Keeping an Eye on China

By Jenny Hubbard, CFA
May 2019

Over the last few years, we have witnessed the continued expansion of the middle class and the creation of sophisticated digital retail platforms in China. These demographic shifts and technological advancements have fueled a boom in cross-border commerce in China, a trend that has proved particularly beneficial to businesses selling discretionary products such as branded apparel, footwear, and cosmetics. Most of the companies we follow in these industries are reporting unprecedented rates of revenue and profit growth in China. In this piece, we will review these developments in more detail and contemplate the opportunities and risks presented by investing in companies with increasing exposure to the Chinese consumer.

A Dynamic Shift in Distribution Channels

Historically, Western brands established a presence in China through a combination of joint ventures, third-party distributor relationships, and brick-and-mortar stores. Compared to the efficient distribution methods available to vendors today, this approach was a capital intensive, multi-year endeavor. Progress was often hindered as Western companies struggled to cater marketing messages and product design to the very distinct Chinese consumer. For example, Nike and other early entrants to the Chinese market experienced these fits and starts.

The Rise of Tmall and WeChat

Recently, it has become much easier for foreign brands to quickly build a meaningful presence in China. While many companies are now active in the digital commerce market, Alibaba’s Tmall and Tencent’s WeChat played a foundational role in catalyzing cross-border commerce in China and are the platforms of choice for Western brands.

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In exchange for an upfront fee and commission on goods sold, Tmall allows foreign vendors to establish a digital storefront and control the display, distribution, and supply of products as though the brand owner was operating its own site. As the risk of counterfeit and lower-quality goods looms large in China, Tmall’s practice of conducting quality checks and requiring a hefty deposit from brand sellers that is lost if they are caught selling counterfeit goods quickly validates a brand’s reputation among Chinese consumers. In addition, Tmall provides its sellers with a range of analytic tools such as daily sales updates by product, which informs design, inventory management, and pricing decisions. Today, over 14,000 foreign brands sell through Tmall, with more than 80% of those companies joining since 2016. In total, brands from around 60 countries sell on Tmall, with brands from Japan and the United States leading the way.1

WeChat, a multi-purpose messaging and social media app, is growing its partnership with Western brands in tandem with Tmall. Tencent developed an application for WeChat that closed the gaps in what had previously been a disparate mobile internet experience. Since the majority of Chinese consumers access the internet through their mobile devices, this was a very important development. Among WeChat’s many capabilities, one that has been particularly useful for foreign vendors is a feature that enables the establishment of customer websites, or mini apps, run within WeChat itself. These mini apps are a customizable, shareable interface within the larger app that can be used for anything from pop-up shops, to product launches, to in-store checkout. Through this seamless, mobile-first, consumer experience, WeChat offers yet another way for Western brands to access Chinese consumers with minimal risk and upfront capital investment.

While Tmall and WeChat dominate the digital commerce market in China, they operate alongside many other well-established and up-and-coming platforms. Noteworthy examples include Sina Weibo, a microblogging site in which Alibaba is a major holder, iQiyi, China’s version of Netflix, and Xiaongshu (Little Red Book), a startup that is part e-commerce portal and part social media platform.2 Going forward, it will be interesting to see how the digital commerce ecosystem continues to evolve and to what extent Western brands can utilize these platforms as yet another access point to the Chinese consumer.

How is This Impacting the Brands We Own or Follow?

Currently, few publicly traded consumer discretionary companies, other than Nike and Estee Lauder, disclose revenue metrics for China in their public filings or provide any form of consistent commentary on digital growth rates. Disclosures are typically limited to a breakdown of international and North American revenue figures or disclosures for Asia Pacific revenue. Thus, we had to combine a variety of metrics and sources to demonstrate the explosive, high-margin revenue growth many of our holdings and other companies we monitor are realizing in China.

  • Nike’s revenue growth in China averaged 19% over the last two years with an operating profit margin of 29%. This compares to a flat growth rate over the last two years in North America, its largest market, with an average operating margin of 15%.
  • Estee Lauder, one of the few companies that references Tmall in its filings, launched a Tmall store in late 2017. In 2018, the company reported 29% revenue growth in China, up from 6% in 2017.
  • V.F. Corp disclosed that the Vans brand grew revenue in China 35% in the last nine months and 40% in the fourth quarter, while The North Face brand grew 17% in China over the last nine months and 27% in the fourth quarter. Timberland, a brand that didn’t grow in the U.S., grew 30% in China in the fourth quarter. For its wholesale channel, which includes all V.F. Corp. brands, the company grew wholesale revenue in China 35% in the fourth quarter vs. wholesale revenue growth in the U.S. in the “high single digit range.”

Will These Rates of Growth Continue?

While the aforementioned companies are clearly benefitting from powerful tailwinds in China, we are unsure if this positive momentum is sustainable. Going forward, will a traditionally protective Communist state remain hospitable to growth in platforms promoting individual and group expression, as well as increased access to Western brands and marketing messages? Presently, President Xi Jinping seems to emphasize the economic benefits of growing cross-border commerce over other agendas, but the perception, if not the actual orientation of his priorities, can quickly change. While history doesn’t necessarily provide a clear indication of the future, it does inform us of key policy measures that have dramatically altered demand for consumer goods in China in the past – and could yet again in the future.

For instance, in 2012 an anti-corruption campaign aimed at curbing the practice of luxury gift giving to authorities pressured sales of luxury goods in China for two years. Today, efforts to tighten the grip on Daigou merchants (agents who purchase overseas goods for Chinese consumers for a fee) coupled with trade tensions between the U.S. and China in late 2018 created concerns about slowing demand for foreign brands in China. These fears have since abated on signs of progress in trade talks and the recent introduction of more stimulative policy actions from President Xi’s administration. However, a shift in the administration’s stance toward consumption, Western goods, and censorship of digital commerce and content could quickly alter the velocity of sales. Simply put, rarely do such high growth rates come without risk.

As a result, we take a very conservative stance when assessing the contribution from China to our current consumer discretionary holdings. We try, as we always have at Diamond Hill, to think about the long term, what could go wrong, and how the stocks are priced relative to a normalized growth potential. Although the favorable backdrop in China for Western brands could persist for some time, we believe we are at the point for valuations where more things could go wrong than right. Thus, we lean toward taking some chips off the table and reducing our exposure to brands with increasing exposure to China as we patiently monitor the complex, and potentially very volatile trends, at work in this important consumer market.

As of April 30, 2019, Diamond Hill owned shares of V.F. Corp.

1 Ramachandran, Vijay, “Five Things to Know About Selling Cross-Border on T-Mall.” Pitney Bowes, www.pitneybowes.com/us/blog/tmall-marketplace-strategy.html
2 Ren, Yuan. “Know Your Chinese Social Media.” The New York Times. 19, Nov. 2018. https://www.nytimes.com/2018/11/19/fashion/china-social-media-weibo-wechat.html

The views expressed are those of the research analyst as of May 2019, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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