Where Brands Are Missing a Trick in China

HANGZHOU, China — Sophisticated, picturesque and renowned as the centre of China's centuries-old silk trade, the city of Hangzhou has a reputation to maintain within fashion circles. If any city has an intimate understanding of luxury, locals here often boast, it is theirs. Given its opulent heritage and the influx of tech wealth the city attracts as a vibrant innovation hub — Jack Ma calls it home and built his Alibaba empire here — luxury brands were right to think that Hangzhou was a goldmine. But they may have been overly enthusiastic as they opened one boutique after another in recent years.

Hangzhou illustrates how some luxury brands could have got their footprint a bit wrong in China. As part of McKinsey & Company's 2017 China Luxury Report, the consultancy has identified a conspicuous "mismatch" between supply and demand for luxury across the Chinese mainland. By comparing the number of households with an annual income (in purchasing power parity) of more than 300,000 RMB (about $45,000) to the number of luxury brand stores in each city, analysts have identified where they believe some of the biggest opportunities and challenges are.

“Hangzhou is a good example of a city where you have a lot of stores and a [comparatively] low share of wealth. It has 7 percent of China’s luxury store concentration but only 1 percent of China’s wealthy consumers,” says Benjamin Durand-Servoingt, associate partner at McKinsey and co-author of the report.

“[Brands] are being a bit more careful in the way they are managing their network, especially the big names. [Some have] closed down a couple of stores which were not strategically driven and then for some they were more aggressive or too pushy in some of the cities. They came with too many stores.”

“That said, I think there are still some big luxury brands…that are not at full maturity in their network [meaning] they still have room to open more.”

Indeed, while cities like Hangzhou appear to be oversaturated, others like Foshan could be underserved and underexploited in terms of their luxury retail offer. “Foshan is interesting with about 2 percent of China’s wealthy population for below 0.1 percent of luxury players’ stores,” he adds.

Riding the ‘third wave’

Overall, the number of stores opening on the Mainland more than tripled between 2008 and 2016 and the tipping point came in 2014. The main driver behind this latest expansion comes from what McKinsey calls the "third wave" of luxury players including brands like Gucci, who launched ecommerce on their own site for certain products last month, and Saint Laurent.

Unsurprisingly, fashion capitals like Beijing and Shanghai lead the pack with 17 percent and 15 percent of the weight of the country’s luxury store network respectively. Other major cities with the highest concentrations of luxury stores include Hangzhou, Shenyang, Chengdu, Nanjing and Guangzhou.

David Zhao, CEO of Chinese fashion e-tailer Shangpin, which sells everything from Lanvin to Topshop, agrees that there is a huge opportunity to capitalise on the wealthy consumer living outside top tier cities. “In the first year [of our business] almost 35 percent of sales came out of Shanghai and Beijing [but] now it’s less than 23 percent,” with cities like Wuhan, Nanjing and Chongqing growing in importance and market share.

But what may come as a shock to some industry insiders is just how unaligned the market appears to be in certain places. The report outlines how 80 percent of China’s luxury stores are located in just 15 of China’s top tier cities (as measured by GDP). Yet 75 percent of the country’s wealthy consumers actually live outside these cities, which suggests that brands could be missing a very big trick if they are not present beyond the top 15.

Smaller cities don't yet have the commercial infrastructure that can support what luxury brands need.

There are several reasons why brands have been reluctant to invest in some of the more far flung affluent cities but travel retail and e-commerce are two of the main ones.

With almost six international trips each on average per year, wealthy Chinese consumers account for a major share of China’s travel abroad. The globetrotting Chinese are motivated by dissatisfaction with the domestic shopping experience and the significantly more affordable prices abroad in places like Hong Kong, South Korea, Japan and Europe (compared to those in China which get inflated by high taxes). This coupled with the growing market share of the e-commerce channel means luxury brands can now access pockets of wealth in regional cities without necessarily having to open a slew of monobrands there.

