China’s duty free star set to shine even brighter
In this special report, Martin Moodie and Jason Holland examine the rise and rise of China Duty Free Group and examine a compelling new Morgan Stanley report that projects an extraordinary surge in China’s travel retail market. Such explosive growth has telling repercussions not only for China but also for international travel retailers, Morgan Stanley notes, particularly in the world’s biggest duty free market, South Korea.
In the second part of this special analysis, The Moodie Davitt Report Senior Retail and Commercial Analyst Min Yong Jung examines how South Korea’s all-important daigou market is evolving in the wake of China’s sweeping new ecommerce law, introduced on 1 January.
China Duty Free Group (CDFG) is the dominant force in the fast-developing Chinese duty free industry, with annual sales of around US$200 million in 2002. There are 150-plus duty free outlets managed or operated by CDFG, while it supplies all but a few key independent duty free locations in the country. – The Moodie Report, November 2003
2018 was another landmark year for China Duty Free Group as China’s pivotal role in defining the future of travel retail was emphatically underlined. CDFG confirmed full-year sales of CNY34.48 billion, which translates to €4,394 million (US$5.1 billion) at 31 December exchange rates, and represents a momentous surge of +118.78% year-on-year.
This thrusts China’s travel retail powerhouse into the top five (at number four) for the first time. – The Moodie Davitt Report, August 2019
“We believe downtown outlets will drive a quadrupling of China's duty free sales to US$24bn by 2025 – disrupting overseas retailers and players at domestic airports.
“We believe China duty free will remain a closed market and that domestic players will share a growing pie. CITS [CDFG’s parent] is the best stock proxy for China duty free as it has over 90% market share and is expanding in Hainan and downtown markets.” – Morgan Stanley, July 2019
Summary of impact on each sector from projected growth in China’s duty free market 2019-2025
Source: Morgan Stanley Research, Refinitiv consensus estimates for P/E, as of July 11, 2019.
Morgan Stanley expects daigou demand to remain stable in South Korea in the near term, while Chinese inbound traffic growth (up 24% in 2019 and 14% in 2020) could cause genuine travellers’ duty free spending to increase
The soundbites above from The Moodie Davitt Report, which has tracked CDFG’s remarkable progress over the past decade and a half, tell their own extraordinary story.
16 years is a mere blink in the eye in China’s characteristically long-term view of the world and even in travel retail terms is relatively short. And yet it will go down in history as the period that redefined the travel retail landscape – and China’s position within it.
The maths are startling. A +2450% turnover in 15 years is impressive going in anyone’s language.
But the really exciting growth still lies ahead according to Moodie Davitt Business Intelligence Unit projections and a new report quoted above from Morgan Stanley, which projects a quadrupling of China’s duty free sales (from the likely 2019 figure) to US$24 billion by 2025.
The report from the investment banker and financial services specialist’s research division –written by Morgan Stanley analysts Hildy Ling and Edouard Aubin – points out that the growth rate for Chinese duty free is much higher than the 3% CAGR for Chinese overseas luxury spending projected by Bain & Co.
China’s duty free market to grow at a 28% CAGR, outperforming onshore and overseas markets
Source: Bain & Company, Morgan Stanley Research. e = Morgan Stanley Research estimate for China DF market size; Bain's estimate for overall Chinese luxury spending and proportion of onshore/offshore spending
Projection of China's duty free revenue growth
Source: Morgan Stanley Research estimates
The Moodie Davitt Report believes it is simply a matter of when not if CDFG’s blossoming downtown duty free store network on the Mainland is opened to Chinese travelling shoppers
“China represents just 8% of the global duty free market, even though Chinese consumers accounted for a third of global duty free sales in 2018, on our estimates,” Ling and Aubin comment.
Multiple factors, ranging from strong government support for the sector to increased professionalism and consumer focus within it, will drive that progress, Morgan Stanley concludes.
Chinese duty free pricing is competitive and could fall further, another key driver of growth, it notes
“Based on our checks, prices of duty free goods at China’s major airports are already comparable to overseas levels.
“Downtown prices are roughly 15% higher than overseas, but we see room for this gap to narrow as downtown outlets have lower rental costs (15-20% of revenue) than airports (over 40% of revenue), lower labour costs (8% of revenue vs 14% for overseas players) and high gross margins (55%).
In fact, downtown duty free prices declined by 10% YoY in 1H19.”
