Alibaba's Killer O2O Strategy

Summary

• The 63% growth rate of Alibaba's core commerce business is almost unfathomable, even given the strong tailwinds of China's rising consumer market and online penetration.
• One element that is behind this is a clever strategy that blends online and offline retail to create a virtuous cycle.
• In the process, Alibaba is embarking on a wholesale remake of the Chinese retail landscape.

We are looking at some bigger companies for our SHU portfolio, which we started at the end of September (it's up 18% since then), as it is fairly heavily skewed towards smaller companies:

And just by accident, we're stumbling onto a really big one and we were not aware what kind of opportunity it still contains.

We were investigating the difference in share performance between JD.com (JD), a company we hold in the SHU portfolio and Alibaba (NYSE:BABA), as the share prices have diverged strongly from August onwards:

And then we hit on the following really amazing graph:

This has alerted us to something quite phenomenal. The incredibly high revenue growth of Alibaba, and the fact that it has been re-accelerating since the beginning of last year.

We were impressed with JD.com being able to re-accelerate growth, but that is fairly modest compared to what Alibaba has been doing. Companies that are already large are not usually able to pull this off, let alone having 60%+ growth rates, this is simply phenomenal.

We have to say that we were not aware of the fact that Alibaba is growing considerably faster than JD.com due to this (from SA):

JD.com is gaining on Alibaba's e-commerce market share, according to an eMarketer report using data from Analysys International Enfodesk. In Q2, Alibaba's business-to-consumer Tmall e-commerce platform held a 51.3% sales share in the Chinese e-commerce retail market. JD.com was up to a 32.9% share, up from a 17.7% share in 2014. The gains largely came from the region's consumers moving away from consumer-to-consumer sales. JD.com's Q2 revenue was up 44% on the year to $14B but the company reported a net loss due to marketing expenses.

Indeed, as we showed in a previous article, JD.com has indeed grown faster if you start measuring early, but the last couple of years, Alibaba has caught up and overtaken JD.com.

This clearly leads us to consider Alibaba as another interesting addition to our SHU portfolio (we have now bought 50 shares at $178.50), so here we'll give you one of our deliberations, the so-called O2O strategy, which we'll explain below.

Growth

Alibaba is helped by a good amount of tailwinds. First, Chinese retail sales are still growing at roughly 10% a year:

The re-acceleration of Alibaba's revenue growth actually becomes even more impressive in the light of declining growth of retail sales. However, online sales are a rising proportion of these sales:

These are projections for the coming years as well, and if these materialize, that's one heck of a tailwind.

Alibaba's new retail strategy

Anyway, if you think these distinctions between online and offline still make sense, think again. China in general, and Alibaba in particular, are at the forefront of blending the two worlds, unleashing all the advantages of big data and machine learning from the online world to gain the upper hand in the offline, bricks-and-mortar retail world.

This is creating a hybrid model, or O2O (online-to-offline) model and offers one clue on how Alibaba can actually grow at such phenomenal rates. CEO Jack Ma described it as (per Fortune):

the integration of online, offline, logistics and data across a single value chain.

And indeed, the company has been buying (or engaging in strategic alliances with) bricks-and-mortar retail left right and center, like Intime Retail, the Lianhua and Sanjiang chains, and the Bailian Group, for instance. The O2O model seems simple on the surface:

But it's all about leveraging its existing online data and amassing even more offline data, which could cement its competitive advantage, a few examples:

• Leverage offline data for location-specific knowledge that enables the company to create a perfectly matched shopping experience for each location, putting pressure on traditional developers.
• Leveraging big data and machine learning to make store experiences more personalized, putting pressure on legacy retailers.

Speaking about developers, here is Wang from Wanda's Dalian, a big developer:

Wanda's Wang calls O2O "the biggest cake in e-commerce." And because of the different ways the retail market has developed in the West and in China, there's good reason to think that it won't be a Western e-commerce giant like Amazon, nor Western superstores chains like Wal-Mart that get the biggest piece of this cake, but their Chinese e-commerce rivals.

