There’s just one thing wrong with this story—Douyin and Kuaishou aren’t really short video apps anymore.

Douyin supports videos anywhere between 15-seconds and 15 minutes, livestream content that may stretch over an hour, as well as mini-games. Kuaishou’s in the same boat, with a vibrant video game streaming scene to boot. The label “short video platform” has outlived its usefulness. 

Let’s take a quick look at why the term “short video platform” is less helpful than before and why it matters.  

What’s wrong with calling them ‘short video platforms’?

When short video apps first rose to prominence in 2013, they really were about short video. The Chinese term duanshipin (“short video”) was used to highlight the difference between an emergent content format (snackable video) and an established content format (tv-style streamed programming).

“Short video” wasn’t meant to stick around. It’s the type of term that should have gone away once everyone got the memo that online video doesn’t have to be a mobile-friendly version of 21- or 42-minute made-for-television programming.

However, the term persisted.

The term was easier to understand than alternatives, such as the alphabet soup of UGC, PGC, and PUGC (User Generated Content, Professionally-Generated Content, and Professional User Generated Content—don’t ask). Further, “short video” was easier to build a working, commonly-accepted definition around, becoming the default nomenclature for video content anywhere under five minutes.  

Without question, Douyin and Kuaishou are the most successful platforms built on short video content. Both boast eye-popping numbers of daily active users and increasing impressive shares of users’ internet time.

Note: The Douyin figure in the table above is a total for all mainland apps belonging to parent company Bytedance. Douyin is Bytedance’s most popular app. 

However, in 2019, these platforms started supporting different content types. Today, short video remains a platform staple, but it’s far from the only type of video available on Douyin and Kuaishou. A report released by Kuaishou earlier this year illustrates this nicely. 

Kuaishou has 300 million daily active users, of which 170 million watch livestream and 100 users engage in livestream e-commerce each day. (That, by the way, makes Kuaishou China’s fourth-largest e-commerce platform.) As Kuaishou further broadens its capabilities in e-commerce and cloud gaming (in Chinese), the range of on-platform activity will become even more diverse.

Given this range of activity, it’s no longer accurate to call Douyin and Kuaishou “short-video platforms.” 

Why does it even matter?

It might seem a little academic to object to the term as a catch-all for Douyin and Kuaishou. 

However, as these companies prepare to go public, names matter. 

Kuaishou is reported to be considering a $5 billion IPO next year. Bytedance, as part of its judo-wrestling match with the Trump Administration, may IPO TikTok, Douyin’s overseas cousin. Getting frames of reference right is an important part of each company’s dance with public markets. 

That’s because company valuation is an interplay between stories and numbers: Every number that makes up a valuation has a story behind it, just as every story about a company has a number attached to it. Terms like “short video” straitjacket stories these companies can weave and narrow potential investors’ appreciation of what Douyin and Kuaishou really are. The onus is on Douyin and Kuaishou to develop and field-test nomenclature that conveys their platforms’ depth, content diversity, and what they might offer in the future. 

Bilibili sets an instructive example. In its investor overview, it states “[W]e have evolved from a content community inspired by anime, comics and games (ACG) into a full-spectrum online entertainment world, covering a wide array of genres and media formats, including videos, live broadcasting, and mobile games.” That’s the sort of framing required to fight mischaracterizations like “the closest thing China has to Youtube.”

What would be a better name? “Online entertainment world” is a little too Rick and Morty for my taste. I’d stay away from hackneyed riffs on “super-app” and go with “entertainment hub,” encompassing video, gaming, and, increasingly e-commerce. 

Whichever way Douyin and Kuaishou decide to frame themselves, you can be sure they’ll steer clear from the term “short video platform.” Kuaishou, probably first in line to IPO, already calls itself a “platform.” That’s apt. The only reference to short video in the company’s online introduction is in the company timeline (Chinese). That highlights the degree the term “short video” is a relic. It’s outlived its usefulness, and sells these rich, diverse entertainment platforms short.     

In case you missed it, the founder of Pinduoduo, Colin Huang, recently stepped down as CEO. The move was announced a week after Huang eclipsed Jack Ma as China’s second-richest person. That feat was underwritten by a sudden, rapid increase in Huang’s personal wealth, adding $25 billion in six months on the back of Pinduoduo’s surging stock price. 

Analysts described Huang’s sudden departure, and immediate appointment of CTO Lei Chen as his replacement, as “unexpected.” That’s a polite way of saying, “We don’t know what the bloody hell is going on.” 

The circumstances look odd

Huang’s sudden resignation comes as Pinduoduo gains traction in China’s e-commerce—on the basis of self-reported GMV numbers, Pinduoduo may have as much as 10% of China’s e-commerce market. He stepped down amid the convergence of four events: the pandemic’s catalytic effect on e-commerce in China, Pinduoduo’s strong reported GMV growth, a sharp jump in the company’s share price, and Huang’s concomitant increase in personal wealth.

I’ll put it as plainly and objectively as I can—stepping aside in these circumstances looks odd, and dents confidence in Pinduoduo’s staying power.

Here are the two charts that matter.

The market has rewarded Pinduoduo for its advances into incumbents’ market share. At the time of writing, Pinduoduo’s share price has increased 120% this year. Huang, who held 43.3% of Pinduoduo’s shares before his resignation announcement, saw his wealth explode by $25 billion.  

So, why leave when everything’s going so damn well? Without a cogent explanation, analysts may question Pinduoduo’s resilience. Cynics may even have flashbacks of other significant shareholders in high-flying Chinese companies using sky-high share prices to cash out on the down-low.

Inconsistencies in words and actions

In a release circulated to media outlets, Huang said he would step back from day-to-day management to work on the company’s long-term strategy and corporate structure. That’s a pretty limp explanation, and it sows confusion—it’s the CEO’s job to think about strategy and corporate structure. 

McKinsey, a consultancy, articulates the six main elements of a CEO’s job as: 

Setting the strategy, aligning the organization, leading the top team, working with the board, being the face of the company to external stakeholders, and managing one’s own time and energy.

The very activities Huang relinquished the CEO role to perform are the two first elements on a CEO’s list of responsibilities. Either Huang’s understanding of a CEO’s responsibilities is deficient, or the explanation around his departure contains material omissions.

The inconsistencies don’t stop there.

Media outlets have breathlessly recounted how Huang has given away some of his shareholding. That’s true, to an extent. From the chart below, you can see Huang donated a small chunk to a charitable foundation and returned another chunk to an (unnamed) angel investor. 

The biggest “giveaway,” around 8% of the company’s shareholding, goes to the Pinduoduo Partnership. As flagged in Huang’s internal memo to staff, this may be part of a move to incentivize up-and-coming managers. Nice in theory, but currently the only members of the Pinduoduo Partnership are ex-CEO Huang and current CEO Chen. Huang is also the authorized representative and director of Qubit GP Limited, a corporate entity that owns the shareholding. That’s cozy, convenient, and potentially lucrative. 

Putting that together, Huang’s effective company shareholding hasn’t decreased from 43.3% to 29.4% as intimated. He still has effective control of around 37% of the company’s shareholding and retains 80.7% of Pinduoduo’s voting shares. 

Make no mistake, Huang is still the boss. However, for some reason he’s not comfortable wearing the CEO’s hat, nor is he comfortable with Pinduoduo’s leadership extending beyond him and co-founder Lei. 

Lingering gaps in corporate governance

Critically, Huang’s handpass of the CEO role to Chen means that Pinduoduo’s senior management team looks emptier than a movie theater during a Covid-induced lockdown. There’s no CFO (which I view as problematic), no COO, and no CTO. 

Pinduoduo has never had the former two roles. That’s fine for a start-up, but incredibly difficult to justify when Pinduoduo’s $100 billion-plus market capitalization is higher than 98% of listed stocks in the US. Can you imagine the headlines if Shopify, another $100-billion-plus e-commerce company, had similar corporate governance gaps? It’s time for some adults in the room to give investors additional confidence in the company’s corporate governance. 

At this point, Pinduoduo fanboys might point out the company appointed a VP of finance as part of the company’s leadership shakeup. The company’s previous VP of finance, Tian Xu, resigned for personal reasons in April 2019. He lasted 10 months in the job. The new VP of finance will have his work cut out for him. Pinduoduo faces questions from investors on issues including:

• Allegations of aggressive revenue recognition, as flagged by Lightstream Research and Blue Orca Capital.
• The “Critical Audit Matter” that Pinduoduo’s auditors, Ernst & Young Hua Ming LLP, identify in its annual report regarding the company’s practice of classifying subsidies as marketing expenses, rather than costs of revenues. 
• The scale of “free traffic” Pinduoduo supplies to merchants. 
• Declining cash and equivalents, which plunged 75% year on year to RMB 5.53 billion ($780.5 million) in Q1 2020 from RMB 22.50 billion ($3.35 billion) in Q1 2019. However, Pinduoduo does have cash reserves it could apply in the future.

These issues aren’t trivial, and it may only be a matter of time before investors start asking smarter questions. I’d say the company needs to appoint a CFO to answer those questions satisfactorily. 

Pinduoduo declined to comment on this story.

Changes bring fresh doubts

Huang’s decision to relinquish the CEO role but retain significant shareholding and control over Pinduoduo should raise more scrutiny. His publicly announced rationale for leaving the top job at this point in time doesn’t pass the sniff test. 

My working hypothesis is, relieved of the CEO title, Huang gives himself a layer of protection if something goes wrong. He may even be able to sell some of his shareholding without raising too many eyebrows. 

That hypothesis may make some uneasy, but there’s a lot about Pinduoduo that could give investors pause. Pinduoduo’s share prices have more than doubled this year. The company seems to be pulling out all the stops to sustain its growth trajectory, including allegedly subsidizing as much as 60% of the purchase price of some items during June’s 618 e-commerce extravaganza. At this critical juncture, sudden CEO departures and corporate governance gaps raise questions about what’s driving decisions at Pinduoduo, and dent confidence in the company’s staying power. I’ll be looking for reassurances at the company’s next earnings call.  

Clarification: This article has been edited to clarify the questions raised by investors referred to in the second to last section.

If you’ve read TechNode for any length of time, you’d know that Tencent, one of the world’s ten largest companies, has a massive video game empire. It owns stakes in the following game publishers and developers:

You see, Tencent’s the only video game company that has ownership of developers that make games, the channels where games get distributed and the digital entertainment platforms where gamers watch gameplay. This means Tencent has deep moats to defend its game empire against present and emerging competitors, especially ambitious domestic rivals Netease and Bytedance.  

There’s a lot to unpack here, so let’s start with the video game value chain. 

The video game value chain

The gaming value chain describes how gaming content is created, distributed and marketed to gamers. Different gaming formats, such as PC, console or smartphone, will lead to varied value chains. However, we can generalize and say the gaming value chain looks something like this:

The intellectual property is licensed to a publisher, who then finds or green-lights studios to make compelling games. The distributor delivers the finished game physically or digitally, so it ends up in the hands of consumers. Consumers play the game, talk about the game and watch others play the game. Money changes hands along the value chain in different ways—royalties, advances, sales revenues, marketing campaigns, digital item revenues, and gifts for video game streamers. 

Vertical integration means operating across multiple layers in the value chain. Some gaming companies are already active in one or two spots along the value chain. Take-Two Interactive, for instance, is a publisher and developer. Valve, another diversified gaming business, is a publisher, developer and digital distributor. 

However, Tencent’s presence across the value chain goes much, much further than Take-Two Interactive, Valve, or any other competitor. As you can see from the table below, it directly owns or has invested in assets across the entire value chain in and outside China. 

It’s difficult to not overstate how impressive this is. Just like the British Empire, the sun never sets on Tencent’s gaming empire—at any time of the day, anywhere in the world, gamers are engaging with video games Tencent has some level of ownership in. 

Moats create safe distance from ambitious domestic competitors

Tencent’s investments across the value chain highlights two important points. 

First, Tencent isn’t the largest gaming company in the world by accident. Tencent knows that it’s not enough to have a few erratic hits—you have to have the infrastructure in place to turn games into multi-year interactive franchises, and that means some level of control over intellectual property, distribution channels and streaming portals. 

Second, Tencent has a good eye for companies that span a couple of layers in the value chain. It was early money into Epic Games, which was in the early stages of developing smash hit Fortnite. Epic Games owns the Unreal Engine (a commercially available game engine which also powers their internally developed video games) and the Epic Games Store, a game distribution platform. The potential of both the Unreal Engine and Epic Games store is so (wait for it…) epic that a well-respected indie investor has a six-part essay on it. 

Taken together, we can conclude Tencent has the cash and investment approach to select and pick winning assets inside and outside China. Tencent can further use these strategic investments and partnerships with game developers to choke the access Netease and Bytedance have to leading intellectual property and game titles.

Here’s how:

• Tencent can cross-pollinate domestic and overseas gaming titles by bringing hit overseas titles to China and taking hit domestic titles overseas.
• Tencent’s investment team doesn’t stop scouring the globe for promising gaming companies
• Outside investments, Tencent can leverage its distribution channels to strike opportunistic partnership deals with companies it hasn’t invested in, like a 2018 deal with Square Enix Group.
• Even if Netease or Bytedance titles enjoy some success, they may be locked out of featuring on Tencent-invested streaming platforms Huya and Douyu (which have three-quarters of China’s game streaming market).

These moats are particularly important in a context where Netease has raised $2.7 billion from a secondary listing in Hong Kong and juggernaut Bytedance is looking to step up its nascent gaming business. 

Netease and Bytedance may have Tencent’s hefty gaming revenues in their sights, but they’re essentially playing on a chess board that Tencent’s designed and has firmly in its grasp. They’ll have to flip the chessboard if they’re to unseat the emperor penguin from its throne.

“The China Hustle,” a documentary from a few years back, depicts a special type of stock market fraud. Obscure Chinese high-tech manufacturers, agricultural producers, and mining companies would list on overseas stock exchanges. Investor conferences, investment funds, and stockbrokers played up each company’s connection to China’s growth miracle, stimulating investor demand and precipitating share price spikes.

