Thu. Aug 6th, 2020

The Future of E-Commerce and Retail Will Be Written in China

7 min read
The Future of E-Commerce and Retail Will Be Written in China

We believe China is ground zero for the future of
retail and the West will learn from and adapt the experiments that are already
moving to scale in the East.

Consider Alibaba, the Chinese Internet giant whose
wide-ranging businesses span e-commerce, offline retail, fintech, online video,
maps and browsers, and artificial intelligence. By end of its latest fiscal
year (March 2019), Alibaba’s business model appeared to have reached peak
fruition, as the company took pole position as the world’s largest e-commerce
platform with a GMV (gross merchandise value) of over US$850 billion (a factor
of well over 2x Amazon, which moved some $300 billion of goods in calendar year
2018), but was also third in digital advertising, just behind Google and
Facebook. What could possibly change?

Experiments
in retail

A lot has been changing at Alibaba in the past two
years, above and beyond the headline GMV metric. Alibaba’s experiments in what
it calls “new retail” have gained a scale and urgency scarcely imagined a year ago.
Over 1.3 million of China’s 6 million mom and pop stores have signed up for the
company’s Lingshoutong initiative.1 Lingshoutong refits the shops,
supplies them directly using Alibaba’s logistics channel, aggregates offline
and online data, and extracts a monthly commitment of throughput in return.

Additionally, Alibaba’s high-tech food/grocery retail store
concept, known as Hema, is expanding quickly. Figure 1. These outlets serve as walk-in restaurants, food and
grocery purchase points, and warehouses for online delivery (within 30 minutes
in a three-kilometer radius)–all at the same time. There are now 170 Hema
stores in operation (as of September 2019), with two being added each week.
Already, Hemastores in operation for
over 18 months are reporting revenues of 50,000 renminbi per square meter, up to
five times what traditional offline stores can generate. Sixty percent of Hema’s
sales are through the online delivery channel, making the stores far more
productive, for far more hours of the day, than pure offline stores.2

Figure
1: Hema’s footprint is expanding rapidly

Sources: Alibaba quarterly disclosures.

Unsurprisingly, China seems uniquely ready to adopt
the Hema concept. Organized channels for groceries are currently underdeveloped
compared to those in the United States, where over 90% of groceries already
pass through established super/hypermarkets. In China, wet
markets, the Asian equivalent of farmers markets that sell fresh meat and
produce, still account for more than 70% of the country’s grocery sector. This
signifies the boundless potential for Hema as it keeps on driving the new
retail experience involving online and offline integration.  Figure
2.

Figure
2: How China shops for food versus the United States

Source: Alibaba presentations, 2018 Investor Day, Sep 17-18, 2018.

There is more. Alibaba’s online shopping Taobao
platform is no longer content with making ad-based recommendations, which were
driven by keyword bidding by merchants. Recommendation feeds driven by consumer
opinions have gained priority, as have sharing, short-form videos, and live
streams. Taobao claims a 58% improvement in conversions when users view short-form
videos. Additionally, gross merchandise value (GMV) driven by live streaming
rose nearly four times in the past year.3

Ambitions are also rising at the recently acquired Ele.me,
an online food delivery platform. Not content with its over 200 million user
base, Ele.me is now eyeing the nearly 800 million e-commerce user base of Taobao
and Tmall, another Alibaba e-commerce platform, and the 900 million users of Alipay,
Alibaba’s digital payments platform, to substantially expand its reach.4

Retail space owned by Intime Retail–now a part of
Alibaba–is being used for experimental “Tmall pop-up stores,” which allows
consumers to walk in, sample inventory, access a large apparel collection on
giant touchscreens within the store, pay with Alipay, and choose self-pickup or
home delivery. Alibaba also has a furniture store that uses augmented and
virtual reality to show consumers how an item will look in their homes. And retail
stores owned by Sun Art Retail, in which Alibaba has a 31% stake, are
dedicating space to products directly sourced from Tmall. These products can be
sampled with an eye to the online purchasing habits of people in the immediate
vicinity of the store–tastes the offline store may not have been aware of
before, but known to Alibaba via its ecommerce operations. Greasing the wheels
of this transformation is a planned logistics investment of $15 billion over five
years.5

The
need for a retail transformation

Is there a method to this cornucopia of initiatives?
Alibaba’s new long-term target to transition from working with 10 million small
and medium enterprises (SMEs) to 10 million profitable
SMEs provides a clue.6 As e-commerce penetration rises to nearly 20%
in China,7 the existing silos of offline and online retail raise
vital questions: Are brands and merchants more profitable, or less, as e-commerce
grows larger? Does Alibaba’s rising “take rate”–the percentage of GMV that
flows into revenues–come at the expense of its merchants’ profitability, or is everyone
truly better off–do merchants enjoy better profitability even as Alibaba raises
its own monetization?

