Grab hold through corporate-owned stores

Retail Research | March 2015

China's Retail Market: within Reach

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Derek Chen Director of Retail Tenant Representation, China derek.chen@ap.jll.com +86 21 6133 5378

Steven McCord Head of Research, North China Retail Research Lead for China steven.mccord@ap.jll.com +86 10 5922 1371

Tom Gaffney Regional Director, Head of Retail, Hong Kong tom.gaffney@ap.jll.com +852 2846 5803

Special thanks for Linda Yu for her contributions to this paper.

International retailers are carefully assessing expansion strategies outside of their developed-country home markets, where growth is slowing and their number of existing stores is already high. China remains a compelling market for global retailers, especially as the country’s economic growth, even if moderating, continues to present a plethora of untapped opportunities as the world’s second-largest retail market. In this paper, we examine how the benefits of a corporate-owned structure in Tier I cities inform the direction in which international food and beverage and fashion retailers should move to grow their brands within the vast China market.

Key highlights

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“China’s most retail-savvy cities, Beijing and Shanghai unanimously remain the two primary frontrunners”

Make Beijing and/or Shanghai the starting point – and go corporateChina’s biggest opportunities are attainable from an aptly positioned retail presence in the country’s most desirable Tier I markets: Beijing and Shanghai. In JLL’s City Momentum Index, Beijing ranks number three in the world and Shanghai number five. Given the importance of these cities, many global retailers run corporate-owned stores here rather than use partnered business models such as franchises; the corporate trend also extends to China’s other Tier I cities, Guangzhou and Shenzhen. However, widely considered China’s most retail-savvy cities, Beijing and Shanghai unanimously remain the two primary frontrunners when it comes to corporate ownership in China, and this has been substantiated by the actions of global retailers in recent years. While far fewer of these retailers have made the same corporate leap within second and third or fourth-tier cities and beyond, a growing number of them are making the long-term investment needed to secure ownership of each store opened in China to ensure full control of their brand across the country.

When a corporate store performs well, the retailer reaps all of the ensuing monetary rewardsOne of the biggest benefits of corporate control is direct exposure to profits, all of which then belong to the retailer. Even in cases where a franchise is used to enter the market, there is always a strong push for retailers to buy back their top-performing stores; this prevents their biggest revenue gains from being diluted by a local partner. Considering the huge growth potential of the market, retailers in China have even greater incentives to set up direct-owned stores. Corporate ownership further reaffirms entitlement by ensuring that the retailer captures the most of its market in absolute terms.

Entering or expanding at the corporate level assures absolute brand protection in the China market – something franchisees cannot offerThis is crucial to a brand’s reputation and ultimate survival in the market, particularly as consumers become more selective in their purchases. Given that franchises do not invest in the brand itself, they have little incentive to allocate resources – which take away from their revenues – to safeguard brand equity. In a poor sales performance environment, this means that principals are willing to fight back in a bid to save their brand rather than abandon it during a low period. Franchise partners, on the other hand, are much more likely to give up on a brand when its sales dip and its reputation falls. Franchisees are prone to dropping brands from their portfolios – decisions made mainly based on current sales performance or near-term projections – as investing in a brand’s long-term market viability is not a priority for them. Franchisees have also been known to form the habit of pushing only select brands to top landlords, failing to make the effort needed to secure the best locations for all brands in their portfolios. This puts “bottom-feeder” portfolio brands at a great disadvantage, often without retailers even knowing.

“We understand the critical need for retailers to present a multichannel brand capable of seamlessly merging the worlds of online and offline”

Setting up the right structureAmong China’s Tier I mega-cities and the clear favourites for corporate-controlled entry in the country, Beijing and Shanghai offer some of the highest levels of transparency in China. This fact is of great benefit when considering all of the legalities involved in setting up and running lawful operations throughout the country. Global retailers must carefully weigh the legal complexities tied to each business model prior to taking the plunge into China. Simultaneously adhering to both corporate compliance and Chinese policy can often become tricky and complicated once the number of stores opened by an international retailer in China increases exponentially and across lengthy distances. As such, global retailers are strongly advised to first fix their China expansion strategy, and then establish their legal structure accordingly. This greatly reduces the risk of the retailer later becoming constrained by the limitations of a legal structure, in terms of where they are permitted to legally open stores in China. Also, looking at the wider picture, we understand the critical need for retailers to present a multichannel brand capable of seamlessly merging the worlds of online and offline, but in the context of this discussion, our focus is on international food and beverage (F&B) and fashion retailers establishing physical stores in the China market, which remain absolutely essential.

