Recently, we opined on the challenges for e-commerce in China, particularly with regards to trust, privacy, payments and logistics. We noted the distinctive characteristics of the Chinese e-commerce ecosystem, credited online platforms for providing convenience and choice, but expressed concerns regarding profitability. A year has passed and despite superlative growth in volumes, profitability remains unclear and questions about how traditional and e-commerce retail formats will work together in the future remain unanswered.

– Online Surge

E-commerce remains one of the most transformative forces shaping domestic Chinese consumer behavior. Total volumes have risen from RMB 3.6 trillion in 2009 to 12.7 trillion this year, with the number of online shoppers doubling to 270 million. Over the same period, traditional channels have only experienced 15% annualized growth. E-commerce has reduced distribution costs, enhanced price transparency, and provided an improved customer experience. It has also brought high quality branded products to third- and fourth-tier cities that have lacked department stores, shopping malls and well-known high street shops.

Although traditional retailers dwarf e-commerce in the absolute number of sales, the ongoing platform wars have resulted in fierce competition. From 2008, online as a percentage of total retail sales as increased five-fold, from 1.2% to 6.3%. In late 2012, Jack Ma, founder of Alibaba, repeated is oft-argued position that Chinese bricks-and-mortar businesses will be replaced by on-line shopping in the near future and spoke of a “new revolution” that will destroy the traditional retailing order. Jianlin Wang, Chairman of Wanda Group, argued instead that both are more likely to meet in the middle, re-enforcing one another to create a “win-win” scenario and presented Ma with a bet that online consumption would not surpass 50% of total retail volume, as Ma seemed to argue, within 10 years. The reaction? “Ma ultimately demurred.” However, on November 11, 2013, the so-called “Singles’ Day”, sales on Tmall, Alibaba’s flagship e-commerce property, reached RMB 35 billion sales, besting the 2012 figure of RMB 19 billion by 75%, giving credence to Jack Ma’s view.

– Online, Offline or Brand is King

Regardless of the size, the impact of e-commerce on traditional retail channels is disruptive. Consumers are increasingly “trying offline and shopping online.” The China Chain Store and Franchise Association released a report in April that 62 out of top 100 retailers have already established an online presence, up from 59 in 2012. However, only 9 of these retailers reported having revenue greater than RMB 100 million, but they are looking to grab a share of the pie. Extending sales from offline to online seems to be the best way for offline retail businesses to protect sales. Take furnishings retailing for example, but has presented challenges. Xinlinmen, a leading mattress and bedding company, recently announced a decision to implement an offline-to-online (O2O) strategy, as did Yihua Timber through an agreement with Tencent. However, Xinlinmen, along with other retailers such as Macalline and Easyhome, signed restrictive sales agreements with the major e-commerce platform operators to safeguard the sales performance of their traditional channels. Further, many of the pioneers of this model have been put out of business. One good example is the bankrupted furniture company Niuwo, which provided offline furniture displays and demonstrations, but implemented its sales process online, and burned through all of its shareholder’s capital just months into operations.

Compare instead IKEA’s performance in China to the current predicament faced by Macalline, Easyhome, Niuwo and Xilinmen. IKEA has maintained strong sales growth with no meaningful online operations. In 2013, its sales in China are expected to grow 20% to RMB 6.3 billion despite economic uncertainties and concerns in the real estate market. The IKEA brand, shopping experience and product quality seems to exceed the value that online platforms deliver. In other words, it is clear that in the furniture sector, brand is king.

– Other Questions

In addition to whether the channel or brand is king, there are questions about the whether analysts are being too aggressive in extrapolating future forecasts. While we are true believers in the growth of e-commerce, current rates of growth may not be sustainable. For example, there has been massive uptake of e-commerce in third- and-fourth tier cities, where the quality of transactions is less transparent and the competition from offline retailers is weak because they are simply not there. When traditional retailers inevitably present themselves in Pu’er, Lancang, Huishui, Guiyang and other similar cities, will they (i) open and fail; (ii) open and slow the growth rates of online spending; or (iii) open and thrive through a synergistic O2O-type strategy? Also, will platforms like T-Mall that currently command large fees from sellers be able to innovate enough to remain channel owners, or will strong brands increasingly “go direct” to consumers online? It is worth noting that certain platforms online are already losing their luster. While Alibaba, for example, is benefiting from T-Mall’s growth, its older sister-platform, Taobao, has seen its reputation suffer due to the prevalence of counterfeit goods for sale.

To be clear, we do not question that e-commerce is changing consumption patterns and will grow in size. But we believe this is likely just one intermediate stop in the evolution and modernization of consumer behavior in China and the importance of strong branded consumer goods. Brands favored by consumers will benefit as a greater portion of their sales moves online. The value of online sales platform will decrease their costs, allowing for more investment in both online and traditional channels, which will benefit consumers. Moreover, in the near- and medium-term, the ongoing battle between the online and traditional channels will not negatively impact brands, and may in fact benefit them and provide them greater leverage in taking advantage of the “platform wars”. Branded products, in the end, are what Chinese consumers want to buy.

– Please drink responsibly

We would urge all to keep this in mind as the market slurps down large glasses of e-commerce Kool-Aid, and as a drunken malaise descends upon the valuation of traditional retailers. We would also keep an eye out for opportunities as exuberance creates irrational mispricing, for example in the valuation of strong brands that may become temporarily tarnished for being seen as “too offline.”