A subscriber suggested I look at Sun Art Retail as a potential investment opportunity. And, wow, thanks for that. There is a lot of fascinating stuff going on with this company.

First, the basics of Sun Art.

An Introduction to Sun Art Retail Group

Founded in 2000, Sun Art is a leading Chinese retailer with 484 hypermarkets in 232 cities (as of December 2020). These large retail stores are typically 6,000-10,000 sqm and hold +20,000 SKUs. The company has recently and successfully expanded into ecommerce. And ecommerce has become its other core business. Today, most of their revenue is from hypermarkets and ecommerce. The company is also experimenting with superstores, mini stores and other retail formats.

But the big issue is that Alibaba partnered with Sun Art in 2017 as part of its new retail initiative. The objective was to digitize its offline stores. And in October 2020, Alibaba bought majority control of Sun Art and is fully incorporating it into its ecosystem. So this company is a very unique combination to two things.

1. It is a leading hypermarket company in China.
2. It is a key strategic asset in the Alibaba ecosystem. It is foundational to Alibaba’s new retail / OMO strategy.

Let me talk about #1 first.

Some Traditional Retailers Have Very Strong Business Models.

In 1998 and 1999, Groupe Auchan and Ruentex independently opened their first hypermarkets in Shanghai. This was the same period that Walmart entered China. And about five years after Carrefour entered.

Group Auchan and Ruentex formed a joint venture and combined their operations in 2000. But they kept their two respective brand names, Auchan and RT-Mart. This joint venture became Sun Art and they set out to become the market leader in Chinese hypermarkets. They grew steadily and consistently, reaching 400 stores in 2015.

Their significant competitors in China include Walmart China, Yonghui and Carrefour (recently sold to Suning). And, prior to 2017, these businesses were fairly similar to hypermarkets everywhere. The business model is based on large stores (6-10k sqm) with a large selection of goods at the lowest prices. For consumers, there is no reason to go anywhere else for most purchases. The local hypermarket has everything and nowhere else is cheaper.

In terms of strategy, these stores have three main competitive advantages:

• Purchasing economies. They use their superior scale to squeeze suppliers on price and terms. They pass these savings onto their customers, offering prices others cannot beat.
• Additional economies of scale in geographic logistics density.
• Some share of the consumer mind and switching costs.

In certain geographies, this can result in a virtuous cycle. A large hypermarket can dominate a circumscribed, slow growing market. It can offer a superior service (big selection, low prices) that competitors cannot match. Look at Walmart’s ROIC in its original, core markets of Arkansas. That’s how the Walton family became billionaires.

In China, this is more complicated. The rapid growth makes it harder to dormmate and maintain superior scale. I call the China version of this strategy “profitless growth”. I wrote about how JD has long been doing this strategy. And this is why JD’s profits are higher than they appear on their income statements. My summary was:

“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).”

Carrefour China

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We do see some traditional retailers with powerful business models. Such as hypermarkets. Also, membership clubs (i.e., Costco). I also like furniture stores and some jewelry stores.

But, as I have said many times, competitive dominance does not necessarily mean big profits. So while Walmart has been a cash machine of a business model, tradition supermarkets (in the US) have usually had tiny operating margins (<2%). Fresh produce and perishable goods have more difficult unit economics.

But, overall, Sun Art has one of the few attractive retail business models. And then China went digital. And most hypermarkets have responded in two ways:

Physical Retailers Shifted Towards Fresh Products, Dairy and FMCG.

Sun Art has responded to digital disruption fairly effectively. As ecommerce grew in China, there was a lot of pricing pressure in certain categories. Basically, the products you need infrequently or not urgently. And products that are non-perishable. So margins on books collapsed and book stores went out of business. And hypermarkets shifted away from books and toys.

Sun Art, like most hypermarkets, shifted heavily towards fresh produce and food. And fast moving consumer goods. Basically, the stuff you need frequently (because delivery costs add up) and that can go bad (i.e., perishable food). So that’s food and FMCG.

In 2020, Sun Art’s hypermarket revenue was 57% fresh products and dairy. FMCG was 38%. And we see the same pattern in their few superstores and mini-stores (more on this later).

Physical Retailers Added Mobile Apps and Cheap, On-Demand Delivery.

Sun Art calls this “Advancing Phygital Development”. And that term “phygital” just doesn’t work.

In July 2017, Sun Art launched a stand-alone mobile app (RT-Mart Fresh), offering 1-hour delivery to customers within a 3km radius. And it mostly covered fresh food and FMCG. We have seen this strategy from physical stores going digital over and over. It’s the one-two punch of a mobile app plus cheap on-demand delivery. If you offer both of those, you can effectively expand your floor space to a 2-3km radius around the store. Customers can shop from their sofas just like they shop in the store. But building a successful mobile that people use is actually difficult. And it’s much harder to do cheap, fast delivery outside of China.

