3/28/13

GROWING PAINS

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

Don Davis , Editor in Chief

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.

Analysts typically put Taobao's sales into the category of consumer-to-consumer, or c2c e-commerce, even though most of its sellers are entrepreneurs who buy goods from Chinese manufacturers or wholesalers to sell on Taobao. They characterize as business-to-consumer, or b2c, the sales that take place on more regulated marketplaces like Tmall and through the e-commerce sites of major retailers. And that portion of e-commerce is now taking off. While Macquarie estimates that c2c sales this year will be more than double b2c sales, it projects 55% growth in b2c through 2015, versus 35% in all of e-commerce.

Taobao's early dominance of e-commerce has trained Chinese consumers to turn first to online marketplaces for a vast array of merchandise and low prices. To compete, major competitors have created their own web shopping malls in hopes of offering comparable selection. These include companies that have raised large sums from venture capitalists and public share offerings, such as 360buy.com, No. 2 among Chinese e-commerce companies, which has raised more than $2.2 billion, and No. 10 Dangdang, which pocketed $272 million in its 2010 IPO. (Jingdong announced in March 2013 it was changing its e-commerce domain name to JD.com from 360buy.com, and introducing a new mascot, a dog named Joy.)

For a company like Le Saunda, a Chinese manufacturer of high-end shoes that's been selling online for two years, the prospect of trying to draw enough online shoppers to its own e-commerce site is still too daunting. To promote "self-built web site sales, you need a lot of promotion in order to have enough customers," says Ken Yang, e-commerce director. Instead of building its own site, Le Saunda operates storefronts on marketplaces like Tmall, 360buy, Amazon.com.cn (No. 8 among Chinese e-commerce sites), Yintai.com (No. 28) and Dangdang.

These marketplace operators compete fiercely for the loyalties of Chinese consumers, and of the retailers that sell on their sites. Last summer, for example, 360buy launched a round of well-publicized price cuts that were quickly matched by competitors Suning and Gome. The prices were so low the government warned retailers not to violate laws against selling goods below cost.

To woo sellers, such major players as Alibaba, 360buy and Suning offer loans to online retailers. That's important because small companies have trouble getting loans from China's banks that prefer to lend to the country's giant state-owned companies, says Julia Q. Zhu, who previously worked at Alibaba and recently founded consulting firm Observer Solutions in Washington, D.C. Alibaba's AliFinance arm has made more than 200,000 loans since starting its program in 2010, handing out $2.2 billion in the first half of 2012. The average loan is $10,200, Alibaba says, and is often used to buy merchandise.

Big marketplace operators are also competing in fulfillment, building extensive delivery networks in a country without a national delivery service like UPS or FedEx. 360buy announced in November it would let other retailers use its service that provides same-day delivery in 23 cities and next-day delivery in more than 150 cities. The 360buy service includes collecting cash on delivery, a payment method used in as many as 80% of Chinese e-commerce transactions, Macquarie says, in a country where credit cards are not commonplace. Alibaba announced in January it would work with major financial institutions, logistics companies and retailers on a $16 billion project to create a nationwide delivery network.

These investments and price wars take their toll on profits. While Alibaba is profitable—the privately held company reported to part-owner Yahoo Inc. net income of $782 million on $2.9 billion in revenue for the nine months ended June 30, 2012—many of its competitors are not.

VIPShop, No. 13, proudly reported a $6.3 million profit in the fourth quarter of 2012 and a full-year loss of only $9.5 million compared with a $156.5 million loss in 2011; Dangdang increased revenue 44% in 2012 but its operating loss increased 94% to $71.2 million. Jingdong Mall, operator of 360buy.com, projects finally becoming profitable in the fourth quarter of 2013.

The losses may be cooling investor excitement. One indication: Chinese group-buying site Lashou, which raised $155 million in three investment rounds, put off an IPO planned for 2012.

In the face of this tough competition, Western retailers have had mixed results selling online in China. Amazon, the dominant e-retailer in North America and Europe and No. 8 in China, acquired Chinese online bookseller Joyo in 2004, rebranded it Amazon.com.cn and expanded into general merchandise and as a platform for other sellers. Amazon executives emphasized in January plans to step up investment in China, where it operates 13 distribution centers, according to MWPVL International Inc., a logistics consulting firm. Wal-Mart, which does not operate its own e-commerce site in China, last year raised its stake in Shanghai-based Yihaodian, No. 24, to 51%.

