(2a/2) BABA: Back for Business
Retracing Alibaba's missteps and route to redemption
In our previous post in this series, we examined in detail how the stage was set for PDD to make a grand entrance, with the side-effects of Alibaba’s premiumization strategy creating both vendors and addressable customers for PDD to target directly.
Initially in this post we intended to go through:
Why PDD was able to take share from Alibaba.
What changes Alibaba has made recently that make us optimistic.
What risks prospective investors may face.
However, the post became too long to send via email again, and we had to split it into parts 2a and 2b. We shall focus on why PDD was able to take share from Alibaba for now, examining in detail where Alibaba slipped up. A critical prerequisite for course correction is to understand where they went wrong.
First, a bit of housekeeping - please can you let us know the best day to send future updates out on:
The battle for Chinese ecommerce was believed to have been settled, yet PDD proved to be the perfect challenger for four reasons (in addition to the ideal macro conditions, which we have already covered):
Management. PDD had remarkable management, well-versed with trial-and-improvement.
Tencent. PDD enjoyed Tencent’s support, leaning heavily on WeChat, especially the four key WeChat features (official accounts, moments, groups & WeChat Pay).
Strategy & tactics. PDD made use of multiple micro-innovations that were uniquely suited to its early customers that competitors struggled to keep up with.
Competitor response. Alibaba did not have the same levers – due to misdiagnosing the situation it also failed to respond appropriately.
PDD’s management is remarkable – its founder also has a special connection to value investing through his mentor.
The founder of PDD, Colin Huang, was able to largely stay out of the limelight, even as PDD grew and blossomed. He deserves his own post, but we note here that Colin has a special connection to value investing.
Through his mentor, Duan, a 26-year-old Colin had lunch with Warren Buffett in 2006, while working as a Google software engineer.
Duan himself was an exceptional entrepreneur & asset allocator, making a 100x return on a legendary trade in NetEase that yielded over US $200 million from just US $2 million in just a few years – indeed his stake was worth over 70x the initial investment in less than 24 months. Media graced Duan with the moniker “Chinese Buffett”.
Colin also became an outstanding asset allocator with a distinctive style.
Consistent with real options theory, he preferred to have a wide portfolio of quite different projects running in parallel, dedicating his attention to whichever had the highest ROI, though his propensity for risk appears to greatly exceed most investors.
Consequently, Colin was able to simultaneously drive multiple initiatives to rapidly trial-and-improve PDD, quickly abandoning any with lesser prospects.
PDD was to go through significant changes before it could take the fight to Taobao, but when it did, PDD saw explosive growth comparable to WeChat.
Tencent offered strong support to PDD, both financially and operationally.
PDD started off purely as a WeChat official account, without even its own app. Though Tencent already invested in JD, it also wanted to hedge its bets and reduce the likelihood of JD overshadowing itself, so it invested in PDD as well.
Apart from Tencent’s investment, WeChat was pivotal. While WeChat’s Official Account & Moments played a key role during PDD’s incubation, WeChat Groups and WeChat Pay would play an equally significant role in its amplification.
WeChat Groups enabled PDD’s early viral marketing campaigns – the “Team Up, Price Down” promotion (later driving the creation of TEMU overseas).
A play on the traditional referral model, this also incorporated certain aspects of multi-level marketing.
To enjoy a sizeable discount, a user must share a link with a set number of family and friends, each of whom can click the link to help the original user come closer to their goal, and are also free to share the link with others to enjoy the same discount.
For example, to enjoy a CN ¥3,000 (just over US $400) discount on the above scooter, a user might share with five others, each of whom may share with five others again.
Thanks to WeChat Groups, these quickly became viral in the more rural parts and smaller towns where people knew each other well (a major difference between rural China and many Western cultures). These discounts were extremely attractive to older, more price-sensitive users.
Though WeChat did not allow sponsored advertising back then, to support PDD, it allowed these links to be shared for multiple years (whereas it blocked other platforms like Taobao).
