NEW YORK, United States — In the past two weeks, Armani and Burberry both announced strong China growth numbers in spite of the country’s luxury slowdown, but their sources of success were not the same. While Armani’s pivot to second- and third-tier cities has been cited as a major driver of its 39 percent profit gains, Burberry’s growth was attributed to demand in major hubs like Hong Kong and Shanghai after the company implemented a more upmarket approach to promotion. Meanwhile, when Louis Vuitton-owner LVMH reported disappointing numbers earlier this year, chief executive Bernard Arnault stated that, despite a previous push into second-tier cities, Louis Vuitton will slow its lower-tier expansion to “avoid becoming too commonplace.”
Clearly, a growing number of fashion brands are examining the market opportunity beyond Beijing, Shanghai, and Guangzhou in China’s second- and third-tier locales, which are expected to see the most rapid rates of growth in China over the next few years.
It’s hard to exaggerate the importance of the retail markets in China’s roughly 460 second- and third-tier population centers. The Boston Consulting Group has projected that both wealth accumulation and consumption in these locales will surpass that of the first tier in coming years. More than half of the country’s economic growth, 60 percent, is expected to come from these cities by 2020, while 80 percent of the country’s market for mid- to high-priced fashion will originate there. Tellingly, of Foreign Policy’s "75 Most Dynamic Cities of 2025," 29 are in China.
Indeed, in the not-so-distant future, luxury companies’ ability to appeal to consumers in these cities will be as important to their growth in China as their growth in China has been to their overall global earnings. Despite the numbers, and the fact that the second tier has helped some companies beat the slowdown, some high-end brands such as Louis Vuitton, Chanel, and Dior have stuck with or switched over to a more cautious expansion model. Chanel, which began opening stores in second-tier cities only two years ago, hopes to “stay exclusive” because “it’s strategic to not be everywhere,” as the company’s global CEO Maureen Chiquet stated back in January.
To be sure, lower-tier retail expansion is not without its challenges, including real estate issues, logistical dilemmas, and differing consumer habits. In contrast to the mad rush for retail real estate in saturated areas such as Shanghai and Beijing, many lower-tier cities are actually facing a glut of mall-building, with high vacancy rates that are likely to discourage brands from entering until they can guarantee that the location will flourish. The average vacancy rate for malls in second-tier cities is currently 10.5 percent, and much higher in individual cities such as Shenyang, where the rate stands at 17 percent. In addition, despite growing populations, these cities lack labor forces skilled in high-end luxury retail, leaving brands wary of diluting their images through sub-par service.
Another challenge is different and unfamiliar consumer behaviour. Several recent studies have shown that consumer habits in the lower tiers do not match up with those in larger cities, and different strategies are needed for brands to succeed there. Specifically, research has found that second-tier shoppers tend to be more impulsive, more conspicuous, and less brand-aware than those of the first tier.
According to a study published in mid-May by advertising company Publicis Group, which surveyed a pool of respondents who spend at least $10,000 a year on luxury, consumers in second-tier cities are still interested in purchasing “obvious luxury” in the form of logos and flashy items as opposed to the first tier’s heavier focus on sophistication and quality. Gifting practices were found to remain high in second-tier cities, with 40 percent of respondents stating they had given luxury goods as gifts to associates or acquaintances. Brands tapping celebrities for endorsement at major events in Shanghai or Beijing might also take note of the fact that more respondents from the second tier said they would be willing to make a purchase if a product was endorsed by a famous figure.
These characteristics of second-tier cities are not without their benefits, nor are they much different from those faced by the first luxury labels to enter larger cities. Consumers with less brand knowledge may serve as a “blank slate” for companies to educate about a label’s heritage, and real estate is less expensive and easier to come by than in larger locations. Entering these cities early also avoids the risk of the market becoming saturated before a brand can establish itself, a challenge currently facing many companies in the upper tier. Additionally, both Chinese and smaller foreign brands have more breathing room in these cities with less competition from the world’s fashion behemoths.
As labels remain vigilant about identifying the right time to expand to the lower tiers, China’s rapidly growing e-commerce market remains an increasingly popular alternative to brick-and-mortar stores. According to research by Ogilvy & Mather China, online shopping options are critical in areas where luxury goods are not yet available in retail stores. Although consumers from these cities also travel to the first tier to make purchases, the rate at which they are using e-commerce is growing. E-commerce is not always a perfect short-term alternative, however, because a different set of logistical issues complicates e-tail in China, with quality assurance and reliability figuring significantly in delivering luxury goods to wealthy Chinese customers with high expectations.
This complicated terrain has not stopped companies from entering the second, third, or fourth tier or making plans to do so in the future. And for even the more cautious brands, it’s not a question of “if” but of “when” — and more importantly, “how.” Despite Burberry’s tier-one-heavy growth, the brand is far from absent from the second tier and still plans to open 25 new China stores in 2014. The challenges, however, are manifold: they must enter before the market becomes too saturated but not overextend themselves; they must find ways to appeal to the conspicuous consumers of smaller cities without alienating the craftsmanship-oriented clients in the larger locations; and they must come up with clear digital marketing and e-commerce strategies, all while educating consumers and preserving a distinct sense of brand heritage. Although a good expansion strategy will certainly be a balancing act, the long-term payoff is so high that the challenges will not keep luxury brands from China’s lower-tier cities for long.