However, U.S. home improvement retailer Home Depot Inc. closed its seven bricks-and-mortar stores in China last year, and Metro Markt, the consumer electronics retailer subsidiary of Metro AG of Germany, announced in January it was closing its stores and e-commerce site. Meanwhile, U.S.-based Toys 'R' Us and luxury goods retailer Neiman Marcus announced plans late in 2012 to begin selling online in China.

Another U.S. brand that launched its own e-commerce site last year is handbag manufacturer Coach Inc., which went live in November at Coach.com.cn. Coach, which operates 70 stores in China, projects selling $300 million there this year, but did not break out an online projection.

Most Coach stores are in China's largest cities, and the new e-commerce site is attracting new customers—it has shipped to customers in more than 110 cities, many where there are no Coach stores, says David Duplantis, executive vice president of global digital media and customer engagement. At least 40% of purchases on Coach.com.cn are by new customers.

There are challenges, including the many unauthorized web sellers of Coach products in China. The Coach site emphasizes that it is the only authorized online seller of Coach goods in China. "China is the only market where we have to do that," Duplantis says.

That's just one of many peculiarities of China that Western retailers will have to understand if they are to be successful in what will soon be the world's largest e-commerce market.

don@verticalwebmedia.com

@dondavisIR

Alibaba: China's e-commerce goliath

While Amazon.com Inc. accounts for roughly 30% of U.S. online retail sales, Alibaba Group Holdings Ltd. commands about 80% of China's e-commerce market.

Jack Ma, a former English teacher, founded Alibaba with 17 associates in 1999, aiming to use the Internet to assist Chinese entrepreneurs. In 2003, they launched the online marketplace Taobao, which attracted millions of sellers by charging them no listing or commission fees. Today, Alibaba says 6.6 million merchants sell on Taobao and there are 500 million registered shoppers.

Aiming to attract bigger brands to a less bazaar-like site, Alibaba in 2008 launched Taobao Mall, later renamed Tmall, which today hosts 50,000 storefronts representing 70,000 brands. Unlike on Taobao, brands pay Tmall an annual fee of $5,000 to $10,000 and a commission of 1% to 5%.

Alibaba created several other web-related businesses. Among them is Alipay, a PayPal-like service that claims 800 million registered accounts and some $350 billion in 2012 transactions, including payments of utility bills and peer-to-peer transfers. Another is Alibaba.com, a web portal that some 29.4 million users, including many Western web retailers, use to source goods from 2.5 million suppliers, many of them Chinese factories.

Alibaba has had its missteps. In early 2011 the company disclosed that 100 of its employees had helped 2,300 Alibaba.com suppliers commit fraud. Alibaba fired the employees and by February 2011 had paid out nearly $2 million to defrauded buyers from its Fair Play Fund, created in December 2009 to compensate buyers in case of fraud. Also in 2011, the U.S. government added Alibaba to a list of "notorious markets" where pirated and counterfeit goods are freely sold. Alibaba, which says it took 63 million dodgy items off its marketplaces in 2011 and employs 200 people to prevent trademark violations, was removed from the list in December 2012.

Alibaba also made news last year when it raised $7.6 billion to buy back about half of the 40% interest in Alibaba held by Yahoo Inc., in a deal that valued Alibaba at roughly $40 billion. Alibaba is widely expected to go public in 2013 or 2014.

Meanwhile, Ma, now said to be worth $3.4 billion and China's 11th-richest billionaire according to Forbes magazine, announced in January plans to resign as CEO. "At 48 I am no longer young for the Internet business," Ma wrote in an e-mail to the company's 24,000 employees. He will remain as executive chairman.

Topics:

360Buy.com, Alibaba Group, Andrew Stockwell, China e-commerce, Coach, Dangdang, David Duplantis, Gome, Jack Ma, JD.com, jingdong mall, Macquarie Capital, Peggy Yu Yu, Suning Commerce, Taobao, Tmall, Vipshop

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