Trouble is, many companies were cooking the books, with eye-watering revenue growth stemming from a web of fraud. As the real value of these huckster companies came to light, stock prices tumbled, and naïve investors were left holding the bag. All up, over 200 Chinese companies were found to have engaged in some kind of China hustle, resulting in $50 billion in securities fraud. 

Digital fraud

“New China Hustles” don’t involve manufacturers, agricultural producers, or mining companies engaged in the physical economy. Instead, these hustlers involve digital economy actors like digital advertisers, online education providers, and consumer commerce companies. 

Take the recent fraud admissions from Luckin Coffee and TAL Education Group, respectively a digital-first coffee vendor and an education provider with a swag of online-only sub-brands. In both instances, fessed-up fraud involves inflated online purchases. Mobile gaming company Cheetah Mobile and online tuition provider GSX are staring down the barrel of shareholder lawsuits about inflated user numbers and sham revenues.

Why the sudden tech angle?

Investors know technology and internet stocks have outperformed the market. That breeds comfort with these stocks’ high-risk, high-reward growth profiles—scale first, profits later. This leeway suits hustlers well. 

But even in tech, eventually you have to come up with some numbers. When predicted growth falls short, falsified revenue and user growth keep stock prices on an upward trend and can help evade questions around sketchy business models, elusive profitability, and evaporating cash reserves. 

When it comes to growth, digital hustlers have grey areas they can exploit. In the case of Luckin Coffee and TAL Education Group, we’re looking at fake users and inflated revenues. With bad intentions, it’s pretty straightforward to perpetuate digital fraud—a couple of clicks here, a few numbers into a dashboard there, and you’ve got an additional 20% extra app users this month!

Indeed, digital companies with management acting in bad faith can be equivalent to a black box. You can use satellite images to cross-check an obscure cobalt mine’s stated output. However, there’s limited scope to do the same for an obscure gaming company’s user revenue. It takes the continued effort of well-resourced skeptics and short sellers to yank away the façade. 

Manipulating markets

When digital actors define their own growth metrics, monitor their own performance, and report against that performance, they are simultaneously their own referee and cheerleader. That’s dangerous, particularly when sophisticated hustlers know what metrics move markets and aren’t afraid to use that to their advantage. 

Luckin Coffee is perhaps the most brazen example. As the now-famed anonymous short report hauntingly suggested months before Luckin admitted to sales fraud, “Luckin knows exactly what investors are looking for, how to position itself as a growth stock with a fantastic story, and what key metrics to manipulate to maximize investor confidence.” Armed with that knowledge, Luckin Coffee fooled institutional and retail investors. It would be reckless to assume other hustlers didn’t have the same level of situational awareness and the willingness to exploit that for financial gain. 

Indeed, I fully expect the next crop of Chinese companies to fall from grace to be cunning PR operators—unafraid to grease the wheels with analysts, press, and commentators to head-off accusations of manipulated metrics and insulate multi-billion dollar market capitalizations. 

Fast and fraudulent

Victims of securities fraud are not exclusively “Bitcoin Bros” or “Youtube Day Traders.” Victims include a mix of ill-considered, ill-informed, and innocent pension funds, investment banks, and individual investors. 

Scandal-ridden Wirecard also shows securities fraud isn’t something that just emanates from China. Low-tech and high-tech companies with lackluster, incompetent, or downright deceitful management are listed on exchanges worldwide. Perverse incentives that obscure poor management and bad companies exist across venture capital and public markets. 

However, there’s a reason why it’s called a “China Hustle.” The feverish desire for above-average returns, information asymmetry, lack of oversight, and loose corporate governance notions, all make China suited to unchecked financial manipulation. 

Luckin and TAL have admitted to user fraud. But I’m sure they’re not alone. There are credible short-seller reports on Uxin, Iqiyi, and GSX, and I reckon that most of these will eventually be vindicated. 

So, what do you need to be on the lookout for?

First, there’s digital manipulation, like fake users, bogus sales, and inflated transaction volumes. Next, there’s accounting wizardry that results in flexible (or non-existent) definitions of revenues, costs and cash, related-party transactions, and frequently revised or inconsistent reporting formats. 

If you’re seeing user growth that dramatically exceeds third-party data or costs are defined differently each time you open an earnings release, it may be time to take profits and abandon ship. 

China Tech Investor is a weekly look at China’s tech companies through the lens of investment. Each week, hosts Elliott Zaagman and James Hull go through their watch list of publicly listed tech companies and also interview experts on issues affecting the macroeconomy and the stock prices of China’s tech companies.

Make sure you don’t miss anything. Check out our lineup of China tech podcasts

This week, James is taking some time off with his newborn, so CTI regular Michael Norris fills in as cohost. He and Elliott discuss Alibaba, Bilibili, and Pinduoduo’s Q1 earnings, as well as what the possibility of Chinese companies delisting from US exchanges will mean for investors.

Please note, the hosts may have interest in some of the stocks discussed. The discussion should not be construed as investment advice or a solicitation of services.

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Watchlist:

• Tencent
• Alibaba
• Baidu
• iQiyi
• Xiaomi
• JD
• Pinduoduo
• Meituan-Dianping
• Luckin Coffee

Links:

Bilibili and the niche vs mass market dilemma– Pingwest

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Aswath Damodaran, the “dean of valuation,” says company valuation is the interplay between stories and numbers. Every number that makes up a valuation has a story behind it. Every story about a company has a number attached to it.

The growth story of Pinduoduo has been described as “miraculous.” It’s the fastest-growing e-commerce scale-up in China, cracking the RMB one trillion (about $141 billion) in transactions milestone in less than half the time it took Alibaba and JD. That, alongside a few other numbers, tells the story of an irresistible force shaking up China’s e-commerce landscape. If you took that story to the bank and picked up PDD shares at IPO, you’d be up 150% right now.

PDD’s growth story is on the verge of a plot twist: revenue growth is weaker than it should be. Questions are also mounting over its subsidy scheme. Here’s why it needs to write a new chapter better suited to its current circumstances, before investors get wise and start asking tougher questions.

Houston, we have a monetization problem

Two issues threaten to derail PDD’s tale of incredible growth and disruptive innovation.

The first is revenue growth. PDD’s revenue growth has missed analyst estimates two quarters in a row.

A quick word on PDD’s revenue: 90% comes from “online marketing services”, not commissions from e-commerce transactions. “Online marketing services” include keyword bidding and advertising placements such as banners, links, and logos. 

That means the best gauges of revenue health are the number of merchants on PDD and their online marketing services spend.

Here’s what those figures look like, per PDD’s annual report: Where do your eyes gravitate when you see this table?

I look at the last line. Merchants are spending next to nothing on online marketing services, despite massive increases in GMV. That RMB 5,257 per year works out to just $61 a month. The 64% increase looks impressive, until you realize it comes from such a low base.

But maybe it’s not the average merchant who matters, but the big ones. We’ll assume the Pareto Principle applies to PDD’s online marketing services revenue, whereby 20% of merchants are responsible for 80% of revenues.

Under these assumptions, top merchants might be spending an average of RMB 21,030 on PDD online marketing services. That’ll buy you one-tenth of a front-page banner on Taobao.

Scale vs advertising

PDD’s online marketing services are either cheap-as-chips, or merchants are parking their money elsewhere. On paper, Pinduoduo’s online marketing services, particularly keyword bidding, should follow a tight supply and demand model. Low per merchant revenue suggests that few merchants are keen to shell out .

In the short-term, PDD can divert attention away from low merchant spend by trotting out the hackneyed line that advertising revenue will pick up with increases in platform GMV and user expenditure.

However, there’s plenty of evidence that scale doesn’t automatically translate to big digital advertising bucks.

Given that Pinduoduo is already China’s second-largest e-commerce platform by users and third-largest by GMV, it’s only a matter of time before savvy investors ask why merchants aren’t spending more on digital advertising and preferred product listing slots.  

Subsidy accountability

The second issue that threatens to derail PDD’s growth story relates to subsidy accountability and investor relations.

PDD has never had a CFO. The previous VP of Finance departed in April 2019 (Chinese). The company is on the search for a CFO as it continues a subsidy program that is the longest ongoing subsidy program in China’s e-commerce history.

The subsidy program’s results are worth standalone treatment outside this article, but here’s the CliffsNotes version:

Supporters have argued the subsidies have given PDD more users and engagement. Detractors have argued the short-term spike in platform GMV masks issues with stubbornly low user spend and is too high a price to pay for continued losses.

Two charts show why Pinduoduo desperately needs an adult in the room to run a ruler over the subsidy program.

The first chart looks at GMV growth. It suggests subsidies may have been a stopgap to arrest declining sequential change in trailing 12-month GMV growth, but they didn’t work for long.

The second chart shows PDD’s cash and cash equivalents. This is, in part, a measure of how much free cash PDD has got on hand to commit towards its growth. Its subsidy program has cut that number by half.

Together, these two charts suggest that Pinduoduo may be overpaying to fight gravity. Any future CFO must determine whether it’s in the company’s best interest to continue a subsidy war with Alibaba, JD, and Suning. As I will discuss below, there are uses for cash other than incinerating it to juice metrics.

In addition to needing a CFO, Pinduoduo is walking on a few eggshells. It’s been called “the largest bubble in Chinese internet history” by Guosheng Securities (Chinese). The folks at Guosheng reckon PDD is subsidizing merchants and users, running up losses to keep products on the platform artificially cheap. This, they contend, is what’s driving PDD’s GMV growth. PDD has been suspected of not having the right payment clearance processes in place (in Chinese). All this signals a mounting level of market and regulatory scrutiny as Pinduoduo gets a seat at the big boy table.

A new story for Pinduoduo

If you buy into PDD’s current growth story, this is probably why: the scale of its e-commerce marketplace approaches Alibaba.

The story has worked wonders so far. Pinduoduo added $15 billion in market capitalization between Q1 and Q4 2019. That works out to roughly $100 in market capitalization for each user it added over the same period. Clearly, investors have high expectations for what PDD can do with its scale.

The warning signs covered earlier could sour these expectations. Even with PDD’s strong growth, merchants aren’t spending big on online marketing services, leaving a hole in revenues. And that’s not to mention macroeconomic or pandemic-induced headwinds that may dampen digital advertising spend or consumer confidence.

PDD’s growth story must change, before investors realize GMV growth isn’t attracting more online marketing services revenue.

PDD’s new narrative should center on its war chest.

The company raised $1 billion in March. That follows a similar-sized debt financing round in September 2019. That was after a follow-on equity raise in February 2019, also to the tune of $1 billion. Get the picture? PDD is a money-raising machine.

At present, Pinduoduo has a good chunk of these proceeds (and more)—about $5 billion—stashed away in highly-liquid short-term investments.

This war chest creates an opportunity for Pinduoduo to mold itself into a Tencent-like investor. The latter’s investment record is stellar—of the 800 companies Tencent has invested in, 160 hold unicorn status. Of these, five have generated returns of more than $1 billion, six have generated returns of more than $5 billion, and one company (unnamed) has generated returns of more than $10 billion.

Even if Pinduoduo doesn’t quite match Tencent’s lofty returns, their eye for disruptive commerce models could still be highly lucrative—think GGV Capital, who focus on spotting opportunities that transfer between developed and developing economies.

An appetite for change?

I predict that a combination of business challenges and increased scrutiny will make it challenging for Pinduoduo to keep parroting its previous growth story this year. But I’m not sure how much narrative shift the company is up for.

The company’s success to date and its current share price are powerful forces that could tempt it to stay course. Why rock the boat, especially when you have the mother of all scapegoats—COVID-19—up your sleeve?

We won’t have to wait long to find out. Pinduoduo’s Q1 2020 earnings will be with us very, very soon.

Correction (May 12): An earlier version of this article wrote that Pinduoduo added $15 billion in market capitalization between Q1 and Q4 2020. In fact, this happened between Q1 and Q4 2019.

Correction (May 14): A previous version of a chart in this article incorrectly labelled LTM GTV as Quarterly GMV. It also wrote that Pinduoduo’s CFO stepped down in April 2019. Pinduoduo has never had a CFO, and it was the VP of Finance who stepped down.

Well, here we are. A little over a year after I wrote about Luckin’s fast-and-loose corporate governance and the all-too-cosy nexus between management and venture capital, Luckin has admitted that it used significant sales fraud to prop up its frothy valuation.

But you, dear reader, are more street-smart than that. You know that if there’s anything to be learned about Luckin Coffee, it’s that there’s always more than meets the eye. And as Luckin’s most vocal critic, there’s still a lot I want to know following the company’s recent fess-up.

How much fraud are we talking about, really?

First up, a cross between a cryptic crossword and a reading comprehension test. Luckin’s fraud announcement reads:

The information identified at this preliminary stage of the Internal Investigation indicates that the aggregate sales amount associated with the fabricated transactions from the second quarter of 2019 to the fourth quarter of 2019 amount to around RMB 2.2 billion. Certain costs and expenses were also substantially inflated by fabricated transactions during this period.

In essence, Luckin’s ballparked the revenue-side fraud. RMB 2.2 billion is around USD$310 million, which works out to about half the sales Luckin expected from Q2, Q3, and Q4 2019.

But did you notice the line about “substantial” inflation of “certain costs and expenses”? A lot of commentators didn’t.

This still-unquantified question is critical—if you remember the anonymous short report distributed by short-seller Muddy Waters, it laid out evidence that Luckin’s misdemeanors may extend well beyond double-counted cappuccinos. Specifically, the report claims the company inflated advertising expenses and procured coffee machines at prices above market rates from a business partner of Chairman Lu Zhengyao, both as ways for Luckin’s unscrupulous management team to siphon funds from the company.

Given the report’s current track record and management’s pattern of using fast-growing companies to enrich themselves, investors must ask themselves how big an iceberg is sitting below that $310 million in sales fraud.

How far does the rot go?

You can probably tell that I’m thoroughly unconvinced by the company’s attempt to pin the fraud on its COO and his underlings.

