How Come Companies Like Procter & Gamble Always Lose to Local Brands in Small Towns? | From Tier 1 to Tier 5, What Happened (Part 2)

Over roughly the past two months we interviewed 11 people who work in this industry — at big personal-care and household-goods companies, and in every kind of job along the distribution chain. This series runs to three articles, all trying to answer one question: why did the traditional distribution systems of the big personal-care companies collapse? This is the second.

Previously: In yesterday's article, we described how the big personal-care companies have lost the control they once had over everything. They now make compromises with all sorts of business partners, and even change product launch plans at the last minute — hard to imagine at large companies that pride themselves on standards and rigorous process.

The problem underneath is that their traditional sales-channel systems have collapsed. That sales network, spread across the globe like capillaries, was their lifeline. Procter & Gamble and Unilever were once treated almost as legends in the Chinese market, and that rested on one thing: a stable, powerful distribution system. E-commerce broke the stability first. Consumption grew more varied than ever before, and consumers traded up — both of which collided with the mass-market products the big companies sold. As the channels through which consumers get information changed, the big companies grew confused about how to find their customers, and the fast-rising force of e-commerce demolished their confidence.

When they tried to copy their tier-1 and tier-2 playbook, step by step, into tier-3, -4 and -5 cities, every problem erupted at once — above all when they saw the completely different rules of the game that local companies had built in this much larger market, and found those rules hard to break. That is what this article is about.

As China's tier-1 and tier-2 markets grow saturated, multinational consumer-goods companies have tried to push their distribution channels down into tier-3, -4 and -5 cities to reach a broader market. There they have run into a tough rival: local brands.

This tempting market is made up of more than a billion people. Before the foreign companies arrived, local companies were already fighting hard over it — as hard as Procter & Gamble, Unilever and L'Oréal fought in Beijing, Shanghai, Guangzhou and Shenzhen in the 1990s. Over the past decade and more, local companies including Liby, Nice Group, Blue Moon and Shanghai Jahwa shaped the commercial landscape here, along with consumers' habits, preferences and awareness.

Market-research reports have begun using the word "counterattack" for local brands. In the Top 10 Chinese Home Care Companies ranking published by the global market-research firm Euromonitor International, Liby held 15.3% of China's home-care market in 2014, first on the list. Unilever ranked third and Procter & Gamble fifth, with 7.5% and 6.5% — the two of them together still less than Liby alone. Procter & Gamble, long strong in hair care and personal care, saw its share fall year by year from 15.2% in 2009 to 12.7% in 2014.

Until at least 2010, in fact, local and foreign companies mostly left each other alone. Each grew fast in its own market, with little conflict between them.

Between 2000 and 2009, Procter & Gamble's global sales doubled, and the biggest single contribution came from the spending power of China's tier-1 cities. Multinational consumer-goods companies, Unilever among them, were copying what had worked for them in Europe and the United States, expanding across China's tier-1 and tier-2 cities through supermarket chains such as Walmart.

Local companies did the opposite. They aimed at China's tier-3 and tier-4 cities and put down roots through privately owned small supermarkets and personal-care specialty stores. That may be why you see row upon row of small shops in so many tier-3, -4 and -5 Chinese cities today: local companies, single-handedly, cultivated a sales channel whose stores are tiny one by one but extraordinarily numerous in total.

According to figures that Wu Kun, general manager of Chando's business division, gave us, the brand is now in 13,000 personal-care specialty stores nationwide, most of them in tier-3 and tier-4 cities. Official filings from Proya, another local cosmetics company, show that in 2015, 62.28% of its sales came from personal-care specialty stores, which "have a large base in tier-2 and tier-3 cities and in towns and townships."

After 2010, saturation in the tier-1 market meant foreign companies were the first to run out of growth. They turned to the local brands' home ground — tier-3, -4 and -5 cities. But building a foothold in a new market is never easy, and here they had to "remake" one.

"Just as the multinationals wrote the rules of the game for the supermarket channel in tier-1 and tier-2 cities, local brands wrote the rules for tier-3 and tier-4 cities," Wu Kun said.

Old experience cannot simply be copied into this market. The big companies face not only different consumer behavior and habits, but distributors and retailers that work in different ways. The mismatch runs through the whole system.

The most important piece of it is the pricing system.

By the time you see a bottle of shampoo on the shelf of a small supermarket in a tier-3 or tier-4 city, it has passed through the brand's factory, an agent (this link sometimes exists), one or several tiers of distributors, and finally the supermarket's retail operation. Each of them takes a share of the profit, and together they set the final price you pay.

