Inside China's Emerging Consumer Revolution

There is a lot of talk about the rise of the Chinese consumer and local sportswear maker Xtep International Holdings is in the thick of the revolution. The Hong Kong-listed company reported a 22% surge in revenues to US$300 million for the six months to June 2010, with net profit up 22% as well to US$55 million. We’re now No. 3 or No. 4 in China, says Terry Ho, the company’s CFO and company secretary. “One day we will be No. 1.”

 
Ho spoke to CFO Innovation’s Cesar Bacani on emerging consumption patterns in the world’s largest market, how Xtep is riding the boom and other issues.   
 
Your business is right in the middle of the consumption revolution in China. What have you learned about emerging consumer spending habits?
In the past 10 years China has accumulated capital from the outside world and now it is building a strong, powerful country. The infrastructure is there already. Most of the people can afford a basic standard of living. The lower and middle class is coming up. But of China’s 1.3 billion people, right now only a third are consumers. There is still a vast majority, two-thirds, that are not consuming.
 
We see [growth in consumption] happening mainly inland. It’s very mature in Beijing and Shanghai; what has been done has been done already. So we [at Xtep] focus on Tier 2, Tier 3, Tier 4 cities, where people are getting pay rises and are willing to spend more. These are the [emerging] major consumption centres in China.
 
Then you have the majority that are still poor, who are not earning enough to consume. They are farmers, very low income. But this is going change. Everybody is going to have a pay rise, especially the farmer nowadays. You see some farmers paying RMB2,000-3,000 to get a cell phone to hang around their neck, but they don’t know how to use it and they don’t have the network [coverage].
 
Consumption is really coming up and very fast and very strong in China. We see the overall GDP growth rate to be in double digits. If we narrow it down to the sportswear sector, we see that it’s very healthy still, 15% to 20% industry growth [annually].
 
In the hierarchy of consumer spending, though, where would sportswear be? Is it one of the first things people buy after food and other basics?
If you don’t have a mobile phone, then you buy one. But you don’t buy a mobile phone every three months. You use it for two years and when it’s outdated, you change to another one. Sportswear, apparel, people need to wear clothes to go out. In the past, a white t-shirt was good enough; if you had a piece of cloth over the body, then it’s fine. But now you care about how people look at you, you look at your peer group and then you don’t want to look bad. So you try to improve your appearance.
 
But they are not millionaires, rich kids. Only very few can afford to wear Armani. The middle class is spending more than in the past, but they are not spending as much as in developed countries. The usual price tag for daily wear is between RMB100 to RMB300 [US$14 to US$44]. Anything above RMB300, consumers may think a bit longer. Is it really what they need? Is it really value for money?
 
If you look at the consumption patterns in a city like Shanghai or Beijing, the spending is a bit higher than RMB300. But inland, [apparel with] price tags of RMB200 to 300 are the usual things that people there can afford to buy.
 
Typically we price a T-shirt at RMB138 to RMB168. Shoes are a bit more complicated [to make], so we sell lifestyle footwear at RMB200 to RMB250. Functional footwear like running shoes are at RMB250 to RMB300, slightly more expensive so [buyers] can show people that they can afford to pay more, but not really over the top.
 
ADVERTISING AND PROMOTION
How do you maintain your pricing given rising labour and other costs in China?
You need to pass on [increased costs] to the customer. The increase in our ASP (average selling price) has outpaced the increase in costs. The ASP for footwear [in the six months to June 30, 2010] is up 7% while ASP for apparel products is up 14%. We’re moving up slowly. Not in a big jump, but in a way that people can afford.
 
You need to spend on promotion, you need to tell people how good you are, and when you build up your brand power, then you can raise the ASP. This is why we have to tell people we are a major player in China, that we represent good, young, worthy to buy, value for money and stylish sportswear. This is how we stand out from the others. We are a sponsor of the TV singing contest Super Girl, which is equivalent to American Idol. We use [contestants and winners] in our TV commercials, also movie stars.
 
All that costs money.
It’s worth spending. We budget about 11% to 13% [of revenues] a year for advertising and promotion expenses for the whole group. If we can improve the gross profit margin [from the current 40.7%], we may move it to 12%-14%. In the past it was single digit. But now that gross profit margin has improved, we put the money back into promotion.
 
We have guidelines on how to spend the money. Each year we sponsor a big event. In 2008 it was the Olympics. In 2009 we were the sole sponsor of the National Games. This year we sponsored the World Expo [in Shanghai]. Secondly, we sponsor sports events related to our major themes, running and football. The third part is TV commercials. We have ads in eight to nine channels and we sponsor concerts and have contracts with celebrities [as endorsers]. How we allocate the money is 30%, 30% and 40%.
 
FACTORIES AND OUTSOURCING
Let’s talk about your factories. We’ve all heard about labour shortages, labour strikes, more stringent environmental standards and so on. How does Xtep deal with these?
We are at a different level. For apparel, we outsource 93% [of production]. For footwear, because we have a long history of making shoes, in-house production is about 60%. We are very asset light. The company’s net asset value is about RMB3 billion and RMB2.4 billion is cash. Only one tenth is the factory. Most is cash.
 
We don’t have any problems with the rules and regulations. We always have been a good [corporate] citizen. We’ve got very wide space [in the shoe factory]. Everybody’s got a lot of space in the working environment and also we don’t have much overtime. We don’t have too much trouble with our employees.
 
Are you happy outsourcing rather than actually owning and controlling the factories?
The footwear is fine. We are quite happy for footwear [to be done 60%] in-house. But apparel, we would like to increase in-house production to 10%, 20%. You’ve got to respond to the market quickly. The apparel turning rate is much faster than the footwear.  
 
