The community message board on China’s leading consumer-to-consumer (C2C) e-commerce website Taobao.com has heard the news: Baidu is coming. China’s preeminent search engine intends to launch its own C2C site this year and Taobao’s loyal users are waiting to see what happens.
When CHINA ECONOMIC REVIEW typed the word "Baidu" into Taobao’s search function we found a posting by a Taobao seller identified as Allen67Lau, who was contemplating opening a store on Baidu’s site.
"I hope Baidu will not disappoint us, although I think Taobao’s number-one status cannot be shaken," he said. "At present I think Baidu’s advantage is technology, while that of Taobao’s is its user base, which is much more important."
In early October, Taobao announced to a room packed with journalists in Beijing that it would keep its services free of charge to users. It will do this thanks to an investment of more than US$730 million over five years from its parent, Alibaba Group. Many analysts speculated that the move was driven by Baidu’s imminent arrival in the e-commerce space.
But Christina Splinder, director of corporate communications for Alibaba Group, denied any Baidu connection. The investment was driven, she said, by evidence of growing penetration of online shopping and a surge in trading on Taobao.
In the first half of this year, Taobao posted US$6 billion in gross merchandise volume (GMV), nearly matching its volume for 2007 as a whole. GMV is expected to be pushing US$15 billion by the end of 2008.
"We are very optimistic about the long-term growth of e-commerce in China, even in this economic environment, because e-commerce penetration is accelerating. That implies that e-commerce will actually grow faster than internet user growth," Splinder said.
The real deal?
Taobao’s bold expansion plans – along with the proliferation of niche sites and the expected entrance of one of China’s net heavyweights to the market has only further fueled the buzz among China’s IT mavens that e-commerce, after years of promises, has begun to mature in earnest on the mainland.
To others, though, it represents nothing more than the natural evolution of an industry able to ride on the back of the world’s largest internet user base.
"I wouldn’t say e-commerce is just starting to take off, I think we are seeing a gradual, growing effect for e-commerce just like any internet business in China. I’m pretty optimistic about the sector," said Neil Shen, a founding managing partner with venture capital (VC) firm Sequoia Capital China and one of the pioneers of the country’s internet industry.
China’s online shopping market is still in its early stages compared with the US’s, which is expected to do US$148 billion in online sales in 2008, up from US$128 billion last year, according to Forrester Research. By contrast, Shanghai-based tech consultancy iResearch projects the China market to grow to US$18.45 billion this year, although this is more than double last year’s figure of US$8.2 billion.
The central government is also paying closer attention to the industry, identifying e-commerce as a priority in the 11th Five-Year Plan. Zhang Chenhao, senior analyst at research firm JL McGregor in Shanghai, believes Beijing’s goal of stimulating domestic consumption to offset the impact of a global economic slowdown will keep e-commerce growth rates high through the current credit crisis.
While there are encouraging signs that e-commerce as a whole is approaching a tipping point, many of the same issues that have dogged the industry from its infancy – such as trust, payment systems, and logistics – continue to this day.
A raft of new entrants, both large and small, will face significant challenges in achieving meaningful profits for the next few years. Indeed, according to Rocky Lee, head of DLA Piper’s VC and private equity (PE) practice in Asia, some VC investors are already beginning to sour on China’s IT market.
"There’s been a real reduction in interest in the internet sector, primarily driven by the fact that there’ve been a lot of promises made by entrepreneurs in Web 2.0 and e-commerce in China, but very few entrepreneurs actually delivered the numbers," he said.
"Existing [internet] business will probably still receive funding, high valuations and a lot of hype. But for new businesses, I would be surprised if they were to even raise capital at all."
According to the Asian Venture Capital Journal, VC and PE investment in the broad IT sector in China dropped to US$704.7 million in 2007 from US$787.6 million in 2006.
Beyond the comfort zone
The lack of familiarity with online shopping remains the chief obstacle to growth, said Wang Fang, an analyst with iResearch. The company estimates that the penetration rate of shopping online for internet users in China is 20-30%, compared with around 60% in the US. Other data puts China’s penetration at 33% compared with a global average of 86%.
