Western multinationals expand into China

Since the mid-1990s, many Western multinationals have established beach-heads in China by focusing on the three main population centres. The question now is whether to move beyond these major cities. John Quelch and María Ibáñez Gabilondo discuss the case for geographic expansion, reviewing the strategies that several leading multinational companies in retailing and consumer goods are already pursuing

There are six reasons why leading western multinationals are embracing the opportunities and risks of expansion.

First, in the boardrooms of many western multinationals, slower growth in the developed economies following the global economic crisis requires more strategic emphasis on increased sales from the emerging economies as the principal source of top-line growth.

Among these emerging economies, none looms larger in potential than China. In 2009, while the rest of the world struggled to combat declining GDP, China achieved 8.9 per cent GDP growth with retail sales increasing by 15.8 per cent.

Second, to ensure social harmony, the Chinese central government is keen to spread the country's new-found wealth beyond the east coast to the second- and third-tier cities and to rural areas.

The allocation of certain Chinese government stimulus funds in 2008 and 2009 to retail sales incentives and easier credit supported this objective.

Third, the Chinese have been quick to learn the marketing and brand-building strategies of Western multinationals. As a result, many established regional, Chinese-owned companies in outlying provinces have strengthened their management skills and market positions, while new businesses outside the network of state-owned enterprises are being opened every day by a new generation of Chinese entrepreneurs.

Fourth, expansion beyond the east coast may be essential to survival. Over time, the Chinese market is likely to evolve from a collection of provinces and regions with distinctive local tastes into a national market. The central government has a strong geopolitical as well as economic interest in making the transportation infrastructure investments that will connect the dots and make distribution and supply chains more efficient.

Fifth, successful Western multinationals that are now generating annual profits in China are inclined to reinvest them there. These locally generated funds can be used to build national distribution and national brand recognition without the need for any headquarters subsidies. Currently, competition is often less intense and media advertising and retail space costs are much lower in the second- and third-tier cities, and in rural areas.

Sixth, the Chinese market is increasingly the bellwether for international corporate success. It used to be the case that no multinational could claim respect unless it had a strong position in the United States, often cited as the most competitive market in the world. Increasingly, that mantle is passing to China. A multinational's performance and relative competitive strength in China are being used by investors as indicators of the company's overall attractiveness.

GEOGRAPHIC SEGMENTATION

Success and profitability in China is a strong commendation for any Western multinational because the size and fragmentation of the China market pose significant challenges. With a population of 1.3 billion, China ranks first in the world.

A common classification for business expansion purposes divides the country into four tiers: Tier 1 now includes the four municipalities, 27 provincial capitals and a few prosperous prefecture cities such as Shenzhen and Dalian; Tier 2 covers the remaining prefecture cities; Tier 3 includes the city districts and county-level cities; and Tier 4 covers the remaining rural areas in the 1,600 counties.

The rural population is 60 per cent of the total but represents only one-third of total consumption. There are more than 120 cities with populations of more than one million and ten with more than four million.

To simplify decision-making for its clients, McKinsey has identified 22 geographical clusters that collectively represent 82 per cent of China's urban population. One McKinsey client, a food and beverage company, has classified the 22 clusters into four subgroups: stronghold clusters where they are already well-established; must-win clusters where they feel they must succeed; up-and-coming clusters where potential growth beats the market average; and wait-and-see clusters, which are lowest in priority.

Adding further complexity to the geographical variances in per capita income is the fact that the Chinese population embraces more than 50 minority nationalities and 250 spoken dialects. There are huge cultural as well as economic differences.

In urban areas, socioeconomic mobility plus an influx of ten million people per year from rural areas means that the display of brands becomes an important device to signal social status.

However, in rural areas where population mobility is lower and Communist Party traditions linger longer, everyone knows each other's social status, consumers are more conservative and individualistic, and less likely to show off their relative wealth in public

SEGMENTATION BEYOND GEOGRAPHY

Although critical to shaping a national rollout strategy, Western marketers cannot rely on geographic segmentation alone. They must consider levels of brand loyalty, varying attitudes towards foreign and domestic brands, and demographic segmentation based on age and – special to China – only-child status.

