Find First-Tier Consumers in Hundreds of Cities

Rising disposable income levels across China’s second- and third-tier cities mean more opportunities for purveyors of branded goods.by Francis Bassolino and Matthew SmithFirst-tier or second-tier city? Many foreign analysts and strategists fall into the standard practice of categorizing cities in China to determine which markets to enter or how to expand beyond the traditional entry points, such as Beijing or Shanghai. A far more effective approach is to target the “first-tier consumer”—a consumer defined more by spending behavior, income, and lifestyle than by home geography. (Though the qualifications that define a first-tier consumer lack standard guidelines, analytical frameworks for this research often include savings, car ownership, ownership of luxury goods, and disposable income.) This approach is particularly effective for marketing and selling luxury products and branded goods in general.

Given the rapid pace of development throughout China, many companies find that negotiating a successful brand launch in a first-tier city is no longer a sufficient market-entry or expansion move. Cities such as Beijing; Guangzhou, Guangdong; and Shanghai have a large share of first-tier consumers—but they no longer have them all. More than 50 percent of the richest Chinese live outside traditional centers of wealth. Given current macroeconomic trends that support broad-based growth across the country, growth in China’s middle class and wealthy consumers over the next five to seven years will occur primarily outside the traditional first-tier cities.

The question that remains is how to tap the first-tier customers that live outside Beijing, Guangzhou, and Shanghai. These customers have the desire and ability to consume branded products. They are also able to allocate a larger share of their income to these products because the cost of living in second- and third-tier cities is generally lower.

Look deeper

First-tier consumers in China’s second-tier cities offer some of the most attractive growth opportunities. For example, at the end of 2009, Suzhou, Jiangsu, (population 2.4 million) had nearly 16,000 residents worth at least ¥10 million ($1.5 million) and more than 900 residents worth at least ¥100 million ($14.9 million) (see Table 1). With rapid growth predicted over the next decade, the number of millionaires in Suzhou should continue to rise. This increase in wealth will not be limited to the top quartile of consumers, as defined by disposable income and net personal wealth. Alaris Inc. projects that given the trajectory of current growth patterns, Suzhou’s overall 2010 gross domestic product (GDP) may reach ¥740 billion ($110.3 billion), up 11 percent over 2009. (The city’s GDP grew at an annual rate of 15 percent over the past 25 years, 5 percent higher than China’s national annual growth rate.)

Alaris research shows that in Suzhou urban residents’ per capita disposable income may reach ¥26,350 ($3,928) in 2010, up more than 10 percent over 2009. This growth rate is not unique to Suzhou—it is a common trend in rapidly growing second- and third-tier cities across the country. Disposable incomes in these areas are rising and will foster higher demand for branded goods as consumers and companies move beyond basic needs to more emotional purchases (as they make direct connections to a brand personality) and functional demands (as they seek higher relative performance) from the products they consume. Many brands— both foreign and domestic—have prominent representation in Beijing and Shanghai but are under-represented in second-tier cities with wealthy households and companies.

Follow the money

Some companies that sell branded goods have already begun rapid expansion into second-tier cities to take advantage of burgeoning demand. For example, Harley-Davidson, Inc. has expanded outside of Beijing and Shanghai to open new motorcycle dealerships in cities such as Chengdu, Sichuan; Dalian, Liaoning; Qingdao, Shandong; Wenzhou, Zhejiang; and Xiamen, Fujian. Steve Wasser, managing director of Harley-Davidson China, says that the company will double the number of Mainland cities with dealerships to 15 cities by 2012.

With so many up-and-coming second-tier cities, which areas stand out in the search for the top-tier consumer? Somewhat surprisingly, such consumers are everywhere. Northeastern cities such as Dalian and Shenyang, Liaoning; and Harbin, Heilongjiang; as well as Yangzi River Valley cities such as Changsha, Hunan; Nanjing, Jiangsu; and Wuhan, Hubei, represent the strongest retail growth markets. But hundreds of cities will be rich targets for many levels of consumer products, and regional statistics suggest that many of China’s top-growth areas will be outside of traditional markets (see Table 2).

The average compound annual growth rate (CAGR) for these second-tier markets from 2000-09 (adjusting for the outlier Qingdao, where annual growth rates reached 42 percent) was nearly 15 percent, according to PRC National Bureau of Statistics figures. Interestingly, the CAGR for regional GDP trails behind the retail sales growth numbers. This gap likely reflects the lack of accounting for the gray economy and pent-up consumer demand in these previously underserviced markets.

