China retail: Asset-heavy to asset-light

Suning Appliance is changing the way it does business. Having become China's largest electronics retailer on the back of a traditional bricks-and-mortar approach chain store, the company is now adding click to its brick.

Last month, Suning launched an open platform program underpinned by an online-to-offline (O2O) link that integrates the entire retail process, from procurement to shipment to after-sales service. For shoppers, it means paying the same price, regardless of whether a product is bought online or in the store.

Speaking at a recent conference, Jindong Zhang, co-founder of Suning, said the approach is a response to the next phase of evolution in China's retail industry.

"Pure B2C e-commerce players barely turn profitable, while about 80% of online merchants who sell their products through B2C platform are actually losing money. We believe an O2O integrated retailing model is the only way to expand in the market substantially," Zhang explained.

Suning is one of the most aggressive traditional vendors trying to bite back at e-commerce players eating its business. Last year, the electronic appliance market descended into a price war when pure online retailer JD.com, formerly known as 360Buy, offered to cut its gross margin to zero. Suning and Gome Electrical Appliance in turn offered to match or undercut their rival's prices.

This multi-platform challenge is markedly different from the competitive environment in which these retailers emerged. Seven years ago, when Gome bought 501 stores from China Paradise Electronic Retail, the third largest player in the market, making its network twice the size of Suning's, it could justifiably claim supremacy. Now it is about more than bricks and mortar.

Private equity firms face a new reality as well. China retail investments used to be fairly straightforward: provide capital to help a business scale up, offer supply chain and branding expertise to improve efficiency and quality, and then take it public. Nearly a decade on, some of the creatures these PE firms created are among the incumbents that dominate virtually every segment of retail.

It all comes back to business model and implied cost, and while consumption growth in China remains comparatively robust, it is slower than before, which magnifies the impact of change.

Cost pressures

"There is no doubt that consumer demand is growing fast. But companies should adjust themselves from a hyper-growth environment to a more rational growth environment. In the old days, many businesses only thought about driving revenue growth. That ‘cowboy strategy' won't work anymore," says Derek Sulger, managing partner at Lunar Capital. "Companies have to think more about margins, costs, as well as professional management."

Chief among these cost concerns are real estate and labor - both have seen sharp increases, particularly in the first-tier market in China.

The average hourly wage for an employee of a foreign-invested enterprise was RMB55 last year, compared to RMB30 in 2007, according to government statistics. Property developers, meanwhile, have pushed up rental prices eightfold in the last 10 years, making China one of the most expensive commercial property markets in the world.

One option is to abandon expensive, and increasingly saturated, first- and second-tier cities in favor and move deeper into the country's interior, although this strategy presents costs and challenges of its own. Another is to switch from asset-heavy to asset-light retail by pushing into the online market.

"We are seeing more private equity firms increase their investment in online stores in tier-one cities, while simultaneously increasing investment in physical stores outside the tier-one cities in order to establish brand across China," says C.V. Ramachandran, Asia Head for advisory firm AlixPartners.

Retail experience from across the globe can still be brought to bear, whether it is in-store operational improvements, pricing realignment to offset inflation or better quality after-sales service. Indeed, it is not only emerging chain stores in China that require assistance; a new opportunity set has opened up in helping turnaround established players that are struggling to cope with the changing retail dynamic.

TPG Capital stepped to restructure Hong Kong-listed Li-Ning last year, as the retailer faced pressure from Nike and Adidas at the top of the market and from Anta and Peak Sports at the bottom, and with the entire domestic sportswear industry drowning in excess inventory.

Store closures and inventory cuts narrowed first half net losses to RMB184 million ($30 million), compared to a full-year deficit of RMB1.98 billion in 2012. Jin-Goon Kim, a partner at TPG who was brought in as executive vice chairman of Li-Ning, believed "the worst is behind," although the company has yet to prove it can follow this up with sustainable top-line growth.

