It did not take long for the initial frenzy surrounding the opening of Costco Wholesale Corp.'s first store in China to fizzle out.
The U.S. bulk retailer's Shanghai site launched Aug. 27 to queues so large that it was reportedly forced to shut early and limit admittance to 2,000 customers at a time. Costco CFO Richard Galanti said a remarkable 139,000 people signed up for membership on that first day, Yahoo Finance reported.
Yet local Chinese media reported Sept. 2 that customers were canceling their memberships as prices of certain items were raised and highly sought-after products, such as Kweichow Moutai Co. Ltd. liquor, were no longer available. Costco briefly offered the iconic drink at 1,000 yuan below its retail price again before customers returned in droves.
While flash sales may continue to be effective in drawing crowds, Costco faces an uphill battle if it is to enjoy long term success in the Chinese market. The Issaquah, Wash., company is up against stiff competition from deep-pocketed homegrown e-commerce players such as Alibaba Group Holding Ltd. and JD.com Inc. that are branching into physical retail, as well as established brick-and-mortar companies like Yonghui Superstores Co. Ltd.
It is also a relatively late entrant to a market that has proven difficult for international companies to gain a foothold in, and many are on the retreat. France-based Carrefour SA in June agreed to sell an 80% majority stake in its 234-site Chinese operations to local home appliances retailer Suning.com Co. Ltd. Germany's Metro AG is said to be nearing a deal to sell its China business, with a host of Chinese companies reportedly interested.
Costco did not reply to S&P Global Market Intelligence's requests for comment.
The ongoing U.S.-China tariff war may be the most acute and immediate challenge for Costco. Unlike its rival Walmart Inc., which says that 95% of the merchandise sold in its Chinese stores is sourced locally, Costco imports about 50% of products at its Shanghai warehouse. U.S. agricultural and food imports including wheat, seafood and pork are subject to tariffs as high as 62%.
Zhang Ruohai, chief data analyst at CITIC Securities, said the tariff issue will impact Costco's pricing strategy in the short to mid-term and may affect foot traffic at its store.
"Costco has less stock keeping units on its online platform and its prices are not that much different from its online competitors. There is very little incentive for customers to sign up for membership if they do not shop at the physical store. Therefore Costco has to focus on keeping its prices competitive at its store," said Zhang.
Foot traffic is especially important as Costco generates about 10% of its revenue from membership fees. Its basic Gold star fee is 299 yuan in China, the lowest Costco offers across its operations in the Asia-Pacific region, which include Taiwan, Japan and South Korea.
Richard Zhang, Costco's senior vice president for Asia, told AFP in an interview that some fresh produce from the U.S. has been replaced with imports from Australia in an effort to keep prices low. But supply chain diversification is unlikely to be sustainable, especially for warehouse chain operators of limited scale, according to Wai-Chan Chan, global consumer goods practice leader at consultancy Oliver Wyman.
"Sourcing is a problem for any retailer that opens one or two shops in the beginning. There's no scale for private labels, or for anything. They can actually lose money. That would be the challenge," he explained.
Chan noted that retailers face the difficult prospect of having to expand fast and accept a loss in the short term in order to gain a foothold in the market, but Costco seems keen to take a conservative approach for now. CFO Galanti told analysts during its third-quarter earnings call in May that Costco will open another store in China in about a year or two, provided that "all things go well."
"China's a little unique in many ways, aside from any issues right now with tariffs. That's not hopefully a long-term issue. Each item has to be registered separately. We're fortunate in the sense that we have a successful operation in Taiwan, [from] which we were able to bring some key people. But we want to hire from within and like we do in other countries," Galanti said during the call.
In contrast, Walmart plans to open 40 Sam's Clubs members-only outlets in China by 2020 and spend $1.2 billion on logistics. The company entered China in 1996 and has had a bumpy ride, with store closures and frequent management changes a feature of its time in the country. But it is by far the most longstanding international peers, with 400 sites under its various store formats.
Digital first
Chan said the struggles of foreign retailers are not largely down to a failure to localize as most have made efforts to hire local teams, as Galanti alluded to, and adapt their product mixes to Chinese tastes. Rather, it is a lack of a strong digital presence that has impeded their growth.
"The future of grocery retailers and foreign companies in China is about being part of an ecosystem. Now you need a digital footprint to drive traffic to the store," Chan said, citing Walmart and Taiwanese chain RT MART International Ltd's tie-ups with JD.com and Alibaba, respectively, to act as fulfillment centers for their online grocery business.
Notably, Walmart sold off its lackluster online business Yihaodian in 2016 to JD.com in return for a 5% in the Chinese e-commerce retailer. Both companies later invested $500 million in grocery delivery business Dada-JD Daojia. Walmart's merchandise, including goods from Sam's Club, can be bought on the Dada-JD Daojia platform and delivered to the doorstep in as fast as half an hour.
Alibaba has made no secret of its commitment to the "new retail" model, which seeks to remove the boundaries between physical and online commerce. It plans to roll out more of its Hema grocery stores and continue to invest in delivery services.
The challenge these cash-rich, internet-first competitors pose is stark. A study carried out by CITIC's Zhang tracking the average price difference between Costco and the Metro hypermarkets found that Costco was cheaper by 38.8% on 40 locally sourced food, beverage and daily items. In comparison, the price advantage offered on its e-commerce platform was only 0.2%.
Costco is yet to offer this type of proposition but it has had an online store on Alibaba's Tmall platform since 2014, through which it sells its private-label Kirkland goods. Oliver Wyman's Chan noted that such products have struggled to gain traction in China.
"Private label will always be a difficult thing to do in China, compared to other parts of the world. The most successful companies still have very low participation when it comes to private labels in their businesses," said Chan.
Jason Yu, general manager for Greater China at market research provider Kantar Worldpanel, said that while Costco's online store has barely registered on the radar, the initial reception of its Shanghai warehouse shows that there is a place for its core proposition in the country.
"Costco has to offer differentiation by offering high quality, often imported products because their target audience is middle-income, car-owning households from first tier cities," said Yu. "High quality fresh produce, food and daily items will always have strong demand among Chinese consumers."
As of Sept. 26, US$1 was equivalent to 7.13 yuan.
