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Urban Planning in China’s Beauty Market

With a population numbering more than 300 million people, China's emerging cities represent a huge opportunity for international beauty marketers.

Zhao Meng is a 27-year-old librarian from the city of Changchun, population 7.5 million, in the northeastern province of Jilin.

Every morning, Meng rinses, cleanses and tones her face, before applying a serum, moisturizer and sunscreen.

Like many Chinese women, Meny largely eschews color cosmetics, though she does use BB cream every day in order to keep her complexion looking bright and white, and she has been known to wear eye makeup on special occasions.

Her favorite beauty brands—DHC and Shiseido—come from Japan. Her local shopping centers, which include Changchun Department Store, Parkson Shopping Center and a Wal-Mart, currently stock some international brands, which Meng prefers to use over homegrown beauty products—though she is looking forward to the day when she can have access to even more.

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“I like foreign cosmetics because I feel as though the materials are relatively natural and not harsh on my skin, and also the technology is more advanced,” Meng says. “There are more international brands in my city now, and when new brands come to Changchun, I will certainly buy them to try.”

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Meng can expect to see a deluge of international brands coming soon to stores near her. As growth in China’s top-tier cities slows and opportunities for expansion within Beijing and Shanghai become increasingly tapped out, more and more companies are banking on explosive growth in China’s third-, fourth- and fifth-tier cities—the new frontiers of the Wild Wild East. China’s city tiers are defined by location, population and income, though the classifications are something of a moveable feast, with cities sometimes considered one tier or another, depending on the criteria being used by the various researchers and government departments doing the classifying. There’s little doubt about the first tier, which encompasses China’s most-developed cities—Bejjing, Shanghai, Shenzhen and Guangzhou, along with the Special Administrative Region of Hong Kong&mash;but between the second and third tier, categorization gets a little cloudy, with many cities previously considered third-tier (because they aren’t technically provincial capitals) now commonly thought of as second-tier cities because of their wealth.

To put these numbers in context, within China’s 665 cities, only five are considered Tier One and anywhere between 35 and 60 are currently thought of as Tier Two.

Beyond these urban centers, more than 300 million people live in China’s smaller cities. China has 13 cities with a population of more than 10 million, 88 cities with more than five million inhabitants and 335 cities with more than one million people.

Despite the lack of clarity in China’s city-tier classifications, there seems to be universal agreement that the lower end of the spectrum—tiers three, four and five—holds the greatest opportunity for international brands to grow and expand within Mainland China. “There’s huge potential,” says Kevin Chong, a Shanghai-based partner with Bain & Company and coauthor of the recently released 2013 “China Shopper Report.” “I see a lot of growth coming in the future, and given the low level of penetration of international brands, there’s even more growth they can tap into.”

Fabrice Weber, president of the Asia Pacific Region for the Estée Lauder Cos. Inc., agrees the potential is massive in China’s lower-tier cities, with his company’s brands currently on sale in 69 cities around the country and demand from consumers to bring at least one of its lines to 350 locales nationwide. “Tier-one and tier-two consumers have migrated to shopping through different channels, many of them abroad and online, which leads to a softening of the domestic market,” says Weber. “Tier three is very meaningful because the spending power is there. We see great potential in the years to come.”

As the country’s population urbanizes, the middle class is expected to grow exponentially. Experts say the number of households with an annual income of more than $11,730 will grow from 141 million in 2010 to 400 million in 2020. Figures from Boston Consulting Group project both wealth accumulation and consumption in second- and third-tier cities surpassing that of the first tier in coming years. BCG estimates that more than half of the country’s economic growth, 60 percent, will come from these cities by 2020, with 80 percent of the country’s market for mid- to high-priced fashion originating there.

Even as far back as 2011, second- to fourth-tier cities in China had a combined disposable income of around 8 trillion yuan, about $1.3 trillion, compared with $163 billion in first-tier cities. And consumers aren’t afraid to spend, with retail sales of consumer goods in tier-three, -four and -five cities totaling about $278 billion between January and August 2012, up 14.3 percent year on year, according to market research firm Nielsen, which also estimates that lower-tier cities currently account for 64 percent of China’s retail sales.

