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Investing in China’s

Retail Industry
April 2006
Mergers & Acquisitions (“M&A”) is
transforming China’s once closed
retail sector. Deal activity has
surged over the past two years
as consolidation of the young
modern retail trade has begun. Investing in China’s
The familiar global trend of rapid
chain formation to achieve stronger
Retail Industry
buying power over suppliers has
been established, and M&A is the
tool by which retailers are rapidly
linking once fragmented regional
markets. This irreversible trend
provides a multitude of investment
opportunities for multinational and
domestic corporate and private
equity investors. Domestic players
are rapidly building scale in a
competitive land-grab to acquire
the best local assets to form M&A activity in China, 1999-2005
Number of
national chains, and the thirst for US$ bn announced deals
capital this creates is generating
opportunities for private equity
investors and foreign corporates.
Multinational retailers now enjoy
unprecedented freedom to operate
but those who entered during
the period when the industry
was heavily regulated have
legacy issues to deal with such
as buying out Chinese partners
and integrating operations. New
entrants have the option to make
outright acquisitions of existing
retailers or establish their own
domestic sales network. In this
report, we take a closer look at
those retail categories where M&A
activity is most active, and examine
the opportunities for investors.
014
Investing in China’s Retail Industry

Retail revolution
I n the overall scheme of China’s economic reforms, the retail and distribution sectors have been
amongst the last to be deregulated. The broad thrust of China’s economic policy over the last
20 years has been to develop manufacturing, particularly export-orientated manufacturing. The
modern retail trade did not emerge from the central planning system until the mid-1990s, and so to
allow local firms time to develop sufficiently to be able to meet foreign competition, foreign access
to domestic retail and distribution markets was only gradually permitted. During these 20 years,
China’s astonishing economic growth and increasing openness to the outside world have led to
the rapid emergence of an urban middle class of increasingly sophisticated consumers who are
demanding higher quality, variety and innovation from their retailers.

However, China’s retail revolution is not limited to the major urban centres. The unprecedented
migration from the countryside to the cities has boosted the size of the second- and third-
tier urban retail market, and rural markets remain significant. The complexity of this unevenly
developed market and the sheer size of the country make China both an attractive and daunting
market to understand and approach.

Prior to China’s accession to the World Trade Organisation, foreign retailers had to accept a host
of restrictions on their operations designed to slow their rate of growth. However, since 2002
most restrictions have been eased and multinational retailers enjoy unprecedented freedom,
including the option to establish wholly-owned foreign enterprises (WOFEs) rather than operate
through a joint venture (JV). As a result, confidence has increased and foreign retailers are growing
both organically, by opening new stores, and also through M&A, by buying existing chains. A
decision by the Ministry of Commerce (Mofcom), the industry regulator, to devolve responsibility
for approving small- and medium-sized▪ foreign-invested retail operations from Beijing to local
provincial Mofcom entities from 1 March 2006 further eases the process for multinational retailers.

At least 35 of the global top 50 retailers are now in China. In 2005 alone, Mofcom approved over
1,000 investments by foreign-invested retailers and wholesalers with contractual foreign direct
investment (FDI) of US$1.9bn. Yet these companies are barely scratching the surface: foreign-
invested retail operations accounted for just 2.6% of total retail sales in 2004. Of the country’s top
100 retail chains by revenue in 2004, just 17 were foreign-invested, with only one foreign player,
Carrefour of France, making it into the top ten.

The reality is that domestic operators continue to dominate China’s retail sector, with strong
support from the government. In 2004, Mofcom selected 20 flagship retailers—including Shanghai
Bailian (Group) Co, China’s largest retailer with revenues of Rmb72.1bn (US$8.9bn) in 2005—for
special financial support. Beijing knows that with its market opening up steadily to global
competition, its domestic players must modernise, innovate and raise standards if they are to
survive. Indigenous “national champions” are already emerging, nurtured by a government keen to
create major retailers with strong domestic share and the ability to expand overseas. As in other
sectors, the government appears to be focusing its support on state-owned or ex-state-owned
companies—but it may be the quicker moving domestic private companies that grow the fastest,
and M&A will be their tool of choice.

