[2014] Alibaba Shows the World What China's Middle Class Is Worth to Investors

Top 15 Year in Review: Alibaba

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In 2014, Alibaba Finally Showed the World the Investment Value of China's Middle Class

Without the middle class, Alibaba could never have listed in New York. Serving it has been Jack Ma's only route to success over the past 15 years.

Over those years, China's economic opening unleashed a surge of material desire. The post-80s and post-90s generations, today the most energetic, creative and consumption-hungry groups in the country, grew up during rapid economic growth. They never knew the hardship of scarcity, and they want more services. They are now roughly 25 to 35 years old. Around the world, people this age are called "young consumers"; in the United States they are "millennials"; in China, they have grown into the middle class.

Meanwhile, the internet, and now the even faster-growing mobile internet, has transformed both business and daily life.

Walmart, though now under challenge, was born of America's middle class, car culture and suburbs, and it put a number on the value of the American middle class. Alibaba has done the same: it has tapped the most important resource of this era.

As Jack Ma told CNBC in an interview at the New York Stock Exchange, "We want to be bigger than Walmart." When trading closed that day, Alibaba was worth US$231 billion, making it the world's second-largest internet company after Google and putting it close to Walmart's US$248 billion.

When Amazon and eBay, the companies Alibaba is most often compared with, were founded in the 1990s, America's middle class had long since matured. Many retailers, Walmart among them, were already fighting over that market.

Alibaba keeps mining the value of the middle class. This year, for example, it entered the ride-hailing app business, launched more internet finance products such as Yulebao, and opened Tmall Global, its cross-border shopping brand.

Walmart went public in the 1970s and proved an enormously valuable investment over the following decade or so. If you had been smart enough, or loyal enough to the company, to buy 100 Walmart shares in its first year as a public company (1970) and never touched them, by 2000 you would have owned 204,800 shares worth about US$11.25 million. Even with just 100 shares, nine stock splits would have turned them into 51,200 shares worth more than US$2 million.

For employees, though, the magic of compounding was another story. If you joined Walmart in 1990 and bought 100 shares, the same 20-odd years later they would be worth only about US$20,000. From 2000 to 2005, Walmart's stock did not rise at all.

Behind Wall Street's enthusiasm for Alibaba today lies the fear of missing the next Walmart.

How Is Alibaba Building Its Blueprint of Consumer Services for the Middle Class?

A McKinsey report published in March this year, Mapping China's Middle Class, finds that the "upper middle class," households with annual disposable income of 106,000 to 229,000 yuan, is becoming the mainstream of China's middle class. These consumers spend more time on leisure and travel, and they favor international brands and online shopping.

Their spending habits are distinctive too.

They are not content to leave their health to chance; beyond working out, they demand better food;

They are not content with domestic products, and often buy from overseas;

They are not content to keep their horizons and footsteps in one place, so they love to travel;

They are not content to wait by the roadside for an empty cab, and will pay to save time or for better service;

They may dislike flashy logos, but they want affordable luxury and can afford it;

They are not price-sensitive, yet they still look for value for money;

In short, they want not just a life, but a lifestyle.

As the chart below shows, in 2014 Alibaba set out to prove it can provide every one of these services to the middle class.

As a Result, Alibaba Reaped Huge Gains Over the Past Year

In the Fight for Users' Time, Alibaba's Biggest Rival Is Tencent

By industry, BAT (Baidu, Tencent and Alibaba) are not really direct competitors. But in the fight for users, which is especially fierce in the mobile internet era, they are, and the rivalry between Alibaba and Tencent is the fiercest of all.

According to the latest data from the China Internet Network Information Center, China had 632 million internet users as of June 2014, 527 million of whom went online by mobile phone. Tencent's third-quarter 2014 earnings report showed WeChat's monthly active users had risen to 468 million, while its older product QQ, though growing slowly in recent years, had reached 820 million monthly active accounts.

Alibaba's third-quarter report, its first after listing, showed that as of September 30 Taobao and Tmall had 307 million active buyers, up 52% year on year and equal to the entire population of the United States. And from "ALL IN Wireless" in 2013 to "ALL IN Mobile E-commerce" in 2014, Alibaba has pulled nearly two-thirds of those users onto mobile: the same report put monthly active mobile users at 217 million.