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Corporate ownership further guarantees full commitment to the brand, so that empty promises can be avoidedA strong obligation to the brand means that it will be developed by taking the most conducive and sustainable path. Due to the misalignment of incentives between a franchise partner and a principal – because of their conflicting goals – franchisees are less inclined to focus on building brand longevity despite the risk that such a move poses to a brand’s future. Given that their main interest lies in creating the largest profit margins possible in the quickest period of time, franchise partners often fail to deliver as promised time and time again, especially when alternative options available to them offer better chances of boosting their bottom lines.

Principals are much more dedicated to sound store management, a process that begins with the store’s fit-outCorporate practices tend to set high standards for all brand stores in China, thereby increasing consistency in quality at each and every single location, present and future alike. From the initial store set-up to customer service standards, principals in China are generally run under much higher and stricter standards than franchisees; quality control monitors are typically set into place from an early stage and serve as useful mechanisms to thwart misguided management. By comparison, the same checks and balances are more likely to be omitted or far less reinforced at franchisee stores in China, which severely hinders quality control on a daily basis. Such discrepancies are perhaps most clearly evident within the store fit-out period, during which franchise partners commonly substitute low-cost supplies for the interior design, modifying the final look and feel of a brand store despite contracted agreements with the principal stating otherwise. Stores constructed with cheap materials and underqualified labour pose greater health and safety hazards, and deteriorate faster. In some cases, shoddily built stores start physically falling apart even before the end of a typical two or three-year lease. The stores are built for quick set-up and equally quick tear-down.

“Franchisees are less inclined to focus on building brand longevity”

Principals are better equipped financially to drive demand momentum in the market via comprehensive marketing campaignsIf not all, then the majority of franchisees in China fail to take seriously the marketing aspect of the business, and even landlords at major shopping centres express challenges in persuading franchisees to devote resources to meet this end. Most franchisees presume that the often intangible value of marketing is one that their store can do without in their quest to keep operational costs to a minimum. This conceptual difference plays into the larger picture, and ultimately has a significant impact on the final location of a store. Given their much larger operating budgets, principals often sign off on generous leasing expenditures, justifying the high cost under their overall marketing strategy which prioritizes brand visibility in high-profile locations as a measure to boost brand awareness and growth. Without this rationale, however, franchisees are generally much less willing to devote such large expenditures to rental budgets. Therefore, despite the strong positioning of franchisees to negotiate competitive rents due to their knowledge of the local market and their connections within it, they frequently rule out prime locations due to their higher rents. Consequently, both the brand’s presence and growth potential in the market suffer from these missed opportunities.

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Tier I city consumers expect a higher level of customer service Due to their profit-driven nature, franchisees are disincentivised from training store employees, and consequently, staff workers are often incapable of properly maintaining a store and its inventory, or providing shoppers with quality service, all of which impacts the level of service customers receive and influences their impressions of a brand. Most significant is the inability of employees to adequately serve the customer – either through a lack of product knowledge or the inability to provide useful or relevant advice. While this kind of mediocre service is still acceptable in lower-tier cities, consumer expectations in Beijing and Shanghai are higher than ever. Poor customer service will succeed in pushing customers away. Further compounding the situation is that untrained store employees with few opportunities to learn or acquire new skills have no reason to stay and will often jump quickly – within weeks or days – to the next competitor, even if the wages offered there are only nominally higher. The danger here is that the trend in itself facilitates a worrying continuum of under-skilled employees, and this will only continue to clash with consumers’ rising demands for better service.

