September 6, 2018

This article will be featured along with other articles addressing investment opportunities in Australasian agriculture in Volume 5, Issue 3 of the GAI Gazette which will be distributed in conjunction with Global AgInvesting Asia 2018, held in Tokyo on 2-3 October 2018.  Join us in Tokyo to hear valuable insights and best practices for investment strategy from the expert speaking faculty.  Learn more and register.

By Anthony Chan and Greg Park of Isola Capital

A decade ago, in the summer of 2008, Chinese consumers were shocked by the melamine milk scandal where contaminated baby milk formula and related food products claimed the lives of six children and hospitalized 300,000 victims in China. The impact of this horrifying scandal hit home for consumers the importance of food traceability, supply chain integrity, and trusted distribution channels. Food safety was perceived previously to be primarily affected by the combination of soil and water contamination, air pollution, and poor production practices. However, in the decade since, the Chinese consumers have experienced over 227,000 food safety incidents, of which three quarters were classified as resulting from criminal behavior.¹ The food safety issues appear throughout the entire supply chain from production to processing, to handling, and to distribution. These range from food input substitution, recycled inputs, contaminated products, cariogenic additives, and misrepresentation of expired produce, among other harmful acts, for the sake of making a profit from unsuspecting consumers.

The Chinese government passed the Food Safety Law in 2009, which strengthened governmental controls and oversight, and created strict standards and penalties. In 2015, the Food Safety Law was amended to increase regulatory oversight along the entire supply chain, with more coordination between the relevant regulatory bodies and tough penalties to be imposed on those in violation. The private sector players in the food industry have been quick to react to support the efforts from the public bodies to enhance food safety standards and address the massive trust deficit that had been created among consumers in relation to food products; with specific changes to traceability, food labeling, supply chain integrity, and development of trusted distribution channels, and with a view towards rebuilding consumer confidence.

The rationale for continued development and investments into the food industry, from the primary producers, through to value-added players, to the brand owners through to distribution channels, are clear. There is still enormous upside to the market in China due to the demographic trends, coupled with rapid technological adoption by the Chinese consumers. In 1999, when Alibaba (the largest e-commerce company in China) was founded, there were only 29 million people classified as middle class in China. By the time Alibaba was listed in New York in 2014, middle class in China had reached 420 million and exceeded the entire U.S. population. The expectation is that the middle class will exceed 600 million within the next five years.² China’s official population is 1.4 billion, close to four times the size of America, the world’s largest economy. Food consumption as an average across all demographics accounted for 31 percent of China’s annual urban household expenditure back in 2015, with a size of US$1.4 trillion.³ By 2020, it is expected that 60 percent of every dollar spent online globally will come from China’s consumers.⁴

China’s e-commerce market is already the largest in the world, responsible for more than 40 percent of global transaction value.⁵ Last year, online retail sales surpassed the US$1 trillion mark for the first time and are forecast to reach US$2.7 trillion by 2021.⁶ The fact that China’s e-commerce market is the largest in the world should not come as a surprise given its population and vast landmass, which makes e-commerce a highly attractive solution for distribution. Just 10 years ago, China’s share of global e-commerce was virtually insignificant, with a contribution of less than 1 percent.⁷ Today, the size of the Chinese e-commerce market is nearly 130 times larger than what it was just 10 years ago.⁸

Some of the key macro factors behind this unprecedented growth involves the perfect storm of increasing urbanization, higher disposable incomes, and increasingly sophisticated consumers. As of the end of 2017, it was reported on Xinhua that China’s urbanization rate had reached 58.52 percent, with 813.5 million permanent urban population, up 101.65 million from 2012.⁹ The increase in urban population was the equivalent of the fourteenth largest country in the world, fitting in between Philippines and Egypt.

According to the data released by the National Bureau of Statistics of China, the urban disposable income per capita grew 130 percent between 2008 to the end of 2017. When the likes of Carrefour and Walmart entered the China market in the mid 1990’s, the Chinese consumers were still a mystery. Very few had experience with imported brands and products. The large-scale hypermarket with evolving formats reflected the challenge to cater to consumers who would spend time roaming down dozens of aisles and overwhelmed by hundreds of thousands of stock keeping units (SKUs). Fast forward to two decades later, an average urban Chinese consumer is increasingly well informed through online information, social media, and more importantly, real-life experiences through travels and visiting other countries.