Offshore and downtown duty free to drive China's growth
Source: Generation Research, CITS, Morgan Stanley Research. e = Morgan Stanley Research estimates
China duty free could account for 13% of Chinese luxury spending by 2025 (2018: 6%)
Source: Bain & Company, Morgan Stanley Research. e = Morgan Stanley Research estimate for China DF market share; Bain's estimate for overall Chinese luxury spending and proportion of onshore/offshore spending
The report mirrors The Moodie Davitt Report’s previously stated view that there will be further liberalisation of duty free policy both on Hainan Island (offshore duty free) and on the Mainland.
The Moodie Davitt Report believes it is simply a matter of when not if before CDFG’s blossoming downtown duty free store network on the Mainland is opened to Chinese shoppers (only foreigners can shop in them today).
“We expect Hainan’s duty free policy relaxation to continue along with the opening up of the province,” writes Morgan Stanley.
“In the medium term, we expect pre-departure downtown duty free to be opened to Chinese outbound travellers, with pick-up at airport arrival halls.”
Capacity expansion to drive growth of duty free shopping
Source: Company data, Morgan Stanley Research estimates
Duty free spending in 2018 was far less than the limit
Source: Morgan Stanley Research. *Spending limits: Downtown – Rmb5k for each returned outbound traveler (excluding those traveling to HK/Macau/Taiwan), Rmb8k for each outbound traveler, Rmb8k for each domestic traveler to Hainan. Note: 2H18 average spending for Shanghai Airport
The report predicts that China duty free will remain a closed market and that its domestic players will share a growing pie. “CITS [CDFG’s parent company -Ed] is the best stock proxy for China duty free as it has over 90% market share and is expanding in Hainan and downtown markets,” Morgan Stanley says.
“We upgrade to Overweight and raise our price target by 36%, to Rmb105, to reflect our constructive view of its medium-term earnings outlook.”
Chinese shopping spending per capita in Hong Kong, South Korea and Japan vs offshore duty free on Hainan Island
Source: Korea National Tourism Organization, Hong Kong Tourism Board, Japan Ministry of Land, Infrastructure, Transport and Tourism, CITS company data, CEIC, Morgan Stanley Research; Note: Spending per capita for China tourists in Korea, HK and Japan are based on survey results; Korea DF and Sanya DF are calculated based on DF sales over traffic; Japan DF data is calculated on overall tourists
Hainan duty free spending limit since 2011
Source: customs.gov.cn, hainan.gov.cn, Morgan Stanley Research
Here are some of the key findings from the report:
- China’s duty free sales are expected to quadruple to US$24 billion by 2025, implying a 2018-25 CAGR of 22%, which is far higher than the 3% CAGR for Chinese overseas luxury spending projected by Bain & Co.
- Duty free sales as a percentage of Chinese luxury wallet share will increase from 6% currently to 13% by 2025.
- China duty free as a percentage of Chinese luxury spending is expected to increase from 6% currently to 14% by 2025. Meanwhile, the proportion of overseas luxury spending by Chinese will decline from 70% currently to 50%, according to Bain.
- Despite growing at a 25% sales CAGR, 2016-18, China is still just a US$6 billion duty free market, accounting for 6% of Chinese luxury spending. This compares with US$70 billion of luxury spending by Chinese consumers overseas, US$20 billion of Chinese tourist spending in Hong Kong’s retail market, and US$14 billion foreign spending (mainly Chinese) in Korea’s duty free market.
- Chinese consumers contributed at least a third of global duty free revenues in 2018. Despite this, the China market accounted for just 8% of global duty free sales.
- For the broader luxury retail market, Bain and BCG estimate that Chinese consumers do just 30% of their luxury spending at home – and they expect that figure to reach 50% by 2025.
- Sales of downtown outlets (including Hainan Island) are expected to see a nearly sevenfold increase by 2025, rising from US$1.6 billion in 2018 to US$11 billion. This will mainly be driven by 15% capacity expansion, including the Haikou mega mall in 2023, accelerating a demand shift away from onshore/overseas retail markets.
- Based on checks of popular cosmetics products, China’s duty free prices are already comparable – at roughly a 5% premium – to Hong Kong and Korean duty free prices (assuming consumers can get 10-15% discounts from listed prices there) and are about 30% lower than onshore retail prices.
Average spending on shopping per tourist in South Korea: Chinese spend more than other countries
Source: Korea National Tourism Organization, CEIC, Morgan Stanley Research
Government policy relaxation has boosted duty free sales in Hainan
Source: PRC Ministry of Commerce, Wind, Morgan Stanley Research
- Hong Kong and Korean retail prices have risen by about 8% year-on-year relative to Chinese airport prices in 1H19. Morgan Stanley expects China’s duty free pricing to become more competitive as the market matures and increases in scale.
