In late January, Hangzhou was struck by a freak snowstorm thick enough to snarl its major thoroughfares, paralyze its airport and postpone its trains. While many residents took the day off, cars kept flowing onto E-Commerce Drive, where the Alibaba Group, China’s most famous internet startup, is headquartered. Many of the company’s 8,000 workers faced a slushy slog to get to work, but by 10 a.m. the halls were bustling. Outside, employees hurled snowballs at the bronze Mongolian warrior who stands, naked and stoic, in the center courtyard. Everyone in sight looked to be in the cheeriest part of their mid-20s.
Inside, in the global sales division bullpen, a false summer prevailed. From every cubicle sprouted a bouquet of plastic sunflowers and real bamboo (distributed by HR to symbolize growth), and salespeople nodded aggressively as they pitched membership in the company’s premium exporter certification program to overseas suppliers. When a sale closed, managers swung wooden clackers in the air to celebrate. Most were smiling; few were sitting down.
It all reinforced Alibaba’s public image of youth, high morale and slick techno-idealism. But in another salesroom in the same complex, a group of around 100 salespeople for the group’s B2B flagship trade platform Alibaba.com (1688.HK) were busily sabotaging that image by helping criminals defraud foreign merchants, producing the worst public relations disaster of the company’s history.
“Essentially what happened was, sales staff were colluding with what appears to be professional criminals to create false business licenses that got around the China Gold Supplier (CGS) program’s authentication and verifications system,” said Linda Kozlowski, director of international corporate affairs for Alibaba.com, in a telephone interview with China Economic Review. The criminals created around 2,300 storefronts on Alibaba’s trading platform from which they advertised popular consumer electronics goods at “unbelievably low prices,” she explained; when a seller overseas placed an order, the crooks kept the money and shipped nothing.
Alibaba managers publicly announced preliminary results of their internal investigation on the day this magazine prepared to go to print; a criminal investigation is underway. In the same text, the company announced that charismatic Alibaba founder and chairman Jack Ma had accepted the resignations of Alibaba.com COO Elvis Lee and CEO David Wei, who was interviewed at length for this story (the internal investigation revealed no wrongdoing by either). The head of human resources who oversaw the hiring of the guilty sales staff, Deng Kangming, has been demoted.
Fraud among suppliers is nothing new in China, and the money involved – US$1.7 million – is relatively minor by corporate standards. Kozlowski said that the amount was so small that Alibaba wasn’t even legally obligated to disclose the news under Hong Kong Stock Exchange rules. “We could have tried to sweep this under the rug,” she said.
Coming from an organization as publicly idealistic as Alibaba, however, that may not be enough. The scandal aggravates existing problems, gives comfort and encouragement to the company’s multiplying competitors, and annoys investors already disappointed by Alibaba.com’s stock performance. It also supports arguments that the basic viability of Alibaba’s strategy – toward international trade in particular – is flawed.
As for its mission, Alibaba presents itself as the champion of the Chinese business underdog: the big guy behind the little guy. But as parts of the company turn to serve multinational corporations, corporate value statements emphasizing small businesses look increasingly nostalgic.
Most at risk is the company’s unique culture, its mixture of Western and Chinese, dot-com and traditional, international and local; the plastic sunflowers, the real bamboo, and all the free energy the group could expect from employees who thought they were signing up at a different kind of company. On February 21, 2011, the golden youth of the Alibaba Group came to an abrupt end.
The way we were
Alibaba has always prided itself on its unique corporate culture, and still does. “We’re not a private company and we’re not a state-owned enterprise,” Ma said at a press conference in Beijing in January. “We’re a social company … We don’t want to become an empire.”
The uniqueness extends to the way it operates, which some find off-putting. Brian Wong now heads global sales for Alibaba.com (his division was not involved in the CGS scandal). He was the first American to join Alibaba in 1999, back when it was 50 people working out of two residential apartments, but he quit within two years in exasperation.
“When I first came to the company, I thought the place was chaotic,” Wong said. Raised in Palo Alto, California, he was unimpressed by a corporate environment in which strategic restructurings were tolerated, and even encouraged, twice a year. “The normal human being is not meant to keep up with that rate of change.”
Wong returned to the US, went to business school and took a job at a more conventional operation. Less than two years later he was back at Alibaba, having learned to appreciate what once appeared to be chaos for nimbleness. “Alibaba has to reinvent itself on a regular basis … [It] is successful because of what I originally thought was a flaw.”
