Costco Wholesale Corporation Enters China the Smart Way

By Eshna

Costco has a knack for doing things differently and ending up with a success story. For example, defying all retail logic, the world's third-largest retailer -- with roughly 670 retail warehouses -- has just one private label brand (Kirkland Signature) that it uses to sell anything from wine to vitamins to men's shirts.

Given its penchant for doing things differently, it's maybe not surprising, that Costco entered the $2 trillion Chinese retail marketin an unconventional way. In November, it opened for business in the country through a single virtual (Internet) store without any investment in real estate. This move has been a huge success, with sales crossing $6.4 million in the first month of operation. Is this beginner's luck or a result of Costco's business acumen?

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Source: Mike Mozart

Factors at playCostco set up a store on Chinese e-commerce giant Alibaba's Tmall Global platform, where it is offering its Kirkland Signature products and other items. Chinese consumers can receive the goodswithin five to 20 daysof purchase. Costco is using its base in Taiwan to support operations and leveraging its new Chinese partnership for inventory storage.

The reason this warehouse club retail specialist, which derives less than 3% of its revenue from online sales, wouldapproach the vast Chinese market through e-commerce can be understood only if we look at the benefits behind the alliance.

Local partner: CNN Moneyreported last month that a recent survey found that"60% of companies told the American Chamber of Commerce that they felt less welcome in China than in the past." There are a number of reasons behind this. In the recent past various foreign players such as Microsoft, Volkswagen, Apple, and Qualcomm, have been charged under the country's anti-monopoly and antitrust laws; the government's austerity drive has hit retail sales, luxury and otherwise; and the preferential treatment that the Chinese authorities once doled out to foreign companies is slowly leveling off.

Against this backdrop, Costco's latest arrangement has made its entry smooth and the path thereafter could also remain hassle-free as it has added a local flavor to its operations.

Understanding buyer preferences: Costco's initial reluctance to enter China emanated from the fact that many of its U.S. counterparts, such as Wal-Mart, Home Depotand Best Buy, have struggled in the nation. These companies have not properly gauged the local population's buying patterns and habits. The current arrangement gives Costco leeway to experiment with the products it intends to sell in the country, and to analyze trends inthe spending patterns of Chinese consumers.

Crucial cost savings: Costco's business model is to offer merchandise at razor-thin margins, while generating 75% of its profit from membership fees.Buyers do not pay membership fees to use the e-store in China, yet Costco has to keep prices low to simulate the brick-and-mortar environment. So it's crucial for the company to contain costs to make this business profitable.

Tmall Global does not require companies to have local storage facilities, helping Costco avoid some up-front capital expenditures that would have been required otherwise in moving into China. The Wall Street Journal reported that merchants pay an annual fee of $5,000 to $10,000 to register on the online marketplace, along with a $25,000 refundable deposit.

No licenses: Unlike other e-commerce portals, Costco does not need a local business license to set up the online store as it has. Obtaining a business license is becoming a complex and lengthy process in China as the government phases out tax breaks and incentives, which were used to attract foreign investment in the past.

Sans a business license, Costco must adhere to some advertising restrictions. It cannot advertise on other portals such as Tmall Mainland and Taobao, which drive 80% of China's online retail sales. But Costco is a big brand that, unlike smaller companies, can survive with less marketing. The brand's popularity with Chinese buyers was clear when the retailer sold $3.5 million worth of goods on China's Singles Day shopping event on Nov. 11.

Of course, there are challengesDespite Costco's phenomenal entry into China's e-commerce market, there is no dearth of competition. As more and more sellers sign up on Tmall Global, competition will only grow and companies would eventuallyhave to cut product prices to drive traffic. Lower pricesdirectly impact margins, and in the absence of significant volumes, they can cripple overall financials.

Five of the 10 leading Chinese department stores are already registered on the platform, along with 100 international sellers.Over time, Costco will have to reduce its dependence on the partnership for supply chain management and take matters under its own control.

These are early days for Costco in China, and there is nothing guaranteeing its long-term success. But there's no denying the brilliance of the company's strategy. Without significant capital investment, it has devised a ploy to reach millions of consumers, establish a strong local presence, avoid licensing hassles, and buy time to understand Chinese tastes before investing in physical stores (if it chooses to do so). This model might just start a new trend among retailers expanding into uncharted territories.

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ICRA Onlineand Eshna Basu have no position in any stocks mentioned. The Motley Fool recommends Costco Wholesale and Home Depot. The Motley Fool owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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