In 2000, there were only 10.5 million overseas trips made by China tourists. This year, the China Outbound Tourism Institute estimates that there will be 156 million overseas trips made by China tourists, an increase of 1,380 percent.¹⁰ The development of the Approved Destination Status program from the Chinese government that was relaxed over time, together with easier visa regulations for independent travels, have propelled this trend. The spending power of Chinese tourists is enormous, with an aggregate US$261.1 billion spent in 2016 according to the UN World Tourism Organization, which dwarfs the U.S., at only US$123.6 billion.¹¹ This is despite the fact that only around 7 percent of the Chinese population have a passport. As the Chinese consumers are increasingly exposed to a variety of culture and experiences, top destinations for Chinese tourists include Hong Kong, Singapore, Japan, Australia, the U.S., and Italy, where they can experience a vast array of high quality consumer food products, among other experiences that these groups of consumers are keen to explore.

With this macro context put into perspective, the additional catalysts for rapid adoption by the Chinese consumer for leveraging e-commerce was driven by two important developments; that is, leap in technological adoption and constraints to offline competition.

Unlike the rest of the developing world, e-commerce in China was mobile-driven from the start. Due to the vast geographical reaches of the country, the Chinese government invested heavily into telecommunications infrastructure using mobile technology, ensuring that people could be connected more efficiently. In addition, as China was elevating its capabilities as the factory to the world, with fully integrated supply chains with scale to manufacture smart phones and peripheral devices, the emergence of the three dominant BAT (Baidu, Alibaba, and Tencent) technology companies provided the interface, content, and transaction services capabilities to the Chinese consumers. In 2010, there were already more than 300 million users accessing the internet through mobile devices in China,¹² and this user base provided the necessary scale required for e-commerce players to flourish. By year end 2017, the number of internet uses in China reached 772 million, with 97.5 percent of users accessing through a mobile device.¹³ Through mobile technology, e-commerce players can now track and analyze real-time shopping habits of its customers and tailor their offerings, thereby creating the largest big data market in the world.

The Chinese banking system is dominated by the big four banks, which are all state owned. Their focus has traditionally been lending to state-owned enterprises and large corporates with a focus on asset-based lending. As a result, the lack of consumer lending and the development of consumer credit data has resulted in low credit card penetration rates. Instead, conventional payment methods such as credit cards have given way to online payment systems. With the mobile infrastructure in place and high levels of penetration rate, China opted to adopt next generation payment platforms that were more suitable for a mobile-centric world. As a result, Chinese consumers did not have to deal with the cumbersome process of getting a credit card issued or having to carry a credit card at all times. All that was needed was a mobile phone linked to a bank account through Alipay or WeChat Pay. With over 1.3 billion mobile phone users in China and most of them connected to either Alipay or WeChat Pay, which collectively have around 94 percent market share of e-commerce payment channels in China, the gross merchandize volume of China online payments reached US$8.7 trillion in 2016.¹⁴

Like most things in China, modern retail trade formats such as hypermarkets and supermarkets have evolved quickly to adapt to the increasingly sophisticated Chinese consumers. The growth of smaller format supermarkets, premium grocery stores, and convenience stores cater to different segment consumers that are better informed and for those who seek immediate gratification. Over the past decade, the cost of real estate and consumer behavior has changed so much that it is no longer economical to building large scale traditional shopping malls and hypermarkets. The new generation of Chinese consumers are curious but fickle at the same time, and are spoilt by the ease of purchase by accessing the online platforms such as Taobao/Tmall (Alibaba), JD.com, and Meituan. These platforms are in turn able to leverage the logistics platforms such as SF Holdings and ZTO to deliver products to consumers.

The trends that favored the development of the Chinese e-commerce market has had a similar impact on the market for fresh foods. Despite comprising only 2 percent of the overall market, the online fresh grocery market experienced 82 percent annual growth in the past five years.¹⁵ Like the rest of the world, e-commerce in China initially focused on non-perishable, non-food items such as consumer electronics, home appliances, apparel, and household goods. With continued market development and intensifying competition, leading e-commerce players were increasingly broadening and differentiating their product offerings. Identifying online fresh groceries as one of the few untapped categories remaining that was ripe for disruption, leading e-commerce players began to leverage their online retail and logistics experience with hopes of reshaping the market.

