January 17, 2017 7:00 pm JST
FT Confidential Research

Falling costs drive bricks-and-mortar renaissance in China

Narrowing online-offline price gap brings new lease of life to physical stores

© AP

  • Falling rental costs and surging online customer acquisition costs are renewing the business case for bricks-and-mortar stores in China, as the cost premium for offline purchases slides to a level FT Confidential Research data suggest many consumers are willing to pay.
  • This is particularly so in third-tier and smaller Chinese cities, where customers are particularly keen on a hands-on shopping experience. In conjunction with rising incomes, this is driving rapid lower-tier expansion by established and new brands.
  • The physical store model will remain under pressure, however, particularly in first-tier cities where costs have not fallen as much as in smaller cities. Yet the distinction between online and offline retail will continue to blur as companies exploit new technologies to drive sales.

Bricks-and-mortar is making a comeback in many parts of China. Even as online captures an ever-larger slice of retail sales (see chart), changing shopping habits are breathing new life into the physical store model.

The shift is being driven by narrowing price differentials between goods sold offline and online, as logistics and rental costs fall and online customer acquisition costs rise. In lower-tier cities, where consumers remain predisposed to offline shopping, these trends are helping revive the business case for expanding physical store networks.

Online price advantage fades

Our research found that Chinese consumers are willing to pay a premium if it guarantees better quality and service, but not a large one. In FTCR's survey of 1,000 Chinese consumers, 55.5 per cent said they were willing to buy a product in-store if the price premium was less than 10 per cent, while 19.3 per cent said they would be willing to do so if the premium was under 20 per cent (see chart).

This suggests that physical retail stores can continue to play an important strategic role for those companies that can keep the offline price premium minimal, although physical stores are likely to remain key in certain sectors.

Our survey suggests that baby products is one such sector, along with groceries, cosmetics, alcohol and home appliances (see chart).

An overwhelming share (71.3 per cent) of shoppers for baby products and accessories said their ability to check product quality meant they wanted to shop in a physical store (see chart). Across a number of product categories, the ability to guarantee quality was seen as a key advantage of buying in a store.

Apparel shoppers, on the other hand, would much rather buy online. The overwhelming preference to buy such goods online is forcing retailers to ensure in-store prices are at comparable levels. Of the 69 local and regional retail sales managers we surveyed, more than half (53.6 per cent) said they were selling goods at the same price or lower than those offered online.

Online no longer guarantees lower cost

The argument that online operations are necessarily cheaper to run than physical stores is increasingly coming into question. Just 40.6 per cent of managers with whom we spoke said customer acquisition costs were lower online than offline.

The cost-per-click of Tencent Social Ads, which run on its WeChat and QQ messaging platforms, rose to Rmb1.6 last year from Rmb0.5 in 2013. Wei Zhe, a private equity investor and former Alibaba.com CEO, reportedly estimated that consumer acquisition costs have doubled in recent years to about 20 per cent of revenue for online retailers.

At the same time, rental costs have fallen. Average rents for ground-floor prime retail space in 15 big cities in China have dropped 20 per cent over the past two years, according to CBRE, an international real estate company. Winshang.com, a Chinese commercial property portal, estimates monthly rents at Rmb800-1,000 per square metre in second-tier and more affluent third-tier cities - much lower than in first-tier cities, where rents can reach Rmb3,000 per sq m.

Rent accounts for 10-15 per cent of revenue for retailers industry-wide, although bigger brands are securing preferential rents of below 10 per cent from shopping mall owners in overbuilt lower-tier cities.

Backing up this cost data, 40.6 per cent of managers we surveyed said offline costs were falling relative to those of ecommerce, with just 24.6 per cent stating the contrary.

Third-tier cities lead bricks-and-mortar expansion

These cost dynamics are making a bricks-and-mortar strategy particularly compelling in smaller Chinese cities.

Residents of lower-tier cities are less receptive to making online purchases than their peers in big cities, our research has found. This in part reflects lower internet penetration rates and less experience with online shopping (see chart), but also a consumer preference in such cities for a hands-on shopping experience.

In key sectors, both established and new brands are building up a bricks-and-mortar presence in third-tier cities and below:

  • We previously noted the strength of own-branded smartphone stores as a sales channel in third-tier cities. Oppo, owned by Guangdong-based BBK Electronics, has leapfrogged saturated first-tier city markets to build extensive physical sales networks in lower-tier cities, with only a fraction of its sales coming from online channels.
  • UBS estimates physical stores account for over 60 per cent of cosmetics sales in second- and third-tier cities, versus just 14 per cent in larger urban centres. In even smaller cities, bricks-and-mortar may be the only sales channel for cosmetics. Hong Kong's Watsons attributed revenue growth of 9 per cent in 2015 to expansion in smaller cities, and planned to have 3,000 stores open by the end of last year, up from 2,483 at the end of 2015.
  • Lower-tier cities provide a cheaper entry point for online companies to go offline. Three Squirrels, an online nut seller that opened on Alibaba's Taobao online platform in 2012, is planning to open 100 "experience" stores this year, located mainly in third- and fourth-tier cities. Meanwhile, in 2015 Fang Jianhua, the founder of online clothing company Inman, said the company intends to open 10,000 outlets in 1,000 Chinese cities within five years, citing high online customer acquisition costs.

Blurring lines between online and offline

Alibaba is a key example of a Chinese internet company moving offline; its purchase of a stake in offline discount grocer Sanjiang Shopping Club last November was just the latest of many investments in bricks-and-mortar. Such acquisitions allow it to tap into sectors in which consumers still prefer to buy goods in-store and provide exposure to lower-tier cities where online shopping is less prevalent.

With store expansion now back on the agenda for many companies, the integration of online and offline operations, particularly among companies in sectors such as apparel, footwear and accessories, cosmetics and personal care, and home goods and furnishings, has assumed even greater importance.

Offline retailers are finding new ways to integrate online resources. Even when in stores, the vast majority of Chinese shoppers still turn to the internet to inform their purchase decisions: 89.8 per cent of consumers we surveyed said they research product information on mobile devices while in-store.

Stores are also offering services beyond those available on their websites, according to 87 per cent of managers interviewed. A manager of a Nanjing branch of French cosmetics brand Sephora said the outlet has established a WeChat group to inform regular customers of promotions and new products, and to fulfil orders.

Limits to store building resurgence

It is important to note, however, that this resurgence of bricks-and-mortar may be limited to lower-tier cities, given higher rental costs in first-tier cities. Furthermore, there is the distinct possibility that as less-connected lower-tier consumers become increasingly internet-savvy, they will follow their first-tier compatriots and turn away from the high street.

This is certainly a risk for companies, such as Oppo, that are taking advantage of a customer base that is, for now, less familiar with other options available in the market. Inman's goals also appear ambitious, given the highly competitive nature of the apparel sector.

Irrespective of these trends, the rise of online-offline integration is set to continue and deepen, maintaining the strategic value of the physical store, despite repeated predictions of its demise.

This article was first published on Jan. 12 by FT Confidential Research.

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and Southeast Asia. A team of researchers in these key markets combine findings from proprietary surveys with on-the-ground research to provide predictive analysis for investors.

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