How Cities Power Growth

On January 10, the United States-based coffee chain Starbucks opened one of its biggest shops ever — occupying four stories and 400 square meters — in Xiamen, China.

If you’ve never heard of Xiamen, you are probably in good company, but you might also be missing a stellar business opportunity. Starbucks’ renewed focus on cities, particularly new and rapidly growing urban centers, is aiding the company’s recent turnaround. Starbucks began life as a quintessentially urban operation. But eventually, it was opening up more stores in the suburbs than in cities. By 2007, battered by the sagging United States economy, the company was faltering. That year, for the first time in its history, the coffee chain witnessed a drop in traffic. Analysts warned that the company had saturated its markets, and the stock fell 50 percent.

It turns out that the company was not looking for expansion opportunities in the right places. By focusing on places like Xiamen — a city of 600,000 that will see another nine Starbucks shops open over the next few years — the corporation appears to have rediscovered its urban groove. And the new strategy is boosting its bottom line. Profits last year rose 142 percent to $945.6 million.

That Starbucks ever felt a need to turn its back on cities is ironic, because the world is urbanizing on an unprecedented scale. On May 23, 2007, according to researchers at the University of Georgia and North Carolina State, a tipping point was reached. For the first time in history, city dwellers outnumbered the Earth’s rural population. Over the next few years, predicts the United Nations, metropolitan populations will swell to represent two-thirds of the people on the planet. In China alone, says the McKinsey Global Institute, urban areas are expected to add 400 million residents by 2025, exceeding the entire headcount of the United States today, about 311 million.

This change presents both an enormous business opportunity and a challenge. Consumers who live in cities are very different from their rural counterparts. “Urban consumers are more globally connected,” says Allen Scott, urbanization expert and professor of geo-graphy and public policy at the University of California, Los Angeles. “They have more in common with city dwellers in other parts of the world than with rural residents in their own country. They tend to be more prosperous, more adventurous in their consumer choices and more pressed for time.” In other words, they are ideal marketing targets for modern consumer goods.

Some managers see urbanization as the corporate chance of a lifetime. Muhtar Kent, CEO of the Coca-Cola company, calls the rise of cities part of a “new equilibrium” that will drive sales over the next few decades. “We will continue to see massive urbanization unfold as the world moves off the farm and into the cities,” he said at last year’s Consumer Goods Forum. “For the next 10 years, an urban population the size of London will emerge about every 40 days.”

Yet urbanization is happening largely in places like Xiamen — cities so new that they are not even on the radar screens of many corporate executives. To take advantage of the demographic shifts, managers will need to revamp their strategy. Instead of segmenting the world on a country-by-country basis, they will need to hone in on specific cities.

The concept of emerging countries is being replaced by one of emerging urban centers. Within the next two decades, some six hundred cities will account for 60 percent of the world’s economic growth, according to Richard Dobbs, director of the McKinsey Global Institute, an economic think tank. The urban centers of Delhi, Shanghai, São Paulo and Moscow will each separately reach a gross domestic product in excess of $500 billion at purchasing power parity by 2025, more than the annual economic output of Belgium today. Among McKinsey’s latest predictions is that by the year 2025, the Chinese cities of Tianjin, Foshan, Nanjing and Hangzhou will be more economically important than Athens, Barcelona, Rio de Janeiro or Munich.

CEOs are increasingly dividing markets into specific urban centers rather than nations. “The trouble is that if you’re grouping by countries, you will inevitably be underweight in some areas and overweight in others,” says Dobbs. “China, for instance, is not a single market. To think that you would cover it all from Shanghai or Beijing is as ludicrous as thinking you could cover all of the United States from New York. On the other hand, Jakarta [the largest city in Indonesia] is going to be more important to a corporation than Xinjian [a sparsely populated Chinese province bordering Tibet].”

So how can companies best take advantage of world urbanization?

Realize that demographic changes are happening at an unprecedented pace. To keep up with these changes, corporations need to be highly proactive about expansion plans.

Take the experiences of two luxury goods groups: LVMH, which holds the Louis Vuitton brand, and PPR/Gucci. LVMH has been fearless in its embrace of new urban markets. The company launched its expansion into Asian cities in the early 1990s, and 10 years later staged a big push into India. In 2009, the company opened a Louis Vuitton store in the Mongolian capital of Ulaanbaatar, and the Inner Mongolian Chinese city of Hohhot. There are Louis Vuitton shops in Ho Chi Minh City in Vietnam and Yekaterinburg, Russia. CEO Bernard Arnault says he’s considering an outpost in Lhasa, Tibet.

