Capital Flywheels

Tencent’s Opportunity Beyond China – Games, not WeChat

Given the recent bout of market volatility, it’s a good time to revisit some businesses and/or explore new ones.

One of the ones on my list is Tencent (700 HK), China’s leading social network and digital entertainment player. Tencent has been a phenomenal performer over the long run. Despite rising close to 9x in the last 5 years, Tencent’s best days still seem to be far, far ahead of it. The stock is off ~15% in recent weeks, which seems short-sighted for a business that is likely to sustain double digit growth for a long time.

Tencent 5 Year Performance

Last August, in my post Tencent vs Alibaba on the Quest to Go Global, I argued that Alibaba potentially has a more attractive long-term story given that ecommerce has an easier path out of China. Although there are sizable ecommerce players globally such as Amazon and Mercadolibre, ecommerce penetration remains very low in a global context meaning most of the future pie is still up for grabs.

I argued that Tencent would have a much tougher time growing beyond China since the most attractive asset (WeChat) would need to compete directly with the global juggernaut, Facebook. Facebook is already quite well penetrated globally with 2 billion users out of the world’s 7 billion people (6 billion excluding China). Facebook has likely nearly penetrated essentially all internet users in the world ex-China, and social networks are not easy to dislodge.

But recently I realized that even if I am right about the challenges for WeChat, I arrived at the wrong conclusion for Tencent as a whole. Tencent has a very credible path out of China through games.

Although WeChat is clearly the most distinctive asset with an incredible moat in China, Tencent is still largely a gaming company with approximately half of revenues coming from games.

Tencent is already the world’s largest game publisher, and what I neglected to consider is that games are quite fungible across geographies and cultures and very easily adapted for local languages.

Top Game Makers.png

Source: Newzoo

Tencent’s gaming business should continue to grow and become ever more global as gaming becomes ever more prevalent in all countries. The world’s youth are growing up with games and continue to play into adulthood.

Tencent today already owns or controls some of the top global gaming studios and IP such as Riot (owner of League of Legend franchise) and Supercell (developer behind Clash of Clans). Tencent also owns significant stakes in Epic, Pocket Gems, Glu Mobile, among many others.

Through games, Tencent already has a bridge to the world. Perhaps one day that bridge can be utilized as a trojan horse to introduce the world to WeChat. But that would just be icing on the cake.

The Future of Ecommerce: Utilitarian vs Social

When people think about ecommerce today, they likely think about ecommerce along the lines of C2C (consumer-to-consumer), B2C (business-to-consumer), or B2B (business-to-business) – in other words, classification by type of buyers and sellers.

Or perhaps people think about 1P (1st party) vs 3P (3rd party), depending on whether the ecommerce platform itself engages in the direct buying and selling of goods. Amazon is 1P and 3P while Ebay is purely 3P.

However, both of these classification methods are simply the digitized forms of long-standing offline commerce analogies. They are neither new nor native to the world of digital commerce.

Ecommerce appears to be evolving and giving rise to more native forms of commerce, which I think can be loosely classified as utilitarian vs social.

The Current Ways of Doing Things

Although ecommerce has been around for over 20 years now, it still bears a striking resemblance to offline commerce.

Consider the way ecommerce businesses/platforms are classified today. C2C, B2C, B2B and 1P vs 3P. Both of these classification systems are applicable to both offline commerce and ecommerce.

Online C2C would be Ebay, where users are largely trying to sell used items to other users. Offline C2C would be school students trying to swap cards or goods or garage sales. The offline world never really formalized C2C because, I suspect, there isn’t much money in this part of the market. The fact that Ebay took off so much faster than Amazon in the early days is simply because the offline competition was non-existent and Ebay filled a vacuum. But in the long run, Amazon was destined to outstrip Ebay because Amazon operated in B2C, a much larger part of the market.

Online B2C would include Amazon and essentially every branded/professional ecommerce business out there where consumers buy from a business. This is also how most offline commerce is conducted – in malls, on the streets, mostly everywhere.

Likewise, online B2B is not too different from offline B2B. For the most part, going from offline to online likely meant swapping phone calls for internet clicks.

