June 2012

The topic of China’s consumer market tends to conjure up the catchphrase “1 billion customers” and companies from around the world have flocked to cater to this market. As consumers in many developed countries have increasingly become overleveraged from years of easy credit, China’s consumers have remained mostly underleveraged. Even as China’s consumption growth has slowed recently, it is still expected to remain on a positive trajectory. After the start of the global financial crisis in late 2008, China’s economy remained more resilient than most would have expected. This was helped partially by a vast government stimulus program, but was due mainly to the consumer revolution underway in China as disposable income has continued to rise.

Although China has long been criticized for being an investment-led economy, it is keenly aware of the need for balancing its economic growth. The government has created incentives favoring domestic spending and set a target to raise consumption as a percentage of GDP to 50% by 2015. In one example, it has just recently introduced a US$4 billion package to encourage the use of energy efficient appliances.

Consumer Market Overview

To put China’s consumer market into perspective—as of 2011, the country’s store-based retail sales market was US$1.3 trillion and has grown at a 12% compound annual growth rate for the past decade. Food and grocery-related items made up the largest category, comprising 42% of all store-based sales. But as disposable income has increased, particularly in urban areas, and consumers have traded up, discretionary categories such as apparel, electronics and leisure have grown at even faster rates.



In just the past decade, China’s GDP per capita has tripled from approximately US$1,500 to about US$4,700 and as of 2011, its urbanization ratio rose to over 51%. This increased consumption power is further supported by an average of 11% growth in annual disposable income over the past 10 years. Since the 2008 crisis, retail sales have been growing at healthy double digit rates—17% in 2011. But for many global companies trying to reach this billion-plus consumer market, figuring out how to attract and retain a following in the hyper-competitive Chinese market has been troublesome.

One Country, Many Markets

 

Many tend to think of China as a homogenous market because of the predominance of the population’s Han ethnicity and of the use of Mandarin as the official language. But, in fact, China—which stretches more than 3,000 miles across—is many markets combined with numerous local dialects and regional preferences across its vast landscape. What sells in northern China may be very different from best sellers of the South or West, especially when it comes to such items as food and discretionary brands. Multinational brands preferred by wealthier consumers of coastal provinces may give way to much more fragmented local brands in less affluent cities. This presents challenges in how a major brand or a retail concept can really leverage and scale up in China. If a brand is successful in the coastal city of Shanghai, does that mean it will also be popular in Chengdu? For a company with ambitions to reach nationwide success, a key factor is its ability to modify its products to serve the unique local preferences of varying regions. Better yet, companies often need to introduce multiple sub-brands to enjoy the benefits of larger scale.

 

The Importance of Street Shops

Unlike in the U.S. and other developed countries where department stores and modern retail outlets dominate with efficient distribution channels, China still relies on numerous small shops lining pedestrian alleyways for the quick expansion of a brand. While Western shoppers often find apparel and shoes in chain department stores, malls and discount retail outlets, in China, overall department store sales as a percentage of total retail sales make up only 8.5% in major cities and 5.4% elsewhere across the nation. The typical mode of Chinese retail still involves opening tens of thousands of small shops in pedestrian-only shopping areas due to the country’s low penetration of cars. This is done to achieve extensive coverage into cities of varying sizes and affluence. This current model, however, creates an inefficient multilayer distribution system in which consumers typically have to pay up for quality. It has also led to a high fragmentation of brands. In my years of traveling to China, I have always marveled at the much higher retail prices of apparel and footwear products compared to those in the U.S. A company aiming for widespread reach must determine how to best develop its distribution network given the necessity for China’s street-level shops. It must also learn to control these many locations to maintain its brand image and product integrity. In addition, to sustain and protect its business model from eroding, a firm needs to focus on offering good quality to customers over the long term rather than try to maximize profits over the short term by raising prices.

Brand Awareness and Loyalty

While Chinese consumers are becoming more aware of brands and tend to equate higher prices with brand names and better quality, brand loyalty is still low and needs to be nurtured. Although 45% of Chinese consumers believe that a well-known brand represents better quality, the bulk of Chinese consumers prefer trying multiple brands in any given household product category, according to a recently study by consulting firm Mckinsey & Company. In the U.S., 71% of those surveyed said they would likely to stick with their favorite brands. Meanwhile only 46% of Chinese consumers said they would do the same. The same study, however, also showed that as income levels rise, loyalty toward higher-end brands seems to increase—good news for makers of more established brands.