“The trend in itself facilitates a worrying continuum of under-skilled employees, and this will only continue to clash with consumers’ rising demands for better service”

Landlords of the best-performing shopping centres are only interested in considering strong brands with well-managed storesIt is here where we see importance of location coming back to form a vicious cycle which demonstrates the crucial need for brands to be both properly set up and run in order to win over top landlords, and spaces, at the most promising properties in the market. Brands with highly visible stores surrounded by the largest and most suitable crowds of target consumers will have the best odds at flourishing in the market. Landlords of the most sought-after destinations will enjoy a first pick of brands, and those with strong-performing, well-organised stores that prove popular with crowds will stand out from all others. Even with the rapid rise of online shopping, brick and mortar stores are set to retain their value to the overall market presence of a brand, and because of this, both new and old brands – no matter how established – will continue to require access to key commercial properties.

Corporate stores are designed to meet the preferences of increasingly sophisticated Chinese consumers, many of whom are becoming much worldlier with their shoppingIn the past two years, Chinese consumers have begun to travel abroad in droves. As they shop abroad, they experience higher levels of customer service, which they come to expect back home. Furthermore, many regularly shop abroad due to lower taxes and greater selection; this has given them extensive experience with foreign retail environments within a short period. Long considered a shopper’s paradise for its ubiquitous brand selection and its reduced prices relative to Mainland China, Hong Kong is no longer the only go-to destination for progressively wealthy Chinese consumers, who now have the means to travel to world-famous fashion capitals, such as Paris, New York, and London, where they can access an even richer assortment of products at more competitive prices. As Chinese shoppers become further exposed to a greater variety of sophisticated retail markets through more frequent travel abroad, their brand experience expectations will continue to rise. As most of the overseas markets that Chinese customers are visiting function as the home markets of many retailers wanting to enter or expand within China, the corporate store will have the obvious advantage over the franchisee in replicating the in-store experience of its home market in China. This allows the retailer to naturally appeal to Chinese consumers once they return home.

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“Hong Kong is no longer the only go-to destination for progressively wealthy Chinese consumers, who now have the means to travel to world-famous fashion capitals”

“Brands with highly visible stores surrounded by the largest and most suitable crowds of target consumers will have the best odds”

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When corporate control is not an option for a Tier II city, go for the next best thing: a mixed strategyOut of practicality, franchising may be a necessity in order to quickly access Tier II markets. However, retailers should only franchise in these cities by applying a strategy that would enable them to incrementally regain control in the top-performing markets over the medium-term, especially in key regional hubs where consumer expectations are changing most rapidly. The so-called Tier 1.5 markets, as defined in our flagship publications “China 50 – 50 Cities that Matter” and “China 60 – From Fast Growth to Slow Growth”, are the regional hubs typified by Chengdu and the wealthy satellite cities of Tier I cities, characterised by the likes of Tianjin and Nanjing. These markets offer a level of demand depth and sales productivity potential that will likely justify corporate control within a few short years. When consumers in these markets reach a level of sophistication comparable to those in Tier I markets, retailers will want to secure corporate ownership as the risks associated with using a franchise at this point will supersede the earlier benefits of fast market penetration.

“Franchising may be a necessity in order to quickly access Tier II markets”

“According to our recent study in ‘A Magnet for Retail’ Shanghai ranks number two in Asia in international brand presence”

The first-mover advantage gap is closing rapidly in well-developed markets where brand selection has ballooned – making the need to enter Tier I cities under corporate control necessary now more than ever Going corporate in Tier I markets like Beijing and Shanghai backs international retailers with the support and ammunition needed to break into these crowded markets, where strong competitors have already carved out sizeable corners of the market. According to our recent study in “A Magnet for Retail: Tracking the Expansion of Retailers Across Asia Pacific”, Shanghai ranks number two in Asia in international brand presence, immediately after Hong Kong, and Beijing ranks number four. At the same time, international retailers relying on local partners also need to move swiftly or risk getting stuck with dubious and/or mediocre franchise partners. The ability to act promptly offers retailers greater assurances of establishing a presence and getting ahead of rivals, even in highly competitive markets.

