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Flagship Stores and E-Commerce: Recipe for Retail Success in China

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The evolution of the retail sector in China differs greatly from the evolution in the West, requiring retailers to focus their expansion efforts on over-the-top flagships and e-commerce.

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Take a stroll down any of Shanghai's most famous shopping streets and you'll find that they put New York's Fifth Avenue to shame. These streets showcase enormous, glamorous flagship locations of the world's most luxurious and well-known brands.

Last week, Uniqlo (PINK:FRCOY) announced that it would open its largest store on Shanghai's major, prominent shopping street, Huai Hai Road, by the end of 2013. The Japanese-based fast fashion retailer joins a host of foreign retailers who have launched notably large and opulent flagship stores in Shanghai over the past few years.

Sephora just opened a five-story, 16,000-square-foot flagship store, which is now its largest store. Forever 21 opened its largest store in Asia last fall. And Apple's (NASDAQ:AAPL) Shanghai flagship, which mimics the New York flagship, is its most profitable store globally.

The "bigger store strategy" isn't limited to Shanghai. In Chongqing, a Tier 2 city in western China, Louis Vuitton (PINK:LVMUY) opened a two-story flagship location covered in crystalline bulbs, allowing it to dazzle shoppers at night (pictured). And the palace-like store isn't the only one; luxury retailers all boasting large, glamorous flagships line an entire walking city street.

shanghai shopping cartier louis voitton storesYet at the same time, Nokia (NYSE:NOK) announced that it would be shuttering its flagship store on Shanghai's other famous shopping street, Nanjing Road.

Why is Nokia closing down its flagship store while other retailers are focusing so heavily on flagship locations? It's partly because of its poor performance in the country. But more importantly, it's because of a strategic change in retail channel development. Management stated it would focus more heavily on e-commerce going forward. This strategic direction isn't surprising, given the rapid migration of consumer spending to e-commerce.

In 2012, online retail sales increased 55% to RMB 194 billion ($31.5 million) and are expected to grow 37% to RMB 265 billion ($42.7 million) in 2013. Online shopping is booming in China; in my opinion, it is a far more important channel in China than it is in the US. Jack Ma, founder of Alibab Group Holdings, agrees. He projects that even at a conservative rate, online sales will account for 30% of total retail sales in China in the next five years, as compared to about 5% today.

According to a newly released report by Jones Lang LaSalle, the rise of e-commerce is impacting brick-and-mortar stores since shopping malls are beginning to emphasize food and beverage options as well as entertainment, rather than shopping. Shopping malls are expected to evolve into channels for restaurants, and retailers that offer unique products not as readily available online.

So why in the world are foreign retailers continuing to dish out record amounts of capital to open some of the world's greatest flagship locations in China?

Because flagship stores remain a vital entry point strategy for retailers in new international markets. In China, flagships create an impression of a brand, and can often be used to elevate the perception of the brand's value compared to that of the West. For example, Coach (NYSE:COH) has famously positioned itself next to Louis Vuitton, Prada, and Gucci stores in China, offering a more luxurious image than it has outside of the mainland.

As I recently wrote, Chinese consumers are often unfamiliar with a product because it has only recently become available. Thus, many Chinese consumers today prefer to be introduced to a brand via a brick-and-mortar store since they want to physically experience the brand and product. Additionally, it is difficult to find new brands online. But once they are familiar and comfortable with a retailer and its product, consumers often begin shopping for that brand online rather than visiting the store.

The rise of e-commerce in China means that retailers need to get more creative with their physical locations and provide incentives to shop in a store, such as building elaborate flagship locations that offer a unique experience, which could include events, stylists, and strong customer service. However, ordinary purchases will increasingly be made online.

Foreign retailers have found it difficult to physically expand in China, with most falling behind store count targets. To effectively capture the Chinese market, retailers should forgo aggressive physical store expansion and implement a hybrid model in which they open fancy flagship locations in major cities, but focus more on developing an e-commerce platform with strong distribution and logistics capabilities.

The evolution of the retail sector in China differs greatly than the evolution of the retail sector in the West because e-commerce in China is present and rapidly growing before brick-and-mortar stores have the chance to expand. Retailers investing in China should keep focusing on building relationships between their brands and consumers with over-the-top flagship locations. But they should also rely on e-commerce as a volume driver of sales. There will never be room for a large chain of mediocre stores in the Chinese retail market.

Kristin Graham, CFA, is currently a consultant partnered with CRG, a multi-channel retail services company that assists retailers entering and expanding in China. She lives in Shanghai.
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