The competitive environment is intensifying with the disruptors themselves becoming disrupted. After the sector’s long run of success, investor preconceptions on barriers, network effects and incumbency benefits now need to be re-evaluated.
Host: Greg Kuhnert, Co-Head of 4Factor
In conversation with:
Varun Laijawalla, Emerging Markets Equity Assistant Portfolio Manager
Niall Hartnett, Analyst
Anindita Nag, Analyst.
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Over the last few years, the Chinese e-commerce space has faced significant disruption. Accounting for in excess of 30% of total retail sales, this is now higher than the US, where e-commerce is only 24%. The gross merchandise value of all online sales in China has been growing at a compound rate of 31% since 2013, showing tremendous growth and a very, very big opportunity.
In 2014, when Alibaba debuted on the US stock market, it had 87% share of the Chinese online retail market. Over that time, Alibaba has grown its revenues from US$5.5 billion to US$105 billion. However, their market share in their core e-commerce business has dropped to 55%, so there has been significant disruption in this sector over the last few years, especially occurring during the COVID period.
A key disruption has been in segmentation. What I mean by this is, if you are an American and you want to buy a new product, then you will shop on amazon.com. If you want to buy a second-hand product, you will shop on ebay.com.
Historically, China e-commerce was the same, albeit much, much simpler to navigate because of its duopoly structure. If you wanted to buy electronic goods, you would go to jd.com and, if you wanted to buy anything else, then you would go to Alibaba, using either Taobao for generic products or Tmall for branded products.
What is changing and what new entrants into China’s e-commerce space are realising is that product segmentation is not the only way to organise e-commerce. E-commerce can, in fact, be organised by audience segmentation too. Now that difference sounds subtle but really it is quite important because what it means is that e-commerce is no longer about merchandising and product curation per se. Rather, it is about aggregating audiences often through digital initiatives entirely separate to e-commerce.
So, for example, one of the disruptors we have seen in e-commerce so far is Pinduoduo, a social e-commerce platform, which has grown from nothing to 13% share of the industry in just five years. More recently, we have seen Meituan, which is better known for its food delivery app, break into the industry of community group buying. Going forward, we think investors will hear a lot more about digital platforms edging into e-commerce.
Why investors should care about this is because the disruptors are becoming disrupted. Preconceived ideas around barriers to entry, competitive modes, network effects and incumbency benefits are all under threat from this change.
Community group buying is a relatively new retail business model in China and revolves almost entirely around two key pillars: firstly, well-established online ecosystems; and, secondly, the strength of social media. As opposed to traditional grocery shopping, buying in this model works on a pre-order basis. Consumers go onto WeChat or a Mini Program, where they can see a list of products being offered by their group leader, who is usually the owner of a small local business, and they will place their order with the group leader. By the next day, these goods will have been procured and delivered to the group leader for the consumer to collect.
The model has been most successful in lower tier cities, where, in addition to value and convenience, consumers also get greater product variety. This is because their small local grocery store usually won’t have the scale or sourcing capability that a large CGP platform like Meituan can offer.
We have been more interested in trying to understand what benefits entering the industry can provide to the platform. Relative to running a supermarket or a traditional online grocery platform, we think the key benefit of using a model like this is lower operating costs to the platform. The main benefit that platforms are experiencing is being able to tap into a much wider range of customers.
What really makes entering the industry attractive to a platform like Meituan or Pinduoduo is that, over time, they should be able to cross-sell higher margin products from their other businesses to these grocery consumers and, therefore, a few years down the road, they will be able to monetise a much larger customer base.
We see the community group buying market as a large and attractive market. This clearly hasn’t been missed by the industry participants and the competitive environment has been intensifying rapidly, with most major internet companies entering the space, either directly or indirectly, over the last year.
Eventually, however, there should be room for an oligopolistic market structure in this industry. It is likely that the online grocery market in China will have perhaps 3-5 incumbent players, which should present a range of opportunities to us. As we see it, the optimal scenario for the industry would be that multiple players can continue to operate several models.
I think the 4Factor framework is really quite helpful in evaluating opportunities, particularly in this sector. Let’s take as an example the market darling, which is Alibaba. If you look at this stock today, it has got 59 buy recommendations, not a single sell recommendation. However, I would argue that, if you evaluate this business through the 4Factor lens, you will end up with much more of a nuanced view of what is actually happening on the ground. It is, undoubtedly, a high-quality business that has generated almost US$90 billion in free cash flow over the past five years. However, I think the more important thing is the change in their strategic positioning and that is something that really crept up on them in the past five years or so and that has come down to competition.
