Third-Party Logistics in China: Still a Tough Market

Third-Party Logistics in China: Still a Tough Market By Diana Huang and Mark Kadar Mercer recently completed a survey of the third-party logistics (3PL) market in China, in conjunction with the China Federation of Logistics and Purchasing. The study included interviews with a wide range of both shippers and providers serving the Chinese market, as well as detailed research into the overall characteristics and trends influencing the growth of transportation and logistics services in China. The primary finding of the study was that the third-party logistics market in China is finally off to a fast start, driven by the opening up of the market to foreign firms and government commitment to growing China s share of the world economy. However, Mercer s study indicates that there is still a bumpy ride ahead for providers of logistics services in this market, given a range of challenges from both the supply and demand side. Most shippers in China are still relatively unsophisticated in terms of their logistics needs, although the increasing presence of multinational corporations is ramping up demand for higher-end services. On the supply side, the 3PL market is highly fragmented even the largest providers have less than a 2 percent market share and foreign 3PLs in particular seeking to establish a presence will face significant obstacles. Over the longer term, both market and political forces are likely to change the landscape of providers, set new industry standards, and stimulate more and higher value-added demand for logistics services. A Growth Market for Logistics The size of the potential market for such services in China is mind-boggling, given that the country has a population of 1.3 billion and a GDP of US$1.1 trillion. Transportation and logistics expenditures were $230 billion in 2001, or approximately 20 percent of GDP. Although outsourcing accounts for only $4.7 billion, or less than five percent, of this figure, the market for such services is still in its early stages of development. Compared to overall logistics services, which are growing by about 7.5 percent annually, outsourced logistics services in China are reported to be growing by 25 percent per year, leading both North America (10-15 percent annual 3PL growth) and the rest of the world (5-10 percent). In fact, several of the most promising providers in the Chinese market say that they have experienced annual doubling of revenues in the past couple of years. Shippers that Mercer surveyed said that while only about 22 percent of logistics expenditures are spent on 3PL today, they expect outsourcing to account for 50-60 percent of total expenditures in 3-5 years. Yet, while there is obviously enormous potential for growth in this market, the challenges uncovered by Mercer s study indicate that fully realizing that potential will be difficult and will take time. Key factors that are expected to stimulate the growth of outsourcing include the increasing activity of multinational corporations in China, as well as overall pressure to reduce the to-market cost of goods, both domestically and for export. Governmental interest in the development of China s logistics 3 Mercer on Travel and Transport

infrastructure is also promising: Establishing national logistics centers and large-scale logistics enterprises is part of the next five-year plan, and key government ministries have publicly called for encouraging domestic companies to develop partnerships with 3PL providers and to outsource a greater percentage of their logistics needs, as well as for reducing regulations that hinder entry of foreign 3PL providers into the market. China s entry into the World Trade Organization (WTO) is also a critical factor, as it committed the country to greater liberalization in domestic logistics, including allowing foreign companies to operate wholly owned logistics units by December 2004. Drivers of (and Barriers to) Demand for 3PL Services Nearly a third of all shippers interviewed by Mercer cited pressure to reduce logistics costs as a key challenge, and this is the top reason given for outsourcing logistics: As one director of white goods manufacturing noted, competition is fierce, and margins are decreasing, so we are looking to external logistics providers to reduce our logistics costs in order to maintain profitability. Other logistics challenges cited by shippers depending on industry include the need to shorten cycle time, reduce inventory levels, and improve service/reliability (Exhibit 1). Exhibit 1 Shippers Key Logistics Challenges Top Challenges by Industry Lower logistics costs Shorten cycle time Improve service level 19% 21% 27% Automotive Reducing inventory levels (39%) Apparel & Textile Shortening cycle time (42%) Reduce inventory level Enhance reliability 17% 16% Consumer Electronics and Food/Beverage Lowering logistics costs (39%, 44%, respectively) % of respondents (weighted 1 ) 1 Top three responses weighted by order of importance (#1 = X3; #2 = X2; #3 = X1) and calculated as % of total weighted responses. Most demand for 3PL services in China currently comes from multinational corporations. Although over 88 percent of the shippers surveyed outsource their direct transportation needs, only about 48 percent outsource logistics services. There is also significant difference in outsourcing behavior between Chinese companies and multinationals; while 70 percent of multinationals outsource their logistics services, only 16 percent of Chinese shippers do so. By industry, IT & telecommunications, consumer electronics, and automotive show higher rates of logistics outsourcing, while rates are lower than average for apparel, chemical, and food and beverage companies. 4 Mercer on Travel and Transport