This general lack of consumer loyalty among Chinese shoppers suggests that companies need to think more creatively about their marketing message. One leading multinational firm recently adopted a clever campaign to ramp up penetration of its diaper products into the Chinese market. Instead of just creating the typical television ads to increase its brand awareness, the firm sponsored an in-depth sleep study, visiting 6,000 homes. It handed out free diapers as part of its study, which concluded that babies fell asleep faster and slept more soundly while wearing their diaper over other brands. To strengthen its brand loyalty, the company also invited parents to submit photos of their sleeping babies and ultimately featured more than 200,000 photos of sleeping babies on its website. This created a good brand association with mothers and has helped the firm become China’s top choice for diapers in recent years.

Tale of Two cities

With the rapid rise of income and a growing class of “nouveau riche,” China’s luxury market is fast becoming a much-talked about growth segment. It is estimated that luxury goods industries will grow at a 25% compound annual growth rate over the next five years against 11% general consumption growth. Many reputable foreign brands have already established a strong presence in China and are now rapidly expanding into second- and third-tier cities. Stroll down some major shopping streets in Shanghai or Beijing, and you’ll get the feeling you’re on Rodeo Drive in Beverly Hills. International brands dominate the luxury market in China due to their long heritage, consumer aspiration and quality. Several locally grown firms also are vying for a piece of the action with “pseudo-foreign” luxury names. However, their results have been spottier. As consumers become increasingly sophisticated about “bona fide” international brands, local luxury brands may be hard-pressed to develop the right strategy to compete. In the mass market, the story is different. Although large multinational corporations do dominate certain sub-segments, such as carbonated drinks and shampoos, the competition is generally more balanced. Chinese brands lead foreign brands in many product categories owing to their knowledge of local tastes and local distribution chains. For example, food staples such as instant noodles and ready-to-drink teas are dominated by two Chinese firms originating from Taiwan. In the electronic retail segment, two well-known local firms lead the market.

Case Studies

To further illustrate how firms have dealt with the challenges of marketing in China, let us first consider China’s sportswear industry. This area is dominated by a handful of strong local players alongside more famous international sportswear brands. The industry experienced a period of strong growth in the mid-2000s, peaking a few years ago during the hoopla of the Beijing Olympics. Sportswear makers aggressively expanded their store networks each using a distributor model with well over 7,000 stores nationally. But the growth eventually cooled down after the Olympics and, as a result, the unchecked over-expansion caused many firms to lose control of their distribution channels with much unsold inventory. Deep price cuts across the industry also damaged brand image and differentiation among brands. Most in the industry have suffered in the form of lower sales, compressed profit margin and drastic decline in market cap. The entire industry is now undergoing restructuring to clean up inventory and retrench.

Meanwhile, by comparison, China’s women’s footwear industry has seen a positive growth trajectory in recent years. The industry itself is more bifurcated than that of the sportswear industry with one strong player dominating the higher-end market and another dominating the lower-end mass market. Many other smaller manufacturers also cater to this growing market. Although the two leading local players have thousands of store locations each, they have established these shops through a disciplined expansion using self-owned stores versus a distributor model to control the inventories, product pricing and quality. Brand image and differentiation among shoemakers are also better defined for consumers and the two industry leaders have avoided direct competition. These leading shoe makers have consistently topped consumer surveys and, as a result, have thrived and profited from a sustainable, and therefore healthier, market expansion.

What does this all mean for investors?

It is no doubt that China’s consumer market will remain an investor focus for years to come. But before one becomes enticed over the possibilities of “1 billion customers,” companies and investors need to recognize both China’s opportunities and the challenges. To find and build sustainable retail brands in China, investors should look for these qualities: companies that can have broad appeal with either a core brand or (more likely) a multi-brand strategy; firms that have demonstrated control over their sales channels preferably via a direct self-owned retail model or a flat distribution channel; and firms that are proactively building long-term customer affinity through effective marketing campaigns. In addition, careful consideration over how to position and differentiate a brand from mass marketing to luxury branding is paramount to a firm’s success. By focusing on the right kinds of companies that are able to successfully tap Chinese markets, long-term investors should be able to harness the rewards of a billion consumers.

 

The views and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writers' current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein.

The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information.

 

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