"Local brands can do distribution well because they have a stable pricing system. Big companies like Unilever still have work to do there," said Zhou Tian, who works at Unilever, speaking to QDaily by phone.

That pricing system has its own rules in tier-3 and tier-4 markets, and the rules were written by the local companies that got there first.

"For the personal-care specialty-store channel in tier-3 and tier-4 cities, 35% of retail is the standard local companies set. It's very hard now for a foreign brand to get into this channel," Wu Kun told QDaily. "Foreign brands used to set the supermarket channel at around 70% of retail, and they can't turn around and offer that same price to the specialty stores. Neither the shop owners nor the agents will accept it."

That "35% of retail" ex-factory price was a strategy local companies adopted as they expanded into tier-3 and tier-4 markets, meant to raise penetration fast. By widening the profit margin for agents, distributors and retailers, they seized local sales resources quickly.

At the start, what local companies wanted most in tier-3 and tier-4 markets was market share and brand penetration, not high profit. That set them apart from listed companies such as Procter & Gamble, Unilever and L'Oréal, which answer to the capital markets and to shareholders, and whose goal is to make a lot of money.

Two entirely different goals led to two entirely different ways of acting.

"On pushing distribution downward, pressure and resistance from competitors actually aren't the main thing. The main thing, always, is cost. What matters most is our cost of coverage and our efficiency of coverage," Zhou Tian said. He offered an extreme case: for Unilever to cover a grocery store in a yurt 1,000 kilometers from downtown Urumqi would, he thinks, be unrealistic on cost alone.

Liu Yiman, director of Tmall's overseas direct-sales business, has come away with much the same impression from dealing with big companies. "Big companies put enormous effort into building a distribution system, but the pressure is heavy and the cost is high. By tier-3 cities the pressure and the cost are already heavy. In tier-4, -5 and -6 cities they simply can't solve it; the channel has no capacity to go that far down. Even so, whenever we brief them on Rural Taobao, a lot of CEOs ask us right after the meeting to find them a village they can go see for themselves."

"Pushing distribution downward is a priority every year, but it's hard to do. We really have no price advantage. We won't set our ex-factory price very low — with our fixed costs, it's hard to push it down," said Li Leihan, who works at Unilever.

In the market, this shows up as higher retail prices. Foreign companies are not blind to it. As an employee at a Century Lianhua store in Anhui province put it: "Foreign fast-moving-consumer-goods brands used to run few promotions. Later, fighting local brands for share, they ran buy-one-get-one and gift-with-purchase deals very often."

Local companies found another route into the supermarket channel as well. Most of them use agents, rather than shipping straight from the factory to Walmart and Carrefour the way Procter & Gamble and Unilever do.

Direct supply cuts out the middleman and saves money, but it demands more of a manufacturer's management systems and execution. Local companies don't have that kind of forceful management system. A more important reason, though, is that they saw how complicated regional markets are. "Consumer behavior and shopping habits are completely different from one region to the next. Even Walmart and Carrefour split the country into several regions," Wu Kun said. "If we supplied Walmart and Carrefour directly, everything would be standardized and there'd be very little flexibility. Let a local agent work with the local Walmart or Carrefour, and there's more room to move."

So local companies' channel marketing is planned from the bottom up — again the opposite of the foreign companies. "Foreign firms believe in a top-down mindset, advertising for instance," Li Leihan said.

"The marketing department thinks it has spent a lot of money on a lot of advertising, but in tier-3 and tier-4 shops you simply don't see our materials [Unilever's promotional materials] — the pillar wraps are all Liby and Diaopai. In tier-3 and tier-4 cities, seeing is believing. You see a brand in the first shop, you see it again in the second, and you become very willing to buy the brand you keep seeing," Li Leihan said.

Beyond the billboards and signage at physical stores, you may also have noticed local brands "rising" on television. Kans, Liby and others have title-sponsored variety shows over the past few years, and annual marketing budgets above 1 billion yuan are no longer unusual. But title sponsorship buys short-term marketing effect; once a local brand has built up a huge amount of noise that way, its dependence on TV advertising tends to fall.

Foreign companies, meanwhile, are known for depending on TV advertising — even as they put a growing share of their ad money into digital media. According to figures Nielsen CCData gave QDaily, 14 of the 15 personal-care brands that spent the most on TV advertising in all of 2015 belonged to foreign companies.