Drilling down into beauty, Kantar Worldpanel estimates the current value of China’s skin-care industry at around $14 billion, representing year- on-year growth of more than 13 percent, though in lower-tier cities, that growth jumped to 17 percent for the same period. As for color cosmetics, Kantar puts the total value at $1.5 billion in 2013, representing year-on- year growth of 14.9 percent, with more than 22 percent growth in lower-tier cities.

Tellingly, of Foreign Policy’s “75 Most Dynamic Cities of 2025,” 29 are in China and some of them are still commonly classified as third tier, including Foshan (ranked 13), Wuxi (36), Xuzhou (62) and Tangshan (72).

These cities have also been identified in research from Ogilvy & Mather as popular “test markets” for international brands. Their locations, relative to tier-one cities, make them an ideal starting point for international brands looking to expand into smaller cities, without straying too far from developed logistical or distribution channels. They are the jumping-off point from which brands make their way westward.

Foshan is a city of 7.1 million people, located in the southern province of Guangdong. It’s the third-largest manufacturing base in the Pearl River Delta region, behind Tier One superstars Guangzhou and Shenzhen, primarily producing house-hold appliances, tools and furniture.

Wuxi, in Jiangsu province, meanwhile, has been called a “third-tier city with second-tier importance,” because of its relative wealth and proximity to first- and second-tier cities such as Shanghai, Nanjing and Suzhou. Brands such as Louis Vuitton have already opened in Wuxi, population 6.4 million, whose main economic drivers include textile manufacturing and solar technology.

Also in Jiangsu province is the city of Xuzhou, which is an important transportation hub, linking Shanghai with China’s northern provinces. The city’s history dates back to at least 1600 BC; the current population is about 8.6 million people.

Though Tangshan, in northeastern Hebei province, is known as the site of one of the world’s most destructive earthquakes (the 1976 quake measured 7.8 on the Richter scale and killed an estimated 250,000 people), the completely rebuilt city, current population 7.5 million, has increasingly become one of northern China’s most important industrial cities and has been a major coal-mining center since the Qing Dynasty.

These cities are far from being one-horse towns, with highly mobile and increasingly wealthy populations numbering in the many millions of people.

Within a market as huge as China, it’s impossible to pigeonhole a single “Chinese consumer.” Different cities and regions have not only achieved different stages of economic development and access to modern retail, but there are also vast distances and varying climates across the country.

Consumers in tier-three, -four and -five cities are generally thought to be less educated and informed about international brands than their compatriots in first-tier cities, though the culture of beauty is just as evident in regional China as it is in Shanghai or Beijing. The penetration of sectors such as color cosmetics and fragrances is comparatively low all over the country, because of a traditional cultural desire to bring out a woman’s natural beauty through a flawless and milky white complexion. Thus, skin care is the dominant sector nationwide, with this dominance more pronounced in lower-tier cities, where it accounts for up to 75 percent of beauty sales.

Despite their reputation as the “poor cousins” of China’s eastern seaboard elite, Jason Yu, general manager of Kantar Worldpanel’s Shanghai Office, says that women in China’s lower-tier cities are willing to pay a surprising premium for beauty products.

Kantar runs purchasing panels with 40,000 families across China and Yu says that research has shown that women in third- and fourth-tier cities use almost as many products as women in first-tier cities as part of their daily regimen—seven on average, compared with eight for first-tier women. Moreover, lower-tier consumers are using emerging products, such as eye toner and serum, even more than women in first-tier cities.

“People have this misconception that lower-tier consumers use less beauty products than those in first-tier cities. For men, that’s probably true, but for female consumers, we didn’t find substantial differences in beauty usage, in terms of number of products used,” says Yu.

“In the big picture, there’s not really [a big difference],” says Chris de Lapuente, chief executive officer of Sephora, which opened its first store in China in 2006 and today has more than 127 stores there. “It’s such a vast country there may be some assortment tweaking—for example, the northern cities having earlier drives on moisturization than the south because of the drier weather.”

