"Taobao Brands" Are Stuck on the Road to an IPO. 12 Charts on the Stories They Tell

And the questions they dodge, wittingly or not.

Last week came a report that Ruhnn Holdings was planning a US listing next year, and in this year of Pinduoduo's IPO, people started talking about "Taobao brands" again.

By Baidu's count, on the day the Ruhnn news broke, search interest in "Taobao brands" jumped from 0 to 429. The next day it rose to 1,665.

Ruhnn is not a company consumers deal with directly. Its business is finding internet celebrities, then using them to promote products and run stores on Taobao and other e-commerce platforms. It cleared 22 million yuan in net profit in 2016, and Zhang Dayi is one of its three biggest IPs.

There is a whole cohort of companies like it, in very different lines of business. Three Squirrels sells nuts and snacks; Lily & Beauty sells cosmetics; Yujiahui and Mask Family sell face masks. What they share is a dependence on Taobao, Tmall, and JD.com.

In 2016, nearly 50 companies built on online retail gathered at the Shenzhen Stock Exchange for a listing symposium on the ChiNext board. One executive there said: "Sooner or later we're all going to come here and ring the bell."

Afterward, Three Squirrels, Puppyoo, Inman, HSTYLE, Liebo, Yunifang and others either filed A-share prospectuses or listed on the New Third Board. In 2017 alone, nearly 10 Taobao brands applied to go public.

For most of them, though, nothing happened after the prospectus went in.

This January the CSRC rejected Lily & Beauty's IPO; regulators doubted that it still operated independently after taking money from Alibaba. Independent earnings are one of the things the CSRC looks at hardest. Three Squirrels went through filing, suspension of review, refiling, and suspension again.

By the Shanghai Securities News's count, Huimei Group, Handu E-commerce, Hanhoo, Hongbei Technology, Jixiang Sports and others are stuck at the stage where their IPO counseling filing has merely been accepted — some of them for a year already.

In two years, exactly one of these companies, Yujiahui, made it onto ChiNext.

A new concept, a hard road to the market: what do the Taobao brands' stories have in common, and how many questions do they leave open?

Taobao brands all talk about being "independent," but from production to sales they do almost none of it themselves

QDaily took four companies as samples: Three Squirrels in nuts and snacks, Lily & Beauty in cosmetics, and Yunifang and Mask Family in face masks. All four sell staples, the kind of goods that ride out economic cycles, so the numbers in their prospectuses say more about the companies themselves:

• Three Squirrels is something new — a snack giant that makes no snacks;
• Lily & Beauty's products come from other companies' cosmetics brands, its channel is Alibaba, and all it does is sell;
• Yunifang and Mask Family are the two face-mask brands that took off on Taobao, and their products are almost entirely contract-manufactured. Yunifang's parent, Yujiahui, went for an A-share listing;
• Mask Family's parent, Shanghai Yuemu, chose instead to be bought by Zhonglu Co., which makes "Forever" bicycles.

All of them use the word "independent" when their prospectuses describe what they do. Three Squirrels: "In product R&D the company has a clear direction and sound plans, and stays committed to in-house R&D spending." Yujiahui calls itself "a company built around its own brands, selling through internet e-commerce." Lily & Beauty, which does brand agency work and marketing, points to "the enormous body of customer purchase data it has accumulated."

Meanwhile, of the several hundred million to well over a billion yuan of goods these companies sell each year, almost none is made by them.

Three Squirrels has no factory. Suppliers, processors, sales platforms, logistics and delivery — all of it sits with partners. It develops the product, buys the ingredients from suppliers, hands them to contract manufacturers, and then sells the finished goods on Tmall, JD.com and other platforms.

Lily & Beauty is pure sales; it doesn't even have a brand of its own. Its revenue grows by adding brands to its licence list.

In 2015 it picked up agency rights for Lancôme, Avène and Kanebo, among others; those new brands brought in 205 million yuan, equal to 31.28% of 2014 revenue. In 2016 it added L'Oréal Paris, Sulwhasoo, Shu Uemura and Kose, worth 283 million yuan, or 25.01% of 2015 revenue. In the first half of 2017 it added Hera and Pony Effect; the new brands contributed 15.59 million yuan, or 1.25% of 2016 revenue.

The two mask makers, Yujiahui and Mask Family, lean just as heavily on contract manufacturing. They handle the formula and the brand; someone else runs the production line.