Kim's high-level involvement suggests that Li-Ning recognizes the contribution TPG can make in a turnaround situation and the PE firm is able to wield influence that outweighs its minority position. In other cases, where the founder's ownership position might be stronger and his control more complete, a minority investor could struggle to bring about desired changes.

Lunar Capital's Sulger notes that many of the problems in China's consumer sector are tied to weak governance, not a drop in fundamental demand for what companies are selling. This thinking influenced Lunar Capital's decision to focus on mid-market control transactions.

"Companies often lack good professional managers and the ability to make timely strategic decisions. Therefore, we believe that the more control you have, the more ability you have help make those decisions in real time, rather than waiting to react to a problem," Sulger explains. "You also have a greater ability to bring in professionals who can help address challenges as this market evolves."

However, control deals remain the exception to the rule in China. In cases where the retailer is large, listed and in needs of new direction, a buyout isn't necessarily feasible - Li-Ning, for example, has a market capitalization of $1.2 billion, so a substantial amount of money, plus owner support, would be required to assume control.

As for smaller companies, there is often a residual discomfort in allowing a third-party to take a majority position, especially if it is a private equity firm with existing investments in the sector. "Entrepreneurs will be cautions if investors leaking their business strategies to their competitor if they sit in both companies' boards," says John Yang, a partner at Excelsior Capital.

Confronting the challenge presented by online retail requires a deep understanding of where a portfolio company fits into the changing sector.

Taken on their own, the numbers are astounding. As of July, China had 820 million internet users and 334 million 3G subscribers.

Online shopping gross merchandise volume reached RMB1.3 trillion ($190 million) in 2012, according to Beijing-based consultancy iResearch, accounting for 6.2% of total retail sales. It is expected to reach RMB3.6 trillion - or 10.8% of total retail sales - by 2016. McKinsey & Company puts current US online shopping activity at $220 million, or 5% of total retail sales.

Apparel and footwear make up just over a quarter of online sales in China, with computers, communication and consumer electronics (3C) a few percentage points further back.

Mixed fortunes

However, as David Wei, CEO of Vision Knight Capital Partners, points out, an increase in online shopping doesn't hurt traditional retailers across the board. He divides companies into four groups. First, those selling products that can be digitalized will be replaced by online platforms, as illustrated by HMV's slide into bankruptcy. Second, retailers of standardized products, such as electronic appliances, will be "killed softly and slowly" by e-commerce.

"It will be a bloody fight among Gome, Suning and JD.com," Wei said earlier this year. "They will continue fighting in the next 3-5 years. Both sides - traditional retail and online peers - are losing money. Gome and Suning are losing margin, while JD.com can't improve margin."

Third, retailers offering non-standard products that can't be sold online easily, such as furniture, will benefit from the growth of the internet in terms of wider marketing reach. Finally, retailers that provide offline services that can't be replaced by online businesses, for example wedding shooting photo services, will carry on regardless.

Many venture capital investors are watching the first and second categories with interest. In addition to eating into the market share of bricks and mortar retailers, e-commerce platforms are engaged in a fierce battle with each other. High valuations and uncertainty as to the future prospects of these firms, most of which have yet to turn a profit, have prompted a number of VC firms to hold back.

According to AVCJ Research, venture capital investment in the e-commerce space peaked at $4.15 billion in 2011, jumping from $915 million the previous year. However, it slowed to $3.4 billion in 2012, and only $383 million has been deployed year-to-date.

Tmall, a B2C site under Alibaba Group, JD.com and Suning.com are ranked as the top three e-commerce sites in the country, with Tmall claiming 50% of the market. AlixPartners' Ramachandran expects online sales to swell to 25% of total retail sales in the next 3-5 years, with the space "dominated by pure e-commerce players like Alibaba."

In other words, new entrants are unlikely to survive. This is in part the function of a market that remains fragmented and defined by consumers who are motivated by price rather than any sense of brand loyalty. It means that e-commerce sites are effectively buying market share, building up scale in order to go public at the highest possible valuation, and this explains their notoriously high capital burn rate.