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Pricing strategies are growing in significance in China, and corporate stores are more suited than franchisees to manage this aspect of the businessGiven that Chinese customers, particularly in Tier I markets such as Beijing and Shanghai, are more aware of overseas markets, they are increasingly hesitant and reluctant to pay price premiums for foreign brands, especially when they venture abroad and see their counterparts buying identical merchandise at reduced prices. Entering the China market at the wrong price point is more likely to drive away Chinese customers, who are increasingly wary of foreign brands taking advantage of them given their far distances from trend-setting European and North American markets. Furthermore, as online Chinese retail giants Tmall and JD become more competitive in China by offering affordable prices and fast delivery, global retailers will be under added pressure to provide cheaper prices and better services in China. US e-commerce platform Amazon even has plans to launch an international feature allowing China-based shoppers to purchase products from its home website in the US or through the company’s other online shops in notable retail markets such as France or Italy; this shows just how competitive the retail market in China is becoming. As the competition intensifies, the ability of a store to offer globally competitive prices will become increasingly important. Compared to franchisees, corporate stores are in a better position to set more competitive pricing points, given their greater ability to absorb and/or offset the cost differences elsewhere in their budgets.

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For Tier III cities and beyond, use a franchise to quickly penetrate the market over the short and medium termsLess important than Tier I and Tier II cities, Tier III and beyond comprise underdeveloped markets that lack the degree of sophistication found in major markets. Consumers in Tier III markets and beyond are less discerning, more forgiving, and easier to please. Therefore, the potential fallout from the risks associated with applying a franchise model is more contained and manageable in a lower-tiered market – and it is precisely here where the franchise avenue can thus provide the great advantage of convenient and relatively hassle-free entry. Another advantage of resorting to a franchise in these cities is the cost-saving benefit as corporate stores are more expensive to run in remote and dispersed locations.

Corporate ownership is unnecessary in Tier III cities and beyond during the first five years in China, but retailers should commit to these cities for the long-haul and take back control of key stores once these markets have matured Over time, store winners in newly matured markets will warrant the switch back to corporate control. Just as stores in even the smallest of towns in developed countries are worthy of corporate ownership, so may be the eventual case with some of China’s lower-tiered markets. As these cities develop, retailers will need to evaluate which stores in which places are worth their while – leaving those that are not, to remain in the hands of a capable franchise – and be prepared to pull the trigger on corporate ownership when the time is right. It will unlikely be imperative to regain control of all stores at once, and as such, retailers will benefit from some leeway in prioritising the most important of these markets. This will reduce the scale of operations logistically, making the entire process of taking back control in these markets much more manageable.

Select mass market and/or value brands are exceptions that can do well by starting in Tier II marketsLower-priced retailers in the right markets can sometimes be better off building momentum in China by skipping Tier I cities altogether and entering a more localised Tier II or Tier II market where the presence of foreign brands is limited or non-existent. Russian brand Sportmaster has done well with this approach, leveraging its socio-economic ties to North China and expanding its presence to multiple stores in the region. While Beijing and Shanghai have bigger and more attractive markets, smaller markets have less competition, particularly from retail heavyweights. In Tier I markets, these weaker brands suffer from inferior locations – resulting in low brand recognition – and high rents, which would otherwise afford them strategic spaces in high-visibility locations within Tier II or Tier III markets. The benefits of corporate entry into these lesser markets could be optimised by opening a cluster of stores in the area to help offset the costs of operating in a more remote location.

“Countless international retailers in China have used franchisees to achieve both speed and depth with market penetration”

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Franchisees are irreplaceable when it comes to achieving both fast and vast penetration of the market, simultaneouslyIn this regard, the corporate store approach is largely incapable of competing with the franchise approach, and that becomes truer the lower the tier of the city. Particularly in smaller cities, the need to operate swiftly, in a manner that produces concrete results fast, is crucial to getting ahead of the market and catching up to competitors. Countless international retailers in China have used franchisees to achieve both speed and depth with market penetration, opening upwards of hundreds of stores across the country. However, with this model, retailers need to be mindful of becoming overly reliant on the partner, as it will be that much more challenging to break free of the franchise and operate on their own when the time comes.

Using a franchisee allows the principal to unload some of the risks involved with their foray into ChinaLess capital is required of the principal when it teams up with a local partner, and because of this, it is easier for the global retailer to pull out of the market if the partnership fails. Considering the majority of leases span a duration of two or three years, principals also benefit from the cushion of shared costs over the entire period of the partnership. Specifically, in extremely localised markets that are riskier for foreign brands in terms of their connection to the local customer, putting some of the risk onto a local partner is helpful, as it allows the risk to be managed very closely. Franchise stores also tend to see much quicker returns than corporate stores, given that direct-owned stores generally have longer ramp-up times and require greater initial investment and capital to get off the ground.

