China retail 2.0: The O2O effect

Some are officially licensed; others are not but have genuine goods, which suggests they have stock to sell offline but aren't necessarily allowed to operate online as well; and a third category comprises fakes. Alibaba polices Tmall but it can only move so fast against the offenders. Somewhere along the line, Li-Ning is probably losing out.

The company's travails are well-documented. It took the fight to Nike and Adidas, hiking prices and focusing more on first-tier cities, but ended up losing out not only to these global giants but also to lower-cost local rivals. TPG Capital and GIC Private invested in 2012, looking to initiate a turnaround but losses have widened, largely driven by restructuring costs.

It is unclear to what extent the rise of e-commerce has exacerbated these difficulties. There is barely a bricks-and-mortar retailer in China that hasn't been forced into some degree of existential crisis.

Bain Capital completed its exit from Gome Electrical Appliances earlier this year after a near seven-year holding period that failed to live up to expectations. In the early years, Gome was overshadowed by power struggle between the jailed founder and the company's then chairman, but latterly the competition from well-financed e-commerce platforms has been relentless.

Gome's strength used to be in its network of retail outlets that served as a bellwether for growing consumer activity in China's lower-tier cities. Now the focus has switched to engaging consumers online rather than on the high street. The electronic appliance market descended into price war when JD.com offered to cut its gross margin to zero in 2012. Suning Appliance, a Hony Capital investee, and Gome in turn offered to match or undercut JD's prices.

Supermarket chains are also under pressure, with Walmart last week unveiling plans to turn around stumbling China sales by opening 115 new stores, upgrading more than 90 existing outlets, and furthering its online-to-offline (O2O) operations. Walmart has a 51% stake in Yihaodian, China's largest online supermarket, which now offers delivery of certain necessities within three hours.

In addition, the supermarket chain is planning a hypermarket app through customers can shop anytime and anywhere, with the option of home delivery or pick-up at a nearby store. This is intended to counter the threat presented by Tmall and JD.com's own food businesses, for which consumers now not only turn to for non-fresh produce but increasingly for fresh produce as well.

Both Sunning and Gome are also embracing the O2O model, trying to transform their businesses by integrating offline and online elements of the entire retail process, from procurement to shipment to after-sales services. This engagement is the right way to go because the victors are likely to be those that offer a combination of online (customer interface) and offline (supply chain solutions), although the model in different segments will vary.

There are certain products that do not translate well into an online retail context - wedding dresses and furniture spring to mind - and these will be more defensible. At the same time, for categories that do work online, shoppers may depart the broad-based marketplaces for more specialized, consumer experience-oriented verticals.

The lesson for private equity is: be careful where you invest. The days of helping a business scale up, introducing supply chain and branding expertise, and taking it public are long gone. Deal-sourcing is therefore becoming more like business model-spotting - identifying an approach that is disruptive or defensive enough to prevail in the land of O2O giants.

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• Consumer
• Greater China
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• Consumer
• China
• TMT