Consumer goods companies have long poured investment into China, driven by visions of the country’s billion consumers and the belief that first movers will reap a permanently disproportionate share of one of the twenty-first century’s biggest markets. In one market in particular, packaged foods, the scope is undeniable: in 1998, packaged food will account for 20 percent of the country’s $200 billion food and beverage sales, or $40 billion. Sales of some items, such as milk powder, instant noodles, biscuits, and soft drinks, have already topped $2 billion.
Yet despite this potential, most foreign food and beverage companies are find-ing it difficult to attain even modest profitability in China. Pre-tax returns on invested capital for the 2,500 largest food and beverage joint ventures were less than 6 percent in 1995.1 Even among the 200 largest joint ventures, average returns were only 3 percent for those operating for three years or less, and around 10 percent for those in operation for four or more years (Exhibit 1)—certainly below the risk-adjusted cost of capital for China. Moreover, returns among these ventures vary enormously, from minus 36 percent to 60 percent.
These erratic results, coupled with the Asian economic crisis, are prompting investors to look closely at their performance in China. Many are realizing that their businesses are not well positioned to be profitable. Some are lowering their growth expectations and postponing option-creating investments while they search for a successful formula. One executive of a multinational company earning less than 6 percent pre-tax return on capital after 10 years in China sums up the situation thus: "We are still in China. Our business has been doing reasonably well, but it has been a long, tough struggle." This company has abandoned the once-popular "one by two" goal—$1 billion in sales by 2000—and settled for a target roughly one-fifth of that sum.
Our work with consumer companies and recent McKinsey research reveal the causes of these difficulties and highlight key decisions that those striving to build profitable businesses in China must make. The research involved reviewing the reported performance of 2,500 joint ventures in packaged food, and studying the more prominent ones in detail. We interviewed senior executives from 20 multinational, Asian, and Chinese packaged food companies, and benchmarked the finances and operations of 13 of these companies.
Our research identified a small group that has built initially successful businesses by mixing five key ingredients for success, but no single player exemplifies best practice along all dimensions. Indeed, the lesson appears to be that China is such an unforgiving market that only a few broadly based companies with extensive international experience are likely to possess the skills, resources, and stomach to succeed on their own during the early stages of market development. Those less well endowed might consider alliances as a way of complementing skills and sharing risk, or simply find inexpensive ways to learn about the market before they commit themselves.
Recipes for disaster
China’s processed food market has a rich and complex competitive landscape in which most prominent Asian and multinational food companies are staking a claim. Their approaches to product positioning and their mindsets vary widely and have profoundly influenced their performance in China thus far (see the boxed insert, "The market contenders").
The sharpest contrasts emerge if we compare the different approaches that Asian and multinational companies take to China, and their results. Asian companies are almost twice as likely as multinationals to achieve a minimum threshold return on invested capital during their first four years of operation, although they are only fractionally more likely to experience success later (Exhibit 2). These findings reflect clear differences in approach and operating styles. There are advantages and disadvantages in the way both sides function.
Asian companies have quickly become profitable by selling affordable products, expanding their distribution coverage rapidly, and employing low-cost yet initially effective organizations. But the sub-sequent failure of many to build strong brands and manage distribution tightly has undermined this early success. One Asian-funded joint venture that enjoyed a leading market share in the early 1990s underinvested in its brand franchise and distribution network, leaving itself vulnerable to savvy marketing from a new competitor. It now comes a distant second in both sales and brand awareness.
Meanwhile, the multinationals are grappling with a different set of issues. Several have introduced products from their home markets that require the Chinese to adopt new eating habits. The result: low early demand. Some are discovering that traditional resource-intensive approaches involving large fixed asset bases and prolonged expatriate deployment have done little to boost growth in demand. And some have compounded their problems by building state-of-the-art manufacturing facilities and inadvertently investing substantial working capital in trade credit.
Yet against this somber backdrop, a small number of companies stand out. They have found the ingredients for profitable and sustainable consumer franchises. They range from Chinese township- and village-owned enterprises to Asian entrepreneurial startups and multinationals with global products and brands.
Five ingredients for success
The winners in China’s packaged food market seem to be doing five things right. They select structurally advantaged categories, price at value-for-money levels, build scale quickly, invest in local marketing, sales skills, and organizations rather than assets, and build enduring brand equity.
