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This is Part 2 of an article by Jeffrey Towson about the aspects of Alibaba’s “new retail” strategy.

In Part 1, I discussed uni-marketing and how the view of new retail for merchants and brands is very different than the view for consumers. A quick summary:

  • For consumers, the view is great. They are going to get what they want, where they want it and when they want it. New retail is a purification of demand.
  • For Alibaba, the view is spectacular. Their huge online marketplace is going to be merged with parts of the physical marketplace. The number of users and the amount of activity on their platform is going to increase dramatically.
  • But the view for merchants, brands, and retailers is more confusing. New retail upends many of their businesses, strategies, customer relationships and maybe even their brands.

In this part, I take an asset and resource view of all this, which I think is a much easier way to understand it.

Point 1: Digital competition is a lot about key resources, which are usually intangible assets.

You can look at competition with various frameworks.

  • Michael Porter famously described five economic forces, which tend to play out over the longer term in more stable industries.
  • Columbia Business School Professor Bruce Greenwald argued that one force, competition, is actually far more important than the other four.
  • Warren Buffett focuses mostly on competitive advantages and their durability.
  • Wharton’s George Day writes about dynamic competition and the constant move and counter-move of many businesses.

I focus mostly on digital competition (note: China is the global epicenter for this). This is a lot about how new digital tools and data are changing the competitive dynamics of traditional industries. For example, retailers traditionally compete on fixed costs and fixed assets (lots of stores, get bigger than your competitor). But ecommerce has a different dynamic. There is a lot more focus on the degree of participation of consumers, merchants and other users.

It can get confusing. And a useful approach is just to take a resource and asset view. Stop looking at the economic forces and competitive advantages, and just look at the assets used to compete. One company has 10 factories and the other only 5. One company has a famous brand that everyone knows and the other is unknown outside of one region. In digital competition, this usually means comparing intangible assets like technology, IP, captured customers, business linkages, and data.

If you take an asset view of competition in ecommerce and new retail, I think there are three big things that jump out as particularly important in a marketplace platform. Note: Alibaba is a marketplace and a pure digital competitor. JD is more of a hybrid of a marketplace (enable transactions but don’t take inventory or be the seller of record) and a direct retailer (buy and sell the goods yourself). For marketplace platforms (like Alibaba and VIP.com), the resources that matter are:

  • Captured online consumers. Their number, time spent, money spent and their participation on the site. And your degree of capture.
  • Captured online merchants and brands. Their number, their percent of business on the site, the integration of their operations into the site and their marketing activity on the site.
  • Content creators. Although this can be done as another type of retail (like Amazon’s digital media) or as an audience-building platform (like Youku)
  • Data from ecommerce, entertainment, social media and other sources.

These assets (both the users and the degree of activity) on the platform enable virtually everything else.

  • You can add new services and products.
  • You can add new types of revenue streams (transaction fees, marketing services, operational services, gifting, advertising, etc.).
  • And hopefully, you can use these assets to build competitive barriers. Network effects are the most desired. But there are also data network effects, MSP advantages, softer data advantages and linked businesses.

I view Alibaba as a particularly powerful version of this with three interconnected platforms: a marketplace platform, an audience-building content platform, and a payment platform.

These core assets cost a certain amount of money to acquire (plus time and difficulty). It’s a useful way to look at a company. But it’s also important to remember that these asset costs are different from the value they can then create. Similarly, the cost of a factory is different that the market value of the products it creates. And the cost of a college degree is different than how much you will make from it.

If you take an asset view, the sequence for marketplace platforms is usually:

  • Get an initial critical mass of users, merchants and data. There is usually a chicken-and-egg problem to get started (to get the consumers you need merchants, but to get merchants you need consumers).
  • Grow the number of users and their activity, mostly by data and digital tools. In marketplaces, personalization and curation are two of the big guns for this. Ancillary moves into new products and services or into new geographies (cross-border ecommerce) also really work.
  • Try to protect the platform with network effects, linked businesses, softer advantages and assets that are difficult to replicate.

Point 2: How these assets change over time is really important.

Alibaba is a virtual marketplace (so far). There are lots of supporting and complementary services (entertainment, payments, logistics / delivery, credit, etc.) but the core business remains connecting consumers with merchants and brands. And then making money from their transactions – and also from the marketing and other spending by merchants and brands on the platform. It’s a virtual shopping mall (Tmall) and a virtual trading bazaar (Taobao).

So what is the big difference between the intangible assets that create virtual marketplaces and the tangible assets that create real shopping malls? One of the most important differences is how these assets change of time.

If we were looking at a real shopping mall or bazaar, we would depreciate the PP&E over time. There would ongoing capex to maintain and maybe additional to grow. And in times of higher inflation, these assets can be a big problem as they really increase the cost structure. Plus there is also the real estate and land price aspects, which can be particularly important in downtown locations and in places like China.

But a marketplace made of intangible assets doesn’t necessarily decay over time. It certainly doesn’t straight-line depreciate. You may have to spend to keep it running (a type of maintenance capex, operating cost and customer retention cost) and for required upgrades – but the economic goodwill (not accounting goodwill, which is nonsense) should increase over time. And it doesn’t get hit by inflation (although labor costs can be a problem).