Today, Alibaba is restructuring again: Jonathan Lu, CEO of the group’s domestic consumer-to-consumer and business-to-consumer (C2C and B2C) business Taobao.com, adds Alibaba.com to his responsibilities.
In the beginning, of course, everything was simpler, and “chaos” was easier to manage. Jack Ma, a former schoolteacher and serial entrepreneur, conceived of the idea for Alibaba.com when searching for the term “Chinese beer” on a US search engine. He couldn’t find anything, so he built a website that was little more than a bilingual online telephone directory for US importers looking for Chinese suppliers. The business plan, if simple, was elegantly so, and compelling enough to convince a group of institutional investors including Goldman Sachs (GS.NYSE) and SoftBank (9984.TYO) to put up US$25 million.
It was a good investment. A year after fundraising was complete, Alibaba.com was already turning a profit. Small- and medium-sized traders flocked to the platform. With an exploding user base and rapid revenue growth, all run out of a few racks of servers, Alibaba.com went on to list in Hong Kong in 2007 for US$1.7 billion.
It was the biggest internet IPO since Google (GOOG.NASDAQ), but the after-party was short-lived. One year later, the global economic crisis decimated trade volumes, and Alibaba.com’s stock took a decimal point off its value. It has since recovered to trade between HK$12-18 (US$1.54-2.30). Even so, in late February shares in Alibaba.com still traded around 50 times earnings, indicating high growth expectations. The company has a market capitalization of nearly US$10.5 billion, 56.7 million registered members, 8.2 million storefronts and total revenues that reached US$607 million in the first nine months of 2010.
The first victory encouraged Ma to widen the scope of his mission. “Originally we just cared about a very small field, e-commerce, focused on B2B,” said Jane Jiang, one of Alibaba’s original founders and a former student of Ma’s. “But through the years, I think the vision of Jack and the vision of this company changed.”
Just two months before Jiang spoke to China Economic Review in Hangzhou, she had taken over the trust and fraud team, in part to investigate a strange spike in complaints. Jiang al
luded to the difficulty of the investigation during the interview: “Sometimes you can see people are fraudsters, but sometimes it’s unclear: There’s no proof, there’s just one buyer’s complaint,” she said. “Over 99% of suppliers, including the China suppliers, are good people.”
This 99% figure became a staple of Alibaba’s defense during the scandal: Only 2,300 out of nearly 750,000 users came under investigation. But the changing vision Jiang talked about – which came to include domestic trade, cloud computing, logistics and training – may have meant managers had that much less attention to pay to troubles at the flagship.
Kozlowski emphatically rejects this interpretation, arguing that there is no causal link between organization size and corruption.
Whether the fraud issue ends up being a storm in a teacup or not, some wonder how much growth the future holds even if verification issues are sorted. Global Sources (GSOL.NYSE), a US-based company that also specializes in matching Chinese suppliers with Western importers, is the company most likely to benefit from Alibaba’s troubles. It is much smaller than Alibaba.com and handles far fewer transactions. Wei said he doesn’t consider Global Sources a competitor, and Global Sources also says the area of overlap is small. But the company’s model is in competition with Alibaba’s, and the two firms do compete for suppliers – in fact, pricing for their respective supplier membership programs is quite similar.
According to a former employee who requested anonymity, Global Sources was once very concerned about Alibaba.com’s dominance at the low end of the market. In addition to lowering prices, it also created a product, Global Sources Direct, which competed for smaller-volume orders with Alibaba.com’s AliExpress site. It also claimed that its verification system was more robust than Alibaba.com’s – a claim lent weight by the CGS scandal.
More relevant is that Global Sources attained success largely by steering clear of the online model. Craig Pepples, Global Sources’ president of corporate affairs, explained the company’s reasoning: “Everybody gets extremely excited about e-commerce, but online shopping in China currently represents 2% of the total retail value. In the US it’s 4%. And it’s large retailers doing the importing.”
Dealing with the small suppliers and customers, even online, drove costs up without doing much for revenues, he said. “Everybody thinks, ‘Click here, everything is so easy online.’ Actually it’s not.
