Disruption and opportunity: China’s retail revolution

China’s consumer slowdown has prompted concern among economists and investors. But a closer look at the country’s retail trends reveals a case for long-term optimism.

9 minute read

retail shop front in china

Hema isn’t your average supermarket. Walk through its doors and you’ll see shoppers scanning fruit and vegetables with their smartphones for nutritional information and recipe tips. At seafood counters, customers use nets to fish out live lobsters that can be taken home or cooked fresh at the on-site restaurant. Overhead, shopping bags whizz by on conveyor belts, en route to couriers primed to fulfil online orders.

Owned by e-commerce giant Alibaba, the fast-growing Hema chain is an example of what’s known in China as ‘new retail’, a seamless blend of physical shopping and digitisation. In-store experiences like the seafood restaurants tempt customers to Hema’s locations across China. But the brand also provides the one-click convenience of a sophisticated e-commerce operation: Hema shops double as logistics centres, facilitating delivery of groceries to local customers within 30 minutes of an order.

Alibaba’s move into the grocery sector is just one of several dramatic developments that are shaking up Chinese retail. Although a slowdown in consumer spending since mid-2018 has sparked concern about the health of the wider economy, China’s fiercely competitive retail landscape continues to offer opportunities for innovative companies.

With China’s growing importance on the global stage, it is important to understand the true health of the Chinese consumer and any requisite implications for global growth. And at a more granular level, investors are eager to understand the drivers of change and position themselves to benefit from these fast-changing retail trends. 

Consumer spending slowdown

With household consumption accounting for 40 per cent of Chinese GDP growth and 68 per cent in the US (according to Oxford Economics and the Bureau of Economic Analysis respectively) the relative importance of the Chinese consumer to its economy is far below that of advanced economies. However, that static snapshot ignores the maturing direction of travel and investors are right to be somewhat cautious.

The slowdown in Chinese consumer spending growth began in the second half of 2018 and has continued into early 2019. Spending over the Lunar New Year holiday in January totalled just over RMB 1 trillion ($149 billion), 8.5 per cent higher than the same period in 2018 but the slowest rate of annual growth since 2005, the year official data on consumption first became available.1

“The slump in car sales, profit warning by Apple and slowing housing sales all attracted international attention and led to concerns about China’s consumption running out of steam [in 2018],” says Tianjie He, senior economist at Oxford Economics in Hong Kong. “But the slowdown in overall consumption – looking at the quarterly household survey data – has been gradual and contained.”

She cites various factors behind the slowdown, including the government’s crackdown on peer-to-peer lending in 2018, which had knock on effects on the availability of consumer credit. Then there was the economic uncertainty surrounding the ongoing trade spat between China and the US, which has made consumers more reluctant to spend.

The automobile sector has been particularly hard hit.  Year-on-year car sales were down six per cent to 22 million in 2018, according to the government-backed China Passenger Car Association – the first decline in two decades.2 As well as macroeconomic factors, government policy has played a role – tax breaks introduced to offset an industry wobble in 2015 rolled off last autumn, leading many prospective buyers to delay car purchases in the expectation new stimulus measures will be introduced.

Maturing market

There are other, structural reasons behind the decline in car sales that illustrate wider consumer trends. Over the past decade, 200 million cars have been sold in China. Many middle-class families who want a car and can afford it have already purchased their first one; hence the industry driver is transforming to more of a replacement cycle with naturally slower growth. And a similar effect is being observed in other sectors: purchases of expensive items such as smartphones and washing machines have begun to moderate as the consumer market matures.

This may cause a drag on the government’s efforts to rebalance the economy away from unsustainable debt-fuelled state investment to consumer-led growth, even if retail spending is now outstripping gross fixed capital formation as a contributor to GDP.

Over the longer term, the government needs to expand its social safety net to encourage citizens to spend more of their savings and continue lifting rural communities out of poverty and into urban affluence. This should allow China to sustain consumer spending growth as a result, albeit at a more modest level than over the past decade.

“We still have a long-term consumption-driven play in China,” says Alistair Way, head of emerging market equities at Aviva Investors. “I’d interpret the recent slowdown as a natural maturing of the market, rather than anything more severe. The underlying trends are still strong: household incomes look good and Chinese consumers have been able to sustain spending without accumulating debt to the extent of their counterparts in the West.” 

Experiences vs luxury brands

As the breakneck consumption of the past decade begins to slow, Chinese retail is becoming more fragmented and unpredictable. But one overarching trend looks to be unstoppable: the rise of e-commerce. Online retail sales grew 24 per cent last year, according to the official statistics bureau. As of the end of 2018, the internet accounted for 18.4 per cent of total retail sales in China, compared with 9.7 per cent in the US.3 Aviva Investors expects e-commerce as a proportion of total Chinese retail sales to grow further, to around 20-25 per cent in 2019.

One consequence of this is that traditional retailers are having to become more creative; in a market where customers can now use virtual-reality apps to browse the shelves from the comfort of their homes, high-street chains rely on technology to tempt customers into shops. At the Shanghai branch of Sephora, a cosmetics chain, sales teams on the make-up counters are equipped with tablets that can show customers how different shades of lipstick would look like on their face without trying each one.4

A related trend is a renewed focus on ‘experiences’. Where conspicuous consumption of luxury Western brands was once a marker of status among shoppers in richer ‘Tier 1’ cities, millennials are choosing to spend more on travel, entertainment and eating out.