Chinese consumers have virtually no history of catalogue sales, and thus are unaccustomed to making purchases without being able to first inspect the goods. Widespread fraud and the relative newness of the internet have also made customers wary of online shopping. Gwo-Ing Lee, who founded a high-end bridal supply startup in Beijing called ixi360.cn, has had to find ways of overcoming this consumer reticence.
"We have an offline aspect to our e-commerce," she explained. "We hold events and have the equivalent of a sample sale where our members can touch and feel some of the goods. Our sales are a lot higher when they can see what they’re trying to buy."
But Lee and many analysts believe that e-commerce is at an inflection point in China. Although penetration is low, the younger consumers are more willing to shop online. And most in the industry tip their hat to Taobao for forging the path.
It is almost impossible to overstate the website’s role in introducing Chinese consumers to online shopping, and thus helping spur the growth of e-commerce. Analysts across the board see the firm as largely responsible for educating consumers about e-commerce by inviting them to try the service free of charge.
Alibaba Group’s payment system, Alipay, as well as consumer protection programs, have also helped allay fears of fraud among a population unaccustomed to making purchases in cyberspace.
Along the way, Taobao toppled one of the world’s most recognizable internet firms, eBay, which was the only player in China’s consumer-to-consumer (C2C) auction market when Taobao first entered the space in 2003. (See "Foreign laggards: Two case studies of struggle" on p38)
To the victor have gone the spoils. As of the second quarter of this year, Taobao held a 76% share of China’s online shopping market as measured by GMV, according to iResearch. Eachnet, which is backed by eBay, held an 8% share, while Pai Pai, the e-commerce site run by China internet giant Tencent, was at 9%.
That Tencent – which is regarded by many as China’s strongest internet firm – has such a relatively small e-commerce footprint is further testament to Taobao’s strength. In Baidu, however, Alibaba faces a competitor with the pedigree and technology to give them a run for the money.
"Baidu has a chance to run its e-commerce business quite well," said Zhang of JL McGregor. He noted that Baidu’s advertisers, who are mostly small to medium-sized businesses, could be converted to sellers for Baidu’s e-commerce platform, and from there link up with a diverse internet user base.
Baidu believes that it brings a technological advantage to the table, which can give it the edge in e-commerce.
"We have a large user base, who enjoy our many search and community products. Our deep understanding of their needs will give us a strong competitive edge in C2C," the company said in a statement to CHINA ECONOMIC REVIEW.
The big opportunity for Baidu is to direct search requests for products to sellers operating on its own C2C platform rather than competing e-commerce platforms such as Taobao or Pai Pai.
"Baidu’s a significant threat [to Taobao]. It’s a giant company with a ton of information. As a search engine it’s got tremendous ability to funnel you to vendors on its own site," said Mark Natkin, managing director of Marbridge Consulting in Beijing.
Raising the bar
It could be argued, however, that portraying the Taobao-Baidu battle as a zero sum game is short-sighted. Given the low penetration rate and China’s massive population, more competition – and, by extension, more investment – may be exactly what e-commerce needs.
This pattern has been played out with each new major market entrance, according to Alibaba’s Splinder. She said that periods of intense competition in China’s e-commerce sector have had the effect of growing the overall market.
When eBay was the lone player in the C2C e-commerce space industry GMV was less than US$150 million, according to iResearch. Two years after Taobao’s entry in 2003, GMV had risen to US$2.3 billion. Pai Pai came along in 2005 and GMV was pushed beyond US$8 billion last year. The market is projected to grow to US$18.4 billion in 2008.
Splinder expects Baidu’s entry to raise the e-commerce stakes even further.
"We think that competition is very healthy. Because as long as Taobao can maintain a reasonable level of market share, who wouldn’t want to have a tenfold increase in market size? So we really welcome Baidu’s entering into the market," she said.
Regardless of the outcome, Taobao and Baidu – along with leading business-to-consumer (B2C) sites Joyo/Amazon and Dangdang.com – will continue trying to be all things to all people, selling a wide range of goods across as wide a swath of the country as they can manage.
