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Experts: Costco could beat the odds in China's challenging retail sector

Although Costco Wholesale Corp.'s plan to open its first Chinese store in Shanghai comes during a challenging period for foreign hypermarket operators in the country, industry experts told S&P Global Market Intelligence that the U.S. warehouse retailer may have a better chance at success in the market through adaptability and a distinctive business model.

Costco has an online-only presence in China via Alibaba Group Holding Ltd. The retailer first began selling to Chinese consumers in 2014 using Alibaba's dedicated cross-border e-commerce channel, Tmall Global, before launching a flagship store in September 2017 on the primary Tmall.com shopping site, where product offerings were expanded to cover categories such as healthcare, food, apparel, personal care and digital appliances.

"Testing the waters on Tmall should have given Costco some level of confidence. ... That's why they are actually entering the brick-and-mortar space now," Jason Yu, managing director of Kantar Worldpanel Greater China, said in an interview.

The physical store could similarly serve as a test for Costco to understand the Chinese market and its consumers' offline shopping behavior before the company opts to expand its presence and possibly integrate its online and offline channels, Yu added. "Chinese consumers seek omnichannel shopping — they not only shop online but also have the need to experience products offline."

However, the different lifestyle and changing consumption habits of Chinese shoppers might be obstacles for the U.S. retail giant, which sells in bulk and usually places its stores in suburban areas.

"Compared to the U.S., Chinese families have smaller households, live in smaller spaces and own smaller fridges. They prefer high-frequency shopping closer to home for fresh products, and therefore need less bulk items and frozen food," said Jiangming Huang, an associate professor specializing in marketing and retail management at the business school of Renmin University of China in Beijing.

"It will be very difficult for Costco to succeed in China if it completely replicates its product selection and packaging from the U.S.," he added.

Costco China did not respond to a request for comment by S&P Global Market Intelligence.

Struggles in the Chinese hypermarket sector are not uncommon. South Korea's Lotte Shopping Co. Ltd. is selling off its Lotte Mart stores across the country after mounting losses, and E-Mart Inc. has also moved to exit the market. Meanwhile, France's Carrefour SA implemented cost reductions to compensate for slowing sales. Prior to these developments, Britain's Tesco PLC pulled back its retail presence in China to a minority stake in a joint venture.

These outcomes were not anticipated by market observers nearly a decade ago, when foreign hypermarket players showed "sweeping momentum" in China with rapid store expansion and high consumer appeal, according to Chuncai Hu, general manager of Shanghai-based retail management consultancy Shangyi Consulting.

"In 2006, for example, foreign capital-backed companies accounted for about 26% of the top 100 retailers in China, with the market predicting the proportion to surge to 50% to 60% in 10 years," Hu said.

But foreign hypermarket chains took a hit as the rise of e-commerce brought more merchandise, lower prices and improved convenience. Tesco's 2013 agreement to combine its Chinese multiformat retail operations with those of state-run China Resources Enterprise marked the turning point for foreign players in the market, according to Hu.

In response, these retailers are trying to "transform themselves" in China and develop operating models for higher efficiency and profitability, Kantar's Yu said. Efforts include cutting back on store space and diversifying retail formats.

"Carrefour, for instance, launched Carrefour Easy, a store format between supermarket and convenience store usually located in residential neighborhoods to be close to consumers," Yu said.

Other retailers started targeting China's middle class, with Walmart Inc.'s Sam's Club serving as a prime example. The members-only warehouse chain, which has more than 800 locations globally, runs 10 physical stores in China and an online flagship store through JD.com Inc. Members pay 260 yuan per year for access to high-quality products, imported items and in-house brand Member's Mark, in addition to services such as express fresh delivery and discounts at partner stores.

Costco uses a similar business model, charging annual fees of US$60 or US$120 for memberships in the U.S. The company generates most of its profit from membership fees while selling goods at significantly lower margins than most retailers to achieve high volume. The fees account for approximately 70% of Costco's net income before taxes, and its gross margin is only about 11%, annual results from the past three years show.

However, Yu said: "It's still hard to tell whether most Chinese consumers are willing to put down a fee in exchange for cost-effective shopping, as membership-based retail is still in its infancy in China. But based on the case of Sam's Club, such a business model is working."

The Shenzhen location of Sam's Club has been said to generate more than 10 billion yuan in revenue annually, compared with the 3 billion to 4 billion yuan in revenue generated by a well-performing hypermarket, according to Shangyi Consulting's Hu. Sam's Club China did not respond to an inquiry from S&P Global Market Intelligence about its profitability.

Hu believes the alternative retail format could provide a stronger foothold, saying: "Sam's Club's and Costco's business model, which focuses on cost-effectiveness, services and the middle class, stands a better chance of triumphing in China and differentiating itself when compared to ordinary hypermarkets."

No matter the business model, any foreign entrant to China must be adaptable, according to Renmin University's Huang, who pointed to Sam's Club localizing its stores by adding more fresh-food offerings, shrinking frozen-food portions, and providing services such as fish cutting. "In Asia, the fresh-food category is key to a supermarket's performance," he added.

Obtaining local knowledge and talent are also essential, Huang said, especially against competition from well-known Chinese chains like Yonghui Superstores Co. Ltd. that have established relationships with suppliers and governments plus a thorough understanding of local policies and consumption habits.

Beyond strategy, a key lesson for Costco to learn from earlier players in China is to keep up with the times, according to Hu. "A foreign company might be the most advanced upon entry, but it's not easy to maintain that amid changing consumption trends," he said.

As of May 23, US$1 was equivalent to 6.39 Chinese yuan.