DISTRIBUTION
In the latest interim report, Xtep reported the total number of brand retail outlets at 6,579, up 8% from the previous period, and 36 flagship stores, from 30 previously. You must be investing heavily in your distribution network.
We don’t run [or own] our stores. It’s on a franchise model. We sell to the exclusive distributor and the distributor sells to franchisees. We have 28 distributors, which sell Xtep products in their own stores and to their franchisees.
 
We hold a sales fair four times a year. We show 1,000 different styles of shoes and another 1,200 types of apparel. All the distributors, all the shop owners, about 4,000 to 5,000 people, come and choose the items they want to buy. We sell to them at a discounted retail rate.
 
For example, this shirt is sold to the consumer for RMB100. We sell it to the distributor for RMB40. So he sells it in his flagship store for RMB100 [and makes RMB60 in gross profit]. He sells the item to his franchisees for, say, RMB50. The end customer still pays RMB100 [for gross profit of RMB50 for the franchisee].
 
So you don’t spend on building costs, rental, maintenance and other expenses?
We don’t spend anything on rental, we don’t spend on staff costs. To run a retail store, a lot of things can kill you. The salespeople, they stay for a few hours. They’re quite mobile . . . Just imagine if you are managing 6,000 stores and then each store has staff of three, you’re talking about 20,000 staff. It’s quite a problem.
 
And there’s a lot of local things you have to take care of. You can’t have all the knowledge of how Shandong people do things, those in Guangdong, Shenzhen, Sichuan. What’s their behaviour, what they like, what they dislike, how the language works. You’ve got to have the local knowledge to do that. It’s better to leave these to the distributors.
 
Doesn’t this arrangement make it difficult for Xtep to control quality, image, branding and so on?
It’s just like McDonalds, Starbucks. It’s the same model. We change our store designs every two years and [distributors and franchisees] follow our design. I tell you exactly how to decorate, and how to treat the customer. When you come to the sales fair, you don’t just take the item that you like. You are trained how to sell them. For example, during the summer season, I will tell you why we sell this soccer series and the design concept behind it. When your customer comes in, you don’t just persuade him to buy one piece of clothing. You tell him how to match with the pants, with the running shoes, how to look good in the total outfit.
 
How do you make sure the franchisees are up to the job?
For example, if Mr. ABC wants to open a store in Guangdong, what he will do is go to [our exclusive distributor] there and apply to become a franchisee. He submits a proposal and the distributor will assess his experience, how much capital he has, and more important, where he will locate the outlet. He can’t just pick and choose. It’s not his free will. The distributor has to assess everything, and then he informs our sales and marketing department for further approval.
 
If the application is approved after this two-level assessment, this guy will come up to us for training. We will give him a manual. If his stall is 100 square metres, he will get a manual suitable for a 100 sq m stall on the exact layout, the shelving, lighting.
 
At the sales fairs, you come to be trained and you come to learn about all the new collection, how to sell to your customer and why we are selling these clothes. You’ve got to train about the background, the theory, what we are selling, what is our concept, what is our culture.
 
How does Xtep make sure distributors and franchisees are implementing all these things?
We have what we call ‘invisible customers.’ They are out there everywhere. They pretend to be customers, to see if the store is dirty, for example, and then you get [bad] marks for that.
 
What’s the mortality rate for the franchisees that you have?
You try to improve and educate them. You don’t straight away kick them out. You tell them what they had done wrong and then hopefully they’ll improve.
 
How did this distribution model come about? Was there a period of trial and error before Xtep perfected it?
The business model, if you compare it to all the big brands like Adidas and Li Ning, it’s always worked this way. In sportswear, the core and central focus is how to promote your brand and to have good products. Adidas, they don’t own their own stores. Just one or two shops in New York, for example, that [function as] a showroom. Other than that, it’s always franchise model.
 
DISNEY SPORTS
You own the Disney franchise for sportswear in China. How is that coming along?
We have signed three contracts. The first contract is for Mainland China. The second contract is for Hong Kong, Macau and Taiwan. The third is for Middle East and Southeast Asia. Disney grants licenses by geographical area. It’s for sportswear called Disney Sports. We created this brand. We do the design, we make the sportswear and then sell it through the distributor and franchisees. We pay Disney for the rights in the form of royalty.  
 
We signed the contracts in 2006 but it takes time to build up a team. The products only came up in 2008. It’s only been for two years, so right now Disney Sports is very small [at 6.8% of sales]. I think we can make a very good progress, especially in 2014, when there’s going to be a first ever Chinese Disneyland park in Shanghai.
 
Is the Disney Sports brand sold in Xtep stores as well?
No, it’s different. The distributors and franchises are different. Even for the design, it’s separate. You cannot have the same group or even the same people designing for Xtep and designing for Disney. They’re two completely different concepts. Disney Sports is for teens, 13 to 18. Xtep is for more mature age groups, 20 to 30 years old. The [proportion of] male and female buyers is quite balanced. There are more females buying Disney goods; it’s over 60% for apparel.
 
Disney is very careful about their image. They look at everything. The three stores we opened here in Hong Kong, they come to inspect again and again. The shelving, they even need to polish it, everything must be shiny, the curve of the Mickey Mouse ears must be just right.
 
What is the goal here? Are you looking at Disney Sports accounting for 50% of total revenues?
It won’t be that much. The core business is definitely Xtep, which is already No. 3 or No. 4 in China [in a market dominated by Nike and Adidas and local brands Li Ning and Anta]. One day we will be No. 1 . . . Anything is possible. There’s no reason why a Chinese brand cannot overcome Nike.
 
 
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