But analysts believe these large general online retailers will struggle to earn profits. While Taobao broke even in August, the firm’s revenues came from pay-for-performance advertising rather than sales. Experts say it is unlikely that Dangdang or Joyo/Amazon are turning a profit. (Both firms declined to be interviewed.)
"It’s hard work to be the Amazon of China," said Hans Tung, a partner at Shanghai-based Qiming Venture Partners, which has invested in several internet-related companies.
"You have to build this infrastructure that satisfies so many different people. If the inventory control ability is not there then you add costs before you can monetize and turn that into revenues."
Tung believes Taobao acts as the "great equalizer" in the e-commerce state, as customers will search Taobao, Dangdang and Joyo/Amazon in search of the cheapest price. In this environment, specialty firms have the best chance of success, albeit on a smaller scale. "How can you beat someone who seems to have everything? You have to be differentiated. We have to pick niches that are differentiated or else it’s very difficult to compete against Taobao," he said.
Diamonds and wine
This move toward specialization is aided by the fact that the market is no longer limited to books and videos. As they become more accustomed to online shopping, Chinese consumers are expanding their horizons to include everything from high-end wine, to baby clothes, and even diamond jewelry. One of the companies Qiming invested in is VANCL.com, a mid-range brand of business casual wear.
The firm’s CEO, Chen Nian, who was one of the founders of Joyo, said companies like Joyo and Dangdang face ever shrinking margins as their businesses grow. Given this trend, he sees specialization as the key to winning in this market.
"VANCL’s direct sales of business casual clothing is specialized and not easy to fall in the cutthroat competition for the same product," he said.
The firm was established in October 2007 and had revenues of around US$290,000 as of January 2008. By the end of July, revenues had grown to US$10.2 million.
Chen tips the overall e-commerce market to continue to grow at a fast clip but he doesn’t expect most B2C firms to turn a profit over the next three to five years. Several analysts support this view, noting that, while the overall size of China’s e-commerce industry is growing, individual players have yet to crack the code.
This is hardly a phenomenon restricted to China (Amazon famously took years to turn profitable in the US) but the nature of the challenges e-commerce firms face here is, to a degree, unique.
Issues of scale
The central problem is one of scalability. While an e-commerce site may be strong in a certain vertical market or a geographic area, it faces a slew of new problems – ranging from finding suppliers, warehousing facilities or logistics providers – when entering new markets.
Another key obstacle to scalability is the fact that most goods in China are still purchased on a cash-on-delivery (COD) basis. According to some estimates, COD represents 60-70% of all online purchases. (See "Pay the piper: Making online purchases in China" on p36.)
"E-commerce in China as we know it is cash-on-delivery. It’s not true e-commerce," said DLA Piper’s Lee. "That’s scalable in China to an extent but not scalable to the extent of eBay in the US. You could argue that the cost of labor is low, but when you sell goods in China your margins are paper thin."
Beijing-based market research firm CCID Consulting put credit card issuance in China at 110 million as of the end of May. But no matter how many cards are distributed, online usage will continue to be limited as long as banks persevere with their stringent security measures. These include requiring card holders to sign paperwork in person before they can start shopping online.
"It’s not the customers not trusting online payment but the banks being concerned about online fraud," said Leehun Lee, Greater China president at First Data, an electronic payment provider.
The costs to enterprises arising from this lack of a credit system go beyond simply hiring staff for delivery. For example, VANCL entices first-time buyers by allowing them to make their first purchase of select goods for RMB68 (about US$10), a price at which they make no profit. However, many customers sign in with false names to apply for the package multiple times. This practice could be cut back with increased credit card usage.
Derek Sulger, a partner at Lunar Capital, who co-founded Linktone and Smartpay, said that, given the obstacles facing e-commerce in China, it’s still early in the market’s evolution for niche and specialty players to thrive. But he believes that the overall picture for e-commerce in China remains promising.
"The general line is this sector is for real. When I look at the sector now, certain things have changed," Sulger said. "A culture of commerce is evolving."