In terms of 1P vs 3P, almost all offline businesses are 1P where the buyer interacts directly with a seller that owns and controls the inventory. Online 1P is the same and includes the digital channels of all of the offline 1P businesses. This includes the branded stores for Apple, Nike, Adidas, etc.

Offline 3P would be mall operators. The essence of a 3P business/platform is effectively to be a landlord. Mall operators provide a space for businesses to sell. Online 3P platforms would include Amazon, Ebay, Alibaba, and JD, all of whom are digital landlords. 3P is clearly a more commonly viable business model online because digital real estate is theoretically infinite. There can be an infinite number of online 3P platforms. And who doesn’t want to be a landlord collecting rents without having to do the branding and selling work?

So at the end of the day, ecommerce today isn’t all that different from offline commerce. They are largely direct analogies other than swapping out of physical storefronts for digital storefronts.

The New Ways of Doing Things?

What’s interesting is that ecommerce is starting to evolve in ways that offline commerce cannot follow. And this is enabled by social media, supercharged by the fact that we always have an internet-connected device with us at all times. This new way of doing things is social ecommerce, and eventually the old way of doing things will likely be viewed as utilitarian e/commerce.

Social ecommerce is just starting to take off in the West, but has been a game-changer in Asia, particularly China.

Here are some examples.

Social ecommerce includes live streaming on Taobao (Alibaba platform). This is effectively QVC for the digital age. But on steroids because you not only watch/hear from sellers, you also see comments from other potential buyers.

Source: TechinAsia

Social ecommerce includes WeChat (Tencent messaging platform) stores with integrated messaging. Buyers can message and interact directly with potential buyers in the WeChat messaging app – keeping them updated on new products, offer coupons, and deepen the brand story.

Source: WeChat Agency

Social ecommerce includes PinDuoDuo encouraging you to round up friends to help you bargain for discounts.

Source: WalktheChat

What social ecommerce accomplishes is that it makes buying fun, all the time. Buying has always had an element of fun in the offline world, but it required coordination. For example, people (friends and/or families) go to the mall together so that you can get advice and encouragement (or tasteful critique). But that takes coordination. Ecommerce made it very easy for us to shop, but it has not made it easy for us to coordinate to recreate that level of fun. That’s what social ecommerce promises to accomplish.

Social ecommerce also connects us with opinions that we may not otherwise have in our offline lives. Perhaps you don’t have people in your life that would have the best opinion/advice, social ecommerce broadens your scope. That is something that offline commerce can never accomplish or compete with.

The benefits do not solely accrue to consumers. In fact, the benefits are probably even greater for sellers that adapt. Take Taobao live streaming for example. There are many sellers now that will livestream directly from factories to gauge what buyers are most interested in. The buyer will then purchase inventory based on the feedback with minimal inventory risk. This is a phenomenal benefit as it reduces the working capital necessary to run the business. As I’ve discussed in my previous post, the platform/player that has the greatest influence over retailer working capital will likely dominate for a very long time.

Ecommerce’s Shifting Landscape

Social ecommerce has already arrived in Asia, and it is starting to appear in the West.

For example, Apple is rolling out Business Chat, which promises to allow users to directly message businesses creating a whole new way of marketing and selling.

Source: Apple

And the gorilla (in the West) is Instagram, which recently rolled out a “Shop Now” button. This is potentially transformative because Instagram is already a very important platform for branding and advertising. Users already follow brands/influencers with an affinity for the products and designs posted. The “Shop Now” button would close the commerce loop.

Source: Wall Street Journal

Of course, every ecommerce post is obliged to comment on Amazon, the de-facto king of ecommerce in the West at the moment. With the emergence of social ecommerce, Amazon’s market positioning appears to be weakening and is ever more dependent on its utility aspects. Amazon still dominates if you already know what you want but want it fast and at a reasonable price.

However, Amazon is not a particularly strong platform for discovery other than for a very narrow range of “similar items” recommendations. People love Amazon because it useful, not because it is fun. Unless Amazon adapts quickly, Amazon risks being eclipsed by social ecommerce players that are superior in discovery if the logistics gap should ever close.

