Internet Research SECTOR REPORT. E-Commerce. Chinese online retail: poised for investable growth. Investment Summary. 24 June 2013

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1 Internet Research SECTOR REPORT Chinese online retail: poised for investable growth Investment Summary We disagree with market s general pessimism on online retail in China, on both market potential and business model terms Online Retail 1.0 companies are harvesting their infrastructure investments in the forms of open platform. A new breed of Online Retail 2.0 companies is leveraging big data, digital marketing, mobile Internet and flash logistics to compete and grow. Profitability is no longer elusive Led by Alibaba and Jingdong (JD), online retailers are expanding their infrastructures and ecosystems with new marketing, discovery, delivery/logistics, payment and outsourcing business models We have BUY rating on VIPS, QIHU and SINA and HOLD on BIDU. Research team 24 June 2013 Eric Wen Head of TMT Research Yu-Heng Fan, CFA Advertising, Online travel, E-com China Renaissance Research team members equityresearch@chinarenaissance.com China Renaissance Securities (Hong Kong) Limited 1

2 Internet 24 June 2012 E-commerce BUY HOLD SELL Poised for investable growth Top picks Ticker Rating Target Qihoo 360 QIHU US BUY US$57 Vipshop VIPS US BUY US$38 Source: CRSHK Stocks or companies mentioned Name BBG code Rating TP Curr. price 14 PE Vipshop VIPS US BUY 38US$38 US$26 17 Qihoo QIHU US BUY US$55 US$45 23 SINA SINA US BUY US$73 US$57 45 LightInThe LITB US NA NA NA NA Box Dangdang DANG US NA NA NA NM Alibaba NA NA NA NA NA Jingdong NA NA NA NA NA Dianping NA NA NA NA NA Meituan NA NA NA NA NA Jumei NA NA NA NA NA 1haodian NA NA NA NA NA Suning NA NA NA NA CH Tencent 700 HK NA NA HK$ Source: CRSHK, CapitalIQ Price performance and volume data Jun/08 Nov/08 Apr/09 Sep/09 Feb/10 Jul/10 Dec/10 May/11 Oct/11 Mar/12 Aug/12 Jan/13 Source: CapitalIQ. Research team Tianli Wen CRII Index Yu-Heng Fan, CFA E-commerce Index China Renaissance Research team members China s e-commerce sector has explosive growth potential ahead, in our view, across all segments We suggest investors to focus on e-commerce 1.0 companies who have completed their initial investment cycle and are renting out their infrastructures through open platform We selectively endorse certain vertical e-tailers and e-commerce 2.0 companies who use big data, digital marketing and flash logistics to compete. We also highlight traffic gateways as choice for investment. We disagree with market pessimism on e-commerce After Macoxlane (MCOX US) and Dangdang s (DANG US) IPO in 2010, fierce competition have swept Chinese online retail. Investors have adopted a pessimistic stand towards Chinese e-commerce due to its unprofitable situation. Our recent survey of the sector concluded the otherwise. E-commerce can not only grow substantially, it can also post substantial profits. E-commerce 1.0 is bearing fruit Early e-commerce investments focused on building infrastructures. Such investment is now bearing fruit as later comers no longer have access to capital. We expect open platform initiatives of Jingdong s and DANG s to help improve their profitabilities. Some vertical e-tailers are already enjoying strong growth and decent profitability, thanks to their category s unit economics. E-commerce 2.0: big data, flash logistics, digital marketing and mobile Internet On top of e-commerce 1.0 infrastructure a new breed of asset light e-commerce companies are emerging, with innovations on big data, digital marketing and flash logistics. Further surrounding Alibaba s ecosystem our survey already found companies that will soon reach public market scales. Market potential is huge and penetration is low It took fifteen years for online advertising to reach a scale as big as print advertising. Online video is now 8% of TV advertising. Online retail is now 6% of offline retail but China s retail market is 340x of print and TV advertising in size. Focusing on scarce resources for e-commerce Resource scarcity likely leads to asset appreciation. We draw investor attention to mobile Internet which is just at the beginning of resource allocation. We also expect Internet traffic and last mile delivery assets to appreciate over time. Key financial of stock mentioned Revenues (US$ mn) Non-GAAP op. profit (US$ mn) GAAP EPADS (US$) E 2014E E 2014E E 2014E Vipshop 692 1,602 2,619 (4.3) (0.04) Qihoo SINA (7.8) Baidu 3,328 4,451 5,550 1,803 1,965 2, LightInTheBox 200 NA NA 0.4 NA NA (0.20) NA NA Dangdang 834 NA NA (76.7) NA NA (0.89) NA NA Source: CRSHK, CapitalIQ consensus China Renaissance Securities (Hong Kong) Limited 2

3 Recent reports in the past Vipshop Holdings( VIPS US, BUY: PT:US$38), 30 May 2013, Share price volatility creates buying opportunity SINA Corporation (SINA US, BUY: PT US$73) 1Q13 Review, 20 May, 2013, Raise PT to US$73 to reflect upside in Weibo ad sales Vipshop Holdings (VIPS US, BUY: PT US$38) 1Q13 Review, 20 May, 2013, Strong 1Q result and 2Q momentum TP to US$38 QIHOO 360 Technology Co. Ltd (QIHU US, BUY: PT US$42) 1Q13 preview, 6 May, 2013, Robust topline growth; search the 2H focus YY Inc.(YY US, BUY: PT US$22) 1Q13 review, 3 May, 2013, Momentum likely continues; Reiterate BUY BIDU (BIDU US, HOLD, US$99) 1Q13 review, 26 April, 2013, Not yet out of the woods YY Inc.(YY US, BUY: PT US$21) 1Q13 preview, 23 April, 2013, Results likely strong; Reiterate BUY BIDU (BIDU US, HOLD, US$100) 1Q13 Preview, 16 Apr., 2013, Still in business transition Qihoo 360 Technology (QIHU US, BUY: PT US$42) NDR takeaways, 22 March, 2013, Casting a wide net at a time of change YY Inc.(YY US, BUY: PT US$21) 4Q13 review, 8 March, 2013, Results likely strong; Reiterate BUY Youku Tudou Inc. (YOKU US, BUY: PT US$25) 6 March, 2013, Executing sales growth during the mobile transition Sina Corporation (SINA US, BUY: PT US$63) 27 February, 2013, Robust Weibo sales growth; improving profitability YY Inc.(YY US, BUY: PT US$21) 14 January 2013 Capitalizing on demand for live online entertainment Key charts and tables Exhibit 1: China retail and online retail market forecast, GMV and transaction volume Rmb bn 2009A 2010A 2011A 2012A 2013E 2014E 2015E China retail 13,268 15,700 18,392 20,717 23,203 25,523 27,565 Y-Y (%) 22.3% 18.3% 17.1% 12.6% 12.0% 10.0% 8.0% Online retail ,194 1,657 2,097 2,641 % of China retail 2.0% 2.9% 4.2% 5.6% 6.9% 7.9% 9.6% Y-Y (%) 105.2% 76.4% 70.5% 48.0% 36.2% 25.7% 32.1% Online retail segments B2C/B2B2C ,290 C2C ,062 1,201 O2O NA Online retail segment growth B2C/B2B2C 106% 200% 210% 97% 69% 46% 36% C2C 103% 65% 47% 32% 23% 12% 14% O2O NA 97% 133% 111% 66% 56% 41% Online retail segments % B2C/B2B2C 8% 13% 23% 30% 35% 41% 47% C2C 89% 84% 73% 64% 57% 50% 44% O2O/Group Buying 3% 3% 4% 6% 7% 9% 10% Source: CRSHK, National Bureau of Statistics, iresearch. * O2O includes group buying (less product group buying), classified services, map O2O, online loyalty but excl. Taobao Ju. Taobao Ju is included in B2C Exhibit 2: China B2C retailer profitability comparison, per order basis Vipshop DANG Jingdong 51BUY (Tencent) Jumei VANCL Yihaodian Revenue per order Gross margin 23.4% 17.2% 7.5% 4.5% 25% 40% 15% Gross profit Fulfilment cost per order (26.6) (12.5) (28.0) (36.0) (15.0) (36.0) (20.8) Adjusted gross profit (15.8) OPEX per order (47.7) (8.4) (18.8) (9.0) (35.0) (24.0) (16.0) Operating profit per order 3.9 (5.4) (17.6) (24.8) 12.5 (12.0) (12.8) Operating margin 1.8% (6.0%) (4.5%) (5.5%) 5.0% (10.0%) (8.0%) Source: CRSHK. 51BUY is part of Tencent Exhibit 3: Conversion rate of different performance ads formats Search PSP Contextual SNS Baidu Taobao Conversion rate 2-4% 2-6% 1-3% 2-6% 1-2% Source: CRSHK industry compilation from BIDU, QIHU, Taobao, Tencent Exhibit 4: Cost Per Click (CPC) of different performance ads formats Search PSP Contextual SNS Baidu Taobao Cost Per Click (Rmb) China Renaissance Securities (Hong Kong) Limited 3

4 Relevant reports in the past Vipshop Holdings (VIPS US, BUY: PT US$25) 14 January, 2013, An under-rated leader in deep discount retail Qihoo 360 Technology (QIHU US, BUY: PT US$42) 14 January, 2013, Platform expansion in full swing; initiate at BUY Key charts and tables (con d) Exhibit 5: Alibaba Group C2C, B2C/B2B2C, group buy, and B2B GMV, sales, Take Rate and Peer comp table (Rmb bn) E Alibaba Group GMV ,290 -Taobao Jishi Tmall B2B NA NA NA NA NA -Ju Alibaba Group Revenues Taobao Jishi Tmall B2B Ju Alibaba Rev./GMV (Take Rate) -Taobao Jishi 0.7% 1.3% 2.2% 2.4% 2.8% -Tmall 0.0% 0.0% 2.0% 2.6% 3.0% -B2B NA NA NA NA NA -Ju 0.0% 0.0% 0.0% 3.7% 5.5% Peer take rates -ebay (~Taobao Jishi) 10.9% 10.7% 11.0% 10.9% 11.0% -Rakuten (~Tmall) 8.5% 8.2% 8.0% 7.9% 8.0% Source: CRSHK, Company data Exhibit 6: Dianping, Buding and Taobao Life lead in mobile O2O apps (m) DAV (m) Daily time spent (m min) Time spent per day(min) Dianping ( 大 众 点 评 ) Buding Coupon ( 布 丁 优 惠 券 + 布 丁 电 影 票 + 布 丁 爱 生 活 ) Taobao Life ( 淘 宝 生 活 + 淘 宝 电 影 票 ) Baidu Shenbian ( 百 度 身 边 ) QQ Meishi (QQ 美 食 ) Source: iresearch Exhibit 7: Cross border B2B and B2C sites in China and their market share estimates Market size (mn US$) 700 2,000 5,500 13,000 Market share 100% 100% 100% 100% B2B/B2B2C (GMV) 70% 78% 68% 39% Dhgate ( 敦 煌 网 ) 44% 46% 30% 13% ebay Chinese merchants 13% 11% 26% 19% AliExpress ( 阿 里 速 卖 通 ) 9% 15% 10% 5.4% Tradetang ( 易 唐 ) 2.0% 2.5% 1.2% 0.8% Milanoo ( 米 兰 ) 2.6% 3.0% 1.0% 0.5% B2C (Revenues) 29% 22% 32% 61% LightInTheBox ( 兰 亭 集 势 ) 3.7% 3.0% 2.1% 1.5% DealeXtreme ( 帝 科 思 ) 11% 6.4% 3.2% 1.3% DinoDirect ( 大 龙 ) 1.1% 1.5% 0.5% 0.2% Others 13% 11% 26% 58% Source: CRSHK, ebrun China Renaissance Securities (Hong Kong) Limited 4

5 Exhibit 8: Valuable table summary 20/6/2013 P/E Revenue growth 2013E 2014E PEG ratio 2013E 2014E Y CAGR Gross margin Vipshop NA 132% 64% 75% 22% Qihoo % 50% 63% 86% SINA % 27% 22% 64% Baidu % 25% 27% 77% Source: CRSHK, CapitalIQ Exhibit 9: Online retail as percentage of total retail sales Exhibit 10: Online B2C retailer profit equation 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 2.3% 2.8% 3.0% 3.9% 3.9% 4.3% 4.7% 4.9% 4.8% 5.5% 5.6% 6.5% 5.4% Gross Profit- Fulfillment Retail Business (Order Size- Procurement Cost per Order- Fulfillment) Scale Marketing+ Technology + G&A OP income/ loss 1.0% 0.0% 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 China Source: US Census Bureau, NBS, iresearch. Chinese online retail includes B2C,C2C and group buying US Service Business Source: CRSHK Marketplace Commission + IT /AD /Finance /Fulfillment Service Exhibit 11: Margin quadrant of Chinese B2C retailer (Number=2012 revenue) q Exhibit 12: Online retailer growth phase and nature of their price wars Gross Margin 30% 25% VANCL 4,500 VIPS 5,500 Jumei 2,500 20% 1haodian 6,800 DANG 15% 7, % 5% 360BUY 60,000 51BUY 6,000 0% Revenue per order (Rmb) Source: CRSHK. Revenue in Rmb mn Source: CRSHK Exhibit 13: Time spent trend of Taobao Jishi and Tencent Paipai Exhibit 14: Market share of group buying by GMV (March 2013) Time spent (m hr) Taobao Paipai Taobao:Paipai Others 5% Ju (Alibaba) 3% Gaopeng (Tencent) 3% Lashou 10% Nuomi (RENN) 11% 55Tuan 12% Meituan 37% Dianping 18% Source: iresearch Source: Tuan800 China Renaissance Securities (Hong Kong) Limited 5

6 Exhibit 15: ADX connects DSP and SSP Exhibit 16: Process diagram of typical online retail fulfilment Customer Customer take place order Customer Return Choose COD Pay online Allocate to certain warehouse Picking and Packing re-shelving Allocate to the last-mile shipping partner Allocate to the inter-city logistic partner E-commerce Company Warehouse Logistics Supplier Inventory management Product supply chain Monitor the speed and service level Forward logistics Reverse logistics Cash flows Source: Baidu Exhibit 17: Time spent market share of e-commerce Source: CRSHK Exhibit 18: Time spent market share of mobile payment apps 1, China Mobile 1% Lakala 2% China Telecom 1% Others 2% Tenpay 14% Alipay 80% E-commerce PC E-commerce mobile Source: iresearch Source: iresearch Exhibit 19: Monthly Time Spent of Chinese online retail companies, quarterly average (mn hr) 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 CQGR Taobao Jishi 3,013 3,515 4,761 4,082 3,856 3,957 4,630 4,554 4,398 3,596 4,752 3, % Tmall , % Jingdong % Tencent Paipai (3.8%) Vipshop % Dangdang (3.0%) Tencent 51BUY/QQ Buy % Meituan % Jumei % Amazon China (5.3%) VANCL % 55tuan % Renren Nuomi % Suning % 1haodian % 1haomall % Tuan % Source: iresearch China Renaissance Securities (Hong Kong) Limited 6

7 Contents Financial Summary Vipshop 9 Financial Summary Qihoo Financial Summary Dangdang 11 Why investors need to care about e-commerce 12 Offline retail gets the message: change or be changed 15 Online retail starts to impact offline retail in a visible way 15 China is leapfrogging US in online retail penetration 16 B2C to take nearly half of the market by 2015 but O2O will grow faster 17 Breadth push: no retail segment is immune from the online assault 17 Depth push: big data drives Online Retail Open platform links Online retail 1.0 infrastructure with 2.0 intelligence 21 Getting the profitability equation right: reason for optimism 23 Universal path to B2C profitablity: balance of scale and unit economics 25 B2C: Blue Ocean or Red Sea? 28 Potential: online prevails over offline and revenue-per-order upside 28 Challenge: Red Sea or Blue Ocean? 31 Alibaba and JD s logistics ambitions could change B2C landscape 32 International B2C and B2C outsourcing: growing niche markets 33 Factors that may limit Tmall s ability to improve its take rate 33 C2C: is it a winner take all market? 35 How big can Taobao win? 35 Social e-commerce: a new frontier and revenue source 37 Factors that could limit Taobao Jishi s potential to increase Take Rate 39 A discussion on Alibaba s Take Rates 40 Is Alibaba s Take Rate really comparable with ebay and Rakuten? 40 Tmall s Take Rate is significantly higher than Jishi s 40 Adding logistic service can increase Take Rate 40 O2O: at nascent stage but already with substantial players 42 Service economy is a substantial part of retail sales 42 O2O infrastructure platforms have emerged, as well as competition 44 Market consolidation opportunity can emerge in months 45 Export sites: C2C, B2B, B2B2C and B2C form a fragmented market 47 Online payment and cross-border delivery change B2B into B2C 48 Next direction in cross-border e-commerce: 2B or 2C? 48 Fulfillment and logistics: the privilege of the big players 49 Sorting and warehousing defines an e-commerce platform s strength 49 Arterial, inter-city and last-mile delivery capabilities: own or outsource? 50 Competitive landscape of Chinese e-commerce delivery industry 50 China Renaissance Securities (Hong Kong) Limited 7

8 Jingdong s fulfilment open platform vs. Alibaba virtual fulfilment th Five Year Plan addresses transportation challenges and shortages 52 Consolidation isn t likely to affect competition for pricing 54 Offline retailers: how are they fighting back the war? 55 Rationalizing offline presence is a common strategy for offline retailers 55 Offline retailers work with B2B2C and O2O to compete with B2C 55 Taobao ecosystem incubates extensive line-up of outsourcers 57 Aliyun and CSN are e-commerce outsourcers, too 57 Cross platform e-commerce service is emerging: focusing on big data 58 PC Internet companies: learning to cope with e-commerce 60 Tencent: using e-commerce to maintain user base loyalty 60 BIDU: biggest competitor to Taobao P4P ads 61 QIHU: biggest beneficiary of e-commerce advertising boom 61 SINA: using social e-commerce to monetize Weibo 62 Mobile Internet: what has it changed and what can it change? 63 Mobile is an incremental force for e-commerce 63 Mobile payment is a game changer and an enabler in the backend 64 O2O, flash sale and social e-commerce: initiating apps on mobile 65 Mobile payment is still a very small mobile Internet category 66 Valuation and peer analysis 67 China s e-commerce sector will take its shape in the next 6-12 months 67 Currently traded Chinese e-commerce stocks are reasonably priced 68 Appendix A: Reconciliation of GMV with postal statistics 69 Appendix B: Company & product mentioned 71 Disclaimer 74 China Renaissance Securities (Hong Kong) Limited 8

9 Financial Summary Vipshop Fiscal year-ends December 31 Exhibit 20: Income statement (Rmb mn) 2012A 2013E 2014E Company Description Vipshop (VIPS) is China s tenth largest online retailer by gross merchandise sales (GMS) and the largest flash sale retail operator with 50%+ revenue market share. Gross revenues , ,619.5 Agency cost Business tax Net revenues , ,619.5 Cost of revenues (537.6) (1,226.5) (2,019.6) Gross profit R&D cost Sales marketing cost (32.3) (69.1) (118.1) G&A cost (25.5) (47.8) (67.8) Operating profit GAAP (11.9) Share based compensation Operating profit non-gaap (4.3) Finance income (cost) Other income/cost Pre-tax profit (8.8) Income tax (0.7) (11.7) (23.3) Net income (9.5) Number of ADS, diluted EPADS (0.2) Gross margin 22% 23% 23% Operating margin, non-gaap (0.6%) 3.4% 4.1% Net margin, GAAP (1.4%) 2.3% 2.8% Source: CRSHK, company Exhibit 21: Balance sheet VIPS s traffic ranks No.9 in terms of users but No.5 in terms of time spent within China s online retail universe. VIPS has the 2 nd highest repeat purchase rate in China online retail, after Taobao Tmall. About 70% of VIPS s GMS is apparel, shoes and sportswear. Industry View Flash sale is a niche market in the Rmb1t online retail market, only 1.6% of GMS in 2013, comparing to B2C (36%), C2C (60%) and group buying (2%). We expect overall online retail to grow 31% YoY in 2013 while flash sale to grow 119% YoY. Exhibit 22: Cash flow statement (Rmb mn) 2012A 2013E 2014E (Rmb mn) 2012A 2013E 2013E Cash and cash equivalent Net income (9.5) Accounts receivable Adjusted for Prepayments Share based compensation Total current assets ,554.6 Depreciation Equity investment Amortization Property and equipment One-time write-offs Intangible assets Changes in Goodwill Account receivable (2.8) (13.6) (20.2) Prepayments and others Prepayments 0.4 (3.7) (6.4) Total assets ,626.4 Account payables Account payables Deferred revenues Deferred revenues Accrued liabilities Accrued liabilities Cash from operations Short term debt Capex (12.4) (24.0) (52.4) Total current liabilities ,128.5 Cash paid for equity investment Long term debt Cash from investing (113.7) (124.0) (152.4) Additional paid in capital Purchase/Issuance of company shares Treasury stock Cash from financing Statutory reserves Change in cash Accumulative deficit/loss (176.0) (139.1) (65.5) Cash at beginning Total equity Cash at end Total liabilities and equity ,626.4 Source: CRSHK, company Source: CRSHK, company China Renaissance Securities (Hong Kong) Limited 9

