WEIGHING SCALE
A Chinese retailer tries to battle giant local competitors and an emerging foreign one.
By Abe De Ramos

Imagine yourself the CFO of a US$1.5 bn-a-year retailer of consumer electronics and household appliances that saw its sales and profits rise by about 50% last year. You have a cash reserve of US$200m and no debt, allowing you to easily plan to more than double your store network this year. By numbers alone, you would seem to be in an enviable position. But James Zhang, who holds the job for China Paradise, which now owns 229 stores in the mainland, hardly feels like it. Being stuck in third place in a fast-growing, cutthroat market is nowhere near his comfort zone, especially when the second-largest competitor nearly doubled its profit, while the market leader has twice as many stores. If that were not enough, America’s Best Buy, the largest consumer-electronics retailer in the world, has found its way in. A war of scale is brewing, and Zhang is upping the ante by trying out an old business model that has never been tested in the industry in China.

This is what the battlefield looks like. Because of rapid urbanization and a growing middle class, domestic consumption in China has become the new hotbed for retail potential. Private consumption grew 64% to 10.4 trn renminbi in 2005 from 6.3 trn renminbi in 2000; as a component of consumption, retail sales soared 97% to 6.7 trn renminbi, according to a report by investment bank JPMorgan. And as the nascent private-housing market continues to grow, so will the market for products that the new homeowners use. Latest state figures say sales of air conditioners grew 17% a year from 2000 to 2004, while digital products such as mobile phones grew 24%. Yet the penetration levels of these items remain low, as is the reach of the retailers that sell them. Zhang says only 20% of consumer-electronics shops in China are operated by the top five chains; the rest are either regional or smaller, independent operations. As the biggest chains grow, the margins of those that do not have strength in numbers will inevitably get squeezed, paving the way for consolidation.

“We have a mounting task at hand to compete with our bigger competitors,” says the 35-year-old Zhang. “The final game is about increasing your margin.” In a vast country like China, that game is synonymous with market dominance, and China Paradise is quick to the draw. Just four years ago, it had all of 14 shops in Shanghai. Aggressive store build-up and acquisitions quickly turned it into a serious competitor to national players Gome and Suning. Last April, it agreed to acquire Dazhong, the fourth-largest in the sector and the market leader in Beijing, with 60 stores across the capital. This follows earlier buyouts of smaller assets in Guangdong, Fujian, Henan, and Sichuan provinces. “I spend 30% of my time helping the CEO formulate strategic decisions on the M&A front,” says the British-educated Zhang, a trained accountant. “We plan to open between 90 and 100 stores a year for the next three years.”

That may do little to change the status quo. Suning, the second-largest player, plans to grow by no less than 100 stores a year, say analysts. Gome, the largest player and owned by the fourth-richest man in China, has an even higher goal of 125 a year. If these targets are accomplished, China Paradise – whose shops go by the brand name Yolo – will have 293 stores by the end of the year, 10% behind Suning and 48% behind Gome. While the gap would narrow, China Paradise would still not have the scale to justify demanding a higher margin from its suppliers, a threat to its long-term profitability. In fact, Zhang warned investors in April that the Hong Kong-listed company might not achieve its first-half profit target, leading to a 20% decline in its stock price in one day. Zhang knows the company needs more than scale to survive, and he thinks the solution is to take a bigger inventory risk – a new phenomenon in the sector.

The More, the Merrier

Think of the Chinese consumer-electronics retailers as glamorized concession stands. In most developed markets, retailers purchase products from the vendors and display these on the shelves by functionality; an Apple iPod, for example, would be on the same shelf as a Samsung MP3 player. As economies of scale go, how cheaply retailers pay for the items depends on the volume of units they buy. The mark-up in their selling price then dictates their margins and profitability. In China, the retailers do not buy the goods from vendors; instead, they provide the space in their shops for the vendors to display their products. Customers hop from one display to another if they want to compare brands. As with any consignment arrangement, the profit of the retail-space providers – which mostly comes in the form of rebates – depends on the number of units they actually sell. The more units sold, the higher the rebates.

This system is good for the retailers from a cost perspective. The amount they charge the vendors for display space – which varies according to prominence and square-footage – usually covers the cost of setting up the store. Zhang says China Paradise on opening day recovers the average 1.3m renminbi it spends on refurbishing the shops, which are mostly under lease agreements. They get a windfall – up to 5m renminbi – when they open new shops during the “Golden Week” holidays of May and October. Likewise, staff cost is minimal as vendors send their sales representatives to the store premises. At China Paradise, only 30% of workers in its stores are on its payroll. As such, its staff cost is only 1.5% of sales. The bigger cost drivers for the company are marketing (1.8% of sales) and rental space (2.7% of sales).