Multinational manufacturers and importers active in China are more likely to outsource logistics because they have sophisticated logistics needs and experience with high-quality subcontractors in other countries. The light-asset nature of many importers also means that they must rely more heavily on 3PL providers. In contrast, traditional state-owned enterprises (SOE s) are the least likely to use 3PL services, as they have the in-house assets and people to handle logistics. They also lack experience in managing external vendors and can be slow to realize the benefits of outsourcing. Cracking the SOE market will likely be difficult, and could prove to be a critical barrier to the growth of outsourcing, given the size and reach of these companies in the Chinese market. In terms of the type of logistics services available and in demand, the increasing presence of high-quality foreign 3PL providers is expected to eventually raise industry standards on the supply side, while retail consolidation and rapid emergence of national chains will create demand for higher-value services. At present, however, demand for 3PL services in China is still relatively undifferentiated, with basic transportation and warehouse management accounting for the majority of logistics services outsourced (Exhibit 2) as well as three-quarters of 3PL providers revenues. Exhibit 2 Shippers Current Level of and Selection Criteria for Logistics Outsourcing Services Outsourced by Shippers 1 Criteria for Selection of 3PL Providers 2 Direct transport services 43% Industry/operation experience 31% Domestic transportation management 43% Reputation 18% Freight forwarding 33% 10% Lower price 16% Warehouse management 33% 5% Network coverage 16% Logistics information services 10% 25% Own strategic assets 9% Value-added services 5% 28% Integrated logistics providing capabilities 4% Integrated supply chain management 3% Good IT system 4% 50% % of shippers outsourcing % of respondents (weighted) Substantial amount Moderate amount 1 Different services are weighted by usage (substantial use = X2; moderate use = X1; no use = X0) and calculated as % of total weighted responses. 2 Top three responses weighted by order of importance (#1 = X3; #2 = X2; #3 = X1) and calculated as % of total weighted responses. Only includes shippers that already outsource. The lack of demand for higher-value services can be traced to difficulties on both the supply and demand sides:! Nearly 70 percent of the providers we interviewed believe that their clients are simply not ready to outsource more. Shippers significant in-house assets are one barrier to greater outsourcing, as is lack of experience in managing the interface with 3PL providers. Furthermore, none of the 5 Mercer on Travel and Transport

Chinese companies surveyed track all logistics costs, and this makes it difficult for them to understand the true value 3PL providers can offer (Exhibit 3). This last fact represents a significant barrier to growth, as better tracking of logistics costs is likely to be a daunting task for companies that lack high-quality information reporting and retrieval systems.! Shippers believe that high-quality, well-established providers are few and far between and that industry credibility is a problem. Although thousands of companies in China claim to be logistics providers, only half a dozen players are considered reliable, high-quality providers with the scope and scale to fully meet shippers requirements. All providers are good at sales and marketing, said one shipper we interviewed, but not so good at operations. They promise much more than they can deliver. Shippers saw most 3PL providers as trucking companies with poor IT systems. Exhibit 3 Costs Tracked by Shippers 100% 93% 80% 79% 79% 76% Multinational Companies 60% Chinese Companies 47% 37% 20% 0% Administrative costs Transportation and warehousing costs Inventory costs Based on our survey, providers are well aware of the reasons why shippers choose to outsource; e.g., to reduce costs, enable more focused attention on the core business, improve service levels, and simplify complex operations. But interestingly, providers do not appear to have as good an insight into why shippers choose not to outsource (Exhibit 4). For example, providers see the cost of logistics and a poor conception of what logistics means as much more important to the outsourcing decision than may truly be the case for shippers. It is possible that the logistics outsourcing market in China is moving toward severe bifurcation, based on the differing views that shippers have of foreign versus Chinese 3PL providers (Exhibit 5). Shippers tend to see foreign 3PL providers as strong in IT systems, industry/operational expertise, standardized operating processes, and international networks. Chinese 3PL providers are viewed as offering lower prices and as having strong local knowledge, domestic network coverage, and good central/regional government relationships. Among those shippers that expressed a preference, twice as many multinationals as Chinese firms preferred foreign 3PL providers; the preferences were almost exactly reversed for Chinese 3PL companies. Foreign 3PL providers receive nearly all of their revenues from multinationals, primarily because their role has been 6 Mercer on Travel and Transport

limited mostly to serving the import/export-related logistics needs of their global clients. For Chinese 3PL providers, revenues are nearly evenly split among Chinese and multinational clients. Exhibit 4 Reasons for Shippers Not Using 3PL Providers: Two Perspectives In-house capabilities already 29% 33% No confidence in service level 13% 23% Good providers not available 3% 22% Fragmented entities in charge of difference parts of supply chain 0% Not convinced of benefits 6% 6% 19% Too expensive 4% 11% Shippers' views Bad experience in past 0% 3% Providers' views Wrong concept/mindset 2% 22% % of respondents (weighted 1 ) 1 Top three responses weighted by order of importance (#1 = X3; #2 = X2; #3 = X1) and calculated as % of total weighted responses. Exhibit 5 Shippers Views of Foreign and Chinese 3PL Providers Advantages of Foreign Providers Advantages of Chinese Providers IT systems 79% 75% Lower price Industry/operational expertise 51% 45% Local knowledge Standardized operation 44% 34% Domestic network coverage International network Financial position Logistics talent 13% 10% 31% Preferred by: 30% of all shippers 37% of MNCs 15% of Chinese shippers Preferred by: 22% of all shippers 19% of MNCs 31% of Chinese shippers 27% 14% 9% Relationship with central local government Ownership of some strategic assets Flexible operation 0% 20% 60% 80% 100% 100% 80% 60% 20% 0% Note: The charts show the advantages cited by all shippers who expressed a view, including those shippers who preferred to ousource to a different nationality of provider. Growth through Partnership It is believed that some 16,000 companies in China are registered as logistics providers. Even among the market leaders surveyed by Mercer, none have more than a 1.4 percent market share. Four distinct groups, however, appear to be emerging in the 3PL services landscape (Exhibit 6): 7 Mercer on Travel and Transport