10 Financial Summary Qihoo 360 Fiscal year-ends December 31 Exhibit 23: Income statement (Rmb mn) 2012A 2013E 2014E Net revenues Company Description Cost of revenues (32.8) (87.8) (151.3) Gross profit R&D cost (156.3) (257.7) (323.5) SG&A cost (92.5) (173.7) (236.3) Operating profit GAAP Share based compensation (50.6) (59.2) (68.1) Operating profit non-gaap Finance cost Other income/cost Pre-tax profit Income tax (11.4) (18.7) (44.6) Net income, GAAP Net income, non-gaap Number of ADS, diluted EPADS, GAAP EPADS, non-gaap Gross margin 90% 86% 84% Operating margin, non-gaap 29% 27% 32% Net margin, GAAP 13% 16% 21% Net margin, non-gaap 31% 28% 33% 24 June 2013 Qihoo 360 Technology Co. Ltd. (QIHU) Is a leading Internet platform company in China as measured by active users. Monthly active users on PC reached 442mn as of September 30, 2012, ranking it No.1 among Chinese Internet companies, according to iresearch. Major products include online security, browser and various value added services. QIHU derives its revenues from advertising (personal startup page, browser and search) and games (web and client). Industry View QIHU belongs to the multi-business segment of the Internet sector. Multi-business Internet companies are typically traffic leaders who can turn their traffic into revenue by more than one monetization means. We expect performance advertising market to grow 60% and web game market to grow 38% in We expect overall online advertising market to grow at 42% and overall game market to grow at 22% in Exhibit 24: Balance sheet Exhibit 25: Cash flow statement (Rmb mn) 2012E 2013E 2014E (Rmb mn) 2012E 2013E 2014E Cash and cash equivalent Net income Short term investment Adjusted for - Accounts receivable Share based compensation Prepayments Depreciation & amortization Deferred tax assets Interest income (6.7) (6.7) (9.8) Total current assets One-time write-offs Equity investment Changes in Property and equipment Account receivable (29.4) (43.0) (44.9) Intangible assets Prepayments (6.7) (20.0) (22.5) Goodwill Account payables (1.0) - - Deferred tax & others Deferred tax assets (5.5) (10.3) 18.9 Total assets Accrued liabilities Account payables Cash from operations Deferred revenues Capex (73.9) (189.0) (94.7) Accrued liabilities Purchase of intangibles (1.5) (1.5) (1.5) Tax payables & others Purchase of short term investments Total current liabilities Cash paid for equity investment Long term debt & others Interest income Additional paid in capital Cash from investing (68.6) (183.8) (86.4) Treasury stock Purchase/Issuance of company shares Statutory reserves Cash from financing Accumulative deficit/loss Change in cash Total equity Cash at beginning Total liabilities and equity Cash at end Source: CRSHK, company Source: CRSHK, company China Renaissance Securities (Hong Kong) Limited 10

11 Financial Summary Dangdang Fiscal year-ends December 31 Exhibit 26: Income statement (Rmb mn) 2010A 2011A 2012A Company Description Net revenues 2,282 3,619 5,194 Cost of revenues (1,776) (3,118) (4,469) Gross profit Fulfilment (286) (475) (736) marketing (77) (150) (196) Technology (65) (90) (153) G&A (68) (84) (137) Operating profit GAAP 15 (284) (489) Share based compensation - (11) (11) Operating profit non-gaap - (273) (478) Other income/cost Pre-tax profit 19 (204) (444) Income tax 12 (24) - Net income, GAAP Net income, non-gaap 31 (228) (444) Number of ADS, diluted - (217) (433) EPADS, GAAP (0) (3) (6) EPADS, non-gaap 1 (3) (5) Gross margin 22% 14% 14% Operating margin, non-gaap 0% -8% -9% Net margin, GAAP 1% -6% -9% Source: CRSHK, company China Dangdang Inc. operates as a business-toconsumer (B2C) e-commerce company. It primarily engages in the sale of books, audio-visual products, periodicals, and electronic publications through its Website, dangdang.com. The company also sells general merchandise products, including apparel; home and lifestyle products; baby, children, and maternity products; consumer electronics; apparel and accessories; and footwear, handbags, and luggage. In addition, it operates the dangdang.com marketplace program, which enables third-party merchants to sell their products. Industry View We expect B2C market GMV (Gross Merchandise Value) to grow 69% YoY in 2013 to Rmb385mn, taking up 30% of the total online retail market. Exhibit 27: Balance sheet Exhibit 28: Cash flow statement (Rmb mn) 2010A 2011A 2012A (Rmb mn) 2010A 2011A 2012A Cash and cash equivalent 1,692 1, Net income 31 (228) (444) Restricted Cash Adjusted for Accounts receivable Share based compensation Inventories 896 1,583 1,486 Depreciation Prepayments Amortization Total current assets 2,732 3,185 3,380 One-time write-offs Fix asset Changes in Intangible assets Account receivable (8) (50) 10 Prepayments and others Prepayments (45) Total assets 2,801 3,286 3,583 Account payables Account payables 866 1,486 1,564 Deferred revenues Deferred revenues Accrued liabilities Accrued liabilities Cash from operations (14) (142) (134) Short term debt Capex (42) (62) (66) Total current liabilities 1,387 2,128 2,810 Proceeds received 1,728 1, Total liabilities 1,387 2,128 2,844 Cash from investing 48 (1,261) 613 Additional paid in capital 1,788 1,829 1,854 Effect of exchange rate changes (13) (15) 2 Statutory reserves Change in cash 1,616 (1,499) 240 Accumulative deficit/loss (22) (92) (91) Cash at beginning 76 1, Total equity 1,414 1, Cash at end Total liabilities and equity 2,801 3,286 3,583 - Source: CRSHK, company Source: CRSHK, company China Renaissance Securities (Hong Kong) Limited 11

12 Why investors need to care about e-commerce E-commerce, pioneered by ebay and Amazon in the US almost twenty years ago, is now changing China s economy in a big way. Consider that: In 2012, China s domestic retail was an Rmb20tn market. China s export and import were US$2tn each; The verifiable GMV (Gross Merchandise Value) of China s online retail market was Rmb1.2tn (6%). Verifiable GMV of China s cross-border e-commerce market was only US$13bn (0.6%); Over the past decade, Chinese Internet revamped the Rmb69bn (2012, source: Mresearch) newspaper and magazine industry. In 2012, online advertising (incl. search and Taobao P4P ads but excl. video) reached Rmb69bn in revenues (source: iresearch). Online and offline reached 50:50 split of market shares. Even though game console has not existed in China, PC Internet games leapfrogged in China to become an Rmb60bn a year market in 2012 (source: Ministry of Culture). In this case, online completely took over from offline. Both pales in comparison in the transformation that investors are about to see, in our view. In 2012, China s TV advertising market reached Rmb85bn and movie box office reached Rm17bn. In the same year, online video had revenue of only Rmb6.8bn, ~8% of TV and movie industries. Mobile video and multi-screen technology are rapidly reshaping the landscape of the connected television. But the addressable market of e-commerce is even bigger than the aforementioned opportunities, and e-commerce is at a lower percentage of offline commerce than online advertising is to offline advertising. In domestic e-commerce sector, there are four segments, with the first three segments commonly referred to as online retail. The B2C/B2B2C segment had an annual GMV of Rmb385bn in Alibaba Tmall is the leading player with 57% (incl. Taobao Ju) followed by Jingdong (360BUY) at 16%, Suning ( CH) at 4.4% and Tencent at 3.9%; The C2C segment had an annual GMV of Rmb774bn in Alibaba Taobao Jishi is the leading player with 92% market share, followed by Tencent Paipai at 7%; The O2O segment had an annual GMV of Rmb35bn in 2012, of which Rmb21bn was group buying. Meituan is the leading player with 22% share, followed by Dianping at 11% and Alibaba s Taobao Life; The B2B segment s GMV is difficult to verify as most service providers charge membership fees without tracing transactions. Hence we exclude B2B in our calculation of verifiable GMV s. Market leaders is Alibaba s 1688.com; The cross-border e-commerce segment is much smaller in terms of verifiable transaction volume. Without doubt, Alibaba Group plays a dominant role in the landscape of China e-commerce. Alibaba touches upon almost every segment and sub-segment and dominates in most of them, as shown in the table below (Exhibit 29). We believe for Alibaba to enter online real estate and online auto trade is just matter of time. In addition, Alibaba acquired meaningful stakes in SINA Weibo (Social e-commerce), UCweb (mobile web app), Umeng (mobile ads) and AutoNavi (LBS), further expanding its footprints. It is perhaps more important for investors to realize than Alibaba s direct business line that Alibaba s ecosystem extends far beyond its direct businesses. A big element of Alibaba s The e-commerce opportunity is huge by scale Alibaba s presence in Chinese e- commerce is pervasive China Renaissance Securities (Hong Kong) Limited 12

13 ecosystem is (1) its e-commerce outsourcing/service partners, often referred to as Taobao Partners ( 淘 拍 档 ), (2) its contextual advertising program, often referred to as Taobao Ke ( 淘 宝 客 ) and (3) its logistic open platform called China Smart Logistic Network (CSN), internally code name Ground Net ( 地 网 ). These elements of Alibaba s ecosystem continue to incubate large size companies. Online Retail is rapidly evolving from 1.0 to 2.0. In 1.0, companies reach for scale. Jingdong (360BUY) is the biggest beneficiary of the 1.0 era during which it builds the most comprehensive in-house warehouse and last mile delivery network. It is now turning this into its competitive advantage by renting it out to third party merchants. Dang Dang (DANG US), another beneficiary of the online retail 1.0, is also seeking to improve its gross margin by servicing third party merchants on its platform. It has already achieved tangible results. Online retail 1.0 companies asset values are underappreciated by investors, in our view Exhibit 29: Major e-commerce segments and Alibaba s presence in them Segment Alibaba brand Alibaba brand in Chinese Market leader 2012 market size (GMV or revenues, Rmb bn) Alibaba market share, 2012 Competitors C2C Jishi 淘 宝 集 市 Alibaba 774 ~90% Paipai (Tencent) B2C/B2B2C Tmall/Ju/LOO 天 猫 / 聚 划 算 Alibaba % Jingdong, Suning, 51BUY (Tencent), Dangdang Flash sales Tmall Temai 天 猫 品 牌 特 卖 Vipshop 7.4 Very small Vipshop B2C export AliExpress 速 卖 通 LightInTheBox % Dhgate, LightInTheBox, ebay B2C/B2B2C import Taobao Global 淘 宝 全 球 购 Alibaba 48 Dominant ebay, Amazon, Rakuten B2B export Alibaba.com 中 国 供 应 商 Alibaba Global Source, Dhgate B2B domestic 1688.com 1688 Alibaba 17* 33% MadeInChina O2O Taobao Life 淘 宝 生 活 Meituan and Dianping 35 Significant Meituan, Dianping Search ad/psp Alimama P4P 阿 里 妈 妈 Baidu 41 ~25% Sogou, Qihoo, Tencent Soso Contextual ad Alimama/Taobaoke/T ANX 阿 里 妈 妈 / 淘 宝 客 /TANX Alibaba 8.5 ~40% Baidu, Google, Tencent GDT Mobile ad Alimama mobile union 阿 里 妈 妈 无 线 联 盟 AdMob 1.0 NA AdMob (Google), DoMob, 91 Payment Alipay 支 付 宝 Alibaba 3,659 51% Tenpay, ChinaPay, 99Bill, Yeepay Mobile payment Alipay mobile 支 付 宝 移 动 支 付 Alibaba 151 NA UnionPay, Tenpay, ChinaMobile, Lakala Cloud computing Aliyun 阿 里 云 Alibaba NA Significant Baidu, 21Vianet, Tencent Online travel Taobao Travel 淘 宝 旅 游 Ctrip 173** ~10% Ctrip, Qunar, elong Online real estate Taobao Real Estate 淘 宝 房 产 Anjuke Anjuke, Soufun Source: CRSHK, iresearch, *, service revenues as GMV is difficult to calculate. **transactional GMV. OTA revenues=5-10% GMV Profitability is often viewed as the Achilles Heel of Online Retail 1.0 companies because they had to invest heavily into offline logistics in the early days of their business. Without resorting to FUPPS (Fake-Used-Pirated-Private Label-Smuggled) goods, online retailers cannot obtain a decent margin to cover their depreciation and marketing cost. The only exception is Vipshop, which takes advantage of an inventory bubble in China s apparel industry to successfully build a platform for selling out-of-season goods. Some other vertical B2C retailers (cosmetics and furniture) have also achieved tangible profits. Yet Online Retail 1.0 companies find it advantageous to collaboration with offline merchants and Online Retail 2.0 companies, who use an asset light model to tackle e- commerce problems. Some of these companies use Google for their marketing and maintains minimum warehouse capacity until they receive the order. After investing in SINA Weibo, Taobao expects to increase the Click Through Rate (CTR) of relevant P4P ads on Taobao by 30%. A new class of asset light e- commerce companies is emerging E-commerce enabling is now becoming a booming business As investor s appetite for funding 1.0 companies waning, new and old players of online retail all have to learn to work with third party logistic providers (3PL). China s 3PL is China Renaissance Securities (Hong Kong) Limited 13

14 significantly inadequate to tackle the challenge of e-commerce from the view point of warehouse space and trucking facilities. China s twelfth Five Year Plan will bring some relief, but investment already made by existing 1.0 company could turn their investment into meaningful competitive advantages, in our view. Lastly, facing constant assault of new innovations from e-commerce, offline retailers have resorted to different measures. Large retailers have gone high end, trying to make offline shopping a luxury and multipurpose experience. Mid-sized retailers have tried to differentiate with the kind of merchandise they offer. Many of them started looking at O2O (Online-to-offline) to create new shopping scenarios. E-commerce is not necessarily the enemy of offline. While mostly direct B2C, competes head on with offline retailers, they help brands sell their products. Further, most platform B2C (B2B2C), helps both offline retailers and brands to compete in the Internet era. Brands are learning to work with the Internet to maximize their competitiveness. A bourgeoning e- commerce outsourcing industry is helping offline brands and retailers to conduct business online. O2O is a small but the fastest growing segment of Online Retail. It mainly addresses the service economy, which is a significant portion of retail economy but has a very low penetration rate (<1%). O2O is still at the very early stage with a fragmented competitive landscape. But leading companies like Meituan and Dianping have already reached significant size. In the future, with possible involvement by Weixin (Tencent) and Baidu, O2O could see more consolidations and platform emergence down the road. Reacting to the challenges of online retail, offline retailers are experimenting with new strategies to survive O2O is revamping the offline service economy. Meituan and Dianping have led the sector but other platform competitors are emerging China Renaissance Securities (Hong Kong) Limited 14

15 Offline retail gets the message: change or be changed Online retail starts to impact offline retail in a visible way In 2012, the scope of impact from online to offline retail started to broaden. With the exception of luxury/specialty and hyper markets/foodmarts, most retail segments experienced slowing top line growth and negative profit growth, according to our survey of seventy-five listed retail stocks: Consumer Electronics (CE): CE appears to be worst hit by online retail. Revenues dipped into negative growth territory in 1Q12. Revenues of Gome Electronics (493 HK) declined 18% YoY in 2H12 while that of Suning only grew 4% YoY (Exhibit 30); Department Stores (DS): DS is also negatively impacted by online retail as segment topline growth slowed to single digits (Exhibit 31); Apparel and Shoes (AS): Many Chinese apparel brands have their own store networks and AS revenue declined into negative territory in 3Q12 (Exhibit 32); Hypermarket/Foodmart (HF) and Luxury/Specialty (LS): These two segments appear to be relatively protected against the assault by online retail. Revenue growth remains at high double digits (Exhibit 33 and 34). Consumer Electronics, Department Stores and Apparel are worst hit by online retail Exhibit 30: Revenue growth trends of consumer electronics retailers Revenues (m Rmb) 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5, Q2007 1Q2008 1Q2009 1Q2010 1Q2011 1Q2012 YoY growth 80% 60% 40% 20% 0% -20% -40% Exhibit 31: Revenue growth trends of department store retailers Revenues (m Rmb) YoY growth 45,000 35% 40,000 30% 35,000 25% 30,000 25,000 20% 20,000 15% 15,000 10% 10,000 5,000 5% 0 0% 1Q2007 1Q2008 1Q2009 1Q2010 1Q2011 1Q2012 Revenues YoY growth Revenues YoY growth Source: CapitalIQ. Based on three listed consumer electronics retailers with continuous record Source: CapitalIQ. Based on thirty-four listed department store retailers with continuous record Exhibit 32: Revenue growth trends of apparel brands/retailers Exhibit 33: Revenue growth trends of hypermarket/foodmarts Revenue (m Rmb) 35,000 YoY growth 50% Revenues (m Rmb) 70,000 YoY growth 35% 30,000 40% 60,000 30% 25,000 20,000 15,000 10,000 30% 20% 10% 50,000 40,000 30,000 20,000 25% 20% 15% 10% 5,000 0% 10,000 5% 0-10% 1Q2009 3Q2009 1Q2010 3Q2010 1Q2011 3Q2011 1Q2012 3Q2012 Revenues YoY growth Source: CapitalIQ. Based on twenty listed apparel brands/retailers with continuous record 0 1Q2010 1Q2011 1Q2012 Revenues YoY growth Source: CapitalIQ. Based on eight listed hypermarkets/foodmarts with continuous record 0% China Renaissance Securities (Hong Kong) Limited 15

16 Exhibit 34: Revenue growth trends of luxury/specialty stores Revenues (m Rmb) 35,000 30,000 25,000 20,000 15,000 10,000 5, Q2011 3Q2011 1Q2012 3Q2012 YoY growth 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Exhibit 35: Revenue growth trends of retail sector combined Revenue (Rmb m) YoY growth 200,000 40% 180,000 35% 160,000 30% 140, ,000 25% 100,000 20% 80,000 15% 60,000 10% 40,000 20,000 5% 0 0% 1Q2010 3Q2010 1Q2011 3Q2011 1Q2012 3Q2012 Revenues YoY growth Revenue YoY growth Source: CapitalIQ. Based on ten listed luxury/specialty stores with continuous record Source: CapitalIQ Based on seventy five retail stocks in CE, DS, AS, HF and LS Taken as a whole, seventy five Chinese offline retail stocks we track showed a sharp slowdown in revenue growth starting from 1Q12 (Exhibit 35). China is leapfrogging US in online retail penetration China online retail as percentage of total retail sales has surpassed the US in 1Q12 and now stands at 6.5%, comparing to US s 5.4% (Exhibit 36). Exhibit 36: Online retail as percentage of total retail China has leapfrogged the US in terms of online retail as percentage of total retail 7.0% 6.0% 5.0% 4.0% 3.9% 3.9% 4.3% 4.7% 4.9% 4.8% 5.5% 5.6% 6.5% 5.4% 3.0% 2.0% 2.3% 2.8% 3.0% 1.0% 0.0% 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 China US Source: US Census Bureau, NBS, iresearch. Chinese online retail includes B2C,C2C and group buying Several reasons contributed to China s overtaking of the US in the area of online retail. First, we believe Taobao has made a major contribution to the growth of online retail in China. Almost a generation of young Chinese not only buys and sells, but also lives and works on Taobao. In selected segments, some Chinese companies even conduct businesses only on Taobao. They are called Tao-Brands ( 淘 品 牌 ). Secondly, China s inefficient offline retail infrastructure provides fertile ground for online retail to attack the offline shopping experience. Goods distributed in China normally have higher channel mark ups than in developed markets. Furthermore, Jingdong has directly confronted traditional retailers in 3C (Computer, Communication and Consumer Electronics) using its superior price points and logistics networks, significantly accelerating the migration of offline retail to online. Last but not the least, the high price of gasoline and constraints on personal car consumption (which leads to congested urban traffic) encouraged the development of online retail. Inefficient offline retail infrastructure, healthy competition between Taobao and Jingdong, congested cities and gasoline price are factors behind online retail s dramatic rise in China China Renaissance Securities (Hong Kong) Limited 16

17 B2C to take nearly half of the market by 2015 but O2O will grow faster We estimate China s online retail market (including B2C, C2C and O2O but excluding B2B) grew 48% in GMV in 2012, with B2C growing 98%, C2C 32% and O2O 111% YoY. B2C was 30% of the market transaction volume in 2012 but we project it to grow to 47% by 2015 (Exhibit 37). B2C is growing faster than C2C. But we expect O2O to be the fastest growth segment from 2014 Exhibit 37: China retail and online retail market forecast, GMV and transaction volume Rmb bn 2009A 2010A 2011A 2012A 2013E 2014E 2015E China retail 13,268 15,700 18,392 20,717 23,203 25,523 27,565 Y-Y (%) 22.3% 18.3% 17.1% 12.6% 12.0% 10.0% 8.0% Online retail ,194 1,657 2,097 2,641 % of China retail 2.0% 2.9% 4.2% 5.6% 6.9% 7.9% 9.6% Y-Y (%) 105.2% 76.4% 70.5% 48.0% 36.2% 25.7% 32.1% Online retail segments B2C/B2B2C ,290 C2C ,062 1,201 O2O NA Online retail segment growth B2C/B2B2C 106% 200% 210% 97% 69% 46% 36% C2C 103% 65% 47% 32% 23% 12% 14% O2O NA 97% 133% 111% 66% 56% 41% Online retail segments % B2C/B2B2C 8% 13% 23% 30% 35% 41% 47% C2C 89% 84% 73% 64% 57% 50% 44% O2O/Group Buying 3% 3% 4% 6% 7% 9% 10% Source: CRSHK, National Bureau of Statistics, iresearch. * O2O includes group buying (less product group buying), classified services, map O2O, online loyalty but excl. Taobao Ju. Taobao Ju is included in B2C Breadth push: no retail segment is immune from the online assault China s online retail industry (B2C, C2C and O2O) started with similar models to that of the US in the category of books and electronics. Dang Dang (DANG) and Joyo (now Amazon China) were the earliest pioneers. DANG started in 1999 and Joyo in 2000 (later acquired by Amazon in 2004). A detailed look at the breakdown of the retail industry in China and comparing to the US reveal that books were not the best online retail segment in China because unit prices of books are very low comparing to the US (Exhibit 38). B2C pioneers like Jingdong started to attack the 3C segment (Computer, Communication and Consumer Electronics), which together occupies ~7% of China s retail trade, compared to the 0.2% of books (2-3% in the US). Except fresh foods, all other retail segments are affected by online retail Compared to the US, Chinese spend less on Construction and Home Improvement, Furniture, Cosmetics, Books and Medicine but more on 3C, Apparel, Autos and Gasoline. Some of these differences might be due to monopoly and import pricing (Autos and Gasoline) and piracy (Books and AV), but others (3C, Apparel, Home and Furniture) may be due to social habits and economic development. The rapid growth of online retail in China has proven that, with the exception of raw food and collectibles, no retail segment is immune from e-commerce. Over the past five years, an increasing number of retail segments that previously were thought to be unsuitable for e- commerce, like expensive products and standardized products have now proven to be quite successful by retailing online. Even in the previously unthinkable segment of fresh foods retail, 1haodian and Jingdong have successfully launched the businesses recently. Our observation shows that online retail can leverage the Internet to benefit consumers in the following ways: Retail segments with high online retail penetrations are: Books, Cosmetics, Apparel and 3C. Segments with low penetrations are Gasoline, Autos, Restaurants, Medicine, Home Improvement and Jewelry China Renaissance Securities (Hong Kong) Limited 17