The same process can be true for other businesses that rely on intangible assets. Share of consumer mind (a Buffett term) is a big deal for Coca-Cola. Intellectual property and data / claims history can be important in technology and insurance. And so on.

But two differences I think about for intangible assets versus physical assets are:

  • Intangible assets can increase in real economic value over time – and often quite powerfully. This is good news.
  • Intangible assets are easier to replicate and often do not offer the types of competitive protection you get with physical assets. This is bad news (and why network effects and soft advantages can be critical).

Here’s how this can play out in marketplace platforms:

  • The more customers that come, the more valuable (and necessary) it is for merchants and brands to participate and compete with each other through marketing.
  • The more stores that arrive the more options consumers have and the richer their experience.
  • The more transactions and data from transactions, browsing and others sources (entertainment, etc) the more personalized and engaging the experience. This can enable more spending and engagement.
  • The more this ecosystem grows, the more difficult it is for a new competitor to replicate the entire ecosystem. The assets grow organically and become harder and harder to replicate.

Note: Parts of this can be described as a network effect. But it’s more about the degree of participation. Most MSPs do not have network effects and derive their value from their intangible assets.

Additionally, you get some competitive protection from an ability to cross-subsidize different parts of the platform (girls get free drinks at bars, men pay more). You can create complementary networks (Taobao helps Alipay and vice-versa). Yu can get linked businesses (Amazon’s cloud business subsidizes its logistics). And so on.

Question 1: How does “new retail” change a resource view of ecommerce?

This is the question I have been thinking about a lot. And a lot of this article is me thinking out loud.

But new retail is clearly a massive jump in the assets on the marketplace platform. And while all the talk is about physical retail, is Alibaba actually adding physical assets to their platform? I don’t think so. I think they are just leveraging in the intangibles of the tangible assets.

To me, new retail looks like it adds two big assets to the platform that Alibaba doesn’t have today. These are offline sales data and physical retailers, merchants and brands as users.

Take the “new retail” initiative in convenience stores. Alibaba is providing digital tools that transform mom-and-pop convenience stores in China. They plug in the tools and the stores gets three basic benefits.

  • Online customers can be driven into the stores from the local area (maybe). The merchant gets access to local online customers the same way an online merchant does. And they can market to them. Although in this case you are fighting for the customers in your neighborhood, not nationally. And you are fighting against other digitized local merchants, not every merchant in China.
  • They get digital tools that upgrade their payments, inventory, and supply chain. They get a bit of a store tech upgrade. Ideally, they get more efficient operations. Although adopting these tools also creates switching costs.
  • They get data that helps them choose their inventory for what people in that neighborhood actually want. This is hugely important and is part of Alibaba’s “uni-marketing” initiative.

And what does Alibaba get?

Well, the physical merchant just became as user in their marketplace platform. They add the transactions, the user and the data of the physical merchant without adding the physical assets. And they also probably got some new offline customers, but most everyone in China is already on Taobao.

So Alibaba is not going to own a lot of stores, such as Hema supermarkets or convenience stores. They are going to perfect the various business models and franchise out the system, the data and the technology tools. And for the hypermarkets, they will likely put that in a separate, associated and asset-heavy partner. And they will remain the data / tech partner for this, as they has done in logistics with Cainiao. The core marketplace, the engine of Alibaba, is going to remain tangible asset-lite and intangible asset-rich.

Now imagine they roll this out to 100,000 convenience stores in China? How many of those stores can be moved onto their ecosystem in this way? And then supermarkets? And then department stores? With a resource view, the size of the “new retail” opportunity is massive

Question 2: Who will own the customers in “new retail”?

This strikes me as a big question. Merchants are on Taobao and Tmall because they have to be. That’s where the customers are. They may also have their own branded website but they are also on Taobao and Tmall. And they can drive their customers to their stores and their own websites from here to a certain degree. But if they leave the Alibaba ecosystem customer retention is a problem. Famous companies like Zara and Apple have their own brands and customers. But most small merchants do not have this type of loyalty.

So this raises a question for new retail: if a physical merchant unplugs from the platform, do they take their customers with them? Or do those customers start getting directed to a different convenience store down the street? Who owns the customer in new retail?

WRITTEN BY: Jeffrey Towson

GUEST POST BY: JEFFREY TOWSON

H&M and Zara are two companies I pay a lot of attention to in China.

  • They have great business models. Fast fashion is really impressive in general.
  • They are popular with Chinese consumers.
  • They are both following market leader Uniqlo in terms of expansion into second and third-tier cities.
  • They seem to be growing steadily, despite slowing growth in apparel overall.

Overall, both look like big winners in China going forward. But I think there are two potential threats emerging. More on this in a second. First a quick diversion.

I keep a list of questions that I think are both important but difficult. These are things I try to figure out over time. One of these questions is “will fast fashion work the same in China as elsewhere?”. As exemplified by Zara and H&M, fast fashion has been a stunningly powerful business model. It continues to expand in the Europe and US – and is now growing in emerging markets. But it’s still not clear to me how well it will do in China, where consumers are fickle, competitors are ferocious and mobile/ecommerce appears to be changing almost everything in retail.