- Downtown (Sanya and post-arrival in Shanghai) duty free prices fell 6% year-on-year in 1H19 and are now at only a 5-10% premium to Chinese airport duty free outlets, based on pricing checks. “We see room for downtown duty free prices to decrease further as rental costs at Chinese malls are normally 15-20% of revenue, much lower than 40% or more at airports,” the report states.
- China has been relaxing its duty free policies to bolster domestic consumption. In Hainan, the government has recently lifted the annual purchase limit. “We expect such trends to continue and for more stores to open as Hainan develops. For downtown duty free on the mainland, the government has allowed the opening of more pre-departure and post-arrival stores,” the report says. “In the medium term, our bull case scenario builds in the possibility that the government will allow Chinese consumers to purchase products before departure, which is currently only allowed for foreigners.”
- The report predicts that China duty free will remain a closed market and that its domestic players will share a growing pie. “[CDFG parent company] China International Travel Service is the best stock proxy for China duty free as it has over 90% market share and is expanding in Hainan and downtown markets,” it says. “We upgrade to Overweight and raise our price target by 36%, to Rmb105, to reflect our constructive view of its medium-term earnings outlook.”
- The report forecasts a limited impact on daigou activity in the near term, unless:
1. Chinese downtown outlets offer discounts similar to Korean players,
2. Chinese duty free operators improve merchandising power to secure bestselling products and luxury brands
3. Duty free spending limits are raised for downtown sites in China.
- “If we assume that 30% of daigou sales shift to Chinese downtown duty free outlets, this would reduce Korean downtown duty free sales by about US$2.8 billion, equivalent to 12% of Korea's total duty free market size in 2021-22,” the report notes. “Also, fast-rising Chinese duty free sales could take some share of Chinese outbound travellers’ spending from their overseas spending; thus the potential share shift could eventually limit the growth potential of Korea’s duty free market.
- China's duty free market development will absorb an increasing amount of spending by Chinese tourists, especially in the cosmetics and light luxury segments. Chinese tourists accounted for 30% of Hong Kong retail sales in 2018. Assuming 30% of demand shifts back to the mainland, Hong Kong retail sales would see a -10% decline in the medium term.
- Hainan Island duty free and downtown duty free will grow from US$1 billion currently to US$11 billion in 2025. This is stronger than airport duty free, which Morgan Stanley expects to increase from US$4 billion in 2018 to US$13 billion in 2025. The analyst estimates downtown (including Hainan Island) duty free will account for 46% of China’s duty free market share by 2025, up from 25% currently, but still lower than the 80% portion of Korea's market in 2018.
- Cosmetics accounted for 49% of China’s duty free sales, higher than the global level of 38%. Fashion & accessories has a lower share – of 8% (global level of 14%) – indicating more room to catch up as the China duty free market matures.
China duty free price comparison (listed price)
Source: Jessica’s Secret, CITS, Morgan Stanley Research. *End-consumer purchase price from China online platform via daigou channel; Prices as of May 2019; *Listed price only: Korea DF provide bulk purchase discounts; HK DFS / retailers provide promotional discounts from time to time
- Luxury spending has already been shifting gradually from overseas to the domestic market. Chinese spending on shopping per capita has been declining in Hong Kong, Korea (excluding the duty free market) and Japan – all key outbound markets for Chinese tourists – since 2014/15. Meanwhile, spending per shopper at Sanya’s downtown duty free has been increasing. Apart from currency movements, Morgan Stanley says pricing trends and a favourable policy environment are major reasons behind such trends.
- The Chinese government has been relaxing policies, including duty free policies, to encourage domestic consumption. Morgan Stanley expects this to continue for both island duty free and downtown duty free for outbound Chinese. Meanwhile, the Chinese government has been tightening policy externally in order to curb capital/consumption leakage from daigou traders.
- Any stricter implementation of cross-border ecommerce rules could curb daigou demand. From 1 January, 2019, daigou merchants are obligated to register and pay taxes. This should put pressure on the profit margins of daigou vendors and individuals, whose key competitive advantage in the business is affordable pricing.
- Korea’s downtown duty free sales have been largely supported by Chinese shoppers, especially daigou. The percentage of sales attributed to Chinese shoppers rose steadily, from 68.3% in 2015 to 83.7% in 2018. Korea recorded US$17 billion of duty free sales revenue in 2018, with half of that coming from the daigou business.
