There’s a unique scene that plays out almost every afternoon at the Canadian – US border crossing near Vancouver. If you drive by the US side at around 4pm, there’s a good chance you’ll spot tour buses, with rows of expensive-looking clothing neatly arranged up on the ground. Behind these Burberry, Hugo Boss, and Brooks Brothers shopping bags are Chinese tourists patiently waiting for their purchases to be taxed by customs agents. On some days you may even spot Lunar team members – many of us call Vancouver our second home.
It’s a new trend that’s playing out all over the world: Chinese consumers, with higher levels of disposable income and an increasing appetite for consumer goods, shopping in the United States, in Europe and everywhere else. Chinese consumers now account for 1/3rd Gucci and Prada’s overall revenue. Just 10 years ago this number was negligible.
According to the China Outbound Tourism Research Institute, about 70 million Mainland Chinese tourists travelled outside China in 2011 and spent around $70 billion USD. The “one country, two systems”, or shopping malls, of Macau and Hong Kong have also seen dramatic inflows. 7.7 million tourists from the Mainland arrived in Hong Kong in the fourth quarter of 2011, an increase of 24.7% over one year prior. At the same time in Macau, a record high of 4.4 million Mainland Chinese visited.
Upper and middle classes consumers have arrived in China, and they are spending abroad. However, what does this imply for domestic consumption?
We have a theory about the extraordinary growth of China’s “carefree spenders” or “月光族” (literally, “the tribe of empty wallets at the end of the month”). Limited domestic consumption and savings options have created pent-up demand that has spilled overseas. If LVMH was the world’s central bank, they would have been draining Chinese consumer liquidity from the system by flooding the market with duty-free handbags.
At what point does the aggressiveness of overseas consumption materialize in the domestic economy, where Chinese have been better known for their high savings rates, rather than their spending habits?
We believe a transformation is already underway, and that the surge of luxury demand signals the advent of broader domestic consumption, rather than the infinite desire for Gucci that current trajectories imply.
In 2010, only 15% of Chinese households had incomes of over RMB 100,000, or USD 16,000, per year. By 2015, this number will grow to 50% of households according to estimates by Deutsche Bank, close to the same levels of GDP per capita as the state of Mississippi in the United States.
As 50% of Chinese households approach the “Missisippian” level of income, they will also have “Missisipian” burdens – tax, increasing housing costs and rising inflation. Moreover, they will adopt some “Mississipian”-like concerns. In addition to the traditional Chinese focus on education, demand will grow for trustworthy branded products, health care, beauty items, convenience and leisure.
This emerging demand is evident in the most recent quarterly earnings announcements of multinationals operating in China. If 2007-2011 was the quadrennial where Chinese consumption contributed disproportionately to Prada’s bottom line, going forward we believe the focus should be on the impact to KFC.
Yum! Brands, the operator of Pizza Hut and KFC restaurants worldwide, saw a 14% quarterly rise in Chinese operating profits, and the Company plans to open 600 more stores this year, out of a total of more than 4200 locations in the country. Other multinationals are seeing similar growth. Relevant to our core belief on the strong market for baby products, Mead Johnson, a producer of baby powder, now sees 29.5% of its sales come from the Chinese market. This revenue contribution rose 45.3% from last year. Mobile phones are a necessity in China, not a luxury, so we would also note Apple’s 250% increase in revenue from iPhone sales in China as an indicator of “middle class” consumption – irrespective of price.
China’s traditional indicators of economic growth, meanwhile, are slowing. For example, enthusiasm is waning in the Chinese property markets. April home sales were down 16% in China. Exporters and businesses that benefit from infrastructure spending are also lagging. United Technologies, a leading elevator maker reported a 9% drop year over year of sales in China. Vale, the iron-ore producer reported a 12% drop of Chinese revenue. Hydraulics maker Eaton and construction equipment maker Caterpillar are also reporting general slowdowns in their China business units.
Investors should take note. Additionally, its likely no coincidence that these trends are emerging just as policies designed to deliver Premier Wen Jiaobao’s commitments to rebalancing the economy are taking bite.
Our conclusion: the era of export- and infrastructure driven profits, coupled with property gains, being spent overseas on luxury goods may be waning. The emergence of growth in consumer brands as a more dominant force in the domestic economy, fueled by consumers turning inland, is upon us.