China logistics: Filling the gap

"The success of our business hinges on our ability to provide superior customer experience, which in turn depends on a variety of factors. These factors include our ability to continue to offer authentic products at competitive prices, source products to respond to customer demands, maintain the quality of our products and services, and provide timely and reliable delivery, flexible payment options and superior after-sales service."

Of the potential weaknesses disclosed by Chinese e-commerce giant JD.com in filings ahead of its $1.8 billion US IPO, "timely and reliable delivery" received particular attention, not least because of the firm's plans to address the issue by building out its own infrastructure.

JD is a poster child for e-commerce growth and the growing pains that come with it. The company plans to spend up to $1 billion on supply chain improvements over the next three years and made no secret as to the reason why: China's warehousing and last-mile delivery services are insufficient to meet the needs of online retailers that want to reach more consumers without sacrificing on quality.

JD and its counterparts are not the only ones clamoring for better infrastructure. Demand is driven by changing domestic consumption patterns, which have also stimulated growth in third-party logistics (3PL) and the roll-out of organized bricks-and-mortar retail.

"You have to get something from A to B in the most efficient way and cost-effective way and you do that through modern logistics," says Sachin Doshi, head of non-listed real estate investments for Asia Pacific at Dutch pension fund APG Asset Management. "It is very hard to deliver goods on the same day to someone in Shanghai or Beijing if you spend a lot of time in a shed trying to find things."

The companies seeking to fill this gap require capital and PE players, whether fund managers or institutional investors, are willing to provide it. According to AVCJ Research, $4.8 billion has been invested in warehousing and trucking and courier services in China in the last 18 months.

Several express logistics players - the last-mile service providers - have received funding to support nationwide expansion plans, notably SF Express. On the warehousing side, this year APG invested $650 million in Warburg Pincus-backed e-Shang, Shanghai Yupei received $250 million from RRJ Capital and Temasek Holdings, and a consortium featuring Hopu Investments and several Chinese institutional players injected $2.5 billion into Singapore-listed Global Logistic Properties' China business.

PE represents just one portion of the capital entering the sector, and while the fundamentals are in China's favor, there are still concerns at the pace of deployment, particularly in warehousing.

"The unleashing of investment seems to be as much for the future potential of the land as for the need to service the logistics sector," says Mark Millar, a China logistics veteran who now serves as managing partner of industry consultancy M Power Associates. "Some people are building a pipeline for future development but others - and it's mainly local companies - are speculating."

Growing pains

The growing pains in China's logistics sector are tied to the evolution of the economy as a whole. Having made its name as the factory of the world, China is now an emerging hub for consumer spending. As the economy evolves, so must the infrastructure that underpins it.

Meeting the needs of modern domestic retail is far more complicated than those of export-oriented manufacturers. Products go through warehouses and distribution centers where they are broken down into smaller consignments, often relabeled or repackaged, and then released in increments, based on end-user needs. It requires a level of service, geographical coverage and infrastructure that China simply does not possess in scale.

Euromonitor International projects that consumption in China will grow from RMB21.1 trillion ($3.4 trillion) in 2013 to RMB27.1 trillion in 2016. Online retail sales alone will more than double over this period, reaching RMB3.8 trillion, iResearch estimates. However, logistics cost as a percentage of GDP is 18% in China compared to 8% in the US. Logistics space per capita is one twelfth that of the US, and even with projected expansion from the current 550 million square meters of space to 2.4 billion sq m by 2029, the per capita figure will still be one third that of the US.

GLP claims that only 20% of the existing supply can be classified as modern, with much of the stock too small or obsolete. It feeds into the still highly fragmented 3PL market. "One of the reasons some players struggle to grow is that it is hard to secure warehousing space," says Jeffrey Perlman, a principal at Warburg Pincus.

