How To Identify Emerging E-Commerce Businesses At Good Valuations
Previously, we discussed the various business models of JD.com, Alibaba, and Meituan.
To conclude this deep-dive E-Commerce series, I have three topics to share in this article:
- Why E-Commerce Business Models are Often Misunderstood
- Why Scale is Critical for Marketplace Business Models
- Sources of Funding for E-Commerce Business Models
To prevent confusion, do read my previous articles before continuing:
Let’s begin!
Why E-Commerce Business Models Are Often Misunderstood
At the first level of thinking, as investors, we SHOULD avoid business models with huge losses on their Income Statement.
However, this thought process brings about an issue.
During the early stages of a marketplace model scaling up its operation, it is often seemingly cash-burning. As a result, investors would assign a zero or even negative valuation to the business.
Upon second-level thinking, we need to ask ourselves – why is the management comfortable with the losses? What’s the bigger strategic picture?
This level of thinking is what separates good investors from the rest.
Similar to Software companies, marketplace models have very low incremental costs to host additional merchants or serve additional customers.
Instead of looking at the Income Statement, let’s focus on the Unit Economics of the business. It’s about going back to the basics – the direct revenues and costs associated to run a company’s business model.
In a typical Software company, the unit economics are as such:
In Year 1, the company may have to spend $150 to acquire a customer that generates a $100 revenue. If we measure it based the Income Statement, the company is losing $50.
At this point, most investors would swear at the management for mismanaging the business.
However, by putting on a pair of different lenses, we know that the customer acquisition cost (CAC) is a one-time cost. Over time, the customers may subscribe to additional modules on their software and it will increase the revenue.
In the example above, the lifetime value (LTV) was $600 while the one-time CAC was $150. That makes the LTV/CAC ratio 4x.
This means for every dollar of CAC spent, the company gets back 4x. Isn’t that highly efficient?
At this point, you might be asking me, “But Kelvin, how is a software example relevant to a marketplace model?”
It is the same.
Marketplaces need to ramp up their sales & marketing aggressively to acquire as many customers as possible, especially when they are starting out.
When a business is misunderstood, it tends to have low valuations because investors are not comfortable with the business model.
Because of that, investors who use the concept of Unit Economics to guide their analysis are often rewarded with the opportunity to buy into emerging marketplaces at cheap valuations.
Far-sighted management should understand that marketplace scale is the number 1 priority above the profitability of the marketplace.
But isn’t profitability more important?
I like to offer a different perspective.
In the earlier stages, profitability is important but obtaining absolute market dominance is a do-or-die outcome for marketplace business models.
Why is that so?
Marketplace business models benefit from network effects and upon obtaining scale, its competitive position becomes extremely difficult to dislodge.
This means other competitors will find it increasingly harder to compete over time. It’s a winner-take-it-all situation. There is no in-between.
Once dominance is achieved, profitability can be gradually obtained through increasing take-rates. An example would be eBay, a mature marketplace, which has a blended 10% take-rate and enjoys an operating margin of 26%.
Why Market Dominance is Critical
To explain why market dominance is critical, I would like you to assume your identity as a merchant selling GIM T-shirts on Lazada and Shopee.
*All numbers are fictional and they do not represent actual numbers.
Lazada takes 6% of your sales while Shopee takes 8% of your sales. Given a choice, which platform would you choose to sell your products on?
Your instinctive answer would be Lazada.
What if I add another variable? Shopee brings in 30% more volume than Lazada.
With that, the entire Unit Economics for you as a merchant has totally changed.
Your Store’s Unit Economics under Lazada and Shopee:
While your gross profit margin is lower on Shopee, if you understand that your business is all about volume, you will see that the absolute gross profit is more important than gross profit margin.
So if you had went with Shopee, despite them charging you 33% more (8% versus Lazada’s 6%), they have also made you an extra $204.
The first principle of a marketplace is to get as many merchants as possible on board. Marketplace operators who are looking for dominance prefer to monetize slowly by having a lower take rate to build out the size of their marketplace.
Once a marketplace operator obtains a size gap of 30% – 50%, between themselves and their competitors, it should be sufficient for them to raise take rates. With expenses remaining relatively flat, the profits will start to gush in like an open dam.
Apart from take-rate, there are other aspects such as average order value and order frequency which will increase the revenue without incremental expenses.
A marketplace that is monetizing too quickly may risk having its position dislodged by another competitor that is more patient but greedy in the long-term instead.
When Sea Ltd created its Shopee marketplace, Sea wanted to narrow the gap between themselves and their competitors.
