China Retail Market Entry

China Retail Market Entry With global consumer growth changes, foreign retailers need to consider carefully their strategy and approaches with regards to both geographical and consumer purchasing habits when entering new markets like China. As China s consumer retail trends continue to grow and outpace more developed markets, its retail infrastructure had lagged behind leaving considerable growth opportunities emerging in the retail E-commerce sector. Global retail markets that are more mature are showing decline or long term stagnation, and as a result, retailers are looking to change their focus to developing markets like China, adjusting their efforts to embrace e-commerce as the primary supporting link to the consumer. China Retail is BIG business - retail sales in China amounted to nearly USD 2.1 trillion in 2010, equivalent to nearly 50% of USA sales. It is getting BIGGER fast. USA annual retail growth is approximately 2%, whereas China is approx. 15%. China retail sales are expected to double in the next three years, growing from an expected CNY17.47trn (US$2.56trn) in 2011 to a projected CNY30.21trn (US$4.42trn) by 2015. The Chinese government has also spent a considerable amount of effort to ensure the country s internal infrastructure has developed in terms of its logistic capabilities to support the predicted increase in domestic growth fuelled by internal consumption. In light of the fact that China does not have a developed consumer credit cycle, China is expected to have more than 20 years of solid retail growth ahead in the lower to upper middle markets. One of the most important elements to China is that companies need to operate on a local cost basis. This is sometimes is the biggest challenge for foreign retailers in China as the cost basis vary differently from city to city. This is the secret to the foreign companies that have succeeded in China and have had longevity by being positioned to grow with the market as it has grows. Based on such expected growth for the Chinese retail sector, many retailers are planning to enter China, though careful consideration needs to be given on how to do this. This paper will address some key points and considerations associated with this process. Key Considerations when developing a China Strategy Retailers who wish to enter China must consider many dynamics that may be different or just running at a different cycle to their operations in more developed countries. China is a new generation of spenders - they are IT savvy or aware, but the country s consumers have developed a lot faster than the country s retail infrastructure. China has still not developed

any real consumer credit market and cash is still the most common method of payment. This creates short term difficulties for retailers, though show longevity for growth in the retail consumer sector. Changes in consumer growth cycles between the different market sectors; The internet revolution and e-commerce shopping trends - the internet generation is the core, not the secondary market; Increasing brand awareness that is not necessarily for the major brands - local consumer trends can differ from other more developed markets; Lack of brand loyalty; Geographical challenges and the different economic cycles between tier 1, 2 and 3 cities; Logistics and distribution challenges; Real estate - continuous changes in key shopping destinations like shopping centres/malls and related leasing issues including managing leases; Training issues and rapidly increasing staff cost; IP protection and local branding needs to be a key focus; Owning your own brand and controlling these elements are very important; How do you operate under a local cost infrastructure to stay competitive - this is probably one of the most important challenges. Due to China s population and considerable growth potential in its consumer spending habits, there are many challenges facing market entry. Any strategy must include the above considerations. Careful planning around the key channels is important to any successful strategy for China, which should take the above considerations in account. How to Enter the Chinese Retail Market Once a market entry strategy has been agreed, the retailer must then consider the implementation of: Incorporation & licensing IP protection & local branding issues Identifying and setting up sales channels Targeting key staff, looking at retention & training issues Look at branding & loyalty issues Look at price points Look at any real estate and leasing management issues Introductions to other services e.g. real estate, legal, brand or marketing services Warehouse management & stock control Setting up distribution & delivery services, core e-commerce arrangements & alternative support e-commerce channels Any strategy must start with a full understanding of the differences in the Chinese consumer markets and the vastly spread younger consumer. Providing product availability at competitive pricing generally reduces IP issues as the Chinese who can afford to buy the genuine item generally do. Due to numerous factors, a full bricks and mortar strategy for any retailer would be very hard to service the market potential. It would also be expensive and difficult to maintain, therefore retailers should look to a balance of flagship stores with e-commerce and franchise strategies to service demands. This requires very careful consideration.