Chong agrees, noting that Bain’s latest report also shows women in lower-tier cities are more informed that one might think, though they are still at a “repertoire” stage of purchasing, in which brand loyalty is low (in this case virtually nonexistent) and consumers are focused on trying many different brands and products in order to find what works best for them. “The major misconception is that these consumers are a lot less sophisticated, but with the Internet and [because] many of these consumers spend time in more affluent cities and know what the brands are, they are actually more sophisticated than some brands think they are,” Chong says.

Carsten Fischer, representative director and corporate senior executive officer of Shiseido, says that as lower-tier city consumers become more plugged in digitally, they are virtually as knowledgeable as first-tier consumers, though they don’t have the same access to personalized service, which could help encourage brand loyalty. “In the current digital age, we do not see much of a difference in the amount of information available to people in these cities, and we don’t consider that there is much regional disparity regarding consumer’s knowledge about cosmetics or demand. However, in smaller cities there are fewer opportunities for a consultation with a beauty consultant than in the larger urban areas,” he says.

The biggest difference in purchasing behavior is actually the brands they use, with the first tier dominated by international names, including Estée Lauder, Clinique, L’Oréal and the like. Such brands first entered the market just as consumers were becoming accustomed to the idea of using beauty products (after cosmetics were banned by Mao during the Cultural Revolution) and have successfully defined the category in top-tier cities.

At the same time, though, Chinese brands were taking advantage of their local knowledge by entering the market via smaller, more-affordable cities, where they still dominate.

“In the smaller cities, consumers are more likely to be using local brands, or even counterfeit products or copycat brand names. The product is definitely different, but in general, the kinds of products people are using are very similar,” Chong says.

Thus, the burning question becomes whether consumers in lower-tier cities will choose international brands if given more access than they currently have.

Although there is curiosity about international brands and an unquenchable desire for newness among China’s rising middle class, MEC Global China’s chief strategy officer, Thomas Nolsoee, warns that Western brands should expect stiff competition from local players who already have a firm foothold in these markets. “Coming in and just being international doesn’t necessarily do the job,” says Nolsoee, “and you will be competing with local brands consumers are equally interested in.”

Major competition for international brands in lower-tier cities includes the low-cost and still-dominant Dabao, which accounts for almost one in two skin-care purchases in China’s fourth- and fifth-tier cities, according to Kantar. Although it is considered a “local brand” by Chinese consumers, the company was actually acquired by Johnson & Johnson in 2008.

Other major Chinese players include Peichoin, a Shanghai-based brand that dates from 1931, and Herborist, which is owned by local giant Shanghai Jahwa and is one of only a few Chinese brands to have successfully grown its presence from being in primarily lower-tier cities to attracting young and hip consumers in first-tier cities. Price wise, such brands aren’t necessarily inexpensive. “When you look at some of the midrange local brands that are selling well in tier- three and -four cities, they are not necessarily cheap brands,” says Yu. “We are talking about products priced between 100 and 200 yuan ($16 to $32), so they are really masstige brands.”

Gao Xue, 25, from the city of Haikou on Hainan Island (known as “China’s Hawaii”) sums up the attitude of many Chinese consumers who believe that products by local brands are better, as they are perceived as being specifically designed for Asian skin. “I like Asian brand skin-care products because they are more suitable for Asian skin. Even if there were more American and European brands in my local stores, I don’t think I would buy them,” she says. Beyond these challenges, there are also the physical and organizational difficulties of logistics and distribution facing any international brand looking to expand into China’s vast interior.

A major hurdle is the traditional retail environment that is still predominant in smaller cities. Though there is little doubt that the Wal-Marts, Tescos, Carrefours, Watson’s and Sephoras of the world are, along with everyone else, looking to expand as rapidly as possible, there are still a great number of small cities without large, self-service hypermarkets or other major multibrand retailers.