Despite the great market potential for online fresh groceries, there were many hurdles to overcome; the most critical of which was the challenge of gaining the trust of the consumers. Consumers preferred to touch and pick the produce they were buying. Given the food safety concerns of the Chinese consumers, e-commerce players were faced with the challenge of ensuring integrity of the supply chain, which included higher logistics requirements both in terms setting up a cold-chain network and reducing delivery times. It was clear that having a pure presence online was not enough to address the consumer demand.

Founder of Alibaba, Jack Ma, coined the term “New Retail”, which basically integrates online and offline channels by leveraging modern logistics and big data. Over time, retailers of fresh groceries began to adopt this approach with much success, at least for the companies that could afford it. New Retail offered a seamless experience for the customer, both online and offline. Not only can customers place orders for fresh groceries online, purchases can be made at offline stores where a customer can pick and choose the produce they are buying. Heavy investments in infrastructure to keep food fresh and reduce delivery times are now starting to pay off; whereby goods can be delivered to customers in less than 30 minutes upon purchase for a destination that is within a 3 kilometer radius of the physical store. By using QR codes, customers can now obtain relevant product information, including traceability information such as tracking the journey of the produce from the farm to the shelf before making a purchase.

New Retail can now offer Chinese fresh grocery consumers with a much wider range of choices and convenience, including foreign products (fresh and value-added). Retail e-commerce spending is expected to reach US$245 billion by 2020.¹⁶ In 2016, around 70 percent of Chinese consumers shopping for imported products were aged between 24 to 32,¹⁷ and food and beverage were one of the top three most popular categories.

The sheer scale of the Chinese consumer demand, coupled with entrepreneurial pursuit has spawned a grey market channel of commerce that leverages online/offline resources, called “Daigou” or literally translated in Chinese as “buying on behalf”. Daigou takes orders from Chinese consumers by physically acquiring items, including food products, from overseas markets to satisfy consumer demand. The cross-border channel is projected to grow 43 percent in 2018 to US$115 billion.¹⁸ Some of these trades involve large premiums that Chinese consumers are willing to pay for authentic and high-quality food products. An example includes baby formula acquired from Australia that sells at least four times the retail price in China, a reflection of the legacy food safety fears that were triggered a decade ago.

The Chinese consumer market represents a growing opportunity to all food producers across the globe, from upstream primary producers through to branded value-added products. China will likely be one of the largest distribution markets for most food players for relevant products. With the advent of increasingly sophisticated consumers that have growing disposable incomes, there are ample opportunities to find strategic ways to either partner or invest into the growing demand for quality food in China, one that leverages a highly developed e-commerce eco-system, with the infrastructure logistics and a mature online payment system.

ABOUT THE AUTHORS

Anthony Chan is CEO of Isola Capital Group, a multi-family office owned platform focused on alternative asset investments. Chan had an extensive career in investment banking with Credit Suisse, Citigroup, and Lehman Brothers Asia before transitioning to private equity and principal investments. He has broad investment experience across the Asia Pacific region in the consumer, education, food safety, industrial, and technology sectors.

Chan attained a Bachelor of Commerce (Finance and Economics) degree from The University of Sydney, and a Bachelor of Law degree from The University of Sydney Law School. He also is a graduate of the financial engineering program of Stanford University and attended the Stanford Executive Institute.

Greg Park is a director of direct Investments at Isola Capital Group. He has extensive experience advising corporate and financial sponsor clients in the agriculture and consumer industries on mergers and acquisitions, and financing transactions in Hong Kong, New York, London, and Seoul at leading international investment banks. Park holds a Master of Business Administration from the Tuck School of Business at Dartmouth College, a Master of Arts from Seoul National University, and a Bachelor of Arts from Korea University.

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DISCLAIMER: All views, data, opinions and declarations expressed are solely those of the author(s) and not of Global AgInvesting, GAI News, GAI Gazette, or parent company HighQuest Group.

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