On top of this, WeChat also provided a link to PDD from its digital wallet – just like for JD. The link is marked “Buy Together” in the image below – also note JD’s logo (“Specials”) immediately above.
Existing balances on WeChat Pay drove down the cost of decision-making for many rural customers – because there were few other ways to spend.
Apart from the payment feature that is necessary for any ecommerce platform, WeChat Pay supplied another surprising benefit for PDD – lots of existing balances, which had a similar effect to prepayment.
To understand this phenomenon, we need to go back to 2014, when WeChat first released its Red Packet feature – which in turn tapped a far older tradition.
Around two thousand years ago, special coins associated with warding off evil and bringing fortune began to appear in China, and were popularly given to children. Over the course of a millennium, this tradition gradually evolved to its current form – adults gifting children with money, especially during the Spring Festival.
The brainchild of a Tencent developer, the Red Packet feature was quickly hacked together.
Originally intended only for internal use (Tencent has a company tradition of seniors gifting juniors red packets), its popularity soon spurred a public release on WeChat.
Gamification proved the secret to its success – for example, the sender can limit the number of recipients, say ten, and the total sum, sharing it in a group with many more members. Only the first ten would receive a randomized share of the total pot.
This created a competition and therefore entertainment value: only the fastest would win money. A popular rule soon appeared that the recipient of the largest amount would have to send their own red packet, adding replayability.
Red packets spread like wildfire.
In 2015, to further drive the adoption of WeChat Pay, Tencent sponsored the equivalent of the Superbowl in China – CCTV’s Spring Gala.
690 million viewers tuned in (despite being a then record low) to the TV program. These viewers were then able to shake their phones at specific points to receive random cash gifts from Tencent.
During that one show, 11 billion user “shakes” were recorded, and Tencent only spent CN ¥500 million (around US $70 million).
Previously, Alibaba’s Alipay was dominant, with nearly 50% market share to Tencent’s 20% in 2013, but thanks to the Red Packet and other micro-innovations, Tencent reached nearly 40% by 2016.
Over time, cash balances on these wallets accumulated – especially in the rural regions, where older & less digitally savvy consumers had few ways of spending the money (or did not know how to).
While JD also had access to WeChat’s user base, PDD targeted this pool of money far more effectively, by making it easier to shop.
Gunning for less digitally savvy & rural users first, PDD developed multiple micro-innovations of its own to win business.
Most ecommerce platforms rely on more users, higher purchasing frequency and bigger orders to drive GMV, but PDD decided to forgo this last lever to increase conversion and frequency.
As can be seen in the image below, PDD removed the shopping cart altogether (the red button goes to the checkout page directly), to minimize purchasing friction and maximize conversion.
Other platforms could not easily replicate this daring innovation, which decreased customer drop-offs and greatly simplified the user journey for older users.
Unfortunately for Alibaba, their platforms were also unable to immediately replicate this shortened journey – instead being organized to increase the number of items in the shopping cart.
On top of this, PDD designed and trialed many marketing tactics, many incorporating gamification, to cheaply acquire more users.
Finally, PDD specialized in necessities, especially agricultural produce and non-branded items, which appealed to rural users, but were looked down upon by Alibaba and JD’s most premium users – making it hard for them to carry comparable products
As digital penetration increased, customer acquisition costs also increased for Alibaba, but it did not have access to WeChat levers, and no alternatives existed.
This was the critical blow from Alibaba’s spat with Tencent. With over a billion active users across both WeChat and QQ, Tencent functioned as the upstream feeder, directing traffic into its own ecosystem partners for monetization.
Worse was to come.
Alibaba’s hardball tactics – in part driven by the very nature of its business – won it few friends in the highly competitive Chinese tech arena.
Instead, Tencent amassed a formidable who’s-who of Chinese business leaders to take on Alibaba: the anti-Alibaba coalition.