! Large state-owned enterprises, such as Sinotrans and COSCO, are strong in transportation and warehouse assets, have national networks, and typically maintain good relationships with central and provincial governments. The problems these companies face include overstaffing, a lack of customer orientation, and the need to improve service levels. Many are in the process of or about to start restructuring to improve efficiency and economics. Some are also upgrading their capabilities, such as IT systems, to enhance their competitiveness.! Medium-size Chinese logistics providers, such as EAS and PGL, have emerged in the past 10 years. These are generally privately owned and tend to focus on one or two key industries. These firms have enjoyed the fastest growth in the market due to their light-asset nature and high efficiency. They face challenges of securing sufficient financial support, attracting management talent, and developing organizational structures that will sustain their growth and profitability.! Logistics divisions of manufacturers and distributors, such as Haier Logistics and Attend, primarily provide services to internal customers. Most have indepth knowledge of the industries that they serve and reasonable network coverage, but they are weak in marketing. The fate of these players is uncertain, as some parent companies are looking to spin off logistics divisions under IPOs, while others are willing to sell these divisions to the first buyer who appears.! Foreign companies, such as APL and Maersk, have limited operations in China, typically entering the country with their customers in an effort to service those customers global needs. They are characterized by advanced IT systems, operational expertise, and strong global networks. These players are being challenged by their high cost structures (compared to Chinese firms) and their lack of on-the-ground capabilities in China. Commitment to China by corporate headquarters is mixed, as many are being negatively impacted by worldwide cost control efforts. Exhibit 6 Major Players in the Chinese 3PL Market Foreign logistics providers APL Maersk HTB Panalpina Exel Danzas TNT Schenker FedEx UPS DHL Internal logistics departments of Chinese companies Annto Logistics Haier Logistics Attend Logistics Ding Xin Logistics TCL Bright Dairy & Food Konka Traditional Chinese transportation companies COSCO Sinotrans China Materials Storage and Transportation Co. China Shipping China Resources China Post CRML CRE Emerging Chinese logistics companies EAS St-Anda PGL Hurry Top China Overseas Logistics Jiuchuan Logistics Source: China Warehousing Association, China Logistics Market Demand and Supply Analysis Report. 8 Mercer on Travel and Transport

Forty-five percent of 3PL providers surveyed reported execution problems, including issues in managing subcontractors as well as clients expectations (Exhibit 7). Regarding future growth, both Chinese and foreign providers are concerned about finding qualified people, government restrictions, and ambiguous policies (Exhibit 8). Chinese firms further cited the cost of developing IT systems as constraining, while foreign 3PL companies worried about customers unrealistic expectations. Exhibit 7 3PL Providers Major Execution Challenges Subcontractor management 24% Lack of agreement concerning requirments/expectations 21% Poor infrastructure 16% Client resistance to change 13% Staffing problems 9% Poor client data 7% % of respondents (weighted 1 ) 1 Top three responses weighted by order of importance (#1 = X3; #2 = X2; #3 = X1) and calculated as % of total weighted responses. Exhibit 8 3PL Providers Challenges to Growth Challenges for Chinese Providers Challenges for Foreign Providers Finding qualified people 29% Government restrictions Regulatory issues 23% 24% Finding qualified people Government restrictions 23% 20% Regulatory issues IT systems/ development costs 17% 12% Client rigidity/ unrealistic expectations Client rigidity/ unrealistic expectations 9% 2% Incompatible culture 50% 30% 20% 10% 0% % of respondents (weighted 1 ) % of respondents (weighted 1 ) 1 Top three responses weighted by order of importance (#1 = X3; #2 = X2; #3 = X1) and calculated as % of total weighted responses. 9 Mercer on Travel and Transport

Consolidation of 3PL providers is highly likely to continue, given that companies with outstanding performance over the past few years are achieving growth via acquisition. Equally, many 3PL providers that want to grow, but are still cautious about making large investments, are looking for alliances (from equity JVs to arms-length partnerships) that can provide complementary skills and thus quickly expand their capabilities and reach. Chinese companies in particular want partners who can provide overseas networks, financial support, management experience, and other complementary functions. Foreign companies are looking for partners who can provide customer relationships in China, strategic assets (vehicles and warehouses), local operational skills, and domestic network coverage. At present, however, while discussion of partnering is widespread, few providers appear to be actually committing themselves to specific alliances. Mercer believes that this current lack of forward movement is one of the most serious obstacles to the longer-term growth and development of third-party logistics in China both international and Chinese logistics providers will find partnering absolutely necessary to succeed in this very challenging and rapidly changing market. 10 Mercer on Travel and Transport