18 Niche products: Taobao s rise in prominence shows that the Internet is very good at tackling industries which produce small batch products that meet with diverse demands (long tail demand). Online retail s benefit to consumers is to find it. Electronic components, wedding, gifts and furniture also fall into this category; Sophisticated but quantifiable products: 3C products have complicated specifications and short lifecycles due to rapid changes in technology. Distribution through offline channels is often too slow for these types of products. Online retail s benefit to the consumer is to understand it and get it before it becomes obsolete ; Fuzzy but rational products: Fashion, cosmetic, diamond and wines are characterized by rapid change, high mark-ups but established quality standards. Channel margin tends to be high and channel transparency is low. Online retail s benefit to consumer is to pay the right price and get it before it becomes out of date. It is also worthy to note that the popularity of social networks helped consumers to understand what they are buying even when there is no detailed product specifications to compare. Online retail recommendation sites like Meilishuo ( 美 丽 说 ), Mogujie ( 蘑 菇 街 ) and SINA Weibo are successful in these scenarios; Diamond and fashion showed that categories with (1) clear grading system and with (2) with fuzzy social network feedback loop can both prosper with e- commerce Niche, hard to evaluate, low transparency, easy to fake and new products are five categories of products that are suited for online retail Authentic products: In a country with numerous fake and low quality products, online retail s (especially B2C) centralized nature ensures the product is authentic. Online retail s benefit to consumers is to buy what is intended ; Exhibit 38: Retail sales breakdowns and online percentage estimate in US and in China US (US$ bn) China (US$ bn) US online % China online % Major US online retailer Major China online retailer Restaurant and catering 11% 11% 1% 1% Yelp, Groupon, Angie's List, Opentable Meituan ( 美 团 ), Dianping ( 点 评 ), RENN ( 糯 米 ), CTRP ( 携 程 ) Food, beverage and tobacco 13% 12% 2% 2% Amazon, Walmart 1haodian ( 一 号 店 ), Jiuxian ( 酒 仙 ), Winenice ( 酒 美 ) Apparel 8.5% 9.0% 20% 25% ebay, Amazon, JCPenny, Macy's Alibaba ( 淘 宝, 天 猫 ), VANCL ( 凡 客 ), Vipshop ( 唯 品 会 ), various Tao brands ( 梦 芭 莎, 麦 包 包, 裂 帛, 韩 都 衣 舍 ) Cosmetics & personal care 5.8% 4.4% 20% 20% DrugStore, Skinstore Jumei ( 聚 美 ), Lefeng ( 乐 蜂 ), Alibaba, Jingdong, 1haodian, Vipshop Jewellery 2.2% 2.1% 20% 5% Blue Nile 9Diamond ( 九 钻 ), Zbird, Kela, Davidnile Office product 1.1% 1.8% 25% 8% Office Depot, Staples Jingdong, Tencent ( 易 讯 ), Alibaba, Suning ( 苏 宁 ), Gome ( 国 美 ) Sports, books and enter. 3.1% 0.4% 30% 10% Amazon, Netflix, Liberty Interactive DANG, Amazon, Jingdong, Alibaba, Suning, Damai ( 大 麦 ) -Among which: books 0.5% 0.2% 40% 30% Amazon DANG, Jingdong Home electronics, A/V equip., comm. Products 3.5% 7.3% 30% 25% Amazon, New Egg, Sears, Apple, Dell, CDW, Bestbuy Jingdong, Tencent ( 易 讯 ), Alibaba, Suning, Gome Medicine 5.9% 4.2% 10% 10% DrugStore JXDYF( 金 象 网 ), Jingdong, Alibaba Furniture 1.9% 1.3% 10% 10% Sears Meilele ( 美 乐 乐 ) Petroleum products 11% 16% 1% 1% Intercontinental Exchange Sinopec, PetroChina Auto 17% 24% 1% 1% Auto Parts Warehouse BITA. Autohome ( 汽 车 之 家 ) Const. and home improve. 6.4% 1.6% 10% 5% Home Depot, Sears SFUN, Liba ( 篱 笆 ) Others 10% 5.0% 10% 5% flowers, Yelp, Opentable, Craigslist Dianping, 58, Ganji ( 赶 集 ) Total 100% 100% 8% 6% Amazon, ebay, Walmart Alibaba, Jingdong, Suning, Tencent Total retail sales (2012) 4,357 3,341 Source: USCB, NBS, CRSHK China Renaissance Securities (Hong Kong) Limited 18

19 New products: The rise of social networks makes it possible to popularize a product with word of mouth. Online retail lowers the barrier for new products to reach consumers. Online retail s benefit to consumer is to suggest alternatives. At this point there are still few retail segments that are untouched by online. Restaurants contribute to 10% of the retail economy, yet we estimate the online component of the restaurant/catering segment is only 0.5%, despite the boom and bust of a thousand Groupons in Food & Beverage, Furniture, Medicine, Petroleum and Automobile remain largely offline. We believe with the exception of Petroleum all can be penetrated by online retail in due course. Not only does online retail have a profound impact on consumers purchasing behavior, it also brings benefits to producers and retailers. Fast deployment speed, rapid consumer feedback, lean inventory and low warehousing costs are just a few examples. Some brands now exist purely online. Depth push: big data drives Online Retail 2.0 We categorize classic B2C and C2C as online retail 1.0. The B2C model started with Amazon (AMZN US) in the US in the category of books in Amazon later expanded to Electronics and General Merchandise. But Japan s Rakuten (4755 JP) introduced a variant in 1997 which is often called B2B2C (or the Platform B2C model) while the Amazon model is often referred to as the Direct B2C (or the Vendor B2C model). The main difference of B2C and B2B2C is that the former takes inventory risk of the goods it sells while the later doesn t. The Chinese equivalent of Amazon is Jingdong and of Rakuten is Tmall (Alibaba). Lately both Amazon and Jingdong have also added B2B2C element to their business models. The C2C model started with ebay (EBAY US) which was founded in 1995 to sell collectibles. The Chinese equivalent is Taobao (Alibaba). The major difference between ebay and Taobao is that the former charges a listing fee and a transaction fee while the latter relies on advertising as a means of monetization. As a result, Taobao s revenue-to-gmv ratio is significantly lower than ebay. Online retail 1.0: Scale driven, capital intensive, low capital efficiency and low profitability The phrase online retail has an online portion, which is technology with data mining, and a retail portion, which is a retail business plus supply chain management. Another way to put it is click-and-mortar, or e and commerce. Historically, investors have observed that online retailers that focus on the online, or the click portion, are more similar to Internet companies, with high profit margins, low capex and strong cash flows but low barriers to entry. Online retailers that focus on the retail, or the mortar portion, are more similar to retail companies, with low profit margins, high capex, average cash flows but high barriers to entry. In China s Online Retail 1.0 era, scale becomes the paramount goal for most participants. Alibaba over-invested in IT infrastructure to build a utility grid for e-commerce. Jingdong and other B2C sites built warehouses across the country. Due to China s poor infrastructure, online retailers brought many functions in house in order to give consumers a complete shopping experience. They do what works now, not what should work ten years later. Their short command chains are often responsible for their victory against overseas competitors like ebay and Amazon China. We observed the following characteristics of Online Retail ) Homogeneous products, which tends to lead to cut-throat price competition; 2) Primary procurement capability, with no advantage against offline competitors; In China Taobao and Tencent Paipai are leading C2C sites. Tmall is B2B2C site and Jingdong is B2C site In the early days of online retail, most participants pursued scale at all costs Online retail 1.0 lacks differentiation, business insight and process optimization. It leads to either low monetization or high cost China Renaissance Securities (Hong Kong) Limited 19

20 3) Preliminary catalog and supply chain management capability. Early online retailers treated websites as a giant catalog for displaying the products without knowing the Internet s power in updating, targeting, recommendation, marketing, back office integration and supply synchronization; 4) Preliminary fulfillment capability, acting more as a parcel porter and relying on investments to drive fulfillment. The success of Online Retail 1.0 companies primarily relied on (1) external capital funding, (2) founders intuition in designing marketing campaigns and (3) founder s decision making capability under cloudy and chaotic conditions. Taobao s success over EachNet (ebay China) and Jingdong s success over Amazon China are largely results of their founders marketing charisma, tight integration of in-house functions and competitors slow execution resulting from internal bureaucracy. So far these successes often lead to successful market share gains, but not profits. Online Retail 2.0: Data driven, low capex, high capital efficiency and high profitability As the capital market turns more cautious with e-commerce investments, the pace of innovation in both the online portion and the retail portion of online retail has intensified. LightInTheBox (LITB US) is an example of online innovation. According to its public filing, VIPS has achieved two quarters of continuous profitability as of 1Q13. A study of LITB revealed the following competitive advantages: Flash manufacturing: LITB sells niche, high margin but low volume goods globally. Wedding gowns are its largest segment with different variants; Deep supply chain integration: LITB tightly integrates with its key manufacturers, providing consumer data and demand information; Big data: LITB uses crawler technology to predict popular style and demand requirements. It also extensively uses Google to market to long tail customers globally for its niche, high margin but low volume made goods; Outsourcing non-core operations: LITB maintains very few warehouse facilities and outsources all shipments to third party. Vipshop (VIPSHOP US) is a good example of retail innovation. Vipshop successfully turned profitable in 4Q12. A study of its success revealed the following competitive advantages: Flash fulfillment: The flash sale model does not maintain regular inventory and does not require repetition of stocking. This drastically improved warehouse efficiency. VIPS has only four warehouses nationwide while a competitor of similar size DANG has more than thirty; Sourcing: Vipshop successfully tackled the inventory issue of the apparel industry and obtained merchandise at an attractive cost of goods sold. Before VIPS, online retailers had not paid attention to the balance sheet of their suppliers; Customer targeting: VIPS targets 2 nd to 3 rd tier cities consumers who have fashion desire but lack fashion access. Repeat customers reached as high as 75% and repeat purchase volume reached as high as 90%; Despite Chinese online retailers success over their overseas competitors, they have until recently failed to generate meaningful profit for their investors In the future, e-commerce companies will be big data companies, orchestrating supply chains to meet individualized consumer demand China Renaissance Securities (Hong Kong) Limited 20

21 Vendor service: VIPS provides value to its upstream suppliers. In the early days online retail was essentially an afterthought to offline retailers. VIPS provides an important vendor service to its suppliers to manage their production inventory. In addition, Meilishuo, Mogujie and soon SINA Weibo s collaboration with Taobao and Weixin s O2O experiment are good examples of online innovation. All of them are involved with integrating social networks (SNS) with online retail to leverage the Internet s power to target, recommend, market and service customers. Alibaba has realized this trend and increasingly models itself as a Big Data company. We believe more and more Online Retail 2.0 companies will emerge to optimize existing infrastructures. We conclude characteristics of Online Retail 2.0 as the following: 1) Data driven, smart e : To leverage the value of online and to improve the useroriented services powered by the internet tools such as data mining, SNS, CRM, search and recommendation, customer behavior modeling, machine learning, etc.; 2) Logistics driven, efficient commerce : To leverage the value of retail, companies invent smart business models that tackle each element of the profitability equation. Flash sale and O2O are two examples; 3) Leverage mobile Internet: Mobile Internet brought profound change to how online retail is conducted online. Mobile Internet has proven to be impact consumers impulse buying in a very big way; 4) Asset right. While being everything to every consumer is the early trademark of Online Retail 1.0, Retail 2.0 tends to shy away from heavy involvement in every part of the value chain. In fact, Online Retail 1.0 leaders like Alibaba and JINGDONG have both evolved to outsource their excess infrastructures to open platform partners. We, however, still expect Online Retail 2.0 leaders to retain core competencies in customers, fulfillment and brand awareness. Instead of asset light, Online Retail 2.0 leaders try to aim for asset right ; 5) Supplier chain orchestration: Proper work for proper partners is the illustration of Online Retail 2.0, in our view. The competition of online retail must be a competition of ecosystems because e-commerce involves a very long value chain. Online Retail 2.0 leaders play a role of supply chain orchestrator. It owns the data flow from engagement to production to distribution and service. Collectively the Online Retail 2.0 ecosystem maximizes the profitability of each customer. Open platform links Online retail 1.0 infrastructure with 2.0 intelligence In 2012, more and more B2C retailers started to develop their own platform (B2B2C) revenues. In 2012, Jingdong s B2B2C GMV rose by 400%, while its overall GMV grew by 98%. For DANG, its B2B2C GMV rose 166% while its overall GMV grew by 43% (Exhibit 39). As Online Retail 1.0 companies realize the appetite of the capital markets will not fund their unbounded expansion, improving utilization and efficiency of their logistics investments becomes a pressing priority. This isn t bad news for Online Retail 1.0 at all, as scarcity value will lead the price of their logistic investment to rise. At the same time, Online Retail 2.0 companies realize their asset light model subjects them to more competition. Both 1.0 and 2.0 camps realize they cannot corner the market alone and increasingly will start to collaborate. It could turn out that Online Retail s early investment in infrastructure could be their best strategy retrospectively. The platform business charges an online rental fee and a revenue sharing commission to external merchants based on a series of pre-determined factors. The platform also controls quality and provides logistic support. Exhibit 39 showed that the platform fee business model mirrors the offline channel fee structure. Categories with high gross margins like LITB and VIPS are two examples of e-commerce 2.0 innovation which focuses on either (1) e- or (2) commerce Online Retail 1.0 companies can rent out their infrastructure for money because investment dollar for their kind of massive build out has ended China Renaissance Securities (Hong Kong) Limited 21

22 apparel, jewelry and baby product are charged a high commission rate while those with low gross margins like 3C and book are charged a low commission rate. This fee structure largely mirrors offline practice of charging channel fee as a margin markup. Fulfillment cost is charged separately. The opening of 3 rd party platform enriches the product offerings of the operator, leading to higher traffic and better customer value. But it also introduces some new management and execution challenges: Amazon globally already has 40% of its GMV coming from 3 rd party platforms Quality control and incentives: the 3 rd party platform business is similar to offline retail s franchising model. Normally platforms require those participating merchants to pay sizable cash deposits in order to compensate customers when disputes arise; Product delivery speed and cost: Platforms open their warehousing and shipping capacity to the participating merchants in exchange for service fees. However, more logistics complexity compromises delivery speed and cost. So far, Amazon Joyo provides the highest quality warehousing and logistics services. Domestic B2C companies are still testing their 3 rd party warehousing solutions; Exhibit 39: Third party platform policy of major B2C retailers Tmall JINGDONG (360BUY) Dangdang Amazon Tencent (QQ Buy+51BUY) Platform GMV as % of total, % 16-18% 15-20% ~40% 60% Qualification of merchants Cash deposit (RMB) Placement/Rental Fee (RMB) Warehouse and shipping Tech services (RMB) Commission Fee as % of Transaction Businesses registered in China 50K-150K per year (drug store: 300K) Non, but high marketing fee Merchants pay the fulfilment fee to the logistic companies directly, around RMB10-20 per order 30K-60K per year, based on the annual GMV and customer ranking Registered capital more and RMB500K 10K-100K per year Registered capital more and RMB500K 10K-50K per year (food and baby store: 300K) Businesses registered in China 6K 6K-12K NA 6K Warehouse: RMB0.1 per unit per day if the storing >2 mo. Fulfilment: charging is competitive Fulfilment: charging RMB8-10 per order to the merchants NA Warehouse: charging by volume and storing days Fulfilment: charging by units, orders and weight NA NA NA NA Apparel 5.0% 8-12% 8-12% 10% 5% Shoes and bags 5.0% 8-12% 5-10% 10% 5% Outdoor and sports 5.0% 5-10% 5-10% 10% 5% Baby and maternity 5.0% 2-5% 8% 8% 2-5% Beauty and personal care 4.0% ~5% 5-10% 6% 4% 3C and electronics 2.0% 3-6% 1-2% 4% 0.5-2% Home appliance 2.0% 4-8% 2% 4% 2% Household and furniture 5.0% 5-8% 4-8% 10% 5% Jewellery and accessories 5.0% 5-12% 10-15% 15% 5% Food 2.0% 2-6% NA 7% 1% Book and media 2.0% NA NA 8% 1% Healthcare and drug 3.0% NA NA 6% 1% Instrument 2.0% NA NA NA 2% Services 2.0% NA NA 10% 2% Auto and auto parts 2.0% NA NA 7% 2% Telecommunication 0.5% NA NA 10% Travel 2.0% NA NA NA Source: CRSHK Registered capital more and RMB100K 30K-50K per year NA China Renaissance Securities (Hong Kong) Limited 22

23 After sales services: given the inconsistency in quality of merchants, a 3 rd party marketplace usually draws more customer complaints. Platform operators need to beef up their service capabilities to maintain customer loyalty; Conflict and competition: On a 3 rd party platform there will be competition not only among participating merchants but also between merchants and the platform s own direct B2C business. Platform operators need to balance transparency and fairness with its own internal operations. Getting the profitability equation right: reason for optimism In the Online Retail 1.0 era, profitability was low, but why is it low? In fact, even in E- commerce 1.0 we find profitability may not be as elusive as investors think. However, from a sustainability standpoint, vertical e-tailers selling fake, smuggled, off-season and whitelabel brand goods will eventually face bottlenecks for the profitability they achieved, in our view. Achieving profitability is not as elusive as the market once perceived After we cross examine the major B2C players, we found that revenue per order and gross margin still play a major role in online retail s profitability today (Exhibit 40). B2C retailers who are able to generate high revenue per order and/or decent gross margins will be able to afford a decent gross profit per order, which can act as a war chest to fund OPEX to reach profitability. This is because OPEX is often a fixed cost in nature. Revenue per order and gross margin are the most important parameters of B2C profitability today. These two are largely determined by industry, competitive landscape and brand positioning As of 4Q12, Vipshop and Jumei stand out. Vipshop is a flash sale apparel site while Jumei is a regular cosmetic B2C site. Both of them are able to generate high revenue per order above Rmb200 and gross margin of 20-25%. This gives them gross profits above Rmb50 per order to offset their fulfillment costs and OPEX. On the opposite of Vipshop and Jumei seems to be Jingdong (360BUY), Dangdang (DANG) and 51BUY (Tencent). Jingdong and 51BUY are 3C B2C vendors that are capable of generating very high revenue per order. However, competition in the 3C sector leads to very low gross margins, 7% for Jingdong and only 4.5% for 51BUY. 3C also requires high fulfillment cost per order, leading to these two companies posting losses. Online Retail 1.0 is still largely retail rather than online On another dimension of the above two is VANCL, a low end retailer with revenue-perorder of only Rmb120 but having high gross margins of 40% at one time because VANCL used to sell its own branded products. We believe its gross profit of Rmb48 per order definitely affords it a good level to support its fulfillment and OPEX. However, at this point its operational issues prevent it from achieving profitability. Its revenue per order has also declined. Exhibit 40: China B2C retailer profitability comparison, per order basis, an illustration (as of 1Q13) Vipshop DANG Jingdong (360BUY) 51BUY (Tencent) Jumei VANCL Yihaodian Revenue per order Gross margin 23.4% 17.2% 7.5% 4.5% 25% 40% 15% Gross profit Fulfilment cost per order (26.6) (12.5) (28.0) (36.0) (15.0) (36.0) (20.8) Adjusted gross profit (15.8) OPEX per order (47.7) (8.4) (18.8) (9.0) (35.0) (24.0) (16.0) Operating profit per order 3.9 (5.4) (17.6) (24.8) 12.5 (12.0) (12.8) Operating margin 1.8% (6.0%) (4.5%) (5.5%) 5.0% (10.0%) (8.0%) Source: CRSHK. 51BUY is part of Tencent We notice that Vipshop and Jumei achieved profitability both because they sell premium or quasi-premium products to 2 nd to 3 rd tier cities. The product premium safe guards the revenue per order and customer geographies safe guards the gross margin. On the contrary, China Renaissance Securities (Hong Kong) Limited 23

24 VANCL is not able to achieve high revenue per order because its brand position is mid-tolow end. Once VANCL loses its gross margin advantage it sank to losses. Both Vipshop and VANCL need to deal with returned goods which is a characteristic of the apparal industry. This leads to their fulfillment cost per order being higher than peers of similar complexity, for example, Jumei. Hence for B2C retailers, their path to achieve profitability could be to: 1. Increase revenue per order. This usually is difficult because revenue per order is a characteristic of the goods sold. B2C retailers, however, must enhance their logistics sophistication to enable new categories, cross selling and order combination to achieve higher revenue per order. We believe Jingdong (360BUY) stands a good chance to achieve profitability through this route; 2. Increase gross margin. This again is usually difficult because most B2C players are price takers in their industries. B2C retailers can enhance gross margin by either growing in scale (greater negotiation power with suppliers), or selling white-label brands, or selling to 2 nd to 3 rd tier cities. We believe Vipshop, Jumei, Jingdong and 51BUY can follow this route; 3. Reduce fulfilment cost per order. This is also difficult because fulfillment quality can affect consumer satisfaction. Fulfillment also is closely related to the goods retailers sell. However, VANCL s fulfilment cost per order is certainly above the benchmark, which is clearly an area of improvement; 4. OPEX per oder: Most of OPEX are fixed cost in nature, except marketing cost priced on a per-click basis. Controlling marketing costs hence becomes a priority for most B2C retailers. Can a B2C retailer achieve both scale and profitablity? US consumers spend 6% of retail sales on comestics, translating into a market of US$253bn a year. Chinese consumers, however, only spend 1.3% of retail sales on comestics, translating into a market of US$43bn. This potentially signals tremendous growth opportunity for online comestics retail in China but also a bottleneck for its category leader Jumei. DANG is another example of verticla top-out. DANG s market share in online book selling already exceeded 50%. After generating heady growths in 2010, VANCL, a vertical B2C retailer of apparels, hit a wall in 2Q11. Huge write-offs of apparel inventory sent fulfillment cost skyrocketing, damaging gross margin (including fulfillment cost) to -10% from 20-30% (Exhibit 41). We believe VANCL s misstep is largely as result of execution deficiencies rather than hitting the bottleneck of apparel. Poor procurement practices led to huge stockpiles of unsellable inventories which have to be dealt with at deep discounts prices. Lower prices damage the brand image of VANCL, leading to premium customers leaving the brand, depressing the gross margins and eventually making the business model unprofitable. Apparel is 9% of China s retail sales, which translates to an annual market size of almost Rmb1.9 tn. We estimate the online portion of apparel is worth Rmb466bn (25%), of which Taobao/Tmall sold about Rmb300bn. The estimated revenues of Vipshop for 2013 is only ~Rmb8.5bn. While VIPS s market share is still low, its unique flash sale business model is not accepted by every consumer. Scale is often a bottleneck of vertical retailers So far vertical online retailers haven t hit the ceiling. VANCL s crisis in 4Q11 is likely an executional issue Intellectual property and brand infringement could be B2C s hidden bomb China Renaissance Securities (Hong Kong) Limited 24