Careful planning starting from the maturity of the consumer to accessing sales channels and supply chain management, all needs to be considered when developing any plan for China, as in many cases the best opportunities could even be in the secondary cities, which has often been proven to be the case. China knowledge is essential to developing a plan. Options for Market Entry Strategy A multi-channel approach is becoming the most common strategy adopted in China as it allows for greater flexibility. For a larger retailer this may include the retailer building out a select number of flagship or concept stores, then using this market position to support an e-commerce or franchise expansion strategy. For the smaller retailers this may include using an e-commerce strategy supported by their own e-commerce portal and bolting on a number of multi-channel options from e-commerce, TV shopping network to retail concessions. A small retailer or retailers with limited product range may even just have an agent arrangement managing their web portal, product distribution and payment collection. As such the retailer does not even need to put resources on the ground as in China they can manage their web portal content from the country where their core retail operation is based. As China is very diverse in terms of population and consumer growth development, a multichannel approach allows for a retailer to service the very diverse elements that will become evident as part of any retail strategy. E-commerce A multi-channel approach will probably consist of building a presence through E-commerce, which is the fastest way to build a brand and support distribution channel in China. Many retailers will find it hard to mention and build out a full bricks and mortar strategy in China, as they may have done in more developed markets, due to cost and market related restrictions as well as the lengthy timeline. In addition, key shopping destinations like malls can change virtually overnight with new buildings, even cities being developed, leaving retailers with poor performing leases. Franchising If a Retailer desired to build out a physical presence, this would be best rolled out with a number of master-franchised partners or individual franchisees across China, which would be attractive to mid to larger retailers. Franchising may not be the standard model as compared to more developed markets, though for China, such a strategy will provide for a fast-tracked bricks and mortar expansion approach as these partners/franchises can manage leasing, staffing costs and risks much better and more cost effectively than the retailer. In any event, distribution would be crucial to support any expansion strategy. Building out their own stores Retailers are best to focus on building out core flagships/concept-like stores, and using them to create a larger brand, image and presence in key cities in China. Retailers can then rely on expansion and sales distribution, though supported by an e-commerce sales and distribution model. It is important that retailers should keep control of their flagship stores as this is key in maintaining brand presence in the longer term, though they can add-on and change through a multi channel approach.

Regulatory Framework Structuring & Regulatory Elements Since 2004 the restrictions in respect of retail have been largely lifted. This freedom means that a foreign retailer has many options (or indeed combinations of options) to consider when entering the China market including: Central WFOE/JV with branches or separate WFOEs as operational bodies? M&A acquisition or Greenfield? Combination? What is the role of a central HQ? Which support and services can be provided to operational entities? What restrictions? Possibility of local government support for regional HQ status. How to establish a tax efficient structure Expansion through own stores, franchises or jointly operated stores? Which cities as target first tier? Second tier? Third tier? Others? There are many challenges to choosing the right structure for China, from IP to ensuring you have the local protection, and factoring in the very diverse populations and geographical servicing challenges. Any retailer needs to consider that in China nothing will be perfect, things develop quickly and there will be constant changes. There are aspects which a retailer must achieve and place priority on with any structure: 1) Controlling your product and brand delivery the retailer must be able to be the brand owner and control its destiny. 2) Cost competitiveness - just by being a foreign company you can add 20-30% in costs over your competitors. 3) Just because someone is Chinese, it does not mean they are connected - there are 1.3 billion Chinese people in China. Companies entering China will find the new generation will not work with the old; the people from the south will not work with the people from the north. They will say we are all Chinese though rarely is this the case. Loyalty in China is very linked to benefits, though this in itself can turn on you if what you have becomes too valuable. These aspects would be the biggest factor in most Chinese entry strategies. As with most things that develop quickly you have to allow for a structure that is clear on what you want to achieve, though at the same time allow for a structure that can change as the market changes.

Incorporation options & licensing China s incorporations and licensing laws are different to most countries, though they are generally defined. Retail regulations over recent years have been changed to make it easier for foreign retailers to enter and do business in China. How a retailer incorporates and operates in China is one of the most important elements of the China planning phase. If this is not undertaken carefully, considering both commercial objectives and the respective regulations, it can be costly and difficult to change in the future. A common and big mistake for China entry, is not considering both commercial operating and compliance requirements at the beginning of the process. Generally a typical cross border China structure will be a WFOE or a JV, depending if the regulations require the retailer to have a local partner in China for its particular industry. Wholly Owned Foreign Enterprise (WFOE) Joint Venture (JV) The best option would be to use a JV structure, to allow for a number of potential master franchise (China) partners. E.g., a separate China Partner and hence JV for the North, East, South and West, and e-commerce partner. This would enable a number of partnerships, and allow for royalties and/or profit to be repatriated to Hong Kong. Many retailers opt to use a Hong Kong/China cross border structure for the following reasons: The Hong Kong company can act as an Asian holding company for China and other Asian entities. Hong Kong companies provide a certain standard of credibility for its China and international operations, compared to using a traditional offshore jurisdiction. Withholding tax on dividends from the WFOE/JV to a Hong Kong holding company is only 5% compared to 10% other jurisdictions. Lower withholding tax in China for royalty fees of 7% if IP is held by a Hong Kong company as compared to 10% for other jurisdictions. Minimal profits tax for the Hong Kong company at 16.5%. Tax exemption on non- Hong Kong sourced profits. More convenient for RMB trading. A Hong Kong company is relatively cheap to maintain and easy to manage.