▪ Mofcom defines small- and medium-sized retailers as:


1) those multinational companies with no more than three stores in China (each a maximum 5,000 sq metres in area) and no
more than 30 stores worldwide; or
2) those with no more than five stores in China (each a maximum 3,000 sq metres) and no more than 50 stores worldwide

PricewaterhouseCoopers
024
Investing in China’s Retail Industry

The urge to merge


L arge-scale retailers, domestic and foreign alike, are expanding aggressively in a bid to grow
their networks and boost their bargaining power with suppliers, following a well-established
global trend. The quickest way to gain critical mass is through an acquisition, which can give an
industry player a head-start over its rivals or (in the case of multinational retailers) allow it to catch
up after a late entry. While the handful of major foreign-invested acquisitions in the retail sector to
date have gained significant media interest, by far the greatest M&A activity in the mainland retail
market is domestic, with a land-grab mentality emerging in a game of grow-or-die. Both state-run
and private players are rushing to consolidate in a range of retail sectors, from home appliances
and food retailing to sports and fashion.

This wave of M&A activity is just beginning. Since the modern trade has only been in existence
for around ten years, there are still many retail categories and geographical markets where
established chains simply do not exist—resulting in a shortage of suitable acquisition targets.
However, rapid market development means that targets are emerging with incredible speed.
Some 70,000 new supermarkets opened outside major cities in 2005, while the Beijing municipal
government expects to see around 600 new convenience stores and supermarkets open in its
suburbs in 2006 alone.

This unprecedented chain store expansion will fuel M&A activity as industry players try to build
scale and market share outside their regional strongholds. Chain store operations have already
moved beyond food and home appliances to mobile phones, clothing, sports, DIY/home
improvements, personal care, toys and office equipment. Acquisition and consolidation inevitably
will follow in these and other retail categories as competition grows and local players expand
beyond home markets. The number of outlets controlled by China’s top 30 domestic chain stores
rose 21% year-on-year to 16,665 in 2005, while total sales generated by these companies climbed
31% to Rmb491bn (US$60.5bn) in the same period.

As an aside, this retail revolution


is also spurring a further wave
of M&A activity in the supplier
base as retailer power becomes
a reality. Already hard-pressed
by price wars of recent years,
a shake-out is highly likely in
industries from white goods
to personal care products as
larger retailers seek to increase
their power over a narrower
range of suppliers.

PricewaterhouseCoopers
034
Investing in China’s Retail Industry

Food retailing
T he arrival of modern trade—hypermarkets, supermarkets and convenience stores—has
transformed food retailing in China. This has come at the cost of traditional food retail channels
such as wholesale markets, wet markets and small food stalls. Numerous forces are fuelling the
rapid emergence of modern trade in this category: rising incomes and expectations amongst the
emerging middle-income segment; increasing ownership of refrigerators, eliminating the need for
daily grocery shopping; changing lifestyles, with young couples both working and unable to make
daily trips to the wet market; and growing concern about the proliferation of counterfeit and low-
quality goods following a spate of food related scandals and health scares.

Hypermarkets in China differ from their western counterparts in several ways: many are split on
two floors, with non-food and food on separate floors; many hypermarkets lie in downtown areas
rather than out in the suburbs; low car ownership obliges retailers to provide courtesy buses
to take customers to and from residential areas; staffing levels are far higher than in the west;
average individual spend is very low, at less than Rmb80 (US$9.90) per customer; yet customer
traffic is high, prompting retailers to adapt layouts to incorporate large numbers of basket
shoppers—notably at cash tills.

Local retailers are also helped by three key competitive advantages over their multinational rivals:
they have a good understanding of the local customer; they enjoy strong relationships with central
and local governments (essential when securing prime sites and winning permission to acquire
local state-owned retailers); and they have long-standing partnerships with suppliers (one of the
more difficult tasks facing foreign retailers).

Yet food retailing is one of the few categories in which foreign retailers have made significant in-
roads, in part because they have brought more innovative formats to the market. Carrefour was
the leading foreign retailer in China by sales value in 2005, according to Mofcom, ranking ninth on
the overall list of top chain store retailers with sales of Rmb17.6bn (US$2.2bn). The other retailers
in the top 30 were Wal-Mart, Thai-invested Lotus Supercenter and Metro Jinjiang Cash & Carry Co
(a JV between Metro of Germany and the Shanghai-based Jinjiang International Group). Carrefour
had 78 mainland stores by end-2005, followed by Wal-Mart with 56 stores, and Metro, with 27
stores.