25 While we are optimistic on China s B2C growth outlook as a whole, similar to C2C, intellectual property and brand infringement are potential hindrance to the sector s healthy growth. Fake ( 假 货 ), pirated ( 盗 版 ), smuggled ( 水 货 ), used ( 二 手 货 ), excess inventory ( 尾 货 ) and private label ( 白 牌 ), or FUPPS (Fake-Used-Pirate-Private-Smuggled) are responsible for some of the sector s profitablity. While excess inventory and private labels are perfectly legal businesses, they also face product cycle and fashion risks. Some e-tailers, like DANG, has had persistent low revenue per order and gross margin, because it refuses to sell FUPPS goods. As a result, its profitablity is vulnerable to price wars as a public company. Since its founding, Alibaba has been combating with FUPPS on its platform. There are risks in both selling and not selling FUPPS goods Exhibit 41: VANCL s crisis in 2011 Hitting a wall at quarterly run rate of Rmb800m Revenues (Rmb m) Adjusted gross margin 40% 30% 20% 10% 0% -10% -20% 0 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11-30% Net revenues Adjusted gross margin Source: CRSHK. Adjusted gross margin=gross margin-fulfilment cost as percentage of revenues Universal path to B2C profitablity: balance of scale and unit economics As the diagram below shows (Exhibit 42 and 43), gross profit and fulfillment are two of the most important parameters in the early days of a B2C retailer. Gross profit is a product of three parameters: unit price, volume and gross margin. Most of a B2C retailer s variable cost is captured in its adjusted gross profit (which includes fulfillment cost) and most of the fixed cost is captured in the marketing, technology and G&A bucket. When a B2C retailer generates enough gross profit to cover its fixed OPEX, it starts to turn a profit. Reflecting on the margin curve, gross margin tends to be flat as it is determined by industry and competition. Operating and net margin first take a dip to cover the fixed cost and recovers to sustainable levels. The sweet spot of investment is highlighted by the red box below. When B2C retailer gets big enough, it can gain on the gross margin level, or in some cases generate negative payment cycles to produce free cash flows. Some B2C business models are born with good revenue per orders and gross margins (Vipshop and Jumei); others with good revenue per order but poor gross margins (Jingdong and 51BUY); still others are born with poor revenue per orders but good gross margins (VANCL) and lastly some have poor revenue per orders and poor gross margins (DANG and 1haodian). However, those with a less ideal mix of revenue per order and gross margin are not doomed to fail. They can improve their profitbality by: Industry and competition determines the gross profit margin and operational excellency determines the operating margin China Renaissance Securities (Hong Kong) Limited 25

26 Exhibit 42: Online B2C retail profit equation Exhibit 43: Amazon s GP, OP and NI margin since 1995 Gross Profit- Fulfillment Retail Business (Order Size- Procurement Cost per Order- Fulfillment) Service Business Scale Marketplace Commission + IT /AD /Finance /Fulfillment Service Marketing+ Technology + G&A OP income/ loss 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% -70% GP margin OP margin NI margin Source: CRSHK Source: CRSHK (1) increasing revenue per order by expanding merchandise categories and encouraging cross sale and order combination; (2) achieve economics of scale to squeeze gross margin from suppliers. Neither means is easy. Order combination and speed of delivery are natural enemies. Expanding merchandise category must invest in infrastructure first. Delay in delivery hurts consumer experience. Achieving large scale, doubtless to say, requires many years of price competition. Similarly, those with favorable product mixes are not without risks. As consumers mature and supply chains tighten, gross margin and order size could get squeezed. To achieve long term profitbality, we argue that gaining profitability through fulfillment and purchasing power are the universal paths. For vertical retailers, market entries will eventually diminish profitability and market size will eventually limit their growth potentials. While industry characteristics determines near term profitability of B2C retailers, in the long run profit must come from logistic improvements and purchase economy Exhibit 44: Magic quadrant of Chinese B2C online retailers (Size represents gross revenue in 2012, Rmb mn) Gross Margin 30% 25% VANCL 4,500 VIPS 5,500 Jumei 2,500 20% 15% 1haodian DANG 6,800 7, % 5% 360BUY 60,000 51BUY 6,000 0% Source: CRSHK. Revenue per order (Rmb) New business models are emerging in online retail China Renaissance Securities (Hong Kong) Limited 26

27 As most Online Retail 1.0 companies running into the profitablity quagmire, new business models are starting to emerge and offer more than a gimpse of optimism. Flash sales, social e-commerce and flash manufacturing are three online retail business model innovations. Vertical e-tailer in selected segments like cosmetics and furniture have quickly ramped up profitability. These segments tend to be those with low barriers to entry, low brand presence, rapid changes and open-ended sourcing choices. We have yet to see what mobile Internet can bring to the landscape. Consumer-To-Business (C2B), by the definition of Alibaba Chief Strategy Officer and CEIBS/CKGSB professor Zeng Ming ( 曾 鸣 ), represents an entirely new way of industrial production by pooling consumer preferences directly to send to manufacturers. Instead of mass production of goods pushing to the consumers. Mr. Zeng believes the Internet will enable one-to-one production and one-to-one marketing. We expect more innovation to come in the C2B space, signaling e-commerce s expanding presence from consumer frontend to supplier back-end. Lastly, the service retail economy is an untapped market with very low Internet penetration. Group buying, online loyalty, LBS and online directory have produced sizable first generation companies like Meituan, Dianping, AutoNavi/NavInfo and 58/Ganji and have attracted market entries by Baidu, Alibaba and Tencent. We expect continuing innovation and competition to accelerate market adoption. New business models like flash sale, flash manufacturing and social e-commerce have risen. C2B, service e-commerce and mobile Internet could be three areas of new innovation in online retail China Renaissance Securities (Hong Kong) Limited 27

28 B2C: Blue Ocean or Red Sea? As we examine China s B2C segment of online retail, we are impressed by its potential and diversity, as well as its challenges. Potential: online prevails over offline and revenue-per-order upside A key difference between China and US online retail is the mix of B2C operators versus offline turned online retailers. In China, B2C web sites dominate the top ten lists. Only Suning and Gome, offline electronic retailers, made it to the top ten. We believe it is likely that Gome s 10 th spot will be replaced by cosmetic online retailer Jumei in In the US, however, nine out of top ten online retailers are offline turned online (Exhibit 45). In the US, nine of top ten online retailers are offline turned. In China only one out of top ten is. Exhibit 45: Top 10 B2C online retailers in China and US by GMV (for platform) and gross sales (for direct) Rank Name Category Global online (US$ bn) Name Category 1 Tmall+Ju Platform B2C 35 Amazon Direct+Platform B2C 61 2 JINGDONG (360BUY) Direct B2C 10 Staples.com Offline turned online 11 3 Suning Offline turned online 2.7 Apple.com Offline turned online Tencent Platform+Direct B2C 2.4 Walmart.com Offline turned online Amazon China Direct+Platform B2C 1.5 Dell.com Offline turned online DANG Direct B2C 1.2 Office Depot Offline turned online Yihaodian Direct B2C 1.1 Sears.com Offline turned online Vipshop Flash B2C 0.9 Liberty Media Mail/TV VANCL Direct B2C 0.7 OfficeMax.com Offline turned online Gome* Offline turned online 0.7 Best Buy Offline turned online 2.7 Source: CRSHK. Gome will likely lose to Jumei as the 10 th largest online B2C in China in 2013 Global online (US$bn) Does this mean US offline retailers are more competitive than their Chinese peers? To some degree, yes, but to a larger degree, no. While online sales as percentage of total reached 45% for Staples, that of Dell was <10%, Apple <5% and Walmart <1%. On the contrary, Suning s online sales reached 15% of its total in Yougou ( 优 购 ), the online subsidiary of women s shoe brand Belle International (1880 HK), had ~Rmb700m in sales, roughly 2.5% of its total. Womai ( 我 买 ), the online subsidiary of China Agri-industries Holdings, or COFCO ( 中 国 粮 油 ) achieved ~1.5% of parent company s sales. Yintai.com ( 银 泰 ), the online subsidiary of the Yintai Department Store, had ~4% of its sales (Rmb m) online in With the exception of 3C retailer Suning, offline retailers have not been able to launch any effective defense against the online retailers. Due to the short history of retailing in China, offline retail industry tends to be more fragmented than their US counterparts. When facing the assault of online retailers, the offline retailers have less purchase economy to defend themselves in price. Even in the 3C sector where Suning and Gome have a commanding duopoly, Suning s campaign to catch up with Jingdong (360BUY) in online market share ran into significant fatigue in 4Q12 and Gome has totally failed to launch any effective competition to Jingdong. Supermarkets and foodmarts are retail segments that are relatively immune to online retail. However, online retailer 1haodian capitalizes on the convenience factor for urban families, who many do not possess a big car to buy food staples (rice, oil, detergents, seasoning, etc.). Gross revenues are expected to reach Rmb14bn in 2013 after hitting Rmb6.8bn in haodian faces a very different competitive landscape comparing to its US peers who must stand the heat from competing with the global purchase economy of the US$469bn Walmart. Chinese online retailers face far less competition from the offline than their US counterparts. China Renaissance Securities (Hong Kong) Limited 28

29 Chinese online retailers have a head start over their offline counterparts We believe this difference in Exhibit 45 can first be explained by the power of branding. Branding plays a pivotal role in US consumers choice of purchases, but in China consumers are more open to experiment with new retailers. Secondly, most Chinese offline retailers are not as Internet savvy as their US counterparts. Despite heady growth, Suning.com s online sales were only a quarter of JD s (360BUY) but its operating margin has deteriorated to only 2% Suning ( CH) is China s leading 3C retailer with an online+offline total market share of 8% in 2012 (JD had about 5%). It launched its online division Suning.com in February Online sales grew ~200% in 2011 and 157% in 2012 (Exhibit 46). However, its online sales were still only a quarter of JD s. Furthermore, its operating margin has deteriorated from ~8% to ~2%. Because of the relatively short history of Chinese retailing, online retailers are able to compete at the same starting level as their offline competitors. The outcome of the competitive landscape may be very different from that of the US, in our view. Exhibit 46: Suning ( CH) online sales, total sales, gross margin, operating margin trend 1Q2011 2Q2011 3Q2011 4Q2011 1Q2012 2Q2012 3Q2012 4Q2012 1Q2013 Online sales 1,290 1,279 1,441 1,910 1,923 3,357 4,276 6,714 4,499 Offline sales 19,293 22,369 21,953 23,907 20,718 21,193 20,964 19,233 22,702 Online percentage 6.3% 5.4% 6.2% 7.4% 8.5% 13.7% 16.9% 25.9% 16.5% Gross margin 18% 19% 19% 18% 19% 18% 18% 17% 16% Operating margin 7.4% 7.9% 5.4% 6.1% 5.3% 4.0% 2.9% 0.4% 2.0% Source: CRSHK. Company data. Excl. Redbaby, a childcare B2C site acquired by Suning Online retail profitability should improve with improvement in revenue-per-order As we analyzed in earlier sections, Chinese online retail s revenue-per-order today is largely determined by the type of products being sold while gross margin is largely determined by offline practices. Selling white labeled goods, fake goods and smuggled goods are often the source for profitability. In the long run online retailers can increase revenue-per-order by offering more product categories, encouraging cross sale and order combination. Order combination and speed to delivery is always a natural enemy, but strong B2C operators excel in balancing the two. Further, as online retailers grow in scale, they can also improve their gross margins through greater negotiation power with suppliers. Together, revenue-per-order and gross margin lead to higher gross profit to cover the expenses. Different B2C models co-exist in China; vertical e-tailer tells market is at early stage China s state economy was liberalized only since the 1980 s. Evolution of offline retail was already rapidly growing before online retail came in to make a deep impact. The time difference between offline and online retail is only a matter of a decade. China is the only country in the world where the direct B2C model (the Amazon model) and the platform B2C model (the Rakuten model) co-exists. According to Nikkei, Amazon Japan generated a gross sales of US$500bn (US$6.1bn) in 2011, compared to Rakuten Japan s GMV of JPY1.25 tn (US$15.2bn). Direct B2C is 1/3 of platform B2C in Japan. In US, we estimate Amazon s platform sales is ~40% of its total GMV. In China, JD s GMV is ~1/3rd of Tmall s, similar to Amazon Japan s gross sales to Rakuten s GMV In China, JD (360BUY) generated gross sales of Rmb60bn, compared to Tmall s GMV of Rmb190bn in Rmb10bn of JD s gross sales is platform sales. Tencent, offering of both platform (QQ Buy) and direct B2C, had a 2012 GMV of Rmb15bn, according to our estimates, of which direct B2C generated Rmb6bn and platform B2C generated Rmb9bn of GMV, China Renaissance Securities (Hong Kong) Limited 29

30 according to our estimates (Exhibit 47). Therefore, China s ratio of direct B2C to platform B2C is similar to Japan s and US s. Exhibit 47: China B2C market size and share estimates, ranking by 2012 GMV E B2C GMV s (Rmb bn) Taobao Tmall Taobao Ju Jingdong (360BUY) Suning.com (incl. Redbaby) Tencent (51BUY+QQ BUY) ** 30 Amazon China Dangdang (DANG) haodian Vipshop (VIPSHOP) VANCL* Gome (including Coo8) Jumei Newegg Other B2C GMV market shares Taobao Tmall 0% 0% 32% 46% 49% 54% Taobao Ju 0% 0% 0% 5.1% 7.8% 7.7% JINGDONG (360BUY) 13% 16% 16% 14% 16% 15% Suning.com (incl. Redbaby) 0% 1.0% 0.8% 2.8% 4.4% 4.8% Tencent (51BUY+QQ BUY) 0% 1.4% 1.3% 1.1% 3.9% 4.6% Amazon China 10% 10% 5.6% 3.1% 2.3% 2.2% Dangdang (DANG) 10% 8.6% 4.8% 2.6% 1.9% 1.7% 1haodian 0.0% 0.5% 0.6% 1.4% 1.8% 2.2% Vipshop (VIPSHOP) 0.0% 0.0% 0.5% 0.9% 1.4% 1.3% VANCL 0.0% 1.4% 2.4% 2.1% 1.2% 1.0% Gome (including Coo8) 0.0% 0.5% 0.5% 1.0% 1.1% 0.9% Jumei 0.0% 0.0% 0.0% 0.2% 0.6% 0.9% Newegg 5.0% 4.8% 1.9% 0.7% 0.4% 0.3% Other B2C 63% 57% 33% 18% 8.1%*** 3.5% Total 100% 100% 100% 100% 100% 100% Source: CRSHK, iresearch. *Adjusted for fiscal year end in June. * *QQ BUY is platform B2C and 51BUY is direct B2C. ***Other B2C GMV market share declined due to (1) market consolidation and (2) small B2C open stores on platform B2C At this stage China s online retail industry is still characterized by a variety of vertical e- tailers, such as VANCL in apparel, Jumei and Lefeng in cosmetics, Meilele in furniture and 1haodian in daily products. DANG and JD have actively cultivated platform sales in recent quarters. In 1Q13, platform sales (marketplace) already reached 31% of DANG s total GMV. Many of the new online retail concepts also find their counterparts in China. Vipshop, for example, is China s Gilt Groupe or FAB. In China at least 4-5 companies are trying to mimic the Groupon model. The leading player is Meituan. Lastly, China s Dianping, founded in 2003, was even one year ahead of its US counterpart Yelp.com. The existence of vertical e-tailers probably suggests that China s manufacturing economy and distribution channel are full of inefficiencies. Over time these inefficiencies will be ironed out, leading to dominant online retailers like Amazon in China. But on the other hand, one can also argue that China s young retail industry puts many online retailers at the same Chinese online retail is characterized by a variety of vertical e-tailers. DANG and JD have recently turned to open platform for profitability China Renaissance Securities (Hong Kong) Limited 30

31 starting level of the learning curve as the offline retailers. Over time, the online retailers can take offline retailers market, especially if they do so with their own brand. Challenge: Red Sea or Blue Ocean? In the past two years, the capital market has grown pessimistic on the profit potential of Chinese e-commerce companies for several reasons: (1) poor performance of listed companies like Alibaba.com (B2B), Mecoxlane (MCOX) and Dangdang (DANG); (2) persistent deficiency in profitability for industry leaders like JD; (3) a major culprit for (1) and (2) above, repeated price wars among online retailers that destroyed industry profitability. Why do online retailers launch price wars? Do they grab more market share from offline retailers or from each other? Is price wars long term helpful or harmful to the sector as a whole? In our view (Exhibit 48), price wars in the explosive growth stage (>100% YoY growth) of the sector help the industry to collectively gain market share from offline retailers. Since online retailers do not own their own brands, price is the best brand initially to grab consumer attention. However, as online shopping penetration deepens, online retailers start to grab market share from each other. Price wars become a strategic weapon for selected, not all, e-tailers to gain an advantage. The market then enters a high growth stage (50-100% YoY growth). Lastly, when the sector moves from high to stable growth (<50% YoY growth), profitability becomes the overriding concern for most sector players and price wars start to become subdued. Operation quality and efficiency starts to become the key successful factor. In 2013, we predict the entire B2C sector to grow 68% YoY, down from 97% YoY growth in The market is transitioning from explosive growth to high growth, in our view. We predict in , price wars will become strategic weapon of selected e-tailers to gain market share Exhibit 48: Growth phases of Chinese online retail, an illustration Source: CRSHK We predict that in the next few years, only companies with operational excellence and/or deep pockets for strategic spending (like Tencent) will be able to execute price wars to its advantage. This will widen the distance between leaders and followers, in our view. As the chart below outlines, rich cash flow, standard products, suppliers support and marketing capability are four pre-conditions to launch a price war. While price wars help the launching company with market share, category expansion and operating leverage, it also diminishes China Renaissance Securities (Hong Kong) Limited 31

32 customer loyalty, exposes operational bottlenecks (which can turn into an advantage by debottlenecking it) and harms profitability. Lastly, price wars only benefit standard products. For e-tailers with unique sourcing of merchandise, the effect of price wars is limited. Exhibit 49: Precondition, goal, gain and loss of price war Source: CRSHK Alibaba and JD s logistics ambitions could change B2C landscape In 2012, Amazon Japan s revenue reached roughly 44% of Rakuten s marketplace (Rakuten Ichiba) GMV and this ratio has been rising. In other words, Platform B2C is about 2/3 of Japan s total B2C GMV and direct B2C is about 1/3 but direct B2C is rising in market share. In the US, Amazon s MarketPlace GMV is roughly two thirds of its direct selling revenues. We translate this into Amazon s platform B2C GMV being about 40% of its total GMV. But in Amazon s case, platform sales are rising in share as Amazon aggressively expands its marketplace offerings. In China, we estimate the country total Direct B2C is ~22% of total GMV, a figure smaller than both Japan and US. Will China go the way of the US or Japan? We believe the US and Japan experience showed that direct and platform B2C will probably converge to be equal in GMV sizes. Direct B2C has advantages over platform B2C because it has better control of the consumer s shopping experience. The most obvious benefit is shipping can combined orders on direct B2C but on a platform B2C each order from merchant will lead to a different parcel shipped at different time. DANG s low fulfillment cost also pointed to possibility of low fulfillment cost per order if the delivery network only takes down-link logistic flows while public delivery networks often have built-in two dimensional logistic flows. However in China s situation today sourcing of goods is often not transparent and FUPPS often mix with authentic goods. This means direct B2C s centralized control of sourcing often cannot lead to price advantage in competition but platform B2C s decentralized sourcing practice can. It is under this context that direct B2C companies like JD and DANG are both ramping up their platform sales. But in the meantime, platform B2C leader Alibaba is also aggressively investing in proprietary logistics in order to mitigate B2B2C s shortcomings in shopping experience. From this regard we can see China is going the same way as US and Japan. Both direct B2C and platform B2C are learning from each other s tricks. In the long run platform and direct B2C should have similar weights but in China in the short run platform sales is the dominant B2C format thanks to Tmall But similar to US and Japan, both platform and direct B2C operators in China are borrowing each other s competitive strengths China Renaissance Securities (Hong Kong) Limited 32

