China consumer: Brand power vs traffic might

Kathy Xu, founder and president of Capital Today, has invested in companies that have come to define China’s e-commerce ecosystem, from JD.com to Meituan. This doesn’t make it any easier to order groceries in Shanghai during lockdown.

Local media recently published what it is claimed are messages Xu posted to a neighbourhood forum, seeking access to the community group-buying channel that could deliver steamed buns and milk. “I have a large family and we need bread and milk,” she said.

For the time being, the government has assumed control of supply chains city-wide. Residents source food by placing orders with volunteer community heads who organise deliveries made by government-certified vehicles. Luxury items – which now include tissues – are out of reach, regardless of how much money is offered.

When AVCJ caught up with one consumer-focused investor based in Shanghai, he was 29 days into a lockdown at Yanlord Riverside City, a large residential community for 4,200 households. Out of the 12,000 residents, 500 had tested positive for COVID-19.

“The property management staff were all sent into quarantine, rubbish piled up downstairs, and volunteer community heads have started running things. Deliveries have been banned because the delivery guys got infected. My current major concern is food,” the investor said, adding that he exchanged three apples for a packet of garbage bags.

“I spend so long fighting over fresh produce on mobile. Investors in Shanghai today have no interest in looking at projects.”

Authorities have eased the lockdown in Shanghai in recent days, but it’s unclear when it will end. The city previously employed a strategy of close monitoring with minimal social intrusion. It wasn’t enough to stop the virus. Shenzhen took a tougher stance, was liberated after a one-week lockdown, and is now held up as an example to others – even though the lockdown cost CNY 60bn (USD 9.4bn).

How many “city circuit breakers” can China withstand? Stockpiling of household goods is happening in Guangzhou, and some lower-tier cities have imposed similar measures despite having zero cases. Shanghai’s lockdown brought half of China’s logistics network grinding to a halt.

“The world's largest and most complete supply chain has been disrupted, and it is impacting all walks of life,” said a second investor in Shanghai. “I’m looking for stability in my deals this year.”

Up and down

China’s rapid recovery from the first wave of COVID-19 proved a boon for the consumer sector, especially in areas that catered to changing, more tech-enabled habits. Private equity investment in the space rose from USD 293m in the first half of 2020 to USD 497m in the second half and then reached USD 4.4bn in the first half of 2021, according to AVCJ Research.

Confidence in the recovery was accompanied by stellar IPOs. Yatsen Holding, the PE-backed parent of cosmetics brand Perfect Diary, raised USD 616.9m in Hong Kong in November 2020, gained 75% on debut, and achieved a market capitalisation of USD 16bn in February 2021. Skincare brand Winona was worth USD 11bn following a 272% gain on its first day of trading in Shenzhen in March.

“Perfect Diary took less than four years from brand creation to listing, changing the previous perception that consumer brands grew too slowly and weren’t sexy; Winona’s listing in Shenzhen also blew away the market,” said Zoe Dong, a director in the consumer team of China Renaissance’s investment banking division.

Capital flooded into the sector. Several investors noted that a start-up’s valuation might rise several-fold despite no change in the fundamentals. Competition for deals was intense.

“Term sheets had to be submitted after the initial chat, and payment completed in two weeks. This severely disturbed investment rhythm. People were rushing through customer research, visits to upstream and downstream partners, and running comparisons with competitors. You can’t make decisions at that pace,” said Mike Miaoshou, a partner at consumer-focused DayOne Capital.

The fervour didn’t last long. In the second half of 2021, PE investment in the consumer sector fell back to USD 988m. It coincided with fresh outbreaks of the virus. The catering industry, for example, grew 18.6% year-on-year in 2021, but posted contractions in August, November and December. The China Cuisine Association blamed it on “returning pandemics.”

At the same time, uncertainty over the future of existing overseas-listed Chinese companies and the prospects for others following the same path led to a rout in concept stocks. Perfect Diary fell by 97%, slipping below the USD 1 threshold at which delisting becomes a risk. Valuations consequently adjusted in the private markets.

Root causes

Regulation was also a contributing factor. Community group-buying platforms were highly prized by investors following the initial COVID-19 outbreak for the role they played in food delivery during Wuhan’s lockdown. Many investors believed this would become the dominant channel for sourcing fresh produce – and right now it is the only way to shop in Shanghai.