That’s because COO Liu Jian hasn’t got a clear motive. He has very little financial interest in Luckin’s share market performance—in fact, according to Luckin’s pre-IPO prospectus, he’s got a grand total of zero equity in the company. Zilch. Nada. Bupkis. Yes, he’s got a handful of stock options, but just barely enough to incentivize you to come to work early and leave late—nothing close to worth committing fraud and ending your career over.

Chairman Lu Zhengyao and CEO Qian Zhiya, on the other hand, have more skin in the game than a sumo wrestler. Luckin’s initial prospectus reported that Chairman Lu Zhengyao owned 30.53%, an investment fund owned by Lu’s sister (yes, you read that right) owned 12.4%, and CEO Qian Zhiya owned 19.6%.

These shareholders, not Liu, had the most to gain from Luckin’s doctored financial results.

It was Luckin’s better-than-expected Q3 results that precipitated a 160% increase in Luckin’s stock price between November 2019 and January 2020. January, of course, was when the company went back to public markets for an additional capital raise. The prospectus used for that capital raise revealed the Lu Zhengyao, Lu’s sister, and Qian Zhiya have cashed out varying proportions of their shares through stock pledges. In layman’s terms, that’s when you use shares as a security for a loan. By using part of his handsomely-valued Luckin shares as collateral to take out loans, Lu Zhengyao has made away with in excess of $500 million. That amount would have been much, much smaller if Luckin’s numbers were accurately reported.

All this makes it hard to believe that COO Liu Jian would commit fraud without the actual or constructive knowledge Chairman Lu Zhengyao, CEO Qian Zhiya and CFO Reinout Hendrik Schakel. My present hypothesis is that Liu, as a long time errand boy for Chairman Lu Zhengyao, has taken the fall to buy time for Luckin’s management to work out their next move following a quarter rocked by an extended Chinese New Year and COVID-19.

Luckin’s less-than-an-A4-sheet-of-paper response to a damning short report, and its attempt to pin the fraud on an implausible culprit, evidence complete disrespect toward the investment community’s collective intelligence. If you’re in any way involved with Luckin Coffee (and God help you if you are), you shouldn’t be satisfied until the whole board has been replaced, alongside the company’s worse-than-useless auditors.    

Where does Luckin go from here?

Even if Luckin’s numbers were real, the company would still face serious business challenges.

Let’s consider it as a Harvard Business School-style case study:

You’re the incoming CEO of a grab-and-go coffee kiosk business in China. You’ve expanded to 4,500 stores very quickly, but your sales are a mere pimple on those of your established competitor. In January 2020, a bull market and hype around your coffee network has allowed you to raise $800 million in debt and equity to continue fueling your expansion. What do you do?

As I’ve argued before, there’s a semblance of a business case behind Luckin’s freebies and discounts. The largest cost in the China’s coffee and café scene is rent. By running grab-and-go (rather than sip-and-stay) stores, Luckin saves on that expense line item. It pockets some of the savings and reinvests some of the proceeds to entice repurchase and refer new customers, and drives a strong loyalty program for frequent customers with above-average purchase frequency.

Nice in theory. But where that business case falls apart at the seams is its reliance on blitzscaling over physical assets. “Blitzscaling” is Silicon Valley code for the science, art, or witchcraft of rapidly building a company to capture large markets. It usually relies on years of losses underwritten by investors. Wannabe blitzscalers need to operate in large markets, have massive or zero-marginal cost distribution, enjoy high gross margins, and take advantage of network effects—easy enough for a social network or a platform company, but disconnected from reality in the case of people making cups of coffee. That’s been proven in Luckin’s case, where a shaky value proposition outside China’s metropolises and rapid store expansion have made a hot mess of its balance sheet.

Can it come back from the brink?

The recent rush in consumers looking to cash in their Luckin coupons makes it appear like the company’s close to folding. That’s not strictly true. Luckin’s still got enough cash on hand to make a proper go of selling coffee, juice, and beverages. However, Luckin’s ambition and expenditure need to downsize from “Venti” to “Short.” 

If there’s any shred of commercial sense at the company, they’ll take a butcher’s knife to the store network, closing underperforming locations as boldly as they opened them. This would slim down Luckin’s cost profile to something much more manageable.

The turnaround wouldn’t stop there. Luckin’s business lines would need a re-think. The plan to deploy vending machines across the country should be scrapped. Yes, vending machines offer distribution at a lower cost than grab-and-go kiosks, but limit what type of beverages Luckin can sell. High-margin beverages like coffee, milk tea, and juice should be front-and-center and are best sold from kiosks. It can partner up to introduce snacks, meals, and non-beverage products into its offer, rather than going it alone. Most importantly, Luckin will have to put in the hard yards of finding, nurturing, and expanding pools of grab-and-go coffee customers in China. That necessitates pumping the brakes on carpet-bombing coupons and discounts, and a focus on cultivating real loyalty in office precincts.

Make no mistake, this would be a Herculean effort—a turnaround predicated on business smarts and an acute sense of priorities. But Luckin also needs urgently to reclaim investor confidence.

The investment community now knows Chairman Lu Zhengyao and CEO Qian Zhiya profited by pledging their shares for loans. Even with one fraud culprit named and shamed, it’s going to be hard for the Chairman and CEO to claim squeaky-clean corporate governance while they’re at the helm. If they’re serious about Luckin cracking China’s coffee market, they should announce a transition and stagger their exits. Without significant change at the top, Luckin remains a frothy latte with a double-shot of unjust enrichment.

The rate of Oyo’s demise in China is dizzying. No sooner had TechNode reported a 60% reduction in Oyo’s China workforce, local news outlet Jiemian broke news of a further 3,000-head layoff. That brings the cull to 72% of Oyo’s China workforce. 

Despite being a glorified real estate company, Oyo is a consumer internet company.

The only silver lining for SoftBank, Oyo’s biggest backer, is that it has just enough cash in the kitty to paper over an Oyo-sized hole on its balance sheet.

Favorite Son

While Oyo certainly isn’t SoftBank’s largest investment, it’s reported that Oyo ranks among SoftBank CEO Masayoshi Son’s favorite portfolio companies. SoftBank’s Vision Fund has invested in 91 companies, including household names like Uber, Grab, Nvidia, and Bytedance. 

The initial spark has turned into a steady flow of capital.

Among that all-star cast, Oyo has received special treatment. Masayoshi Son was said to be charmed by Oyo founder Ritesh Agarwal and his business model—improving fallow assets, giving budget hotels a makeover, and improving search and booking efficiency. A former Masayoshi Son favorite, Jack Ma, created a $146 billion windfall for Softbank.

The initial spark has turned into a steady flow of capital. To fuel Oyo’s expansion in India, SoftBank led Oyo’s Series B ($100 million), its Series C ($90 million), and its Series D ($250 million). SoftBank opened its coffers further and led two later funding rounds worth a combined $2.8 billion to help Oyo export its model to overseas markets. Masayoshi Son has encouraged and enabled Agarwal to try and crack China, the US, the UK, and Japan at the same time—a feat no other consumer-focused digital platform has attempted. 

It’s no secret that the Vision Fund’s recent track record has raised eyebrows.

With reversals in each of those markets, this plan looks to have backfired. With the latest layoffs from China added in, Oyo has slashed more than 8,000 jobs since June 2019. That’s around three times the number of employees WeWork let go after it imploded in the lead-up to its IPO. 

Black and red

It’s no secret that the Vision Fund’s recent track record has raised eyebrows. Its portfolio companies Uber and Slack quickly shed market capitalization following respective IPOs in May and June 2019. Those selloffs made it hard for SoftBank to cleanly sell its stakes and head for the exit. A few months later, WeWork’s aborted IPO precipitated multi-billion dollar losses and sharpened questions around SoftBank’s go-hard-or-go-home strategy. An avalanche of smaller failures followed. Wag, CloudMinds, Rappi, Getaround, Zume and a handful of other bad ideas with too much SoftBank capital have adjusted their valuations or shed staff in the last few months. 

SoftBank has so far made a $10 billion profit from its Vision Fund investments.

However, despite the Nelson Muntz-style pointing-and-laughing, the Vision Fund has still delivered positive returns. Well, kind of.

Last month, the Vision Fund disclosed an operating loss of 225 billion yen (about $2.05 billion) for October-December, compared with a 176 billion yen profit in the same period a year earlier. The most favorable read-through suggests that, even taking into account some of SoftBank’s financial engineering and accounting wizardry, it’s so far made a $10 billion profit from its Vision Fund investments.

So what impact could Oyo’s downfall have on the Vision Fund’s profit pool? 

In the context of the $100 billion Vision Fund, SoftBank placing a multi-billion dollar bet on India’s largest hotel chain probably passes the sniff test. But look a little closer, and the smell gets slightly more iffy.

Despite being a glorified real estate company, for SoftBank’s purposes, Oyo is a consumer internet company. To date, SoftBank estimates the fair value of Vision Fund investments in the consumer internet sector is $15.8 billion. Analysts reckon anywhere between 20% and 33% of that figure can be attributed to SoftBank’s investment in Oyo. Masayoshi Son has bet big on his favorite portfolio company.

Even-handed analysis suggests SoftBank’s track record in the Middle Kingdom remains largely intact. 

Currently, it’s highly questionable whether that bet is anywhere near paying off. Overseas expansion is estimated to have lifted Oyo’s valuation five-fold, so SoftBank wouldn’t be pleased with pullbacks and reversals in markets like China, the US, and Japan. Capitulation in Oyo’s second-largest market, China, means the company’s current $10 billion valuation looks like a pipe dream.

As Oyo attempts to pull itself from the brink of a WeWork-esque meltdown, SoftBank is keeping a careful eye on the damage bill. Tactical retreat from a couple of overseas markets and consolidation in India might be enough to salvage SoftBank’s investment. But, if Oyo gets outwitted and outplayed in India, SoftBank could be starting into financial black hole. 

Clued-in China investments

The nature of venture capital investing lends itself to spectacular successes and equally spectacular failures. The “Venture Capital Power Law” suggests 6% of deals make 60% of returns, and over 50% of deals won’t ever come near a return. 

Although Oyo’s fortunes in China have indeed flopped, even-handed analysis suggests SoftBank’s track record in the Middle Kingdom remains largely intact. 

Outside of its part-stroke-of-luck-part-stroke-of-genius investment in Alibaba, SoftBank’s Vision Fund deserves credit for decisive investments in Didi, Bytedance, SenseTime, Ping’An Good Doctor, and Alibaba’s local services investment vehicle. These investments will bear fruit, with profits likely harvested for SoftBank’s second Vision Fund. 

Yes, there’s also some poorly thought-out investments there too. Ever heard of OneConnect? Me neither. Would you want to touch China’s cash-burning second-hand vehicle market? Didn’t think so. 

But, those failures matter less than media hype has us believe. Here’s ex-Andressen Horowitz Partner Ben Evans on failure in venture capital:

None of this means that failure is good—failure is horrible and painful for everyone. You’re not supposed to fail. Nor does it mean that doing stupid things is good, nor that screwing up is good. It certainly doesn’t mean that no tech company that failed ever did something stupid or screwed up, nor that no VC has ever made an investment that they shouldn’t have. People screw up in tech all the time. But failure is part of risk, and failing, by itself, does not mean that anyone was stupid, or screwed up.

Venture capital firms get better returns by having more really big hits, not by having fewer failures. Oyo swung the bat in China, hard. It didn’t connect, but SoftBank’s next China-related investment very well just might hit a home run. 

Oyo, the SoftBank-backed budget hotel chain, is in a world of pain. Oyo has slashed over 5,000 jobs since June 2019. That’s a similar proportion (~20%) but twice the number of employees WeWork let go after it imploded in the lead up to IPO. The two firms draw ready comparison due to their SoftBank-led capital injections, aggressive expansion plans, enigmatic CEOs, and struggle to make more money than they spend.

In a two-part series, I’m going to piece together what went wrong and explain what Oyo’s demise in China means for SoftBank, Vision Fund One, and Vision Fund Two.

Let’s begin with what went wrong.

Burning cash in turf wars

Oyo was started in May 2013 by Ritesh Agarwal, a 19-year-old Thiel Fellow. It started by aggregating and standardizing budget hotels and hostels in India—improving fallow assets, giving budget hotels a makeover, and improving search and booking efficiency.

Maybe some of the trigger-happy capital injections were warranted.

The model was quick to attract SoftBank’s attention and capital. To fuel Oyo’s expansion in India, SoftBank led Oyo’s Series B ($100 million), its Series C ($90 million), and its Series D ($250 million). A year after Oyo’s November 2017 launch in China, SoftBank even kicked in a $1 billion dollar Series E to bankroll Oyo’s global ambitions. Oyo’s status as India’s largest hotel chain kept the dollars rolling in.

Maybe some of the trigger-happy capital injections were warranted. Oyo’s expansion in India and entry into China was a little like the Eastern Front before winter—swift, decisive, and dotted with victories. Less than 18 months after launching in Shenzhen, Oyo surpassed Home Inn and Hanting to become China’s second-largest hotel group, managing 10,000 hotels in 320 cities. China, it seemed, had the requisite conditions to allow firms like Luckin Coffee and Oyo to blitzscale over physical assets.

But that growth wasn’t exactly cheap.

Oyo’s China operations posted a $197 million loss between March 2018 and March 2019. That loss accounted for 60% of Oyo’s $325 million in losses in that period. While that’s not WeWork levels of capital incineration, the China operations’ EBITDA margin of -66% is enough to make even Luckin Coffee’s accountants blush.

Part of that expenditure is inherent in Oyo’s business model. Oyo aggregates and standardizes the experience and amenities at independent hotels, working with independent hotel partners for a cut of their revenues. That necessitates a sales network to win over independent hoteliers, capital outlay to get the hotel up to scratch, and ongoing spend to attract patrons to Oyo-branded hotels. 

Yet part of Oyo’s initial spend was an accidental turf war Oyo sparked between itself, Meituan and Ctrip.

I can safely bet Agarwal didn’t know what his openness and candor would lead to.