This dynamic has attracted plenty of long-term capital. Since the global financial crisis, sovereign wealth funds and pension funds have sought operating partners that bring them exposure to the asset class that goes beyond a blind pool. Joint ventures and fund management structures give the likes of GLP and Goodman - which works with Canada Pension Plan Investment Board (CPPIB) in China - additional firepower to what sits on their balance sheets.

Local execution capabilities are an important consideration. E-Shang, which has grown from a start-up to 1.5 million sq m of capacity in less than three years, is a prime example.

Having recognized logistics as a beneficiary of the urbanization and rising domestic consumption theme, Warburg Pincus noted a gap in the market for a national-scale warehouse developer. "Even for businesses in our retail portfolio, the lack of available warehouses to store goods was an impediment to growth," Perlman says. "We felt there was an opportunity to find the right local partner and build this platform, which would be primarily focused around domestic consumption."

The team wanted a local partner with the ability to acquire land in scale, and not just in one specific market; the ability to control construction costs and deliver projects on time, an important consideration when seeking repeat business from clients who require build-to-suit projects; and a substantial portfolio of existing tenant relationships, to ensure that there was sizable demand to meet this new supply.

They found no one among the local incumbents that ticked all three boxes. Their solution was to start from scratch with Jeffrey Shen and Sun Dongping. The former used to work for Prologis so he came with a rolodex of tenant relationships plus development expertise. The latter owned a contracting business for modern warehousing and had also developed a number of projects on his own account. He offered construction and land-sourcing expertise.

Land-sourcing was also a factor when GLP brought in the consortium of Chinese investors earlier this year. The company is the largest independent player in the market with over 9 million sq m of gross floor area and about the same again in its development pipeline. But in a fast-evolving environment it wanted partners that could deliver more customer relationships and better access to land.

Know your market

While China has yet to reach the level of saturation seen in developed markets, there is already evidence of tighter land supply in larger urban areas that account for the bulk of demand and therefore the highest concentration of warehousing. This is in part because local governments would rather see land put to other, more lucrative purposes.

"If you build a production facility on a piece of land you might be creating 5,000 jobs; build a warehouse on the same piece of land are it is probably 500 jobs," says M Power's Millar. For a local authority, warehousing is not a big contributor in terms of income generation, taxes and payroll. So supply is relatively tight."

Phil Pearce, managing director for Greater China at Goodman, notes that government recognizes the current supply chain inefficiency and the need for better logistics infrastructure. To this end, policies have been introduced to support the industry.

However, obtaining land in tier-one cities is becoming more difficult, which means logistics providers must either move to the periphery or seek out brownfield sites that can be redeveloped. For example, Goodman has a facility in Langfang, a third-tier city in Hebei province, but one that is in close proximity to Beijing. The company has also bought brownfield sites in Suzhou and is looking at doing the same in Beijing and Shanghai. Multi-level warehousing is also coming into vogue.

For all industry participants, it is a question of finding a balance between demand and supply, leasing price and acquisition cost. And it works both ways. "There are cities where it's easier to get land but you have to be careful," says Pearce. "We are confident on the demand side but in some markets there will be incidents of oversupply as everyone jumps into these areas where it is easier to secure land."

Much of this bullish sentiment can be tied to the very visible needs of e-commerce. A couple of years ago, e-commerce accounted for 3% of GLP's total leased area in China; now it is 25%. Goodman has gone from zero e-commerce three years ago to close to 20% today, with e-commerce companies responsible for 30% of leasing deals struck in the last 12 months.

The combination of restricted supply and rapidly expanding demand has created an attractive economic proposition. But the relationship between the e-commerce and the logistics industry has yet to find equilibrium.

For example, both Alibaba and JD are investing in their own logistics infrastructure, although in different ways.

Alibaba is primarily an online marketplace, facilitating transactions rather than shipping from its own inventory. The company does not directly own physical infrastructure, but in China Smart Logistics - a joint venture with express delivery companies and real estate developers - it has developed an information platform that serves as a conduit between buyers, sellers and logistics partners.

