In this four part series, I look at how “new retail” changes the strategies of market leaders Alibaba and JD. My take is basically five points:

Point 1: China is ground zero for the digital transformation of retail.

See Part 1 here.

Point 2: But “new retail” is not just supermarkets and convenience stores. It’s much bigger and more sweeping than this.

See Part 1 here.

Point 3: JD has been successfully following a strategy of “profitless growth”. But this is different than the pure digital competition seen in Alibaba and in “new retail”.

Point 4: “New retail” is a bold extension of Alibaba’s strategy of pure digital competition into the physical world. And it hinges on the strange “economics of participation”.

Point 5: Alibaba’s “new retail” strategy is going to increasingly challenge and complicate JD’s strategy.

***

In this part, I continue with Point 3 – that:

JD has been successfully following a strategy of “profitless growth”. But this is different than the pure digital competition seen in Alibaba and in “new retail”.

I have argued that JD’s management are the Spartans of online retail (article here). For most of their existence, there were neither the clear leader nor the favorite to win. They were usually smaller than their online competitors (Amazon, Dangdang, Newegg) and they were very much smaller than their offline competitors (Suning, Gome).

But the growth of Chinese e-commerce was stunning and JD was smart and caught the wave. And they also just outfought and outran their many competitors. They executed remarkable operational growth, did bold category expansions, fund raised aggressively and fought bitter price wars (which they often won but not always). Like the Spartans, they just fought better than others. And they eventually got to the top of the rapidly rising Chinese e-commerce market.

And their business model throughout much of this 17 year fight has mostly been online, direct retail, not a marketplace or other multi-sided platform. They bought from suppliers, built warehouses, managed inventory and sold their goods directly. It was a fight mostly within the economics and competitive dynamics of traditional retail, which I call the “Western front”.

My take is that JD’s strategy as a direct retailer has mostly been the following:

1. They use their superior scale as a retailer to achieve lower cost of goods sold via purchasing power. By being bigger than their rivals, they get their goods cheaper which means higher gross margins than most.
2. They also use their superior scale to achieve greater efficiencies and lower operating costs. This is mostly about being more efficient in the retail platform, the logistics network and the delivery system (maybe). Online retailers are usually cheaper than offline retailers (i.e. no real estate). And larger online retailers can be more efficient than smaller online retailers, by having lower per unit costs in the major fixed costs (logistics, platform operations, etc.).
3. So JD has a lower cost structure by purchasing power (point 1) and economies of scale (point 2).
4. JD then uses this cost advantage, not to make profits, but to offer lower prices than their competitors. They accept very low profits in order to increase market share over time. And this increases their relative scale even more. Which makes points 1 and 2 even greater. Their strategy is a virtuous cycle of “profitless growth”.
5. In addition to points 1-4, JD also maximizes their spending on technology and logistics. They keep outspending their competitors on the things that will eventually make them even cheaper and better. So JD spends lots on automated warehouses, robots and other R&D projects. And they keep building out their logistics network.
6. Basically, the strategy is to slash spending on the necessary costs (Point 1 and 2) and maximize spending on the strategic costs (Point 5).

The net result is JD pulls further and further ahead of their competitors over time. Their superior cost structure is passed on to consumers as lower prices and better service – and also enables larger spending on strategic fixed costs and assets. And you can see this in JD’s financials – minimal profits but rapid growth, increasing market share and steadily increasing spending on logistics, marketing and technology (both in total and as a % of sales).

Note: this is a common strategy for direct retail. You can see a similar approach in Walmart’s “everyday low prices” and in a lot of what Amazon does. But it’s a bit different in China because Chinese e-commerce is rising rapidly overall and a lot of this has just been about keeping up with the market.

But what JD is doing is very clever, and it’s absolutely brutal if you are trying to compete with them. Just try to match them on products, prices and service (especially delivery).

The problems with China’s Western front (i.e., direct retail economics).

One problem with the above strategy is that it only works to a certain size. You get to a certain scale of operations (fixed cost plus fixed assets) in a geography and the returns and benefits of further increasing scale decrease. For example, Walmart had tremendous profits and returns on invested capital in their original operations in Arkansas and the Midwest. But they never got the same returns as they expanded to the east and west coast of the USA. Trees don’t grow to the sky and economies of scale in fixed costs (like logistics) don’t go on forever.

JD is not yet at this point of diminishing returns and advantage in China. E-commerce growth is still rapid, with lots of new categories to move into. The retail infrastructure of the country is still fragmented and with low productivity. And China is just a really big country.

But eventually this war on the Western front, with traditional retail competitive dynamics, will show decreasing returns and advantages.

And there is another problem.

This strategy doesn’t really work that well in online retail. It works really well with physical stores because it enables you to offer your customers better prices across a broader selection of goods. Walmart has everything and is cheap. And the fixed assets required to offer this are difficult to replicate.

But in e-commerce, it is fairly easy for another company to replicate your selection and your prices. The barriers to entry that protect you in the physical world (your scale in physical assets and fixed costs) mostly don’t exist in the online world. And winning on price is just much more difficult in online competition. In e-commerce, you have to win on price, selection and user experience. That’s a key difference.

And this brings us to Alibaba and the war on the Eastern front, which I will discuss in the next Part.

***

That’s it for Part 2. In Part 3 (located here), I will go into Alibaba’s approach and how it contrasts with JD.

Cheers, jeff

Part 1 is here.

Part 3 is here.

Part 4 is here.

———