Brand loyalties are more likely to become entrenched in categories (such as moisturising creams and skin regimes) which are highly personal and where the risk of switching is seen as high. In other categories, brand loyalties are not fixed and a strong value proposition from a newcomer can quickly upset the carefully cultivated market share of any Western brand. Because consumers are often not yet locked into specific brand loyalties, Western multinationals such as L'Oreal have found that a portfolio of brands at multiple price points, some positioned as global, some as local, can cover multiple consumer segments.

While foreign brands are believed superior in quality (and therefore command a price premium) by most Chinese, three caveats are in order. First, there is a consumer segment – mainly male Communist Party members – that is nationalistic and seeks to buy Chinese.

Second, there is confusion over which brands are foreign and which are local. This is partly because many ‘foreign’ brands are made in Chinese factories via joint ventures, partly because some foreign brands seek to cultivate a local image through recruiting Chinese pop and sports stars as endorsers, and partly because some Chinese brands adopt Western names to try to burnish their images and boost their prices.

Third, reflecting an uneasy historical relationship with China, Japanese brands are not regarded as highly as in the West, except in the cosmetics category where Shiseido is well established.

PRICE AND ADVERTISING SENSITIVITY

Compared with other Asian economies, China is more competitive. Simply put, there are 1.3 billion people competing for advancement, with women accorded almost equal opportunity to be in business and start companies. This is reflected in consumer behaviour. At every level of society there is a value consciousness that translates into emphasising the shorter-term price advantage over the longer-term buyer/seller relationship.

Even brand-conscious, well-off consumers typically search across multiple stores from street markets to shopping centres and on the internet to find the best deal. Consumers openly discuss the prices they have paid for goods and services. Many are members of buying groups (tuangou) to increase their negotiating leverage.

Competitiveness on the supply side plus the sheer size and GDP growth of the Chinese market means that more product choices are becoming available in more product categories to cater to an increasingly segmented Chinese marketplace.

New, potentially profitable segments are being identified and addressed by marketers each day. For example, one third of Chinese chocolate consumers now seek products with added calcium, a benefit that adds nutritional credibility and justifies a higher price.

Adding to the current emphasis on price competition is the fact that commercial advertising is not trusted by most Chinese consumers. There are two reasons. First, during the communist era, goods were only advertised when there was excess inventory or when they were of poor quality. Second, the only national advertising is delivered by the central government-controlled television channels that are part of the CCTV network.

CCTV channels tend to be viewed and trusted less by consumers in the Tier 1 cities. They rely disproportionately on word of mouth from friends, internet search and point-of-sale information. Advertising on local television and radio stations is viewed as more credible.

MARKETING ADAPTATION

Unsurprisingly a one-size-fits-all approach to penetrating the complex Chinese market is unlikely to work. Marketers committed to penetrating the entire country and increasing their national market share have to invest in adapting marketing programmes.

For example, rural areas require stripped-down, basic versions of mobile phones. Nokia, therefore, cut out functions such as Bluetooth to hit more attractive retail price points and now claims a 40 per cent share in rural markets. Downsized package sizes are also needed to enable poorer consumers to sample Western brands: Coca-Cola launched a 200ml bottle in rural areas of China in 2004 to hit a CNY1 price point.

Colgate-Palmolive has had to launch different toothpaste flavours to cater for consumer preferences in different regions. Xingxing sells fridges in rural areas with mouse protection covers on the compressor hoses and with motors that can withstand wide variations in voltages.

Such adaptations of the marketing mix cost money. A company that aims beyond the Tier 1 cities will have to run several marketing programmes in parallel and incur extra production, marketing and management costs. The hope is that extra sales, market share and profit will result from the adaptation investment – particularly enough profit to more than cover the investment costs.

EXPANSION STRATEGIES OF WESTERN RETAILERS

Distribution in China remains highly fragmented. The number of retailers per capita is ten times the level in Australia. Even in Shanghai, where modern retailing has achieved high penetration, traditional mom-and-pop stores still account for 40 per cent of retail sales.

There are virtually no national distributors for any product category: distribution coverage depends on the accretion of individual relationships with a patchwork quilt of small wholesalers and retailers, most of them unsophisticated and providing few value added services beyond the physical handling of goods. Distributors often operate only on a cash basis with their customers.