In the US, the O2O leaders are traditional retail chains who see this as a way to compete with Amazon (AMZN). In China however, the O2O leaders are the big tech firms themselves, like Alibaba, Tencent (OTCPK:TCEHY), Baidu (BIDU) and JD.com, as China doesn't have that many brick-and-mortar chains, the market is way too fragmented for that. But Alibaba is finding a way around that.

A whole different level

Recently, Alibaba has taken this strategy to a whole different level, from Chinamoneynetwork (our emphasis):

The retail giant has now unveiled an even more ambitious plan to transform 10,000 mom-and-pop convenience stores across China into a vast network of Tmall.com brick-and-mortar outlets, where consumers can shop, pick up packages, make orders online or even apply for and receive small loans. It's the first step in Alibaba's broader plan to turn as many as six million convenience stores into smart service centers equipped with Alibaba's e-commerce infrastructure and capabilities in financial technology, logistics and travel services.

Six million convenience stores, if you had to read that twice you're not the only one, we did too. There were more observations in that article worth repeating:

"These Tmall shops will be a supermarket, a post office, a travel agency, or even a community bank," said Lin Xiaohai, vice president of Alibaba. "Behind every digitalized Tmall shop, there is synergy to be achieved (via Alibaba's platform) on supply chain, branding, sales services, etc. (These stores) will not just be a retail end-point, rather a new starting point to observe user behavior."

Then there is HEMA, Alibaba's line of innovative grocery stores is telling, from Fortune:

Inside, shoppers find a carefully curated selection of 3,000 products from 100 countries, with an emphasis on high-end dining. Consumers can order online through their mobile app and get delivery within 30 minutes, within a 5-kilometer radius. Or, in a true expression of the O2O vision, they can shop in-store. Digital price tags are updated in real time, and shoppers can scan bar codes, pay via the HEMA app and have purchases delivered for free. To emphasize the "experiential" element, HEMA stores also organize special customer events and even offer a dedicated "food booth" zone where shoppers can have their groceries cooked for them. Meanwhile, detailed shopping behavior, on everything from purchases to movement around the store, is captured via the mobile app.

Two big takeaways for investors

• These strategies allow Alibaba not only to ride the wave of Chinese retail sales growth and leverage it with the increasing online penetration, it also puts the pressure on traditional retailers.
• There are strong elements of increasing returns working here as much of it is driven by ever more granular customer data, leveraged by machine learning. This is not unlike how Google (GOOG) (GOOGL) and Facebook (FB) have cornered the online ad market (as we explained here). Size (big data) gives you advantage and allows you to gather even more data, reinforcing the advantage. The specifics differ, but the mechanism is basically the same.

We're only touching on one element of the Alibaba strategy, albeit the most important one at least for the near future and this is rather impressive. Basically, it amounts to a wholesale reorganization and rationalization of the Chinese retail landscape, nothing more and nothing less.

It will convert millions of existing mom and pop stores into effective outlets, little logistical hubs and gatherers of information, fortifying Alibaba's position in a virtuous cycle.

For the stores, the advantages are substantial. Suddenly they can offer their clients a multiple of products and services, and are plugged into an efficient logistical network and supply chains.

Even from a societal point of view, we see important benefits, as this allows many of these little stores to survive, even thrive and become part of something really efficient. Little retail massacre here, with all the associated possible negatives we see elsewhere (mall closures, neighborhoods declining, etc.).

Perhaps one shouldn't be surprised that even Amazon has given up on conquering the Chinese market, from SA:

Amazon (AMZN) is running Kindle ads across Alibaba's China-based shopping sites in a move that suggests Amazon has given up on trying to compete in that market. Alibaba and JD.com (JD) dominate the Chinese e-commerce space with Amazon scraping out less than a 1% market share after a decade of trying, according to Recode.

Analyst’s Disclosure: I am/we are long BABA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.