China’s retail sales have doubled in three years, but slowing GDP growth is worrying GPs with retail investments. Michelle Phillips reports.

In numbers, China’s retail sector is booming. Revenue and profit have both doubled over the past three years, with sales of over RMB 532 billion (€65 billion; $85 billion) in 2011, according to Thomson Reuters.

Yet it’s increasingly difficult to grow the bottom line. A UBS Investment report shows 45 percent of surveyed Chinese retailers reported falling more than 5 percent short of expected earnings in H1 2012.

All large retail chains in China, in response, are revising growth plans and focusing on profitability, according to William Shen, head of Greater China at Headland Capital Partners.

Profit margins have been hit by rising costs and salaries, which are growing faster than revenues. The Global Retail Development Index estimates a 15 percent annual rise in salaries, and a 30 percent rise in rent.

“The day of cheap labour is past,” says Shen. As such, even a small drop in sales growth can cut into retail profits.

But the real threat forming on the horizon is the country’s slowing GDP growth, which many sources believe is permanent. As the economy slows, people spend less and that can mean original profit forecasts (and projected returns) for retail investments may have to be revised downward.

Shen says that retailers can no longer rely solely on China’s growth story. “It used to be that you open a store, and people would come – that’s no longer going to work,” he says. Instead, stores need to devise a long-term sales strategy and carry out operational changes to realise it.

“High growth can mask inefficiencies,” he says.

Headland introduced an operational programme in its retail operation Yonghui Superstores, allowing stores across the country to compare tactics. By studying not only which products sold well but why, Yonghui achieved a sales growth of 48 percent last year, Shen says.

Beijing-based Hao Capital’s investment in furniture retailer Ju Tai Long is another example. When the firm first invested, Ju Tai Long was a franchise model and Hao couldn’t control products and services in all the stores. When Hao changed to a directly-owned model, allowing the individual owners to take more control of their own domain, the chain grew from RMB 20 million (€2.5 million; $3.2 million) in sales in 2006 to over RMB 1 billion in 2011.

Changing the business model and consolidating the training for managers and employees made all the difference, according to the firm. It allowed the operation to grow from 200 franchise stores in 2006 to more than 300 directly-owned stores today and still provide the same level of service.

Inefficient stores will be forced to close as GDP growth slows, adds Derek Sulger, founding partner of Lunar Capital. Underperformance becomes a particular danger in the franchise model (the most common model in China), because manufacturers don’t always know how much their distributors have sold on the ground.

He cites brand-name sports clothes, which typically sold well to distributors who were reacting to demand rather than buying stock based on market analysis and forecasts. As the clothing fad lost popularity, distributors couldn’t sell all they’d bought and the result was an inventory pile-up, Sulger says.

Even with the challenges, both Shen and Wong say that they would still make another retail investment in China. Shen forecasts double-digit growth for the retail sector over the next few years, an opportunity found in few places in the world. “The key,” he says, “is to find those companies that can outgrow the overall market growth.”

That gets increasingly tougher to do as the world’s growth engine slows.