Select structurally advantaged categories
The choice of product category can determine early profitability: no amount of excellent execution can compensate for a bad decision about where to invest. Our research suggests good companies can achieve returns on investment of 25 to 35 percent or more in structurally advantaged categories, whereas even the best performers in disadvantaged categories struggle to recover their cost of capital.
Advantaged categories have three defining characteristics: immediate acceptance by a large base of consumers, high affordability, and sufficiently robust economics for market leaders even in the face of rising competitive intensity.
Consumer acceptance is a critical driver of profitability. Our work in emerging food markets has identified four levels of challenge in category development. In the most difficult categories, such as breakfast cereals, companies must encourage consumers to try entirely new tastes, textures, and usage occasions. Attempts to form new eating behavior must be supported by education, and typically result in slow rates of trial and adoption. Under these conditions, geographic coverage must be broad to achieve even marginal scale, a necessity that erodes financial returns.
Only slightly less difficult are categories requiring consumers to convert from home-made to bought products such as canned soup. Inducing trial and repeat purchasing is much less expensive in categories in which consumers simply replace an existing purchase with a similar product: potato chips instead of salty fish snacks, for example, or baby cereal instead of congee. Naturally, products already widely embraced by consumers, such as biscuits or fruit juice, require the smallest amount of investment in consumer education.
Product affordability drives volume growth. The average income of China’s 370 million urban residents, the target of packaged food companies, was only $52 a month in 1997. Categories such as soft drinks, noodles, and biscuits are easily affordable at about 25¢ to 50¢ per purchase unit, whereas cheese and dry breakfast cereal, which cost more than $2 a unit, represent a higher hurdle. Similarly, bouillon and chicken powder, which sell at a 300 percent premium over monosodium glutamate, can currently be targeted at only a small fraction of households even in Shanghai, one of China’s wealthiest cities. It may be years before these products are widely adopted. Manufacturers are trying to overcome the barriers by offering smaller sizes, but Chinese shoppers have shown limited interest in small packs after trying them once. Advantaged categories must thus feature products that consumers are comfortable using and that they can afford (Exhibit 3).
Robust economics are critical to sustainability in the face of rising competitive intensity. Categories such as beer and noodles are becoming structurally unattractive because of overcapacity, falling prices, escalating advertising spending, and demands from channels for lower prices and more support. In beer, one of the most overcrowded categories, capacity utilization stands at only 60 percent, and advertising expenditure per premium beer drinker has soared to about $14 a year—about the same as in the United States. It is no surprise that brewers’ average return on invested capital is about 3 percent, and that after-tax margins for some leading competitors declined by 7 percentage points between 1995 and 1996, the year the downturn in the beer industry began.
It is likely that the structure of individual food categories in China will evolve in the same way it has in other developing markets. The number of profitable competitors in a given category at maturity is a function of several factors, including asset intensity, the importance of technological innovation, and the degree of product differentiation. Experience from more mature markets may serve to predict profitability in China. Japan’s number 1 noodle maker, for example, has a 9 percent pre-tax net margin, while the number 4 player has a margin of -2 percent. Before joining the fray, potential entrants into China’s noodle market might consider whether the category will develop acceptable economics for market leaders and assess their own chances of attaining a solid top three position.
The questions for investors are: how much industry surplus is up for grabs, given the competitive situation? Can we capture enough share to earn attractive returns in the short term? What will the industry structure be once the market matures? What are our chances of surviving as a profitable market leader five or 10 years from now?
Price at value-for-money levels
As already noted, affordability is critical to widespread consumer adoption. Selecting an appropriate price band is thus the second critical strategic choice. Our analysis suggests that value-for-money pricing at 30 to 60 percent above mass-market rates offers the best guarantee of broad market appeal.
In the case of several popular products, namely instant noodles, biscuits, soy sauce, and soft drinks, four broad price bands are emerging (Exhibit 4):
Mass-market pricing is usually set by Chinese state-owned enterprises (SOEs) selling largely undifferentiated, low-value-added products. It typically yields a gross margin insufficient to cover a salesforce of adequate size or competitive advertising and promotion. Typical SOE cost structures accommodate gross margins of no more than 8 to 10 percent. Only a few multinationals, such as Coca-Cola, can sustain a business while pricing at this level.