As the products are sold on consignment, the Chinese retailers do not own the goods and thus hold no inventory risk; items are returned to suppliers if they remained unsold for an agreed number of days. Retailers also enjoy the benefit of negative working capital. While they claim their rebates on the day of sale, they do not necessarily remit the payment to the vendors for an extended period of time. At the end of 2005, these “payable days” were as long as 126 days for China Paradise, 111 days for Gome, and 42 days for Suning. (Analysts expect these companies to shorten their payable days in return for higher rebates, but Zhang is not convinced it would make a difference. “Once the vendors get their bills payable, they don’t cash it out; they pass it on to the other end of the supply chain,” he says.)

In any case, the flipside of this low-cost arrangement is that it is also a low-margin model. In 2005, the gross margin of the top three players averaged 8.7% compared with around 25% each for Best Buy and RadioShack, another US electronics chain, which take inventory risk. To be sure, a number of factors influences the total return. Retailers, for one, have weak negotiating powers to begin with because they source their products from separate regional offices of the vendors. “We’re trying to work with some of our vendors to develop a single, one-to-one point of contact,” says Zhang. What remains constant is the fact that vendors would give higher rebates – and in some cases, marketing support – to those that generate more sales. And given the rapid urbanization of China, preference is given to those with the most stores in the most affluent markets. “The higher purchasing power is in a given region, the better terms you get from the vendor,” adds Zhang.

As such, China Paradise is adopting an expansion model different from its competitors. Gome and Suning are building their store and distribution networks across the mainland, establishing a presence in every province even with just a flagship store. While Gome’s aggressive expansion enhances its bargaining position, says Selena Sia, analyst at brokerage firm UBS in Hong Kong in a report, the higher selling and distribution expenses it will incur “will outweigh any higher rebates from suppliers” in 2006 and 2007, as they did last year. In 2005, in spite of an increase in Gome’s average rebates to 4.1% from 3.9% in 2004, its average gross margin declined to 9.2% from 9.5% over the same period.

Suning, on the other hand, is expanding in both tier-one and tier-two cities “to avoid face-to-face competition with Gome,” says Raymond Ma, Shanghai-based analyst at BNP Paribas in a report. Its gross margin, nonetheless, slipped to 9.5% from 9.6%, also due to higher operating costs. China Paradise has done a better job of balancing growth with margins by focusing on its core markets of Shanghai, Jiangsu, and Zhejiang. (Since 2003, it has also expanded into the prosperous eastern regions of Fujian, Sichuan, and Tianjin.) Its gross margin rose to 7.5% in 2005 from 7% in 2004. Its acquisition of number-four player Dazhong in Beijing could further boost this figure. “Acquiring Dazhong would make Paradise the leading operator in China’s two major cities of Beijing and Shanghai, increasing its bargaining power with suppliers,” says Kenneth Ma, analyst at brokerage firm Cazenove in Hong Kong, in a report.

The problem? Competition is building up in the most lucrative markets of China Paradise as well. In Shanghai, where China Paradise had 53 stores as of end-2005, Gome is planning to double its stores to 60 by the end of 2006. Best Buy, meanwhile, will make its presence felt in Jiangsu province, home of number-five player Five Star Appliance, in which it took a 51% stake last May for US$180m. “Because of its experience in logistics systems and customer service, Best Buy will likely raise industry standards in internal efficiency and external services,” says Sia. Specifically, the analyst envisions that Best Buy’s venture with Five Star, which has 136 stores in Jiangsu, “will likely lead to a deterioration of China Paradise’s business outlook in [that province] for the next two to three years.” Zhang disagrees, saying Best Buy is likely to take a passive role, at least initially (see box, “Who’s Afraid of Best Buy?”, below).

Breaking the Mold

In this predatory environment, China Paradise is breaking away from the homogenous way that consumer-electronics retailers have been run in China. Zhang counts on the potential of a business model that tears a page from Best Buy – by increasing the amount of inventory risk it takes on, which analysts estimate at 10% currently. “Only in this way can we differentiate ourselves from our competitors,” says Zhang. This is just part of the equation, however. Because the practice is largely untested in China, the company will adopt it only for private labels – another new idea in Chinese retailing. “We will take inventory risk for exclusive products; otherwise what everyone is selling is exactly the same as our competitors,” Zhang says, declining to give estimates on the proportion of private labels to total sales.