33 In Alibaba s view, according to press coverage, its e-commerce infrastructure consists of three Nets: (1) The Sky Net ( 天 网 ), which is the Internet capability of the Alibaba group of companies. The core competency, in Chairman Jack Ma s view, is big data; (2) The Ground Net ( 地 网 ), which is an offline logistic infrastructure consortium set up undertaken by Alibaba, Fosun ( 复 星 ), Yintai ( 银 泰 ) Groups and eight delivery companies to build a nationwide logistic backbone consisting of eight super warehouses and two thousand point-ofpresence pickup centers; (3) The People Net ( 人 网 ), which is the employment provided by The Sky Net and The Ground Net, reaching tens of millions of job opportunities. Officially the Ground Net is called CSN (China Smart Logistic Network). CSN is capitalized at Rmb5bn (US$800m) and requires initial investment of Rmb200bn (US$32bn) in its first two phases. According to local press, the consortium has received State Council and local government blessing in securing the land for the super warehouses. The goal of CSN is to provide 24 hour delivery within all corners of Chinese mainland. The combined GMV of Tmall and Taobao Jishi was Rmb970bn (adjusted) in CSN aimed to carry Rmb10tn worth of goods in five years. Compared to Alibaba s CSN, JINGDONG s Asia One ( 亚 洲 一 号 ) project seems less ambitious. It aimed to build six big warehouses with a total investment of Rmb6bn. The first Asia One was launched in Shenyang ( 沈 阳 ) in February, JD s GMV in 2012 was Rmb60bn, of which ~Rmb10bn was contributed by platform B2C. Like CSN, Asia One has received blessing from local governments who hope to retain sales tax within their territories. International B2C and B2C outsourcing: growing niche markets With the RMB s appreciation, purchasing agents ( 代 购 ) for Chinese consumers has become a popular business. Taobao Global (global.taobao.com, 淘 宝 全 球 购 ) had Rmb48bn of GMV in 2012, according to our estimates, with 250K sellers. Because of the complicated fulfillment involved in buying globally, operations outsourcing ( 代 运 营 ) has become a necessary step to help purchase agents collect goods, make payments, store in temporary warehouses, report to customs and ship to Chinese addresses. B2C operation outsourcing has longer history. On Taobao they are referred to as Taobao Partners (fws.taobao.com, or 淘 拍 档 ). B2C outsourcing operators provide strategy, marketing, site management and logistic services to offline retailers and brands. In January 2010, Alibaba made a strategic investment in B2C outsourcing company Baozun ( Earlier, Alibaba made similar investments in B2C process optimization software maker ShopEx ( 商 派 科 技 ), which provides software to manage a company s B2C presence in multiple access points. International purchases by Chinese consumers are already dominated by Alibaba and its ecosystem partners. Supplying Chinese-made goods to overseas customers is still a relatively untapped market because of Alibaba s relatively low profile overseas. In this area, Alibaba also has a fast growing business unit called Ali Express ( 速 卖 通 ). Ali Express was originally designated as a small volume export B2B site but it has increasingly become an export B2C platform (B2B2C). Roughly 20% of Ali Express visitors come from China, 15% from Russia, 13% from the United States, 5% from Brazil and the remaining from India, Australia, Ukraine, Spain, UK and Thailand, according to Alexa. Ali Express has become Russia s biggest B2C operator. Competitor Dhgate ( 敦 煌 网 ) has 26% of visitors from the US, 12% from China, 6% from India, 4% from UK and 3% from Canada, according to Alexa. Factors that may limit Tmall s ability to improve its take rate Tmall s unadjusted Take Rate is 2.4% by our estimates, far below Rakuten s 8%. Adjustment to the Take Rate includes: Alibaba s ambitious consortium with Fosun, Yintai and all major delivery companies to build a logistic superhighway might change the competitive landscape between direct and platform B2C in China While JD s GMV has reached 6% of Taobao in 2012, its AsiaOne investment is only 3% of Taobao s Ground-Net project Ali Express is popular in Russia. Dhgate is strong in the US. Both are B2B2C platforms for overseas trade China Renaissance Securities (Hong Kong) Limited 33

34 Advertising by Tmall merchants on Jishi: We estimate 20-30% of Jishi s P4P advertising revenues (12-18% of total) are from Tmall merchants, translating to an annual figure of Rmb2-3bn, which is equivalent to % of Tmall s GMV. This means Tmall s take rate (revenue divided by GMV) should be adjusted upwards by ppt from the current 2.4% to %. This significantly narrows the gap with Rakuten s 8%; Purchasing agencies are already a booming market of thousands, with a mature platform provided by Taobao Completion of transaction of Tmall GMV: We estimate 85-90% of Tmall s GMV figures are actually completed transactions. This means Tmall s take rate should be adjust upwards by ~10% to %; Scalping ( 刷 单 ): Scalpings are faked transactions either to (1) enhance credit score of the seller or (2) meet platform operator s sales quota. Scalping on Tmall has been declining, thanks to Tmall s crackdowns. China Renaissance Securities (Hong Kong) Limited 34

35 C2C: is it a winner take all market? C2C, as China online retail s earliest segment, has recently seen its growth rate start to moderate. From a user penetration perspective, C2C s upside is limited. But from a monetization perspective, it has just begun. Taobao Jishi s Take Rate, defined as revenues over GMV, is still very low. C2C is a segment that established Taobao Jishi s dominance early on. But whether Tencent stands a chance to challenge Taobao Jishi ( 淘 宝 集 市 ) on a scale that is large enough to warrant meaningful monetization is another important question. How big can Taobao win? According to iresearch, China s C2C market has Daily Active Visitors (DAV) of 43m and Monthly Active Visitors (MAV) of 221m, compared to B2C s DAV of 35m and MAV of 250m in 1Q13. Group buying has, roughly, a DAV of 10m and MAV of 120m (excl. Taobao Ju). Only one firm exists in China s C2C market: Taobao Taobao Jishi has dominant market share in Chinese C2C. On a time spent basis, Taobao Jishi has 97% market share with Tencent s Paipai having 3%, even though on a DAV basis Taobao Jishi is 10x of Paipai. In terms of GMV, we estimate Taobao Jishi had 90% of GMV in 2012, compared to Tencent Paipai s <10%. We break down Alibaba s GMV in Exhibit 50 below. In terms of revenues, we estimate Taobao Jishi has even higher market share. Both Taobao Jishi and Tmall s unadjusted Take Rates are significantly below their overseas counterparts. We have separate sessions discussing the adjusted Take Rates of Taobao Jishi and Tmall. Exhibit 50: Alibaba Group C2C, B2C/B2B2C, group buying, and B2B GMV, sales, Take Rate and Peer comparison table (Rmb bn) E Alibaba Group GMV ,290 -Taobao Jishi Tmall B2B NM NM NM NM NM -Ju Alibaba Group Revenues Taobao Jishi Tmall B2B Ju Alibaba Rev./GMV (Take Rate unadjusted)* -Taobao Jishi 0.7% 1.3% 2.2% 2.4% 2.8% -Tmall 0.0% 0.0% 2.0% 2.6% 3.0% -B2B NA NA NA NA NA -Ju 0.0% 0.0% 0.0% 3.7% 5.5% Peer take rates -ebay (peer to Taobao Jishi) 10.9% 10.7% 11.0% 10.9% 11.0% -Rakuten (peer to Tmall) 8.5% 8.2% 8.0% 7.9% 8.0% Source: CRSHK, Company data. * Take Rate is unadjusted. Please see following sections on adjusted Taobao Jishi and Tmall Take Rates The main difference between Taobao Jishi and ebay is that ebay charges a listing fee while Jishi is free to list. As a result, ebay s revenue to GMV ratio (Take Rate) is close to 11% while the unadjusted Take Rate for Taobao Jishi is only 2.4% in The difference between ebay and Taobao is like Free-to-play and Pay-to-play games To make an analogy, ebay s listing fee based revenue model is similar to pay-to-play games. All participants of the service pay a flat fee. The rule is fair but it doesn t maximize some merchants willingness to pay. ebay adjusted its listing fee structure for automobiles due to We compare Taobao s performance ad-driven business model to free-to-play games and ebay s listing fee based business model to pay-to-play games China Renaissance Securities (Hong Kong) Limited 35

36 its higher average selling price, but overall, ebay s entrance fee structure is still fixed in nature. Taobao Jishi s performance ad-driven revenue model, on the other hand, is like free-to-play games. Entrance is free but merchants can bid up the advertising space to get a more advantageous display location. In the game market, we observe the eventual revenue scales of a free-to-play game and a pay-to-play game tend to be similar, under the caveat that game consumption is largely an irrational behavior while e-commerce advertising is largely a business decision. Taobao Jishi is leading the charge for adopting ad exchange technology Taobao Jishi monetizes by advertising, through a program called Alimama ( 阿 里 妈 妈 ). We estimate ~60% of Taobao Jishi revenues of Rmb17bn in 2012 is derived from in-site search, through a keyword search product called P4P ads ( 淘 宝 直 通 车 ). About 40% of Jishi revenues were from network ads, where we are seeing rapid innovation in technology (Exhibit 51): Taobao Union ( 淘 宝 联 盟 ): Taobao Union consists of search union, contextual union and plug-in union. Advertisers of Taobao Union are Taobao merchants. Members of Taobao Union are external web sites; TANX: TANX is an Ad Exchange that connects advertisers and web sites. TANX participation is not limited to Alibaba customers. Both advertisers and members of TANX can be any party; Ad exchange is the upgraded technology of the old ad networks, using real time bidding (RTB) to bring ads buyers and sellers into an exchange of advertisements Wireless Union ( 无 线 联 盟 ): Newly established, it is not yet clear whether Wireless Union is only limited to Taobao merchants. Exhibit 51: Performance Ads programs in China and how they are related to Google ads programs In site ads Alibaba Baidu Qihoo Tencent Google SINA Search keywords/psp P4P ( 直 通 车 ) PhoenixNest ( 凤 巢 ) ClickEyes ( 点 睛 ) TG ( 赤 兔 ) AdWords - Social GDT ( 广 点 通 ) - FST ( 粉 丝 通 ) Other performance AdWin ( 智 胜 ) - - Network ads (external site) Taobao Union Baidu Union Google Affiliate Network Search network - - TG ( 赤 兔 ) AdSense for search - Contextual network Taobao Ke ( 淘 宝 客 ) Protheme ( 北 斗 ) - AdSense for content - Display ads network - Grand Media ( 鸿 媒 体 ) - AdSense for video - Video ads network - Baidu TV - - Plug-in network Ad Exchange TANX - - ADX DoubleClick ADX - Mobile ads Wireless Union - - AdSense for mobile - Game ads - - AdSense for game - Source: CRSHK, Company data Taobao Union pays, on average, 4% of revenues generated from an external ad. Of this 4%, Taobao Union pays 80% to the web site partner and keeps 20% to itself. As such we can say Taobao Union primarily pays by Cost Per Sales (CPS) model, while Baidu Union primarily pays by Cost Per Click (CPC) model. Leveraging Taobao Jishi s 6m and Tmall s 100K merchants, Taobao basically manages the ads budget of 6m advertisers, comparing to Baidu s paid advertisers of 596K in In K advertisers advertised on Baidu and its affiliates. But Taobao Jishi has 6m merchants and Tmall has 500K merchants. China Renaissance Securities (Hong Kong) Limited 36

37 Taobao s TANX platform is China s pioneer ad exchange. Ad exchange (ADX) is an upgraded version of the old ad networks like Google AdSense, DoubleClick Ad Networks or Baidu Protheme. An ad exchange works similar to a stock exchange, with ad buyers and sellers using RTB (real time bidding) technology to buy and sell ads (Exhibit 52). An ad exchange works with other RTB-enabled parties like DSP (Demand Side Platform), SSP (Supply Side Platform) and DMP (Data Management Provider) in order to create this exchange system. By using ad exchanges, advertisers and web properties can win by achieving higher prices and better targeting (hence better ROI). Taobao TANX and Tencent DAX are the only two ad exchanges in operation in China today. We understand that Baidu will launch its ad exchange in the near future. Exhibit 54 and 55 compares Taobao P4P and BIDU search and contextual s conversion rate and cost per click (CPC). Exhibit 52: An ADX connects a DSP and an SSP Exhibit 53: RTB technology enables ADX Source: Baidu Source: Baidu Exhibit 54: Conversion rate of different performance ads formats Conversion rate Search PSP Contextual SNS Baidu Taobao 2-4% 2-6% 1-3% 2-6% 1-2% Source: CRSHK industry compilation from BIDU, QIHU, Taobao, Tencent Exhibit 55: Cost Per Click (CPC) of different performance ads formats Exhibit 56: Search PSP Contextual SNS Cost Per Click (Rmb) Exhibit Source: 57: Social e-commerce: a new frontier and revenue source In e-commerce, the Alibaba Group of companies take roughly 80% of the entire time spent of the sector, compared to Tencent s 3%. In terms of GMV s, Alibaba Group also takes 80% of the market, compared to Tencent s 7%. Can Tencent challenge Taobao Jishi s leadership in C2C Over the past three years, Paipai has consistently lost market share against Jishi in both active users and time spent. The ratio of Jishi users to Paipai users has widened from 6.6:1 to 10.4:1 and time spent ratio of the two has widened from 25:1 to 39:1 (Exhibit 58, 59). Tencent s acquisition of 51BUY ( 易 讯 ), does little to change the difference in Tencent s footprint difference from Alibaba. Time spent of 51BUY is 63% of Paipai but only 1.5% of Taobao. Tencent s online retail assets: 51BUY, Paipai and QQ Buy are still far from tipping the traffic balance to provide meaningful integration to its massive social networking assets. Baidu Taobao Tencent s online retail assets are still far too small comparing to Taobao/Tmall as well as to its own social networking assets China Renaissance Securities (Hong Kong) Limited 37

38 Exhibit 58: DAV trend of Taobao Jishi and Tencent Paipai DAU (m) Taobao Paipai Taobao:Paipai Exhibit 59: Time spent trend of Taobao Jishi and Tencent Paipai Time spent 14 (m hr) Taobao Paipai Taobao:Paipai Source: iresearch Source: iresearch Social e-commerce competition: Jishi-Weibo versus Paipai-Qzone Social e-commerce became a noticeable phenomenon when e-commerce gateway sites like Meilishuo and Mogujie gained popularity in These two sites select certain merchants and feature them on their smartphone apps. When user makes a purchase from these merchants, Meilishuo ( 美 丽 说 ) and Mogujie ( 蘑 菇 街 ) receive Taobao Union revenue share from Taobao. The success of Meilishuo and Mogujie raise the question as to whether Social Networks (SNS) can become more effective gateways to e-commerce. In its early days, Tencent s social ads product, GDT found it difficult to map user behavior data for targeting. SINA Weibo found it even more difficult because, as social media, its social graph has not been as interactive as Tencent s Qzone. Both GDT and Weibo turned to C2C to try to map out SNS users purchase history in order to generate better serve targeted social ads. Tencent is mapping its Paipai and QQ Buy accounts with its Qzone accounts. Alibaba Group s investment in SINA Weibo aimed to achieve the same purpose with Jishi and Weibo. The Daily Active Visitor (DAV) of Paipai is 3.8m and that of Qzone is about 82m (DAV of QQ Buy is 1.2m and 51BUY is 3.3m). Regardless of how we map, there is a significant mismatch between Tencent s e-commerce and SNS property. On the other hand, the DAV of Jishi is 40m and that of SINA Weibo is 25m. There is significant room for account mapping, in our view. Needless to say, since both Paipai and Qzone are housed under one company and have been sharing one account system under QQ, execution is much easier for Tencent s than for Alibaba-SINA s. Online retail s boom creates shortage for high quality traffic. Despite the challenges, Tencent GDT still achieved nearly Rmb700m of revenues in 2012 and could nearly double in 2013, according to our estimate. SINA Weibo has a traffic disadvantage against Qzone (Weibo user base is 30% of Qzone and time spent is 27% of Qzone) but we expect Weibo to make up some of the disadvantages by having higher pricing, enabled by integration with Jishi. We have a BUY rating on SINA s stock based on Weibo s monetization potential with e- commerce. According to our industry checks, integration of Jishi advertising with SINA Weibo can increase P4P ads Click Through Rate (CTR) by as high as 30%. Similar to Weibo-Jishi, Tencent is integrating its Qzone with its C2C web site Paipai (Exhibit 60 and 61). If integrated well, the Alibaba- Weibo alliance can generate better account mapping, leading to better ad targeting and higher pricing for Weibo ads and higher ROI for advertisers (Win-win) than before. China Renaissance Securities (Hong Kong) Limited 38

39 Exhibit 60: Integration Taobao merchant ads with Weibo Exhibit 61: Integrate Weibo social graph with Taobao P4P ads Your friend has just purchased this Source: Weibo (SINA) Source: Taobao Jishi P4P Factors that could limit Taobao Jishi s potential to increase Take Rate Take rate of paying merchants: Although the overall take rate of Jishi is very low, that for the paying merchants averages ~20% by our estimate. Jishi s key priority is to increase paying ratio, which we estimate to be 10-15% (12.5%x20%=2.5% Take Rate). One upside/downside uncertainty for investors is Jishi might engage in high margin advertisers like medical and commercial hospitals; Completion of transaction GMV calculation: We understand that Taobao Jishi s GMV includes those that do not conclude in a transaction. It only counts those who go to the check out step ( 收 订 ). We estimate the ratio of such failed transactions at 18%. The failure can be due to a number of reasons, most of which is simply buyer changing his/her mind. Hence we would adjust Taobao Jishi s take rate upward by 18%. Scalping ( 刷 单 ): Scalpings are faked transactions aimed at enhancing one s credit score. Sometimes sellers also engage in scalping in order to meet platform operator s sales quota. Scalping GMV has no commercial value; Virtual goods ( 虚 拟 物 品 ): Prepaid game cards, online lottery, online travel booking and telephone prepaid cards are virtual goods sold on Jishi. Take rate for virtual goods can be lower than physical goods due to competition; Competition from other performance ads formats: Currently Taobao Union charges 4% of sales for ads (CPS). The conversion rate of e-commerce ads from a click to a transaction is roughly 2-6% (15-50 clicks resulting in one sale). This means for merchandise with lower than a Rmb10 unit price, advertising is likely not profitable; Migration to mobile Internet: Mobile Internet s app dominant environment might make performance ads as a whole difficult to deploy and pricing will probably be lower. 82% of Taobao s GMV completed the payment step. Most of the remaining 18% simply changed their mind after putting goods into the shopping cart China Renaissance Securities (Hong Kong) Limited 39

40 A discussion on Alibaba s Take Rates A number of investor inquiries focus on Alibaba s Take Rates, which warrant a brief discussion. Because Alibaba s online retail business is a combination of the ebay model (C2C) and the Rakuten model (B2B2C), its Take Rate is more meaningful to be assessed on a combined manner. Given Alibaba s dominance in Chinese online retail, its ability to raise Take Rate should also be considered independently from US and Japanese experiences, in our view. Is Alibaba s Take Rate really comparable with ebay and Rakuten? Our conclusion is no. ebay s market place GMV measures those for-sale items that are closed, regardless of whether a transaction is completed. For ebay this calculation makes sense because ebay has insertion fees, a listing fee regardless of whether the goods get sold or not. This will naturally limit sellers incentive to list, thus minimize GMV. To calculate Take Rate (revenue over GMV) based on item listed makes sense for ebay. Taobao Jishi is different. It has no listing fee, which tend to inflate the amount of listings. Its revenue is advertising, which naturally leads to using transacted value, instead of listed value, as the basis to calculate GMV. We however, estimate that there is an 18% difference between Taobao s unadjusted GMV and order cancellation, payment failure and return goods. We believe we must adjust these to arrive at an adjusted GMV as the basis to calculate Taobao s Take Rate because this actually measures the merchants true cost of doing business on Taobao Jishi. The Take Rates of Rakuten and Tmall are more similar in nature. However, two adjustments need to be made: (1) Given Tmall merchants often advertise on Taobao Jishi, this cost needs to be added back to Tmall to make it comparable with Rakuten. According to our estimate, close to 20% of Taobao Jishi advertising are made by Tmall merchants for Tmall s transactional purposes. Tmall itself also has advertising capability; (2) Rakuten s GMV is defined after deduction of failed transactions, cancelled orders and returned goods, according to Rakuten. Tmall needs to make similar adjustment to its GMV. In 2012, Alibaba Group posted an online retail GMV of Rmb970bn, according to media reports and online retail revenue of Rmb23bn, implying a group unadjusted Take Rate of 2.4%. Tmall s Take Rate is significantly higher than Jishi s Exhibit 62 summarizes our estimate Take Rate of Alibaba online retail businesses. After adjustment, Tmall s Take Rate rose from 2.6% to 7.0% while Jishi s Take Rate declined from 2.4% to 2.0%, reflecting the relocation of Tmall merchants advertising on Jishi back to Tmall s Take Rate. The overall Take Rate rose from 2.5% to 3.1%, reflecting our adjustment on (1) incomplete payment transactions, (2) cancellation of order, (3) return of goods, (4) Scalping to make the Take Rate more comparable with Rakuten and ebay. The adjusted Take Rates illustrate that Tmall is easier to monetize than Jishi and hence Alibaba uses Jishi as a traffic reservoir to feed to Tmall for better monetization. Adding logistic service can increase Take Rate What is the ceiling for Take Rate? Amazon s open platform service has a Take Rate of ~20% because it provides logistic support from Amazon s delivery infrastructure (Fulfillment by Amazon, FBA). Even for Taobao Jishi, paying customers are paying as much as 20% of sales to advertise, thanks to Taobao s market dominance comparing to ebay and Amazon. Both US and Japan have more intensive competition in online retail than China. The market share of Alibaba in China s e-commerce is equivalent to ebay and Amazon combined. The biggest adjustment on Jishi is completeness of transaction. The biggest adjustment on Tmall is adding back merchant advertising on Taobao/Tmall The adjusted Take Rate of Tmall is 6-7% but fulfillment and market dominance can both increase Take Rates China Renaissance Securities (Hong Kong) Limited 40

41 Furthermore, Alibaba Chairman Jack Ma s initiation to launch a nationwide smart logistic network should be able to give more room for Alibaba to increase Take Rate. Exhibit 62: Alibaba Group online retail Take Rate Adjustments (Rmb mn) Alibaba online retail GMV, unadjusted ,290 Jishi Tmall Ju Alibaba online retail GMV, adjusted ,073 Jishi* Tmall** Ju*** Alibaba online retail rev., unadjusted Jishi Tmall Ju Alibaba online retail revenues, adjusted Jishi Tmall Ju Alibaba online retail Take Rate, unadjusted 0.7% 1.5% 2.1% 2.5% 3.0% Jishi 0.7% 1.4% 2.2% 2.4% 2.8% Tmall - 3.5% 2.0% 2.6% 3.1% Ju % 3.3% 6.0% Alibaba online retail Take Rate, adjusted 0.9% 1.8% 2.3% 3.1% 3.3% Jishi 0.9% 1.6% 1.7% 2.0% 2.0% Tmall - 3.9% 4.9% 7.0% 6.3% Ju % 3.3% 3.0% Source: CRSHK, Company data. *Adjust for 82% transaction completeness and 3% scalping (assume remaining to be overlap with incomplete transactions) **Adjust for 90% transaction completeness and 0% scalping (assuming all to be overlap with incomplete transactions). China Renaissance Securities (Hong Kong) Limited 41