Value-for-money pricing, the approach chosen for many popular products such as Nabisco’s Oreo cookies and Jianlibao’s sports drink, is defined as a premium of up to 100 percent over mass-market levels. While the economics of each category and each company are unique, our research suggests that a premium of approximately 30 to 60 percent appears to strike the best balance: affordable yet aspirational for consumers, while generating sufficient margins and scale to fund market development. Pricing at this level often means selling products for much less than in developed markets.
High-end pricing involves a premium of 100 to 200 percent over mass-market levels. In many cases, this inhibits demand. Foreign beer brands, many of which are high in price, together command only 2 percent of the market in Beijing, 12 percent in Shanghai, and 24 percent in Guangzhou. These regional disparities are partly the result of differences in wealth; a more important factor is the trend for greater acceptance of foreign goods in the south of China than in the north. Some of the most troubled companies in our survey price in this range despite having built the infrastructure to handle the volume of a lower-end product.
Premium pricing is pitched at more than 200 percent over mass-market levels. Companies that choose to price this high are likely to remain niche players; indeed, this approach may be sustainable only for true premium global brands such as Evian water.
Our examination of the pricing policies of 35 companies revealed that those pricing at no more than 100 percent over mass-market products outperformed those charging a higher premium. They also tended to outperform the average return for their category by a wide margin.
A tiered portfolio approach to pricing can raise overall category profitability. Noodle makers, for example, offer packet noodles at a value-for-money price point and bowl noodles in the high-end and premium bands. A well-positioned soy sauce brand such as Lao Cai (developed by an overseas Chinese entrepreneur) has an entry-price product for mass appeal and several tiers of higher-value products to which consumers can trade up.
This approach has clear benefits. Value-for-money products generate sufficient volumes and gross margins to support brand building and sales infrastructure. High-end and premium products provide additional gross margins and position a company for the inevitable evolution of consumer demand.
Build scale quickly
The third key choice is the breadth and pace of volume growth and geographic expansion. Our survey indicates that large companies do it better. Analysis of five food categories revealed that only the biggest 10 percent of ventures were earning positive returns in two categories. In the other three, only the top 25 percent were profitable (Exhibit 5). Companies sustaining high profitability beyond their fourth year of operation were more than five times larger than those racking up losses.
Scale is all-important in a large emerging market like China. Widely dispersed consumers with limited spending power; fragmented retail, distribution, and media channels; and scarce local talent throughout the industry chain make the country a costly place to do business. Channel and media fragmentation and limited affordability translate directly into abnormally high channel markups, low net price realization, and low invested capital productivity. Coupled with skill gaps and rising competition, this fragmentation also results in high levels of sales, advertising, and promotion expenditure and working capital requirements.
As we saw, selecting categories with high consumer acceptance and ensuring affordability through value-for-money pricing are prerequisites of rapid growth. That said, some companies are achieving impressive growth by expanding rapidly, organizing their geographic rollout sequentially,2 and, where feasible, operating in several categories.
Notwithstanding investors’ claims to the contrary, rapid geographic rollout is possible. Two companies from our sample, one in the dairy business and the other in culinary products, managed to reach the required scale for their respective categories within three years. For the former, this translated into 10,000 outlets with 42 distribution managers in 26 cities; for the latter, 40,000 outlets with 83 distribution managers in 60 cities. Noodle manufacturers are managing to reach 300,000 to 500,000 outlets across 100 cities nationwide within five years.
Rapid rollout is becoming more feasible largely because Chinese distributors have come a long way in a short time. Five years ago, few local distributors had sufficient physical delivery capability, let alone merchandising skills, to meet the needs of most food multinationals. Today, many cities have several reliable distributors. As a result, lack of physical distribution is no longer the main brake on geographic expansion; rather, the scarcity of the management time needed to build and monitor sales and merchandising across far-flung markets is to blame.
Recognizing this constraint, successful companies are building scale by means of a sequenced city rollout and carefully managed distribution. Most begin by building a presence in a single region or cluster of cities, then attack others in succession using cash from markets in which they have dominant shares. Sequencing ensures best use of management time and advertising spending, which often has spillover effects in nearby cities. It also enables lessons learned in one place to be applied in the next.