Shortly after, in November 2017, Alibaba made its 36% purchase of Sun Art and their strategic alliance was launched. This was either great strategy or great luck. Alibaba was launching its big new retail initiative. And their primary focus was grocery stores. And they chose Sun Art as their partner. That was really good fortune. Alibaba also launched their own Hema supermarkets in this same time period.

In March 2018, Sun Art rolled out their TaoXianDa app in two pilot stores. This service offered 1 hour delivery in cooperation with Taobao. Sun Art and Alibaba also began digitizing and restructuring their hypermarkets.

A lot more has been happening. But those were the big moves prior to Covid. Sun Art became very well positioned as both a hypermarket retailer and an ecommerce business. And, impressively, the company had no real change in its financials during Covid.

2020

• Revenue: 95B RMB
• Gross Profit: 25.7B RMB
• Operating Profit 4.9B RMB

2019

• Revenue: 95B RMB
• Gross Profit: 24B RMB
• Operating Profit 4.7B RMB

They were already well-positioned in perishables and food, which were required by consumers even during Covid. And falling sales in the hypermarkets were compensated for by increased sales online.

That’s my take on #1.

1. It is a leading hypermarket company in China.
2. It is a key strategic asset in the Alibaba ecosystem. It is foundational to Alibaba’s new retail / OMO strategy.

But what about #2? What does it mean to have a Walmart-like company within the Alibaba ecosystem?

A Walmart-Like Retailer Within Alibaba Is a Competitive Powerhouse

I’ve frequently said that I like digital-physical hybrids. I like marketplaces like Shopee, Meituan, JD and Taobao that have both digital platforms and extensive physical assets (warehouses, delivery people, etc.). The digital side has nice economics. And those physical assets are hard to replicate and a huge barrier to entry.

The competitive picture I described for hypermarkets (economies of scale plus physical assets) is good. And, as it digitizes, you can add economies of scale in IT and logistics. A hypermarket outspending rivals in IT and logistics can get additional cost savings over time. This is where JD is focusing a lot of its efforts.

But what happens when you combine all this with the Alibaba ecosystem?

Think of all the advantages Alibaba can provide.

• Increased customers and online traffic.
• Decreased marketing and customer acquisition costs.
• An advanced ecommerce platform, which can be integrated into the physical stores and their current mobile apps.
• Data. Especially 360 degree behavioral data about every consumer within 3km of every store.
• IT resources. Think of all the capabilities at Alibaba Cloud. In AI. How many software engineers do you think a typical hypermarket company has?
• Logistics infrastructure. Think Cainiao.
• Financial support. Cash.

Imagine you are a competing hypermarket. Even if you have been digitizing successfully, how can you possibly compete with Sun Art plus Alibaba? Note: Walmart China is partnered with JD and Tencent.

Will Sun Art Be a Profit Center Within Alibaba? Or Infrastructure?

I just mentioned that Sun Art had no major changes to its financials during Covid. Was that really because of its hypermarket plus ecommerce business model? Or was it because they are under Alibaba and it can shift them traffic and sales to them when its wants?

Is Alibaba viewing Sun Art as a business that should grow and become more profitable? If so, could we see rapid growth in the next year?

Or is it viewed more as infrastructure in Alibaba’s greater new retail strategy?

And what Hema/Freshippo? Isn’t that a competitor?

Will Sun Art’s profitability be determined by markets and competition? Or by Alibaba’s intentions and strategy?

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On its webpage, Sun Art now describes its strategy as “to synchronize hypermarkets, superstores and mini stores, integrate online and offline business, develop multi-formats and omni-channels”, and to become a leader in digital transformation and a benchmarking enterprise for New Retail.”

Um. ok.

That doesn’t sound like a hypermarket adding ecommerce and on-demand delivery. That sounds like an ecosystem strategy. That sounds like Alibaba strategy.

In Part 2, I’ll go into Alibaba’s new retail strategy and why Sun Art is critical to this.

Cheers, jeff

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Related articles:

• Could Sun Art Start Growing +30% Under Alibaba? (pt 2 of 2) (Asia Tech Strategy – Daily Update)

From the Concept Library, concepts for this article are:

• Economies of scale / scope

From the Company Library, companies for this article are:

• Alibaba
• Sun Art Retail Group

Photo by Phuong Tran on Unsplash (top)

Photo by Joshua Fernandez on Unsplash

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