But the current state of retail flux makes for a very challenging environment for executives pursuing growth on the mainland. It is difficult to gauge how best to allocate resources when balancing between penetrating lower tier cities in China, improving customer relationship management to better serve Chinese travellers abroad and boosting online channels.

Luca Solca, head of luxury goods at Exane BNP Paribas, argues that “lower tier cities are denser in terms of potential demand.” Therefore it could be worth hunting for “hungry” new luxury consumers who will spend more there than those who are already regular buyers of luxury in bigger cities. But he cautions against “moving too deep into questionable retail contexts, as these tend to negatively reflect on brand perception. In fact, we’re seeing a number of brands trimming their exposure in lower tier cities.”

The volatility of the shopping mall is one factor affecting brands as over 2/3 of their stores in China are located in one. It is also a question of keeping up with rising, evolving and declining neighbourhoods within cities and an increase of street front stores being swallowed up by new commercial real estate developments.

Places with potential and with problems

Durand-Servoingt highlights Xi'an, which currently has 2 percent of luxury brand concentration, as an interesting example of a city with potential. "We see some key players from the third wave that have one to two stores there like Gucci, Saint Laurent, Tiffany and Bulgari. Yet many large luxury brands (from previous expansion waves) were not yet present like Hermès and Chanel." Xi'an sits alongside Dalian, Chongqing, Harbin and Zhengzhou, each with 2 percent of the country's luxury retail concentration.

L’Avenue, a luxury mall located in Shanghai, is partnering with luxury hotels and high-end travel agencies to offer packages to target customers travelling from smaller cities around the country. However, Henry Gao, senior manager of marketing and CRM cautions that “the target market in second-tier cities still have their [own] special consuming habits.”

Not all industry insiders, however, see the ‘mismatch’ between the location of luxury brand stores and the location of China’s wealthy population as so significant. Meimei Ding, CEO of DFO International, a company specialising in fashion management and development which works across a range of cities says that a more nuanced picture is necessary.

Measuring cities by wealth or consumption power is not enough to determine how big or wide a brand’s footprint should be across smaller cities, she suggests, pointing to other criteria brands must consider before putting down roots. “Hangzhou, for example, is a provincial capital. This means it's a political and economic centre, therefore with better and stronger infrastructure for commerce and businesses,” she says. “Smaller cities don’t yet have the commercial infrastructure that can support what luxury brands need. And customers from smaller cities are also going to larger cities such as provincial capitals to do their luxury shopping anyway.”

It's not as easy as five years ago when you could just wait for consumers to come.

What’s more, there is still a general sense of dissatisfaction with the shopping experience across the Mainland. Factors like price, service and product assortment are all key areas where Chinese consumers feel let down. If this remains an issue in bigger cities with full format flagships, it will almost certainly be an issue for smaller cities with smaller boutiques.

Chinese consumers are not losing their passion for spending but where they are spending has implications beyond the industry. “It’s a major concern for the government [too],” Durand-Servoingt offers. “So there have been changes in the taxes, and one of the ideas for the last year has been the development of the duty-free network… where the Chinese consumer is able to buy luxury… for duty-free prices in the mainland.”

“People can now buy from the global market without going abroad,” says Zhou of Shangpin. “We trade products at the European price, and the whole business transaction is under the privilege given by the government. We call this cross-border policy and we keep the whole luxury market transparent for the consumer,” he says.

“But I predict that if brands can’t catch up online then the mismatch we’re talking about will soon be even bigger,” he adds.

It is a point not lost on the authors of McKinsey's report, who suggest that brands need to completely "rethink their mainland business model." By tailoring the merchandise assortment so that there is more perceived novelty and assigning different roles for different stores across the country such as image-building stores, showrooming stores and sales-generating branches, brands can better adapt to the fast-moving retail market.

“It’s not as easy as five years ago when you could just wait for consumers to come,” says Durand-Servoingt. “It now requires much more attention in terms of how to approach and ensure you’ll attract the right consumers.”

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