These questions create a fundamental need to transform
the way retail works. Analysis suggests that between 2011 and 2016, when e-commerce
grew dramatically in China, selling, general, and administrative (SG&A) costs
rose significantly for several retail categories as they tried to keep up. Figure 3. Specifically, consumer
appliances saw their SG&A costs rise 340 basis points, apparel saw a near
500 basis point rise, and personal care spent 80 basis points more.8
These rising costs reflect the parallel universes that exist today: offline
retail channels, demand management, space planning, supply chains, and consumer
analytics have little in common with e-commerce. Increasingly, brands and
merchants seem to be running two businesses for the same product, which unsurprisingly
leads to cost inflation.

Exhibit
3: Across categories, SG&A costs have risen with sales

Source: Bernstein Research, as of 12/16. SG&A refers to sale, general, and administrative costs.

The true promise of omnichannel retail, or new retail,
is a more profitable merchant. The future economics of giant e-commerce
platforms will likely emerge from this promise, and the hope that these
platforms will not simply maintain their share of a shrinking pie, but maintain
or increase their share of an expanding one. Not content to be appropriators or
gatekeepers of consumer demand, these platforms increasingly aim to help
fundamentally change the way consumers shop.

Points
of friction are likely

Not all will be smooth, of course. The real world possesses
far more points of friction than online businesses traditionally encounter.
Offline or omnichannel initiatives address a target market that is five times
larger than online retail, but one-fifth as profitable, or even less so in the initial
years after they’re introduced.9 Even as the strategic rationale for
ongoing initiatives is inescapable, reported profitability is likely to head
downward and stay volatile. Indeed, fundamental questions linger. What shall we
consider GMV in an omnichannel world? Will walking into a Hema store be
considered “offline,” while ordering the same food via the app be considered
“online”?

Elsewhere, the expectations of consumers and merchants
will remain fluid, exposing new threats and opportunities. Consider Pinduoduo (PDD). Founded in 2015, PDD has grown
quickly to become China’s third largest e-commerce platform and has attracted 430
million annual active buyers to its unique model of social commerce, a group-buying
model that weaponizes social networks such as Tencent’s WeChat to propagate
offers. PDD’s rise offers inescapable proof that there are still unmet consumer
needs, despite everything we have already seen in China. And merchants need
more too–more analytics, higher returns on their ad spends, and more
handholding with their supply chain and IT systems. There are companies seeking
to address these needs: Meituan, for example, is not just China’s largest food
delivery and restaurant booking platform, it also provides restaurant
management software that is helping to cement its lead. Elsewhere,
ByteDance–the owner of the vital Douyin short-video platform in China (known as
Tik Tok internationally) does not seem contend with entertainment alone and the
firm is rapidly moving into shopping. As of now, its short-video content
synchronizes into shopping opportunities into Alibaba, JD and others, but it
may expand its own marketplace too, if industry chatter is to be believed.

And thus, to the future of retail. What drives
shopping? Needs, of course, but also habits, impulses and, increasingly, fun.
Shoppers seek convenience, price, and experience, but also identity and social
connection. In the future, will it really matter where we notice a product,
where we try it, pay for it, or how it is delivered to us? These ideas are not
new, but as e-commerce platforms and offline retail move into each other’s
turf, they have acquired an immediacy not seen before. Theory is moving into
financial forecasts, and extant silos of thought are beginning to be challenged–just
earlier, and faster, in China.

Footnotes

  1. Source: Alibaba presentations, 2019 Investor
    Day, Sep, 2019.
  2. Source: Alibaba quarterly disclosures.
  3. Source: Alibaba company reports.
  4. Source: Alibaba company reports.
  5. Source: Alibaba company reports.
  6. Source: Alibaba company reports.
  7. Source:
    China’s National Bureau of Statistics, 2017 penetration had reached the high
    teens.
  8. Source: Bernstein analysis.
  9. Note: Assuming a 5% offline retail profitability
    at scale.

Important Information

Blog header image: d3sign
/ Getty

An investment in emerging market countries carries
greater risks compared to more developed economies.

The
risks of investing in securities of foreign issuers, including emerging market
issuers, can include fluctuations in foreign currencies, political and economic
instability, and foreign taxation issues.

The mention of specific companies,
industries, sectors or countries does not constitute a recommendation on behalf
of Invesco.

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