As Anindita discussed, competitive intensity has been dialled up in the industry. Now I think that is partially because Alibaba made a strategic mistake. Whilst they were very good at penetrating the higher tier cities (the Shanghai’s and Beijing’s), they actually left the door open for new competition to enter the lower tier cities and that oversight has given impetus to some of the disruptors (the Pinduoduo’s and the Meituan’s) to enter the market and aggressively capture share.
If you then switch gears and fast-forward to today and look at this business through the lens of earnings momentum, Alibaba has been forced to enter an investment phase. This is something that they have announced recently. To put it into context, you have got a business where the revenue line has come under pressure from that loss in market share but now you have a business where the earnings line has also come under pressure from that re-investment phase.
In summary, when we look at Alibaba, we see a business that has strategically been weakened and that change in strategic positioning is actually negatively impacting its growth and its earnings potential. As a result, we have taken a negative bet on it in our portfolios despite the fact that it is a consensus buy everywhere you look.
What you have heard from both Anindita and Varun is how those traditional e-commerce marketplaces, such as Alibaba, are being decentralised by these entrants and I think that the decentralisation theme is going to persist and it is going to be led by these social media platforms.
The largest social media platform in China is Tencent’s WeChat, which has about 1.2 billion monthly active users and also has a digital payments platform WeChat Pay set behind it. What Tencent’s WeChat launched in 2016 is something called Mini Programs. The way these Mini Programs work is that you can either scan a QR code if you have an on-demand need or you can search through your WeChat social media home page and find a Mini Program there. We are seeing WeChat Mini Programs start to really gain traction, becoming a medium for e-commerce transactions, be that when using transport or when in a restaurant or when shopping for products.
I think the key difference between China and the US is that the US industry structure means competition is more benign. While you could become incredibly concerned about the share loss from Alibaba through time, actually, the winner within the US so far is Amazon, and its share just seems to be climbing year-on-year-on-year. So, trying to apply the same concerns we have towards China to the US is quite difficult. What I think we should perhaps be focusing on though is, first and foremost, the rise of direct consumer selling and that is really through brands such as Nike, Yeti and Lululemon.
If there is a case to be made for platform competition increasing in the US, then the two assets I think investors should pay attention to are Facebook and its shops initiative and PayPal and its super-app initiative. This is going to take PayPal’s existing payments offering and combine it with a broader financial services and e-commerce offering.
Regulation is a question that we get most from clients – what does it all mean? If you looked at China 20 years ago and you looked at the Chinese companies specifically through the Emerging Markets Index, 20 years ago, 100% of Chinese companies within the index were state-owned companies, entirely run by state-owned entities, state-owned officials. If you fast-forward to today, three-quarters of the companies now are private enterprises.
So the game has changed quietly but quickly in China and I think what you are seeing from the regulatory standpoint is really the regulator, the government, waking up to that change that, unless they regulate their industries, it is really going to run wild and run free.
We don’t think that the motivation of the regulator is to destroy these industries, particularly, as we all know, China has put in place the Great Firewall (as it has been dubbed), which is a combination of legislative actions that have enabled the championing of their domestic businesses whilst limiting access to foreign players, like the Google’s, the Facebook’s and the Twitter’s of this world.
I suppose, by way of opportunities, the one stock that I think looks very interesting on a medium to long-term view, is (as Niall suggested) the non-traditional e-commerce fare, which is Tencent. I think why that business is so interesting is because it is, arguably, the one Chinese internet company with the strongest competitive moat and that stems from their ubiquitous WeChat messenger app.
To wrap some numbers around it, if we look at where the GMV (gross merchandise value) that goes through Mini Programs can get to by the end of next year and if we take that GMV and apply a multiple that its competitors (the likes of Alibaba, Meituan and PDD) are trading on, you can value that Mini Programs opportunity anywhere between US$80-120 billion and that is just looking two years out versus Tencent’s market cap today of around $US700 billion. So, you are looking at quite a significant amount of upside.
In summary, this is a very exciting space, where there is still tremendous growth opportunities, but I think what we have heard is that this is a space that has come under tremendous disruption over the last few years and that creates risks and opportunities. Now, perhaps on the risk side, we have seen community group buying as being a disruption from some of the new players like Pinduoduo and Meituan and we have seen the incumbents like Alibaba, JD, etc., basically getting out blank cheques and writing and investing blank cheques into the industry in order to be a significant participant.
In our view, we are quite cautious on that and, hence, if you look across our portfolios, we have taken capital incrementally away from that space, whereas the second type of disruption which we see - the social media sides of the businesses, short videos, messenger apps and what Tencent is doing - these represent new and significant opportunities to us and are potentially more favourable.
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