Online China a lesson for the future

Experience of existing businesses in China from online ecommerce will provide great lessons for entrepreneurs in the rest of Asia. That the internet will disrupt is a given, but the scale of destruction on incumbent businesses might still be mitigated. If incumbents heed the lessons from China and the time afforded to them by the sheer lack of infrastructure in their respective countries, perhaps the capital destruction might be limited.

I had a very sobering call with a savvy and experienced CEO of a middling apparel label in China. One of the pioneers in identifying the branded apparel opportunity in China in the late 1980s, he grew the business to be a very profitable one. Being early, positioning themselves as a ‘foreign’ brand, focusing on brand building, charging what were then considered high prices and offering product innovation and exclusivity, the business earned gross margins of 80-85% and EBIT margins of 25-35% while growing top-line 20-25% p.a.

In the mid to late 2000s luxury brands like LVMH, Gucci, Prada and the rest expanded in China. With the economy roaring and the consumer spending with gay abandon, this brand onslaught pushed down his brand’s positioning while driving up rental and advertising costs. He was late to recognise the impact of the big boys and lost out to them competitively.

The past three years have gotten worse as the Chinese consumer has embraced online commerce. Apparel, shoes and electronics were the first to migrate. “For our brand, this has been the death knell. It’s a matter of survival at the moment”, said the CEO. The internet has conditioned consumers to look for discounts and deals. It has allowed new brands to access a distribution channel that is not physically constrained. But equally, copycats and fakes have proliferated. Meanwhile, the corruption crackdown in China has constrained the luxury business and gift-giving.

I asked him should this not result in a better bargaining status against malls and department stores, helping him cut costs? His insight was quite educational. In the olden days, he dealt mostly with state-owned malls and department stores. They were well-located and had a depreciated asset base; hence willing to accept rentals that were reasonable.

As the property boom expanded, new developers, especially from Hong Kong have built massive capacity. Since most of them are listed, they want appropriate returns on their capital. That means higher rents, sucking the tenants dry. In Chengdu, a city in Central China, he mentioned mall capacity has expanded ten-fold in the past four years. Landlords remain stubborn and keep shops vacant rather than lock in lower returns. The HK developers will at some time be forced to write down the carrying value of their malls. The internet will force them to accept reality.

A case study: Biostime

My worst-performing stock in 2014 (I sold out of it in August 2014) was Biostime International. Even though we were vigilant on the risks of online retail, I was late to recognise that Biostime too would be a victim of this seismic change. When we first bought the stock in September 2011, it traded at 11-12x forward earnings with a market cap of US$875m. Markets were sceptical on the fortunes of the company as this was a recent listing of a mainland Chinese company in the infant milk formula business; the scars of the melamine scandal were still relatively fresh. But after meeting management and analysing the results, we found that the company had taken advantage of that very scandal and positioned its product advantageously.

It tied up with a couple of foreign brands in Western Europe to manufacture the formula, addressing the Chinese consumers’ mistrust of Chinese formula brands. Biostime also identified the emergence and growth of the ‘baby stores’ as a distribution chain. This was a relatively new format that catered to almost every product related to new-borns, young children and their mothers. Biostime were smart to create a ‘Mama100’ platform that tied every purchase by a customer to reward points, which were monitored by installing a company-specific point-of-sale system. And the final audacious move was to launch their brand at a big premium to even Nestle and Abbott’s products. Sales grew rapidly, margins were robust and competition was slow to spot the opportunity.

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