As well as rolling out products rapidly, successful companies are taking control of distribution by removing layers of distributors and deploying sales teams to monitor distributors’ performance and build skills. They also directly serve emerging grocery chains and hypermarkets, which account for about 9 percent of food sales in China’s top 100 cities.3 Nabisco, for example, enters a new city by selecting the most capable distributor, then providing staff to "shadow manage" and build the distributor’s skills in retail outlet management. New entrants may want to consider piggybacking distribution on top of established multinationals in non-competing categories, or find a local third-party distributor with a record of serving multinationals. Another possibility is to use logistics companies.
Companies willing and able to participate in multiple categories in China, such as Nestlé, President Foods, and Danone, can not only amortize their fixed costs across a broader range of products but also gain a bigger share of a distributor’s business. This translates into clout. One Chinese beverage company whose core product represented as much as 20 percent of its distributors’ profits was able to launch a new product category by persuading them to drop competitors’ lines.
Invest in marketing and sales organization rather than assets
The fourth strategic decision is where to focus resource investments. Our research suggests that divergent approaches to people and asset use may yield surprisingly similar market results.
Two companies making culinary products built similar businesses between 1994 and 1996. Each achieved broad city and outlet coverage, generated about $10 million in revenue, and earned comparable gross margins. But their ways of deploying resources were radically different, and produced contrasting net income and ROIC results. One spent six times as much on SG&A as the other, primarily by employing 27 expatriates against the other’s four, and used four times the capital. The other offered equity incentives to keep local salaries low and outsourced capital-intensive but low-value-adding manufacturing steps to reduce capital investment. This company is now a market leader with near breakeven ROIC, while its competitor struggles with an ROIC of -30 percent.
Companies that succeed in China seek to build marketing, sales, and distribution skills in increasingly local organizations. The effective transfer of brand marketing skills is essential, but brand development must be grounded in a locally adapted consumer proposition. Profitable firms avoid prolonged dependence on expensive expatriates by hiring the best local people and honing their skills, taking advantage of the increasing number of Chinese returning from work or study abroad and the growing pool of local man-agers with multinational experience. Progressive Asian companies often offer equity or performance-linked bonuses to lure talented people from their home markets.
Some companies saddle their China operations with world-class but oversized and overengineered white elephants
Companies often err in focusing on building factories rather than attending to critical sales and marketing tasks. Our research underscores the importance of keeping asset levels low: companies with a sales to asset ratio greater than one are more than three times as likely to achieve an ROIC above 10 percent. Some companies saddle their China operations with world-class but oversized and overengineered white elephants better suited to markets with high labor costs and an efficient logistics infrastructure. One multinational launching a product new to Chinese consumers built a factory that will take eight to ten years to fill.
China’s high distribution costs and the uncertainty over volumes often mean that a smart plant configuration will include several small regional factories rather than a single facility. Using secondhand equipment, adding machine capacity in small increments, and outsourcing inessential asset-intensive activities can reduce investment in fixed assets to acceptable levels.
In a market notorious for credit risk and product returns, keeping working capital tightly reined in is vital. The market leader in one category operates with five days’ accounts receivable outstanding, 25 days’ inventory, and more than 60 days’ accounts payable. Its strong brand and rapid growth enable it to achieve negative working capital levels of up to 30 days. A leading competitor, by contrast, has 10 days’ accounts receivable, 60 days’ inventory, and only 40 days’ accounts payable, and must fund 30 days of working capital by itself.
Clearly, size counts in this game: the greater a company’s market clout, the more assertive it can be with the trade. Yet experience suggests that even companies new to the trade can reduce their working capital through hard-nosed credit management (by demanding cash on delivery or payment on an earlier shipment before delivery of the next, say) and close attention to factory and channel inventories.
Build enduring brand equity
In China as in any consumer market, the companies that build strong brands earn most of the value created by their industry. A case in point is Tingyi, whose Kangshifu brand of instant noodles commands 25 percent of the market by volume and 35 percent by value. Having started out in 1992, Tingyi now rings up more than $600 million in annual sales. While competition has reduced ROIC from more than 40 percent in 1994 to less than 10 percent in 1997, continuing investment in brand building and distribution means that Tingyi’s noodle business is well positioned to sustain its early promise.