42 O2O: at nascent stage but already with substantial players We categorize Taobao Ju s group buying and Vipshop s flash sale as B2C because they both involve selling products without geographic limitations. We classify group buying companies under the O2O (Online To Offline) umbrella because the participating merchants are mostly local service providers like restaurants, entertainment, beauty salons and hotels. According to group buying statistic site Tuan800, restaurants, entertainment, travel and life style services consisted of 50%, 20%, 10% and 10% of transactional values. Service economy is a substantial part of retail sales Restaurants and catering contribute to ~11% of China s total retail sales, making it an Rmb2- tn a year market, with online penetration of less than 1%. We estimate the O2O industry generated a GMV of Rmb35bn in 2012, of which half is from restaurants. Overall, the so called Tertiary Industry ( 第 三 产 业 ), consisting of transportation, telecom, food service, logistics, financial services, insurance, real estate, tourism, education and broadcasting, contributes to an increasingly large portion of China s GDP as the country transitions itself from an export economy to a consumption one. In the telecom, real estate, tourism, education and broadcasting components of the service economy, Internet already made a deep impact through companies like SINA, Youku, Tencent, NetEase, Ctrip, New Oriental, Soufun and BitAuto, etc. Now new companies like group buying companies are emerging in penetrating food service. We also see change brought by mobile Internet in each of the old e-service sectors. Group buying is still growing at very rapid pace despite market consolidation Despite many exits and market share volatility in the group buying sector, the industry GMV is still growing at very rapid pace. We estimate the O2O market grew 59% in GMV in 2012, down from 633% growth in 2011, which was clearly a bubble. We estimate the O2O market to grow 63% in 2013 and 49% in 2014, with new market participants entering, like Tencent Weixin and Taobao Life ( 淘 宝 本 地 ), and penetration in 3 rd -4 th tier cities driving the growth. While product categories like apparel and 3C have moved significantly online, the service economy still has very low online ratio Exhibit 63: Group buying category breakdown, March 2013 Exhibit 64: Market share of group buying companies by GMV, March 2013 Massage and beauty care 7% Others 8% Photo 6% Movie tickets Scheme Park 9% 1% Tourism shows 1% Tourism entrance fee 2% Hotel 10% Restaurants, bars and KTV 57% Others 5% Ju (Alibaba) 3% Gaopeng (Tencent) 3% Lashou 10% Nuomi (RENN) 11% 55Tuan 12% Meituan 37% Dianping 18% Source: Tuan800 Source: Tuan800. *Taobao Ju only counts the local service portion According to Tuan800, the number of group buying sites fell to 943 by February 2013 from the peak of 5,058 set on October 2011 (there were only 400 in mid-2010). Volume has picked up while unit price has been falling. However, unit price saw signs of bottoming out in 1Q13. Market leader Meituan ( 美 团 ) reached quarterly profitability (4Q12) and 55Tuan ( 窝 窝 团 ) announced monthly profitability (December 2012). Market concentration of group buying has increased over time China Renaissance Securities (Hong Kong) Limited 42

43 According to Tuan800, the GMV in market share of the top five group buying companies increased from 68% in March 2012 to 89% in The makeup of the top five has also shifted. Meituan more than doubled its shares to 37% while Dianping gained over 50% share to 18%. Together these two controlled 50-55% of the group buying market. Take rate (revenue over GMV) averages 7-10%, putting Meituan s annual revenue run rate at ~Rmb60mn (Exhibit 63 and 64). Winner of the group buying market share war are Meituan, and Dianping. Losers are Tencent (Gaopeng and Ftuan), Lashou and Ju (Taobao) Nuomi (RENN) saw modest market share gain from 8% to 11% while Lashou ( 拉 手 ) and 55Tuan (Jingdong) both lost 4-5 ppt market share, suggesting learning curve of group buying in China is still steep. Another loser is Tencent, after merging Ftuan into Gaopeng ( 高 朋 ); Tencent has lost over half of its market share to only 3% in March The service-only GMV of Taobao Ju also lost about half of its market share. 55Tuan, Nuomi ( 糯 米 ) and Lashou form the 2 nd tier market players with a combined market share of 30-35%. Restaurant and travel are two most important O2O segments to watch Another noticeable trend over the past twelve months was the change in composition in the group buying categories. Physical product sales declined as a proportion, as the sector continued to squeeze bubble from its product mix (product sales have very low gross margins, except those from Taobao Ju). The percentage of product GMV declined from 15% to 4% in the past year while that of restaurants increased from 43% to 51% (Exhibit 62 and 65). Travel is becoming a fast growing segment of group buying Hotel and tourism GMV also increased as a proportion in the group buying mix, gaining almost 50% from 8% to 11% over the past twelve months. The hotel and tourism GMV does not take into account deals provided by OTA s like Qunar ( 去 哪 儿 ), elong and Ctrip ( 携 程 ) hence the growth should be even more impressive. We estimate hotel GMV from these players is roughly equivalent to GMV provided by group buying companies. Exhibit 65: GMV market share of group buying companies: Meituan and Dianping are gaining shares Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Meituan 15% 16% 18% 20% 21% 21% 24% 28% 28% 29% 29% 33% 37% 37% 37% Dianping 9% 11% 12% 13% 13% 15% 15% 16% 15% 15% 19% 16% 16% 16% 18% 55Tuan (360 BUY) 15% 15% 16% 16% 14% 15% 13% 12% 13% 12% 13% 13% 13% 13% 12% Nuomi (RENN) 8% 8% 8% 8% 9% 13% 11% 12% 13% 12% 11% 12% 10% 11% 11% Lashou 17% 15% 15% 11% 9% 11% 12% 11% 12% 11% 11% 11% 9% 10% 10% Gaopeng+Ftuan (Tencent) 7% 8% 7% 9% 7% 6% 7% 4% 4% 4% 3% 4% 3% 3% 3% Ju (Alibaba, service only) 5% 7% 7% 6% 6% 4% 6% 5% 3% 5% 13% 4% 3% 3% 3% Total (Rmb mn) 1,350 1,462 1,733 1,692 1,769 1,670 1,945 2,110 1,860 1,790 1,870 2,160 2,320 2,010 2,340 Top 5 market share 64% 64% 68% 68% 66% 75% 75% 79% 81% 79% 83% 85% 86% 88% 89% Source: Tuan800 Exhibit 66: GMV market shares of group buying categories: Restaurant and hotel are going up, Product sales is going down Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Restaurant, bar and KTV 40% 39% 43% 42% 42% 42% 43% 44% 46% 49% 54% 48% 52% 50% 51% Entertainment 24% 23% 20% 22% 22% 22% 25% 24% 20% 19% 21% 28% 23% 27% 22% Life style 11% 15% 13% 12% 12% 12% 12% 12% 11% 14% 11% 8.9% 8.6% 8.6% 10% Hotel and tourism 7.9% 7.3% 8.0% 8.0% 8.0% 8.0% 10% 11% 10% 8.9% 8.0% 8.6% 9.0% 8.7% 11% Product 17% 14% 15% 14% 14% 14% 6% 6% 10% 8% 7% 6% 7% 4% 4% Other 0% 3% 1% 2% 2% 2% 4% 2% 2% 1% 0% 1% 1% 1% 1% Total 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Source: Tuan800 Other local marketing solutions: online loyalty, local community, LBS and map apps China Renaissance Securities (Hong Kong) Limited 43

44 Outside of group buying (Rmb21bn), we estimate there is an additional Rmb14bn worth of O2O market spread out across online loyalty, customer service, etc. While group buying is a purchase-based activity, loyalty coupon is redeem-based. The net revenues of Dianping s group buying and loyalty coupon businesses are roughly equal in size, according to our estimate. Other camps of notable O2O companies include: AutoNavi (AMAP US), China s leading digital navigation map maker and its close competitors, NavInfo ( CH) and new competitors like DDmap ( 丁 丁 地 图 ), partially owned by Alibaba, and smaller competitors like Tiger Map ( 老 虎 地 图 ), Careland ( 凯 立 德 ), etc; O2O has seen significant startup activity in leveraging the smartphone s location based capabilities 58.com (58 同 城 ), and Ganji ( 赶 集 网 ), a close competitor of 58 are China s Craigslist. Revenues of the two have reached Rmb m in 2012; 19lou ( 十 九 楼 ), a leading local directory site based in Hangzhou and other local sites like Liba ( 篱 笆 网 ) and Hualongxiang ( 化 龙 巷 ); Buding Couponing ( 布 丁 优 惠 券 ), a smartphone-only couponing application funded by Dr. Kaifu Lee s Innovation Works, competing with Dianping; Tujia ( 途 家 ), an Airbnb-style leisure rental company partially owned by Homeway and Ctrip; Taobao Life (life.taobao.com and mobile apps of the same name) which features services like restaurants, beauty, travel, movie, education, etc. The most popular O2O application on the smartphone in early 2013 is taxi matching. Three to four taxi matching companies based out of Beijing, Shanghai and Hangzhou received venture capital investments. These applications leverage the location based capability of smartphones to match taxi users with nearby taxis. Last but not least, Tencent s Weixin has staked its ground on providing O2O service through Weixin. Weixin was the first to popularize two-dimensional bar codes in Weixin to connect online users and offline businesses. The main product behind Tencent s O2O push is QQ Meishi (QQ 美 食 ), a competing product to Dianping. Like e-commerce 1.0, O2O 1.0 s profitability is very low In the service economy, with the exception of broadcasting and finance, there is a large element of human involvement and hence it is more difficult to optimize than the production economy. Despite Dianping, Meituan, Ganji and 58 have reached hundreds of million RMB in revenue; their profits are dragged down by on the ground presence in local areas. This is similar to E-commerce 1.0 companies early days. We expect the evolution of O2O to also follow the footsteps of e-commerce, with larger 1.0 companies renting out infrastructure to improve ROI and faster 2.0 companies seeking out unique niches to achieve profitability. O2O infrastructure platforms have emerged, as well as competition O2O is a very dispersed and local sector. Dianping and QQ Meishi, as well as most group buying companies compete mainly in the restaurant segment. Online revenue so far only contributes to ~1% of China s restaurant and catering industry. 58 and Ganji are China s Craigslist, but their main service verticals are local yellow pages, online recruiting and property rental. Digital navigation turned LBS company AutoNavi currently still focuses on providing smartphone based navigation software for users. Taxi matching displays strong local focus too, with Didi ( 嘀 嘀 打 车 ) dominating the Beijing market and Kuaidi ( 快 的 打 车 ) dominating the Shanghai and Hangzhou market. 19lou, founded in 2006, remains a Hangzhou-local portal site. O2O is very dispersed in terms of market segments and geographic locations. In most cases companies do not even compete against each other China Renaissance Securities (Hong Kong) Limited 44

45 Hence in most cases, O2O companies do not actively compete against each other. But Baidu, Alibaba and Tencent (BAT) have outlined visions to build a platform infrastructure to host O2O businesses: Alibaba Taobao likely already had a comprehensive platform infrastructure with Taobao Life ( 淘 宝 生 活 ) and ( 口 碑 网 ) as a front end gateway and Alipay as backend support. Taobao Life enjoys an existing business model which charges a fee to the merchants. However, Taobao Life still doesn t have a mobile app and pales in comparison with Dianping in operating matrices; Tencent Weixin has the clearest roadmap with Weixin Public Account ( 微 信 公 共 账 号 ) and two-dimensional code acting as front end gateways and soon-to-be-integrated Tenpay as backend support. To facilitate, Tencent acquired restaurant CRM software maker TongCard ( 通 卡 ) to connect restaurants with their frequent customers. Currently Tencent Weixin mainly features QQ Meishi. Even though QQ Meishi pales in comparison with Dianping in operating matrices, the traffic-driving power of Weixin cannot be overlooked; Baidu Map and Baidu Shenbian ( 百 度 身 边 ): represents Baidu s unique vision to build map service as the front end gateway and leverage its advertising ability as a business model. However, Baidu Shenbian still has very low time spent share and Baidu Map faces a user habit issue of using maps for discovery purposes. Users tends to use search engines and/or social networks to complete their purchase decision process before looking up on a map to find out how to get there. BAT has taken on a platform approach to O2O but the effort is still at very preliminary stage Dianping s dominance in O2O is still very significant, according to iresearch data At this point the gap of BAT with O2O leaders is still very significant. As Exhibit 67 shows, Dianping has overwhelming lead in terms of DAV and time spent comparing to Taobao Life, Baidu Shenbian and QQ Meishi. Exhibit 67: Dianping, Buding and Taobao Life lead in mobile O2O apps (m) DAV (m) Daily time spent (m min) Time spent per day (min) Dianping ( 大 众 点 评 ) Buding Coupon ( 布 丁 优 惠 券 + 布 丁 电 影 票 + 布 丁 爱 生 活 ) Taobao Life ( 淘 宝 生 活 + 淘 宝 电 影 票 ) Baidu Shenbian ( 百 度 身 边 ) QQ Meishi (QQ 美 食 ) Source: iresearch Market consolidation opportunity can emerge in months Among Baidu, Alibaba and Tencent (BAT), we believe Alibaba has the best long term chance to connect the dots to make O2O work as a comprehensive platform of categories and geographies. On the contrary, it probably requires more investment and effort for Tencent to build its O2O ecosystem as Tencent is taking a Direct B2C approach. Its QQ Meishi site directly competes against Dianping and its Gaopeng site directly competes against Meituan. Both, however, are not fairing very well. Furthermore, Tenpay s market share is far smaller than that of Alipay s. We believe Tencent should adopt an open platform approach to provide a better matching for its enormous SNS with e-commerce traffic. We believe there is significant synergy between Baidu and Dianping if Baidu can integrate search ability of Dianping s review content with built-in location awareness from Baidu Map. For Dianping, Baidu also provides a robust business model of location-based advertising. An acquisition of Dianping by Baidu can quickly create an O2O powerhouse. Alibaba s Dianping and Meituan are two leading players in O2O. But the market is probably still one year or more from meaningful consolidation China Renaissance Securities (Hong Kong) Limited 45

46 investment in AutoNavi has already showed the possibility of combining e-commerce with LBS. At this juncture, the product forms of the O2O platform haven t been made clear. With the exception of group buying, none of the other O2O segments have reached mass market adoption. Geography wise and product line wise, the O2O segment is very fragmented. Efforts at building a platform is still at a preliminary stage. These factors will make meaningful horizontal consolidation difficult, in our view. BAT should also balance the risk and rewards of acquiring O2O companies prematurely. The fragmented nature of O2O could make it a fertile ground for M&A in the near future, in our view. Most O2O segments have not reached mass adoption stage, which in our view will hinder their consolidation China Renaissance Securities (Hong Kong) Limited 46

47 Cross border e-commerce: an early market to tap into With RMB s appreciation, purchase agent ( 代 购 ) for Chinese consumers has become a popular business. Taobao Global (global.taobao.com, 淘 宝 全 球 购 ) had Rmb48bn of GMV in 2012, according to our industry check, with 250K sellers. Of course, this pales in comparison with ebay which had a 2012 GMV of US$68bn. Taobao Global, a Chinese language site, features import-to-china products. A mirror segment with longer history is export-from-china web sites. The biggest company in this segment is certainly Alibaba.com (B2B), which at the time of its delisting had a revenue run rate of US$1bn. However, Alibaba.com is a membership based site. It is difficult to come to an estimate for its transactional GMV. For large B2B trading companies, they also rely less on Internet to conduct their business. Cross border e-commerce is now only 0.7% of the total Chinese export in transactional volume We estimate the transactional cross-border e-commerce segment generated US$13bn worth of GMV in 2012, growing 136% from 2011 (Exhibit 67). This excludes Alibaba.com but includes AliExpress and roughly equals only 0.7% of China s US$2tn export market. Export sites: C2C, B2B, B2B2C and B2C form a fragmented market Chinese exporters sell goods on ebay (C2C) and Amazon Market Place (B2B2C) since long ago. In this segment Alibaba has a fast growing business unit called AliExpress ( 速 卖 通 ). AliExpress was originally designated as a small volume export B2B site but increasingly it has become an export B2C platform (B2B2C). According to our industry check, now 50-60% of buyers on AliExpress and Dhgate ( 敦 煌 网 ) are now individual consumers, with the rest being import agents. The two have largely turned from B2B to a B2B2C. Geographic wise, roughly 20% of AliExpress visitors come from China, 15% from Russia, 13% from United States, 5% from Brazil and the remaining from India, Australia, Ukraine, Spain, UK and Thailand, according to Alexa. AliExpress has become Russia s biggest B2C operator. Dhgate has 26% of visitors from US, 12% from China, 6% from India, 4% from UK and 3% from Canada, according to Alexa. Other B2B2C sites include Milanoo ( 米 兰 ) and Tradetang ( 易 唐 ). AliExpress is popular in Russia. Dhgate is strong in US. Both are B2B2C platforms for overseas trade. LightInTheBox and DealeXtreme have strength in Europe and Latin America, respectively Cross border payment and logistic improvement made cross border B2C possible. B2C has overtaken B2B in transaction volume. But market is very dispersed Exhibit 68: Cross border B2B and B2C sites in China and their market share estimates Market size (mn US$) 700 2,000 5,500 13,000 Market share 100% 100% 100% 100% B2B/B2B2C (GMV) 70% 78% 68% 39% Dhgate ( 敦 煌 网 ) 44% 46% 30% 13% ebay Chinese merchants 13% 11% 26% 19% AliExpress ( 阿 里 速 卖 通 ) 9% 15% 10% 5.4% Tradetang ( 易 唐 ) 2.0% 2.5% 1.2% 0.8% Milanoo ( 米 兰 ) 2.6% 3.0% 1.0% 0.5% B2C (Revenues) 29% 22% 32% 61% LightInTheBox ( 兰 亭 集 势 ) 3.7% 3.0% 2.1% 1.5% DealeXtreme ( 帝 科 思 ) 11% 6.4% 3.2% 1.3% DinoDirect ( 大 龙 ) 1.1% 1.5% 0.5% 0.2% Beltel ( 贝 通 ) 0.8% 0.5% 0.2% 0.1% Others 13% 11% 26% 58% Source: CRSHK, ebrun With cross-border logistics and payment infrastructure improving, cross-border direct B2C started to grow strongly. Comparing to cross-border B2B sites, B2C omits one distribution China Renaissance Securities (Hong Kong) Limited 47

48 step, the import agent. In some cases, cross-border B2C even omits import duty if the size of the order is below certain threshold. Among B2C, direct B2C sites like LightInTheBox ( 兰 亭 集 势 ) and DealeXtreme ( 帝 科 思 ) have better control of quality, protection of intellectual properties and benefit of scale in custom clearance. This often means less business volatility than B2B2C, who have to deal with litigations, search engine/sns downgrades and custom disputes. Due to the complicated cross-border logistics involved, these B2C sites usually deal with high margin merchandises like wedding gowns, model aircraft/vessels, eye glasses, false teeth, curtains, oil paintings, gardening tools, etc. Market shares, however, tend to be very dispersed. We estimate that ebay had the highest GMV market share in 2012 at ~20%, followed by Dhgate and AliExpress in the B2B/B2B2C segment. In the direct B2C segment, LightInTheBox and DealeXtreme (DX) are of similar revenue scales, according to public filings. Online payment and cross-border delivery change B2B into B2C Cross border e-commerce started with B2B sites like Dhgate. Most transactions on Dhgate are below US$30K, which in most cases do not necessitate complicated custom procedures. When Paypal and credit cards made cross border payment common and global delivery giants (FedEx, DHL, UP and TNT) made international shipping easy, B2B evolves into B2C by eliminating the import agent altogether. As Exhibit 68 shows, most countries have a US$ exemption limit for small size orders and zero duty for certain electronics. Evolution of cross-border B2B to B2C eliminates the import agent role in the supply chain Exhibit 69: GMV market shares of group buying categories: Restaurant and hotel are going up, Product sales is going down Source: Tuan800 Next direction in cross-border e-commerce: 2B or 2C? Because cross-border e-commerce tends to be those with high gross margins, the segment has been historically opaque and brand-less. As the segment becomes more open, more market entries could happen, in our view. At the same time, because cross-border e-commerce tend to focus on those product categories which have insufficient coverage or variety at their selling countries, it tends to be popular in niche merchandises in developed countries and staple merchandises in developing countries. As variety and coverage starting to improve in these countries, crossborder e-commerce could face more competition. Lastly, as cross-border e-commerce tends to be lesser known in their selling country, market cost tends to be high. LightInTheBox spends ~25% of its revenues on marketing while DealeXtreme, which is responsible for 85-90% of revenues for HK-listed E-Pro (8086 HK) spends about similar percentages according to public filing. Improving marketing efficiency is a common objective for cross-border e-commerce companies. Branding and consolidation could turn out to be the next evolution of cross-border e- commerce China Renaissance Securities (Hong Kong) Limited 48

49 Fulfillment and logistics: the privilege of the big players In e-commerce, fulfillment is a broad term to describe the steps of delivering merchandise to consumers. Fulfillment involves sorting, packaging, warehousing, inter-city delivery and last-mile delivery (Exhibit 70). Logistics is equivalent to delivery in the e-commerce world but in the broader transportation industry, logistics, especially 3 rd party logistics (3PL), often encompasses warehousing. In these circumstances logistics is equivalent to fulfillment. Exhibit 70: Process diagram of typical e-commerce fulfilment Customer Customer take place order Customer Return Logistics for the e-commerce industry often means delivery (excluding warehousing) but for the broader transportation industry it often includes warehousing Choose COD Pay online Allocate to certain warehouse Picking and Packing Allocate to the last-mile shipping partner Allocate to the inter-city logistic partner E-commerce Company Warehouse Logistics Supplier Inventory management re-shelving Product supply chain Monitor the speed and service level Forward logistics Reverse logistics Cash flows Source: CRSHK Sorting and warehousing defines an e-commerce platform s strength After an online retailer receives an order from its web site, it needs to locate the goods, pull them from the warehouse rack, combine them with remaining items of the order, package the order properly and send it to logistic suppliers, whether internally or externally. When scale gets bigger, ability to locate, sort, package and send out tens of millions or even hundreds of millions of parcels with different contents becomes a unique competitive edge. Inefficient sorting and warehouse operation compromises time of delivery, which often requires splitting orders and leads to lower revenue per order. Sorting and warehousing is especially important for companies with ambition to become a full merchandise online retail destination. Take Jingdong and DANG as examples, neither of the two is able to achieve significant profitability on a single category alone. 3C has high revenue per order but low gross margin. Books have low revenue per order and low gross margin. To achieve substantial profitability both needs to improve revenue per order through order combination and gross margin through scale purchasing. We call this the universal way of online retail profitability to differentiate it from other specific means of profitability often associated with a retail segment s unique and current industry structure. In the US, Amazon s forward investment in fulfillment allows it to launch deep price wars during Christmas (Black Friday), an important shopping season for US consumers. Its robust logistics ability can maintain functioning at peak demand while its competitors fail. Over several rounds, such price wars can cause competitors to bow out of competition. Sorting and warehousing capability allows a B2C platform to continue to increase revenue per order and gross margin, eventually reaching profitability on full merchandise scale China Renaissance Securities (Hong Kong) Limited 49

