Why Foreign Retailers Stumble in China

By Anil Gupta & Haiyan Wang

Tesco’s recent decision to transfer its retail operations in China to a joint venture controlled by China Resources, a local state-owned enterprise, is just the latest example of a prominent Western retailer that has stumbled in China. Tesco (TSCO:LN)entered China in 2005. With 131 stores in the country, however, it ranks only No. 8 by size in China’s hypermarket retail segment and commands a tiny 2 percent share of the market. Letting China Resources take over these operations appears to be the right move for Tesco’s shareholders.

Other high-profile failures of Western companies in China’s retail sector include Home Depot (HD) and Best Buy (BBY). Home Depot entered China in 2006. In 2012, it decided to close all seven of its stores and exit. Best Buy also entered China in 2006, but its market share in China’s consumer electronics retailing has been shrinking and was estimated at less than 2 percent in 2012. It would not be surprising if Best Buy also decides to exit from China. Even the French retailer Carrefour (CA:FP) is rumored to be exploring a sale of its China business.

Granted, some large foreign retailers—such as Wal-Mart Stores (WMT), Metro, and Ikea—may well succeed in China. Even then, it’s clear that, relative to almost every other industry, the retail sector remains a stark outlier in that foreign entrants suffer extremely high failure rates.

While unique, company-specific factors always account for some of the reasons behind individual cases of success or failure, the root cause common to all failures is blindness to the global economics of retailing.

Retailing—a Multi-Domestic Industry

Industry economics matter because industries differ in the relevance of global scale, the cost of shipping goods and services across long distances relative to the cost of production, and the degree to which the product or service does or does not need local adaptation. In the case of the semiconductor industry, global scale in R&D and manufacturing is fundamental to competitive advantage, the cost of shipping chips across borders is tiny compared with the cost of R&D and production, and there is almost no requirement for local adaptation. In such globally integrated industries, you win globally or you die globally.

Many segments of the retail sector (e.g., supermarkets) represent the other extreme. While some goods, such as flat-screen TVs, must be sourced globally, most items (milk, meat, melons, moisturizers, and the like) must be sourced locally even if the supplier is the local subsidiary of Coca-Cola (KO) or Procter & Gamble (PG). All other costs, such as store operations, labor costs, and logistics, are almost 100 percent local. Thus, within any particular country, such as China, what matters is local—not global—scale. Also, as a business-to-consumer business, retail requires deep local knowledge of both consumer needs as well as regulations. In such multi-domestic industries, you win locally or you die locally. This is precisely why even the mighty Wal-Mart Stores (WMT) succumbed in South Korea against competitors who were big locally but tiny globally.

Clearly, there are some exceptions in the retail sector. Ikea provides a good example. Given the nature of Ikea’s products, global R&D matters in such areas as product design and materials technology. So does global sourcing and global production. Even for goods that Ikea sources from within China, its buying scale is global rather than local. And while there is some need for local adaptation—e.g., the size of beds and bed-sheets—it is limited. This is why local competitors everywhere, including in China, have a tough time competing against Ikea.

Guidelines for Success
In most segments of retailing (with some exceptions such as Ikea), the formula for success derives directly from playing to the multi-domestic character of the industry. We advance four strategic guidelines.

First, remember that, in global retailing, depth will beat breadth. Give priority to achieving a large market share in a small number of markets over a small market share in each of many markets. Tesco spread its resources too thinly across many markets. This approach slowed it down in building local market share and scale within China.

Second, be open to local joint ventures if they would be helpful in acquiring local knowledge and building local scale at a faster pace. Companies such as IBM (IBM) and Intel (INTC), which operate in globally integrated industries, tend to be wary of local joint ventures, as these would get in the way of tight global integration of local operations. This is a nonissue, however, in a multi-domestic industry such as retailing, which does not require much global integration except at the margins. Also, given the multi-domestic nature of the retail industry, there is very little risk that a local partner can learn from you and then become a global competitor.

Third, go heavy on local adaptation, including in such key areas as store size and format, product mix, and even store branding. The typical Chinese city has far greater population density than the typical American or European city. Also, the typical customer lives in a smaller apartment with a smaller refrigerator and is less likely to own a car. Thus, trying to clone the size and style of the company’s U.S. or European store is unnecessary baggage and would do little to build competitive advantage in China. Home Depot made this mistake in China. A key element of Home Depot’s success in the U.S. and Canada has been designing its stores around the do-it-yourself concept. It took this concept to China. Given the very low labor costs in China, however, Home Depot needed to think in terms of do-it-for-me rather than do-it-yourself.

Last but not least, lean toward relying on local managers to lead most activities, including sourcing, store operations, and marketing. On a selective basis, you will still need trusted expats in senior positions to ensure strategic and financial control, ethical compliance, and sharing of best practices. The mix of local-to-expatriate managers within the top team, however, should be closer to 90-10 rather than 60-40.

Anil K. Gupta is the Michel D. Dingman Chair in Strategy at the Smith School of Business, The University of Maryland. Haiyan Wang is managing partner of the China India Institute, a Washington-DC based research and consulting organization. Gupta and Wang are also the co-authors of Getting China and India Right (Wiley, 2009) and The Quest for Global Dominance (Wiley, 2008).

This post first appeared in Bloomberg Business Week