However, the industry was targeted over price manipulation and unfair competition, specifically low-cost flash deals designed solely for customer acquisition. A string of fines and suspensions followed, and investor sentiment faded. This month, Nice Tuan, which has raised over USD 1.1bn from PE investors, shuttered its business. Several other platforms went bankrupt as an industry China International Capital Corporation once pegged at CNY 1.5trn was almost wiped out.

“Capital naturally pursues monopoly positions. Regulators worried that these companies would monopolize the supply chain, increase prices for end-consumers, and damage people’s livelihoods," an investor in Nice Tuan told AVCJ.

Investors retreated from brands as well as from all kinds of platform internet companies. Last month, coffee brand TIMS China closed a new funding round having adjusted the valuation downwards from USD 1.68bn to USD 1.4bn.

On the positive side, an easing in competition means investors can take their time in selecting targets and enter at more reasonable valuations. Scott Chen, an Asia managing partner at L Catterton, noted that recent macroeconomic developments and changes in market conditions have resulted in “more prudent valuations” compared to a year ago.

“Companies with reasonable price expectations which operate in advantaged categories and have values-centric stories which resonate with consumers, as well as the ability to develop differentiated products and services remain viable investment candidates,” he said.

David Wei, founder of Vision Knight Capital told AVCJ that his firm is accelerating consumer sector investments from its latest US dollar-denominated fund. James Wang, a partner and co-founder at Vision Plus Capital, added that now is a good time to identify companies with resilience and long-term vision.

“If we invest in them and give them enough resources for the winter, these brands can survive through the cycle and even occupy the top positions in the segment," said Wang.

Traffic jams

The rise and fall of China consumer investments is also inextricably linked to a perception that “traffic” is more important than products. In 2019, interest in technology, media, and telecom (TMT) cooled as many industry participants concluded that the incumbent consumer-facing platform plus newer players like Pinduoduo, Kuaishou, and Douyin couldn’t be displaced.

Investors gravitated towards consumer-technology and consumer goods deals, but they took TMT logic with them. Leveraging traffic flow to achieve scale was paramount; profit would come later. They studied the large e-commerce platforms and targeted the top three sellers in each category and sub-category. Some entrepreneurs even created new categories to attract investors.

Faith in the ultimate virtue of traffic in building brands went so far that a widespread “universal formula” appeared: post 20,000 pieces of content on Little Red Book, 8,000 on Douyin, 3,000 on Bilibili, and 150 Q&As on Zhihu, and then pursue live streaming.

“We never look at companies that rely on marketing to drive traffic. We only invest in supply chain and product-driven companies. The essence of the retail business is that your single store needs to be profitable. If we don’t think a franchisee can generate a return within a year, we pass on it,” said Vision Knight’s Wei.

Perfect Diary’s experiences capture both the power and limitations of the traffic philosophy. The company rose to prominence largely based on traffic flow on Little Red Book and quickly became China’s top colour cosmetics brand. But this business model incurs substantial costs.

In 2020, Perfect Diary the company swung from a net profit of CNY 75.4m to a net loss of CNY 2.7bn. Sales and marketing expenses amounted to CNY 3.4 billion, or 65% of revenue. In 2019, it was 41%. This cost line grew to CNY 4bn in 2021, or 69% of revenue, yet momentum slowed. Revenue growth was 11.6%, down from 73% in 2020. In the fourth quarter of 2021, the company reported its first-ever year-on-year retraction in revenue.

“Channel and traffic dividends are temporary. You can reach customers quickly by marketing across different channels, but it does not mean that you can reach them repeatedly. In fact, a customer’s repurchasing decision isn’t based on your marketing, it’s based on whether your product can really meet their needs,” said Alex Wang, a managing partner at consumer-focused Meridian Capital.

Lucky Luckin?

Chinese entrepreneurs are well-known for their tenacity and resilience, which can make it unwise to write off brands. Luckin Coffee, a pioneer in running consumer businesses based on TMT logic, might emerge as the ultimate rejuvenation story.

Founded in 2018, the company quickly became the largest domestic coffee shop brand on the back of aggressive store expansion and apparent willingness to embrace unlimited losses. The goal was to harvest offline traffic when online traffic was getting more expensive.