Clockwise, starting from the top, we have:
Pony Ma – founder of Tencent
Richard Liu – founder of JD
Zhang Lei – founder of Hillhouse Capital
Cheng Wei – founder of Didi
Cheng Yixiao – founder of Kwai (then the number one short-video platform)
Wang Xiaofeng – CEO of Mobike (the bike-sharing service)
Wang Huiwen – second-in-command at Meituan
Zhou Yuan – founder of Zhihu (Chinese Quora)
Yao Jinbo – founder of 58.com (Chinese Craigslist)
Allen Zhu – founder of GSR Ventures (invested in Didi, Qunar, Red, etc.)
Chen Shengqiang – CEO of JD Finance
Yang Yuanqing – CEO of Lenovo
Neil Shen – founder of Sequoia China (previously founded Ctrip)
Zhang Yiming – founder of Bytedance
Lei Jun – founder of Xiaomi
Wang Xing – founder of Meituan
Notably, Colin Huang was missing from this picture because PDD had yet to gain its seat at the table – but that was about to come in short order.
None of these platforms would now be accessible to Alibaba’s Taobao or Tmall.
Management took notice and tried to form its own alliance, including both:
Offline. Mostly traditional retail businesses.
Online & innovation plays. Online and innovation O2O businesses (those that had both online and offline elements).
Various forms of strategic partnerships & investments, joint ventures and outright acquisitions were considered and tried.
Increasing digital penetration saw online customer acquisition costs rising to even exceed those offline, so Alibaba explored ways to drive offline traffic online.
Because digital penetration was highest in the more developed cities, the established ecommerce players such as Alibaba and JD were fighting hard for share, even as PDD benefited from growing digital penetration in lower-tier cities.
With Tencent cozying up to the number two ecommerce platform in China, JD, Alibaba naturally joined forces with number three, Suning (bottom-right below). However, Suning was still very much an offline-first retailer, launching its online arm only to keep up with JD.
Suning also overextended, diversifying into sectors such as finance, real estate and even acquiring a majority stake in Inter Milan, the Italian soccer club.
Alibaba made another major investment in Sun Art, the operator of RT-Market and Auchan hypermarkets in China, and the number one hypermarket / supermarket chain in the country. It, too, failed to offer meaningful returns.
Its other investments were similar.
This was because unlike Tencent, Alibaba’s core business overlapped too much with these investments, generating too little synergy and too much cannibalization.
Yet with its operations being online, it was extremely difficult (both practically and politically) to consolidate Alibaba’s business directly with offline retailers and create an integrated experience for customers.
Apart from these, Alibaba also formed its Hema subsidiary, then a novel format that drove the “New Retail” trend with its omnichannel experience and F&B elements, inspiring many imitators in China and later sweeping across Southeast Asia.
However, this too proved to be a burden. Beyond the first few locations, Hema stores required years of investment before they turned profitable, increasing the overall capital intensiveness of Alibaba, and depressing return on assets.
Alibaba also struggled to reap dividends from its investments in online and innovation businesses.
Alibaba was burned by its investments in Meituan and Kuaidi, who became more closely aligned with Tencent.
The former found Alibaba too overbearing as an investor and rebelled, while Kuaidi was combined with the Tencent-backed Didi in a merger of equals, only to have the original management be sidelined & removed.
Partially as a result, Alibaba tried to do too many things itself, acquiring multiple leading platforms for their users, but struggling to run them well.
Youku, the Youtube of China (in turned formed from the merger of two leading streaming platforms Youku and Tudou) was number one at the time of its acquisition by Alibaba. It soon lost this position to Tencent Video.
Similarly, for Xiami Music & Tiantian Dongting, the top music platforms in China at the time of acquisition – Tencent shut down the links to those from WeChat, and launched its own Tencent Music Entertainment Group in 2016 to compete head-on.
