Why Best Buy Failed in China

For Best Buy Co., Inc. (BBY), China was far from the best experience.

The Minnesota-based company, best known for its big box retail stores that sell consumer electronics products, withdrew from the Chinese market last year by selling off the majority stake in its local partner, Five Star Appliance Co, to a Chinese real estate company. In a statement at that time, Best Buy's CEO Hubert Joly said the sale would allow the company to "focus even more on our North American business." The company had already shut down its branded stores in China in 2011 but will continue to sell its privately labeled products there. (For more, see Is There A Future For Best Buy?)

With its growing middle class and proximity to electronics manufacturers, China represented a huge growth opportunity for Best Buy. After studying the market for three years, Best Buy entered the Chinese market by buying a majority stake in Jiangsu Five Star Appliance – a local retailer – in 2006. It started operations with nine branded stores; the stores mimicked their American counterparts in their layout, organization and selling tactics. This meant that they were stocked with knowledgeable customer service representatives who guided customers through a product mix that consisted of American product staples, such as espresso machines and home entertainment systems.

But the expected flood of customers failed to materialize. Instead, after struggling for six years, the company had a meager 1.8% market share, Best Buy closed down all six branded stores in 2011. The firm had already bought out Five Star Appliance in 2008 to propel its growth in the Chinese market. Then-CEO Brian Dunn said the store would focus on mobile sections of its Five Star chain. However, as subsequent events have shown, that experiment failed as well.

The company's problems in China stemmed from three main issues: piracy, cost-conscious customers and the unpopular big box retailer format.

China’s extensive manufacturing infrastructure made it easier for competitors to make counterfeit Best Buy products and sell them at a lower cost than the store. The Chinese customer also turned out to very price-sensitive, and Best Buy's products were more expensive than that of its competitors. Research has shown that Chinese middle-class customers are willing to pay premium prices for well-known brands. As an example, the country surpassed the United States to become the biggest market for Apple's iPhones, a product with premium pricing. (For more, see What Makes Apple The Most Valuable Company?)

But brand misperceptions can negatively affect sales.

Best Buy's target audience was also middle class, but the company failed to provide adequate explanations for the premium prices of its products with that audience. However, it was Best Buy's failure to work in the local retail format that negatively affected the company's prospects on multiple levels. The firm's bloated cost structure contributed to its expenses and was eventually reflected in product pricing. For example, the firm chose to own and manage operations for entire showrooms instead of renting out space to individual manufacturers like most Chinese retailers.

The latter strategy transfers costs, such as store employee expenses and inventory management, onto manufacturers. Best Buy also replicated its store warranty model in China, where customers are more familiar with manufacturer warranties for products. The problem was that warranties cost extra, which further inflated product prices.

After changing the company's sales model to suit local conditions, then-Asia President David Deno said the retailer's moves in China were "stupid and arrogant." According to Kal Patel, Deno's successor, the store's intentions in replicating its U.S. model was to "change the industry" in China. "What we learned, very crucially, is that in China you cannot make revolutionary change. You have to work at the pace of the Chinese consumer," he added later.

At the time of its exit, Best Buy ran 184 stores in China under the Five Star brand. However, Five Star's geographical reach is limited: a majority of its stores are situated in the eastern Jiangsu province. That restricted reach is reflected in its position in retailer standings. In 2013, Five Star was the 18th largest retailer in the country. Meanwhile competitors Gome and Suning Commerce have stores spread across China and are aggressively opening new locations.

Finally, it was a combination of intense competition from ecommerce stores, such as JD.com and Tmall, and slow growth prospects for the Chinese economy that spelled the death knell for Best Buy's China operations. China's retail sales grew 12% in the first 10 months of last year, down from 13% during the same period last year, according to China's Bureau of Statistics.

Whether Best Buy returns to Chinese shores after the economy improves remains to be seen.

Best Buy is not the first Western retailer to exit China. Home Depot Inc. (HD) quit in 2012. Best Buy, however, hasn't folded its operations entirely and is still selling private-labeled goods in China. Whether it reopens its stores in China after the economy improves remains to be seen.