LOCAL INSURGENTS SHAKE UP CHINAS “TWO-SPEED” MARKET China Shopper Report 2018, Vol. 2 Founders Mentality ®is a registered trademark of Bain Chinas “New Retail,” which is redefining the roles of consumers, merchandise and stores; and Chinese consumers growing preference for products that improve their lifestyle, health and wellness. We observe that insurgents making the most of these external factors exhibit traits of what we refer to as a Founders Mentality ® : an insurgent mission, a frontline obsession and an owners mindset. We see this in three important areas. First, local insurgents rely on consumer-focused innovation in product, branding and assortment. Among their successful moves in product assortment: They focus on a few proven “hero” SKUs or product variants to eliminate unnecessary product complexity and ensure that the young brands limited resources are devoted to a very focused message to the target consumers. YunNan BaiYao (YNBY , 云南 白药), with its Mint and Spearmint toothpastes, is a good example of this. Second, they take a localized approach to route-to-market and marketing. For example, without established offline distribution relationships, many insurgents focus on high-traffic online platforms Local Insurgents Shake Up Chinas “Two-Speed” Market 5 such as Tmall and JD, and are quick to use up-and-coming social commerce and social media platforms like Pinduoduo (拼多多) and TikTok (Douyin，抖音). Also, more than half of the insurgents we evaluated, like ChaoNeng (超能) in fabric detergent, launched their products in lower-tier cities first, a move that enabled them to avoid early competition from multinational brands. Finally, they create a nimble and agile operating model. Their lean, cross-functional organizations give them the flexibility and the freedom to adapt in-market. Instead of waiting for multilayers of discussions and approvals, insurgent brands can move quickly. Their local knowledge and entre- preneurial culture allow them to decide and adapt quickly to market changes. They test and learn and rapidly change course as needed without locking in significant capital expenditures. By establishing an ecosystem of partnerships, including co-manufacturers and co-marketers, insurgents remain asset light themselves. Instead of continuing to lose so much growth to these newcomers, incumbents can compete more effectively by adopting three critical ingredients of insurgents success. We call it the 3D approach. Design for Chinese consumers. Chinese FMCG consumers are unique among their counterparts in other markets. They also are changing fast. Incumbentsespecially multinationalsneed to localize in everything from product design to branding to marketing. While global experience is important, what is often more valuable is a local team that deeply understands both the Chinese culture and the latest trends: the significance of Traditional Chinese Medicine, for instance, or the shopping behaviors of the Chinese millennials born under the one-child policy. Decide in China. The Chinese FMCG market is moving so fast that theres no time for decisions to travel from the local to regional to global headquarters for approval. Multinationals need to delegate innovation, marketing, distribution and other decisions affecting their China business to their China teams as well as change their incentive systems to be more in line with local insurgents. Do it at Chinese speed. While incumbent brands by nature are typically less nimble than insurgents, they can take two proven approaches to boost their ability to act quickly on market opportunities. First, they can learn from scale insurgents like Alibaba and Tencent, which grew fast by leveraging an ecosystem. For example, an FMCG company can focus on core functions such as product development and marketing while relying on players in an ecosystem for other functions such as manufacturing and distribution. The other way to move swiftly to compete against insurgents: deploy micro-battles. These are small, achievable battles that later can be scaled. The micro-battle approach involves an extremely focused initiative that starts by attacking the hardest problem first and iterates on the solution. Cross- functional teams test and learn, with a willingness to fail quickly and adapt. It is a crucial mindset for getting on (or, getting back on) the fast track in Chinas two-speed FMCG market. Local Insurgents Shake Up Chinas “Two-Speed” Market 6 Figure 1:.Fast-moving.consumer.goods.