The focus on rising urban centers has revved up the group’s sales. LVMH’s revenues grew nearly 20 percent to $27.1 billion last year. Asian cities made up 25 percent of those sales. But Arnault says the advantages of setting up shop early in what were once considered exotic locations have had a secondary effect. Boutiques in established markets such as North America and Europe also experienced strong sales, partly because of demand from Asian tourists. Having familiarized themselves with the brand at home, they are eager to buy when abroad as well.

PPR/Gucci’s expansion into growing cities, on the other hand, has been uneven. Analysts have questioned the group’s priorities. For instance, the company ignored markets such as Warsaw and Kiev, while it continued to operate a boutique in Budapest, which in 2009 was the worst-performing store in the group. The company is now pushing hard to catch up with competitors. But its growth still lags behind LVMH and other competitors. Last year, revenues were up just 7.5 percent to $19.7 billion, paling in comparison to double-digit growth at luxury goods rivals such as Ferragamo and Coach.

Because they rely so heavily on urban consumers, tracking the movements of luxury goods sales can be a good way for executives from other industries to identify hot new markets. According to Bain & Co, the top new cities for luxury market expansion in China are Zhuhai, Fuzhou, Hangzhou, Chongqing, Urunqi and Wenzhou. None of these cities is exactly a household name in the West.

“(In terms of demand for luxury goods), we’ve seen a shift from tier one cities like Beijing and Shanghai to tier two and tier three cities,” says Nick Debnam, partner in charge of consumer markets at KPMG China. Gucci set up shop in Wuhan, China, in 2009, and Ferragamo says sales in its Chengdu, China, store now exceed those of its store on London. The focus is not limited to urban centers in China. Burberry, for instance, just opened its first store in Brasilia. Ermenegildo Zegna, the men’s clothing group, is pushing the envelope even further. Late last year, it opened a shop in Lagos, Nigeria, joining the Spanish retailer Mango.

Don’t be afraid to adapt the brand to local markets, but make sure you stand out from the crowd.

Yum Brands — whose brands include KFC, Pizza Hut and Taco Bell — is a heavyweight in emerging market cities. KFC was a pioneer in China, opening its first restaurant there in 1987. By the end of last year, the company had nearly 4,000 restaurants in that country, mostly KFCs. McDonald’s, in contrast, had 1,200, and Subway had just 200. Last year, Yum Brands’ net income in China reached about $750, exceeding its United States profits.

Yum’s success lies partly in its appeal to local tastes. Asians consume a lot of chicken, and can easily identify with the “finger-lickin’ good” product offered by KFC. But the restaurant chain was not afraid to adapt its menu to increase its allure for local taste buds. Peking duck and bamboo soup are among the offerings at KFC’s outlets in China. The company also made sure that service and cleanliness at its stores in China were at a very high level, giving it a competitive advantage over many local restaurants.

Subway, on the other hand, faced an uphill challenge in marketing sandwiches to consumers unused to eating them. The corporation resorted to handing out instructions to diners, explaining how to put together a successful sandwich order and how to eat the final product.

The rise in cities has important knock-on effects.

City expansion has some key knock-on effects. As people leave rural areas in favor of cities, they usually experience a significant rise in income. For instance, McKinsey predicts that by 2025, more than two-thirds of India’s urbanites will be part of the middle class, compared to just over one third today. The impact of urbanization on consumer demand can readily be seen in China. According to a 2009 Gallup poll, 24 percent of city residents in that country planned to purchase a digital camera within the next 24 months. That’s compared with just 13 percent of the rural population. Loosening family ties are another byproduct of urbanization. The multigenerational households of the countryside often give way to smaller family units. Women migrating from rural areas to the cities may enter the work force for the first time, creating fresh demand for feminine products and time-saving devices.

The rise in income associated with urbanization helps explain why luxury good sales are thriving in emerging markets. Porsche, for example, sold just 40 cars in China in 2002, but 3,500 in 2009. “Luxury goods are often at the forefront of taking advantage of urbanization, because let’s face it, you don’t see too many Louis Vuitton shops in the countryside,” says Dobbs. “Even in developed countries, it takes a major city to have the concentration of shoppers and incomes you need to sustain a high-end designer shop.”

Pay special attention to the new “knowledge centers.”

The most dynamic urban centers may be those that attract a large number of knowledge workers. “The biggest winners will be cities that can attract the best and brightest people,” says Richard Florida, who has written about the benefits of urban centers on productivity. “That’s where innovation will happen.” While urban centers in industrialized countries — including New York, London and Tokyo — will likely hold an edge as knowledge centers for some time, some emerging market cities are gaining ground.

Consider, for example, India’s Bangalore, often referred to as the “Silicon Valley of India.” Through government investments in infrastructure and by leveraging ties with the local university, Bangalore has succeeded in establishing itself as a prime research center. The city employs about 40 percent of India’s high technology workers. Daimler, IBM, GE, Google, Motorola, Oracle and Yahoo all have large R&D operations there.