But WeChat and Mobile Taobao are, after all, two entirely different kinds of mobile product, in both purpose and how tightly they hold users. Android data analyzed by Analysys International found that the average user spends more than twice as much time on WeChat as on Mobile Taobao.

Jack Ma's recent remarks to Forbes are also worth pondering: "I think WeChat was a good hand of cards, but it has been played badly... (a good hand) must be used to hit your opponent where it hurts. ... WeChat is not all-powerful, and Alibaba is not that bad."

Beyond the head-on battle between their own products, Alibaba and Tencent are quietly wrestling on another front: using acquisitions, equity stakes and alliances to win over partners and build ecosystems that can attract users on a wider scale. With Baidu all but invisible all year, almost no other voices were heard in China's internet capital markets in 2014.

Besides Tencent, Alibaba Now Has to Watch Out for Xiaomi

Xiaomi is seen as one of the companies most likely to challenge China's BAT trio in the future. QDaily's recent year-end review of Xiaomi's 2014 explained why in detail.

If Alibaba and Tencent are competing mainly for users' time, Alibaba and Xiaomi are competing mainly for the gateways to daily life.

Xiaomi expects to sell 100 million phones next year, and the greater significance of those phones is that each is a gateway to the internet. Xiaomi's operating system, MIUI, has more than 70 million active users; its theme store, app store and game center together log more than 35 million downloads a day, and games are becoming an important source of revenue for Xiaomi.

The contest goes beyond content consumption. Even in courting third-party companies, Lei Jun and Xiaomi closely resemble Tencent and Alibaba, which are using investment to reach into every corner of daily life.

In a recent interview, Lei Jun said Xiaomi had invested in 66 companies across its ecosystem, concentrated in four areas: smart hardware, software, internet services and content. Add the companies Lei Jun has backed personally, such as UC, Xunlei and YY, and the number grows considerably.

In the fight for gateways to daily life, Alibaba's greatest advantage is Alipay. It has grown from a simple third-party payment tool into a super-gateway that helps Alibaba reach into every part of daily life. It is also the reason Tencent built WeChat Wallet, Baidu built Baidu Wallet, and Apple is building Apple Pay.

What Kind of Company Will Alibaba Become?

When Alibaba listed, we analyzed how it, as an e-commerce platform, a financial system and a strategic investor, would shape the course of 10 traditional industries. For Alibaba in 2015 and beyond, we see the following possibilities.

Alibaba will certainly become a heavier company

In 2013, Alibaba was still a highly internet-based company with relatively few physical assets. Its strategy of running platforms spared it investment in procurement, warehousing, logistics and the like; its payments business was built entirely on the internet, and it shrewdly avoided an offline clash with UnionPay.

But for Alibaba in 2014 and beyond, "getting heavier" may be the key to its growth.

Beyond its platforms, Alibaba has moved downstream into logistics. The Cainiao "ground network," built around warehousing and distribution, will turn Alibaba into an unconventional real-estate company;

Its O2O (online-to-offline) push against Tencent has left Alibaba with a large stock of physical retail assets. Linking online and offline can help put those assets to work, but they will inevitably demand more attention;

Internet companies are growing fast, but the sector as a whole is bubbly, and a light asset base does not help a company win a higher valuation. Alibaba's broad buying spree of strong, asset-heavy companies before its listing was part of its strategy, and also a way to bolster investor confidence.

Alibaba may also become an advertising company

When Alibaba listed, Praveen Menon, a senior research analyst at Bloomberg, argued that compared with Amazon, Alibaba's real operating advantage is that it looks more like an advertising company: it relies on huge traffic to earn marketing, commission and other service income, without carrying heavy back-end costs or worrying about business risk.

Alibaba is indeed working out how to earn more the way an advertising company does. From 2012 to 2014, it pushed Tmall hard, spun off a separate key-accounts unit, raised commission rates, and sharply increased the number of ad slots on the Taobao homepage. It earns money by providing services to merchants on its platforms, charging transaction commissions and online service fees, and selling memberships, value-added services and cloud computing.