The big companies have put work into in-store marketing too. Procter & Gamble and Unilever also run enormous sales networks, employing large numbers of salespeople who travel every day between distributors and retailers across the country. Their main job is to make sure the marketing strategy set at headquarters in Shanghai or Guangzhou is actually carried out thousands of kilometers away.

Expanding across tier-1 and tier-2 cities, the big companies grew used to a whole set of practices built around "brand image." They want the point of sale to look the same everywhere, and use that to standardize the brand across different markets. "A good salesperson has to maintain how the product looks at every outlet they cover, whatever the outlet — on the shelf, for example, in the best eye-level spot," Zhou Tian said.

But what the personal-care specialty stores in tier-3, -4 and -5 cities really sell is not the product or the brand image; it is a "relationship." Trust between the shopper and the owner or the clerk is often what decides whether a sale happens. We looked at this in an earlier report on cosmetics stores in a tier-4 city.

That is why local companies care more about building and using this "relationship" than about creating a single, uniform brand image. Over the past 10 years they have spent freely on manpower to build good relations with retail outlets in tier-3 and tier-4 cities, and have run lectures inside the specialty stores on cosmetics, beauty and health — partly to keep the brand visible, partly to help the shop strengthen its own "relationship" with shoppers. The brand is the one that benefits in the end.

Wu Kun told us that in busy periods Chando runs as many as 300 "beauty classes" a month across the country, usually at major cosmetics chains or at important specialty stores in important markets.

These specialty stores teach and inform shoppers in tier-3 and tier-4 cities, much as Walmart and RT-Mart once did for shoppers in tier-1 and tier-2 cities.

For a brand, though, the cost of getting the same product into a corner shop is nothing like the cost of getting it into a chain supermarket. The latter usually means complicated slotting fees and barcode fees, sometimes shelf fees, end-cap fees, poster-promotion fees and more. When local cosmetics companies were first expanding, they deliberately kept away from the chain-supermarket channel and built up privately owned supermarkets and personal-care stores, which cost less to maintain. Controlling these costs was part of the reason.

Blue Moon may be the counterexample. At the end of 2015 it pulled out of the hypermarket chains nationwide, a move not unrelated to what that channel costs to maintain. "Hypermarket customers are mostly low- to mid-end, and marketing in the supermarket channel costs much more. Blue Moon is relatively high-end, but its product line is too narrow — unlike foreign companies, it has no strong portfolio of brands to spread the cost across. So it [selling Blue Moon in hypermarkets] was never going to last," said the Century Lianhua employee quoted above.

In the tier-1 market, though, foreign consumer-goods companies and hypermarkets like Walmart and Carrefour were practically a "perfect match." Around 1995 both Walmart and Watsons entered the Chinese mainland market. As suppliers of enormous size, the foreign consumer-goods companies quickly built good relations with these retail giants and spread their products into every corner of the tier-1 cities.

That should have been a success story you could repeat in tier-3 and tier-4 cities. But the retailers themselves struggled to adapt as they moved down. In the first half of this year alone, Walmart closed or suspended seven stores in Shandong and Anhui.

Even the retailers that did make it down into tier-3 and tier-4 cities are changing. "A few years ago Watsons' brand mix was mostly foreign, with domestic brands in a supporting role. In the past few years, though, brands like P&G's Olay and Johnson & Johnson's Neutrogena have started pulling out, one after another," Wu Kun said. "Sales per store are falling, and they no longer support these brands' financial reports."

Compared with 10 years ago, Wu Kun says, Watsons' fastest-growing business no longer comes from foreign brands but from local brands and from Watsons' own private label — over the past few years Watsons has copied a great many bestselling items from international brands. As Watsons moves down into tier-4 and tier-5 cities, he thinks, what it brings with it is increasingly domestic brands and its own.

As their weight in the market has grown, local companies have begun to attract better people, and they like hiring from the foreign consumer-goods companies in particular. Some executives at local companies, Jala Group and Shanghai Chicmax (owner of the Kans brand) among them, came from Procter & Gamble, L'Oréal and the like; what these companies want is their experience in winning tier-1 markets fast. Such hires bring not just a whole body of market experience but the big companies' mature ways of developing talent — management-trainee programs, for instance.

Now that each side's core market has matured, foreign and local brands are both trying to enter the market the other is good at, and for both it is hard. Both also see the value of working with e-commerce companies like Alibaba and JD.com — and on that front, which the industry regards as its future, the two sides start from almost the same line.

(Zhou Tian and Li Leihan are pseudonyms.)

Cover image from Visual China Group