Tingyi’s initial success was based on a distinctive beef-flavored product in a unique disposable bowl. Since then, it has added regional flavors, new items such as children’s snack noodles, a wide range of packages, and a number of price points. The number of noodle stock-keeping units under the Kangshifu brand now extends to about 70. To build a national brand from scratch, Tingyi spent more than $60 million on advertising and promotion. This outlay enabled it to buy roughly 50 percent of all advertising in the instant noodle category during its first four years, and then hold this at a level equivalent to its value share when competition intensified in the next two years.
Companies such as Tingyi invest to get to know their consumers, then use this knowledge to drive rapid product innovation and adaptation. One company introduced a product that consumers treated primarily as a gift item because of its high price. Research indicated that they would buy it for their own use if the price were lower. Rather than jeopardize the image of its core product, the company developed a cheaper alternative with a lower nutritional content to serve as a mass-market brand. It has generated substantial sales.
Innovation should be supported by extensive product testing and the creative use of pilots
Such innovation should be supported by extensive product testing and the creative use of pilots. Soft drink and confectionery companies have found they must make their products less sweet to appeal to Chinese consumers. Many others are finding that local and regional flavors must be added to make foods more appealing. It is not uncommon for companies to spend up to two years developing products for the Chinese market.
Successful companies are also prepared to spend on promotion in the face of mounting competition. Until recently, advertising intensity in China was low, and companies could build brand awareness and stimulate trial comparatively cheaply. As little as two years ago, $2 million could buy a dominant share of all advertising in a category and launch a product on a national scale. Our survey indicates that companies now have to budget to spend up to $6 million on advertising and promotion over three years to launch a new brand in a single region.
Not all of this is money well spent. Common pitfalls include spreading budgets too thinly across regions and brands, and spending heavily on television advertising for products where trial, repeat purchase, and loyalty are likely to be built slowly and largely independently of media spending. This is particularly true in Western food categories, where the amount of consumer education needed to accelerate product trial and adoption is such that companies might be better off waiting several years before launching their products. One culinary products maker hoping to move Chinese consumers from a traditional but clearly inferior ingredient to one widely used in other Asian markets spent up to 21 percent of its sales on advertising, with little impact on trial and repurchase but a massive impact on net margin, which plummeted to -51 percent.
Companies should be warned, however, that the jury is still out on the effectiveness of early efforts to build brand equity in China. Fickle consumers allocating their limited purchasing power to an exploding number of choices may prove harder to retain than to attract. Status and "face" remain important but unsustainable shapers of early consumer preferences.
Looking ahead, we expect the claim that first movers can build unassailable brand positions with limited spending to prove unfounded. As in any other market, only those with the patience to understand the consumer and the staying power to invest consistently will build real franchises in China.
The five ingredients of success are clearly intertwined. Selecting a product category that does not yet exist in China and that will require massive consumer education is unlikely to permit scale, regardless of pricing. And skimping on investment in brand equity may boost returns in the short term, but will lead to declining volumes and profits when new competitors arrive. The challenge is to get the mix of business development strategies and operating tactics right for all five ingredients.
Although none of the companies we studied has yet achieved this balance, the stronger performers appear to understand that they need it if they are to build and sustain a profitable business. The weaker ones, however, often go overboard on resources or allow global priorities to drive local business development. For their part, Chinese and other Asian companies typically focus on low-cost early market development, yet appear unable to anticipate and react to rising competition.
The truth is that only a handful of food and beverage companies possess the skills and resources to succeed on their own in China. The importance of building scale rapidly and the need to overcome daunting operational and competitive challenges strongly favor a few broadly based multinationals such as Danone and Nestlé. These companies have both experience in emerging markets and readily adaptable portfolios.
Multinationals operating in narrow categories, particularly those that have succeeded by developing streamlined business systems and highly evolved propositions for sophisticated consumers, should think carefully before entering China. Some may prudently decide that conditions are not yet right for them, especially given the state of Asia’s economy; instead, they can seek low-risk ways to learn more about the market. Those intent on early participation could explore alliances with Asian partners, which possess many of the key skills for early success but appear to lack the depth of branding skills needed to excel when categories become hotly contested. 
About the Authors
Jimmy Hexter is a consultant in McKinsey’s Hong Kong office, Javier Perez is a principal in the London office, and Tony Perkins is a principal in the Beijing office.
Notes