From 2015 to 2017, contract manufacturing accounted for more than 85% of everything Yujiahui sold. For Mask Family's main product, sheet masks, the share was above 70%.

An asset-light model has given the biggest Taobao brands fast growth, with revenue or profit up more than 100% in recent years

There is no shortage of snack e-commerce companies, yet the fastest grower is the one that makes no snacks and pours its effort into IP and marketing.

Three Squirrels was founded in February 2012 by Zhang Liaoyuan, formerly marketing director and then general manager at Zhan's Food. It opened for trial operation on Tmall that June, and on Singles' Day 2012 it sold 7.66 million yuan in a single day — a record for one store in one day in Tmall's food category, and first place in snacks and regional specialties. It has held the top spot ever since.

This is the leading snack e-commerce company that "doesn't make snacks." And while every other snack company was scheming to get its products into films and TV dramas, Three Squirrels was building IP, making cartoons and putting up offline theme parks from the day it started. The three squirrels have names: Squirrel Xiaojian, Squirrel Xiaoku and Squirrel Xiaomei. The company wrote backstories for them and turned those into an official animated series. This April the Three Squirrels cartoon, co-produced with Kungfu Animation, began airing on television stations and video sites across the country.

Light on assets, heavy on brand: it has paid well. From 2014 to 2016 Three Squirrels' revenue leapt from 924 million to 4.423 billion yuan, and net profit went from a 12.86 million yuan loss to a 236 million yuan profit. In the first half of 2017 revenue was 2.894 billion yuan and net profit 241 million yuan — margins had climbed another step.

Lily & Beauty, selling cosmetics on Tmall, has grown just as fast. Cosmetics are a peculiar business: the product goes on your face, so anyone who wears makeup will insist on the real thing. And a single item costs more than most mass consumer goods, food or household products included.

Lily & Beauty's method is to buy out stock from big brands such as Lancôme and Avène and sell it through online storefronts. Because it holds the brands' authorization and its supply is guaranteed genuine, shoppers trust its stores almost as much as a brand's own official shop. Buying outright gets it a bulk discount, and its profit is the gap between the selling price and what it paid, less operating costs.

That is how, from 2014 to 2016, Lily & Beauty's revenue rose from 700 million to 2 billion yuan and net profit went from 6 million to 74 million yuan.

Yujiahui and Mask Family, in masks, caught two waves at once: rising mask consumption and cheap internet traffic. From 2014 to 2017 Yujiahui's revenue compounded at 56.18% a year. Mask Family's profit was 23.49 million yuan in 2015 and 267 million yuan by 2017 — ten times higher in two years.

On profitability alone, these Taobao brands look far better than the crowd of internet companies that rushed to list in the US and Hong Kong this year with huge losses and no date for breaking even.

But the asset-light model has a price.

With both ends handed to other companies, Taobao brands have little grip on the supply chain

Staying light and relying on contract manufacturers while you concentrate on brand and marketing builds a name quickly. It also leaves you with little hold over the processors and suppliers. These companies cannot manage what Apple has with Foxconn, where Foxconn must meet Apple's exacting quality standards and Apple in turn buys the machinery its factories need. The way Taobao brands work with their manufacturers, quality problems come easily.

Three Squirrels, the company that makes no snacks, was fined by the Anhui food and drug regulator and then named and shamed by the national one over food-quality problems, in the middle of its sprint toward a listing — which duly stalled. Yujiahui puts the quality risk of contract manufacturing at the very top of its list of management risks.

Lily & Beauty is the extreme case. Three Squirrels, Yujiahui and Mask Family at least own brands. Lily & Beauty owns nothing: it buys cosmetics from brand owners and sells them through online stores, carrying the cost of procurement, warehousing, logistics and customer service.

That model requires it to pay the brand owners in advance. From 2014 to 2016 its prepayments rose from 24.13 million to 61.84 million yuan. Once the goods arrive, the inventory risk is its own. Over the same three years the value of that inventory nearly tripled, from 122 million to 388 million yuan — a third of its assets.

Stranger still, it sells to consumers who pay on the spot, and yet it carries accounts receivable. From 2014 to 2016 those grew almost tenfold, from 16.82 million to 150 million yuan, and the first half of 2017 alone brought 132 million yuan. The reason: it fronts the brand owners' marketing and promotion fees and their store-operation fees.

