A decade ago, buying a car in China was no easy task. You normally went to a big market full of dozens, maybe hundreds, of independent sellers hawking an inconsistent variety of vehicles. You might then buy a car and later discover that it needed repairs, and return to the market only to find your salesperson had disappeared. Buying a car was a gamble until the arrival of the 4S dealerships. Short for Sales, Service, Spare parts and Surveys (customer feedback), 4S stores authorized by foreign and domestic carmakers arrived in the early 2000s and quickly began to set new standards in the car-buying market.

With their world-class customer service, well-trained staff, and comprehensive services, the 4S dealerships guaranteed warranties and long-term customer support. At the same time, the booming auto market in China meant healthy profits for the 4S dealers.

“The profits made by 4S dealers from 2003 to 2005 were truly extraordinary,” says Zhao Hao, associate professor of marketing at Cheung Kong Graduate School of Business. “In the most extreme examples from the time, there were cases of people making returns on their initial investment within three months, and it was fairly common for this investment to be made back within two years.”

That is an incredibly fast return for any industry, but is especially surprising for 4S dealerships, which have a high barrier of entry. At around RMB 20 million ($2.9 million) of initial investment, a 4S dealership is not a cheap enterprise to launch.

But they were able to make money through high sales earnings. When a 4S dealership sold a car several years ago, it could make profits of RMB 30,000 ($4,400) or more–or even RMB 100,000 ($15,000).

That is considerably higher than the profits that dealerships earn in other countries. With such high earnings, more and more 4S dealerships opened up. When auto sales finally hit a speed bump last year, the excitement at the astronomical high returns was over. And the fallout has only just begun.

“Once the market matured, it caused competition within the industry to intensify, and the time it took dealers to get a return on their investment got longer,” says Zhao. “These days, profits are much slimmer, to the extent that if a dealer can make RMB 3,000 ($440) on a sale, he’ll be ecstatic.”

China’s 4S shops are now starting to look more like American car dealerships–only about 20 percent of their profits come from car sales and the rest is earned through other services. This is a drastic departure from a decade ago when 4S dealerships were making 80 percent of their profits from sales.

Sales are not the only area where the 4S dealers are taking a beating.

“While Chinese consumers do go to 4S dealerships for tune-ups in the period covered by the warranty, they prefer not to pay the high costs charged by 4S dealers after the warranty expires,” says Zhao.

“Instead, they take the cheaper alternative of going to a street side repair garage. Since the car repair industry in China is very well developed, particularly at the middle and lower end of the market, going this route is both more convenient than, and as little as half the price of, going to a 4S dealer.”

This has placed 4S dealers under heavy pressure from two sides: competition in new car sales has intensified, while cheaper repair shops deprive them of the profits they might otherwise expect.

To make matters worse for 4S dealerships, they are now getting squeezed by their car-making partners. Because each 4S dealership is beholden to a particular brand of cars, the manufacturer of that brand has a great deal of leverage in dictating the conditions of the 4S dealerships. The carmakers can regulate how large a 4S dealership can be, what kind of customer service it needs to offer, and what types of repair services it needs to provide.

Due to the large profits that 4S dealers were able to make in the past, car factories became accustomed to making extraordinary demands of the 4S stores, asking more from Chinese dealers than they would from dealerships in other countries.

“In Europe, a Volvo dealership I saw was just a small storefront,” says Zhao. “In Beijing, the same dealership would invariably be housed in a huge, luxurious space decked out to rival a five-star hotel lobby. In China, if a dealer doesn’t provide this sort of space, they can’t get permission from a car manufacturer to display and sell their cars.”

According to Zhao, this treatment continues despite the loss of high profits at Chinese 4S dealerships.

All this paints a grim picture for 4S dealerships, but Zhao does not see this as the end of the line for them.

“Some dealers are going to be eliminated,” he says, and “manufacturers need to…let the dealers make a better profit.”

“Only after a healthier balance is reached, with everyone involved making a realistic and reasonable level of profit, will the car industry start to move forward again,” Zhao says.

CKGSB Professor Zhao Hao discusses the trajectory and future of 4S car dealerships.

Q. Why were people suspicious about the 4S model when it first appeared in China?

A. When something new pops up, there are always people who will voice doubts about it. Before the emergence of the 4S model, the typical sales model for cars was the giant sales lot, where many individual sellers and buyers came together to strike a deal without any sort of rules or regulations. This is a very unusual type of marketplace, compared to others around the world. It was a result of the non-standardized, immature state of the Chinese car market at that time.

At the time, Chinese consumers’ buying power was fairly limited, and the selection of cars they could choose was even more so. Under those circumstances, the most important question was whether 4S dealerships could turn a profit, given that they required a great deal of capital to start up. This was the big question mark hanging over the 4S model for many.

