Should Costco Open Physical Stores in China?

Several big box retailers from the U.S., including Wal-Mart (NYSE: WMT  ) , Best Buy (NYSE: BBY  ) , and Home Depot (NYSE: HD  ) , established operations in China years ago, while others like Costco (NASDAQ: COST  ) and Macy's  (NYSE: M  ) are contemplating moves there soon. Costco's reluctance to get into China up until now is perfectly understandable, seeing how companies such as Best Buy and Home Depot have found China to be a tough sell.

Even mighty Wal-Mart has not gained much traction there as it only makes $10 billion from the Chinese market, less than 2.5% of its more than $400 billion in annual sales. Costco and Macy's plan to open online stores in China, and they are keen to avoid the huge costs and high risk elements that made Best Buy and Home Depot beat hasty retreats.

Costco can benefit from the mistakes of others
Costco has already established a handful of physical stores in China's neighbor, Taiwan, where it has recorded considerable success. A lot of that success seems to hinge on Costco's unique ''treasure hunt'' experience which customers seem to love. Other than the low prices that keep many Costco customers coming back, the shopping experience also plays a big part in the attraction.

Low prices can be easily duplicated in online stores, so that is not likely to be a problem for Costco. However, how the giant warehouse retailer will differentiate itself from numerous other online stores which have presences in China remains a mystery.

Costco can learn from the mistakes of Best Buy and Home Depot. These two failed primarily because they failed to adapt themselves to the Chinese market, which is highly price-conscious. Best Buy offered a concept that was a little bit alien to the Chinese consumer and ahead of its time. Top Chinese electronic chains such as Suning and Gome operate warehouse-style stores where sales personnel push various brands to customers and earn commissions. Best Buy's stores in China were pretty much like those in its U.S. home turf, but the better retailing environment was not enough to draw in Chinese customers who perceived its merchandise to be too expensive.

Another big failing by both Best Buy and Home Depot is that they concentrated their stores mainly in large metropolitan cities while largely neglecting the smaller cities. Here they met stiff competition from Chinese retailers, and Best Buy's service style that lets customers try out its products was quickly copied by its competitors, which left it with no unique competitive strengths.

Doing it Wal-Mart style
Chinese retail is very big business; sales in 2010 stood at $2.1 trillion. The country is projected to grow into the world's third-largest consumer market by 2015, behind only the U.S. and Japan.

Wal-Mart plans to open 110 new Sam's Clubs and Supercenters in China over the next three years, but it will close 15-30 more stores there over the next 18 months. The giant retailer has already shut down 11 stores there. Wal-Mart is, in effect, undertaking a drastic geographical relocalization of its Chinese stores from large cities to smaller ones which are located within two-to-five hour drives from the main cities such as Beijing and Shanghai. Wal-Mart also plans to open several distribution centers to ensure that its customers get their merchandise in the shortest time possible.

Costco can certainly duplicate some aspects of its treasure-hunt experience to a certain degree, even when running online operations. A typical Costco store will only stock 4,000 different brands, and only a few brands of each item. For example, you might find only four different toothpaste brands in a Costco store. In sharp contrast, a typical Wal-Mart store will stock about 40,000 different brands. You will find about four dozen toothpaste brands there. Little wonder that Costco is also known as the ultimate anti-Wal-Mart.

 It's easy to find high-quality Persian rugs in a Costco store this week, but the following week the rugs will be gone and in their place you will find name-brand furniture or designer-label handbags. It's this mystery of never knowing what to expect from Costco that keeps customers coming back.

Meanwhile, Macy's took a timid step into the Chinese market in 2012 when it invested $15 million in VIPStore, the operator of the Omei.com website. It's still unclear whether its new venture will be an extension of the VIPStore investment, or something entirely new.

Online stores, just like their traditional brick-and-mortar counterparts, have their pros and cons. In Costco's case, the joy of the treasure hunt is emphasized by the physical shopping experience, and this cannot be duplicated in an online store.

Foolish bottom line
New ventures are almost always accompanied by high degrees of uncertainty. About a decade ago, home delivery was a utopian retailing concept that nobody could seem to master due to the highly complex logistics involved. Companies such as WebVan and Kozmo.com tried it out but failed miserably. Right now, home delivery has become almost banal, and it is expected from nearly all large retailers. Home Depot is the latest retailer to join this bandwagon, after studies showed that its contractors would not mind paying higher fees to get their merchandise delivered faster.

Maybe Costco and Macy's should have been a bit bolder and leveraged the lessons learnt from the mistakes of other U.S. retailers with Chinese operations by establishing physical stores in China. On the other hand, the low-risk nature of online businesses will insulate these companies from any huge losses should the new ventures fail to gain traction.

What else is going on in China?
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