Major food retailers (both domestic and


foreign) are expected to continue their
expansion from tier-one cities into the
tier-two and tier-three markets, which
often lack dominant local players—
making inland cities such as Kunming
(Yunnan province) and Chongqing
municipality some of the more
profitable markets for multinational
food retailers. In a typical acquisition
in February 2006, Hong Kong-listed
Wumart Stores Inc, Beijing’s largest
chain store operator and the tenth
largest in the country, acquired a 75%
stake in Beijing MerryMart—a smaller
rival with 23 stores—for Rmb253.3m
(US$31.3m). When combined with its
earlier acquisition in Tianjin, a Greater
Beijing regional chain is being formed.

PricewaterhouseCoopers
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Investing in China’s Retail Industry

Home appliances
C hina’s home appliance retail sector is not for the fainthearted. Relentless price wars have
reduced margins and created a grow-or-die model for the top five players as they strive to
expand beyond regional bases to achieve economies of scale. The sector is dominated by home
appliance retailers in this category: Gome, Suning, Yongle (Paradise), Sanlian and Wuxing (Five
Star). All have embarked on acquisition trails to meet aggressive expansion targets and outgrow
the competition. The total number of stores controlled by these five companies rose 61% in
2005 alone, while sales increased by 67%. Gome and Suning were the second- and third-largest
chain store retailers in China in 2005, registering sales revenues of Rmb49.8bn (US$6.1bn) and
Rmb39.7bn (US$4.9bn) respectively.

In order to finance this growth, the top home appliance retailers have listed (or soon will list) on
the Hong Kong Stock Exchange. In October 2005, Yongle raised US$115m through a Hong Kong
IPO, while in January 2006 Five Star filed its own application to list. Rapid expansion has helped
Gome, which saw an 88% year-on-year increase in its store network to 426 outlets in 2005 after a
back-door listing in Hong Kong the previous year. Faster build-out of outlets means higher sales
volumes and greater purchasing power with suppliers, which translates to competitive advantage.
Focus on leading suppliers was demonstrated by its February 2006 announcement of annual
purchase contracts worth Rmb2bn (US$247m) with 15 home appliance manufacturers, including
local white goods giant Haier and HP of the US.

Yet as young companies, substantial challenges face these fast-growing industry leaders to
sustain growth and build long-lasting retail models. These players are following a similar path
as the country’s food retailers a few years ago, and rather than solely relying on leaseholds for
expansion home appliance retailers are now looking at buying properties as available prime
locations become fewer. We are beginning to see home appliance retailers looking to acquire
chain store rivals not only for their existing business, but also for their property portfolios. In April
2006, for example, Yongle secured rights of first refusal on Dazhong Electrical Appliance, Beijing’s
largest home appliance retailer after Gome, in the event that it chooses to sell its 60-store chain
within a year.

Even in this cut-throat market, MNCs see opportunities. In March 2006, US retail giant BestBuy,
the world’s largest home appliance dealer with more than 930 chain stores and annual sales of
US$24bn in 2004, announced plans to open stores in Beijing and Shanghai in 2006. BestBuy
already has three sourcing offices in Shanghai, Shenzhen and Beijing, and has started building
relationships with manufacturers, such as a deal with Chinese personal computer maker Lenovo
to sell PCs and laptops to small and mid-sized business consumers.

The challenge for MNCs following the organic route is how to compete with local retailers who
have far higher buying volumes with the local brand manufacturers that Chinese consumers
prefer. Whilst they can leverage some global sourcing relationships, the overlap between product
categories which are common to the US and
Europe and China is not large, and hence many
of those global sourcing relationships cannot be
leveraged into the types of products that Chinese
consumers want to buy. For example, a washing
machine in China is normally a top-loader
compared to US and European front-loaders;
ovens are rare in China and stoves are gas
powered, not electric; and airconditioners often
combination single-room units rather not central
systems.

PricewaterhouseCoopers
054
Investing in China’s Retail Industry

DIY and home improvements


T he reform of the housing system in the 1990s led to the birth of a true property market, with ex-
state employees given the opportunity to buy their rented homes and huge volumes of higher-
quality new housing being built for first-time buyers. Most buyers still look to buy new apartments,
most of which are sold as empty concrete shells which owners have to decorate for themselves.
Retailers are vying for the mid- to high-end section of the market, where better-off homeowners
need to buy everything from coatings to coat hooks in one intense three-month period when their
new apartment is decorated for the first time by teams of decorators. This market is referred to as
the ‘Buy-it-Yourself’ market, as the job is too large to be done by apartment owners themselves,
whose role is reduced to choosing the materials which the decoration team uses.