According to iResearch data for the third quarter of 2014, Taobao is China's second-largest online advertising platform by revenue: about 8.2 billion yuan in ad revenue for the quarter, roughly half of the group's quarterly revenue, behind only Baidu's 13.52 billion yuan.

Alibaba will ultimately remain a consumer system serving the middle class

After the listing, a new organizational chart began circulating inside Alibaba: data at the center, branching out into its three main businesses of e-commerce, finance and logistics, and ultimately converging on a strategic vision of globalization, health and happiness. Jack Ma also said at a summit in New York that he hopes Alibaba will in future pay attention to things like health, culture and education, "things that will lead to serious consequences ten years from now."

Whether in e-commerce, O2O, entertainment, or health, sports and travel, what drives Alibaba is the middle class's ever-growing appetite to consume. What has changed over the years is that our desire is shifting from physical goods toward services and pleasure, which are harder to measure. Seen this way, whatever field Alibaba's ecosystem expands into next, at heart it is a consumer system.

With traffic, capital and technology on its side, Alibaba embodies every fantasy Wall Street investors hold about US-listed Chinese companies. Just as it changed retail and finance in the past, Alibaba may yet win a say in many more traditional industries.

What Should We Watch Out For with Alibaba?

In 2012, the Tmall and Taobao platforms generated more than 1 trillion yuan in gross merchandise volume. That same year, Alibaba's chief strategy officer, Zeng Ming, first proposed that the Alibaba of the future should be a service-providing "collaborative e-commerce platform." This lifted Alibaba out of the e-commerce category and turned it into an ecosystem able to incubate many kinds of business. By 2014, Alibaba could even use

a complex galaxy map

to depict the many species in this ecosystem and how they work together.

In the 1990s, scientists built an experiment called "Biosphere 2" in Arizona, trying to reproduce the energy flows and material cycles of Earth's entire ecosystem in a small, sealed space. After a few years, it became clear that keeping the system running on its own was all but impossible: it had too few species, its cycles fell out of balance, and large amounts of material had to be brought in from outside. Self-sufficiency was out of reach.

We want to ask Alibaba's ecosystem the same questions. Can an ecosystem that grew up around an e-commerce platform, and is now in the middle of a strategic shift, become rich and diverse enough? As it grows, can companies outside it stay unharmed? Alibaba now wields some control offline as well as online, so how big will this ecosystem eventually get?

Taobao can still be called an "anything goes" platform. But Alibaba is gradually shifting from C2C to B2C, and Taobao, dominated by small merchants, has lost some of its appeal next to Tmall, which has brought in many big brands. And because of the change in strategic focus, even Taobao's own "Double 12" festival has disappointed after several years of trying. In future, we may rarely see small brands grow up entirely on Taobao and go on to real influence.

In competing with Tencent for gateways, traffic and user attention, Alibaba added many new members to its ecosystem this year through investments and acquisitions, which has made many specialist companies outside the Alibaba camp hesitate. Some of the companies Alibaba has absorbed will certainly strengthen or round out the ecosystem. But some, brought in purely for strategic positioning, may find no suitable place in the system for now and eventually go quiet or even disappear.

What we should worry about may be precisely the chance that Alibaba turns from an ecosystem into a Gargantua.

Finally, will Alibaba become the kind of traditional big company that can no longer innovate?

With 25 business groups and about 25,000 employees, Alibaba has long been a big company. Its once-controversial partnership system was set up precisely to ward off common big-company ailments such as monopoly, empire-building and bureaucratic rigidity. Beyond technology and business model, it was a change Alibaba made to its own organization.

But a flexible organization does not guarantee lasting innovation. In 2014, Alibaba produced nothing like Yu'e Bao in 2013, a disruptive product that shook an entire traditional industry. Instead it chose to advance steadily and consolidate its position in the fields it already holds.

Alibaba is still a vibrant company. Beyond its solid financial results, we hope to see more breakthroughs and innovation from within.

*The Top 15 are: Apple, Google, Baidu, Alibaba, Tencent, Amazon, Disney, McDonald's, Starbucks, Nike, Xiaomi, IKEA, Uniqlo, Wanda and Vanke. The list will change as the companies' businesses, markets and trends change. *We will follow them, and we will also follow their competitors and partners.

For why we started the Top 15 reporting project, read this article, which we think turned out rather well.