Today, the question has been mostly cleared up. We can see that in the early years of the 4S model, particularly from 2004 to 2006, there were huge profits being made from car sales. In this period, most 4S stores made vast sums of money.

Q. What are the main reasons for this? Why did the market take off to this degree?

A. First, it’s a big market. The late 1990s through 2004 were really the best years for the industry, a complete sellers’ market. Demand far exceeded supply. In fact, sales of new cars in China were increasing by 30-40% annually.

At the time, I was astonished to see those numbers. You could say that the Chinese market was like the Holy Grail of automakers worldwide. In such a rapidly developing market, any company in the auto sector that got its foot in the door — suppliers, manufacturers, 4S dealers or repairmen — could make a fortune.

Previously, only a small group of people could afford a car in China. But during the past decade, this group began to expand, even though car prices were still quite high. For many new car buyers, then, their first car was probably the most expensive thing they’d ever bought in their life, with perhaps the exception of their home. Therefore, people tended to be very wary about making the purchase. In such a situation, the 4S dealerships had one major advantage over the large car lots: the sense of trust they gave.

At that time, if you bought a car at a large car lot, you generally had no contact with the vendor ever again after making the purchase. If a problem arose with the new car and you returned to the lot to find the guy who sold it to you, he might have vanished without a trace. On the other hand, it was integral to the 4S model that customers could always return for service if problems arose. Therefore, many consumers felt that 4S dealerships provided a sort of guarantee that the earlier car lots could not. The ability of 4S dealerships to assuage consumer anxiety in this way was the key to its rapid expansion.

Q. After the 4S concept emerged, it proved extremely popular, and 4S dealers made a ton of money. But recent reports suggest some 4S dealers are now encountering major difficulties, with over 80 percent of dealers along China’s east coast incurring losses. Why is that?

A. Actually, what’s going on now is the situation is returning to normal. The profits made by 4S dealers from 2003 to 2005 were truly extraordinary. In the most extreme examples from the time, there were cases of people making returns on their initial investment within three months, and it was fairly common for this investment to be made back within two years.

So what was the cause of the phenomenon? The ferocious rate of expansion of the market for cars in China. China was one of the last untapped markets for auto makers, and so it’s not surprising that the past ten years have seen both astounding increases in sales of new cars and the entrance into China of almost all the major international car makers.

But with the arrival of these companies, the market began to mature rapidly and the realities of the situation began to catch up with the car dealers. After all, 4S dealerships are a business with a high threshold to entry. Each one generally requires around RMB 20 million ($2.9 million) in start-up capital, or even more in large cities like Beijing, Shanghai, or Guangzhou. In the early days of 4S, the high profits available meant that the number of dealerships boomed despite this threshold. But once the market matured, it caused competition within the industry to intensify, and the time it took dealers to get a return on their investment got longer.

For example, when a 4S dealership sold a car several years ago, it could make profits of RMB 30,000 ($4,400) or more, or even RMB 100,000 ($15,000). These days, profits are much slimmer, to the extent that if a dealer can make RMB 3,000 ($440) on a sale, he’ll be ecstatic. Still, we should remember that profit margins and ratios are still much higher in China than they are in the United States. Therefore, we can see that the decline in profits came as the industry expanded rapidly.

In part because of this, earnings from the sale of new cars is no longer the main source of profits for 4S dealers. In the early days, almost 80% of profits came from sales. Today, new car sales only contribute 20% to dealers’ net earnings. This is true both in China and in the U.S., where most dealers make very little money on sales and instead rely on other services to make a profit.

But dealers in China face an added difficulty. While Chinese consumers do go to 4S dealerships for tune-ups in the period covered by the warranty, they prefer not to pay the high costs charged by 4S dealers after the warranty expires. Instead, they take the cheaper alternative of going to a street side repair garage. Since the car repair industry in China is very developed, particularly at the middle and lower end of the market, going this route is both more convenient than, and as little as half the price of, going to a 4S dealer. So the 4S industry is under heavy pressure from two sides: competition in new car sales has become far more intense, while cheaper repair shops deprive them of the high profits they might otherwise expect.

One other important factor in the decline of profits involves the relationship between car manufacturers and 4S dealers. Because each 4S dealership is beholden to a particular brand of cars, the manufacturer of that brand has a great deal of leverage in dictating what its 4S dealerships should be like. For example, they can decree how large a 4S dealership can be, what level of customer service it needs to offer, what types of repair services it needs to provide, etc.

Because of the huge profits that 4S dealers used to be able to make, car factories became accustomed to making extraordinary demands in this regard, asking more from Chinese dealers than they would from dealerships in other countries. For example, in Europe, a Volvo dealership I saw was just a small storefront; in Beijing, the same dealership would invariably be housed in a huge, luxurious space decked out to rival a five-star hotel lobby! In China, if a dealer doesn’t provide this sort of space, they can’t get permission from a car manufacturer to display and sell their cars. Even though 4S dealerships no longer making big profits, manufacturers continue to expect these standards.