50 In China, however, there isn t such a universal holiday peak like Christmas. As a result, leading players like Alibaba created online shopping holidays like Single s Day (November 11, 光 棍 节 ), Online Shopping Carnival (December 12, 要 爱 要 爱 ). Jingdong has June 18 as its founding anniversary ( 店 庆 ). Other popular online holidays are Online Valentine s Day (May 20 and May 21, 我 爱 你 ), Confession Day (April 20) as well as regular holidays during Chinese New Year, May 1 st Golden Week and October 1 National Day. Arterial, inter-city and last-mile delivery capabilities: own or outsource? The tables below compare different warehousing and delivery options Exhibit 71 and 72). While sorting is definitely a B2C expertise, warehousing can be outsourced, rented or procured. Similarly, a B2C operator can outsource its arterial, inter-city and last mile delivery capabilities. B2C operators with sufficient scale can build their own arterial shipping routes to save cost. However, when it comes to inter-city and last mile delivery of goods packages, different solutions exist. Most B2C s have their own arterial shipping routes to local distribution centers. Shipment between distribution centers to final pickup point can be performed in-house or outsourced Exhibit 71: Comparison of 3 rd party, rental and procured land warehouses Exhibit 72: Comparison of outsource, half outsource and fully owned 3rd party Warehousing Self-owned warehouse with rental land Self-owned warehouse with procured Land Outsource Half outsource Fully owned delivery Key features Turn-key, no capex Easy to manage, low capex High controllability, high capex Key features Pick up + arterial+intercity + last mile Inter-city+last mile only All self-owned Targeted ecommerce companies Small-mid size Taobao sellers Big Taobao sellers or midsized B2C Established B2C with sufficient capital Targeted ecommerce companies Small-mid size Taobao sellers Big Taobao sellers or midsized B2C Established B2C with sufficient capital Expenses and costs High cost per order. Lack of flexibility for improvement Low cost per order with flexibility but rising rental cost Full flexibility through fulfillment improvement Expenses and costs High cost per order, lack of flexibility for improvement Low cost per order with flexibility but rising rental cost Full flexibility through fulfillment improvement Typical company Taobao sellers DANG, VIPS, LITB JINGDONG Typical company Taobao sellers DANG, VIPS, LITB, Alibaba JINGDONG Cost per order RMB8-15 RMB6-16 RMB12-18 Cost per order RMB10-12 RMB6-10 RMB15-20 Source: CRSHK Source: CRSHK Competitive landscape of Chinese e-commerce delivery industry Intercity and last mile delivery of e-commerce goods are often performed by the express delivery industry. There are currently more than a thousand express delivery companies in China. But seven lead players: China Post (EMS), SFE ( 顺 丰 快 递 ), STO ( 申 通 ), YTO ( 圆 通 ), HTO ( 汇 通 ), ZTO ( 中 通 ) and YDE ( 韵 达 ) control 80% of the market. The last five are often referred to as 4T1D ( 四 通 一 达 ). 4T1D adopt the franchise model. But EMS and SFE directly own their stores. We estimate 4T1D collectively ship more than half of e-commerce packages while EMS and SFE have about 15% and 15% market share each. Overseas delivery giants like FedEx, TNT, UPS and DHL have a commanding market share in international letter shipments but have minimum presence (~3%) in e-commerce. The remaining market share goes to small, local shippers. Alibaba and 4T1D have long standing relationships. Taobao and Tmall are responsible for 60% of 4T1D s shipment volume by our estimate. In fact, 4T1D are all headquartered in Shanghai or Hangzhou (near Alibaba s headquarters). All of 4T1D s founders are from the Tonglu ( 桐 4T1D owes >60% of their business to Taobao and Tmall while SFE has <30% revenues from e-commerce. 4T1D are all headquartered near Alibaba China Renaissance Securities (Hong Kong) Limited 50

51 庐 ) county of Hangzhou Municipal. Alibaba Chairman Jack Ma and Honghai Chairman Terry Guo jointly invested in Best Logistics, which in turn acquired HTO. The founder families of STO, YTO and YDE are closely related. SFE s business mix is more diversified. E-commerce parcels account only for <30% of SFE s shipment volume. SFE is headquartered in Shenzhen and traced its roots to delivering goods between Guangdong province and Hong Kong. SFE is the biggest Chinese fast delivery company with more than 150K employees. However, its importance in e-commerce is not as significant as 4T1D. Its efforts at vertically integrating into e-commerce have also failed. As shown in the table below (Exhibit 73), the Chinese postal industry enjoyed extremely robust growth in 2011 and 2012 with parcel shipment volumes rising more than 50% YoY in these two years, largely thanks to e-commerce. As a result, industry revenue growth accelerated to 22% in 2011 and 27% in Exhibit 73: Industry statistics of China s postal industry Total revenues (Rmb bn) Growth rate 14% 14% 17% 22% 27% Letters (b) Parcels (b) Parcels growth rate 19% 24% 26% 57% 55% Source: China Postal Bureau Exhibit 74: Major express delivery companies at a glance SFE STO YTO HTO ZTO YDE # of employees (K) Pickup points (K) Distribution centre NA Headquartered Shenzhen Shanghai Shanghai Hangzhou Shanghai Shanghai Cargo planes Source: CRSHK Jingdong s fulfilment open platform vs. Alibaba virtual fulfilment Among Chinese B2C retailers, Jingdong is unique in that it owns its own logistics operations. Jingdong (360BUY) has last mile in-house delivery capabilities ( 自 营 配 送 ) in 1,039 city districts and rural counties ( In 2012, according to the press, Jingdong shipped 80% of its orders through its in-house logistics operations, which is licensed to carry out delivery business by law. In areas outside of inhouse delivery, which are usually areas with fewer orders to justify building a delivery operation, Jingdong collaborates with 3 rd party logistic providers. For example, YTO helps Jingdong collect all returned goods. JINGDONG made huge investments to build last-mile delivery capability. It has now opened up to 3 rd party merchants Building its own last-mile logistics capabilities costs money, but it also allows Jingdong to open its fulfillment capabilities to 3 rd party retailers. Currently Jingdong offers four types of collaboration levels (Exhibit 74). FBP mode is the classic direct B2C mode. The supplier ships the goods to JINGDONG s warehouse and provides Jingdong with VAT tax receipts. Jingdong takes care of everything thereafter. Jingdong assumes inventory; LBP mode is a new mode. It allows suppliers to send goods to Jingdong s warehouse only after an order has been received. The goods pass through Jingdong s warehouse to go directly to the fulfillment operation of Jingdong. The supplier needs to provide Jingdong with VAT tax receipts. Jingdong only assumes inventory for a brief period of time; Ability to combine orders is a key strength of Jingdong s direct B2C approach, even at open platform settings SOPL mode is the same as LBP mode except that the supplier issues its own VAT receipt to the customer. Jingdong does not assume inventory risk; SOP mode is the classic platform B2C mode (Tmall mode). The supplier only uses Jingdong s virtual store and shopping cart system with no involvement from Jingdong fulfillment. China Renaissance Securities (Hong Kong) Limited 51

52 In three out of the four collaboration modes (FBP, LBP, SOPL) Jingdong is able to fully control the delivery of goods to end users hands. It is able to combine orders into one shipment, something very difficult for platform B2C operators like Tmall to do. Apparently to address this shortcoming in the long run, Alibaba is building up its CSN, which is aimed at building eight super warehouses and more than two thousand delivery points across China. CSN provides a virtual fulfillment operation whereby Tmall or even Taobao merchants can tap into using the LBP and SOPL mode, in our view. However, because Alibaba does not directly own CSN, and CSN will likely need to link itself to the last mile delivery network of its consortium members (both SFE and 4T1D are founding members of CSN), CSN is more like a virtual fulfillment platform that links thousands of delivery companies with thousands, or even millions of merchants. The complexity of the project is high. Exhibit 75: JINGDONG (360BUY) open platform policies Jingdong open platform modes Virtual stores Shopping cart JD warehouse JD delivery JD pickup JD Cash On Delivery VAT tax receipts FBP Yes Yes Yes Yes Yes Yes Yes LBP Yes Yes Transfer Yes Yes Yes Yes SOPL Yes Yes No Yes Yes Yes No SOP Yes Yes No No No No No Source: CRSHK Both Jingdong and CSN have secured subsidized land from local governments for the super warehouses they intend to build. 12 th Five Year Plan addresses transportation challenges and shortages In 2010, Alibaba invested in the Singapore IPO of Global Logistic Properties (MC0 SX). The predecessor of Global Logistic Properties (GLP) is the Asian and Japanese operations of USbased Prologis (PLD US). Prologis sold the logistics operations of Asia and Japan to GIC (Government of Singapore) to pay for debt. GIC subsequently brought GLP public on the Singapore Stock Exchange. In 2013, GLP leased warehouse floor space to Best Logistics (owned by Alibaba). GLP also supplies modern warehouse equipment to Jingdong, Amazon China and VANCL, according to public filing. The business model of GLP is essentially building and renting warehouses. China has severe shortages of good warehouses because the Chinese economy, until today, is built for export, not for consumption Warehouse improvement will revamp China s outdated transportation system According to CB Richard Ellis (CBRE), China s ratio of good quality warehouses to its trading volume is only half of that in Japan and US (Exhibit 76). Its warehouse stock per capital is close to 1/10th of Japan and the US. According CBRE, out of 550m square meters of good storage space, only 1/10th is equipped with modern warehouse equipment. Exhibit 76: Lack of modern warehouse facilities in China Estimated warehouse stock (sq. m) Ratio to total trading volume (per US$K) China Hong Kong Japan USA Source: CBRE Warehouse stock per capita The shortage of good warehouses is a result of the fact that the Chinese economy, until recently, has been built for export, not for consumption. Furthermore, appreciation of the China Renaissance Securities (Hong Kong) Limited 52

53 RMB has driven many manufacturing facilities inland, which further necessitates building inland warehouse facilities to ease transportation to retailers and end consumers alike. It is under this backdrop that we see brisk growth of logistics demand that is unable to be met by the rigid state-owned logistic industry. Third party logistics (3PL) providers have risen up to fill the demand. Logistics expenditure consists of 18% of China s GDP, compared to less than 10% in developed countries, highlighting inefficiencies in China s distribution system, according to CBRE. Road improvement and trucking consolidation to revamp outdated transportation To address these challenges and shortages, the Chinese government has planned major transportation investments in its 12 th Five Year Plan. According to the Plan, China will build a national highway network that can cover 1bn of population under the so called 7918 configuration: 7 highways connecting Beijing to other cities, 9 arterial highways connecting north to south and 18 highways connecting east and west (Exhibit 77). Also for cargo traffic, China s high speed rail system will consist of four vertical lines and four horizontal lines connecting 9 conurbations (Exhibit 78). High speed rail and highway investment in China s 12 th Five Year Plan will significantly improve logistics capabilities of the Chinese economy Exhibit 77: Express train network of China s Twelfth Five Year Plan Exhibit 78: Highway network of China s Twelfth Five Year Plan Source: State Council Source: Tuan800. *Taobao Ju only counts the local service portion Exhibit 79: Delivery and logistics players in China Less-than-truckload logistics (LTL) Letter-post Express delivery Full truckload logistics (FTL) Weight 100 g 10 kg 50 kg 3t China Post EMS 4T1D, SFE Deppon, KXTX, ANE, Transfar Source: CRSHK. EMS is a brand of China Post China Renaissance Securities (Hong Kong) Limited 53

54 Not only is road improvement required to develop China s outdated logistics/transportation industry, China s trucking industry also needs better scale and sophistication. More than 90% of China s truck shipping companies own just one truck, which leads to high logistics cost as a percentage of GDP. Delivery options are classified by weight. Letter grade delivery (up to 100g) has the highest profit margin (Exhibit 79). China Post/EMS and global express delivery giants compete in this segment. The 100g-50kg segment is the express delivery segment and the 10kg-3t segment is the less-than-truck-load-logistic (LTL) segment. EMS, 4T1D and SFE mainly compete in the low weight end of these two segments while Deppon ( 德 邦 物 流 ), ANE ( 安 能 物 流 ), Transfar ( 传 化 物 流 ) and KXTX ( 卡 行 天 下 ) mainly compete with 4T1D and SFE in the high weight end of these two segments. These delivery companies are often referred as arterial logistics ( 干 线 物 流 ). Above 3t is the full-load-truck-logistics (FTL) segment. Competitors in FTL are mostly State Owned Enterprises (SOE) and overseas joint ventures (such as DTW-FedEx JV, SAIC-TNT JV, Sinotrans-DHL JV, etc.). Most of the SOE ports, railways, airlines, export trading companies and postal companies have their own sizable logistics operations in the FTL segment. Consolidation isn t likely to affect competition for pricing It is under this backdrop of logistics supply and demand that we believe China s 3PL providers will continue to see heady growth ahead before any major consolidation. Global logistic companies can often trace their origins to national post. TNT (Dutch), GLS (UK), DPD (France) and Nippon Express (Japan) can all be traced to respective postal services of their nations. Express delivery, however, is an entrepreneurial concept championed by Federal Express (FedEx), United Parcel Service (UPS) and DHL, all originated from the US in the s. The advent of e-commerce pulled both national posts and express delivery startups into the common pursuit of providing shipment for online retail parcels. In 2000, Deutsche Post acquired DHL but UPS s acquisition of TNT in 2013 met with regulatory objections. In Japan, Sagawa Express ( 佐 川 急 便 ) and Yamato Transport ( 宅 急 便 ) are competitors to Japan s national post, Nippon Express. In China, EMS (Express Mail Service) is the express and logistics brand used by China Post (government owned) to compete with private entrepreneurs (SFE and 4T1D) and global logistic giants. The market share among EMS, entrepreneur-owned and global logistic giants/jv s are roughly 20%, 75% and 5%. Within the camp of entrepreneur-started companies, SFE is a clear leader but we believe there could be 2-3 other logistics companies to benefit from consolidation, with one or more backed by Alibaba. This will lead to fewer players but we believe competition will still be sufficient to keep delivery prices low. While Jingdong can be viewed as taking a vertical integration step into delivery, SFE also tested the water at establishing its own B2C service. However, this effort has not been successful. China s transportation industry is very fragmented We believe 4T1D could see consolidation but we see the market still having 4-5 total players to ensure sufficient competition for pricing China Renaissance Securities (Hong Kong) Limited 54

55 Offline retailers: how are they fighting back the war? Offline retailers across the globe are facing the competition of online retailers. But in China the challenge is more severe because offline retailers are almost as young as their online competitors. Our discussion with offline retailers and brands revealed their game plans: (1) consolidating offline presence and focusing on high end, trying to make offline shopping a relaxing and multi-purpose experience; (2) differentiating their merchandises offline but participating in online; (3) for brands, disintegrating local retail presence and building up online presence. Rationalizing offline presence is a common strategy for offline retailers Rationalizing offline presence is a common step by both offline retailers and brands. Their strategy and motivation, however, differ. Big offline retailers are going high-end Big offline retailers are turning to commercial real estate as their next business model. They are going high end, trying to make offline shopping a relaxing and multi-purpose experience. Some of the noticeable developments are: Suning Estate ( 苏 宁 置 业 ), the unlisted arm of Suning Group which owns Suning Electronics ( CH), plans to build 50 shopping malls, 200 flagship stores, 100 luxury hotels and 60 super warehouses by It already operates 16 shopping malls, mostly in 2 nd tier cities near Jiangsu province; Dalian Wanda ( 万 达 集 团, CH), the early pioneer of the integrated shopping mall business model, has opened 67 shopping malls, 38 luxury hotels, 6,000 movie screens and 57 department stores. Wanda plans to almost double its number of malls to 110 by 2014; Mid-sized retailers are focus on differentiation Maoye Department Store ( 茂 业 百 货, 848 HK) plans to differentiate itself by focusing on three segments: high-end fashion, young and trendy and casual home. It also selectively branches into high end malls and manufacturers outlets; Intime Department Store ( 银 泰 百 货, 1833 HK) plans to offer different merchandises for stores at different locations, based on consumption pattern of the surrounding areas; Consolidating offline presence has become a common strategy At one end, old retail locations without sufficient parking space are having increasingly difficult time at attracting customers. On the other hand, online retail has started to impact all kinds of merchandise categories. Opening fewer, bigger and more multi-purpose stores seem to be the trend. Offline retailers work with B2B2C and O2O to compete with B2C While direct B2C retailers are offline retailers enemy, platform B2C s are often offline retailers friend. This is especially true for offline brands, which have less a challenge from e- commerce than offline retail. Tougher transition for offline retailers than for offline brands Almost all major offline retailers have adopted online strategies. Leading offline retailers like Suning already had 15% of its revenues from online in However, for offline retailers the transition has not been easy. Even Intime Department Store, which is considered to be one of the most successful in transition, only has 4% of its total sales from online. Suning posted sharp revenue decelerations and profit declines as it tries to transition itself from an offline 3C retailer into an online/offline mixed retailer of multiple Facing competition from e- commerce, big offline retailers answer is to go high-end into commercial real estate For mid-sized retailers, segmentation and merchandise differentiation are common strategies Brands can transition to online retailing much easier than offline retailers China Renaissance Securities (Hong Kong) Limited 55

56 categories. Other retailers, like Wangfujing Department Store ( 王 府 井 百 货, CH) had to restructure their online retail business due to poor tractions. For brand owners, the challenge of online is much smaller. In many cases it is even an opportunity. However, the road to adaptation is still fraught with risk Septwolves ( 七 匹 狼, CH), a men s wear maker, successfully used online retail destinations to help it manage inventory and increase profitability. Opening its first Taobao store in 2008, Septwolves now manages multiple online destinations in Tmall, Jingdong, Vipshop and 1haodian with different characteristics, as well as 4,000 offline stores. Online retail reached 5% of total sales in 2012; Belle International ( 百 丽, 1880 HK), the leading women s shoes maker, successfully segregate its online sales (through online subsidiary Yougou) from offline channels. Belle supplies different styles and makes of shoes to online and offline. Online sales reached 2.1% of total in 2012, not yet enough to impact the overall business; China Dongxiang ( 中 国 动 向, 3818 HK) had a drastic improvement in its operation in 2H12 after embracing Vipshop as destination for its inventory goods. Septwolves mainly use Internet to manage its inventory. Both Septwolves and Belle segregate their offline merchandise from online O2O might provide an opportunity for offline retailers to connect with online customers For offline retailers, however, the hope is not all lost. O2O provides an opportunity for offline retailers to connect with customers online. For example: Coastal City ( 海 岸 城 ), the largest shopping mall in Shenzhen, uses Weixin to connect with shoppers, providing information as well as dispensing loyalty coupons. Shoppers can scan Coastal City s Two-Dimensional Code to become a member of the mall, and receive push coupons via Weixin; Chaoyang Joycity ( 朝 阳 大 悦 城 ), one of the major shopping malls in east Beijing, used Weixin to attract 140K members which enjoy benefits such as loyalty coupons and store information. In both cases O2O platform provides a customer relationship management platform to offline merchants. Using social networks and location-based push service, these offline merchants can reach and target customers online. Brands are learning to play by online rules In 2011, several Tao-brands (apparel brands grown out of Taobao, with no offline presence) ran into difficulties by using Taobao s group buying service too frequently, thereby destroying their brand image and pricing power. Today in order to protect offline stores, most apparel brands learned to treat online channel as a way to manage inventory and market new designs, but not as main channel of sales. They tend to sell the bulk of newest styles and designs in their own stores, and adjust inventory levels by offloading them to Tmall or Vipshop. Currently apparel is one of the most mature segments in online retail. In most other areas brands are only starting to learn how to online retail to help their business. Going forward, however, online platforms are teaching brands to leverage Internet s broader reach. A near term focus of both Tmall and Jingdong is trying to persuade apparel brands to pre-release their latest designs on web, thereby leveraging Internet s superior ability of reach. We believe in the future, as more and more capabilities become available to Internet, new ways of using Internet will be discovered by offline brands. For example, Internet s superior ability to target and price discrimination has not been widely used by brands. Brands are learning how to deal with different online channels. Pre-release and inventory clearance are now two main reason of online retail China Renaissance Securities (Hong Kong) Limited 56

