The Possible Impacts of Costco's Expansion in China

Introduction

Costco Wholesale Corporation ( trading as Costco) is an American retail corporation which operates an international chain of membership-only warehouses. According to Morgan Stanley analysts, the success of the retail giant depends on ‘quality and quantity at the lowest possible price’. This report will analyse various aspects that might have an impact if Costco were to consider their business expansion in China. A PEST analysis will be applied to identify critical factors from economic, political, social and cultural as well as technological perspectives. Recommendations on the market entry will be also provided at the end.

Company and Market Overview

Founded in 1983 in Seattle, Costco Wholesale Corporation (NASDAQ: COST) aims to provide small-to-medium sized businesses as well as individuals with high quality and consistently cheap retail products including foods, sundries, hardline and softline appliances and ancillary. The annual revenues of Costco ended 9/3/17 (three quarters for FY2017) is $129 billion, including net sales of $126.2 billion and membership fees of 2.8 billion.

Most of the Costco stores are only open to members and the number of current cardholders exceeds 91.5 million (as of 11/26/17). The corporation has 746 warehouses (as of 11/15/17) which operate mostly in the United States and some other nations including Canadian, United Kingdom, Australia, Korea, Japan and some European countries. The corporation has full and part-time employees of 239,000 worldwide. (Costco's Annual Report 2017, 2017)

As current world’s second largest economy, China-the long since the most populous nation on earth -has seen its role on the world stage become increasingly important and has been considered one of the biggest emerging markets in the recent decades. Further exploration of this business environment of this market is important for Costco to take its next action.

Economic Factor

Domestic Economy

Since the implementation of ‘reform and opening-up’ policy in 1978, the Chinese economy has developed at an unprecedented speed owing to the strong In 2016 the GDP in China was worth $11199.15 billion, representing 18.06% of the world economy. The rapidly growing economy has also contributed to the solid increase of household income, particularly in the urban areas (statista.com, 2018). The rise in the disposable income drives up the consumption level and China has become the second largest wholesale and retail market in the world, and Asia’s largest since 2014. With a 10.4% growth compared to 2015, the total the retail sales amounted to 33.2 trillion yuan in 2016 and among these the sales of commodities accounted for 89%. However, China retail market remains highly fragmented. The retail landscape has been mostly dominated with small independent stores, while the total sales of the Top 100 retail chain operators including these domestic and foreign retail giants like Suning, Gome and Wal-Mart only account for 6.9% of the total retails sales of consumer goods in 2015.The size of the emerging retail industry in China provides the best potential for Costco to expand its market. Among various retail MNCs (Multi-National Corporation), Wal-Mart with its Sam’s Club can be the biggest competitor to Costco.

Tax Administration

The 2008 Enterprise Income Tax (EIT) Law applies to both domestic and foreign-invested enterprises, generally at the same tax rate, with special rates applying in certain cases. Meanwhile, China employs its own GAAP system, which is greatly different with the globally accepted GAAP and IFRS standards. Foreign investors like Costco might struggle with these complex and varying accounting and reporting requirement when entering the Chinese market. In the same time, while the Chinese authorities have encouraged the foreign investment, preferential tax treatment, which might include tariff exemption and other tax incentives, might apply to eligible companies under certain categories. The Customs Tariff Commission of the State Council recently announced a big cut on the import tariffs on nearly 200 types of consumer goods, particularly food, cleaning products, home appliances and health supplements. This reduction aims to meet the increasing demand of Chinese consumers for imported goods and will also benefit the foreign retail businesses like Costco seeking for business opportunities in China.

Currency and Foreign Exchange

Chinese currency is Yuan (CNY) or Renminbi (RMB). The Chinese government has been criticized for trying to keep the exchange rate of the currency under its control by holding the yuan at a consistently low level. Similarly, the flow of foreign exchange has been strictly administrated by the State Administration of Foreign Exchange (SAFE) and the People’s Bank of China (PBoC) so as to maintain the control from central government over the foreign fund. Capital injection, cross-border trade and services transactions, overseas financing and profit repatriations, etc. of foreign-invested enterprises are subject to the regulations on exchange control. While China has made promises to liberalize its foreign exchange market when acceding to the WTO, the action has been taken gradually. The risk of instability on currency fluctuation shall be taken into consideration by foreign investor like Costco.

Political Factor

Political System

With the Chinese Communist Party (CCP) has been continuously taking lead since 1949, the political system of the People’s Republic of China consists of multi-system cooperation and political consultation. As the highest organ of the state, the National People’s Congress oversees the central government with final say on legislation, decision, supervision, election and removal.

The reform and opening up policy in 1978 has brought greater autonomy to local provincial government in the economic policy implementation and other areas of policy. Decentralization can be seen in some local authorities not following the strict standard made by the central government and seeking benefits by providing excess incentives. Costco should have a better understanding of the Chinese politics and gain sufficient support from local government before formally entering Chinese market.

FDI Regulation

Although the Chinese economy has been perceived as dominated by state-owned enterprises (SOEs), the recent trend suggests that the private enterprises and foreign investment have become the main driving force of economic development. In 2016, China has attracted a record high $139billion of foreign direct investment (FDI) in 2016, making it the third largest FDI destination in the world.

The outstanding performance can be attributed to the fact that Chinese government has improved market access for foreign investment with various proactive policies and regulations in order to stimulate the foreign investors, especially after China’s accession to the World Trade Organization (WTO) in 2001. A system consisted of a National Negative List and Record Filling procedure has replaced the previous ‘case-by-case approval system’ as the revised version of China’s Foreign Investment Laws came into effect on Oct 1, 2016.

