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The following article by Shaun Rein of the China Market Research Group originally appeared in BusinessWeek:

Recent studies have shown that more than 50% of foreign multinationals expect to make money by selling to Chinese consumers by the end of 2007. This is a dramatic shift from just a few years ago when 70% of companies lost money in the Middle Kingdom—not true of players such as Wal-Mart (NYSE:WMT) and General Electric (NYSE:GE), which leveraged low labor costs to produce in China for export.

The turnaround in the China fortunes for these companies has been fueled by a consumer revolution in first-tier cities such as Shanghai, Beijing, and Guangzhou where the disposable income of the 15 million people in the middle classes has reached over $4,000 a year.

Most of China's 300,000 millionaires live in these urban centers and increasingly buy luxury goods from producers such as PPR, owner of the Gucci Group, and Louis Vuitton. The numbers are not insignificant. For instance, China is Rolls Royce's third largest market after the U.S. and Britain. It is the world's fifth largest market for cosmetics and seventh for retail sales.

Money in the Smaller Cities
Naturally, most multinationals have focused on selling to consumers in glitzy metropolises like Shanghai where hulking skyscrapers punctuate the skyline. However, many overseas companies are making a mistake by targeting just these consumers and neglecting China's less developed cities.

Savvy companies understand that Chinese consumers in second- and third-tier cities such as Chengdu, Wuhan, and Chongqing will be the engine for growth in the coming decade. Some 50 million residents live in these three cities—more than the entire populations of Canada and Australia combined—and they have average disposable incomes that are increasing 15% a year and reached $1,550 in 2006.

Cars, Not Tourists
Consumers in these less-developed cities crave international goods such as Nokia (NYSE:NOK) mobile phones, Hewlett Packard (NYSE:HPQ) computers, or Estée Lauder (NYSE:EL) cosmetics. They want to demonstrate their newfound wealth and express themselves.

An executive from L'Oréal (OTCPK:LRLCY) recently told me that their fastest sales in China are coming from Guizhou, a city in a province that's the least visited by foreign tourists in all of China. Daimler Chrysler's (DCX) Maybach 62 and Ferrari's F430 sold out in Harbin when they were first introduced.

These are three reasons why multinationals should target consumers in less-developed urban centers in China.

Squeezed Margins
Real estate prices have skyrocketed in Shanghai and Beijing over the past five years. Despite government efforts to rein in speculative investment from overseas, Shanghai's commercial rents increased 16% in Pudong and 13% in Puxi year-on-year in the second quarter of 2006 alone.

Rising rents have squeezed margins for restaurants and retail chains and leave little profit even if revenue numbers are growing. Business-to-business companies have had to grapple with spiraling rents, too, and have often relocated to areas farther away from main business areas.

In Wuhan, retailers can buy downtown business space for $3,250 per square meter as opposed to $4,500 in Beijing or $6,800 in Shanghai. Similarly, it costs 15 times as much to advertise in Shanghai than in Chengdu on TV, according to AdAgeChina. Print-media advertising prices show a similar disparity.

Beyond the differentials in advertising costs between first- and second-tier cities, a deeper problem exists. Advertising space is so saturated in big, developed cities that gaining actual reach through advertising is a difficult proposition as consumers are literally bombarded by ads all day long from companies such as Focus Media (NASDAQ:FMCN), and have learned to ignore them. Advertising in second-tier cities is not only cheaper, but likely much more effective in terms of capturing the attention of coveted shoppers.

At the end of the day, too many foreign firms feel as if they have to be in Beijing or Shanghai because everyone else is and because of pressure from boards and investors who do not understand why their companies do not have a China play in the most famous cities. But smart executives will ignore the pressure and herd mentality and will locate where their biggest potential return on investment is.

Labor Problems
Although China's first-tier cities have large worker populations, labor costs are not as low as many as multinationals expect. Everyone from white-collar workers at foreign multinationals to waiters and sales clerks in the service industry rotate through jobs with frightening frequency, seeking the next best opportunity.

Second-tier cities offer a much better opportunity for companies seeking to acquire employees with relevant skills that stay with companies for the longer term. In first-tier cities, workers see too many 'grass is greener' scenarios as they hear rumors of acquaintances leaving jobs to start their own businesses and becoming millionaires or getting poached by other companies that dole out 25% salary increases.

In surveys that my company, China Market Research Group (CMR), has conducted, the first criterion workers in Shanghai or Beijing look at when choosing a job is a balanced lifestyle. Salary was the answer to that question five years ago. However, workers in second- and third-tier cities still choose salary as the most important consideration when looking for a job—followed by job security.

Consumer Choices
Consumers in China's first-tier cities have been bombarded by choice over the last three years from hyper-marts such as Carrefour (OTCPK:CRERF). Accustomed to a plethora of product choices from Sony (NYSE:SNE) to Nike (NYSE:NKE), consumers in these cities are incredibly fickle. Consumers in second-tier cities have less to spend and want a variety of goods to choose from.

These secondary cities will be a boon for forward-thinking companies as China's economy become more integrated with international norms. And they will not have to deal with the problems that plagued their operations when then they first set up in Shanghai and Beijing— such as a lack of transparency in regulations and weak infrastructures.

A bigger chunk of China's 1.3 billion consumers could be within reach for multinationals willing to shift their strategy to less know urban centers.

Source: BusinessWeek: Beyond Beijing - Selling Across China