“Franchise stores also tend to see much quicker returns than corporate stores, direct-owned stores generally have longer ramp-up times.”

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Local partners offer valuable local know-how, which they can use to get around speed bumps in the marketWithout extensive knowledge and/or unrestricted access to a reliable network of contacts on the ground, principals will struggle to operate smoothly in lower-tiered markets, where exposure to and experience with foreign brands is limited compared to Tier I markets. For example, it can sometimes take years to acquire an operating licence for these cities, a task that a local partner can handle much more effectively. Essentially, franchising helps foreign brands leap-frog red tape in China, which would otherwise slow them down significantly. Considering that franchisees have greater ease tapping into local networks of contacts and operating within less transparent markets, the franchisee will be better-equipped to reach out to a range of groups to facilitate orders and oversee multiple chains of command. This is vital to the successful store management of a store in a Tier II or Tier III city and beyond, where the markets and movers within them are much more localised and often less receptive to non-local modes of operation. Such gains are especially obvious within F&B, when local franchisees can be particularly useful in arranging the sourcing and timely delivery of quality local produce and fresh ingredients.

“Franchising helps foreign brands leap-frog red tape in China, which would otherwise slow them down significantly”

Franchisees are well-familiar with the psyche of the local consumer, and this helps to extend the brand’s depth – allowing the retailer to reach out to a greater number of customers in new markets With insight into the mind-set of the local customer, the brand and/or presentation of it or its products can be catered specifically to meet local preferences. By focusing on aspects of the brand that will be most suitable for and appealing to local customers, the brand will have better odds of being favourably received in the overall market. Local partners are heavily motivated to invest the time needed into making sure the brand is suitably modified for the local market given that the reward is a higher sales volume, which equates to bigger store profits. Without rich knowledge of the local culture, global retailers will not only be disadvantaged in their approach to the local market, but also prone to more missed opportunities.

As customers everywhere are being introduced to alternative markets and pulled in a multitude of directions leading them to form new consumer habits and preferences, the need for a sound operating model that can support in-store operations and promote brand growth in China – all while responding and adapting to evolving retail environments – is critical to an international retailer’s survival and success in the country, where market potential remains high.

“Without rich knowledge of the local culture, global retailers will not only be disadvantaged in their approach to the local market, but also prone to more missed opportunities”

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US clothing designer intends to keep China franchise in placeNo plans to regain control of stores beyond Tier I citiesLess than a decade after a US premium clothing brand entered China through a local franchise, the retailer switched its Beijing and Shanghai stores back to corporate control in 2011. Dominating US fashion headlines in the 1990s after customers as wide-ranging as older golfers and younger rappers identified with the designer label, the company reasoned that corporate control on the mainland would only be worth the effort in China’s Tier I markets, where the international and transparent nature of these cities would be capable of providing the support required to make the standard business model feasible.

Since taking back control, the brand has grown its presence in Beijing and Shanghai to around 40 points of sale, while that figure jumps by roughly 200 for lower-tiered cities which rely on some 45 local franchisees to run the business. Over the foreseeable horizon, the company reports that it has no intention to go corporate in second, third, and fourth-tier cities, given that profitability would not be guaranteed to increase taking into account all the costs that would be incurred in such a massive undertaking. The large scale of operations in China – involving hundreds of locations – thus presents corporate challenges for the retailer.

Adding to the corporate debate for the retailer is the fact that the achievements of its local franchise partners in lower-tiered cities are enough to justify keeping them in-position rather than replacing them with a corporate structure. Currently largely dependent on its mixed strategy operational model, which would face serious tax and legal challenges if the company were to go corporate now, the retailer is, in this aspect of the business, strongly discouraged from considering the corporate route in lower-tiered cities.

Despite the gains on paper, the ability to better brand its message to consumers, and the potential to raise revenues, the retailer further remains convinced to keep its two-system operational mode, fearing that slower growth in China will cut into its China profits and leave the company with even less to work with if it went corporate in lower-tiered cities.

