Alibaba is a big internet conglomerate. Outside its core e-commerce business, it owns a whole bunch of other assets (internet search engine, 3rd party payments systems, online video sites, cable internet, social media, cloud storage, digital map services, among other things). However, most of the profitability of the company still derives from its e-commerce platforms, which are separated into four main business lines:

Alibaba.com: the original Alibaba.com is a B2B platform that acts as a middleman between wholesalers/manufacturers and retailers. It also facilitates transactions between Chinese exporters and foreign importers and it’s the real deal – I used to be able to buy (real) 92.5% sterling silver jewelry from certain wholesalers for $3 a piece and drop-ship them on eBay for $40, though the shipping cost ate up most of the merchandise margin. The site has been around for fifteen years and is, needless to say, the biggest of its kind in the world, by a long shot.

Taobao.com: Taobao is Alibaba’s C2C platform or China’s eBay. The site was launched in 2003 and quickly became the third most visited website in China. Taobao provides an exchange for over 7 million vendors who reportedly have placed over a billion products on the site. Taobao’s core customer base is small vendors and the site does not charge them a commission on their transactions. The vast majority of Taobao’s revenue is derived from advertising fees that it charges certain vendors wishing to use premium services.

TMall.com: TMall is Alibaba’s newest B2C platform. Launched in 2008, TMall is a sales platform for established vendors and charges a commission fee for providing the “real estate”. Virtually all large domestic/foreign brands have a presence on TMall, which boasts 70,000 brands. Vendors choose TMall over Taobao because TMall membership exposes them to greater sales by placing their products ahead of Taobao sellers. I believe TMall is currently Alibaba’s most profitable business.

Alipay: Alipay is basically the PayPal of China. It charges a fee every time a transaction is processed through its service platform. Alibaba owns a large stake in Alipay. The rest of the company is owned by employees and the company’s founder.

Ecosystem

Over the years, Alibaba has created an enormous ecosystem unmatched in scale and has made use of very innovative incentive systems to improve the quality of its seller base.

Alibaba uses the usual eBay type ratings system to reward customer service. Higher ratings usually indicate more customer satisfaction, and more traffic is allocated toward better performers. My experience has been that any store with an overall rating lower than 4.6/5.0 will struggle to get customers.

The company also has a zero tolerance policy toward counterfeit products, and does a very effective job regulating vendors. Alibaba’s platforms all require vendors to deposit a large amount of cash upfront; customers can send complaints to the company when they receive counterfeit products and when verified, Alibaba charges the vendor a hefty penalty fee on its deposit.

On TMall, Alibaba charges store owners a fixed “technical service” fee every year and provides vendors with a pre-determined sales target. Vendors that manage to hit these targets can get 50% – 100% of the fee refunded back to their accounts.

Customer service from both Taobao and its vendors is excellent (Amazon-level excellent). Over the years, Taobao/TMall has built up significant infrastructure, which includes the largest call center in the world, to assist customers with their shopping experience. Vendors are usually required to provide refunds within seven days with no conditions attached.

Untapped Pricing Power

While the media/investment community has placed most of its focus on the company’s transaction volume (already in the hundreds of $billions, I think sooner or later will hit a $trillion), one aspect of the business that has never been discussed much is the company’s enormous untapped pricing power.

Taobao, for example, does not charge a sales commission and only makes money on advertising and premium services. eBay, which charges similar fees for these services, takes an additional 10% commission from sellers on the total value of their sales (I closed my store when I figured that I was really working for eBay rather than myself).

That’s a massive difference. Taobao reported $240 billion in transaction volume last year. If they just charge an extra 5% fee on that sales base, that’s an additional $12 billion, 100% margin revenue stream. That alone can justify even the highest estimate of Alibaba’s value!

And a fee scheme like that is very feasible. The average gross margin that vendors can make on Taobao sales is FAR higher than 5% (I believe in the 20% – 30% range). As long as they can realize an incremental gross profit higher than the fee, vendors are willing to stick with the platform.

TMall, which serves established vendors, charges sales commissions that range from 0.1% (mobile phone plans) to 7% (jewelry) of revenue, with most product categories in between 2% and 5% (here’s the fee schedule – http://rule.taobao.com/tdetail-11.htm?tag=self, you can google translate it and check it out yourself). TMall stores are usually operated by brand-name stores that enjoy higher mark-ups than Taobao vendors, both due to their brand value and also lower COGS (they buy inventory in bulk). The majority of these storeowners also operate physical locations that often charge them 20% + of their revenue on rent (not to mention other overhead associated with physical stores), and TMall provides real savings that currently far exceed what it charges.

I think Alibaba’s current business strategy is to use artificially low fees to attract new vendors onto its platforms, then gradually increase its “cut” as transaction volume matures. Jack Ma is a serial monopolist with a very long-term investment horizon and I doubt he will be content with leaving tens of $billions of free money on the table.

Structural Advantages of E-Commerce in China

E-commerce has structural advantages in China relative to more developed economies. I touched upon a few of those in my last article, but here is a more complete list:

Frictional cost: transportation via China Post (state-owned parcel monopoly) is ridiculously cheap. As I mentioned, shipping a pair of 5-lb boots costs US$1.70 from Guangzhou to Beijing, and will arrive on the same day. From San Diego to Seattle, using FedEx for the same service, that will cost you $86.24.

Overhead savings: rental costs are usually a much bigger % of retailers’ cost structure in China than developed countries. This is because 1) concentration of population (people live in apartments rather than houses) in neighborhoods drives up the value of good locations; 2) commercial real estate has to compete with residential real estate for land, which is in a bubble; 3) labor costs close to nothing which means the fixed cost has to go somewhere to make sure the average retailer makes no economic profit (ECO101).

There is little overhead selling merchandise over Alibaba’s platforms. As I mentioned, the commission rates are also very low and are a variable cost, which provides more business certainty to the seller.

Distribution channel: China’s logistics and distribution infrastructure has yet to consolidate. Distribution networks are very under-developed and retailing often involves layers of middlemen that eat into margins. Going online helps retailers circumvent much of this cost.

Capital Constraint: Small vendors (representing over 99.9% of all Chinese retailers) have no access to the banking system, which only lends money to state-owned enterprises or the politically connected. Removing the capital requirement in building out a physical location removes a huge burden.

Also, retailers often have to borrow money from shadow bankers at above-credit card level interest rates to finance their inventory. The possibility of drop-shipping and the data-driven nature of e-commerce sales reduce inventory needs.

E-commerce allows retailers to go capital light. That’s really helpful in a place where capital is scarce and expensive.

Internet Usage: Unlike developed economies where over 80% of the population uses the Internet, China’s internet penetration is below 50%. Out of a population of 1.35 billion, only 618 million had access to the internet in 2013. Increasing internet penetration, especially in broadband and mobile, will drive more traffic to e-commerce sites. Alibaba’s customer base has been expanding at a rate of roughly 60 million people per year in the last five years, the equivalent of the population of the U.K., every single year.

Smog: This gets ignored often but is really important. China is the most polluted country in the world and the air is killing people (http://www.cnbc.com/id/100871380). Reducing exposure to non-filtered air (that’s what you get when you step outside of your apartment) is on the top of people’s priority nowadays. Shopping online helps people do just that.