Rising Chinese consumer demand is evident is e-commerce, or more specifically, online retailing. While this sector has not been a direct focus of our investment activity, it is an important and growing distribution channel for many brands and products produced by our portfolio companies. As the marketplace evolves, beneficiaries are becoming apparent – notably, brands and customers. Challenges are also becoming apparent for online retailer’s reputations, shareholders and logistics providers. Meanwhile, while investor focus has been on funding online retailers, the actionable opportunities may lie elsewhere.

Strong Chinese Consumer Demand Evident

According to McKinsey, 190 million Chinese consumers are now shopping online, with annual sales totaling over RMB 400 billion. By 2016, this is expected to rise to 351 million consumers and sales of RMB 2,200 billion. However, the market is fragmented amongst many providers mostly selling third-party products. The big three online appliance retailers include Jindong, Suning and Gome. Other leading players include Alibaba, through its Taobao and TMall businesses, Yihaodian, an online grocery business recently acquired by Walmart, Dangdang, an online book retailer that has diversified across product lines and is now listed on Nasdaq, and Joyo, a Chinese Amazon subsidiary. Jindong’s revenue alone increased tenfold from RMB 2.9 billion in 2009 to RMB 21 billion in 2011, and it is forecasting a further ten-fold rise by 2015. Suning’s online sales for 2011 were RMB 5.9 billion and they are targeting RMB 20 to 30 billion in revenues for 2012. Yihaodian had total sales of RMB 2.7 billion in 2011, a 335% rise over 2010.

Full Service, at a Cost

Online retailers must cater to customers that may have a low degree of trust in the marketplace, and lack modern payment mechanisms to settle transactions. Most transactions are settled via cash on delivery (COD). In market studies, the consultancy BCG has noted that COD is rated as the most frequently used payment method for nearly half of all online shoppers. However, it provides effective “double confirmation” of purchases, which inevitably results in a higher percentage of returned or refused goods. Additionally, same day delivery in major Chinese cities has become the norm for even small purchases, with fees often waived in tandem with promotions. In other words, people order the product, have it delivered on the same day, and have the opportunity to “look and feel” the item before deciding whether to pay. Analysts have often noted that for businesses such as Amazon in developed markets, same day delivery is the “holy grail”, but has proved cost and logistically prohibitive. Nonetheless, it has become a standard feature in China.

Taken together, the cost structure for online retailing to-date has been high. As volumes have grown, the sector has extended losses and arguably operated under increasingly negative margins. This pattern is not all that dissimilar to the earliest days of online retailing in developed markets. However, many of the barriers were overcome by the rapid evolution of service providers, for example PayPal to provide quick and cheap settlement, which have taken far longer in China to develop along profitable lines.

We see Consumers and Brands as the Early Beneficiaries

As online retailing evolves, Chinese consumers are benefiting. In a marketplace where trust is low, and consumer education is weak, competitive efforts are educating the consumer, should make for more savvy consumers in the future. This is likely to result in future consumers who are not only price sensitive, but also brand and quality sensitive, and eventually more discerning of which brands they own and therefore more loyal. Americans, and Chinese students at Yeshiva University, may remember Sy Syms saying “an educated consumer is our best customer.”

Brands are also benefiting from this online boom. Distribution in China has historically been fragmented, difficult and expensive. China’s top 20 physical retailers accounted for only 13% of total urban retail sales in 2011. In the rush to develop online retailing markets, sellers have new distribution channels that arguably been willing to subsidize sales or bring products to markets previously under-services. Taking skin care and cosmetics products as an example, about 25% of online purchasers said their primary reason for transacting was lack of availability in traditional shops.

Online Retailer’s Reputations, Shareholders and Logistics Providers are Facing Challenges

Leading online retailers are seeing impressive gains in sales. However, they face reputational challenges. Companies have offered aggressive promotions, but failed to deliver due limited inventories or misleading discounting. This has heightened consumer awareness about aggressive marketing tactics, alongside customer expectations of full service at limited cost. The net effect is that recent media coverage has shifted from the scale of the promotions, to the level of customer outrage, leading in some cases to vendors being fined or forced to issue public apologies.

Shareholders are also being challenged to provide for substantial cash burn. To be sure, there has been no shortage of investor appetite for the e-commerce sector. TMT has remained the largest recipient of venture capital and private equity since 2011 excluding financial services, according to AVCJ. However, the scope of the cash necessary to compete is daunting. One online merchant executive warned his backers that ongoing price wars would use up a lot of money, and was reportedly told “we don't have anything but money” by his investors and to “go ahead and spend it.” Another online retailer said that when it comes to selecting investors, they choose the ones that understand the industry the least, and therefore won’t interfere with their plans. The likelihood of further cash burn is evident in ongoing margin pressure. Jindong’s Chairman recently pledged to sell products at zero gross profit for the coming three years. Suning’s online business reported negative net margins of -0.5%, but the company’s Chairman promised that anyone paying lower prices at Jindong or elsewhere would receive an immediate price adjustment and a refund of twice the price difference, adding that he was striving to help his competitors achieve “employee layoffs”. Dangdang also announced that it was “joining the battle.”

Logistics remain a barrier as well, and a significant factor in the cost structure for online retailing. In a recent report, the consultancy AT Kearney noted that “the growth of domestic express delivery—most directly tied to e- commerce—is lagging the exponential growth of e-commerce in China, raising concerns about how well logistics players can handle ever-increasing volumes.” While there have been significant efforts by the central government to improve in this area, systems remain fragmented and inefficient, especially in emerging central and western regions. Thus, retailers both online and offline must rely on distributors as an integral part of their logistics networks and supply chains. To give a sense of the scale of added costs, in recent years this accounted for 18.1% of GDP in China versus 9.5% in the United States.

Actionable Opportunity

Online retailing is powerful evidence of the voracious pent-up demand for products and services in China, and is likely a leading indicator for future consumption trends. Therefore, we believe the biggest beneficiary is the Chinese consumer, and that we are witnessing the ongoing creation of a consumer culture that will contribute toward continued rising demand.

For investors, the mass-market brands that consumers are increasingly understanding, comparing and purchasing are the biggest beneficiaries. If you have a strong brand, and are fighting to get distributed, online retailers provide a forum where both your products can be made available, and consumers can be educated about your pros and cons.

The strain on logistics networks and payment systems will also attract investment and lead to innovation. While the cost of providing same day delivery may remain a function of cheap labor, more pressing opportunities will arise in logistics providers for emerging central and western cities, and other services along that value chain, such as cold storage and transport. Payment systems in particular have begun to emerge with scale, but still struggle to operate profitably and wean transitions off of COD, creating the need, and likely development, of new and innovative services.

As for the future of the online retailers, its probably best to respect the (outspoken) opinions of the entrepreneurs that know the sector the best, and trust in their promises of more sales volumes, discounting, promotions, cash burn and layoffs – but perhaps not in that order.