China’s Unlikely Invaders

HONG KONG, China — Some invasions take place in a climate of retreat. Such is the case with the wave of department stores that have begun a surge into China, despite the country's decelerating economy and the challenges they face from online giants, on one side, and a glut of shopping malls on the other.

“We have spent a lot of time studying China,” said Karen Hoguet, chief financial officer of Macy’s, speaking at a conference last month. The department store is grappling with a sluggish US market and aiming to jumpstart growth by entering China. Yet Houget cautioned: “We haven’t figured it out yet.”

British department store House of Fraser is also set to enter China, opening a store next April in Nanjing, followed by two more stores around the country by 2017. But the fact that House of Fraser was acquired by a Chinese owner last year doesn’t necessarily mean the company can expect an easy ride.

In fact, few department store groups currently operating in the Chinese market have gotten to grips with the country’s complicated landscape and a look at the sector reveals a rather dreary picture. Between slowing macroeconomic growth, decelerating luxury sales dragged down by the Chinese government’s on-going anti-corruption campaign, and the onslaught of e-commerce giants like Alibaba and JD, the country’s department store business model is fast being eroded.

Even those like Adrian Cheng, the third-generation retail heir and wunderkind behind K11 art malls and jewellery behemoth Chow Tai Fook, have struggled to find growth with department stores. In February, Cheng’s New World Department Stores reported plunging profits, down 40 percent in the second half of last year compared to the year before, which the company blamed on the overall slowdown of the retailing industry and increased labour costs.

A quick survey of the most recent earnings results across the highly fragmented Chinese market shows double-digit profit haemorrhaging across the board. Malaysia-based Parkson reported that profit for last year dropped 33.5 percent compared to the year before. Midlevel local peers Intime and Mao Ye International also reported yearly profit drops of 29.7 percent and 28.9 percent, respectively. Profit for billionaire Roger Wang’s Golden Eagle Retail, the market leader around Nanjing and the surrounding provinces, dropped 12.8 percent. Another large affordable national chain, Rainbow Department Stores' yearly profit fell 12.52 percent.

Even the historic Beijing Wangfujing Department Store Group, which opened China’s very first department store in the capital city in 1955, posted a 15.08 percent profit drop in the most recent quarter.

Industry analysts say there is little sign of a near-term turnaround. Indeed, far from offering retailers a promised land, China’s department store sector is clearly a troubled market. So why the surge in interest from foreign names?

Despite the general malaise, there are some bright spots. After the launch of an ill-fated Shanghai venture in 2006, Hong Kong-based department store chain Lane Crawford re-entered the city in 2013 and now boasts a total of three stores in Mainland China. In 2013, Parisian department store chain Galeries Lafayette opened an outlet in Beijing via a joint venture with Hong Kong retailer I.T.

Unlike the vast majority of department stores in China, these two stand out. “The two have very strong brand recognition, heritage and an experienced team on the ground, which have been driving the performance,” said Mariana Kou, a senior consumer analyst at CLSA. “Foreign players are more confident that they can provide a unique shopping experience with better store layout and well-trained staff and bring in a more refined portfolio of brands into China.”

Aside from targeting the luxury end of the market, Galeries Lafayette and Lane Crawford also entered China well after the government’s anti-corruption campaign was implemented in 2012; their business model was never set up to rely on the gifting business, the disappearance of which was a major hit to the sector at large. “In the past, many department stores relied on the use of prepaid gift cards,” said Forrest Chan, director of consumer research at China Construction Bank International. “Prepaid cards were a form of gifting. If you talk to the companies, they will tell you [that business was around] 10 to 20 percent but in reality, nobody knows how much of it was actually related to gifting. So now the practice is gone. That is having a big impact on department stores on a whole.”

That being said, there is cause for concern, namely the glut of retail space nationwide, which is expected to grow over the next few years.

After the government implemented stricter regulations to calm the housing market in 2010, property developers turned their attention to commercial projects and have been on a building spree. Although the introduction of austerity measures put sudden brakes on much of high-end retail demand and slowing GDP dragged on overall consumer spending, projects that had already been committed continue to come down the pipeline.

A study published in March from property consultancy Knight Frank found that in the coming year alone, over 20 new malls will open in Shanghai, while seven new malls will debut in Shenzhen. Similar surges in retail space are underway in all the major cities in China. “If you look at the growth rate in retail spaces, it has far outpaced the consumption growth,” said CCBI’s Chan. “It will take some time for the industry to digest and work through the excess supply.”

