The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.

In 2014, Alibaba succeeded in hosting the largest IPO by dollars invested, with $25B raised by the company and selling to shareholders. Alibaba priced its IPO at $68 per share, and in late January 2015, these shares were trading at over $100. Since then, Alibaba missed 2014 sales growth expectations by more than 5%, resulting in unfavourable changes in equity research guidance and an approximate 20% decline in share price. To meet expectations moving forward, Alibaba is expected to significantly expand the range of goods sold through its websites to penetrate major areas of consumption spending, such as food and medicine. These two categories represent 40% and 12% of Chinese consumption spending respectively, but less than 3% of current e-commerce sales. Expectations are that 10% of Alibaba’s revenue will be derived from the sale of food and medicine by 2018. However, the current logistics strategy is not sufficient to support these expectations, and without a strategic shift, Alibaba will continue to miss future sales targets by an even more alarming amount.

Alibaba & Amazon: A Tale of Two Models

Alibaba and Amazon are the dominant players in their respective markets, while having found success in two different e-commerce models. Alibaba uses a third-party/marketplace (3P) model collecting commission on sales, whereas Amazon operates a direct sales/first party (1P) model. While Amazon tends to collect more revenue per transaction, the limited capital expenditure inherent within the 3P model allows Alibaba to maintain significantly higher margins. In 2014, Alibaba earned a net profit margin of 44.5%, resulting in net profit of $3.8 billion-six times higher than that of Amazon. This disparity reflects the profitability benefits of the 3P model versus the 1P model.

Alibaba avoided tying up cash in inventory and infrastructure, allowing it to create a much more scalable business model compared to one reliant on 1P shipping. In Alibaba’s 3P business model, only Internet access, customers, and a shipping address is necessary for geographic expansion. As a result, the company quickly extended availability of a vast number of product categories geographically across China. In contrast, JD.com began offering e-commerce services before Alibaba and a capital-intensive 1P strategy resulted in a much slower expansion. Today, it is only a small fraction of Alibaba’s size.

However, the models have reverse superiority on product care. Alibaba’s third party logistics strategy gives it limited control over the shipping process, which is operated by separate firms. In contrast, the 1P model allows for complete control of the process, including counterfeit checks, consistently faster delivery times, and a higher degree of handling care by employees. In general, Amazon and JD.com’s models allow for higher quality shipping service, and lower chance of damage and counterfeit. These factors are of heightened importance for goods such as food and medicine.

Gross Merchandise Value

Alibaba generates roughly 86% of its revenues from its Chinese operations. Within this space, Taobao serves as the starting point for most buyers; it is a key gateway to the other a complimentary platform, leverages Taobao’s userbase to drive traffic towards its vetted selection of vendors, for customers seeking higher quality products. Alibaba derives revenue primarily from commissions on sales, advertising revenues, and storefront fees. Altogether, these three streams account for 80% of Alibaba’s Chinese revenues. These revenue streams are each, directly or indirectly, dependent on the value of products sold through Alibaba’s platforms, also known as gross merchandise value (GMV). As a result, increases in Alibaba revenue are most directly correlated with GMV gains, which continues to be the company’s primary goal. The ultimate focus on expansion into food and medicine needs to adhere to increasing GMV.

Over the past couple years, Alibaba has been constantly hindered by the distribution network in China. In 2013 alone, there were 410 million cases of e-commerce complaints in China. According to the New York Times, the inefficiencies in the market led to China spending 18% of GDP on logistics, almost three times of the global average. Despite this expenditure, customers still regularly receive packages late or damaged. Further, poor infrastructure has resulted in safety concerns, as mishandled chemical products led to one person being killed, and seven hospitalized in 2013. Altogether, the average Chinese consumer does not expect their package to arrive both on time and undamaged.

In order to counter these issues, Alibaba is investing in China Smart Logistics (CSL). CSL is an ambitious joint venture launched in 2013, aiming to revamp China’s logistics system by 2021. With a 48% stake in CSL, Alibaba has chosen to take an “asset-light” approach by not owning any of the physical logistics infrastructure in the venture. Rather, using its competency in big data, Alibaba is focusing on providing the IT infrastructure to the 14 other partners in the joint venture. Essentially supporting Alibaba’s 3P model, CSL has the ambitious goal of building a network of key logistics hubs across the nation. CSL is also designed to increase capacity eight fold to 100M packages a day, all delivered within 24 hours of order procurement. However, CSL doesn’t explain how it’s going to improve the quality of these shipments. Currently, Alibaba has a review system in place, where customers can review sellers, and sellers can review distributers. Despite this system, there has been little improvement; the third parties have not demonstrated any interest in improving their operations and CSL will probably not provide any further incentive.