“‘I need this model, I need the casing to be red, the packaging needs to be in German and can I get 20,000 of them?’ That’s a lot of questions, and what if they are coming from a sample hunter in Nigeria?”
Instead, Global Sources has focused on providing real-world services like directories, trade shows and print advertisements in magazines, from which it earns the majority of its revenues. To investors, the results are far superior to Alibaba.com’s. Global Sources stock is up 75% over the last six months (compared with a 22% increase in the Dow Jones Industrial Average), trading at around half Alibaba.com’s multiple.
Turloch Mooney, editor-in-chief at Supply Chain Asia Magazine and occasional contributor to China Economic Review, agrees. Alibaba.com, he said, is going after a difficult-to-serve and risky niche market.
“Is it going to work? I really can’t say. I can say that the big volumes and big value are with the big companies and the enormous trade shows. Unless there are methods to ensure quality and consistency and timeliness and customer service, I think [Alibaba.com’s model] will struggle to work for quite a long time.”
There are also remaining technology hurdles. Pepples said that attempts to use trade software to facilitate transactions failed due to massive customizations required by large clients. For this very reason, Alibaba.com does not handle transactions at present, and its current major software initiative, AliCloud, does not have any cloud-based transaction platform in the works.
Height and weight
To be fair to Alibaba.com and David Wei, stock prices and business performance are not the same thing. This “niche” produced US$393 million in revenues in the first half of 2010, more than three times as much as Global Sources, and that at a higher profit margin. Even before the scandal broke, Wei was working on improving the CGS program.
While the scandal was only made possible by criminal collusion with staff, other problems in the CGS program were structural. When the financial crisis hit, for example, Wei made deep cuts in membership fees: “We believed e-commerce could help Chinese exporters to survive the financial crisis,” he said. “We tripled the supplier base in three years. But the philosophy was not triple the numbers, but triple the survival of our exporters.”
But as the crisis receded, Wei doubled membership fees again. “First we grow height, which is customer numbers. Then we turn to service [which is] weight. It was best to acquire e-commerce customers during the downturn, then increase fees when commerce went up.”
Some analysts hated the move. Paul Wuh, an analyst at Samsung Securities, bashed Wei’s decision and downgraded the stock. “We think it is too early in the development of e-commerce in China and for Alibaba to [slow subscriber growth] and focus on mining its existing paying customers to grow its earnings,” he wrote in an investor note.
Subsequent events showed Wuh’s logic to be exactly backwards: The company already had 2,300 CGS members too many. In an ad-driven model, in which more users mean more revenue, Wuh’s logic made sense. But Alibaba.com’s revenues come entirely from membership fees and value-added services (VAS), which have much higher cost structures than hosting advertisements. Adding a new CGS member adds the cost of third-party verification, which events have shown is critical to credibility.
The fact that Wei appeared to have been on the right track is cold comfort now, especially to shareholders. But the disaster does validate a decision made previously by the group to move into the domestic market, without which Alibaba.com would be facing a far bleaker scenario.
Around 2002, the rapid growth in Chinese domestic internet usage caught the interest of US-based e-commerce firms eBay (EBAY.NASDAQ) and PayPal, which eBay acquired late that year. At the time, the Alibaba Group had a negligible domestic e-commerce presence. But Ma was also looking at the domestic market, and he realized he had to act.
“Jack Ma is very smart,” said Hans Tung, partner at venture capital firm Qiming Ventures (Qiming has invested in popular online retailer Vancl). “EBay had just bought [mainland e-commerce platform] Eachnet, and he saw that if ignored, the connection between eBay and Eachnet could eventually hurt Alibaba. So he used the money generated by Alibaba.com to invest in Taobao.”
The Taobao project, along with PayPal clone AliPay, may have begun as a defensive reaction, but quickly became much more than a hedge. Taobao is now the market leader in Chinese C2C transactions and is moving into the B2C space though Taobao Mall, which already handles one million transactions a day. AliPay is the most popular online payment method by far in China. In 2010 the group overtook Google to become the second-largest seller of online ads in China after Baidu (BIDU.NASDAQ), according to a report by Analysys International, and these ad revenues are entirely thanks to the domestic initiative: Alibaba.com hosts no advertisements.