(FMCG).growth.remained.low,.whileo-speed.growth . between.food.and.beverage.vs .personal.and.home.care.continued Note: Kantar has excluded cigarettes from total FMCG and updated all category data slightly in 2017, leading to minor changes when refreshed with previous years data Sources: Kantar Worldpanel; Bain Bain National Bureau of Statistics of China Annual growth of urban FMCG market value (2012H1 18) Annual growth of urban FMCG market volume (2012H1 18) Annual growth of urban FMCG ASP (2012H1 18) Value VolumeA verage selling price 0 2 4 6 8 10% 2012 13 7.8 1314 6.1 1415 4.7 1516 3.6 1617 4.3 H1 17 H1 18 2012 13 1314 1415 1516 1617 1314 1415 1516 1617 H1 17 H1 18 3.3 0 2 4 6% Inflation Growth without e-commerce 3.8 5.9 5.6 3.0 4.0 4.63 1 1 3 4% 2012 13 3.9 0.2 0.9 0.6 0.2 H1 17 H1 18 1.3 sectors: packaged food, beverages, personal care and home care. 1Combined, these sectors represent 80% of Chinas FMCG purchases. This report, which updates the findings from China Shopper Report 2018, Vol. 1, As Shoppers Upgrade, Growth Returns, includes Kantar Worldpanel shopper behaviors data for the first half of 2018. The new data provides insights into continuing trends that are critical for brands as they set a course for growth in the worlds largest FMCG market. As we have seen for years now, packaged food and beverage categories took a noticeably different growth trajectory than personal care and home care categories. Packaged food and beverages showed weaker performance, with dropping volumes contributing to lower value growth (see Figure 3). Some brands managed to outperform by introducing healthier and higher-quality food or beverages. For example, new varieties that appeal to nutrition-conscious consumers helped the instant noodle category grow by 4.1% in value in H1 2018, driven by the introduction of more premium SKUs by leading brands, like Golden Soup (金汤系列) from Master Kong (康师傅) and Magic Soup (汤达人) from Uni-President (统一). Similarly, the CSD category enjoyed a healthy 5.8% growth in H1 2018 through the growth of small packs and the success of healthier SKUs such as Sprite Fiber from Coca- Cola. Premium brands in yogurt, juice and milk still gained ground. But lower import taxes limited the growth in selling prices for the overall beverage category. Yet while some brands were able to com- mand slightly higher prices by introducing healthier and higher-quality offerings, the increase was not enough to counter the effect of overall declining volume in food and beverage categories. Local Insurgents Shake Up Chinas “Two-Speed” Market 8 Figure 3:.Beverage.and.packaged.food.values.suffered.from.volume.decline,.while.higher.prices. boosted.value.growth.for.some.packaged.foods Note: Kantar has excluded cigarettes from total FMCG and updated all category data slightly in 2017, leading to minor changes when refreshed with previous years data Sources: Kantar Worldpanel; Bain & Company Annual growth of urban FMCG market value (2012H1 18) Annual growth of urban FMCG market volume (2012H1 18) Annual growth of urban FMCG market ASP (2012H1 18) Value VolumeA verage selling price1.0 1.5 4.0 6.5 9.0 11.0% Packaged food 5.8 2.0 0.1 1.3 3.0 2.3 Beverage 201213 1314 1415 1516 1617 10.2 5.7 2.3 H1 17 H1 18 9.3 2.6 3 1 1 3 5% Packaged food 2.7 0.9 2.1 0.9 0.3 1.1 Beverage 3.9 0.3 0.9 0.8 0.1 1.9 0 2 4 6 8 10% Packaged food 3.0 2.9 2.1 2.3 2.7 3.4 Beverage 6.1 9.6 6.7 1.6 2.5 2.1 0.1 By comparison, home care and personal care outperformed. In home care, rising volumes and selling prices led to 5.5% value growth (see Figure 4). Among the factors at play: The increase in input costs in some categories, like pulp, led to higher prices for toilet tissue and facial tissue. However, it was personal care categories that rose above all in the first half of 2018. While volume actually dropped by 2%, selling prices grew dramatically11.5% on averageto contribute to 9.3% value growth, nearly three times the FMCG average. Niche products in skin care and makeup, such as cosmeceuticals and natural products, served as the driving force behind the premiumization. The strong performance also reflects the successful entry of local insurgent brands, which gained share from local and foreign brands alike. Enter the local insurgents Why insurgent brands matter. Marie Dalgar (玛丽黛佳). Three Squirrels (三只松鼠). One Leaf (一叶子 ). Unifon (御泥坊). An army of dynamic young brands bearing these and other newly popular names is capturing a disproportionate share of the growth in Chinas FMCG market, threatening to radically change the rules for incumbents. As we have reported for six years, local Chinese FMCG brands, in aggregate, have been gaining market share from foreign brands across most product categories. With 7.7% value growth in 2017, local brands represented 98% of market share growth. Now it is the local insurgent brands that are making headlines by earning more than their share of that local growth.