My answer to this question, thus far, is that the Western fast fashion giants are well positioned for China and for rising Chinese consumers.

The Zara and H&M business model has been studied extensively. It relies on syncing consumer behavior in stores with centralized design/manufacturing capabilities. Zara is the more extreme case with manufacturing in-house and re-design and shipping done on almost a weekly basis based on customer purchases. H&M, in contrast, has most of its manufacturing outsourced to Asia.

This “quick reaction” apparel platform makes great sense in China. If >50% of a season’s merchandise is re-mixed and re-designed during the season, that enables you to change with rapidly changing Chinese consumers. In this, “quick reaction” has a strength (i.e., reacting in real time to changing tastes) where many other Chinese consumer-facing companies have a perpetual problem.

This operating model also enables them to push discount versions of the latest designs from the fashion capitals (Paris, Milan, etc.) to China stores in a couple of weeks. Having design centralized in Europe also probably helps these stores in China. It is a differentiating strength relative to both local Chinese competitors and to “slower fashion” houses like Gucci and Prada.

Overall, fast fashion still looks like a great approach for rising Chinese consumers.

One more quick aside

(skip to the below points if you’re reading quick).

One of the benefits of fast fashion is you can have multiple style waves instead of 2-3 fashion seasons per year. One result of this is that consumers tend to come in more often as there is frequently new stuff to see. This, in theory, gets you greater revenue (people come more and buy more). You also get a greater “share of the consumer mind” (a Warren Buffett term). Greater frequency of consumer activity generally creates a stronger brand and a better relationship.

Financially, these frequent style waves also show up as less discounting of goods (a perpetual problem in fashion retail), higher revenue, and better working capital. That’s the theory anyway. And H&M and Zara do produce tons of cash, which they can then put into more scale and more stores. It’s a powerful approach when compared to traditional department stores or luxury fashion houses.

That said, it’s not clear to me that you get these same benefits in China. In particular, I don’t know if you see the same increased visits and branding benefits. Cycle times are already pretty fast in China. Most of the textile/apparel production is actually done in China / Asia. And I’m not sure you have the same historical expectations for a seasons’ new merchandise to contrast with. So I’m not sure about the revenue and gross margins of this model in China. Gross margins are typically 60% elsewhere.

Ok. Back to my main point, that there are two threats to the big China dreams of these fast fashion giants.

Threat 1: Ecommerce, mobile, and O2O are happening fast in China – and these companies are not real fast at this stuff.

Retailers are pretty much ground zero for changes in Chinese e-commerce, mobile, and online-to-offline activity. Digital transformation is hitting this sector like just about no other (except maybe auto and transportation).

First, the rapid adoption of everything mobile in China is transforming the interface with consumers. It is no longer just about walking in the mall and then going into a nice store like it might happen in Sweden. The Chinese customer experience is already a combination of the mall, a store, your activities in various online ecosystems and a rapidly developing logistics/delivery network. The two words you hear over and over in Chinese retail are digital and delivery. How this offline-online mix is going to play out and what “new retail” is going to end up looking like is unclear. But Chinese retail is where it is happening really quickly.

Against this rapidly changing Chinese retail landscape, here are some disturbing facts. Zara didn’t have an online store until around 2010 (about a decade after the Gap). And H&M didn’t start online sales in the US until around 2012. They also didn’t open a shop on Tmall until 2014. These companies are notoriously slow in digital stuff.

Both Zara and H&M are awesome in inventory and logistics. That is their strength. They have a powerful supply chain that connects retail activity around the world with centralized design and manufacturing, almost in real time. But they have been pretty slow when it comes to ecommerce and mobile. And these are precisely the things that are happening quickly in China – and that their Chinese competitors are particularly good at.

Threat 2: The local Chinese competition is moving upmarket.

You also need to consider the recent actions of the Chinese apparel giants such as Peacebird, Heilan, and Septwolves. They operate about 10x more stores than the foreign companies. Zara, H&M, and Uniqlo have 200-500 stores each. Helian and Septwolves have 2,000-4,000 stores each.

These big local competitors have historically been cheaper but they are now upgrading and moving upmarket. They are going to increasingly challenge Uniqlo, Zara, and H&M, especially as they continue to expand into second and third-tier cities.

When you combine #1 and #2, things get really interesting. What happens when you combine rising Chinese competitors with big digital, mobile and ecommerce disruptions? Does that change the fast fashion business model that has been so powerful in so many countries? This is the question I have been thinking about.

Anyways, that said, both H&M and Zara do appear to be in great shape in China right now. They both continue to open tons of China stores each year. They have a nicely adaptable model that is well-suited to the continually changing preferences of Chinese consumers. And Chinese consumers keep getting wealthier and wealthier. So that is all pretty great.

These companies may well turn out to be unbeatable in China, just like in most other places. But I am keeping an eye on these two particular threats to their China plans. We’ll see.


The first version of this article was published here