According to research from PwC, 52 per cent of Chinese consumers spent more on these kinds of experiences in 2017 over the previous year, compared with 26 per cent in the US.5 One consequence is that retail centres are seeking to become destinations in their own right, offering a mixture of shopping, restaurant and entertainment options to capture more consumer spending and bring much-needed footfall to their struggling retail tenants. But investors need to be cautious when trying to play these trends, given the fickleness of consumer tastes.

“Investors need to be careful when looking to gain access to long-term consumer trends; there was huge investment in the Pizza Hut chain through Yum Brands, for example, but it turns out Chinese consumers aren’t as keen on pizza as was initially thought. After a huge expansion, the brand owner is trying to fix its offering, and is actually reducing its footprint,” says Jonathan Toub, emerging market equities fund manager at Aviva Investors.

“By contrast, we are anticipating continued strong growth among premium beer brands. The market for beer in China is huge and we expect there will be consolidation in the industry, following a repeat of the trend we’ve seen in other beer markets, where there has been a reduction in the number of competitors and a focus on the quality of the product. The rise of craft-style drinks and improved brand investment should push beer prices up,” Toub adds.

Logistics boom

As well as shaking up traditional retail, e-commerce has had a big impact on the logistics industry. And the internet-driven logistics boom has been given further momentum by government incentives such as subsidised pensions for employees.6

Foreign warehouse operators and investors are increasingly being drawn to the market – Australia’s Goodman Group and US-based Blackstone Group are building massive, multi-storey logistics facilities – while the growth of the sector has also minted home-grown billionaires such as Wang Wei, CEO of Shenzhen-based courier company SF Holding. Nevertheless, it’s an extremely challenging and competitive industry to invest in.

“Logistics in China is difficult to get right due to the fast-changing consumer landscape and the vast distances involved,” says Way. “ Logistics companies face competitive uncertainties and much of the power lies with the big online retailers such as Alibaba, JD.com, Vipshop and Pin Duoduo.”

Aware of the risk of being lumbered with large property portfolios, China’s e-commerce giants have traditionally opted against owning warehouses, preferring to lease facilities through subsidiaries – JD.com recently launched its own logistics firm for this purpose7 – or buy stakes in logistics specialists.

In March, Alibaba bought a 15 per cent stake in delivery firm STO Express for RMB 4.66 billion ($693 million). It is also looking to increase efficiency by leveraging the vast data it holds on customers to map demand and gain access to facilities that enable it to cut delivery times without building physical warehouse portfolios; it runs an online platform, Cainiao, to link up all the elements of the delivery chain.

New retail

The need to offer ‘last-mile’ delivery options is one reason Alibaba decided to move into bricks-and-mortar retail with its Hema shops, which are designed to act as last-mile logistics hubs as well as attractive shopping locations. Hema brings many of China’s recent consumer trends together, including a blend of online convenience and in-store customer experience, along with sophisticated digital targeting and tracking of purchases through mobile payment systems.

On- or offline, everything at Hema is paid for using Alibaba’s Alipay platform, enabling the company to add to the data it owns on customers’ behaviour and preferences. Its figures show Hema shops are almost twice as profitable as traditional supermarkets. Alibaba has even started to monetise the technology that underpins the model by leasing it to other chains: RT-Mart, a supermarket chain, has seen sales rise 10 per cent since bringing in new retail tech.8

JD.com, meanwhile, has opened its own chain of grocery shops, 7Fresh, which operates on a similar model to Hema. However, the revenue e-commerce firms are currently gaining from their high-street presence is negligible when compared to their core internet businesses, which still have plenty of room for growth. E-commerce firms can offer their goods and payment services to remote communities that traditional retailers cannot reach.

Risks and opportunities in e-commerce

Given their competitive advantage, investing in the big internet firms would seem to be a logical bet for foreign investors looking to play China’s long-term consumption story. But there are risks. The first challenge is that, as Chinese internet firms are regarded by Beijing as players in a strategic industry, non-Chinese investors are barred from holding direct stakes in them. This has led to a complicated system based on complex financial structures known as Variable Interest Entities (VIEs).

Foreign investors in Alibaba or Tencent technically invest in VIEs owned nominally by the companies’ executives, which means they don’t have direct voting rights. While this enables a circumvention of the rules, it can leave investors with little say over the companies’ strategies. Due diligence, to ensure any governance issues are quickly identified, is therefore paramount.

Another challenge is that, like Amazon in the West, China’s e-commerce giants are increasingly ploughing their profits into new investments far from their core expertise; from cloud computing to artificial intelligence to fast-food delivery. This restricts the amount of money they can return to shareholders even as their central internet businesses remain strongly profitable.

“The big e-commerce companies want to have a finger in every pie – they’re buying into all kinds of companies, from Indonesian e-commerce to domestic food services – so investors are not receiving much cashflow back right now,” says Toub. “But if these companies focus on what they’re good at, the opportunities are there, as strong growth is projected for the e-commerce sector over the coming years.”

References

  1. ‘China’s lunar new year spending growth slowest since 2005,’ Financial Times, February 2019
  2. ‘Why are the Chinese buying fewer cars?,’ BBC, January 2019
  3. Official figures from the National Bureau of Statistics of China and the US Census Bureau, as of March 2019.
  4. ‘China e-commerce boom fires up logistics sector,’ Financial Times, August 2018
  5. ‘China’s next retail disruption: end to end digitisation,’ PwC, Global Consumer Insights Survey 2018
  6. ‘Alibaba tightens grip on China logistics sector,’ Financial Times, March 2019
  7. ‘JD.com raises $2.5bn for logistics subsidiary,’ Financial Times, February 2018
  8. ‘Alibaba says New Retail strategy is paying off as Hema shopper data shows bigger average spending,’ South China Morning Post, September 2018

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