More on this in a later post. Stay tuned.

The Other Supply Chain Gorilla That May One Day Challenge Amazon

As detailed in my recent post, Amazon has built up quite a formidable competitive advantage through Fulfillment by Amazon (FBA). Not just on the demand side, which every happy Prime subscriber is already familiar with, but also on the supply side.

In that post I concluded the following:

Fulfillment is clearly beneficial on the demand side, but has a lot of supply side advantages as well. It all comes from the ability to control the inventory. That control helps reduce shipping times, which is what consumers are most focused on, but also significantly reduces costs for the entire system.

More importantly, I believe fulfillment has first mover advantages and creates lock-in because merchants have limited ability to fund working capital. The first player to offer fulfillment effectively ups the working capital requirement on subsequent fulfillment competitors. The bar goes up and becomes that much higher.

I argued that fulfillment is a flywheel that benefits the first-mover. Merchant inventory that is held in Amazon’s fulfillment warehouses are effectively locked out of competing platforms. The large variety of inventory and parallel benefit of faster delivery due to fulfillment creates greater traffic for Amazon that further encourages merchants to place an ever greater share of their inventory with FBA. As the flywheel continues, it effectively takes the air out of competing platforms as more and more inventory is locked up with FBA.

Despite the optimistic conclusion, it is an incomplete one. And for observers that purely focus on the US / European ecommerce space, it is easy to be unaware that there is another supply chain gorilla that indirectly touches Amazon and could potentially become a threat. That company is Alibaba.

To understand why, we need to examine the structure of global supply chains.

There is No Such Thing as a US Ecommerce Market, Only a Global One

Amazon is the largest US ecommerce player – an inarguable fact. But this view is reflective only of the demand side of the equation. All marketplaces are composed of two sides – the buyer (demand) and the seller (supply). Amazon can only be considered largely a US business if we consider the demand side of the equation, because whether we like it or not, the vast majority of products on the platform come from Asia, especially China. In this day and age, unless we are talking about a geographically closed system, there is no such thing as a country-specific ecommerce market, but only global ones with the supply side overwhelmingly dependent on China.

If we take a platform view, Amazon’s business is simple enough:

Equation 1: Sellers (Product) –> Amazon (Transaction Mediator and/or FBA) –> Buyers

Amazon has a lot of influence over buyers and sellers in this equation because buyers and sellers are presumably fragmented and small relative to Amazon’s size.

If we take a supply chain view, the situation looks more like this:

Equation 2: Chinese Manufacturer –> Amazon Seller –> Amazon –> Amazon Buyers

This equation reveals that many Amazon sellers are potentially also middlemen that can get aggregated on the other end. However, this is still not particularly problematic for Amazon since Chinese manufacturers are presumably also fairly fragmented with Amazon wielding the most concentrated power in the system.

Through my industry contacts and conversations, I believe >65% of Amazon products are either sourced directly or indirectly from China.

But here is where things get interesting – most sellers likely only have direct relationships with Chinese manufacturers if they are meaningfully large in size. For example, Macy’s, Walmart, Target, etc. likely have direct relationships with Chinese suppliers because they have the resources to manage and interact with such a network. But most of these players largely do not sell through Amazon.com because they view Amazon as a competitor. 3rd party sellers on Amazon are relatively small and many likely do not have direct relationships with Chinese manufacturers.

Where do these 3rd party merchants get their Chinese products from if not directly from a Chinese manufacturer? Increasingly the answer is Aliexpress.

For example:

There are thousands of videos and articles that show how everyday entrepreneurs are turning to Aliexpress as the supplier of choice for their Amazon (and/or Ebay, Shopify, etc) business.

In reality the supply chain equation looks like this:

Equation 3: Chinese Manufacturers –> Chinese Sellers –> Alibaba / Aliexpress –> Amazon Sellers –> Amazon –> Amazon Buyers

This equation exposes one of the, potentially, weakest links in Amazon’s supply-chain-driven strategy, which I believe is largely undiscussed by US ecommerce market observers/investors.