A national poll conducted by Alaris in summer 2010 showed a frequent mismatch in supply and demand: Chinese have the money and desire to consume but the products they want are unavailable (see Tapping Into Consumer Desires). Notably missing from a top 10 list of cities with selected luxury brand presence are several cities with high GDP per capita or high levels of disposable income, including Fuzhou and Xiamen, Fujian; Hohhot, Inner Mongolia; Jinan, Shandong; Wenzhou; and Zhuhai, Guangdong (see Table 3). This ranking of cities by various indicators of consumption and savings suggests that most companies should consider a wide range of factors when moving beyond the first tier.

Other areas that companies tend to overlook as strong potential markets are “smaller” cities near big first-tier cities along the coast. For example, Tianjin ranked as China’s third fastest-growing city in GDP terms. It has a population of more than 8 million, total GDP reaching at least ¥750 billion ($112.7 billion), and GDP per capita of more than ¥62,400 ($9,390). But for market-entry purposes, analysts often try to cover Tianjin from Beijing. Alaris research shows that such an approach yields below-average results as not all Tianjin consumers will travel to Beijing to make purchases. Generally, Tianjin is a first-tier consumer city; it has the disposable income levels, population density, and the general state of development that demand direct coverage and care. Therefore, if economic constraints force a company to choose Beijing over Tianjin, an effective alternative strategy may be to focus on a region—say capturing all of the first-tier consumers of the Bohai region instead of starting a strategy that has less returns to scale in Beijing, Guangzhou, and Shanghai.

A wide open road

Rapid economic growth in Tianjin, Suzhou, and many other second-tier cities may have some analysts worried about the long-term stability of these local economies. But such fears may be unwarranted, as growth is driven by several factors—government spending, improved infrastructure, regulatory changes, and relative competitiveness—that will support development for the foreseeable future.

Government spending

In 2008, the PRC government launched a ¥4 trillion ($601 billion) stimulus plan to help the country weather the economic crisis that began in China almost a full year before financial chaos struck the Western world in late 2008. Among the key components of this plan are funds allocated to infrastructure, earthquake reconstruction, technology advancements, rural development, and environmental engineering projects. With 52 percent of the stimulus aimed at supporting development in second- and third-tier cities, this spending will continue to fuel the development of these areas and underpin sustainable growth.

Improved infrastructure

The stimulus plan adds to infrastructure spending already in the pipeline, with a total of about 3,500 km (1,900 miles) of new transit routes scheduled to be added in China by 2015. New high-speed rail lines, such as the one between Shanghai and Nanjing, will improve the logistics and general speed of commerce of many second- and third-tier cities, linking high-tech, modern services, manufacturing, and other industries. China does not appear to be building bridges to nowhere; many of the transportation lines are already operational and adding value.

Internet access is another infrastructure priority. Internet usage across China has skyrocketed in recent years, with 40 percent of new users residing in rural areas. By June 2010, China’s Internet users reached 420 million—double the number of users in the United States—according to a recent McKinsey Quarterly report. In 2009, more than 87 million Chinese bought products online, up nearly 40 percent over the previous year. Online shopping allows companies to sell to otherwise difficult-to-reach second- and third-tier cities. Given relatively poor distribution channels, inadequate retail formats, and a mismatch between supply and demand throughout many regions in China, the Internet is becoming an excellent channel to identify and service first-tier consumers nationwide. Alaris’s recent work building an Internet-based business-to-consumer strategy for high-end home textiles firm Shanghai Cottonest Information Technology Co. Ltd. showed that more than 60 percent of Cottonest’s customers were located in second-tier and smaller cities. Moreover, the average total purchase value per visit for the second-tier buyer is about 20 percent higher than for the first tier. The Internet is an effective way to reach consumers that are “hidden” in China’s vast market.

A regulatory window

A number of recent factors suggest that reaching more markets is becoming increasingly easy. From a structural standpoint, China’s regulatory environment finally allows international investors to wade into most retail and wholesale markets without restriction (see the CBR, May-June 2010, Understanding China’s Retail Market). Firms now also have more flexibility to choose the investment structure that best suits their needs. Though not all foreign firms can pursue solo ventures in China, they have far more business options than they did a decade ago (see the CBR, September-October 2010, Choosing a Chinese Investment Vehicle). And though these changes affect foreign investment throughout China, increased regulatory transparency and access to a broader range of retail and wholesale opportunities should reassure foreign companies considering a move into a second- or third-tier city. The challenges are now less about legal limitations and more about finding the right human resources to manage a company in second-tier cities.