One of the earliest entrants into this market was B&Q, owned by Kingfisher of the UK, which has
ridden on the back of rapid growth in demand and skilfully adapted its products and services
to these unique circumstances. B&Q has added a full apartment decoration service to its usual
retail operation, whereby customers can design their own apartments and have them decorated
and furnishings installed by B&Q decoration teams. The retailer has designed and fitted out some
15,000 apartments in China to date. B&Q has also embarked on a rapid expansion plan, opening
new stores and making acquisitions. In June 2005, the company purchased and rebranded the
China stores of Germany’s OBI—until then the third-largest player; and in October 2005 it acquired
five of US-based PriceSmart’s 30 stores in Tianjin and the provinces of Heilongjiang, Shandong
and Sichuan for US$13.4m. As of March 2006, B&Q had 49 stores in China, with plans for 60 by
year-end and 100 by 2010.

In furniture retailing, IKEA of Sweden entered China in 1998—though it has been sourcing goods
since the 1970s. By sourcing roughly 80% of its goods in China, the company has managed to
drive down prices since 2000 and extend its customer base. Mainland sales revenues jumped
21% for fiscal 2005, with more than 9m people visiting the company’s two stores in Shanghai
and Beijing during this period. This prompted IKEA to roll out new stores in a bid to gain scale: in
October 2005, IKEA opened a third store in Guangzhou, and in April 2006 it opened the world’s
largest IKEA outlet after its Stockholm flagship store. Another mega store is planned for Shenzhen
in 2007, with seven more stores around the country planned by 2010. After shifting its financial,
operational and purchasing functions from Singapore to Shanghai in 2005, IKEA’s Asia-Pacific
headquarters is expected to follow suit.

The under-developed DIY segment still has opportunities. Home Depot, the world’s largest home
improvements retailer, has been circling China for years. In 2004, it appointed a new China team to
study potential acquisitions; in 2005, it received Chinese government approval to set up mainland
stores; and in February 2006, it was reported to be in negotiations to acquire a 49% stake in
Orient Home, a major domestic player, for some US$200m. Orient Home, part of the Orient Group,
first entered the DIY/home improvements market in Beijing, then Shenyang, before expanding to
Changchun (Jilin province), Chengdu (Sichuan province), Nanchang (Jiangxi province) and Xiamen
(Fujian province) in the first half of 2005 to take its total to more than 20 outlets.

PricewaterhouseCoopers
064
Investing in China’s Retail Industry

Fashion retailing
N ational domestic chains have only started to emerge in the last few years. For example,
Metersbonwe, a casual clothing chain set up in Wenzhou (Zhejiang province) in 1994, has
annual sales of some Rmb2bn (US$247m) and roughly 1,500 stores around the country—over
900 of them franchise operations. Other emerging names include SeptWolves, a menswear
retailer based in Fuzhou (Fujian province) and Youngor, also in menswear, from Ningbo (Zhejiang
province).

Foreign fashion retailers have also been successful in creating a national footprint. Hong Kong-
based casual clothing brands in particular have expanded rapidly beyond tier-one and tier-two
cities. These retailers, led by Giordano, Bossini and Baleno, have sought to achieve scale while
repositioning themselves to a more local offering, all the while under constant threat from local
rivals which learn quickly from competition. Giordano, which entered China in 1992, now has
680 mainland outlets representing about 45% of its total operations. In 2001, mainland China
overtook Hong Kong as the company’s main market. Giordano claims to have been profitable in
China for the past five years, partly thanks to a well-developed local sourcing base and strong
relations with manufacturers. Important for the success of Giordano and other Hong Kong-based
casual clothing retailers was the Closer Economic Partnership Arrangement (CEPA), which gave
Hong Kong retailers an early-mover advantage over the international competition in allowing
them to set up wholly-owned retail and distribution businesses as of early 2004. While the market
is now fully open to all comers, Hong Kong retailers have nevertheless benefited from greater
market familiarity, stronger brand recognition and comparatively long-standing relationships with
suppliers. Yet with time, this competitive advantage is expected to diminish gradually as other
foreign entrants catch up.