Sources told me that CEO Ritesh Agarwal privately met with Meituan’s CEO Wang Xing and Ctrip’s CEO Jie Sun soon after committing to aggressive expansion in China. In these meetings, Agarwal laid out his vision for Oyo to be China’s largest hotel chain. Agarwal wanted to expand China’s domestic travel pie, and give users the choice to book Oyo-branded hotels through either Oyo’s own app, Meituan or Ctrip.

I can safely bet Agarwal didn’t know what his openness and candor would lead to. Both Xing and Sun saw a large hotel chain with its own digital infrastructure as a potential threat, not an ally. In short order, Meituan and Ctrip each hatched up their own independent hotel aggregators and barred Oyo-branded hotels (in Chinese) from being listed on their platforms. Unable to drive traffic through China’s largest online travel agents, Oyo had no recourse but to invest further in online and offline marketing, further upping the firm’s burn-rate.

In April 2019, Oyo capitulated. It agreed to pay an annual “toll”, which guaranteed Meituan and Ctrip facilitate search and booking of Oyo-branded hotels through their respective platforms. Insiders reckon Oyo will cough up around USD 58 million per year to Meituan (in Chinese), and we can expect a similar-sized cheque with Ctrip’s name on it. All up, an expensive lesson in digital competition.

Model 2.0 mess

If you think that sounds something that goes down in an episode of Succession or Billions, then you ain’t seen nothing yet.

After WeWork’s implosion in September last year, SoftBank urged its Vision Fund portfolio companies, including Oyo, to pull their heads in and focus on profitability. Oyo’s solution was to take more of its partners’ profits.

Oyo didn’t expect that China’s independent hoteliers would connect digitally, contest the changes and even protest at Oyo’s Shanghai headquarters.

Around October 2019, it started to unilaterally and retroactively amend contracts with “Model 2.0” hotel partners. Oyo’s Model 2.0 gives hotel partners a monthly income guarantee. In exchange, Oyo has tighter control over hotel operations and takes all the revenue the hotel makes above the monthly income guarantee.

By modifying Model 2.0 contracts, Oyo set out to do two things. First, it wanted to reduce the amount of money it was already on the hook for – paying hoteliers less than they’d been promised. Second, it needed to lock hoteliers into a lower guaranteed monthly income going forward.  

Sources responsible for Model 2.0 tell me that they expected only a small number of hotel partners to kick up a fuss about the revised contracts. After all, Oyo had pulled a similar stunt in India, to minor social media blowback. Oyo didn’t expect that China’s independent hoteliers would connect digitally, contest the changes and even protest at Oyo’s Shanghai headquarters.

Critically, word of Oyo’s bad-faith contract dealings spread at a time when Oyo was renewing agreements with “Model 1.0” hotels. These hotels, which make up most of Oyo’s hotel stock in China, don’t have a monthly income guarantee. Instead, Oyo takes a cut of their booking revenue. Oyo’s brawl with Meituan and Ctrip, squabbles with existing hotel partners and an unclear value proposition led to a mass exodus of Model 1.0 hotels between November 2019 and January 2020. Company insiders tell me that even before COVID-19 broke out, Oyo lost close to two-thirds of its Model 1.0 hotel partners—a stunning reversal of fortunes.  

What remains to be seen is how many Oyo-branded independent hoteliers are left solvent after Covid-19’s roundhouse kick to China’s domestic tourism sector. Funnily enough, some hoteliers have similar doubts about Oyo’s financial wellbeing: Media reports (in Chinese) chronicle hoteliers defying epidemic fears to scramble across the country and livestream attempts to get promised revenue back from Oyo at their offices. You can’t make this stuff up.

Crippled unicorn

Cue the mass lay-offs. An emphasis on lowering cash-burn, reversals in each international market and dented travel outlooks have accelerated Oyo’s downsizing. Just yesterday, local media reported (in Chinese) that Oyo China’s head-count was at 2,734. If correct, then Oyo’s silently slashed around 3,000 jobs outside of previously-announced redundancies.

While it’s conceptually easy to pin layoffs and even Oyo’s potential exit from China on Covid-19, the firm’s maneuvers in the Middle Kingdom have sown the seeds of its own undoing. From unwittingly starting a turf war with savvy travel giants to screwing over hotel partners and hoping to get away with it, Oyo’s compromised prospects in its second-largest market globally.

In the next part of this series, I’ll outline what Oyo’s failure in China means for SoftBank’s Vision Fund.  

The result? Bytedance is making money hand over fist. Based on a combination of corporate updates and internal leaks, it’s already estimated to have made large inroads on Baidu’s ad revenue, as illustrated below, well and truly staking its claim to be the BAT’s new “B.” This year, Bytedance is expected to bank $25 billion in revenue. If the company achieves this, it will have broken the $25 billion-dollar threshold three years faster than Facebook did.

The coronavirus outbreak has wiped billions in market capitalization from China’s digital giants. Those plugged into China’s physical economy, like Alibaba and Meituan, have been hit hard. Alibaba, for instance, shed $26 billion in market capitalization from Jan. 21 to Feb. 24.

Yet for social media and entertainment headline acts, like Tencent and Bilibili, the momentum’s gone the other way. Since the outbreak, Tencent’s added $18 billion in market capitalization, fueled by news of eye-popping gaming expenditure and overwhelmed servers (in Chinese).

Bytedance, as a strict digital economy player with little exposure to physical goods and services, is riding the same wave.

This flurry of activity has made a few players very, very uncomfortable.

Six of the company’s apps made it onto App Annie’s most downloaded in January. And, since the coronavirus outbreak, Bytedance has:

• Scooped up exclusive rights to stream holiday movies
• Revealed plans to make gaming a more prominent force in its entertainment empire
• Tested e-commerce integration with TikTok
• Promoted a popular coronavirus-themed game; and
• Extended from in-app search to a standalone search engine. 

Sources tell me this flurry of activity has made a few players very, very uncomfortable. In particular, the folks responsible for ad revenue at Baidu and Tencent are shitting kittens.

Here’s why.

First, the obvious. Bytedance is capturing eyeballs. Douyin’s latest daily active user figures suggest that a tick under half of China’s internet users open the app each day. And, as early as June last year, Bytedance’s news and boredom-busting entertainment properties commanded a total 1.5 billion monthly active users. That scale has Baidu eating Bytedance’s dust.

Second, something less obvious: Bytedance is nabbing chunks of the digital advertising pie under adverse conditions. China’s digital advertising industry is essentially a zero-sum game, where the top four players command 85% of the money pile.

While the pie’s slowly growing, economic headwinds are making brands look for efficiencies. The net effect is a slowdown in advertising revenue growth across the back end of last year, which bruised Baidu and Tencent.

As ad growth gets harder, Bytedance is one of the few digital advertisers that’s growing advertising revenue at scale and speed. It more than doubled its advertising revenue in the past year. That means price and result-conscious advertisers are reallocating their spend, taking dollars away from other platforms and handing them over to Bytedance.

Why are they doing that? This brings us to the least obvious but most important point—at present, Bytedance’s advertising platform is probably better than Baidu’s or Tencent’s.

Much about Bytedance’s recommendation algorithm is unknown. However, its ability to capture, parse, and stitch together data about news articles, short videos, and games users are interested in is incredibly valuable. This creates all sorts of targeting and retargeting potential for savvy advertisers. Industry chatter (in Chinese) and interviews with a handful of local companies suggest that advertisers believe Bytedance is more cost-effective than Baidu or Tencent.

As Bytedance itself has shown, there’s huge upside running advertising campaigns across its ecosystem. One of the company’s secrets in quickly making inroads into hyper-casual games is how it used Jinri Toutiao and Douyin to run hype-building ads and drive game downloads (in Chinese). Those are the kind of results advertisers are looking for as brands navigate China’s economic contraction.

All this is giving ad teams at Baidu and Tencent cold sweats. Economic contraction and coronavirus dislocated digital advertising growth, yet Bytedance is still hoovering up advertising dollars. If it wasn’t apparent before, it should be now: Bytedance is eating incumbents’ lunch.

If there were an equivalent of cult entrepreneurship guide “Lean Startup” for Chinese internet entrepreneurs, the CliffsNotes version would look something like this:

• Step 1: Get investment
• Step 2: Get users
• Step 3: ???
• Step 4: Profit!

Trouble is, having plentiful users doesn’t always translate into a clear path to profit.

Just ask Little Red Book. Rumors abound that the “social e-commerce” platform gutted its e-commerce division’s staff by as much as half last year. Or ask Quora-like Zhihu, or travel review platform Mafengwo. Together, these three have raised more than $1.8 billion from investors, according to Crunchbase. The return on investment? A combined 220 million active monthly users, and no profits.

Each of these apps is content-driven, but without a successful, scalable monetization model. That spells trouble when trying to convert users and venture capital into profit.

Content castles

Let’s start with each platform’s content and scale.

Little Red Book is a platform to share and read product reviews and lifestyle tips across a gaggle of product categories. Think a hybrid of Instagram, Pinterest, and Net-a-Porter. It cracked 85 million monthly active users in the first half of 2019, of which a high proportion are women from China’s first and second-tier cities.

Zhihu, China’s equivalent of Quora, features Q&A that ranges from the asinine to the profound. Third party sources estimate the app has 35 million monthly active users, reading and adding to the site’s 28 million questions and 130 million answers.

Mafengwo is a travel experience sharing platform, focused on long-form content. The company claims over 100 monthly million users, but it has previously been embroiled in scandals for funny business with its numbers. I’d take that monthly active user figure with some skepticism.

Castles without moats

The trouble with freely available written content is, it doesn’t lend itself to making platforms meaningful returns. For individuals, it might be a way to make a living. But for large businesses, platforms, or portals, freely available written content is typically a loss-leader that aggregates demand and drives sales across other areas of the business.

Consider Meituan’s review platform, Dianping. This Yelp equivalent is the Meituan ecosystem’s most frequently-used function, but generates chump change compared to Meituan’s food delivery and travel units.

For content platforms that aren’t part of the Alibaba, Tencent, Bytedance, or Meituan universes, the trick is building compelling products or services that can cross-subsidize the cost of building and nurturing a large-scale content platform. This is where Little Red Book, Zhihu, and Mafengwo have struggled.

Little Red Book has had a crack at almost everything to make bank. It’s gone into cross-border e-commerce, physical stores, influencer monetization, and in-platform advertising. None of these appear to have gone according to plan.

More alarmingly, monetization efforts through overt in-platform advertising may be driving away users. According to analysis of Quest Mobile data (Chinese), Little Red Book’s monthly active users have declined from 98 to 72 million between August and October 2019. That’s a stinging setback, and the company will need to show meaningful improvement before they can confidently go to investors again.

Zhihu has been down a number of monetization paths in its eight-year history, with similarly displeasing results. It has tried monetizing experts, adding paid content featurettes, and incorporating Q&A livestreams. However, this multi-pronged effort wasn’t enough to stop Zhihu letting go of around 20% of its workforce (Chinese) in late 2018.

The stakes are now even higher. In August 2019, Zhihu raised a $434 million Series F. That’s the largest fundraise in China’s online content and entertainment segment for the past two years, and takes the company’s valuation ($3.5 billion) beyond Quora ($2 billion) and Reddit ($3 billion). All three cornucopias of information are valuation-rich, but none have turned a profit.

Mafengwo’s monetization should have been relatively straightforward: connect passionate travelers who read the platform’s reviews with relevant travel packages and take a cut of the proceeds. This would require pinching share from Trip (formerly Ctrip), which made $549 million from package sales and commission in 2018. And it hasn’t happened: the company recently announced plans to lay off 40% of its staff. Sources inform me that, without a fresh capital injection, things look bleak.

Content + scale still not enough

The internet’s widespread adoption gave rise to a particularly awful cliché: “Content is King.” This cliché has inspired a number of companies that aggregate content, of which a fair chunk have received generous investment. In investing in content-based companies like Little Red Book, Zhihu and Mafengwo, investors like Tencent (which has bet the trifecta) make some justifiable assumptions:

1. High-quality written content attracts audiences
2. High-quality written content across multiple themes or categories gives access to multiple high-value audience segments

But also some iffy ones:

3. Advertisers will pay to access these audience segments
4. Content platforms can provide advertising solutions which are attractive enough to advertisers to redirect spend from news websites and social media
5. Audiences won’t leave as the platform attracts more advertisers and incorporates more advertising formats

You’ve probably spotted that why the third, fourth and fifth assumptions represent some very big “ifs.” Zhihu, Reddit, and Quora—each independent of the digital advertising magnets that are the digital giants—have found out how difficult it is to nab advertising spend.

If I’m honest, I don’t think very much of these companies’ ability to build sustainable businesses and their future prospects as independent entities. However, I commend Little Red Book, Zhihu, and Mafengwo for exploring non-advertising revenue streams. They have recognized the limits of advertising revenue and have been nimble enough to try different commercialization models. Facing uncertain futures and a poor monetization track record, they’ll need to continue iterating while being paragons of frugality.

Eventually, however, we may have to accept that China’s written content platforms need deep-pocketed patrons—whether investors or integration with one of China’s internet giants—to eke out a continued existence.

The latest funding round of each company suggests where things might go: Alibaba’s sizing up Little Red Book as a content extension for Taobao, Kuaishou and Baidu are looking to wrestle over Zhihu’s question-based foothold in search, and Tencent is adding to its small tourism portfolio.

User retention and inroads into commercialization will decide each company’s fate.

Dear TikTok PR,

TikTok is in a unique and delicate position.

On the one hand, you’ve got a breakout hit. Sensor Tower reports that, outside games, TikTok is the most downloaded app of the year and the only app in the top five that isn’t owned by Facebook. This, alongside the success of Douyin, TikTok’s predecessor in mainland China, is cause for congratulations.

On the other hand, your success has brought scrutiny, especially in the US. I suspect you’ve been busy since Reuters reported on an ongoing national security investigation into Bytedance’s 2017 acquisition of Musical.ly. This review, undertaken by the Committee on Foreign Investment in the United States (CFIUS) could, at worst, compel you to reverse the merger that brought TikTok to the US.