Branding & IP Branding an IP protection are key elements of any china market entry strategy. Retailer may look to just keep a foreign brand or adopt a Chinese brand that reflects to build a local market positioning this is a key consideration when deciding how top position and endeavor to build a market share this can be a difficult decision for a long standing foreign brand. IP in China is not an oxymoron. However, retailers need to be take measures to protect their brands and trademarks in China. Increasingly Chinese versions of their brands are equally important with the English versions. Retailers also need to take steps to protect the IP inherent in their trade dress and layout of flagship stores. In addition numerous risks are posed to business secrets and IP in China for retailers engaged in sourcing. Human Resources & Training Locating, retaining talent and dealing with employee disputes is probably the biggest single challenge facing foreign invested enterprises generally. However, this can be especially critical for retailers with their typically large workforce. In addition, human resources of the company are likely to be the greatest single risk to noncompliance and leakage of IP and business secrets from a company. PRC employment law is constantly changing and evolving. The new laws are not only tilted in favour of employees but have also resulted in PRC employees being more aware and militant in asserting their rights. Coupled with a largely pro-employee arbitrator means that all foreign invested companies need to be on guard in respect of such issue. Staffing and training is a key issue in China. Although there is a large population, there has been a shortage of basic skills training, which has not changed and will be slow to change. Staff training will become a noticeable expense for any retailer, though any retailer who offers such training will attract employees. It should be highlighted though that a number of local brands and even some foreign brands rely on other retailers training staff and then poaching them from these retailers. Chinese staff are easily attracted by more money and you will see on many CVs that a year s employment is a long time. Wage costs are growing fast and efficiencies are not - this is what is underpinning the Chinese consumer growth. Salary and related social benefits costs can be far greater than expected. Retail training is important and salary structure should be structured to performance and longevity. This needs to be done right upfront as salary structures are very difficult to change in China - the employee is generally on the winning side. Management Management performance on remuneration is key. This needs careful consideration as unlike the west, management will generally not give notice of termination; they will just leave and take much of the developed staff and infrastructure with them. Accountability and a broader management structure is therefore necessary, which will prevent this issue. One way of achieving this is a longevity and performance bonus scheme. Any management and staff employment and benefits scheme needs careful consideration as it will be one of the top few most important issues.

Real Estate & Leasing Issues Any strategy should consider the real estate issues as these issues alone has been the undoing of a number of foreign retailers. Real estate has proven to be a major headache for retailers entering China due to: 1) New developments and sometimes whole new city centres are established very quickly, offering consumers new and alternative shopping hubs. 2) Leases generally favour the landlord when it comes to a foreign retailer. In addition to the vast geographical elements retailers have to deal with, landlords provide further difficulty as if the shop becomes a success, many landlords will cash in on this success by selling the shop space. Leases tend to be short term, so if you are successful when it is time for lease renewal landlords will increase the rent based on the retailer s success, though if it is not successful, they generally will not adjust the lease terms. Many retailers have found success in building flagship stores adjacent to a successful mall so they are not reliant or restricted by the mall. Franchising strategies have also allowed retailers to mitigate the real estate risks without compromising their expansion strategies. Real estate has many complexities and this needs to be carefully considered as part of any overall strategic planning process. Related Taxes Taxes and related duties from import to local business taxes play a key role in a retailer s price point. These taxes and duties can be considered high compared top neighbouring countries like Hong Kong, though the government is currently reviewing these, with expected reductions in the import side of these taxes and duties in the near future. In China, foreign investment enterprises ( FIEs ) include wholly foreign-owned enterprises ( WFOE ), equity joint ventures ( EJV ) and co-operative joint ventures ( CJV ) that are registered in China. An FIE may be subject to some of the following taxes given the industry and activity the FIE is engaged in. Key Tax and Duty Indicators (a) Enterprise income tax ( EIT ) In China, all resident enterprises, including domestic enterprises and FIEs shall be subject to EIT imposed on the taxable income at the rate of 25%. For FIEs engaged in certain encouraged industries, e.g. the qualified high/new-tech enterprises, a preferential EIT rate may be applied. Generally, the taxable income of an FIE is its gross income after the deduction of allowable expenses and losses. Taxable income generally includes profits, capital gains, dividends, interest, royalties and rents, etc., but dividends received from another resident enterprise (including domestic enterprises and FIEs) could be exempt from EIT. FIEs shall be subject to EIT for incomes derived from both inside and outside China. Foreign tax credits may be granted for the income already taxed in foreign countries, which is limited to the amount of tax that the taxpayer would have paid if the income were sourced in China.

