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LUXURY IN CHINA:TIME FOR A RETHINK

RETHINKING THE LUXURY MARKET IN CHINA

For luxury manufacturers, a significant degree of their strategic growth projection was based on significant margin and revenue growth in China. The assumption was that demand was on the rise and the appetite for paying higher prices was undimmed. These factors combined, promised untold riches in China. However, recent trends suggest that the picture may be changing.

There was surprise in July when a pair of light brown Salvatore Ferragamo Carla leather pumps was sold at a 40% discount, for 3,120 Yuan ($507) on a site run by e-retailer Xiu.com—a price lower than the European retail price.

In a downtown Shanghai outlet of Kering SA (KER)’s Gucci, a light pink Soho leather shoulder bag was discounted 30% to slightly more than 12,000 Yuan; about the same price as a similar bag in the U.S. Such discounting was previously almost unheard of in China, and has sent a shockwave through the luxury industry.

Several powerful forces are buffeting the luxury market in China and will reshape the long-term structure of the market. Luxury brands must quickly grasp these changes and adapt their supply chains to retain profitability and margin stability.

The impact of Chinese government’s anti-corruption drive cannot be underestimated. With lavish gift-giving having been a large part of doing business in China, the clampdown on lavish gifts—which was seen as a popular form of acquiring influence—has seen a large fall in the demand for luxury goods. An additional consequence of the anti-corruption campaign is that state officials are now less likely to misappropriate funds to fuel luxury lifestyles, further reducing the tide of money chasing luxury products.In addition, increasing import duties and taxes on luxury goods are driving prices up to the extent that Chinese shoppers are more likely to do their shopping abroad, often paying far less for their products.

In the face of these challenges, luxury brands have, mistakenly, been increasing their presence in China and expanding supply into a market with reduced demand for luxury products with a smaller tide of capital to spend on luxury. It has created a situation of oversupply and in the face of this, many have had little choice but to discount heavily.“Even during the financial crisis, I don’t think we saw this amount of discounting,” said Franklin Yao, managing partner of Shanghai-based SmithStreet, which advises companies on their China strategies. “Inventory has become an issue for brands across the board, and this is a big problem.”

KEY FACTORS SHAPING THE MARKET

Our research uncovered the following factors reshaping the luxury market in China, presenting challenges and opportunities to luxury brands.

Reduced Customer DemandAccording to recent research, the Chinese purchased a third of all luxury goods sold globally in 2013. Growth in luxury spending in mainland China however, will slow to 2 per cent or less this year—compared to a 30% rise in 2011. In a continued demonstration of the new realities biting lux-ury brands Christian Dior SA (CDI) and Ermenegildo Zegna Group both held sales at their China stores in July, with Milan-based Zegna cutting as much as 40% off menswear, leather items, and shoes.

Brands are now trying to manage the discounting process to retain prestige while maximising revenue. Some have resorted to exclusive ‘flash’ sales for their valued customers. Hermes for instance, dangled price cuts of as much as 50% off on dresses and shoes in April at an invita-tion-only sale, held in the eastern city of Hangzhou, according to reports in the Chinese media. Guests were invited by mail to the four-hour sale, at a hotel in the city’s West Lake district, with no photography allowed, according to a story posted on the website of the People’s Daily, the official newspaper of China’s Communist Party.

The discounting trend would appear to be here to stay. Once discounting begins, history tells us that customers become accustomed to it, and plan their buying activity around discounting sea-son. It is likely that slower spending will drive prices downward with many brands already heavily invested in China. With existing overheads restricting supply without incurring massive losses will prove more of a challenge.

Price Differences Luxury brands are trying to encourage the Chinese to buy domestically and not travel abroad for their luxury shopping. However, savvy Chinese customers, keenly aware of the bargains available, are willing to travel. It is not unusual for many high-end luxury items to cost half as much in Europe as they do in China. Depending on the products bought and the quantities involved, the savings made often cover the cost of the holiday with profit included.

“The price difference between Europe and the mainland can pay for a round-trip ticket for me to Paris or Milan,” according to Anna Hu a 27-year-old marketing executive from Shanghai, who has collected luxury bags since she was 23. “If I could do that and holiday for a few days there, why wouldn’t I?”

China imposes duties as high as 25% on imported products such as leather handbags, dresses, shoes, and watches, depending on their value, according to data from the World Trade Organiza-tion. The country also levies consumption taxes of 20% on high-end watches and 30% for cosmet-ics.

The total effect is to make retail prices in China up to 60% higher, when considering taxes, duties and margins. It is no coincidence therefore, that last year 67% of luxury products purchased by mainland Chinese were acquired outside the country.

Increased customer awareness and knowledge has historically driven prices down. It is likely we will see the same trend take hold in China as shoppers find arbitrage opportunities in Europe and other markets. In the face of this, brand do not have the level of market control to keep both price and demand high in China, which will see overall margins and demand fall – a truly vicious spiral.