But, even before CFIUS got involved, you routinely found yourself caught in blunders and backflips.

First, leaked documents showed TikTok created guidelines to remove content that could offend the Chinese government. You said those guidelines had been superseded, but former employees promptly contradicted these claims.

Then, you massaged over changes to TikTok’s org structure. I can only presume changes to Alex Zhu (Head of TikTok)’s reporting line were intended to create distance between TikTok and Douyin. However, the change (whereby Alex reports to Bytedance CEO Zhang Yiming) make it look like Alex literally and figuratively takes orders from Beijing. Speaking of, a few days ago you thought it would be wise for Alex to cancel meetings with US lawmakers critical of TikTok. It’s still early days, but I anticipate you’ll take some heat for that.

All this all while TikTok backflipped on blocking a US teenager sharing her views on internment of Muslims in Xinjiang and was caught with its pants down again choking traffic to content creators with disabilities, plump body shapes and pro-LQBTIQ views.

So here’s a heads up: there are three reasons why your PR quagmire will get worse in the coming year.

First, you haven’t developed a coherent narrative to assuage fears around Chinese ownership.

Jingoistic politicians aren’t your fault, but you’ll have to go all-out to add substance to your claims that TikTok’s management, operations, apps, markets, users, content, teams, and policies are separated from Chinese government interference.

That’ll be made difficult by your connections to the Chinese Communist Party. These connections spur Bytedance to censor sensitive videos, collaborate with party-related organizations, promote videos praising China’s armed forces and de-tag videos which contain particular political figures.

There’s also the question of TikTok’s workforce. Someone will presumably go on LinkedIn and work out that around one in ten TikTok employees listed are based in China, as of Dec. 18. From the same data set, they’ll also notice that there are very few folks in the US responsible for product, and even fewer responsible for content moderation. These optics are, in a word, bad.

Second, TikTok’s previous content-related SNAFUs will prompt rigorous inspection of its Community Guidelines. These are far, far shorter than what Facebook has developed, and that company is still a long way off getting out of PR purgatory. I know you’ve hired lawyers and former congressmen to pad them out, but I’m not convinced how far “Bear with us, we’re working on it” will go with American officials.

During this process, I anticipate you will be asked to detail how Bytedance and TikTok use human moderators and machine learning to identify, classify, demote and remove offensive content. You might not feel the need to do this, but there are folks out there who are already putting the pieces together. You should take the initiative and show how you deploy human and machine-assisted moderation to block nudity, combat ISIS propaganda and report potential sexual predators.

It’s at this point that, someone, somewhere, will look closely at the nexus between TikTok and Douyin.

You see, it’s no secret that it was only very recently TikTok divorced itself from Douyin’s product team.

It’s also no secret that Douyin’s CEO pledged to use the platform “curate” content around positive values (Chinese), which weren’t named or articulated. The existence of similar editorial or curatorial policies in your overseas markets may be all that’s needed to convince investigators that TikTok could be a vehicle for foreign influence.

There you have it. A full suite of reasons why you’ll be pushing the proverbial uphill in the coming year.

Getting on top of each of these areas may very well be critical for your continued operations in America. CFIUS hasn’t looked too kindly on Chinese tech companies in the recent past, and it appears to be responsive to anti-China sentiment in Congress. For instance, it made a Chinese acquirer sell Grindr, blocked the sale of MoneyGram to Ant Financial, and also prohibited the sale of a US semiconductor firm to a Chinese government-backed investment firm back in 2017.

You’re at real risk of losing the PR battle, which could mean orders to divest Musical.ly and potentially exit your most lucrative overseas market.

You’ll have your work cut out. Good luck.

Michael Norris is a TechNode contributor and Research and Strategy lead at AgencyChina. He owns stock in Meituan, mentioned in this article.

A version of this article originally appeared in the Dispatch, Michael’s monthly newsletter, on November 12.

Alibaba’s 2019 Investor Day came and went without any of the fanfare that marked Alibaba’s 20th-anniversary celebrations in September.

In fact, the company’s Investor Day was so low key that it hardly made a dent in the company’s share price, which was up 3% a week after the relevant announcements.

This year’s Investor Day, hosted by CEO Daniel Zhang and CFO Maggie Wu, consisted of 13 presentations covering marketplaces, logistics, retail, cloud, and financial services.

Taken together, the presentations showcased Alibaba’s tightening grip over consumers’ wallets. All indicators show Alibaba is the dominant e-commerce and payments player, and the operative question is what supports or hinders it converting that leadership into O2O dominance.

First, a few topline numbers.

Alibaba’s marketplaces now report 693 million annual active consumers. If that number’s accurate, it means that around 80% of China’s internet users are active on one or more of these platforms.

Around 20% (~140 million) of annual active consumers in Alibaba’s retail marketplaces spend more than RMB 10,000 ($1,400) per year. That’s 1.5 times the average monthly salary in China.

This user base, plus strong growth in other business units, means big bucks.

Alibaba has increased its revenue seven-fold over the last five years, which beats out digital peers in both the United States and China (see figure below).

And, even when you strip out proceeds from businesses acquired or consolidated in the last year, that momentum has continued over the last twelve months.

Here’s what I took away from Alibaba’s Investor Day.

None of the below should be construed as investment advice. Repeat, this is not investment advice. Do your homework before you invest in anything. There, I’ve made it clear.

1. Alibaba’s retail marketplaces still have room to add users.
2. Alibaba has still got a way to go to connect marketplace shoppers to other services in its ecosystem.
3. Meituan’s not out of the woods yet, but its position looks strong versus Ali’s Ele.me.

Let’s rip into it.

Growth in the tank

China has around 850 million internet users, but not all of them have tried online shopping, according to the China Internet Network Information Center. In its August report, the center counted about three-quarters of mobile internet users as e-commerce users, and a little under half as on-demand food delivery users.

The folks at QuestMobile reckon that there’s a good spread of these potential e-commerce users across different city tiers—about 74 million in first- and second-tier cities, and 128 million in tiers three and below.

To put that into perspective, JD (China’s third-largest e-commerce player) has approximately 320 million active customers.

Additionally, my colleagues and I at AgencyChina have used demographic modeling to estimate that an additional 170 million Chinese internet users will come online in the next five years.

Added together, that means there’s potentially somewhere between 360 and 380 million online shoppers who are either on the cusp of shopping online or will be in the very near future. Although it’s got a fight ahead of it for these consumers’ minds and wallets, Alibaba’s core commerce growth still has plenty of runway left.

Connecting the ecosystem?

Alibaba’s ability to connect marketplace shoppers to other services in its ecosystem is a glass half-full or a glass half-empty proposition, depending on your perspective.

According to the reports, 25% of Alibaba’s annual active consumers are active on its on-demand food delivery platform Ele.me and lifestyle discovery service Koubei. A little less than half that proportion (12%) are paying subscribers to Youku, Ali’s digital media and entertainment platform.

At this point, if you’re the glass half-full type, you’d be pretty satisfied with that current level of penetration and optimistic that Alibaba will strengthen synergies across its ecosystem over time.

However, if you’re a little more pessimistic—like me—you’re looking at those figures and thinking that something’s not quite right. Two possible explanations come to mind:

• Propositions outside Alibaba’s core commerce marketplaces and financial services platform aren’t quite strong enough to attract and retain core commerce customers; and/or
• Integration between propositions isn’t strong enough

Consumer cross-over across the Alibaba ecosystem is something to keep an eye on going forward.

Local consumer struggles

Alibaba’s local services business unit encompasses on-demand food delivery platform Ele.me and lifestyle discovery directory Koubei, which merged last year.

Alibaba’s Investor Day presentation and subsequent quarterly earnings didn’t offer too much detail on how its local services business is doing, outside what it’s legally required to disclose.

From this, we can at least glean that Ele.me’s reported 245 million annual transacting users are significantly fewer than Meituan’s 423 million.

However, each player’s respective year-on-year transaction growth is roughly on par (Ali claims ~40% and Meituan claims ~30%).

That means Ele.me, even with its Koubei tie-up, is a firm second in the on-demand food and services sector.

That’s good news for Meituan’s share price, which has doubled since January this year. That signals the market is increasingly convinced about Meituan’s grip on the food delivery market and its ability to leverage its services marketplace to generate profit.

At the same time, the market is keen to know what Ali’s secondary listing in Hong Kong means for the services scrimmage.

Meituan’s stock is down 7% since news broke that Alibaba is eyeing up a late November listing to the tune of $15 billion. Presumably, some of these funds may be used to fuel a further “subsidy war” to pinch consumers and merchants from Meituan.

Alibaba shares surge 7% in Hong Kong IPO

To me, it underscores that for all the mess fast-flowing capital and loose valuations have caused, markets acknowledge that access to capital remains a key disruptive force.

As goes Ali…

Investors and markets have long seen Alibaba as a bellwether for China’s economy-at-large. However, Alibaba’s Investor Day presentation and subsequent quarterly earnings show that mental shortcut must be rejected. In fact, Alibaba’s marketplaces substantially outperform the “real economy.” China retail sales have grown only 8.2% year to date, and online sales 17%—while Ali’s (not entirely comparable) year-on-year core commerce revenue growth is a whopping 40%. Try chewing on that and see how the market looks.

I am relatively fortunate to have built up a patchwork quilt of connections through my work, writing, and friendship circle. While I’m not holding myself up as someone who sips tea with Jack Ma on Tuesdays, I do have occasional access to a handful of ‘movers-and-shakers’ within China’s tech scene including project managers, operations specialists, and department heads. We do our best to squeeze in coffees as our schedules permit.

The nature of these conversations has changed over the last year. We now gravitate toward difficulties in sustaining growth and making money. As you may have noticed, the eye-popping user growth and tech valuations which dominated headlines before have gradually receded.

The engines that drove spectacular growth in China’s mobile internet – substantial numbers of users coming online for the first time, sharp increases to time-spent-on-devices and an abundance of cash for companies to build products and fight for more users – have shifted down a gear. As a result, China’s digital players now face challenges relarted to user retention and undercooked business models.

Blinkered Vision

When discussing these challenges, I often ask what solutions the company is considering, and where it’s looking for inspiration.

They look for inspiration almost exclusively in the Chinese market.

This, in and of itself, doesn’t surprise me too much. I often ask my own clients about their competitor set, and answers disproportionately skew toward immediate competitors in the same category. Few clients voluntarily offer up potential competitors in adjacent verticals, or seemingly unrelated companies who are re-defining consumer expectations across delivery, after-sales service, and loyalty.

Blinkered views are routine.

However, the rationale behind the all-Chinese competitor set is concerning. In contrast to the domain ignorance that I encounter from time to time (you don’t know what you don’t consider), there’s a selective almost arrogant ignorance at play:

“China’s internet ecosystem is too different.”

“There’s no one overseas that’s doing what we’re doing.”

“I’m not sure the US companies in the same vertical are on the same level as us; looking at how they monetize would be counterproductive.”

It’s this attitude that I’ve come to term as ‘Chinese Tech Exceptionalism.’

Exceptionalism, the belief that countries, movements, groups, or individuals are special or unique, isn’t exactly new.

For instance, it is broadly understood that forms of exceptionalism influence both American and Chinese foreign policies.

Exceptionalism

In recent times, the term ‘Tech Exceptionalism’ has also emerged. It refers to the belief among Silicon Valley firms that they are instrumental to innovation and new value creation. This belief system has led some firms to skirt regulation, flout user privacy, and bend debt and equity financing to fund and expand their ventures.

In a similar vein, Chinese Tech Exceptionalism purports that China’s tech ecosystem enjoys a scale, speed and regulatory environment so unique, that its digital actors:

• Are naturally superior to overseas equivalents, in terms of product innovation or business models;
• Are destined to be dominant when pitted against overseas competitors; or
• Don’t have the same constraints as overseas equivalents

You may have previously seen examples of China Tech Exceptionalism. Breathless calls for overseas firms to give up the ghost and ‘Copy from China,’ claims that China’s tech startups possess unique advantages and stronger work ethic or proclamations that China’s innovation hotspots are primed to dominate the race for talent and funds.

Without getting all academic about it, Chinese Tech Exceptionalism has parallels and origins in the ‘China Model’ – an interpretation of China’s economic growth that ascribes rapid development and poverty reduction to a unique set of political and economic characteristics. Proponents of the ‘China Model’ contend China’s growth trajectory is sufficient evidence for a new form of development, one that delivers consistent improvements to living standards without increased political plurality.

Uniqueness

Exceptionalism elevates (relatively) unique characteristics to some form of inherent superiority. Admittedly, the rapid rise of China’s digital economy is spectacular. It is worth the business community’s attention, study and occasional jaw-drop.

However, as China’s mobile internet enters a period of rising customer acquisition costs and less white space, incumbents and challengers shouldn’t blinker themselves. There’s plenty of room to learn across geographies. That’s because of how connectivity alters supply, demand, and market dynamics tends to be relatively similar.

Indeed, it’s plausible to say that how digital affects various economic levers is jurisdiction or economy-agnostic. McKinsey’s framework below captures this well. While differences exist in strategic landscape and consumer habits, supply, demand, acquisition, revenue, and cost models offer sufficient comparative scope.

Accordingly, it’s equally imprudent for Chinese firms to write off comparative analysis of overseas counterparts and overseas firms to write off Chinese counterparts, on the basis that China’s ecosystem is “too different” or “too unique.”

As I (sometimes successfully, sometimes unsuccessfully) put forward to my acquaintances at China’s tech companies, “different” doesn’t mean “unique” and “unique” doesn’t necessarily imply uniqueness all the way through.

As Luckin Coffee gets its start on the NASDAQ, there’s a conspicuous absence in its corporate filings and press conferences. Yang Fei, Luckin’s CMO and one of the key architects of Luckin’s hyper-growth, is missing in action.

IPO pinch hitter

In March, a month before Luckin Coffee filed for its IPO, I wrote a three-part series on the company. I explained how Luckin was built with money from a network with arguably a few too many personal interests at stake and sketched out the rationale behind questionable freebies and discounts.