Another major issue facing Alibaba’s empire is the presence of counterfeit products. The Chinese State Administration for Industry and Commerce released a white-paper report in early 2015, claiming that only 36% of the products sold on Alibaba as of July 2014 are authentic. The report also cited that the company ranked poorly for reliability and counterfeit prevention versus other Chinese competitors. The report itself caused a 4% drop in Alibaba’s share price, and prompted a class action lawsuit against Alibaba from “misled” investors. All these events occurred despite Alibaba spending over $160M to curb counterfeiting across its networks.

When examining the food industry, one of the largest concerns listed by JPMorgan was a logistics challenge as delivery companies do not have the infrastructure to handle and deliver groceries. Simply put, if Alibaba struggles to deliver clothes undamaged, what hope does it have in selling eggs? Further, when dealing with pharmaceutical products, consumers will not switch their habits to purchasing online if they fear counterfeit drugs. Overall, Alibaba’s 3P model provides little indication that it will be able to support expansion into these categories.

Just-in-Time, Just In Time

CSL alone is insufficient in capturing larger segments of the market. In order to achieve a significant expansion in GMV, Alibaba should adopt a hybrid “Just in Time” (JIT) inventory logistics model on top of its current CSL investment. That is, Alibaba should adopt a 1P system where it holds no inventory, but sources the materials just-in-time to respond to orders, specifically for these new product categories. By using a JIT model with fully owned warehouses, Alibaba is able to capture aspects of both models: improved control over delivery times and increased quality control. All of this can be achieved while maintaining a scalable structure, wide variety of SKUs, and minimal inventory risk, effectively expanding GMV long-term.

Customers will first place their orders through Alibaba’s existing platforms, selecting goods from a number of local, vetted sellers, using a process similar to that used by Alibaba’s Tmall platform to ensure quality. By limiting the sellers to only those located within a certain radius, Alibaba can better ensure that delivery is made in a timely manner. JP Morgan’s data suggests that Alibaba’s same city delivery currently takes between 22 and 27 hours on average. If Alibaba were to implement a similar last mile system as JD.com, using its own fleet instead of a third party’s, Alibaba should see its average customer delivery times drop 6 hours to align more with JD.com’s average. This quicker delivery time will improve customer experience.

Through this model, Alibaba would purchase the products from local sellers and effectively take ownership of the inventory; albeit for a limited time (i.e. a day; hence JIT). During this time, quality check control measures will be taken to ensure authenticity of the products. This check serves a similar role to a customer’s eyes in the store, making sure products are not damaged and goods are not obviously counterfeits. Products would be sorted, and then shipped to customers via Alibaba’s truck fleet. Altogether, this model will ensure the veracity and quality of the products Alibaba delivers. This would only affect intracity deliveries for food, medicine, and future similar categories to ensure rapid delivery and product care, allowing all other segments to benefit from the CSL investment.

Building Up

According to Deutsche Bank, Amazon spends about 2% of its annual GMV on fulfillment related capex, or around $90M to $110M per fulfillment center built annually. Additionally, the high-end in construction costs in China are approximately 91% of the low-end construction costs in the US. Using this conservative ratio, the maximum capex for required fulfillment centers in the eight tier-1 cities that Alibaba already has purchased land rights to, will be approximately $800M. In addition to this, Alibaba would incur operating expenses related to transportation, quality control, and other warehousing related expenses. JD.com’s operating expense related to these costs is approximately 9% of revenue. This figure suggests Alibaba’s current net margins of 44% would be reduced to 35% for new product categories shipped through these hybrid warehouses.

At the end of the day, Alibaba has the proceeds from the IPO to fund this project with over $17B in cash. However, with bullish analysts expecting continued growth from Alibaba, failing to deliver in food and pharmaceuticals is not an option. By investing in a JIT model, Alibaba will be able to better control quality and ensure that the product is delivered on time. Rather than failing, Alibaba can begin competing in the food and health care markets – both accounting for over $2.3T in annual consumption by 2018. Given Alibaba’s current 2.4% penetration in these industries, this accounts for an incremental $22B in GMV for Alibaba. With a 3% monetization rate and a 35% margin, these industries represent approximately $663M in revenue and $232M in annual profit for Alibaba, paying back the initial incremental investment in less than four years. Most importantly the JIT model allows Alibaba to meet revenue expectations by converting on emerging categories, and will allow Alibaba to grow in the future as these categories expand.

Alibaba: Failure to Deliver

Beacon & Eggs

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