So selling more has not bought it any more bargaining power with the cosmetics brands. At the same time, companies that live on e-commerce stockpile goods to take part in the platforms' promotions, which adds to the risk they carry.

Snacks, cosmetics and face masks are not seasonal products, as a rule. Sold online, they become seasonal. The big shopping festivals fall at the end of the year, and brands have to load up for the battle. Stocking peaks tie up a lot of cash, and the inventory risk rises with it.

Three Squirrels' operating cash flow swung hard between 2014 and 2017: minus 186 million yuan in 2015, plus 582 million yuan in the first half of 2017.

Lily & Beauty shows the same pattern — operating cash flow negative for three years running from 2014, then 253 million yuan positive in the first half of 2017.

Inventories, in other words, run higher in the second half of the year and swallow more cash, because that is when the Mid-Autumn Festival, National Day, Singles' Day and Double 12 all land together.

Where Taobao brands really succeed is brand-building, and their selling-expense ratios beat the industry average

Taobao brands love to advertise, and they are good at it.

Three Squirrels concentrates on brand and marketing, and selling expenses have fallen as a share of revenue year after year — just 17.13% in the first half of 2017. Over the same period the A-share snack companies Qiaqia Food, Haoxiangni, Guifaxiang, Laiyifen and Yanjin Shop held steady at about 23%.

Three Squirrels, that is, burned money on marketing early to build the brand, and could spend less later while revenue kept climbing.

Of the two mask sellers, Yujiahui spent 30.42% of revenue on selling in 2017 and Mask Family 25.20% — both below the ratios at Lafang, Shanghai Jahwa, Proya and Mao Geping, cosmetics companies already listed on the A-share market or waiting to be.

Beyond brand-building, all of them caught the boom in e-commerce infrastructure and markets

Taobao brands rose on the e-commerce dividend, but they also needed the plumbing to be finished — factories, logistics and delivery, mobile payment. Only then does building a brand and marketing it become a shortcut to fast growth. Since 2010, online retail has grown faster than total retail sales every year.

The categories these companies sit in are mass consumer goods — food and drink, clothing, household items — where spending grows steadily and holds up when the economy slows. Discretionary categories such as cars and jewellery, by contrast, have seen sales growth fall sharply since 2017.

Narrow it down further. China's snack food industry, where Three Squirrels sits, has been growing fast: annual output value went from 193.138 billion yuan in 2004 to 905.018 billion yuan in 2014, a compound rate of 16.7% a year, and was expected to keep growing at about 17% from 2015 to 2019.

The Chinese cosmetics market was worth 296.1 billion yuan in 2014, 315.6 billion in 2015 and 336.1 billion in 2016 — not fast growth. Online, though, it exploded: cosmetics bought online came to 176.77 billion yuan in 2015, up 32.3%. Within that, B2C grew fastest of all. Frost & Sullivan puts China's B2C cosmetics market at 6.3 billion yuan in 2011 and 52.3 billion yuan in 2015, compounding at 69.7% a year.

And there is a long way still to run. China has about 1.4 billion people, roughly half of them women; a 300-billion-yuan cosmetics market is small against that.

Like every other internet business, their early growth ran on capital

Traditional companies expand on their own cash or by issuing debt. This cohort grew fast on equity financing.

Three Squirrels had the innovation and the IP, but without resources it could never have reached its present size at this speed.

It raised a US$1.5 million Series A from IDG Capital in 2012, the year it was founded; a US$6.17 million Series B from IDG Capital and Capital Today in 2013; a 100-million-yuan Series C from the same two in 2014; and a 300-million-yuan Series D from Frees Fund in 2015.

A company that only stopped losing money in 2015 could expand that fast only with heavy backing from investors.

Lily & Beauty, when it started out, borrowed against its own stock — toner, face masks, sunscreen, eye cream — and against fixed assets like air conditioners, computers and monitors. Then in 2012 Alibaba took an interest: its venture arm bought 20%, a stake later transferred to Alibaba Network. In 2015 it raised a US$100 million Series B from Crescent HydePark, Milestone Capital, Hanli Capital and others.

Yunifang's backers are just as glittering: a Series A from Shenzhen Capital Group in 2013, a Series B in 2014 from Shunwei Capital, the fund run by Xiaomi's Lei Jun, and another round in 2016 from the Qianhai Equity Investment Fund.