One of those articles profiled Luckin CMO Yang Fei. Yang is an unlikely star: in five years, he’s gone from prison to C-suite. Between 2013 and 2015, Yang was arrested, remanded, and sentenced to 18 months’ imprisonment (Chinese link) for violations of China’s advertising law. After his release, he served as the CMO of UCAR, a ride-hailing firm. There, Yang claims to have invented a set of growth hacking techniques which took UCAR from incubation to a $5.5 billion IPO on China’s NASDAQ equivalent in less than 18 months. Luckin CEO Qian Zhiya was previously UCAR’s COO.

Qian and Yang repeated their IPO pinch-hitting with Luckin, which debuted on the NASDAQ a little more than 18 months after being founded. Its shares opened at $25, an almost 50% jump from its IPO price of $17. At the time of writing, Luckin’s share price sits above its IPO price.

An end to the dynamic duo?

On the back of its warm stock market reception, Qian announced plans for Luckin to open 10,000 stores by the end of 2021. That’s four times the 2,370 store locations across 20 Chinese cities it operates as of March 2019. At 10,000, Luckin’s footprint would be far larger than Starbucks, China’s current leading coffee franchise. Seattle-based Starbucks had 3,700 stores in February 2019 and is aiming for 6,000 by 2022.

Qian’s announcement made a break from Luckin’s previous practice, in which significant announcements featured both Qian and Yang Fei.

There’s a mounting body of evidence that the dynamic duo may have broken up: Yang hasn’t made a public appearance as CMO since January. Luckin’s IPO filing documents don’t mention his name or title. And, according to the same documents, he doesn’t have any equity in the company. He’s even absent from Luckin’s Investor Relations website, and they contain no reference to an alternative CMO.

This is all a little strange, given Yang’s previous status as named co-founder, architect behind Luckin’s growth model and the guy who proclaimed that Luckin will keep subsidies in place for the next three to five years.

We’ve asked Luckin Coffee for formal comment, but they’ve declined to speak to us about Yang Fei’s current association with the company and future.

Fall guy

Chinese sources have speculated (Chinese link) that Yang stepped down because of reports about his chequered past. In the lead up to IPO, Chinese media examined his advertising law conviction—something I was first to mention in English in my own column for TechNode. In March, Reuters reported that Luckin Chair Lu Zhengyao sought out blue-chip banks for a loan of $200 million in exchange for a mandate on Luckin’s IPO. Personal financing in exchange for an IPO mandate is rare, and one firm apparently declined to participate in the IPO on this basis.

Perhaps it makes sense for Yang to have stepped down for reputation reasons: his previous misdemeanours may have further complicated the IPO. But, if Yang Fei has departed, then what does it mean for Luckin?

The answer turns on Yang’s current relationship with the company. Even though Yang’s out of the spotlight, I’m not inclined to think he’s out of the picture entirely. Photos of the Luckin’s NASDAQ debut show Yang was present in New York when the company’s stock listed in May. His presence in New York and his absence from any investor-facing documents or organizational charts suggests that Yang’s departure was indeed a PR play.

Indeed, Chinese sources have speculated (Chinese link) that the former CMO is now serving Luckin through an advertising agency he established. If that’s true, then it’s likely business as usual for Luckin and its growth model—aggressive spending on physical locations, operations, promotions, and loyalty programs.

It also means that investors need to keep a careful eye on Luckin’s advertising spend—without the competitive pressure of other firms, Yang’s advertising agency could be taking some cream off the top.

However, if Yang’s completely removed himself from the company, then Luckin’s management team will need to make a call on whether they stick to Yang’s brand of growth. As Luckin gears up to increase its footprint fourfold, unchecked freebies and discounts may weight too heavily on the balance sheet.

With Luckin tight-lipped on Yang’s current role, it might be a slow drip until we have a clear answer on what the future holds for Yang and Luckin’s growth model.

It’s rumored (Chinese link) that at a dinner attended by Ant Financial and Hello TransTech (formerly Hellobike) bigwigs, Ant Financial CEO Jing Xiandong cracked open a bottle of Guizhou Maotai, an upmarket brand of Chinese rice wine, Jack Ma had previously gifted him, worth over a million RMB.

What prompted the celebration?

The short answer is, by taking the wheel of Hello TransTech’s Series D and every subsequent funding round after that, Jack Ma-controlled Ant Financial secured a critical component of Alibaba’s mobility ecosystem designs.

Ali’s mobility gap 

Since Ant Financial’s involvement in Hello’s Series D, Hello has raised RMB 7.8 billion (about $1.1 billion) from investors. That’s a truckload of cash, even for China’s shoot-from-the-hip VC scene. To understand Ant Financial’s investment in Hello and what that means for Alibaba, we need to wrap our heads around two things: (1) why on-demand mobility matters for Alibaba; and (2) what pieces Alibaba had in its mobility ecosystem before Ant Financial pounced on Hello.

On-demand mobility was the missing link in Alibaba’s local services and entertainment ecosystem. Alibaba’s restaurant review, venue booking, ticket purchase, and hotel reservation services are all linked to a common theme: going out and having a good time. This requires adjacent services to transport users from home to venue, between venues, and back home again. As such, on-demand mobility closes the loop between the existing services in Alibaba’s ecosystem.

In Alibaba’s ideal world, users look at where they want to go using the restaurant review tool Koubei, find where they need to go using AutoNavi (a mapping service, not too dissimilar to Google Maps), pay for their meal using Alipay, and head home by plugging into an Alibaba-invested or operated on-demand mobility solution. It’s all about keeping the user in the the mesh of apps, services, and affiliates that make up Alibaba’s ecosystem.

Let’s now have a look at what Alibaba’s on-demand mobility ecosystem had under the hood prior to Hello’s Series D funding round in December 2017, led by Ant Financial.

First, there was Alibaba’s mapping service, AutoNavi. AutoNavi is the “quiet achiever” in Alibaba’s ecosystem. It has over 100 million daily active users, which makes it the most used app in Alibaba’s ecosystem outside Alipay and Taobao (Chinese link). That also makes it the most used navigation service in China (Chinese link), ahead of Baidu maps. In April 2018, AutoNavi rolled out (Chinese link) a ridehailing aggregation service. Users input where they want to go, and can cycle through different providers like Didi, UCAR, Shouqi Limousine & Chauffeur, and Caocao Chuxing, comparing prices and wait times. That move brought AutoNavi closer towards Alibaba’s sweet-spot of asset-light marketplaces, and one step closer to a “mobility super-app” that offers users everything they need to get from A to B.

Second, prior to Hello, Alibaba had a smattering of on-demand mobility investments. Alibaba received a minority share of Didi when Alibaba-backed Kuaidi Dache and Tencent-backed Didi Dache merged in 2015. Despite Alibaba’s further 400 million co-investment in Didi with Ant Financial, Chinese sources claim it doesn’t have a much of a voice in Didi’s boardroom (Chinese link). Alibaba also acquired around 10% of Didi competitor UCAR in 2016. Outside ridehailing, Alibaba had also participated in ofo’s $700 million Series E financing, relieving capital pressure on ofo after hopes of a tie-up with Mobike were dashed.

Bikes and beyond

Enter Ant Financial’s investment in Hello. In my previous article, I laid out why Hello looks a little better off than sharebike rivals ofo and Mobike.

But Hello has used Ant Financial’s capital injection to rebrand and expand beyond bikesharing. At the start of the year, it rolled out a carpooling service. That’s the same service Didi was forced out of after the murder of two Didi female passengers and a male Didi driver last year led to suspension of its carpooling service and a “Delete Didi” campaign.

In February, Hello claimed the new service was performing well, with users across 300 cities logging 7 million rides in the first month of operation. That’s a good sign, because setting up the carpooling service didn’t come cheap. Hello has earmarked RMB 500 million to roll out the service, with incentives for drivers and passengers. If Hello’s carpooling service takes off, the payoff could be significant—Didi’s carpooling service facilitated over a billion trips in the space of three years.

Bizarrely, Hello has yet to make the move that’ll really make it an on-demand mobility contender: integration with AutoNavi. At the time of writing, none of Hello’s services are displayed in AutoNavi’s app, instead relying on traffic from its own app and a mini-program in Alipay. It’s still not clear why this integration hasn’t happened more than a year after Hello joined the Aliverse. This state of affairs is far from ideal, especially when you consider that AutoNavi is the country’s leading navigation service.

In fact, getting Hello’s sharebikes and carpooling service on AutoNavi may be critical for Hello’s future fundraising aspirations. It hopes to raise between $500 million to $1 billion in its next funding round. As part of their due diligence, would-be investors will likely examine app traction and integration with third-party navigation apps before committing funds in a relatively capital-constrained environment.

With Hello, the Alibaba ecosystem gains two forms of on-demand mobility: sharebikes and carpooling. Although this is not the whole on-demand mobility pie, Hello will need to pick its fights carefully if it’s to avoid the scrapheap. With Didi’s carpooling service clouded by regulatory uncertainty, expect Hello to push as hard and fast as it can into that area. But it isn’t on course for a head-on collision with Didi over ridehailing just yet.

First there was Alibaba, which boasted an IPO bigger than Google, Facebook and Twitter combined. Then there was Ant Financial, spun off from Alibaba, which has raised almost as much cash as all US and European fintech firms combined. Now there’s Hello Transtech (formerly Hellobike), which may be valued at $4 billion if a rumored fundraising round (in Chinese) is successful. It’s the other, other unicorn in Alibaba’s sprawling business empire.

In a two-part series, I’ll lay out how Hello is bidding for profits amid the bikesharing meltdown—and its importance in Alibaba’s battle for mobility.

Pedal power

Hello TransTech started out as Hellobike in 2016. Launched two years after Mobike and ofo started operations, Hello was the first bike-sharing operator to build up its business in China’s smaller cities.

That turned out to be a smart play. TrustData estimates about 72% of China’s bike-sharing users are in China’s second- and lower-tier cities. GGV Capital Managing Partner Fu Jixin also reckons that frequency of use in lower-tier cities is higher, with each bike averaging more than four or five rides per day. (GGV Capital was an early investor in Hello.) That compares to an average of three or less rides per bike in first-tier cities.

These data points, plus a less-crowded competitive bikesharing landscape in lower-tier cities, gave Ant Financial confidence to drop $321 million in Hello in June 2018, minting a new unicorn. All up, Ant Financial has now participated in four of Hello’s seven funding rounds, which have raised a combined total of $1.8 billion.

Solid fundamentals

Bikesharing has earned a bad reputation among investors. A wasteful sharebike investment frenzy sucked up $4 billion of Chinese venture capital in 2017, ending in tears as industry darlings filed for bankruptcy or became albatrosses on the necks of their corporate parents.

In contrast, Hello looks different—in fact, it’s already talking about profit. In late 2018, Hello Co-Founder and CEO Yang Lei announced that the company is profitable in around a third of 300 cities it operates in. Although that doesn’t necessarily answer concerns about bikesharing’s ongoing sustainability or profitability, it’s a far better strike rate than rumored numbers for rivals Mobike or ofo.

So, what’s behind this?

One advantage is a smaller fleet. Although there’s no precise figure, analysts estimate (in Chinese) that Hello operates between five and seven (in Chinese) million bikes, a fleet less than a third the size of larger rivals Meituan and ofo at their peak. The company’s modest, yet growing fleet is less of a burden on the balance sheet, with less bikes to produce, distribute and repair. However, without strict controls, capital and operational expenditure could get out of hand.

Another is volume of trips. Last year, Hello TransTech’s 161 million registered users clocked up around 20 million rides a day. This, Chinese analysts reckon (in Chinese), is more than the combined trip volume of Mobike and ofo.

To those familiar with China’s bikesharing scene, one number stands out: Hello’s users. According to Trustdata, Hello’s standalone app had about 3.7 million active users in May 2018—far less than Mobike’s 9.3 millio or ofo’s 11.3 million. However, Hello claims (in Chinese) its total registered user base has cracked 200 million. If those numbers are accurate, it means almost all of Hello’s users come from Hello’s mini-program in Alipay, not the Hello app. Any of Alipay’s 650 million monthly active users can walk up to a sharebike, scan and ride—without having to download a standalone app or pay a deposit. Alipay, of course, is owned by Ant Financial—Hello’s largest shareholder. Talk about having an investor that’s got your back!

Fewer skidmarks

Hello’s lower-tier strategy, smaller fleet and powerful backer make it a safer bet than the ridesharing upstarts that have come before it. Critically, it seems to have sidestepped the key missteps that crippled its rivals—oversupply of bikes and banking on user deposits to finance operations. In my next article, I’ll discuss what Hello is doing in ride hailing, as well as its broader role in Alibaba’s drive to snap up China’s on-demand mobility sector.

Correction: A previous version of this article described Ant Financial as “spun off from but still owned by Alibaba.” In fact, Alibaba does not own a stake in Ant Financial. A deal under which Alibaba would take a 33% share of Ant, announced in 2018, has not yet closed.

I’ve spent a lot of the last month trying to understand Luckin Coffee. I’ve untangled how the convenience-focused upstart was built with money from a network with arguably a few too many personal interests at stake and explained the rationale behind questionable freebies and discounts.

I’ve been asked whether Luckin could ever make a profit and become a sustainable business. It’s an interesting dinner party question, but I think Luckin’s story is more than an individual company’s boom and potential bust—it represents a wave of aggressive startups bringing the online world’s “go big or go home” approach to physical assets.

In this article, the third and final of a three-part Luckin series, I’ll explain the bigger issues that will stick with us whether or not the company ever breaks even.

Expiry date?

Let’s assume Luckin makes it to IPO. Even if it grows out its store network to be bigger than Starbucks, staves off growing cash flow pressures and successfully IPOs, it’ll have to beat the odds if it’s to stick around. Publicly-listed companies tend not to last very long. The average lifespan of a publicly-listed company is around 10 years. Even when just accounting for those companies in the S&P 500—the crème-de-la-crème of listed companies—the average lifespan is 20 years. The boffins at the Santa Fe Institute worked out that this ‘corporate mortality rate’ applies irrespective of what a listed company does, or its performance before IPO—an aerospace company, microprocessor manufacturer and on-demand media services provider have the same average lifespan.