57 E-commerce outsourcing: helping offline as well as online In the world of e-commerce, direct B2C and C2C directly compete with offline retailers, platform B2C (B2B2C), C2C, B2B and O2O actually help offline retailers to conduct business online. In this process a new class of service companies emerged. They are e-commerce outsourcers helping offline companies to do business online. Taobao ecosystem incubates extensive line-up of outsourcers E-commerce outsourcing is probably the most prevalent in the cross-border sector. Because of the complicated fulfillment involved in buying globally and because cross-border e-commerce companies typically do not get involved in logistics, operation outsourcing ( 代 运 营 ) has become a necessary step to help purchase agents collect goods, make payment, store in temporary warehouse, report customs and ship to Chinese addresses. Domestic B2C outsourcer has a narrow scope. Most focuses on the online-portion of e- commerce. On Taobao they are referred to as Taobao Partners (fws.taobao.com, or 淘 拍 档 ). Taobao Partners provide strategy, marketing, site management and logistic services to offline retailers and brands. In January 2010, Alibaba made a strategic investment to B2C outsourcing company Baozun ( 宝 尊 ). Earlier Alibaba made similar investments to B2C process optimization software maker ShopEx ( 商 派 ), which provides software to managing a company s B2C presence in multiple access points. Baozun and ShopEx represent two types of e-commerce outsourcing businesses: one leverages on human consulting and the other focuses on software-imposed process control. Other e-commerce outsourcing companies include eget ( 熙 浪 ), Rkylin ( 瑞 金 麟 ), EC3S ( 兴 长 信 达 ), Leqee ( 乐 其 ) and Centaur (e 店 宝 ), etc., to name a few. Aliyun and CSN are e-commerce outsourcers, too Baozun and ShopEx are e-commerce outsourcing in a narrow sense. In a broader sense the entire Alibaba Group focuses on helping offline retailers and brand do business online. Aliyun and China Smart Logistic Network (CSN, or GroundNet) are two attempts made by Alibaba to provide turnkey choices for web hosting and merchandise delivery to offline brands (Exhibit 80). Aliyun is modeled after Amazon Web Service (AWS) and is now China s only true Infrastructure-As-A-Service (IaaS) provider. On Aliyun Alibaba provides: Computing service by time: Aliyun provides server hosting paid by hour or monthly plans as well as storage and relational database services; Software service by time: Aliyun sells third party CRM and ERP software as data analysis packages in annual packages; Mobile OS: Aliyun has its own mobile OS called YunOS, which had limited OEM tractions due to Alibaba s dispute with Android. Value added services like mobile ads SDK and map API. In the long run we believe BAT (Baidu-Alibaba-Tencent) will likely be China s leading player in cloud computing with Alibaba focusing on e-commerce, Tencent and Baidu on general mobile cloud computing. At this stage Aliyun has a clear focus in providing e-commerce infrastructure while in the long run it can rent out excess capacity to companies from other segments like online game. Similarly, Alibaba s China Smart Logistic Network (CSN) project aims to build a comprehensive logistic infrastructure, together with major delivery partners like 4T1D and SFE. CSN aims to achieve 24 hour delivery for everywhere in Chinese territory with annual E-commerce outsourcers help offline companies compete on line, mostly by working with online e-commerce platforms like Alibaba Aliyun provides comprehensive e-commerce infrastructure so Alibaba can own the massive data generated from normal course of business China Smart Logistics Network (CSN) aims to deliver half of China s social retail sales China Renaissance Securities (Hong Kong) Limited 57

58 volume of Rmb10tn, almost half of China s social retail sales in CSN will take 8-10 years to build. Exhibit 80: Major cloud computing platforms in China Ali-Yun (Alibaba) Q-Cloud (Tencent) Baidu-Yun (BIDU) SINA-Yun (SINA) 360-Yun Classification IaaS IaaS/PaaS PaaS/SaaS PaaS/SaaS SaaS IaaS Year of founding Sep-09 Jul-12 Sep-11 Nov-09 Mar-12 Jul-11 Strategic purpose Build stickiness between SME and end users on Alibaba platform Support Tencent Open Platform initiative. Build stickiness between app vendor and end user SaaS offerings No No Storage, address book, game, music, notes PaaS offerings IaaS offerings Strategic intent Apsara platform ( 飞 天 平 台 ) and ACE (Ali-yun Cloud Engine) Cloud computing, storage, database, bandwidth and distribution services Lock in SME customers to the Alibaba platform Cloud Elastic Engine (CEE) Cloud computing, storage, database, bandwidth and distribution services Not yet clear but could strengthen Weixin's ecosystem Build a user base Support SINA Weibo through Personal Cloud. open platform initiative Then use Personal Cloud to build an ecosystem to occupy a gateway position on mobile App store and Baidu App Engine (BAE) In the future, BIDU will provide IaaS services Mitigate weakness at the mobile device level and extend service to SME customers (QIHU) Build a mobile user base through Personal Cloud. Then connect mobile user with PC user to build an ecosystem to occupy a gateway position on mobile Grand-cloud (Shanda) NA No Storage, address book No App store ( 新 浪 云 商 店 ) and SINA App Engine (SAE) Limited Shanda Cloud Engine Limited Limited Cloud computing, storage, database, bandwidth and distribution services Strengthen Weibo's ecosystem Strengthen browser's ecosystem CR rating A C+ B+ B B C- CR comments Source: CRSHK Alibaba has the most comprehensive IaaS and PaaS offering. It has a firm grip throughout Cloud- Pipe-Device Tencent has comprehensive presence in Device and Weixin offers interesting opportunity to become a Pipe. Transformation to cloud, however, might jeopardize existing revenue stream BIDU is wavering between SaaS and PaaS because it lacks presence in any of the Cloud-Pipe-Device nodes. BIDU is also relatively late to the cloud landscape SINA executed the cloud strategy around Weibo well. User satisfaction is high while SINA Cloud's aspiration is modest QIHU executed the cloud strategy around its browser well. User satisfaction is high while QIHU Cloud's aspiration is modest Unclear Shanda lacks reason and resource to launch a cloud strategy, in our view. Without synergy to other part of the business, strict P&L pressure will likely apply to Shanda Cloud Cross platform e-commerce service is emerging: focusing on big data E-commerce outsourcing service starts with the Alibaba ecosystem, but some companies have branched to the e-commerce value chain. Many of such services focusing on front end marketing. Because backend logistics is often organized by (1) e-commerce 1.0 company s open platforms, (2) delivery companies like 4T1D, (3) flash logistics by e-commerce 2.0 companies like Vipshop and LightInTheBox, front-end marketing is the main area a service company can add value.. Emar ( 亿 码 在 线 ), MediaV ( 聚 胜 万 合 ) and AdSage ( 艾 德 思 奇 ) are three leading digital marketing solution providers that focus on e-commerce advertisers. They frequently work with traffic platforms like Tencent, Baidu, Qihoo, and SINA Weibo on behalf of e-commerce advertisers. Baifendian ( 百 分 点 ) and ipinyou ( 品 友 ) are two smaller firms focusing on e- commerce personalization and AdExchange technologies. According to our industry estimates, total e-commerce ads amounted to Rmb20bn in 2012, equivalent to 26% of total online advertising market (Exhibit 81). Among this Rmb20bn, a little over half was spent in-property, mostly Taobao in-site ads while another half was spent across the open Internet. Further, E-commerce search ads occupied ~15% of total search ads. China Renaissance Securities (Hong Kong) Limited 58

59 Exhibit 81: E-commerce ads market size estimates (Rmb mn) E 2014E Total e-commerce ads 2,471 6,080 12,140 20,431 29,350 39,360 Breakdowns In-property advertising 1,418 3,824 7,685 11,952 16,524 20,743 Full network advertising 1,053 2,256 4,455 8,479 12,826 18,617 Search ads 754 1,459 2,549 4,454 6,017 7,911 Performance ads ,777 3,111 5,235 Online display ads ,262 1,929 Other ads ,410 2,436 3,542 Total online display ads 11,515 15,410 19,969 23,963 30,214 36,781 Total search ads 6,960 10,980 18,780 29,030 39,500 49,375 Total video ads 1,360 2,150 4,250 6,337 8,395 11,146 Total online advertising 21,635 32,220 52,189 78, , ,851 E-commerce ads as % of total online ads E-commerce search ads as % total search ads Source: CRSHK, iresearch, Analysys Consulting 11% 19% 23% 26% 27% 26% 11% 13% 14% 15% 15% 16% Qihoo 360 (QIHU) is a major beneficiary of e-commerce ads. We estimate ~50% of QIHU s PSP/Search ads (~1/3 of total revenues of QIHU) were e-commerce related, translating to a market share of ~3.2% in China Renaissance Securities (Hong Kong) Limited 59

60 PC Internet companies: learning to cope with e-commerce Without doubt, Tencent is the most aggressive among PC Internet companies to embrace e- commerce. In 1Q13, e-commerce revenues contributed to 14% of Tencent s revenues and 1.7% of gross profits. We estimate Tencent s 2012 e-commerce GMV consisted of Rmb 6bn worth of B2C (51BUY), Rmb9bn worth of B2B2C (QQ BUY) and Rmb60bn worth of C2C (Paipai). From a total GMV perspective, Tencent s total GMV of Rmb75bn in 2012 ranked only below Alibaba s Rmb970bn (adjusted) as No.2 (excl. Alibaba B2B as its GMV is uncalculatable), but ahead Jingdong s Rmb60bn. We expect Jingdong to overtake Tencent to become No.2, mainly because B2C s growth rate is significantly above C2C. However, we notice that 51BUY is also growing very rapidly. Tencent: using e-commerce to maintain user base loyalty Over the past three years, outside group buying companies (Meituan, 55Tuan and Tuan800), Tencent s 51BUY registered the biggest CQGR in terms of visitor acquisition, followed by Vipshop, Suning, Jumei and 1Haodian (Exhibit 82). Noticeably however, Tencent Paipai not only lost market share, but also had declining Monthly Active Visitors (MAV). We expect Jingdong to overtake Tencent as China s 2 nd largest ecommerce company by GMV. Tencent s 51BUY unit (B2C) outperformed while its Paipai (C2C) lost its user base Exhibit 82: Monthly Active Visitors (MAV) of Chinese online retail companies, quarterly average (mn) 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 CQGR Taobao Jishi ( 淘 宝 集 市 ) % Tmall ( 天 猫 / 淘 宝 商 城 ) % Tencent Paipai ( 腾 讯 拍 拍 ) (0.3%) Jingdong ( 京 东 ) % Tencent 51BUY/QQ Buy ( 易 讯 /QQ 网 购 ) % Meituan ( 美 团 ) % 55tuan ( 窝 窝 团 ) % Amazon China ( 亚 马 逊 中 国 ) (1.6%) Dangdang ( 当 当 ) (2.7%) Jumei ( 聚 美 优 品 ) % Renren Nuomi ( 糯 米 ) % Vipshop ( 唯 品 会 ) % Suning ( 苏 宁 云 商 ) % VANCL ( 凡 客 ) % 1haodian ( 一 号 店 ) % 1haomall ( 一 号 商 城 ) NA Tuan800 ( 团 800) % Source: iresearch Given that 51BUY s GMV was only 1/10 of Jingdong in 2012, and both had similar growth projections (~100% GMV growth), it is obvious that 51BUY s conversion ratio from visitor to user is very low. Further, e-commerce s profit level hardly matters to Tencent. We estimate Tencent s e-commerce revenues, now at 14% of its total, still has a negative operating margin of 5-8%. Given 3C category s profile of revenue per order and gross margin, Tencent faces a significant uphill battle to turn 51BUY into a substantial profit contributor. The same MAV trend is repeated in the monthly time spent data but with few additions (Exhibit 83): (1) Vipshop had more impressive time spent gains than its visitor gains (+), (2) Suning s had less impressive time spent gains than its user gains (-), (3) 1haodian had impressive gains in time spent to validate its user gains (+). Again, group buying companies posted strong time spent growth across the board (+). Time spent data showed that Tencent Paipai, Amazon China and Dangdang have lost shares China Renaissance Securities (Hong Kong) Limited 60

61 Given Tencent s mixed performance in Paipai vs. 51BUY, we believe Tencent is still on the early stage of its learning curve to try to figure out online retail. E-commerce, at this stage mainly serves as a retainer of user base for Tencent. Exhibit 83: Monthly Time Spent of Chinese online retail companies, quarterly average (mn hr.) 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 CQGR Taobao Jishi 3,013 3,515 4,761 4,082 3,856 3,957 4,630 4,554 4,398 3,596 4,752 3, % Tmall , % Jingdong % Tencent Paipai (3.8%) Vipshop % Dangdang (3.0%) Tencent 51BUY/QQ Buy % Meituan % Jumei % Amazon China (5.3%) VANCL % 55tuan % Renren Nuomi % Suning % 1haodian % 1haomall % Tuan % Source: iresearch BIDU: biggest competitor to Taobao P4P ads In 2012, Taobao Jishi posted advertising revenues of Rmb17bn, of which 60-70% was P4P ads, mostly in-site search. Taobao also extends its contextual ads system through TaobaoKe and is one of the pioneers to experiment with the ad exchange technology. We estimate Taobao advertising revenue to grow 55% in 2012 and will grow 47% in BIDU, on the other hand, posted revenue of Rmb21bn in 2012, growing 54% in We project BIDU to grow revenues by 34% in From a traffic perspective, BIDU, Alibaba and Google have only web presence (no client presence) on the PC. This is different from Tencent, QIHU and Microsoft which have significant PC client presence (QQ chat, 360 security/browser, Office). By 4Q12, Baidu, Alibaba and Google have roughly equal time spent shares, which means Taobao Jishi s revenue per time spent is on par with BIDU s. We see Taobao as equal strength competitors to BIDU, in both revenues and traffic As all businesses (especially offline businesses) turning into e-business, e-commerce advertising will be claiming more and more territories. Comparing to ebay, Taobao s business model is like a free-to-play game, with basic listing free and monetization through P4P ads. It is foreseeable that Taobao in the future will start competing with other BIDU verticals like Finance, Education and Franchising. In the meantime, because mobile search has lower coverage ratio and page length, revenue per thousand queries is only ¼-1/8 of PC search. This, in our view, will challenge Taobao Jishi in much the same way it has challenged BIDU. QIHU: biggest beneficiary of e-commerce advertising boom According to the company, QIHU derives more than half of its advertising revenues from e- commerce advertisers. From a traffic standpoint this makes sense (Exhibit 84). We estimate that QIHU s comparable time spent (PSP+search) with BIDU is about half of BIDU s (excl. QIHU has potential as e- commerce ads destination because its time spent of PSP+Search is already half of BIDU s PSP+Search China Renaissance Securities (Hong Kong) Limited 61

62 non-search) already. The difference is BIDU is 80% search+20% PSP while QIHU is 80% PSP+20% search. Exhibit 84: Total time spent market share of Chinese PC Internet (web+client combined) 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 Qihoo % 15.6% 17.4% 18.0% 18.5% 18.7% 19.1% 18.9% Tencent 21.3% 22.3% 21.7% 20.5% 20.8% 20.3% 19.8% 18.4% Microsoft 22.3% 22.6% 20.5% 19.6% 18.3% 18.1% 16.5% 16.3% SOHU 3.3% 4.7% 5.0% 5.1% 5.3% 5.4% 5.8% 6.2% Youku Tudou 2.3% 2.1% 2.4% 2.7% 2.6% 1.8% 2.0% 2.5% Baidu 2.8% 2.3% 2.2% 2.2% 2.4% 2.5% 2.4% 2.3% Alibaba 2.0% 1.8% 1.7% 2.0% 1.9% 1.9% 1.8% 2.2% Google 0.9% 0.9% 1.1% 1.2% 1.3% 1.5% 1.8% 2.1% PPS 2.0% 2.1% 2.3% 2.2% 2.3% 2.2% 2.1% 2.0% Xunlei 1.3% 1.3% 1.6% 1.7% 1.8% 1.7% 1.7% 1.9% Others 27.6% 24.4% 24.2% 24.8% 24.8% 26.0% 26.9% 27.2% Source: CRSHK, iresearch, Analysys Consulting In 2012, QIHU s advertising revenue was 7% of BIDU s. In our QIHU initiation report on 14 January, we concluded that PSP (Personal Startup Page) from revenue per traffic perspective is equal to search considering both (1) organic monetization of PSP, (2) traffic feeding to search monetization. As QIHU further ramps up its search algorithm, we expect its revenue market share to catch up with its traffic market share. SINA: using social e-commerce to monetize Weibo On 20 May, 2013 we raised SINA s target price from US$63 to US$72 to reflect Weibo s partnership with Taobao merchants, which can generate e-commerce revenue share of US$380mn over three years. SINA Weibo s social graph capability can help Taobao P4P s click through rate by ~30% according to our estimate. The resulted increase in Taobao P4P revenues could be in the neighborhood of Rmb bn (US$ mn a year) if (1) fully implemented on all Taobao keyword searches, (2) all Taobao-Weibo shared accounts are recognizable. We conclude the US$380mn commitment is reasonable. This partnership is especially important because Weibo has significant mobile presence, now the 5 th largest mobile app measured by time spent. The expansion into social networking significantly increased ads inventory on mobile, in our view. While execution is not without challenges, we believe this partnership can mitigate mobile s impact on Taobao P4P ads, in our opinion. Tencent is also trying to leverage social e-commerce by connecting web-based Qzone with its C2C platform Paipai. While Qzone s time spent is 4x of SINA Weibo (more if we count Weixin), Paipai s footprint is much smaller than Taobao (~1/50). This means Tencent will need to leverage non-taobao e-commerce advertisers more. From an execution standpoint, a Qzone-Paipai linkage is easier to implement than Weibo-Taobao. We believe social e-commerce can contribute to US$380mn of Weibo revenues over the next three years China Renaissance Securities (Hong Kong) Limited 62

63 Mobile Internet: what has it changed and what can it change? Mobile Internet has already created sweeping changes in Internet across the board in China. We foresee profound change in mobile payment to O2O and social e-commerce, as both have seen user behavior meaningfully migrating to mobile. Mobile is an incremental force for e-commerce We believe mobile Internet is bringing unprecedented change to PC Internet. The presence of mobile Internet interrupted the normal online-cannibalize-offline roadmap and presents new complexity in the competitive landscape. Some of the challengers are becoming challenged but some of the challenged are offered a new opportunity. According to iresearch, the percentage of mobile (smartphone only) time spent as a total of Internet time spent stood at 12% in 4Q12, compared to 6% in 1Q12. However, the pace of growth in PC Internet time spent has materially slowed (Exhibit 85). So far mobile Internet has presented itself more as a cannibalizing force to PC Internet Exhibit 85: Time spent of PC and mobile Internet (smartphone only), no change after mobile Time spent (m hours) 30,000 25,000 20,000 15,000 10,000 5,000 0 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 PC web PC client Mobile web Mobile app Source: iresearch iresearch s data shows that mobile time spent for e-commerce (incl. mobile payment) has reached 17% of total (PC+mobile). Mobile e-commerce has presented itself as an incremental force to e-commerce. The addition of mobile increased total e-commerce time spent by 25-30%. This is similar to online map and life style, where the addition of mobile increased total time spent by 30-40%. Not all PC Internet segments are so lucky. In fact, in a majority of PC Internet segments, the addition of mobile was accompanied by the flattening or even decline in PC time spent (Exhibit 86-89). We believe this phenomenon exists because e-commerce is still a rapidly growing segment. According to CNNIC, online shopping was only the 10 th largest user segment with 43% user penetration in Internet in China, with online payment the 13 th with 39% user penetration. The relatively low penetration level of online shopping and online payment minimizes the cannibalization effect of mobile Internet, in our view. Mobile Internet s cannibalization effect on SNS, search and game is high because these PC Internet segments have become relatively saturated China Renaissance Securities (Hong Kong) Limited 63

64 Further, our industry check suggested that more online retailer customers use mobile app to check order status, make comparisons/research and browse for fun than they do on PC Internet. As a result, we observe mobile shopping behavior to be less transactional oriented. Order size is also smaller. Online retail transaction step is still performed largely on PC Exhibit 86: Time spent of SNS, PC vs. mobile Exhibit 87: Time spent trend of search, PC vs. mobile 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1, , SNS/IM/Weibo PC web SNS/IM/Weibo PC client SNS/IM/Weibo mobile Search & PSP Mobile search Source: iresearch Source: iresearch Exhibit 88: Time spent of e-commerce, PC vs. mobile Exhibit 89: Time spent of online map and life style, PC vs. mobile 1, E-commerce PC E-commerce mobile PC map & life style Mobile map & life style Source: iresearch Source: iresearch Mobile payment is a game changer and an enabler in the backend As shown above, mobile Internet has very strong incremental effect on online map and life style apps segment, almost raising the PC Internet time spent by two thirds. If enabled by convenient payment, the current online map and life style apps can easily create payment scenarios to enable transactions. At this point, however, both mobile payment and O2O solutions exist as standalone apps, which make the integration of the payment process cumbersome. Three solutions exist: Software Development Kit (SDK): An SDK is a set of software specifications that allows data transfer between two apps. Alipay, for example, has embedded its payment option in popular apps like movie ticketing app Gewara ( 格 瓦 拉 ) and group buying leader Meituan. SDK is now the dominant format for in-app transactions (Exhibit 89); We project the next mobile e- commerce growth hotspot is mobile payment coupled with O2O China Renaissance Securities (Hong Kong) Limited 64

65 Web app: For web payment app to work, the initiating app must be a web app, too (Exhibit 91). We believe web app can be a unique feature of Weixin payment ecosystem. Many standalone (native) apps have light versions of their app built on HTML5 distributed in Weixin through the public account ecosystem. Transactions take place between Weixin server with the merchant s server and are then rendered in Weixin via HTML5 (in this sense Weixin is similar to a web browser). In addition to web app payment, we believe Weixin will also adopt in-app payment modules. However, because most app solutions exist in Weixin in the forms of web app (a light version of their native apps), the key feature of Weixin payment will likely be web app-based, in our view. Gateway: A gateway is a standalone payment app (such as Alipay and Tenpay) existing between the initiating app and the merchant app. Gateway is usually considered too cumbersome for use on mobile. Exhibit 90: SDK in-app purchase via Alipay in Gewara Exhibit 91: Web app payment via express pay in Weixin Source: CRSHK Source: CRSHK O2O, flash sale and social e-commerce: initiating apps on mobile In addition to O2O, flash sale and social e-commerce can also benefit from mobile Internet because it allows consumers to browse merchandises at their spare time and share the information with their friends. The flash sale nature is also very conductive to mobile Internet s fragmentation of time usage. Revenue per order for orders from mobile, however, tends to be low, according to our industry check. Gilt Groupe, the US-based flash sale e-tailer, already has 40% of its traffic from mobile. Gilt intend to leverage historical purchase data to make 1-on-1 recommendations that suit consumers needs when they visit Gilt s site or app. Vipshop, according to our checking, also witnessed rapid buildup of mobile shoppers to 10% of total but its core customer group in 2 nd to 4 th tier cities probably will prevent mobile shoppers to reach as high percentage as Gilt. In SINA Weibo, already 75% of active users access from mobile. Mobile shopping allows shoppers to review and discuss merchandises more frequently before making a purchase decision. But revenue per order tends to be lower China Renaissance Securities (Hong Kong) Limited 65