The company, Zhang adds, has created a new buying unit now dealing with original-equipment manufacturers that could develop products, with unique functionalities, for China Paradise. The CFO estimates that Yolo-branded hi-fi products, for example, could generate margins 10 percentage points higher than what the company gets from established hi-fi brands. Zhang points out that in mitigating inventory risk, scale inevitably plays an important part. “Once we have reached a certain scale, the risk of not selling in one area can be spread down to another area,” he says. Apart from private-label products, China Paradise is adding lighting products to its shelves, a move analysts approve. “Residential-lighting retailing offers high margins,” says an analyst at a US investment bank in Hong Kong, “and there is no intense competition in this segment.” China Paradise estimates that gross margins from these products could be as high as 50%.

While cash is not a hindrance to implementing these plans, its other currency – the share price – is weakening and could render China Paradise vulnerable to a hostile bid. Since it went public in Hong Kong last October, its share price almost doubled to HK$4.3 in April, only to plunge to HK$2 by the end of June – 15% below the IPO price. Zhang says the profit warning was largely to blame, but also, Morgan Stanley Private Equity, which owned 24% of the company since 2003, cashed in on its prior gains and sold half of its shares to the market. “It created a panic,” says Zhang. “The market ignored the good news of our Dazhong acquisition, which we announced at the same time.” The share price has not recovered since; as such, Zhang says he spends 40% of his time meeting stakeholders to communicate corporate strategy. “I’ve met 433 investors and analysts in the half year since the IPO,” he says.

More than that, China Paradise is taking a disciplined approach to convince investors that it is focused on profitability. Last May, it sold its entire interests in seven fully- or majority-owned subsidiaries – including lighting, home-furnishing, and building-material retail operations that rely heavily on sales from new-home developers – and put the proceeds of 25m renminbi into its working capital. “Going forward, a more concentrated business will command a higher price on the stock market,” says Zhang. “Trouble-making units normally require much more investment and management time, so in this competitive environment, we want as much as possible to focus on the core business.” While the divestment was not enough to improve the share price, investors approve of the company’s “clean ownership structure” – something its rivals cannot boast of. “Key personnel in China Paradise’s management team have no significant business activities outside the company,” says Ma of Cazenove.

In the meantime, Sia of UBS advises: “A focus on cost reduction as well as enhancement of customer services might be the answer to curbing profit-margin erosion in the short term.” Zhang agrees – to a certain extent. The CFO suggests that his cost base – mainly driven by marketing, rents, and wages – is already at its tightest. “You can only reduce rent and marketing expenses so much, and marketing directly impacts your sales,” he says. As far as rentals go, Zhang estimates that 20% of the 470,000 sq m total retail space of China Paradise may be sublet “to a non-competing retail chain.” The company announced in late June that it was cutting its work force by 10% to reduce operating expenses. But Zhang says these are solutions that are not likely to be recurring. “Costs can go down by only so much, and they’re already on the way up,” he says. “What can you do? You go with service.”

Indeed, this is where China Paradise also intends to differentiate itself from competitors. Unlike Gome and Suning, it offers unconditional refunds to customers within seven days of purchase, and exchanges beyond seven days. It also operates a toll-free customer-service hotline with a 5,000-line capacity. “We are also trying out a CRM (customer-relationship management) program in Shanghai to analyze people’s spending patterns,” says Zhang. “We estimated that more than 80% of our total sales in Shanghai come from people who have shopped with us more than six times in the last two years. We want to go out to our most loyal customers and attract them back to us.” Even more radical, Zhang says China Paradise is now testing in two stores in Shanghai a shop layout where products are arranged by functionality instead of brand, and sold by its own employees instead of the brands’ sales representatives.

And from his desk on the fifth floor of the China Paradise headquarters in Shanghai, Zhang says he spends 30% of his time making sure that the finance department is lean and agile enough to support the overall growth strategy. His biggest task at hand now is “to work out a level of banking centralization to improve the efficiency” of the finance operations. So far, he is trying out bringing to Shanghai the cash-payment function of the Beijing and Tianjin offices. Zhang is not new to this experience, having centralized the finance function of the British-owned do-it-yourself retailer B&Q in China, as its CFO. “The finance function (in B&Q) doesn’t exist in the regions anymore, which is the ideal situation,” he says.

That was no mean feat for a company with sales of US$524m a year in 50 branches across China. And yet, Zhang says his prior job pales in comparison with the scale of his responsibilities as CFO of China Paradise. “To use an analogy, my role in B&Q was like the role of the finance manager in Beijing,” he says. “You take instructions, you get the support of funding from the group, and you don’t deal with investors. Here, I get involved from the very beginning.” With the battlefield ahead, that is all but expected.