To Beat a Platform, You (Likely) Need a Platform

Amazon is a platform. Our world is now ruled by platforms, and it should be increasingly clear that non-platform businesses are not well situated to fight a platform head-on. Traditional non-platform players like Walmart, Target, Macy’s etc are at a structural disadvantage.

However, platforms are not indestructible, especially if attacked by another platform (e.g. Google leveraging search against travel OTAs such as Priceline and food review sites like Yelp).

In the Equation 3 above, Amazon and Alibaba are both platforms. In the current set-up, only a small buffer zone of middlemen sit between Alibaba and Amazon. Those middlemen are likely to be squeezed in the coming years and could potentially one day put Alibaba and Amazon more in direct contact. More direct contact could potentially reduce the effective leverage that Amazon has over the supply-side of the business since Alibaba is a massive entity. But this current set-up would still imply that Alibaba and Amazon would be upstream-downstream partners rather than competitors with Amazon wielding far greater influence over US consumers while Alibaba holds much more power over Chinese suppliers.

Unstable Equilibrium

However, as mentioned, platforms can be destroyed, especially if attacked by another platform. The question is whether Alibaba could one day wield their platform power over suppliers to try to overcome Amazon’s platform power over consumers or vice versa.

The current situation looks like an unstable equilibrium especially based on Alibaba’s announced plans for the next 5-10 years with respect to logistics.

Alibaba has publicly announced plans to invest $15 billion over the next 5 years to establish a leading global logistics network.

Here’s a choice quote and fairly interesting article from Forbes (my emphasis in bold):

[Alibaba’s] goal is the creation of a capability to [deliver] anywhere in China within 24-hours and anywhere in the world within 72 [hours].

Alibaba aims, according to Zhang, to “build the most efficient logistics network in China and around the world.”

Why does this matter?

Because it potentially allows Alibaba to attack the heart of what consumers love about Amazon’s Prime service – fast delivery. Amazon may have a strong hold over US consumers at the moment, but if Alibaba were to succeed in their goal to establish 72 hour delivery globally, Amazon’s core value proposition in the US could come under threat.

What Do Ecommerce Customers Care Most About?

The industry is well aware that ecommerce customers care about three things – price, convenience, and variety. In the early days, Amazon won on price vs offline retailers since they didn’t have to pay for brick mortar rent and staff. But price gaps have narrowed (and nowadays Amazon isn’t always the cheapest option). Over the last decade, Amazon has effectively reoriented customers towards convenience over price. For similar price (possibly slightly cheaper or possibly slightly more expensive), you can have it in 2 days or maybe even same day.

But at the end of the day, consumers care all about three – price, convenience, and variety. The relative importance of each depends on the relative gap between the options available. Just because consumers currently prioritize 2 day delivery does not mean that consumers no longer care about price or variety.

That is where Alibaba’s threat lies. A cursory look through Aliexpress would easily surface items that are vastly cheaper than what you would find on Amazon (as long as you are not particularly brand conscious).

How many consumers would be willing to wait 3 days (Alibaba’s goal of 72 hour global delivery) instead of 2 (Amazon’s current standard) if their toilet paper, flashlight, etc was 50% cheaper? I am willing to bet that a very meaningful proportion of Amazon’s customers would gladly make that trade-off.

Building the Global Platform

It’s clear from Jeff Bezos’ numerous interviews and letters that he always starts with the customer’s point of view. This is an interesting contrast with Alibaba’s founder, Jack Ma, who has always prioritized platform sellers.

Both are clearly aiming to build the ecommerce platform for the entire world, but have started at different ends. Jeff Bezos with consumers and Jack Ma with sellers. I am a nobody in ecommerce and can only offer my limited insight gained from months of study and speaking with industry insiders, but one thing seems clear to me – Jeff Bezos’ influence over global consumers is nowhere near as great as Jack Ma’s influence over global suppliers. Global consumers are scattered and fragmented around the globe, but Jack Ma benefits from the fact that China is the world’s factory.

Jeff Bezos is a very smart man, but so in Jack Ma.