While some international retailers have chosen to expand via franchise agreements, others are
taking the concession route. Esprit, which was one of the earliest foreign clothing retailers to
enter China in the 1990s, now has 280 concessions. French retailer Etam has moved even more
swiftly, with more than 2,000 stores nationwide—mainly department store concessions. Etam has
benefited enormously from this rapid rollout, with sales climbing 14% in China in 2005 and helping
to drive group profits to US$17.2m in 2005 from a US$68.2m loss in 2004. Tokyo-listed Fast
Retailing Co., which opened its first Uniqlo clothing stores in Shanghai in September 2002, had a
patchy start but is reported to be seeing steady revenue growth, and opened its first two stores in
Beijing in September 2005. In February 2006, Spanish fashion giant Inditex opened its first Zara
flagship store in Shanghai. Zara, a fast fashion high-street brand which opened its first Hong Kong
outlet in early 2004, plans to open more outlets in Shanghai and Beijing by the end of 2006.

The expansion of modern retailing has sparked a renaissance in retail environment and experience,
with developers building high-end shopping malls in first- and second-tier cities across the country
and private equity and hedge fund investors seeking retail property investment opportunities.
Increased availability of quality retail space has also encouraged luxury brands to set up shop,
particularly in top malls in Shanghai and Beijing.

PricewaterhouseCoopers
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Investing in China’s Retail Industry

Outlook and opportunities


A s China’s retail sector continues to evolve, deal activity is expected to remain strong in the
medium term, until consolidation in a particular sector has been achieved. Emerging players
will continue to try follow the trail blazed by Gome, Wumart and Shanghai Yongle, seeking
strategic of financial investors prior to tapping capital markets in order to finance aggressive
expansion through store openings and M&A. Other opportunities will come from the restructuring
of state-owned retailers and the introduction of outside investors. Prospects for private equity
investors in pre-IPO transactions are particularly favourable. The restructuring of the retail sector is
also creating further consolidation in the supplier base and in retail real estate development.

With the market now open to all comers, foreign retailers are also stepping up deal activity, driven
either by a need to acquire existing chains in order to accelerate their entry into the market, or
to take advantage of eased restrictions to free themselves of local partners by setting up retail
WOFEs for some outlets. However, the joint venture should not be written off as being irrelevant
because not all local partners are equal. Some early movers like Carrefour were in some cases
forced into partnerships with unsuitable partners, and freed from regulatory restrictions which
previously limited foreign ownership, it has begun to acquire the stakes of those JV partners in
a number of stores around the country. On the other hand, later entrants such as Tesco could
choose a proven local retailer as its partner, and may retain a JV structure for its operations in
order to take advantage of their local partners’ strengths. In negotiations, leading local retailers
are more aware of their increased bargaining power. The value proposition that a foreign retailer
needs to bring to the table is changing, as these strong domestic players are likely to demand
higher valuations, be less likely to give up control, and be more aware of the alternatives available
from private equity and capital markets.

There is no one-size-fits-all in terms of retail success in China: while regulatory changes under
WTO have created more options for expansion for foreign retailers, finding the right strategy and
investment vehicle remain crucial considerations.

While the lion’s share of M&A action will remain


domestic-to-domestic transactions, that
consolidation process will result in stronger
retailers which will be more attractive acquisition
targets. At the same time, emerging domestic
retail giants in search of new markets will be
stepping up their activity overseas. Home
appliance retailer Gome, which already has six
stores in Hong Kong and is due to open three
more in Macau in 2006, plans to open stores in
south-east Asia—to be followed by outlets in
Europe and the US. The partnership between
Chinese retailers and Chinese suppliers could
be a powerful one, especially in regional Asian
markets where there is more product overlap.
The fight for market share against Chinese
retailers will soon be played out not just in
mainland cities, but in the global market.

PricewaterhouseCoopers
For detailed information, please contact:
China/Hong Kong Retail &
Consumer Leader:
Sonny Doo
Assurance Partner, Guangzhou
Tel: +86 20 3819 2248
sonny.doo@cn.pwc.com

Audit and IPO:


Arthur Kwok
Assurance Partner, Shanghai
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arthur.kwok@cn.pwc.com

M&A:
Graham Matthews
Transactions Partner, Shanghai
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betty.ko@cn.pwc.com Investing in China’s Retail Industry is the second
in a series of thought leadership reports which
IFRS: analyse the key issues facing multinational
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