Sales Contribution A large proportion of luxury market growth is predicated on Chinese customers buying luxury products in China; and doing so in increasing numbers. This assumption lies at the heart of most revenue projections, and has driven the investment agenda for a number of years. Keeping main-land consumers spending is essential for luxury brands as China now accounts for a major portion of their sales. LVMH Moet Hennessy Louis Vuitton SA (MC) received around 30% of its 2013 rev-enue from Asia, excluding Japan, while Kering’s luxury unit received 33% of sales from the region, according to data compiled by Bloomberg.

With this considered, it is logical that we are witnessing the growth of flash sales in mainland Chi-na. A record number of luxury brands approached website Glamour Sales China (GSC) this year to run flash online sales events, said. The website sells off-season products from Fendi, Tod’s, Dolce & Gabbana, and other luxury brands to its 4 million plus Chinese members. “In the past few months, we’ve signed deals for the first time with brands that didn’t work with us for the previous four years,” said GSC Villet, who also introduced “hidden events” this year, re-stricted to VIP customers and catering to brands that didn’t want public sales to tarnish their im-age.

Cartier, the maker of £35,000 watches, sent a WeChat message in June telling some of its cus-tomers about a “high jewellery exhibition” with “all pieces at Hong Kong prices” in North China. Customers could follow up with a salesperson for details.

Having spoken to clients and contacts in the market, such approaches merely staunch the flow from more to less expensive. Customers, armed with more information are making more balanced and informed choices about their purchasing decisions, and with this we are witnessing a drift to a ‘new normal.’ Lower prices and margins may set the tone for future growth unless luxury brands find ways to remedy this.

THE ELEPHANT IN THE ROOM

What is known, but so rarely mentioned, is the sizeable impact that counterfeiting has on luxury brands, particularly in China. According to the US Customs Agency, 84% of seized counterfeit items originated in China and Hong Kong. With other Far Eastern countries such as Vietnam, catching up, luxury brands face a dilemma. They need the low cost manufacturing hubs of the Far East to sustain their margins. However, this increases their risk to counterfeiting as, in some cas-es, counterfeiters and legitimate manufacturers share the same factory—even using similar supply chains in some instances.

Enforcement has grown harder in the internet age. Fearful of discovery, many counterfeiters are now selling direct to customers in small order quantities, reducing the market for intermediaries and the reliance on outdoor trading, the traditional target for enforcement agencies. The internet has also fuelled the demand for counterfeit goods. Customers now know where to go to acquire these goods, with customer feedback and social media then acting as a rating system for manu-facturers. All of this means that trade in counterfeits is not only growing, but is increasingly atom-ised and harder to police.

For luxury brands this is inconvenient, but not fatal. On one hand, there is the loss of potential rev-enue, not just in China, but globally. Secondly, there are the wider implications on brand value and perception. Luxury brands are specific about how they would like their products bought, used and presented. Counterfeiting takes some of that control away. One need only remember how Burber-ry was savaged by counterfeiters in the early 2000s, the damage it did to the brand and the costs incurred in rectifying the damage.

We favour a robust return to the essence of luxury, namely limited-run high value pieces made by expert craftsmen. Considering the costs of policing the counterfeit market and their likely increase, it is better to invest in moving the average price point upwards. Returning most of your brand port-folio to the higher price points should lead to increased manufacture costs, reducing the likelihood of copies.

The challenge of luxury brands has been that, in the quest for wider margins, manufacturers have simplified their production processes. This has resulted in a closing of what we call, ‘the luxury differential.’ This represents the gap you have to maintain against non-luxury products to justify the premium. Non-luxury brands have taken advantage of the technological developments to drive their product quality upwards. Counterfeiters have achieved the same thing, and now create fakes indistinguishable from the originals. These two factors have put pressure on luxury brands to raise the quality of their products. Other industries have succeeded in maintaining strong margins and growing market share.

Where the fashion industry struggles, the luxury motor sector has no such trouble. A lot can be learned from the luxury motor sector. In the luxury motor market, continuous innovation along with strong investment in research and development create products that, from a time and cost per-spective, are not worth counterfeiting. This sort of innovation was what drove the luxury market in the past, and we believe that it is innovation over anything else that will generate long-term sus-tainable growth in the luxury sector.

CONCLUDING THOUGHTS

In order to operate effectively in China and to address the issues above, there is value in seeing the Greater China area as a unique market in its own right. This would mean creating products de-signed for this market and only available in this market. The revenue opportunity in China means that such an approach makes sense, and it allows for a higher price point without the risk of leak-age into other markets. However, to succeed in this the essential consideration is in maintaining or extending the luxury differential, which would ultimately justify the premium price.

Currently, we are working with our clients to understand how to best implement this approach and also:

• Optimise location footprint• Assess current and future product portfolios• Develop international marketing strategies tailored to the domestic market• Build resource security into strategic planning• Develop an innovation framework

Challenging times are often the perfect opportunity for change. As China adjusts to its own con-straints, its market will change. We feel that the strategies outlined above are a great platform of succeeding in this new and growing market.

SEYMOUR SLOAN

Seymour Sloan deliver great ideas that drive progress. We help companies do things differently, delivering market changing solutions.

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© SEYMOUR SLOAN 2014

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