For department store operators, another crucial challenge is a shift to malls as the country’s preferred shopping format. Indeed, the new crop of shopping malls that have popped up around China offer not just retail but dining and entertainment, from cinemas and ice skating rinks to play zones for kids.

Last year, Thomas Lau, chief executive of Lifestyle International which operates Sogo in Hong Kong as well as the Jiuguang chain of department stores on the mainland, said that the company’s Shanghai flagship store, known for being a destination for city’s fashion set, had lost some of its marquee tenants, including Prada, to a mall that opened across the road. Its saving grace was that its Sogo Causeway Bay store in Hong Kong drives around 40 percent of the company sales.

In an effort to compete, department store operators are building new hybrid mall-like properties often called “lifestyle centres.” Last year, Golden Eagle, in one of the more daring moves in the sector, built a large-scale aquarium in one of its stores. Meanwhile New World is adding everything from beauty centres and English schools to themed restaurants. But these strategies are capital intensive and remain nascent at best.

“They are trying to compete with malls on the overall family shopping destination which obviously works in some of them but they’re not as well-designed as malls to be a mall,” said Richard McKenzie, a partner at OC&C Strategy, a consultancy. “Typically department stores are quite vertical. They have lots of floors. It makes a difference for what you’re trying to do.”

The elephant in the room, of course, is the unstoppable rise of e-commerce, which presents tough price competition. Online retail sales in 2014 surged an eye-watering 53.6 percent year-on-year to reach RMB 2.8 trillion, accounting for 10.6 percent of total retail sales in China, according to Knight Frank.

“Ten years ago when we were looking at China, it was: do we want to open or partner with someone to open lots and lots of stores,” said Macy’s Karen Hoguet. “Ten years later, as you might imagine, a lot more is focused on the Internet.”

A growing number of companies are jumping into the digital space with their own e-commerce platforms, but are hindered by the traditional concession model. “They don’t own their own stock, therefore they can’t sell it online,” said OC&C’s McKenzie. “To make it work, you have to work with the brands to set up the site and sell the brand stock online and that’s a difficult thing to do because the brands could do that on Tmall or on their own site and will make higher margins out of it. Unless people like Golden Eagle or Parkson can generate lots of traffic on their own, it’s not obvious why brands should go to them.”

At results briefings, Golden Eagle chief executive Roger Wang has openly expressed his admiration for Neiman Marcus’ success online, but when pressed for specifics on how they expect to compete in a space dominated by the likes of Alibaba, he demurred, saying: “We are figuring it out.” Others, such as Wangfujing and Intime, have set up their digital operations on Tmall.

Even offline, direct merchandising, which provides differentiation is an important strategy to prevent new entrants to the market going the way of existing department stores. “One key difference between the US and China market, in the US market you have a very high ratio of private labels; it can be as high as 50 percent. But in China, in house brand direct sales are usually only a few percent of the overall portfolio, so it’s quite difficult to differentiate from the competition,” said CCBI’s Chan.

A joint-study conducted by Fung Business Intelligence Centre and the China Chain Store and Franchise Association found that private labels accounted for less than 2 percent of revenues for Chinese department store operators, much lower than the 30 percent to 50 percent for retailers in developed markets. It attributed the dramatic difference to a lack of professional in-house buyers, huge capital outlays and inexperienced management.

“They really need to leverage on their operational expertise and heritage — be it US, Europe, Japan — to bring in unique product offerings to stand out,” said CLSA’s Kou.

So far, House of Fraser seems to have gotten off on the right path. It is avoiding the most saturated cities and opting to open in Nanjing, Xuzhou and Chongqing. House of Fraser chief executive Nigel Oddy said its China stores would be positioned as “premium” or “aspirational affordability” and the company plans on promoting its British heritage as a strong selling point. “We want to play on our heritage, our Britishness. There could well be some local brands to complement the Western ones, but the focus is very much on being a quintessential British department store in the way it looks and the brands it stocks.”

“Some marketing techniques can help such as limited edition products partnered with some strong foreign brands to celebrate their first store in China,” said Kou. “They will need to build one very successful store first and build up their reputation in the mainland,” she continued.