China will overtake the US to become the world’s largest economy by 2028, five years earlier than previously forecast, according to the UK based CEBR (Centre for Economics and Business Research). This bodes well for the e-commerce sector which accounts for a whopping 36% of total Chinese GDP today, compared to only 15% in 2008 . In this post, I will look at the particularities of Chinese e-commerce and how and why retail investors should want a slice of this pie.
The global e-commerce market is expected to grow at 16% compounded over the next four years (having already grown at 17% compounded over the last seven years). For context, that’s 1.5x the expected growth rate of the global smartphone market, 2.5x expected growth rate of home ownership and about the same as the forecasted growth rate for the Electric Vehicle market over the same period…so it’s a pretty big number,,.
This is being driven by changing consumer preferences over how and where shopping takes place and improvements in mobile technology to facilitate this transition. 67% of millennials already prefer to shop online (and 56% of Gen X-ers), when compared to brick and mortar. Of these, about half make purchases whilst sitting in bed, 23% at work (and 20% from the bathroom or in the car!), representing how mobile technology has been able to make shopping more convenient and fulfill our endless desire to do things on our own terms. These structural trends are not expected to go away any time soon particularly as a result of COVID-19 which has spurred increased online sales in most industries.
China led growth
Whilst the current global e-commerce market is around $4tn (roughly 5% of Global GDP), the bulk of this market share is in China, which boasts an e-commerce market almost twice the size of the US equivalent. E-commerce accounts for almost 35% of Chinese total retail sales, compared to only 10% in the US. To put this into perspective, approx. 50% of global online transactions each day, happen inside of China and the largest online retailer in China, Ali Baba, has almost double the number of active users on its platform that Amazon has globally (600m vs 330m).
As the first major economy to post GDP growth in 2020, the Chinese e-commerce market is facing two very strong tailwinds; a global structural trend away from brick and mortar to online, and high sensitivity to a booming Chinese economy, which is set to continue to grow 5-8% per annum over the coming decade.
Chinese e-commerce market
The Chinese e-commerce market is not identical to other markets.
- Mobile shopping
Mobile platforms generate 80% of retail ecommerce sales in the country (and 95% of total e-commerce activity) vs 64% globally. Put simply, this is because the average consumer in China spends more time on their smartphone (5 hours, compared with 3 hours globally). Given smartphone penetration is still far from reaching saturation (50% of the Chinese population), existing operators need to have a large-scale mobile retail presence to continue to expand.
2. Mobile Payments
This mobile technology has gone hand-in-hand with mobile payment platforms (such as Alipay, Wechat and Union Pay). In fact, 80% of smartphone users use mobile payments compared to only 27% in the US. The opportunities for newcomers in this space however are limited with Alipay (owned by Ali Baba) and Wechat (owned by Tencent) controlling 92% of the Chinese mobile payments market combined.
3. Omni-Channel Retail & Brand Awareness
The third distinction is that Chinese consumers are more discovery oriented than US consumers (i.e. they don’t always know what they want before they’re online), indicated by the former having more touchpoints with the brand before item purchase (8 touchpoints versus only 4 in the US). This has made omnichannel retail (selling across multiple platforms), international brands and interconnectivity with social networks, particularly important to drive retail sales in China.
Current State of Play
All three main players in the Chinese e-commerce market (Ali Baba, JD and Pinduoduo), cover some form of mobile retail, mobile payments and omni-channel retail but Ali Baba is miles ahead. This is because, whereas, JD and Pinduoduo both have secured strategic investments from Tencent to add additional services to their primary retail presence (e.g. mobile payments and social networking) Ali Baba has been able to integrate these functions across its existing businesses (such as Ali Pay and Lazada).
Resultingly, Ali Baba has the biggest slice of the pie with 60% market share, led by its Business-to-Consumer marketplace, Tmall. To put that into perspective, Amazon accounts for 40% of online retail sales in the US and is widely considered an e-commerce behemoth in the US.
List of Chinese e-commerce players
Tmall China (Ali Baba) – The third most visited site in the world and a brand driven B2C marketplace.
60% Market Share
JD.com (JD) – marketplace with in-house delivery and logistics.
20% Market Share
Pinduoduo – Group buying marketplace (like Groupon).
5% Market Share.
Others – (Wechat Store and Red/Xiahongshu)
~15% Market Share
Ali Baba as an E-Commerce Stock
Whilst Ali Baba is by no means a pure play Chinese e-commerce stock, 68% of FY 2019 revenues came from Ali Baba’s China based marketplaces (compared to 7% from international wholesale, 7% cloud computing, 6% entertainment and 4% logistics services). 85% of this in was via mobile sales. This illustrates that whilst Ali Baba touches many different industries, it is still very much a Chinese consumer focused, mobile e-commerce giant.
Ali baba strikes me as the most defendable business model within the Chinese e-commerce space. This is principally because it meets the threshold of having the strongest mobile retail penetration for the Chinese consumer (with higher gross margins), mobile payments integration and cross border retail presence to drive brand awareness.