Why Amazon is so Hard to Compete Against

Amazon has clearly become an absolute juggernaut. There are likely only a handful of companies today that have the resource and scale to compete with Amazon directly. But most of the companies that do have the resources to compete generally don’t operate ecommerce platforms, leaving the field mostly wide open for Amazon to continue to grow unabated.

I have been trying to grapple with the question of why it has been and continues to be so hard to compete against Amazon. Yes, Amazon has incredible scale, enormous cash flows, excellent assets (e.g. Fulfillment advantages as detailed in my post, Supply Side Advantages of Fulfillment (by Amazon)), but Amazon didn’t always have these advantages. And many of the competitors that Amazon has bested had either similar or even greater advantages in the early days.

For example – scale. A decade ago, Amazon was a tiny minnow compared to the Goliaths of brick and mortar retail. Even today, Amazon is still smaller than Walmart. Scale alone is not what made it hard to compete against Amazon, though it is what makes it even harder to compete against Amazon today.

Same with cash flows. Amazon may have more cash than it knows what to do with today, but its cash flows were materially weaker a decade ago. And certainly the incumbents like Walmart would have been much better positioned from a cash flow perspective to pursue Amazon’s strategy than Amazon was.

The easy explanation would be mismanagement at peers, but that seems like an incomplete explanation to me. After all, EBay wasn’t exactly poorly managed and had an internet lineage just like Amazon. EBay even had greater reach to boot, yet is now mostly an afterthought.

All of these advantages played a part…and ultimately Amazon’s differentiated strategy and perspective on retail helped them pull away, but I believe that one of the biggest reasons why competitors failed and continue to fail against Amazon is because they are never actually competing against Amazon but rather against Amazon’s past.

At any given moment, the observable parts of any company is a summation of decisions – strategic and financial – made some time ago. For most companies, the gap between those decisions and what you see is probably not large because many companies are unfortunately run to a fairly short term time horizon. However, for a company like Amazon, the gap is massive, especially since Jeff Bezos prides himself on thinking 5-10 years out.

From the perspective of a company like Walmart or Macy’s, they likely see Amazon as a large ecommerce platform with wide selection, fast delivery, and a sticky Prime loyalty program. But what they believe they are competing against (and observe) is nothing more than Amazon’s past! And likely the version of Amazon as it was strategically decided 5-10 years ago. Consider that Amazon launched Prime in the US in 2005. Amazon’s competitors are still struggling to compete against Prime with a competitive offering today, but Prime was likely decided far in advance of 2005. Even if competitors were to catch up, they would only be catching up to the Amazon of yore. The Amazon that exists today, the Amazon for which today’s strategic decisions affect, is the true juggernaut that competitors need to beat, but they won’t even know what they are truly up against until it becomes obvious a few years from now.

I think this is the key reason why Amazon is such a formidable competitor, and it is all enabled by years of advance planning. Competitors have a hard time catching up because by the time they know what they are up against, they are already years behind. Even formidable competitors like Google and Microsoft have been blind-sided by AWS, so it’s not just retail where Amazon successfully employs such a strategy.

In order for any company to successfully compete against Amazon would likely require recognizing this asymmetric form of competition and taking a leap of faith to position competitively against the Amazon of the future as opposed to the Amazon of the past. What does the Amazon 5 years from now look like? That’s the true measure of competition.

Supply Side Advantages of Fulfillment (by Amazon)

I wish I had spent more time analyzing Amazon in earnest years ago. But late is better than never. I’ll console myself with the fact that e-commerce penetration in the US is still <10% of all retail sales…and relative to that statistic, even the word “late” seems a bit premature.

Having spent a number of months learning more about Amazon’s history, assets, business model(s), and philosophy, one thing I’ve realized is that Fulfillment by Amazon (FBA) affords the company immense advantages on the supply side that I think are largely glossed over in mainstream media and investor dialogue.

FBA’s benefits to consumers (e.g. demand side) are very well understood: 2-day delivery and potentially faster depending on the category and geography, but I believe FBA builds as great or even greater competitive advantages on the supply side. These supply side advantages are probably key reasons why an FBA-like strategy will be hard (which does have a meaning that is distinctly different from impossible) to replicate for a follower (e.g. Walmart in the future).

