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Best Buy's China Challenge

K.C. Swanson

BEIJING -- When Best Buy (BBY - Cramer's Take - Stockpickr) announced plans this spring for a push into China, Wall Street lauded the move. Analysts figured a huge U.S. retailer should have no problem grabbing a piece of the fragmented consumer electronics market.

The stakes are temptingly big: Best Buy estimates the sector could be worth $100 billion by 2010.

But on the ground in China, no one takes it for granted that Best Buy will prevail, and skeptics think it's shown up too late. Over the past few years, domestic rivals have become increasingly ambitious -- and Best Buy's entry seems to have energized the No. 1 Chinese player, Gome, which recently swallowed one local competitor and hopes to buy more. Gome, which posted $2.2 billion in sales last year, would like to expand beyond its home base into Southeast Asia.

Best Buy claims a far bigger $31 billion in annual revenues. But its international experience is limited to Canada, far removed from the hurly-burly of Chinese retailing.

"No one's shown me what competitive advantage Best Buy's got in this market," says Paul French, a Shanghai-based retail and consumer analyst at market research firm AccessAsia. "I think Best Buy will fail."

Responding to Best Buy, in mid-August Gome said it plans to speed up its expansion through more acquisitions. That follows Gome's $680 million bid, announced in late July, to buy No. 3 electronics player China Paradise. Following the tie-up, Gome will boast 501 stores nationwide -- nearly four times as many as Best Buy.

For its part, Best Buy gained entry to China through the $180 million acquisition in May of fourth-ranked appliance retailer Five Star. The deal gave the U.S. retailer a network of 136 stores concentrated in a southeastern province, but it still lacks Gome's nationwide reach. The company has announced plans for only one Best Buy-branded store, an outlet in Shanghai.

"At this stage, we wouldn't see Best Buy as a threat to the major players," says DBS Vickers analyst Mavis Hui, who has a buy rating on Hong Kong-traded Gome. Domestic electronics retailers already have a major head start, both in staffing and in choosing their store sites, she says. "All the major prime locations have been more or less locked up by the domestic players."

That said, Best Buy is still in buying mode. Earlier this month, chief executive officer Bradbury Anderson said the company is "not done" making acquisitions in China. Local press reports speculate it's in talks with Beijing-based Dazhong, another large electronics retailer. (Dazhong agreed this spring to be acquired by China Paradise, but now wants out of the deal.)

Deals aside, Best Buy will have to contend with China's irksome and persistent retail price wars. Chinese are inveterate bargain hunters, renowned for shopping on price alone. Consumer electronics stores traffic in basics like air conditioners and water heaters, as well as stereo equipment.

Best Buy is used to pushing higher-end fare. It drew 43% of sales in fiscal first quarter 2007 from consumer electronics, including flat-panel TVs and MP3 players. Only 7% of revenues were from appliances.

No wonder, then, that Best Buy's profit margins far surpass those of the top Chinese retailer. Last year, Gome's listed arm managed a profit of only 9.2% of revenues, compared with gross margins of 25% at Best Buy.

To win customers in China, Best Buy would likely have to flip its business model on its head, downplaying its carefully honed brand of customer service (which Best Buy calls "customer centricity") and tolerating much lower margins. It would have to do the exact opposite, in fact, of what pleases Wall Street.

It's precisely Best Buy's strengths in customer service and its position as a go-to spot for high-tech goods that have won it praise from analysts. Best Buy should see a continued benefit as digital TV "enters the sweet spot in terms of household penetration," writes Pali Capital analyst Stacy Widlitz.

The biggest factor in the American retailer's favor is its massive purchasing power with Chinese manufacturers, which has increased with its recent acquisition of Five Star. That buying heft should help Best Buy extract more favorable terms with suppliers, which it could in turn pass on to consumers, possibly helping it take market share.

Still, with prime real estate in the rich cities already taken, Best Buy will probably need to rely on acquisitions to secure the storefronts it needs. It remains to be seen whether a brilliant M&A strategy could help the company overcome its late entry into China.