The success of Taobao and AliPay also cleared the way for Alibaba.com to start serving domestic consumers by adding related products like 1688.com, a B2B platform for domestic trade. The ultimate idea was to knock down the barriers between the subsidiaries to help trade flow s
eamlessly: small Chinese entrepreneurs selling knickknacks through Taobao into AliExpress, which channels them through Alibaba.com’s new US acquisitions Vendio and Auctiva, which in turn feed them into the eBay marketplace – and then the other way around. “They are almost trying to create a cross-border version of eBay which includes China,” said Pepples of Global Sources. “It’s a wonderful vision.”
So far the strategy has paid off, and it means that the Alibaba Group doesn’t need to panic about the CGS affair. But complacency is also inadvisable, and CEO Lu will have his hands full in the coming year.
The challenge with C2C and B2C businesses is the opposite of difficulties with international B2B ventures. It’s not that they are difficult to implement; quite the opposite, competitors are proliferating. “All you need to do is buy a server and you are a peer of Taobao,” Ma joked at a press conference.
Or rather, half-joked. Taobao’s first-mover advantage still allows it to dominate the C2C market in China. But companies like Baidu and Tencent (0700.HK) already have lots of servers and users, and they are increasingly likely to take a shot at Taobao.
B2C, on the other hand, is crowded already, and this is also where the growth is. “Even though C2C transactions still make up 80% of all transactions [in China], B2C is growing faster,” said Tung of Qiming. “C2C is growing 40% [per year], B2C is growing 100%.”
Unfortunately, Taobao only launched Taobao Mall in 2008. Not only are there a host of competing websites, including 360Buy, Dangdang (DANG.NYSE), and Amazon (AMZN.NASDAQ) through its Chinese subsidiary Joyo, there are also the brands themselves to consider – some of which would rather create their own websites and sell direct.
This is not a show-stopper for Taobao; it also sells its mall system as a non-branded backend service. Japanese clothing retailer Uniqlo, owned by Fast Retailing (9983.TYO) runs both a storefront on Taobao and uses Taobao to power its independent site. But there are philosophical considerations. Alibaba was founded on the principle of helping the underdog, the entrepreneur, the small business. Uniqlo is none of those things; it is part of a US$15 billion Japanese conglomerate with 93 subsidiaries and 808 stores.
Journalists who tour the Alibaba Hangzhou campus are frequently taken through the famous “monitoring room.” It’s sparse, with cement walls, a very high ceiling and no furniture – add pews and it would be a chapel. In a way it already is: Visitors and employees come to genuflect before an intimidating wall display tracking the state of e-commerce throughout the group’s subsidiaries, in real time.
Maps and moving charts show popular search terms, product categories, and transactions as they are fed into the system (“john_wang is searching for ball bearings”). One map shows transactions as arrows landing on cities, where they make brief round ripples – the bigger the order volume, the wider the ripple. A line graph tracks macroeconomic data; a closer glance reveals that Taobao maintains its own internal consumer price index, the “TBI.”
The room is slick, and meant for show. But it is also an important reminder of Alibaba’s fundamental strength: information. This company has more data about more companies, consumers, products, and product trends than almost anyone else, and all in one place. Even the scandal produced more information. Alibaba analyzed the data and discovered a pattern from which it developed a new search algorithm to detect fraudulent activity – perhaps one day fraud trends will also be tracked in the monitor room.
If this last suggestion sounds absurd, it’s not. Alibaba may be disappointing some watchers as it sheds its original small-business focus to work with giants like Uniqlo, but the company appears to be turning toward a new corporate value: transparency.
This might seem a calculated retreat, but Alibaba.com had already implemented strong transparency requirements in its highly detailed financial reports, and the company deserves credit for breaking the story of CGS fraud itself.
In a passionate letter to employees, sent directly after the scandal broke, Jack Ma laid down the law: “If we do not face up to reality and find the courage to take painful action, Alibaba will no longer be Alibaba and our pursuit of our 102-year dream and mission will become nothing but a joke!”
Kozlowski said Ma was using the fraud investigation as an opportunity to instill the company’s value system more deeply in employees, and to teach them what transparency and idealism really mean in a corporate environment.
“Part of the reason we are hanging ourselves out to dry a bit is to communicate with our employees through our openness to the public,” she said. A 15-year veteran of the PR industry, she said she came to Alibaba because she believed in its commitment to honesty.
“A lot of American companies wouldn’t be this transparent. You might not believe this, but I actually feel pretty proud.”