Western retailers that either owner-operate or franchise speciality retail outlets have tended to expand their geographical coverage faster than larger retailers such as Carrefour and Walmart. Among the retail brands with the highest number of outlets in China, McDonald's stands out with more than 1,100.

Turning to mass merchandisers, Walmart and Carrefour may be neck and neck in number of stores but there the similarity ends. Walmart emphasises price alone. Its product selection is more standardised. Distribution is centrally controlled. Walmart offers three private-label brands targeting different consumer segments, but the number of private-label products is double that of Carrefour.

Decentralisation of management and flexibility are the hallmarks of Carrefour. Product assortment varies, localised promotions are common and local independent distributors may be used to deliver product to stores. For example, Carrefour sells only Pampers Cloth Dry the brand's most basic product, that targets cloth nappy users in two provinces.

Latecomers to hypermarket and supermarket retailing in China include Tesco and Metro of Switzerland. Metro's strategy has been to establish a single-store foothold in as many cities as possible (38 stores in 19 cities).

Tesco has established a token presence in the big three cities but has aimed to leapfrog Walmart and Carrefour by opening company-financed shopping malls, with Tesco stores as anchor tenants in some smaller cities in the prosperous eastern provinces.

At the other end of the retail spectrum, China has proved to be an especially important growth market for Western premium luxury brands. These companies have opened an impressive number of stores, reflecting the importance of luxury brands as a signal of social status, style and sophistication in a large, highly mobile and competitive society such as China.

So important is the Chinese market that some luxury retailers plan to open secondary chains targeting younger, less wealthy but aspiring consumers, with different product assortments. The percentage of stores of luxury brand retailers that are concentrated in the three major eastern cities is higher than in the case of the mass merchandisers.

DISTRIBUTION STRATEGIES OF WESTERN MANUFACTURERS

Many Western consumer brands are content to expand into emerging markets on the backs of the retailers they sell through in Western markets. Wherever Walmart and Tesco go, they go as well. However, this strategy is rarely appropriate in a large competitive market such as China where the pressures on Western retailers to source locally make it less likely that they will have space to stock Western brands unless they are well promoted. Walmart and Carrefour together account for only 4 per cent of all Chinese retail sales.

The leading global consumer brands such as Coca-Cola cannot wait for Walmart and Tesco or even for McDonald's. They must distribute through hundreds of thousands of points-of-sale throughout China.

Coca-Cola products are bottled in China by Swire, Kerry and others. These companies also own the warehouses and sales centres that coordinate product distribution through a complex web of 30,000 distributors that reach 1.3 million retail state-owned enterprises, former state-owned distributors, now privatised, and new independent distributors.

Coca-Cola and its bottling partners have selected the best distributors. The company has also invested heavily in training the management and personnel of independent distributors, in information technology systems, and in sales incentives to boost volume and distribution points.

Procter & Gamble has achieved 80 percent coverage of markets where consumers have enough money to afford at least one of its entry-level brands. When P&G enters a new market, it first identifies three or four distributors with whom to try to establish a broad retail presence.

Based on comparative performance, P&G then narrows the field to a single distributor. Then it begins shipments to the larger retailers. The distributor has to reach the thousands of small retailers that are often served by bicycle carts. P&G deploys district sales reps and vehicle sales reps at its expense to help distributors improve their selling effectiveness.

For Western multinationals overseas, distribution is the element that most often constrains them or trips them up.

CONCLUSION

Although the growth in online sales in China will be rapid, mass-marketed Western brands must continue to focus on increasing distribution penetration through retail stores. The Chinese national and provincial governments have recently taken more interest in helping Chinese wholesalers and retailers in the interests of improving supply chain productivity and ensuring that foreign retailers do not dominate.

Geographic expansion beyond Tier 1 cities complicates marketing, selling and distribution. Such a strategy typically requires more marketing programme adaptation, administrative cost and risk. But for the Western brands that succeed, the profits will more than cover the increased investment.

John Quelch is a professor at Harvard Business School.

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María Ibáñez Gabilondo is a marketing consultant.

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