JD, on the other hand, carries inventory. The company claims to have built the largest fulfillment infrastructure of any e-commerce company in China to support online direct sales and marketplace business.

"Given the underdevelopment of third-party fulfillment services in China in terms of both warehousing and logistics facilities and last-mile delivery services, we made a strategic decision in 2007 to build and operate our own nationwide fulfillment infrastructure," JD says in its IPO prospectus.

The company operates 86 warehouses with an aggregate gross floor area of approximately 1.5 million square meters in 36 cities as well as 1,620 delivery stations and 214 pickup stations in 495 cities. All its facilities apart from a national customer service center are leased. The company employs approximately 24,400 delivery personnel, 11,100 warehouse staff and 5,800 customer service personnel. Same-day delivery is available in 43 cities and over 70% of packages arrive within 48 hours of an order being placed.

JD plans to expand its infrastructure by acquiring land use rights, building new warehouses and purchasing delivery vehicles. The company has already begun construction on three of five planned of its own fulfillment centers with a view to improving efficiency and reducing reliance on leased premises.

This is in stark contrast to Amazon, which leases 99% of the 84.6 million square feet used for fulfillment and data centers globally. The value of Amazon's land and buildings increased 54% year-on-year to $4.6 billion in 2013, mainly because the firm bought its headquarters. There was a more substantial commitment to equipment and software - up from $6.2 billion to $9.3 billion - which appears to tally with accounts of Amazon investing in technology rather than property.

The long game

JD's strategy does not make logistics providers unduly concerned. As one industry participant puts it, "We think the pendulum is going to move one way for a bit and then move back."

First, JD is unlikely to be able to service all of its needs in house. Second, most e-commerce companies do not share JD's ambitions and are expected to continue leasing, not least because they are growing so fast right now that renting facilities brings welcome flexibility. Third, when growth finally slows, investors in publicly-traded e-commerce companies might start asking why capital it tied up in assets that deliver lower returns than the core business.

Amazon is GLP's largest tenant in China, with Vancl fourth and JD eighth. E-Shang, meanwhile, also counts JD as a client and built China's largest e-commerce fulfillment center for Amazon.

"Logistics is key to their operations so they are probably going to team up with traditional logistics developers," adds APG's Doshi. "The way we see this business growing is a large e-commerce company comes to e-Shang and says, ‘I want to set up a 50,000 sq m facility in Chengdu, why don't you go do it and I'll give you a 10-year lease.' There will be a little bit these guys do on their own but China is a big enough country and the space is large enough for the two models to co-exist."

What warehouse operators have to be wary of are fractures within the fast-growing but volatile e-commerce model as well as among the fragmented collection of logistics and transportation companies that serve them. Consolidation is seen as inevitable in both areas.

"There are a lot of start-up e-commerce companies and so there will be failures," says Goodman's Pearce. "It is very important that we assess the business model of potential customers and ensure we are backing the right one. If we are, then the expectation is they would get bigger and the ones with less viable models would get taken over or close down."

While there are risks for retailers, the broader impact of e-commerce - perhaps better described as digitally enhanced logistics - cannot be ignored. It is percolating through the ecosystem, forming the bedrock for exchanges all along the supply chain.

A major contributing factor to the inefficiency of China's logistics sector is goods hitting multiple touch points: an order goes from manufacturer to 3PL to retailer before being routed through another 3PL to the customer. It is gradually being replaced by multi-channel distribution out of a single warehouse thanks to better configuration and information flow.

Chee-Wee Gan, a principal with A.T. Kearney in Shanghai, puts it in the broader context of a bifurcating market. Warehousing and delivery providers are responding to client needs, resulting in the emergence of a premium segment. "The industry was very poor in terms of standards but now we see a differentiation between better providers and the masses. That is why you are seeing some of these companies getting money."

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• Topics
• Industrials
• Technology
• Greater China
• Expansion
• Consumer
• Logistics
• Transportation
• China
• Warburg Pincus Asia
• TMT
• Consumer
• APG
• GLP
• Goodman