Customers and cost advantages

Realizing that the income gap between urban and rural residents was increasing, the PRC government in 2006 abolished certain agricultural taxes to sharpen the competitive edge and relative prospects of rural residents. In addition, central and local governments allocated a total of ¥218.9 billion ($27.4 billion) to subsidize compulsory education in rural areas for five consecutive years beginning in 2006. This legislation provided an incentive for people to stay in second-tier cities and suggests that local economics will stabilize or improve.

All of these factors complement the one overriding driver of growth: The coastal first-tier cities have a cost base— including labor, rent, and general operating costs—that is 20-40 percent higher than the second-tier competitors. Thus, firms looking for cost advantages are moving out of the traditional manufacturing locations to more cost-competitive areas. As jobs move, wealth expands to other areas.

Challenges of second- and third-tier markets

When setting up shop to capture first-tier consumers in second- and third-tier cities, foreign companies should consider many challenges. Regardless of the type of business operation, the company’s human resources requirements—including the need to hire competent managers who will exhibit long-term loyalty to the international brand—will likely be at the forefront. Currently, after receiving training from international brand leaders, local managers often leave for new opportunities at other local companies. Beginning about five years ago, the turnover rates of managers at foreign-invested firms began to decrease in the first tier and rose slightly in the second tier. Finding good management in the second-tier cities is difficult and retaining trained managers often proves even harder.

Fine-tuning marketing and communication campaigns also can be tricky in lower-tier markets. For example, a recent Alaris market study found that consumers in some markets such as Chengdu considered a cosmopolitan image as a reason to believe a brand story, while consumers in Shanghai thought the same message was crass and boastful. Foreign companies should not underestimate the importance of regional cultural differences when forming their marketing strategy. Just as marketing to a New Yorker is different than marketing to a San Franciscan, Chinese cities also have different cultures.

There is no single approach to take when it comes to distribution decisions, either. From a functional perspective, infrastructure and distribution problems plague some locales, despite China’s rapid growth in transportation infrastructure. Transporting perishable goods, in particular, can be challenging. Carrefour China found a solution to this problem by making each of its supermarkets in China responsible for open purchases of perishable goods. This strategy has resulted in good relationships with local distributors and greater success transporting perishable goods. A local distribution approach also makes it easier for the store to carry products that are customized to regional tastes.

Companies should also consider regional variations in how consumers transport their goods. Many consumers in first-tier cities use autos to transport their purchases, but many consumers in second- and third-tier cities rely on buses, bicycles, or their own two feet. Only 40 per 1,000 people in urban China owned cars in 2009, and far fewer owned cars in the countryside. This means that products must be packaged in a manner that allows consumers to transport them from the store to their homes, using their most common mode of transport. The distribution problem is complex and evolves rapidly. For example, in Shanghai restaurants with no parking have seen decreasing sales per table as more people drive on weekends and evenings. Just a few years ago, restaurants that were primarily frequented by customers who drove to the restaurant had lower average sales.

Focus on regional markets

Entering China today offers more opportunities and challenges than it did just a few years ago. The prize is much larger and the competition much stronger. Yet experience shows that successful firms focus their resources—building brand recognition in one regional market first and then expanding to more markets as the business model and product offering is sculpted to local tastes. Companies that do their homework and make realistic projections of what brands will sell in which markets are off to a good start in the race to tap China’s first-tier consumers, wherever they may be.

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Tapping into Consumer Desires

One hallmark of a successful brand is that it connects with consumers on an emotional level, appealing to an individual’s dreams and aspirations. This connection strengthens the bond between the brand and the consumer and makes the brand difficult for others to copy. A recent Alaris Inc. study divided 2,000 consumers throughout China based on various functional and aspirational attributes and factors. Though the study projected that there would be more brand-conscious consumers in first-tier markets, the survey results found little difference between markets. Aspirational consumers were found everywhere, from the richest environs of Shanghai to the remote towns and cities in fourth- and fifth-tier cities. China’s emergence as the fastest-growing consumer society in the world is not just happening on the eastern seaboard but throughout the entire country.

The table on the left shows several attributes that typically define an aspirational consumer mindset. As the results suggest, this mindset is not bound by geography. In fact, consumers in second-tier cities are more likely to buy their favorite brands, even if the products cost a bit more.

—Alaris Inc.
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[author] Francis Bassolino ([email protected]) is president of Alaris Inc. Matthew Smith ([email protected]) is president of Leo J. Shapiro & Associates LLC. The two firms work together to help companies build brands. Mariusz Trzaskowski and Grace Lewin, Alaris senior associate and research assistant, respectively, also contributed to the preparation of this article. [/author]