Eleme, the food delivery platform, and Ofo, the bike-sharing service, were striking parallels. Founded by university students, both became number one only to lose to more experienced founders from Meituan and Mobike (acquired by Meituan).
At its height, Ofo drew over 200 million MAUs, but its business model was unsustainable. Alibaba picked up those businesses when they were already on their way down.
Unlike Tencent’s hands-off approach to its portfolio companies, Alibaba’s strength was execution. It has a strong, “just do it” type of culture, which saw it integrating and attempting to outexecute acquired companies at their own core businesses.
Worst of all, these various attempts to drive growth distracted management from their core business.
Unfortunately for Alibaba, it was distracted by noise and failed to react appropriately to the rise of PDD in time.
It tried to address the symptoms rather than the root cause.
Taking a step back, it is readily evident that no reasonable amount of offline investment could come close to Tencent’s reach of over a billion MAUs.
Similarly, almost no other online platforms would be competitive, apart from maybe Baidu, with a de-duplicated MAU base of perhaps 700-800 million.
In fact, Tencent had a similar moment in 2010 (we shall not go into that here for lack of space), but the epiphany that Tencent underwent saw it act with renewed focus and take a much more Buffett-like approach to its portfolio companies.
However, Alibaba failed to sense the threat and make up with Tencent or link up with Baidu.
Instead, it noticed NetEase – the same company in which Duan (PDD’s founder’s mentor) made the US $200 million – make good headway with its more premium ecommerce offerings.
Founded by Ding Lei, formerly the wealthiest man in China, NetEase previously relied almost exclusively on its gaming business, and is still the number two gaming company in China behind only Tencent.
Consequently, Alibaba tried to go even more upmarket with efforts such as Tmall Global. Meanwhile, the more established JD and Vipshop were seen as the other major threats with their mid-market offerings.
PDD was only noted as a significant competitor in 2018, when it was only a couple of months away from its Nasdaq IPO, and had 300 million MAUs.
Indeed, in its early days, when Chinese media exposed the presence of bizarre counterfeits on PDD, the platform was quickly dismissed as a viable threat.
We show an example of such counterfeits: the three bottles above are all counterfeits with subtly different characters in the logo to confuse consumers – the real product is below for comparison.
Many observers therefore incorrectly assumed that PDD’s sales were driven by little more than cheap knockoffs of reputable brands. In fact, counterfeits formed less than 1/10 of sales, a figure that was to fall as PDD vigorously fought against fraud.
Instead, PDD made considerable savings in its supply chain, focusing on non-branded merchandise to drive prices down, and making products on its platform accessible to consumers in small towns and even rural regions.
Alibaba initially misread the trend of democratization of ecommerce as consumers trading down.
This led it to deprioritize its own, and much older discount group-buying platform, Juhuasuan, towards the end of 2016 – an understandable move, given that almost everyone in the Chinese ecommerce sector scoffed at PDD at that time.
It reintroduced Juhuasuan in 2019, and launched a special discount version of Taobao soon after, but these actions proved to be too little too late. Within another couple of years, the number of active users on PDD exceeded that on Taobao and Tmall combined.
Recent developments at Alibaba have made us much more optimistic about its prospects; they address more directly long-standing issues as highlighted.
In the next installment 2b we shall discuss what has changed and what risks investors will be taking on by betting on BABA.
A thought experiment: If you were in charge of Alibaba, what would you have done differently?
Full disclosure: We hold a long position in Alibaba and PDD - this is not a solicitation to buy or sell. We have no current business relationships with the companies mentioned in this note, and are not paid to write this piece (other than paying fellow exponents of the research).
Disclaimer: This should not be construed as investment advice. Please do your own research or consult an independent financial advisor. Alpha Exponent is not a licensed investment advisor; any assertions in these articles are the opinions of the contributors.
Excellent and original research on $BABA and peers! Thank you. Keep it up.
This is good stuff. Keep them coming!