According to Nolsoee, up to 45 percent of beauty purchases in lower-tier cities occur in small, mom-and-pop-owned stores stocked with Chinese and other Asian brands. “A lot of international brands are using the more-established distribution into the country,” he says, “but this is one of the flaws of the international brands’ distribution strategies, because they don’t have access to these small stores. The local brands and Asian brands do so well because they have access to this distribution stream.”

Though this traditionally fragmented beauty distribution is an immediate challenge, the logistical situation is improving, with better infrastructure and those incoming international retailers. The French retail giant Carrefour currently operates 220 hyper-markets in 65 Chinese cities and intends to expand into 30 new cities over the next three years. Wal-Mart has announced its intention to open 30 new stores across Greater China in 2013, with a total of 100 stores slated to open over the next three years, and Hong Kong–based personal-care retailer Watson’s, which currently has stores in 150 cities in China, is planning to expand its presence to more than 3,000 stores in 300 cities by 2016.

Lauder’s Weber also points to malls as a major future opportunity in China’s lower-tier cities, with as many as 80 percent of the country’s 2,800 malls currently in tier-one and -two cities, leaving plenty of room for growth. “This is going to be the way into these markets,” he says, “as well as companies in the specialized beauty business, like Sephora, which are expanding rapidly. The department stores are the most developed and we are looking at them to help us to join the party.”

As for Sephora, which is in 47 cities and whose business is growing by double digits, de Lapuente says: “We are recruiting like crazy, strengthening the team and the operations. We’ve only fulfilled a small fraction of what’s possible in this market.”

E-commerce is also developing recently. According to figures from MEC Global, e-commerce penetration in China’s lower-tier cities has virtually tripled, from 11 percent to 30 percent over the past two years. Recently released statistics from Alibaba, China’s largest online retail conglomerate, show sales (across all product categories) in lower-tier cities increasing more than 60 percent in 2012, while first-tier cities saw growth rates of less than 40 percent year-on-year.

For the same period, Lauder saw net sales in China increase about 28 percent in constant currency in fiscal year 2012. Two-thirds of those sales came from e-commerce, mostly from cities where the company’s brands don’t have a physical presence.

Although the numbers certainly look promising, there are just as many challenges in China’s e-tail landscape as there are in the real world of brick and mortar, not least of which is the dominance of C-to-C platforms, such as Alibaba’s TaoBao.

“Some of the international companies think if they open their own brand e-tail portal they can absolutely control the brand and shopping experiences, but the traffic’s not there. People will be going to TaoBao instead,” Yu says. “You have to build multiple partnerships with multiple-brand e-tailers to make sure you are in front of your customers. It’s a bit like the physical brick-and-mortar world—being in Wal-Mart isn’t the end of the story You have to be in hundreds of retailers around China because the trade is so fragmented.”

Julia Zhu is the founder of Observer Solutions, which specializes in China market research and recently released a report covering the potential for online luxury e-commerce in China. She says another factor vital to online success is mitigating consumer concerns about product authenticity and quality, a major issue for a population facing almost-daily revelations of product safety scandals. “This is especially crucial for beauty and unfamiliar brands, given that beauty is one of the categories in which fake products are most prevalent,” says Zhu. “Fast delivery and easy return services or shipping discounts are also key to winning consumers in China’s remote areas since it usually takes a longer time and higher fees to deliver products to them.”

This fast-changing retail environment makes it more viable than ever for international beauty brands to make their way into China’s lower-tier cities, but once they get there, successfully winning over a new generation of Chinese consumers with effective marketing campaigns and popular product offerings is a whole new battle. “Going to a tier-three city is almost like going to a new market, a new country, so creating the brand awareness is vital,” says Weber.

Lin Liu, planning partner at Ogilvy & Mather Advertising in Shanghai, says emphasizing status is key. “The lower-tier consumers are obsessed with the product features and functions, and they also have a greater desire to purchase brands that will give them ‘face’,” she says.

For prestige brands, in particular, the shopping experience—teaching consumers how to use unfamiliar products—is a vital tool for attracting new customers. Consequently, the competition for beauty advisers is fierce. “You can communicate as much as you want,” says Weber, “but the element that will allow you to perform and win is the education of the individual consumer.”