Mask Family raised money only once, in 2013, from an individual investor named Chen Rong. Chen Rong also happens to control the listed company Zhonglu Co. — the very company now buying Mask Family.

But the one Taobao brand that did list has done some questionable things with the money

Yujiahui had the easiest run at a listing. What it has done since is harder to explain.

It listed early this year and raised 782 million yuan. By the end of June it had put 760 million yuan of that into wealth-management products.

The bigger question came at the end of September, when it proposed paying 1.02 billion yuan in cash for 60% of AFU Essential Oil.

On the face of it AFU is a decent buy: a well-known brand with more than 300 SKUs, 96 directly operated counters and 256 distributor counters across 30 provinces and municipalities — exactly the offline reach Yujiahui lacks.

The terms, though, are strange from top to bottom.

AFU's net assets are 194 million yuan. Yujiahui valued the whole company at 1.6 billion yuan, a premium of nearly 750%. That works out to 20 times earnings, far above what cosmetics companies such as Mask Family, Hangzhou UCO and Guangzhou Hanya were worth when they reached the A-share market the same way, through acquisition.

The performance guarantee is odd too. An acquirer normally asks its target to commit to three years of profit. AFU committed to one: 85 million yuan of net profit in 2018. Even if it hits that number, Yujiahui's roughly 1 billion yuan buys it 60% of 85 million, or 51 million yuan of profit — about what the same money would earn sitting in a bank product paying 5%.

The arrangement for the other 40% is stranger still. If AFU makes 60 million yuan in 2019, Yujiahui must buy the remaining stake, at 20 times 2019 profit. Which means Yujiahui buys the lot even if the business collapses, handing the founders and investors including Qiming Venture Partners, IDG and Chenguang their exit. It looks less like an acquisition than like Yujiahui's shareholders emptying the company out.

Taken together, the Taobao brands do show something real — new market space, a new business model, better net margins — but all of it rests on industry, logistics and e-commerce that other people already built. And alongside the fast growth sit the problems: heavy dependence on e-commerce channels, in some cases on upstream brand owners for supply, and moves with the money that don't bear close inspection.

The Taobao brands still queuing to list face an uncertain future

The earnings of "Taobao brands" come almost entirely from the domestic market, and their growth story is a hard sell to foreign investors. So none of them ever rebuilt their shareholding into the red-chip structure used for offshore listings. Once profits cleared the CSRC's bar, an A-share listing was the quickest way out.

Not long after the 2016 meeting between the Shenzhen exchange and the Taobao brands, the CSRC decided to speed up its IPO reviews.

At the time about 700 companies across the two exchanges had filed prospectuses and were waiting. Working through them all might have taken two or three years. With the CSRC moving faster and the A-share market warming up, the timing looked right.

But every one of these companies depends on resources it doesn't own, above all the platforms that sell for it: Tmall, Taobao, JD.com, Vipshop. The channel that keeps them alive is in someone else's hands. And one of the things the CSRC studies most closely in an IPO candidate is precisely whether its operations and earnings stand on their own. In January it rejected Lily & Beauty, questioning how independent the company remained after taking Alibaba's investment.

Three Squirrels, meanwhile, ran into quality problems with contract-manufactured goods, was fined by the Anhui food and drug regulator and criticized by the national one, and saw its IPO interrupted.

Nobody can predict policy. But even if the rules loosened tomorrow, the good years are behind them.

The A-share market has been weak all year, falling repeatedly below the lows of the 2015-2016 crash, and IPO volumes have sunk with it: the number of new listings is under a third of last year's.

There is no money in the market for new shares, and the big listed companies have shrunk too. Even Foxconn, granted special approval to list this year, has fallen below its issue price, shedding some 200 billion yuan from its peak market value.

Nor is it only the A-shares. Hong Kong has Tencent and has taken in companies worth hundreds of billions of yuan apiece — Xiaomi, Meituan, Haidilao — and it has still been knocked down again and again by Tencent's collapse.

The US market is rethinking what the tech giants are worth — Amazon, Apple, Netflix, Google, Facebook have each fallen hard — and the Chinese companies listed there are doubted more than any of them. Alibaba has lost a quarter of its market value from this year's high; JD.com has fallen all the way back to where it listed in 2014.

Internet listings sometimes come in cycles a few years long. As things stand, the Taobao brands missed this one entirely.

Charts / Shuya Zheng, Fangyi Gong

Cover image source: Pixabay