But what Luckin represents is far more interesting than its balance sheet. Luckin is just the latest in a growing gaggle of companies striving to achieve software-like scale across physical assets, fueled by truckloads of venture capital. Uber, a mobility services platform, has 3 million drivers over 600 cities. OYO, an Indian budget hotel chain valued at $5 billion, has grown to 330,000 rooms across 500 cities in five years and plans to be twice as big as the world’s current largest hotel chain by 2023. Mobike, one of China’s last standing sharebike companies, has 8 million bikes deployed around China.

This drive for software-like scale over physical assets is driven by the growing acceptance and prevalence of “blitzscaling.” That’s Silicon Valley code for the science, art or witchcraft (take your pick) of rapidly building a company to capture large markets—usually relying on years of losses underwritten by investors. Originally developed by Reid Hoffman and Chris Yeh, blitzscaling suggests that, under a certain set of conditions, the payoff for this “going big or go home” approach is enough to justify the risk of an Ofo-like financial meltdown.

But there’s a few question marks around the practice. Some doubt whether blitzscaling can work outside of software. Others reckon it’s a market abomination which uses scale to drive up valuations just long enough to let a few people make rich exits at the expense of investors and sustainable traditional businesses.

Funny business

Whether you buy into it or not, “blitzscaling” is gaining traction. It’s a course at Stanford which has hundreds of thousands of viewers online. And, as the practice becomes more widespread, it throws up a few interesting questions.

First, there’s the limits. In Hoffman and Yeh’s original formulation, they believed it would only work in winner-take-all or winner-take-most markets. The pair also believed that wannabe blitzscalers need to operate in large markets, have massive or zero-marginal cost distribution, enjoy high gross margins and take advantage of network effects—not all of which make sense for physical goods or assets. It’s a stiff set of criteria, which arguably neither Uber, OYO, Mobike nor Luckin meet. Yet investors have seemingly put their faith in these companies defying gravity and breaking these boundaries.

This faith has allowed blitzscaling to change capital markets. More and more fast-growing startups are headed to IPO while hemorrhaging money. Last year, 83 per cent of firms that went public hadn’t turned a profit. That’s more than the dot-com bubble. And, as the Wall Street Journal analysis notes, the IPO market has seemingly never been so forgiving for fast-growing, loss-making companies. Last year, loss-leaders that listed on US stock exchanges gained an average of 4 percentage points more than profitable companies that listed. That’s more than forgiving; it’s egging them on.

While it’s not unheard of for capital markets to favor growth over profit, there are legitimate questions as to whether blitzscaling promotes companies being used as speculative financial instruments. There are a growing number of critics who reckon VC money results in enrichment of a few folks at the expense of the chumps left holding the corporate equivalent of a polished turd. That’s because the investors who provide capital injections and a healthy dose of hype to take startups from zero to exit get to cash their chips at IPO.

Third, incumbents and small enterprises not blessed with access to seemingly bottomless venture capital need to grapple with new competitive dynamics. If you’re Holiday Inn, what do you do when OYO gets another billion dollars from Softbank to throw at expansion in your key markets? Stick it out and hope the venture capital-backed minotaur implodes? Partner up with traditional competitors against the challenger? Quickly pivot away from core business? Faced with Luckin’s challenge, Starbucks has embraced delivery and doubled-down on e-commerce. Maybe that’s much-needed innovation. But there will be cases were matching blitzscalers to stay competitive might go astray—leading to unneeded capital outlays, blinding incumbents to potential pivots, or mimicking competitors’ moves into a black hole.

As blitzscaling expands from software and digital platforms like Amazon and PayPal to physical assets like hotels, co-working spaces and convenience stores, more industries and companies will have to confront these questions. And, in my humble estimation, these questions are far more interesting than whether Luckin is going to make bank.

Luckin Coffee, China’s convenience-focused Starbucks rival, is reportedly preparing for a US IPO with a valuation of around $3 billion. A key part of Luckin’s IPO narrative is that it’s a legitimate challenger to the java giant. At the end of last year, Luckin announced plans to overtake Starbucks in both number of physical stores and coffees sold in China.

Luckin CMO Yang Fei reckons the company has what it takes to get there. He’s got confidence that freebies and discounts can be used to attract and build a stable core of loyal users. In this article we’ll take a deep dive into the theory that has made him a cult figure among Chinese startups.

Yang Fei is an unlikely star: in five years, he’s gone from prison to C-suite. In 2015, Yang was sentenced to 18 months’ imprisonment (Chinese link) for violations of China’s advertising law. Without going into excruciating detail, Yang supervised a systematic whitewash of negative reviews about his firm’s clients when he was head of a local marketing outfit.

Due to time served on remand between arrest and sentencing, Yang was released in April 2015. However, citing media reports, local sources (Chinese link) estimate Yang was announced as UCAR’s CMO in March 2015, the month before his release. That means the entire recruitment process took place while Yang was in remand.

Growth guru

How this exactly transpired is deeply unclear. Not much is known about Yang’s arrest, remand and subsequent sentence and release between October 2013 and April 2015. Even less is known about his appointment as UCAR’s CMO.

What is clear, however, is that within two years of his release, Yang literally turned his life around. His achievements as CMO of UCAR netted him “CMO of the Year” in 2017, a spot on the governing council of China’s peak advertising industry body and consulting gigs with state-owned rice wine producer Wuliangye and food-processing giant COFCO.

Yang’s miraculous success was built on a series of growth hacking principles and techniques called “fission marketing,” which he subsequently compiled and published as a book (Chinese link). Yang claims to have used this set of growth hacking techniques to help take UCAR’s ride-hailing service from incubation to $5.5 billion IPO on China’s NASDAQ-equivalent in less than 18 months.

Yang has the numbers to back it up (Chinese link). In his first year as CMO, UCAR’s paying ridesharing users increased fivefold. Over the same period, he took users’ average fare to four times that of competing ride-hailing services. Excluding promotional offers, UCAR’s ride-hailing service was close to profitable at a time when Didi and Uber were burning stacks of cash.

This achievement earned Yang a cult-like following within China’s startup community community—the same kind of status Dropbox’s Sean Ellis or Andreessen Horowitz’s Andrew Chen enjoy in the US. But in 2019, Yang Fei’s growth challenge is monumental. By the end of this year, he’s been tasked with getting Luckin to sell as many coffees as Starbucks (Chinese link). This is perhaps going to be the biggest test of Yang’s much-vaunted growth hacking system.

Luckin Coffee’s push to sell as many coffees as Starbucks this year involves aggressive spending on physical locations, operations, promotions and loyalty programs. Some might think this is pissing money away, ride-hailing and sharebike style. I can’t rule that out. But, before passing judgement, it’s worth looking at where and how that money is spent.

Whether it’s ride-sharing or coffee, Yang Fei’s brand of growth relies on freebies to get the product in the hands of as many potential users as possible, using special offers to repurchase and refer new users, and then a strong loyalty program for loyal customers with above-average purchase frequency. In other words, make it easy to try, easy to try again, and work on the number of those that make it a consumption habit.

Java sales funnel

What makes most observers cringe is Luckin’s never-ending stream of freebies and special offers. Yang doesn’t harbor such concerns. In his first year as UCAR’s CMO, Yang carved out 6 million paying users from 21 million who took advantage of a “top up RMB 100, get RMB 100 cash-back” offer. RMB 100 is just under $15.

Sources close to Yang have told me he’s well-aware freebies can play on human irrationality, sparking increased demand and prompting consumers to impute imaginary benefits to free products.

Some quick-back-of-the-envelope calculations make probable that free coffee works out closer than acquiring a new customer through other forms of advertising. Food industry analyst Zhu Danpeng reckons (Chinese link) that, even with physical stores added in, Luckin’s cost of customer acquisition is about RMB 80. This compares favorably with online-to-offline delivery services, which may have a cost per customer acquisition between RMB 200 and RMB 300.

In December 2018, Luckin CEO Qian Zhiya claimed (Chinese link) that Luckin’s accumulated around 13 million paying customers. This gives CMO Yang Fei an interesting AARRR funnel to work on—twice as large as his paying user base back at UCAR. Yang’s not worried about throwing money at that funnel—he estimates Luckin will keep subsidies in place for the next three to five years.

But, as Luckin inches closer to a rumored IPO, observers are keen to see more data, and better scrutinize whether Yang’s pipeline can cover the costs of maintaining Luckin’s growing physical store presence.

Luckin Coffee, China’s delivery-focused Starbucks rival that opened around 2,000 stores over the past year and a half, is a hell of a dream—a rapidly-growing chain fueled by ambitious venture capital and buy-one-gift-one offers. A little over 15 months from launch, Luckin is preparing for a US IPO with a valuation of around $3 billion.

But it’s time to wake up and smell the coffee. Look closer, and you’ll see a complicated web of related parties, venture capital and blitzscaling. Over three articles, I’m going to take you deep down the rabbit hole. We’ll look at where Luckin’s funding has come from and what blitzscaling physical industries means beyond a fistfight with Starbucks.

Read more: Luckin Coffee admits to sales fraud

In this first article, we’ll look at the people and cash behind Luckin.

Worst kept secret

English-language reports rarely touch on who’s running and backing Luckin. That’s a shame. Had we been a little less concerned with keeping up with Luckin’s “move fast and break things” approach and a little more concerned about where Luckin’s rapid-fire valuations came from, we’d be asking smarter questions.

Fortunately, as soon as Luckin was founded in 2017, Chinese-language reports started putting some of the threads together. Their conclusion? Most of Luckin’s key figures are connected through a company called China Auto Rental Holdings (CAR Inc)—and this makes things a little more complicated than a tussle over hot caffeinated beverages.

CAR Inc is a mobility company listed on the Hong Kong Stock Exchange. It provides short-term rentals, long-term rentals, leasing and chauffeured car services through car-hailing operator UCAR. UCAR’s CEO and Chairman, Lu Zhengyao, is also Chair of CAR Inc. Luckin’s CEO and CMO, Qian Zhiya and Yang Fei, are CAR Inc’s former COO and CMO.

Luckin isn’t Qian and Yang’s first rodeo. While at CAR Inc, Qian Zhiya and Yang Fei helped incubate UCAR and take it to listing on China’s National Equities Exchange. Critically, they took UCAR from incubation to listing in a little over 18 months. During that period, they raised an undisclosed amount for a $5.5 billion valuation at IPO. UCAR suspended share trading on June 14, 2018, as part of a rumored plan to seek listing on China’s A-share market.

Qian and Yang are a dynamic duo with a track record in taking propositions from zero to IPO, and they’re on track to do it again. A cursory glance at Luckin and UCAR’s go-to-market strategies reveals some striking similarities. Luckin’s celebrity endorsements, buy-one-gift-one deals, and public challenges to the industry incumbent are all battle-tested tactics from the pair’s UCAR days. Yang even wrote a book (Chinese link) about this approach.

Related parties, related capital

A web of CAR Inc and UCAR personnel, resources and investors have supported Luckin’s expansion.

Lu Zhenyao, CAR Inc’s chairman, gave Luckin its initial capital injection. He would later become Luckin’s chairman. He also gave Luckin office space (Chinese link) in Xiamen, a city in the eastern province of Fujian, alongside UCAR. Luckin’s $200 million Series-A was stumped up by four investors: Legend Capital, Joy Capital, GIC and Centurium Capital. Each of Legend Capital, Joy Capital, and Centurium Capital have different levels of involvement with CAR Inc.

Legend Capital was once one of CAR Inc’s largest shareholders. Joy Capital, which participated in Luckin’s Series A and Series B, previously invested in UCAR. Li Hui, who heads up Centurium Capital, is reported to have (Chinese link) once worked alongside Qian Zhiya and Yangfei at Car Inc and UCAR, where he was responsible for investments. He and Luckin CEO Qian Zhiya are reported to still hold positions on UCAR’s Strategic Advisory Committee (Chinese link).

Largely funded and operated by a network of associates, Luckin has probably not been seriously vetted. One’s forced to ask—is the plan to build a business, or is the goal just to get Lu and his friends a big payday from an IPO?

Rabbit hole

Enter a Reuters report about Lu’s recent approach to blue-chip banks about Luckin’s IPO. Reuters reports that Lu sought a personal loan of at least $200 million from banks including Goldman Sachs and Morgan Stanley under a deal that would award them mandates in the IPO. Its sources comment that “it is not uncommon for Chinese companies to raise loans from banks hoping for a mandate on an IPO, [but] it is rare for executives or shareholders to request such personal financing.”

The report also noted a blue-chip bank declined to take part in the IPO, due to “a lack of clarity on Lu’s plans for the proceeds.”

This is heavy stuff. If true, Lu’s direct involvement in financing arrangements shouldn’t be taken lightly. It could be that Luckin may be trying to accelerate IPO proceedings and get out fast before the company’s unicorn hype wears off. As an early investor in Luckin, he could stand to profit handsomely from its IPO. Legend Capital, Joy Capital and Centurium Capital could also make tidy sums from IPO proceeds. With cash in hand, Lu and his VC pals would have room to think about their next move after cars and coffee.

In our first step down the rabbit hole, there are signs that Luckin might be a special type of blend.

JD, China’s largest retailer and second largest e-commerce company, had a tough 2018.

Its stock plunged about 50% on concerns about slow economic growth, rising competition, shrinking profits, and a rape allegation against founder and CEO Richard Liu. Adding insult to injury, Pinduoduo, an e-commerce upstart focused on consumers in lower-tier cities, overtook JD to become China’s second-largest e-commerce platform by monthly active users.

A year to forget, by any measure. But it gets worse. There’s a strong case JD lost whatever grip it had on omnichannel retail in 2018, throwing the company’s next stage of growth into question.

New retail race

China’s e-commerce market experienced massive growth over the last decade. About 10 years ago, China was less than 1% of the global e-commerce market. Now, that share is around 40%, with more e-commerce transactions per year than France, Germany, Japan, the United Kingdom, and the United States combined. China’s e-commerce giants, Alibaba, JD, and Pinduoduo, have reached staggering heights and revolutionized the way local consumers shop.

