March 28, 2013, 3:45 PM

GROWING PAINS

E-commerce growth in China is explosive, but profits are woeful. And everything's changing.

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In no market will consumers buy more online than in China by 2014, if trends hold, and in no market will so many major online retailers lose money filling those orders.

It's the China paradox: Growth is so explosive that investors are pouring money into Chinese e-commerce, fueling profit-killing price competition. Chinese e-retailer Dangdang, which went public in December 2010, has since seen many rival web merchants, backed by venture capital, trade profits for business-to-consumer e-commerce market share, the retailer's executive chairwoman told analysts last fall.

"Before and after Dangdang's IPO there was a huge inflow of billions of U.S. dollars into the b2c segment in China," Peggy Yu Yu said. "Selling at or below cost became an easy way for some companies to pump up sales." Dangdang is No. 10 among Chinese online retailers in the newly published Internet Retailer Asia 500 guide.

That ferocious price competition hasn't stopped global brands and retailers from joining China's e-commerce fray since China's entry into the World Trade Organization opened the country to foreign retailers in 2004. Tmall, a major online marketplace operated by Chinese e-commerce behemoth Alibaba Group Holdings Ltd., now offers products from 2,000 non-Chinese brands. And such major companies as Toys 'R' Us Inc., The Estee Lauder Cos. Inc. and Coach Inc. have launched their own e-commerce sites to sell directly to Chinese consumers.

There are big opportunities to sell online in China, says Andrew Stockwell, vice president of Asia/Pacific for research and consulting firm Forrester Research Inc. But global brands need to take into account the challenges in making delivery and accepting payment, the huge scale of e-commerce and, especially, how fast online retailing is changing in China. "The strategy you develop for the next six months can't be your strategy for the next 18 months," he says.

They also need to understand the mindset of China's newly emerging middle class, who will spend their growing disposable income on status symbols, but not on premium-priced everyday products, Stockwell says. "Nobody is going to spend a lot on toothpaste because nobody will see that," he says. "But a handbag, clothing or a mobile phone, they will save three months for that because it's a symbol of wealth and affluence, which is more important in China than in the rest of the world."

And those buying high-end goods value global brands. In a 2011 Forrester survey of Chinese luxury shoppers, 42% said they prefer foreign brands because they offer better-quality goods.

However, Chinese consumers are buying all kinds of goods online, mostly from Chinese e-retailers. The web accounts for 8.1% of total retail sales in China, according to the Internet Retailer Asia 500 guide, compared to 5.2% in the United States.

What's more, with e-commerce in China growing so fast—53.7% in 2011—China's e-retail sales soon could outpace those of the United States. China's Ministry of Commerce reported last year that online retail sales in 2011 totaled 782.56 billion yuan ($125.9 billion). By contrast, U.S. online retail sales grew 15.8% in 2012 to $225.5 billion, according to the U.S. Commerce Department.

China's e-retail sales will reach $258.2 billion in 2013 and $331.7 billion in 2014, predicts Macquarie Group Ltd., part of Australia-based financial services firm Macquarie Group Ltd. If U.S. e-commerce grows at 16% for both 2013 and 2014 it would total $261.6 billion this year and $303.4 billion in 2014, putting China first in e-commerce next year.

Behind the e-commerce explosion is a two-decade-long economic boom. From 1993 to 2011 China's economy grew by more than 16 times, an annual growth rate of nearly 17%, according to World Bank statistics. By 2011, China was the world's second-largest economy, trailing only the United States.

Much of the new wealth has gone to an emerging middle and upper class, who mostly live in China's biggest cities. Boston Consulting Group says the 120 million most affluent Chinese command $590 billion in annual buying power, and that the affluent will grow to 20% of China's population, or 280 million consumers, by 2020.

Along with this robust income growth has come greater use of the Internet, and not just among the urban elite. There are 570 million Internet users, 42% of the population of 1.354 billion, and 220 million online shoppers in China, according to eMarketer Inc., a U.S. market research firm.

Online retail is growing rapidly in part because China's retail industry was so weak. Many Chinese department stores for years leased space to suppliers, gaining none of the expertise in gauging trends and consumer marketing that Western chains acquired. (Notable exceptions are two national chains of consumer electronics stores, Suning Commerce Group Co. Ltd. and Gome Electrical Appliances Holding Ltd., both of which compete aggressively online. Suning is No. 4 among Chinese e-retailers in the Asia 500 and Gome No. 16.)

As a result, Chinese retail remains highly fragmented, with the top 100 merchants representing only 11% of retail sales, says consulting firm Grant Thornton LLP, roughly the same percentage that Wal-Mart Stores Inc. alone commands of U.S. retail sales.

That left a vacuum that Alibaba Group Holdings Ltd. filled. The company launched Taobao as an eBay-type marketplace for small sellers in 2003—and drove eBay Inc. out of China by charging sellers no fees, instead earning revenue mostly through advertising. As Taobao became an increasingly large online flea market—where big brands mixed with startup retailers—Alibaba in 2008 created a second online marketplace, Tmall, for larger retailers willing to pay sales commissions.

Alibaba's two marketplaces account for more than 80% of e-commerce sales in China. Alibaba reported in December 2012 that it has surpassed 1 trillion yuan ($160 billion) in sales on its two marketplaces in the first 11 months of 2012. Tmall says its sales for 2012 totaled 200 billion yuan ($32 billion), double its 2011 sales. The Asia 500 Guide estimates Taobao's 2012 sales at $138 billion.

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