VC backers won't stick around forever so the longer the wait for an IPO the more questions are asked about a company's future.

A handful of the larger Chinese e-commerce firms - those perceived as having sufficient scale to survive - are expected to list, notably JD.com and Vancl, China's largest online clothing retailer. JD.com's investors are indeed betting big, with Ontario Teachers' Pension Plan, Kingdom Holding and Tiger Global among those to put up a $700 million round of funding late last year.

Hurst Lin, a partner at DCM and formerly COO of Sina Corporation, says he stopped investing in e-commerce players in 2010, after backing travel website Tuniu and Dangdang.com.

"The e-commerce sector development is actually very unhealthy now. It is packed with companies engaged in price war in order to lure more customers," he explains. "We may consider returning to this sector as long as business becomes more rationalized in the next 2-3 years - when sites are no longer just competing on price, but emphasizing product quality and logistics services."

There is also a trend for online firms to open offline physical shops, driven by a desire to escape the cutthroat competition of online pure-plays, establish a brand name in the street, and offer more services.

Meilele, an online furniture retailer, has established about 260 stores that offer customized services, coordinate product shipments and supply after-sales services.

"If you are only selling products through e-commerce sites, you will never scale up your business to become a big player in the industry," says Yang Gao, CEO of Meilele. He adds that offline showrooms enhance a customer's shopping experience.

Of course, it helps that the company falls into Wei of Vision Knight's third category - retailers offering non-standard products that can't be sold online easily. Shoppers don't necessarily want to see cosmetics or clothing in a "consumption environment" before purchasing.

The way forward

How, then, will offline and online elements become reconciled in China, if at all? Certainly, the business model as it stands is markedly different from the US. Of the top 10 retailers in the US, only one - Amazon - is an online pure play. In China, eight of the top 10 are online-only, according to iResearch. Industry participants don't expect China to ultimately conform to the US model.

"In the US, e-commerce is important but as a complementary to offline traditional retail. However in China, it will not be a complementary; online players will become the mainstream retailers," Vision Knight's Wei explains. "It will be more important to be online."

He offers two pieces of evidence in support of his argument: on November 11, 2012, online sales reached RMB19.1 billion, exceeding the offline total for the first time, a phenomenon that has yet to happen in the US; and during the fourth quarter of 2012, Taobao's sales revenue was greater than that of Amazon and eBay combined, another first.

In this context, the e-commerce platform war is far from over, which means the incumbents are by no means guaranteed to retain their leading positions for the long term.

"Tmall is dominant now but I don't think it will remain dominator in the next few years. There will be more players coming out, even along the lines of the platforms or online department stores concept," says Ray Yang, head of the consumer investing practice at Northern Light Venture Capital.

There is also expected to be more investment in online brand owners, so-called "category killers" that span multiple brands across women's shoes, fashion and cosmetics. Merchants will effectively move horizontally along the value chain - claiming a larger share of the revenues as they go - by designing products themselves and driving the online marketing. Few will be able to execute this strategy in every segments so there will be numerous winners.

While brands were previously launched only in Tmall, the proliferation of platforms allows a much wider reach. Yang believes these brands now have sufficient scope that they are attractive to venture capital investors.

On the traditional retail side, private equity players are looking to take regional brands national through adding an online element to a predominantly offline proposition. Lunar'sSulger compares selling a product through Tmall to rolling it out in a new department store - the brand has an opportunity to gain traction with a new audience. However, success depends on emulating the model that Suning is investing so much in: integration across platforms.

"Few in China do that well," Sulger adds. "Even globally this has been a challenge, although there are emerging benchmarks like Apple which ensure that when you shop online, you see exactly the same products at the same price you can buy in the stores."

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• Topics
• Greater China
• Consumer
• Expansion
• Buyouts
• Technology
• China
• Consumer
• TMT
• Lunar Capital Management
• Growth capital
• buyout
• TPG Capital
• DCM-Doll Capital Management
• Vision Knight Capital