In Harvard economist Edward Glaeser’s new book, “The Triumph of the City,” the author describes how Bangalore and Silicon Valley took advantage of the everyday personal contact of bright technical minds. In these cities, where ideas have become the currency of growth, the proximity of talented people has given rise to tremendous economic growth.

A city-centric expansion plan has its risks.

If corporate executives are to follow strictly the dictates of consumer market expansion, they will lavish a great deal of attention and investment on Asian markets over the next 20 years, particularly in China and India. Yet this kind of concentration flies in the face of long-held notions of the value of diversification. Traditionally, global outreach has spread risk around. A heavy focus on metropolitan areas in a handful of countries could make corporations vulnerable to the whims of politicians in countries where public policy has not been modernizing as quickly as their economies. Companies that had bet heavily on expanding cities in the Middle East, for instance, were thrown off-guard by the unrest that erupted in that region earlier this year.

A focus on cities poses personnel challenges as well. It may not be easy to move executives out of an urban area that is losing economic stature, such as Munich, and throw them into the managerial ring in the Chinese city of Foshan, for instance. For one thing, the Munich executive is not likely to speak Chinese or be familiar with its culture. For another, the executive may not want to move to Foshan. Because of these factors, “there may be a shift in favor of local talent,” says Dobbs.

Yet the rewards make it all worthwhile.

Despite the challenges, urbanization, for the most part, will be a huge boon for large multinationals. For one thing, it streamlines distribution, which for most corporations is a large cost item. Goods are marketed and distributed more efficiently in cities, in a way that favors big retail operations and works to the detriment of mom-and-pop businesses.

Take, for instance, the phenomenal growth of supermarkets in Indonesia over the past few decades. In the 1980s, supermarkets occupied a tiny niche of the food market in that country, according to the Center for Agricultural Policy and Agribusiness Studies at Padjadjaran University. Only the urban elite shopped at such places. But as Indonesia’s population shifted from 78 percent rural in 1980 to slightly more than half rural today, demand soared. Supermarkets now account for more than 40 percent of overall food retail in that country. The change has in turn boosted demand for processed foods and beverages in Indonesia. Coca-cola expects sales in that country to rise 10 percent this year alone.

Urbanization is touching nearly every conceivable facet of consumer markets. The Canadian government, for instance, credits urbanization in Russia for boosting demand for Canada-made pet food. Apparently, time-pressed city dwellers are far more likely to use prepared pet foods, rather than table scraps. Urbanization is also driving up global sales of coffee, because city dwellers consume much more of the brown liquid than people in the countryside. In what may be a surprise for some, the seed and farm equipment industries also stand to benefit from the move to cities, as remaining agricultural areas seek to become more efficient. Deere & Company, for instance, posted a surge in profits to $1.865 billion in 2010, up from $873 million the previous year, mostly on rising sales to rapidly urbanizing emerging markets.

Managers would make a mistake if they treated rising city populations as a single market. Urbanization will happen in different ways around the globe. In China, for example, second- and third-tier cities are absorbing much of the new growth, which is being fueled by farmers putting down their plows and heading for the nearest metropolis. In India, urbanization is expected to take place mainly in existing centers such as New Delhi and Mumbai, and is being driven by rising populations of educated workers. In Latin America, urbanization continues in big metropolitan centers, but will occur at a far slower pace than it has in recent decades. While a number of cities in Europe and the United States will experience rising gross domestics products, many others — such as Athens, Vienna, Minneapolis and Detroit — are expected to lose economic clout. While urban consumers have a more global perspective than their rural counterparts, their tastes are also influenced by local preferences. Luxury clothing, for instance, is a big seller in China, but not in India, where jewelry is the status symbol of choice.

World urbanization will not be uniformly positive. The growth of cities brings tremendous challenges. For one thing, urbanization will mean worsening pollution (perhaps providing opportunity for green industry). China’s use of coal, oil, wind and other sources of power, for instance, has more than doubled in the last decade. Rising populations will also strain cities’ ability to provide transportation, education and services for their citizens. “The rise in cities means a rise in poverty and slums,” says Saskia Sassen, a professor of sociology at Columbia University and a frequent speaker on urbanization issues. “There are many negative forces behind urbanization.”

Still, for world multinationals, the rising population of existing cities, as well as the formation of new urban centers, presents a huge opportunity for growth. Taking advantage of these opportunities won’t be easy. It requires corporations to re-think long-held notions about diversification and globalization. But for managers willing to adapt their strategy to better fit changing demographics, the rewards will likely be substantial.

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A long-time correspondent for The Financial Times, Victoria Griffith covers business from Boston.