Q. You said there are three reasons 4S dealerships are now suffering: the increased maturity and competition in the market; the competition with car repair garages; and the relationship with the manufacturers. How can the 4S model respond to these pressures?

A. The whole industry needs find a new balance. Manufacturers need to realize that the pressure they’re exerting on the retailers is damaging sales. Perhaps they should let the dealers make a better profit. Of course this type of realignment will take time. Furthermore, there will need to be changes within the 4S sector itself. There are over a thousand 4S dealerships throughout the country for certain brands of cars. The sector needs to undergo some rationalization and slimming down. This is already starting to happen. I noticed that a few dealers have realized that they’re unable to compete and are trying to get out of the market. But the threshold to leaving is also very high. You can’t get back the ten million RMB you may have invested into the dealership.

Some dealers are trying to move up into the high-end market, since that’s easier than leaving altogether and can help maximize the profit they get from each sale. But no matter what, some dealers are going to be eliminated.

In the near future, 4S dealers will be just trying to maintaining their position; there won’t be much more expansion. Only after a healthier balance is reached, with everyone involved making a realistic and reasonable level of profit, will the car industry start to move forward again.

Q. Do you think that other methods of sales such as websites will replace 4S dealerships as the main way to sell cars?

A. Looking at the experience of other mature markets, I think that 4S dealers will stay the primary distribution channel. To the best of my knowledge, nowhere in the world is there a model in which buying a car is done completely online, because of the way cars are: buyers want to test drive first. The biggest role of online car websites is as an information provider, and there is a lot of information you need when you buy a car: technical specifications; and comparisons of different brands. The advantage of websites is that they can turn this ocean of data, facts and figures into something that is easy to understand. But learning all about a steering wheel does not, and never will, replace the experience of actually trying it out and feeling how a car steers. This is especially true in China. In the U.S. and other developed markets, there may be some consumers that go into the process knowing that they want a certain brand of car, a certain model, a certain color, and these consumers could perhaps complete the entire transaction online. But in China, where many consumers are buying a car for the first time, this would be almost impossible.

The way it works in the United States is that consumers can look at the car and buy it directly from the factory’s website. But in the end the website will direct them to a 4S dealership close to where they live to make the purchase. So the dealership continues to play an indispensible role in actually carrying out the transaction. I expect China to gradually move toward this model.

Q. Will we see new forms of marketing emerge specifically catering to the Chinese market?

A. I think we’ll see new forms of marketing emerge that are new to China. But the car market worldwide is very mature; between the American, European, and Japanese markets, almost every method and strategy of marketing cars has been tried. So there’s not that much room for innovation left. What’s more likely is that one of the methods that’s already been tried elsewhere, but not yet in the domestic market, will be brought to and implemented in China. I think the most likely one we’ll see is long-term car leasing, which has become very popular in the United States.

American dealers have realized that most consumers only use a new car for three to five years before selling it to buy a new one. Therefore, they have begun to lease out new cars to consumers for a limited period of a few years. In the US, over half of all new cars are “sold” in this way; at the high end, the rate reaches 80%. In this way, the dealers promote efficient use of capital and stimulate consumer demand; it’s better for consumers, dealers, and car manufacturers alike.

But this model does not yet exist in China, for several important reasons. First, the Chinese used car market is extremely chaotic. For consumers, information on all aspects of product quality is nearly impossible to obtain and verify. Without a more mature used car market, there’s no way that a healthy auto leasing industry will emerge.

This is because there’s no way to determine what a used car’s market price will be after, say, three years. As a result, dealers can’t work out the pricing for a three year lease. Furthermore, China’s financial system currently offers little or no way for dealers to make money by leasing out a car for less than its full, factory-new market price. Still, if these issues are worked out, the model may prove beneficial to China’s auto industry development.

Q. How has car branding evolved in the last ten years? Do companies and consumers pay more attention to it than they used to?

A. Absolutely. I think the role played by the car in Chinese society today is very similar to the one it played in the US in the 1950s and 1960s, and the marketing reflects this. In both eras, the car had just become a part of everyday life for the masses; for many, it was the age when they could buy a car for the very first time. When private individuals started being able to own cars in China ten years ago, the car represented unprecedented freedom and convenience. Before, you lived your life in a tightly defined radius; you couldn’t get anywhere more than half an hour to an hour away by bicycle from where you lived. A car changed all this, and people realized it. What they focused on, then, was the new lifestyle that a car defined; the brand of car wasn’t terribly important.

Today, cars are far more common, and the public has become a lot more discerning. There are more reasons why people buy cars: to commute to work; to help care for children; to make life more convenient; and to serve as a status symbol.