- A key threat to China’s duty free market is potential retail price reduction of China onshore retail prices. This would reduce the price gap between China duty free prices and onshore retail prices, thereby diminishing the attractiveness of the duty free market. This could occur if the government were to reduce import tariffs and value-added-tax (VAT), also brands’ synchronising global pricing by lowering onshore retail prices in China.
- During the development process of the duty free market, duty free operators need to improve their shopping environment in order to attract top luxury brands.
- In the near term, there is risk of another round of global price harmonisation as low RMB depreciation has naturally reduced the price gap between China onshore and overseas prices. But at the same time, the pricing gap between China duty free and onshore listed prices, denominated in the same currency, remains largely similar.
- Like other onshore retail, downtown duty free faces competition from ecommerce. Customers may purchase through apps and pick up at airports (both outbound and inbound counters). Currently, CITS has a separate ecommerce platform for Sunrise airport stores in Beijing and Shanghai, also Sanya downtown duty free mall, which account for over 60% of China’s 2018 duty free sales revenue.
- With different pricing strategies across various cities/ports and a small revenue base for the remaining individual stores, Morgan Stanley does not expect large-scale implementation of online duty free platforms.
Impact on Korean duty free
Korea’s downtown duty free market is skewed to daigou demand. Morgan Stanley estimates roughly 70% of downtown revenue came from daigous in 2018. With the emergence of large, corporate daigous after the change to China’s ecommerce law, the daigou contribution appears to have increased further this year.
Considering such a high sales mix, the analyst thinks near-term duty free sales mainly depend on daigou activity, and a daigou demand shift to China downtown duty free stores is unlikely to be meaningfully visible within the next one or two years. It says three key changes are needed before a daigou demand shift emerges:
- Change in pricing advantage if China duty free offers discounts: Generally, daigous are receiving 20-30% discounts (including various promotions) to the retail duty free price at downtown stores in Korea. Thus, the price arbitrage opportunity for daigous is good enough to bring them to Korea. For corporate daigous who are compliant with regulations, Korean duty free operators give a further discount to secure their profitability. If China’s downtown duty free operators are willing to give such a big discount at the expense of their gross margins, a more visible traffic shift could be possible. The major reason Korean duty free stores bear such a margin burden stems from the 48% fall in Chinese inbound traffic in 2017. Owing to severe discounting, Shilla’s gross margin dropped 300-400bps at that time (a 600-700bp contraction from its normal margin).
- Brand/product sourcing – how fast can China duty free achieve merchandising power? The daigou business model imposes a heavy working capital burden (bearing inventory first), thus they’re very keen to secure bestselling products. Even with a high discount, they are reluctant to buy products and brands that are not popular with Chinese consumers. Hence, even within the Korean downtown duty free market, merchandising power to offer bestselling items is critical to attract daigou traffic. Also, for genuine Chinese travellers, not only are luxury cosmetics brands a necessity, but top luxury brands (LVMH, Chanel, Hermes) are required as well. In Korea, generally it takes two to three years to get all top brands at a site in the case of a very successful site.
- Policy change to China’s duty free limits: Unless daigous hire foreigners, they must comply with current duty free limits (Rmb5,000 for Chinese returning from overseas travel excluding Hong Kong/Macau/Taiwan, or Rmb8,000 for outbound Chinese travellers). In Korea, daigous have no spending limit.
Morgan Stanley expects daigou demand to remain stable in the near term, while Chinese inbound traffic growth (up 24% in 2019 and 14% in 2020) could cause genuine travellers’ duty free spending to increase. If 30% of daigou sales shift to Chinese downtown sites, this could affect around US$2.8 billion in sales, equivalent to 12% of Korea’s total projected duty free market size in 2021-22.
If these three prerequisites are met, daigou demand could shift to Chinese downtown duty free sites. Also, end-consumers’ shopping patterns could change from shopping via the daigou channel to making purchases at downtown duty free sites or China onshore retail sites (offline and online).
Taking the Chinese government’s policy direction into consideration, it will not be easy to maintain daigou sales over the long run. Hence, we expect daigou sales will eventually be replaced by genuine travellers’ shopping demand. Fast-rising Chinese downtown duty free sites could take some share of Chinese travellers’ overseas spending, potentially posing a long-term threat to Korean duty free operators, not only for Korea duty free sales, but also at their overseas sites (such as Hong Kong and Singapore sites run by Shilla).
The Moodie Davitt eZine
Issue 265 | 6 August 2019
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