In 2017, the Ministry of Commerce of China released a new iteration of Catalogue and it clearly list the industries where foreign investment is prohibited, restricted or encouraged while industries that are not listed in the Catalogue will be granted domestic treatment. Regarding the wholesale and retail industry, the new Catalogue has removed the restriction on foreign business entering the area of ‘construction and operation of large-scale agricultural product wholesale market’ that previously impeded in China, which has provided more fair treatment to foreign businesses like Costco.

Social-Cultural Factor

Social

With the advanced technology, increasing consumption capacity and more mature shopping channels in China, the product and service provided in the retail market are becoming more plentiful. Supply excess has further strengthen the leading role of consumers in the retail shopping and Chinese retail market has gradually swift from supply-driven to consumer-driven. Along with the rise in the household income and change in the structure of main consumption force, the Chinese consumers in the new era do not focus on the price only but also request for more personalized products to meet their need. More and more Chinese customers, especially emerging middle-class, are willing to pay the premium price for better quality and service.

The mode of membership-based retail store was introduced to China by foreign retail providers two decades ago and has made a great impact on the Chinese retail industry. In August 1996, the Chinese first membership-only warehouse-Sam’s Club- opened in Shenzhen, following by Makro and Metro later in the same year. However, these initial attempts did not go smoothly as Chinese customers were not familiar with the concept at that time. After two decades, Chinese customers are more sophisticated and also familiar with this business model. Therefore it should be the right time for Costco to enter the market.

Culture

The official language of China is standard Mandarin (Putonghua). Although there are increasing population that can speak English as the second language, a lack of understanding of the cultural and cross-border communication can hamper-and actually has hampered- foreign business taking further steps in Chinese market. Wal-mart, for example, has learned the lesson in a hard way. Chinese society has perceived achievement and personal relationship in a collective way (‘Geert Hofstede cultural dimensions’ 2010) and Chinese people with this highly collective nature would prefer to live with their extended family members. The difference with the American society where shows highly individualism led to inappropriate business strategies and has also challenged the business model of Wal-Mart as a whole.

Companies should also keep in mind that general change and the effect of differently held values on the consumption behavior of China’s younger generation. Unlike the traditional generation, China’s youth are better educated and have more exposure to different cultures; as a result, they are more optimistic, open-minded and individualistic, with a broader vision of the world, motivating them to pay much more attention to environmental and social concerns than their elder family members. Costco should also adapt to this new generation of young consumers by differentiating their offerings and adjusting their branding and marketing strategies to attract younger consumers.

Technologies

E-retail

It is worth mentioning that recent years have witnessed an explosive growth of electronic transactions in China, owing to the huge Internet population and rapid shift of consumers to online shopping. As the world’s largest online retail market, China’s online retail sales of goods increased by 25.6% yoy to reach 4.19 trillion yuan in 2016. Of which, mobile commerce (M-commerce) has begun to take the lead, playing a more important role in the online market. It is therefore suggested that an online shopping channel shall be built up by Costco, together with the off-line store being established.

Logistics

Decades ago these foreign retail giants like Carrefour and Tesco have suffered a great deal expanding their business in China because of the un-developed infrastructure on distribution and logistics. Along with the explosive growth in the E-retail, the logistics and supply chain industry has been experiencing dramatic development over the years. ‘New technologies and new business models, such as O2O and omni-channel retailing, created by greater adoption of the Internet are reshaping China’s retail landscape.’ Specialized in the warehouse management, Costco could take the advantage of the booming logistics network to enhance the operation efficiency.

Market Entry

Entry Mode

Choosing the right vehicle shall be on the top of the list for the foreign business to consider their Chinese expansion. According to the current Chinese regulations, the foreign investor can either set up a wholly foreign owned enterprise (WFOE) or cooperate with local partners to establish a joint venture (JV) in order to open up the store in China. Franchising and contract management are also employed by some foreign retailers like MacDonald and Parkson. Considering the size and nature of Costco as warehouse store, the structure of WFOE and JV can be appropriate options.

The mode of joint venture (as the only legal approach for foreign investment previously) has been employed by foreign retailers like Carrefour, providing opportunities to utilize existing sales networks and customer base as well as the production facility from local partners that largely minimize the operating cost. However, it is quite critical to find a trustworthy partner and the negotiation with partners can be challenging. The foreign business normally felt uncertainty due to the limited control on the business management and employment.

With the loosen policy on foreign direct investment, foreign retail investors including Wal-Mart(via Merger and Acquisition) and Best Buy(Greenfield investment) are able to establish their own independent entity in China, with no restriction to employment and complete managerial control. Along with the greater flexibility, the foreign investor might have to spend more time and money establishing their business framework and seeking for local resources. A new mode of selling products via Cross-Border E-Commerce(CBEC) platform has been adopted by some foreign retailer as a cost-saving way of kicking the tires of the Chinese market. Companies rely on domestic platform (e.g. Tmall.com/JD.com) in China to acquire market share, brand equity and a relevant consumer base in China.

Locations

Big stores have been targeting for the first- and second-tier cities like Shanghai and Shenzhen for long. However, these large retail providers are also losing their price advantage due to the rising rent costs and fierce competition. On the other hand, the urbanization in China has provided opportunities for medium-sized cities to become large cities with stable infrastructure and strong customer demand. Above facts suggested that Costco should place its focus in second –tier and third-tier Chinese cities. Rather than a cookie-cutter approach, it shall be also noted that city-specific solutions shall be designed to fit the needs of increasingly sophisticated consumers.

Conclusion

The large size and complexity of Chinese retail market provides huge potential to Costco, but also poses a tough challenge to this warehouse-style retail giant. In order to achieve the success, Costco should establish a right team that are familiar with the Chinese market and maintain a close relationship with the local government, as well as making good use of the E-retail trend and advanced supply chain and logistics system. Meanwhile, the company shall adapt to the changing society so as to outperform other competitors in the fierce competition.