(b) Business tax ( BT ) FIEs engaged in providing taxable services, the transfer of intangible assets or the sale of immovable assets shall be subject to BT. The taxable services do not cover processing, repair and replacement services which shall be subject to value-added tax ( VAT ). BT is levied at rates that vary from 3% to 20% depending on the nature of the services and industry. Generally, the 3% rate applies to the construction, communications and transportation; the 5% rate applies to services, royalties and interest; and rates between 5% and 20% apply to entertainment services. Generally, BT is imposed on the gross receipts of the taxpayer without any deductions. In practice, BT will also be applicable when FIEs reimburse overseas companies for fees or expenses incurred outside China as the tax authorities consider such remittance as either being fees for services rendered or intangibles used in China. China is now undertaking BT and VAT reform, by which the BT taxpayers will be gradually converted to VAT taxpayers and VAT will replace BT eventually. Shanghai is the first trial city of which some companies (including FIEs) in service industry and transportation industry have been converted to VAT taxpayers. (c) Value added tax ( VAT ) VAT is imposed on the sale of goods, the provision of processing, repair and replacement services and the import of goods within the territory of China. The standard VAT rate is 17% and a reduced rate of 13% or even 0% applies to certain items. VAT taxpayers are divided into two categories, i.e. the general VAT taxpayers and the small-scale taxpayers. General VAT taxpayers are taxed at a rate of 17% and are allowed to claim input VAT credit against Output VAT. Small-scale taxpayers are taxed at a rate of 3% without input VAT credit. A VAT refund may be available for export. In general, exports are not subject to VAT. In addition, a refund of input VAT incurred on materials purchased for the export goods is available in line with statutory VAT refund rates provided for specific items. (d) Consumption tax ( CT ) Manufacturers or subcontractors processing or importing certain types of consumer goods in China shall be subject to CT. CT is applicable to prescribed non-essential and luxury, or resource-intensive items, such as tobacco products, alcoholic products, cosmetics, precious jewellery, fireworks, petroleum and motor vehicles, etc.. CT is generally imposed ad valorem, or as specific duty depending on the value of the goods produced, processed or imported. (e) Urban maintenance and construction tax ( UMCT ) All entities and individuals (including FIEs) who are taxpayers of BT, VAT and/or CT shall be subject to UMCT in China. Based on the localities of the taxpayers, the tax rates vary from 1% to 7% on the amount of BT, VAT, and/or CT actually paid.

(f) Customs duty ( CD ) CD refers to the tax levied by Customs on the value or quantity of the goods exported and imported. Import CD is levied at both general and preferential rates. A preferential import CD rate may be applied to imports originating from countries or regions that have entered into trade agreements with China. Under current China CD regime, most exports are not subject to CD in China. (g) Stamp duty ( SD ) SD is levied on certain documents executed or used in China, including prescribed contracts, written certificates of transfer of property rights, business accounting book and permits. For the prescribed contracts, the SD rates range from 0.005% to 0.1%, depending on the specific type of contract. Import/Export Stock As many retailer manufacture stock in China this can be an advantage, though there is a difference in classification for stock manufactured for export and local sales consumption. In determining a retail product mix a retailer should consider how much they decide to import or what the mix should be to ensure it achieves the right product mix and price points. Summary China s early stage but clear growth in its consumer and related retail sector is a welcome site for retailers looking for growth, though they will face many challenges and difficulties in the China Retail Market Entry process. Although there is great appeal for foreign brands, it is not necessarily only the bigger brands which need to consider these important challenges. Operating under a local cost infrastructure is the key to success, and this is where a lot of the smaller to medium sized brands have an opportunity and in some cases an advantage to the bigger brands. Retailers are convinced they need to be in China, though they are seeking a low CAPEX route for China entry, and more importantly a route that supports their eventual need for expansion and operations as they grow in China. Cost efficiencies are one of the most important elements that a foreign retailer will face in China. A multi-channel e-commerce strategy will allow for a fast-track and cost effective approach, though distribution and marketing are the key elements to this strategy. Most retailers require a simple direction they can relate to in order for them to visualise how to build a potential presence in China, taking into consideration of numerous local elements and operating parameters, and the help needed to be successful. CRG s Consulting Division provides such strategic planning, operating advice, assistance and support to retailers who seek to enter China, fast tracking their approach and reducing their risks and costs. Briefing Papers available for download: China Retail Overview E-Commerce in China Franchising in China China Regulations and Incorporations Prepared by CRG s Consulting division & FCP Corporate Services Limited Providing China market entry advice & services to foreign retailers www.fcpcorporate.com This paper and its distribution is governed by the disclaimer and confi dentiality statement which is available on the company s website. This paper should be read in conjunction with the company s disclaimer and confi dentiality statement.