But brick-and-mortar retail accounts for three quarters of China’s total retail sales. It’s no secret that China’s e-commerce giants want a piece of that action. Since 2016, Alibaba, JD, Suning, and NetEase have opened physical stores, partnered with existing retail chains, invested in automated convenience stores, and experimented with private label direct-to-consumer propositions. (For an in-depth look, you can check out a presentation I’ve delivered on the subject).

As China’s leading e-commerce companies, Alibaba and JD made early moves to snap up pieces of the brick-and-mortar pie. Alibaba led with Hema, an “omnichannel” supermarket that services both online and offline orders. JD countered with a string of offline retail partnerships companies including with supermarket group Yonghui and American behemoth Walmart. Since then, Alibaba and JD have been scrambling over and around each other to expand and fortify their omnichannel retail offerings.

Bravado vs. reality

JD’s offline retail play involves a series of bold decisions.

From new retail’s outset in 2016, JD shied away from matching Alibaba’s omnichannel expansion. It currently operates three omnichannel supermarkets, compared to Hema’s 100-odd stores dotted across first and second-tier cities.

In 2017, JD went big on automated convenience—think 7-11 without a cashier. It committed $4.5 billion to retail-related artificial intelligence research and unveiled plans to launch over 100 cashier-less, staff-less convenience stores by the end of 2018.

Also in 2017, JD CEO Richard Liu announced it would open one million mom-and-pop convenience stores between 2017 and 2022 under a franchise model. This is retail ‘blitzkrieg’ on an unprecedented scale. As a reference point, 7-11 has around 65,000 worldwide. Assuming it acquires 200,000 franchisees per year under its plan, JD expects to open three times 7-11’s worldwide footprint each year, for five consecutive years.

Despite the bravado, there are clear signs these decisions haven’t gone to plan.

Alibaba’s Hema supermarket is an unqualified success. Analysis from China Merchant Securities, a securities and trading firm, suggests Hema stores that have been in operation more than 18 months make anywhere between three and five times more revenue per square meter than China’s traditional supermarket chains.

That’s a significant blow for JD, which could have been an omnichannel first mover. Hou Yi, Hema’s CEO, is a former JD Logistics executive. He was originally tasked with spearheading JD’s omnichannel retail efforts. Reporting by 36kr suggested that Hou Yi’s defection to Alibaba last year was precipitated by frustrations with CEO Richard Liu’s tepid commitment to omnichannel. If true, decision-makers and shareholders must be sorely lamenting the misstep.

JD’s unmanned convenience stores haven’t found a foothold. An estimate using China’s two largest mapping services, Baidu Maps and Gaode Maps, shows that JD has probably opened around a dozen out of the hundred unmanned convenience stores it originally planned. This isn’t surprising. Unmanned convenience propositions fell on hard times last year, as about a dozen chains went out of business.

Two years into its plan to build the world’s largest retail franchise, JD has accrued an estimated 50,000 mom-and-pop convenience stores under its franchise model. In April last year, Richard Liu claimed JD gained 1,000 franchisees a week. While impressive, that’s well behind schedule. Further complicating matters is that we don’t know how many mom-and-pop retailers have actually become franchisees, as opposed to those have signed up for JD’s retail-as-a-service solution. Chinese analysts speculate that it conflates the two to puff up announcement numbers.

Concerted effort

At this stage, it’s fair to say JD’s new retail missteps are combination of bad luck and inopportune timing.

Omnichannel supermarkets were a breakout hit, rather than the cost-intensive new retail posterchild JD thought they would be. Unmanned convenience stores presently add more costs than they save, but future technical maturation could tip that balance. JD’s also found convincing mom-and-pop convenience stores to cough up franchise fees and forfeit current supplier arrangements is a hard sell, particularly in cities and towns where JD isn’t a household name.

JD’s new retail struggles have important ramifications for its future growth.

To date, JD’s growth has been driven by two engines: a focus on high-margin product categories and expansion from Tier 1 to Tier 2 cities without compromise to its much-vaunted same-day delivery standards.

As I wrote previously, JD is trying to develop new engines to survive the end of easy growth. These include extending from online to offline retail, entry into lower-tier cities, and developing service revenue from its logistics network. Its mom-and-pop convenience store push shows that offline retail efforts are linked to its entry into lower-tier cities. The plan was to quickly accumulate JD-branded stores in lower-tier cities, boost brand awareness, and shape consumers’ e-commerce purchase habits.

All fine, in theory. But, to quote Mark Twain, “How empty is theory in the presence of fact.” Fact is, JD’s new retail big bets haven’t exactly paid off.

With a handful of omnichannel supermarkets and struggling unmanned convenience stores, JD’s extension from offline to online retail hangs in the balance. Two years into its “retail blitzkrieg,” clouds hang over its fledgling franchise network. To be a new retail contender, JD needs a concerted effort to turn things around.

As I wrote previously, China’s digital economy has reached a turning point.

Before, new user growth could offset digital businesses’ strategic and commercial missteps. Double-digit or triple-digit MAU growth could mute criticism of flimsy unit economics, absent strategy, dodgy investments, or lackluster monetization efforts.

Now, internet user saturation within China’s consumer class makes it harder to avoid scrutiny with eye-popping user growth. Companies like Meitu, JD, and Zhihu are facing tough questions: shareholders and investors want to whether these platforms can turn their impressive scale into profits.

Weaker players might have a hard time meeting impatient investors’ demands for return on investment, but China’s digital giants are adapting. They are repositioning themselves to adjust to new market dynamics, developing strategies to take advantage of enduring opportunities as mature businesses.

Previously, China’s internet companies grew by latching onto investment frenzies in a particular product or industry vertical, known as fengkou (literally “a gap where a strong wind blows”) in Chinese startup lingo. These rapid influxes of capital and speculative behavior are so notorious that leading Chinese executives have joked that investors could pump in enough money to make pigs fly.

Investment frenzies have reshaped markets, delivered exponential growth, and minted some of China’s internet success stories. Meituan, Didi, and VIPKID were built off all the back of them. These companies identified white space, shaped user behavior, and benefited from oodles of capital to achieve scale and outlast a slew of competitors to win winner-take-all or winner-take-most positions. However, as the mobile internet’s white space shrinks, these investment frenzies are more volatile and less conducive to value-creation.

The recent struggles of live-streaming, bike sharing, and automated convenience stores illustrate the danger of relying on speculative investment flows. My own analysis estimates 80% of live-streaming players with Series-A funding didn’t last two years. ofo, a bike-sharing firm, has gone from a $2 billion valuation to the verge of bankruptcy. There are now serious doubts that Bingo Box, the automated convenience store darling backed by GGV Capital, can survive long enough (Chinese link) to make a meaningful dent in China’s retail landscape.

Six durable white spaces

China’s digital giants—Baidu, Alibaba, Tencent, Bytedance, Meituan, Didi, Pinduoduo, and JD—are looking for something more durable than spaghetti-against-the-wall investment flows.

When they first burst onto the scene, today’s digital giants were a thin, interfacing layer between consumers, products, services, and attention. Now, being a thin, interfacing layer isn’t enough. The giants are making themselves thicker in a way that adds new users, gives depth to existing offerings, deepens competitive advantage, and creates new revenue streams.

The giants are pursuing six avenues to growth:

New Tech R&D: China’s digital giants can develop or apply technology to existing or new operations. Leading players, such as Baidu, Tencent and Alibaba are developing leading capabilities in artificial intelligence, big data, and cloud computing.

Industry digital transformation: They can also offer new products and services to industry. Having shaped consumers’ digital behavior, China’s digital giants are lining up to lead the digital transformation of traditional industries such as retail, hospitality, tourism, and agriculture, packaging software and platforms as services.

Overseas expansion: They can seek growth overseas. China’s digital giants consider themselves well-placed to service mobile-first emerging markets, such as India and South-East Asia. These markets also have the growth prospects associated with relatively low existing internet user penetration.

Lower-tier cities: They can develop products, services and experiences for consumers in lower-tier cities. The stunning rise of Pinduoduo, Qutoutiao, and Kuaishou have shown that existing e-commerce, news, and entertainment apps don’t always meet the needs of users in China’s populous third, fourth, and fifth-tier cities.

Local services: They can further penetrate and digitize food, accommodation, shopping, and transportation markets. The size of the local services market and its potential for further digitalisation means the competition between “super-apps” like Meituan, Ele.me, Didi, and Alipay is just getting started.

New mediums: They can also explore new ways to search, connect, shop, and get informed. Innovations in newsfeeds, multimedia messaging, gamified reading and social commerce present opportunities to unseat incumbents in search, social media, and e-commerce.

Who’s playing where

Each of China’s digital giants has restructured in the last two years. That’s no coincidence. China’s digital giants are re-orienting themselves for future growth. If you cross-reference each restructure’s relationship to the above growth directions, you get a pretty good sense of who’s playing where for future growth.

Alibaba and Tencent’s investments, products and proxies will fight for market share across all six growth avenues.

Baidu continues its push to be relevant beyond search through artificial intelligence investments and applications.

Bytedance plans to take its content creation and recommendation products into lower-tier and overseas markets. At the same time, its recent tinkering with e-commerce integration and social messaging shows that it’s thinking about next-generation video commerce and social media.

Meituan hasn’t abandoned its ambition to be a super-app but has doubled down on services to restaurants and retailers on its platforms, with new features like order-management systems.

JD will strengthen its core business through investments in smart logistics, expand its offline retail partnerships and open up its logistics network to third parties.

Didi’s quest to become the world’s largest transport platform in 10 years continues unabated with overseas expansion, investments in developing markets’ ride-hailing services and autonomous driving tests.

Pinduoduo, China’s newest force in e-commerce, will improve merchant quality and test the upper limits of user growth.

As China’s digital economy has reached a turning point, China’s digital giants haven’t stood still. They’re seeking out durable sources of future growth. In so doing, they’ve set the stage for a new wave of intense competition.

We’ve reached a turning point in China’s digital economy: Growth has been easy. Now, it’s getting much harder.

Since 2010, a constant stream of new internet users and fast money has driven a digital boom. China is now the world’s largest e-commerce market, the world’s leader in mobile transactions and home to around a third of the world’s digital unicorns. But building on that growth looks a lot harder now. The three engines that propelled China’s digital economy—new users, time on device, and capital—are starting to stall.

China’s mobile internet is reaching saturation. China now has more than 800 million internet users. China’s urban consumer class—households an annual income over $16,000—are pretty much all connected to the internet.

Time on device might not have much growth left in the tank either. QuestMobile data shows China’s internet users averaged 5.7 hours on their mobile devices per day. Assuming full-time employment and a decent night’s sleep, there’s about eight hours of non-work, non-sleep activity in a day. As average time on mobile devices nears six hours a day, it’s probably reaching a hard limit.

The hot money that fueled new products and aggressive customer acquisition may also be running dry. Zero2IPO, a Beijing-based investment banking and advisory house, reckons fundraising activity in China has slumped to its lowest level since 2014. This fundraising downturn has sparked talk of a ‘capital winter which threatens both fledgling and mature internet and tech startups. According to data from Zero2IPO, VC funds raised less than RMB 100 billion (around $15 billion) in the first half of 2018, down from over RMB 200 billion in the second half of 2017.

But Chinese VCs are still investing, albeit more conservatively, spreading money over more, smaller deals. CrunchBase data suggests China’s venture capital activity in Q4 2018 is not materially different from Q3 2017. It reports that Q4 2018 saw $17.9 billion invested across 666 fundraising activities, compared to $18.8 billion over 331 fundraising activities in Q4 2017. If that’s accurate, then fears of a “capital winter” may be exaggerated.

The tech sector isn’t immune to China’s economic uncertainty. Policymakers, academia and private sector acknowledge there are economic headwinds. Factory activity is at its lowest level in two years and slower retail growth suggests consumers are tightening their belts.

China’s internet and tech firms are cutting costs where they can. At the start of the year, Baidu’s CEO, Robin Li, wrote an open letter to employees saying “The Chinese economy has shifted to a lower gear, with every company under severe pressure from nationwide economic restructuring.” He implored staff to “decrease costs and raise efficiency” across Baidu and its clients.

China’s largest job-seeking website reported that tech-related job advertisements are down by a fifth compared with the previous year. Hiring freezes and staff cuts have been reported from digital device manufacturers like Huawei and Xiaomi to platforms and ecosystems like Bytedance and Meituan. In addition, firms are slashing perks like business-class travel, after-hours meals and sign-on bonuses.

Some established players have been feeling the pinch for a while. As early as 2016, Tmall’s cost of customer acquisition outstripped average revenue per user. JD is facing a similar issue—the cost of acquiring a new user or winning an inactive user back is growing twice as quickly as the amount of average revenue it can make from each user. Even e-commerce upstart Pinduoduo isn’t immune: its cost of new customer acquisition grew more than 500% between 2017 and 2018.

A turning point

When the pie stops growing, industry competition gets serious. As China approaches higher levels of internet user saturation, China’s competing platforms, apps and digital services are playing a zero-sum game for attention and traffic. This, coupled with economic headwinds, means a few things for China’s tech sector.

First, it spells trouble for immature monetization models. Without a high-margin service that effectively cross-subsidizes the skyrocketing costs of user acquisition and engagement, digital businesses are at the mercy of their investors’ patience.

Second, it fortifies established platforms with large user bases. Buckets of cash are needed to pinch market share from existing services. And, if funding conditions in China are indeed taking a turn, stumping enough cash is going get harder.

Third, it changes the big, hairy questions we ask about China’s digital economy. What we should ask now isn’t how China’s digital landscape is different or where China’s digital economy is leading or lagging. Rather, we should ask: What white space is left? What pivots are available? Is it possible to challenge China’s established tech giants? What’s the next big thing after mobile internet?

In my next article, I’ll explore how China’s established tech players are looking for answers to these questions in a world with little new user growth and less fast money.