Why Ali Baba is superior to competition
Strong Mobile Customer Penetration (and a more profitable business model)
Based on Chinese internet users of over 855 million, Ali Baba boasts an 83% penetration rate for its B2C and C2C platforms (Tmall and Taobao), which are the two largest online marketplaces in China. About half of the Chinese population are users of Ali Baba and over 85% of total yearly sales on Ali Baba’s platform, come from mobile (with total GMV larger than Amazon and Ebay’s yearly sales, combined). This deep penetration has allowed Ali Baba to leverage network effects across its platforms (the platforms drive traffic to each other thereby lowering acquisition costs) and as a result, Ali Baba is usually the first shopping experience for Chinese customers. This deep penetration has allowed the company to maximize revenue per user relative to its competitors (GMV per active user was CNY 730 versus CNY 143 for Pinduoduo and CNY 362 for JD).
Direct Customer fulfillment
Ali Baba is often described as the Amazon of China whereas in fact, it operates more as an ‘Ebay’ of China. Tmall, it’s B2C platform, gives businesses direct customer fulfillment so they manage the warehousing and shipping of goods to the end customer. This allows Ali Baba to charge servicing fees for marketing on its platform but it does not have to take inventory on its own balance sheet. This vastly improves the overall net income margin for Ali Baba which is 22% (vs 5% for Amazon, 1% for JD) and Gross Margin OF 44% (vs 40% for Amazon, 15% for JD).
Mobile Payments Technology
Ali Baba also owns a 33% stake in Ant Financial, a mobile payments and microlending platform. Ant has the largest share of the Chinese mobile payments market (54%) in an industry which is set to double in size by 2025. Wechat is second in size at only 38% market share. This dominant position has allowed Ali Baba a virtual monopoly on mobile payments as it can integrate this with it’s online e-commerce platforms.
Omni-Channel Retail via cross border e-commerce
Outside of China, Ali Baba is the furthest ahead in integrating its business with global brands and cross border e-commerce. This is primarily facilitated by Ali Baba’s controlling stake in Lazada, a South East Asia focused e-commerce business (with 200million active internet users across these regions). In these regions, e-commerce accounts for a meagre 3-5% of total sales reflecting lack of existing providers and strong runway of growth ahead. In 2009, Ali Baba also purchased Koala from rival Netease (integrated into Tmall) to build out its import strategy; allowing global merchants direct access to the Chinese consumer. This will allow Ali Baba to accelerate import/export services, have (exclusive) access to international brands selling into China, and drive brand awareness.
The biggest risks to backing this tech behemoth is regulatory uncertainty in China. The two specific risks to the price of Ali Baba stock (though these developments still have a corollary impact on the broader sector) are:
- Ant Financial
Ali Baba has a 33% stake in Ant Financial, whose long awaited IPO came to a grounding halt as Chinese regulators suspended the offering and proposed last minute changes to Ant’s business model. Whilst founded as an online payments platform, Ant has grown beyond this and this has become the sticking point for the regulators. 63% of Ant’s revenues come from matching consumers to lenders via its platform (this was 44% of revenues in 2017 speaking to the spectacular growth this division has experienced). Ant uses its own proprietary technology to provide customers with credit scores (Zhima credit scoring system), compiles lending risks and then securitize debt via third parties or to pass this on to conventional banks.
Chinese regulators want to treat these type of platforms as financial institutions and not tech companies, and resultingly want Ant to put up its own capital against these loans (30% of capital for joint loans with banks versus current 2%). This resultingly limits Ant’s leverage and growth rate, particularly if Ant also has to apply for new banking licenses.
Whilst Ant is not Ali Baba’s core business, the elephant in the room here is the Microlending/P2P scandal in 2008. During this period, China saw a rise in scandals and mismanaged debt which the government is keen to avoid the second time around.
My take on this is that unlike in 2008, the tech giants are providing a service which conventional banks have been unable to provide. Credit cards are not pervasive in China and financial records are largely inadequate in rural areas. This has limited access to credit in remote areas and to date, the biggest four conventional banks give out 75% of their total loans only in the form of mortgages (in 1H 2020). This has left a gaping hole for new microlending entrants who have the digital footprint and know-how to provide this service (and pick good borrowers from bad ones). Whilst Ant may be hamstrung by new regulations, this will likely come at the expense of short-term growth as this service cannot feasibly be performed by existing conventional banks or other private businesses without the same scale and expertise. In other words, the overall business opportunity remains intact but Ant will have to wait longer to achieve the same outcomes or at least, until regulators are more comfortable.
- Anti-monopoly Laws
The second major risk to Ali Baba is an overhaul of the existing competitive framework in China for e-commerce. As we established above, Ali Baba relies on its massive network to be as effective within the e-commerce space. However, in 2020, the Chinese government first applied a monopoly law to fine Ali Baba (alongside others).
The newly contested issue is platform integration or exclusivity arrangements that Ali Baba may have for that prevent users from going on other platforms. This is a big blow to the company and so far, it is unclear how this will play out, particularly as there are so many avenues that they could pursue this with Ali Baba. For me, this is the single biggest risk to the stock as Ali Baba relies heavily on its expansive network to be effective.
I am bullish China and Chinese e-commerce. Ali Baba is the natural choice for investment, as it’s the biggest, most exposed and the most defendable business operating in the sector. Ironically, the biggest risk to this position is that regulators see these strengths and force Ali Baba to concede market share to allow new entrants in the market. Despite this, Ali Baba is sizably ahead of the competition and has cemented a strong position with the Chinese consumer. This should make policies short of actively breaking up Ali Baba, to be nothing but a slow burn; as what pieces of business Ali Baba may eventually lose to competitors will likely be more than offset by its levered position (and natural monopolies) in this fast growing industry.
Verdict: Cautiously Bullish (pending impact of regulatory investigation)
Timeframe: 3-5 Years