However, the exposure of a large-scale financial fraud saw Luckin relegated from NASDAQ to the over-the-counter market in June 2020 and the removal of key executives from management positions and from the shareholder register, including the founder and chairman. This incident didn’t kill the company, as many had expected, but it accelerated the transition to version 2.0.

“Luckin has demonstrated that if you start from TMT logic you can move to consumer goods logic. For Luckin 2.0, the successful launch of a raw coconut latte last year showed that the company is paying attention to products. When product recognition among consumers rises, their emphasis on subsidies falls, and unit prices of products can be increased. Everything enters a positive cycle,” said Dayone’s Miao.

At the end of 2021, Luckin had 6,064 stores, of which 4,397 were self-operated and 1,627 were affiliates. It was officially China’s number one, surpassing Starbucks’ 5,557 outlets. Moreover, the self-operated stores recorded a net profit of CNY 1.25bn versus a loss of CNY 435m in 2020. Overall revenue rose 98% to CNY 7.9bn, while a CNY 5.6bn net loss turned into a CNY 686m profit.

Alice Luo, founder of consumer-focused Bright Capital, noted that Luckin’s TMT genes have left a unique and positive mark on the brand. First, the large number of stores has created a network effect. Second, the ability to collect and analyse consumer feedback data has contributed to new product development.

Participating in a recent Q&A organised by Centurium Capital, Luckin's largest shareholder, Weiming Zhou, a senior vice president at the company, said: "Launching a single good product does not reflect competitiveness. What’s really useful is a mechanism that can quickly and continuously launch good products. This mechanism is based on Luckin's full set of digital data. It is this massive data that supports the innovative mechanism.”

While TMT logic might be additive, investments in this sector are underpinned by enduring wisdom, notably: back long-term structural trends rather than ephemeral hot themes. Vision Plus Capital’s Wang emphasizes the importance of selecting products for which there is inelastic demand because they are more resilient to cycles. He places coffee in this category but not milk tea, citing stronger brand loyalty for the former.

A shift in consumer preferences towards healthier food and beverages is identified by several investors as a significant long-term trend. Vision Knight’s Wei takes it a step further by only backing companies with integrated channel and product coverage rather than one or the other.

“We have a hot pot ingredients supplier, Guoquan, that has its own products and supply chains, its own stores and customer members,” he explained. “In addition, we invest in upstream pure supply chain companies. No matter how fierce the downstream competition is, upstream suppliers with high entry barriers remain profitable.”

Value creation services is positioned as another point of differentiation. It is central to BA Capital’s consumer proposition, with the firm’s operations executives outnumbering investment professionals. According to Michael Zhang, a managing partner at BA Capital, the value creation team often gets involved before a deal has closed. This has led to assistance in areas such as recruitment that enabled the firm to win over management teams.

Dayone takes a similar approach. Miao points to the firm’s investment in discount grocery store chain Hotmaxx. At the time, Hotmaxx had one outlet, so Dayone was heavily involved in drafting the expansion plan, to the point of contributing ideas on store design. It now has over 400 outlets.

“We get involved in a company’s business, and then we withdraw,” he explained. “If other portfolio companies require similar functional modules, we go in and replicate.”

Communication keystones

One lesson learned is that building brand power should be prioritised over ramping up sales. Jinfeng Huang, founder of Perfect Diary, captures the dynamic in neat anecdote: when a Perfect Diary lipstick broke, customers doubt the quality; when the same thing happened to a Shu Uemura product, the first thought is that it isn’t being used correctly.

Terms such as “private domain traffic operation” have crept into the Chinese star-up lexicon as entrepreneurs and investors look for ways to boost traffic and sales, while debates about online versus offline brands continue. But no one looks to draw that distinction when discussing Apple.

Channels are a means of reaching customers; private domains are an extension of this, a continuous and in-depth communication tool. Sales are the outcome of effective execution. Chen adds that L Catterton’s approach is rooted in understanding what matters most to consumers and then working with founders who share the same ethos.

“We tend to engage more with founders who seek customer loyalty and sustainable growth by innovating to meet real needs and building enduring emotional connections with consumers,” he said. “Supply chain management, as well as online and offline marketing are important too, but the overall value proposition to consumers is paramount.”

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Greater China
• Consumer
• Expansion
• Technology
• China
• TMT
• Dayone Capital
• BA Capital
• Meridian Capital
• Vision Knight Capital
• L Catterton