Fresh pasta bar to enter China as corporationBut the company is open to franchise options for the futureWith a presence in 32 countries, the pasta brand is eyeing China as its 33rd country to help the brand continue expanding in the wider market beyond its home borders of Europe.

Looking to introduce its fresh pasta bar concept to Chinese consumers by way of Shanghai later this year, the company has chosen the corporate strategy to allow it to manage fully how the brand is presented and its message communicated to customers. The restaurant’s open-kitchen casual dining pasta experience will still be a relatively new sell to even the more open-minded of Chinese diners. With a strong belief in the F&B concept, the brand has decided that arriving in China solo is the best way to keep its interests at the forefront rather than risk entering the market aligned with a big player that may overshadow the company’s interests and message to customers.

Once the brand has been established and the operational side of the business has been tried, tested, and proven in China, the retailer plans to increase its presence in Shanghai to a small cluster of locations before expanding to other cities in the country. Although the retailer foresees China being a big enough market capable of supporting the overhead for a headquarters office and strong management team, it is not averse to considering a franchise strategy to swiftly penetrate the market if a suitable partner can be found.

The company’s philosophy stresses that the brand not be limited by any business model – be it corporate or franchise – but ultimately driven by the best option available in the market, regardless of whether that comes in the form of a corporate hire or a local partner. Therefore, even at the expense of faster entry into China’s Tier II and Tier III cities, the retailer prefers to invest more time upfront into finding the right fit for the company.

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Stakes too high for US restaurantAmerican restaurant chain opted to back out of China franchiseAfter frustrations grew over a lack of compliance from its local partner in Beijing, an American casual dining chain pulled its China franchise – before regrouping and re-entering the country via Shanghai under corporate control in 2012 – in a bid to salvage its brand so as not to risk further damage to its reputation. Poor practices repeatedly chipped away at the brand’s image and subsequently neglected to promote the store’s concept in the market. This made it difficult for local consumers to get on board with the brand’s foreign menu and themed casual dining experience.

Despite strong investment support that enabled the F&B retailer to set up everything for the franchise, providing the joint venture with a promising start on paper, the daily operational failures were enough to bring down the brand. The biggest issue was that the franchise partner neglected to fulfil the terms of the franchise agreement. For example, the franchise partner regularly invited friends to the restaurant and ordered the chef to cook Chinese food for them, which they ate in the main dining area where customers were seated. Patrons who saw the store owner and his guests eating stir-fried rice instead of high quality grade cuts of steak were given the wrong message, leading diners to speculate if anything was wrong with the food on offer.

Because the actions of the franchisee further diminished the brand’s power, it was hard for local consumers to adopt the relatively new and foreign dinner habit of indulging in imported beef. The brand further experienced difficulties in influencing sizeable crowds, leading to its failure to carve out its own niche in the restaurant business.

Several attempts to rectify the situation with the franchise partner failed to turn the situation around, and eventually, the franchisee spoiled the brand’s image to the point of serious concern; the retailer was left with little choice but to separate itself from the China franchise.

Iconic American fashion believes corporate control is better than franchiseCorporate control applied to help bolster Ralph Lauren brand in ChinaInternational media reports described how Ralph Lauren has worked hard to win back customers since buying out its local partner in 2010; it has closed down former points of sales around China and reopened in new locations across the country, while upgrading much of its China merchandise to cater to a more pronounced premium market.

Widely criticised for failing to focus on the strength of the brand’s reputation as a world-class leader in fashion, the local partner did not actively build upon the Ralph Lauren name in an advantageous manner to sustain its future in the larger market. Consequently, the brand was unable to appeal to enough of its target customers – the affluent and rising middle-class shoppers in China.

After being worn down by a succession of challenges, the brand came out of the franchise model somewhat damaged as the brand had not been given the proper treatment it deserved. Customers were further put off by exceedingly high price tags as the franchise arguably set prices too high, hurting the brand’s wider reputation in the market.

The most harmful outcome of operating through the franchise, however, was that Ralph Lauren’s success in China was set back by a few years. This significantly stunted the brand’s full market potential.

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