That is why Shopee chose to operate with low take rates initially. The management had the foresight to be patient and they understood the dynamics of the marketplace very well.
In an interview, former Sea President Nick Nash laid out the unit economics at maturity of Shopee as such:
With such Unit Economics at maturity, it makes sense for Sea to invest in sales & marketing aggressively in advance to grow their scale. That is why investors should not be worried about the current losses.
How Are E-Commerce Business Models Funded?
Whether a marketplace’s losses can translate to profits depend on whether they can seize the coveted No.1 place – because that’s where monetization happens.
To get there, huge financing is required to do two things:
1) fund any sales and marketing wars to acquire the highest number of customers, and
2) build the scale necessary to be the best place for merchants to sell.
Without the financing to compete, forget about the promised land of profits.
So how do these E-Commerce businesses get financing?
There are many ways to obtain financing. These are separated under two main categories: internal and external methods.
- Internal methods include taking profits from other segments to offset losses or making use of the negative cash conversion cycle. I’ve explained it here.
- External methods include taking on more debt and raising money by issuing equity to other investors.
JD.com has a negative cash conversion cycle to finance their investment needs.
Meituan Dianping has its highly profitable business unit “In-store Hotels” to support investments in “Food Delivery” and “New Initiatives”.
For Sea, it has a highly profitable gaming business unit called Garena that provides financial resources to Shopee. Shopee’s biggest competitors are Tokopedia and Lazada.
Lazada, which was acquired by Alibaba, may not have access to a constant stream of financing while Tokopedia has to rely on external investors. This meant that Shopee does not have to worry about financing issues and it can focus on strategy and execution.
Over time, Shopee took the lead ahead of its competitors.
Self-financing is my preferred method because there is less shareholder dilution and the business can focus on scaling its size without distractions from external shareholders.
If you are investing in a marketplace that is heavily reliant on external financing, it can be scary because it is at the mercy of its investors.
Whether it will able to dominate also hinges on how the business model is funded.
As mentioned previously, Meituan Dianping was faced with the risk of losing its funding until its Food Delivery business got profitable and de-risked the entire business model.
With that, I hope this series of articles on the E-Commerce models had been useful to guide your thoughts about investing in marketplaces.
But before I end this article, I have included a bonus sharing!
Here, I will share about my evolving idea regarding the profitability of companies.
BONUS: High-Profit Margins are Lame
I like profits. You like profits. Investors like profits.
But investors who are focusing too much on profits are likely to end up choosing average companies. In the end, mediocre companies will provide you with average stock returns.
When a fantastic company has high-profit margins for several years, it means one thing to me…
It is not reinvesting enough into R&D and not aggressive enough to enter new industries.
You see, when they invest, expenses increase and profits are reduced artificially.
That’s what I want to see.
As a business, what good is there in my high-profit margin if I do not:
1. Increase my R&D spending to come up with better products and accelerate revenue growth?
2. Find ways to spend it meaningfully? The profits turn to cash and cash is earning mediocre returns. Cash should be deployed meaningfully instead.
If a business has high profit margins, it is letting go of opportunities.
We are living in an accelerated technological world.
I do not want a company to reduce innovation and research expenses to show high profits, just because the company wants to satisfy analysts on Wall Street.
I want a company that can invest heavily in useful programs. I want them to reduce profits artificially because the management knows those investments, while it may make the income statement look bad temporarily, will give returns of many folds in the future.
I want to invest in a company with positive Unit Economics, and is investing massively into the future.
Then what about companies who have obtained absolute dominance and can finally slow down their pedal on their investments?
The irony is… it’s time to sell them because their returns are likely to become average. They have reached the final stages of their corporate life cycle.
Then, once again, it’s time for us to go back to the drawing board and find companies who are investing heavily.
Look at Amazon.com, it has a market capitalization of more than $1 trillion.
It has an extremely profitable business unit called the Amazon Web Services – but take a look at Amazon’s operating profit margins!
Its operating profit margin is in the low single digits. From FY 2012 to FY2017, Amazon.com’s margins were razor-thin.
Do you think it happened naturally or the margins were designed to be this way? Was it a coincidence or was it planned? At their size, they are still reinvesting heavily.
This is why looking at accounting profits are not that meaningful.
Prioritising Unit Economics instead of profits are what will push you from an average investor into an amazing investor.
I hope my article has benefitted you. If it has, please pay it forward by sharing it with more people!
By the way, feel free to also check out my Growth Investing Secrets Podcast on Apple Podcast and Spotify for more FREE investing resources!