example, Uniqlo started in Shanghai and built up seven
stores there before expanding to Hangzhou. There are a number of advantages to
this approach. A retailer can do in-depth research and focus resources on the most
attractive 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 cities
in the same region first before moving out to other regions. Several mass apparel
retailers from Hong Kong such as Baleno, Giordano and Bossini used this approach
initially. Retailers can benefit in a number of ways. They can develop a more efficient
regional logistics network and they can take advantage of cultural similarities among
consumers 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-
try’s most affluent customers quickly and buildings a solid financial and branding
foundation for further expansion. Mango’s strategy is an example of this approach. Franchise frenzy

In addition to directly owned sales out-

lets, franchising presents an attractive
Franchise stores are very common in China option for expanding geographically,
but strong controls are needed. This
approach is widespread in China. Over
5400 stores of the leading five apparel
# of stores, 2006 Total retailers in China (84 %) are franchised.
Under such a scheme, authorized
dealers open individual stores under
Baleno 2993 150 3,143
the retail brand. Typically all branded
products are then sold exclusively
Jeans West 804 481 1,285 through franchised and directly
managed stores. The brand franchiser
also plays the role of distributor,
Giordano 594 120 714 84% are
franchised stores
supplying products to franchised stores.

Bossini 500 175 675 Testing business models and formats be-
fore national rollout is critical. There is no
“One Size Fits All” in China. People in
Esprit 539 89 628
different cities prefer shopping in differ-
ent formats for apparel. Even within the
Grand total 6,445 same city, running a standalone store
versus a counter of similar size in a de-
Franchise stores
partment store has different economics.
Directly managed stores
Therefore, it is advisable to test the
format first before entering a new city.
Setting up counters within department
Source: Company annual reports; literature search stores is a prudent way to test the
market before expanding into new cities.

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

There were signs of revival in late 1990s, along with strong retail growth in general
and successful reform of state-owned enterprise (SOE) department stores to draw
back customers. The arrival of international department stores also added new life
to 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 grew
from 1600 stores in 1999 to about 2200 in 2004. Results from a consumer survey
conducted by Euromonitor showed that department stores are still the preferred
retail format for customers for non-food products such as clothing, cosmetics and
furniture. Department stores accounted for nearly half of total retail sales of clothing
and footwear in China.

Department stores remain a key channel for apparel and footwear

Retail distribution of Chinese clothing retailers’ core products in 2003

Others 11% 9%
13% 15%
2% 18%
Grocery retailers 5%
7%
8%
12%
40%
39%
Specialists 20% 32%
45%

49% 50%
45% 45%
Department stores 35%

Men’s wear Women’s Children’s Fashion Footwear

Source: Euromonitor wear wear accessories

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

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

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 50-80
brands within a store. The owner charges the concessionaires 15-30 % of their
turnover (depending on the store location and floor) as commission. Most
department stores offer a one-year contract to concessionaires, but some evaluate
tenants as frequently as every quarter and poor performers are asked to leave. In
general, department stores in China lack concept or marketing skills.

International department stores started to enter the Chinese market in the early
1990s. Parkson from Malaysia and Pacific from Taiwan were the pioneers. Parkson,
which entered China in 1994, is the largest MNC department store chain in China
with 38 stores. Pacific Department Store currently has nine stores. MNC department
stores, which are typically better managed, have a more appealing shopping
environment and a better brand mix compared to their SOE counterparts. They are
expanding rapidly. Parkson, for example, has aggressive plans to expand to 100
stores after a successful IPO in Hong Kong. Other Asian and western players are
rumoured to enter the market soon.

SOE department stores are usually old-fashioned, relying heavily on concessionaire

sales and focusing on short-term profitability, resulting in poor floor planning and a
chaotic tenant mix. Although they still have a positive image among older
consumers, they find it increasingly difficult to attract young consumers due to their
tired store image. However, SOE department stores do have one advantage – their
locations. They usually occupy prime locations in shopping districts and therefore
can charge their tenants very high rents.

Department store strategies

Department stores are primarily a real-estate game. The key is to secure prime
locations in shopping districts. It is now difficult to find such locations in tier 1 cities
but not impossible, as some major cities are undergoing city centre redevelopment.
However, opportunities are still abundant in secondary cities where numerous retail International players
development projects are underway, with developers eager to find anchored tenants
with strong brands to boost the value of their projects.
provide better customer
service, plus an enhanced
So far, there is no national department store chain. Local players are mainly city or
regionally focused. International players such as Parkson are far from achieving shopping experience.
national coverage. A national chain would command huge economies of scale, both
in operations and in branding.

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

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

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Other specialist formats

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

DIY stores

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

Sports shops

With more leisure time, Chinese consumers are increasingly interested in sporting
activities and watching sports on TV. Multi-brand multiples have a limited presence
in China. Mono-brand stores are the dominant format because customers treat
branded sportswear as a fashion item rather than a functional product, thus they are
more effectively served through mono-brand stores. In addition, mono-brand stores
have 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 has
2,196 stores in China and is opening on average of 1.5 stores a day. Adidas is not
far behind with 1,535 stores. Following China’s successful bid for the 2008 Olympic
Games, sales of sports goods retailers are expected to remain strong for the next
few years.

Shopping malls

Numerous new shopping malls have been built in recent years. China is how home
to 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 town
north of Shenzhen, close to Hong Kong. Chinese shopping malls are usually part of
much larger mixed-use residential, office and entertainment complexes. Many
remain showpiece malls, devoid of crowds of shoppers and sales, while others are
experiencing strong growth because they are better designed and managed. The
key 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 retail
development in China. OC&C has detailed research on all these formats which are
published in separate folders.

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

Conclusion
Retail in China undoubtedly represents an attractive market for local and
international firms alike, but the market conditions are getting tougher. Seizing this
enormous opportunity not only requires an appropriate strategy but also faultless
execution, perseverance and audacity. It is still not too late for new entrants, but the
price will not be cheap. Statistics indicate that 70 % of the world’s top 50 retailers
have 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 already
made inroads, driving at high speed along this slippery road as the national
economy continues to grow requires refining the business model to tackle both
format 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

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Retail practice

The retail industry is one of OC&C’s strongest areas of expertise.

Internationally OC&C is recognized as one of the leading providers of
board-level advice on strategy and performance improvement to major
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almost every product and service category.

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