It All Starts With Control

I found it easiest to understand trying to work backwards from 2-day speedy delivery. Amazon didn’t invent 2-day delivery. FedEx and UPS have been doing it faster for even longer and Amazon does rely on partners for last mile delivery. Both UPS and FedEx have been offering overnight delivery for decades. So what are the benefits to doing fulfillment in-house? It starts with control.

But before we get to that, I discovered there’s a whole universe and art to product delivery. So some background might be helpful.

Shipping Models – Dropshipping vs Fulfillment

I’ve never dabbled in merchandising/retailing until my recent experiments selling on Amazon Marketplace, Ebay, and Shopify. Hence, I didn’t even know there was such a thing as dropshipping and how that differs from fulfillment, but the differences are large and important.

Starting with the most basic model (e.g. what Ebay started with) where inventory is owned and controlled by the seller – When a transaction occurs on the platform, the seller sends the inventory. This could be some used trinket or old iPhone in your garage, which formed Ebay’s legacy image of being a “used goods” platform. Simple enough. Under this model, inventory is only handled by the seller. The platform never touches the inventory.

Then there is something called dropshipping, which divorces inventory storage from the seller as well. These are the resellers that are buying cheap inventory from China and reselling it on Amazon or Ebay, etc. But big department stores like Macy’s also rely on this method as well. When a transaction goes through, the seller relays that order to the manufacturer / supplier (e.g. a factory in China) and has that manufacturer ship the product to the end buyer (or ship it to the seller that then forwards it to the buyer). This effectively reduces inventory handling and storage for the seller because the seller becomes more of a middleman. Under this model, the platform never touches the inventory, and the seller might also never touch the inventory depending on how the supplier leg of the process is set up.

Bigcommerce.com has a wonderful piece going over the details of dropshipping, including this helpful image:

One thing that is interesting with the dropshipping model is that it can be a service offered by the platform as well. For example, Shopify offers dropshipping services as does Mercadolibre, the Alibaba of Latin America. When offered by the platform, the platform handles the shipping details. The seller simply has to get the manufacturer to deliver the product to the local dropshipping drop-off point.

Then there is fulfillment. Under this model, inventory is stored and handled by the fulfillment partner (which is also the platform in the case of Amazon FBA). The moment a transaction happens, the fulfillment partner (e.g. Amazon) handles and ships the inventory. The seller does not need to do anything post-transaction. The only obligation for the seller in terms of inventory is pre-transaction…how to get the inventory from the supplier to the fulfillment partner.

Also from Bigcommerce.com:

Back to Control

For FedEx and UPS to accomplish fast delivery, it’s essentially a three step process:

Quickly / efficiently take the package from the drop-off location to your long-haul network (probably airfreight if cross country). This process should take just a few hours if done efficiently.
Transport the package to a location close to the final destination. This is probably done by air overnight if distance is far.
Once the package is close to the final destination, do last mile delivery. This process probably takes just a few hours.

In toto, 2 day delivery is not difficult with enough scale and at a price. An efficiently honed operation like that of FedEx and UPS can reliably do one day delivery.

The key word is efficiently. Whereas FedEx and UPS and Amazon are all efficient, without fulfillment, Amazon can’t reliably offer 2-day delivery on 3rd party merchandise because there is no guarantee that the seller will be efficient in handling the parts of the process they are responsible for. Without fulfillment, Amazon does not have control over the inventory, and therefore the process is only as efficient as the weakest link.

What about dropshipping? As mentioned, Amazon could offer a dropshipping model that effectively gives them control of the shipping and handling process, but the passing of that control from the seller to the platform only happens post-transaction. The core difference between a dropshipping model and a fulfillment model is when the platform gains control of the product – under a fulfillment model, the platform has effective control of the product before the item is sold, while dropshipping model only transfers control once the product is sold. The moment the product is sold, the 2-day count down starts immediately…despite the efficiency of the combined Amazon/USPS/FedEx/UPS network, the seller does have to play ball and immediately get the package to the delivery partner at the local dropshipping drop-off point within a short period of time. Any delay (e.g. the seller didn’t read their notifications quickly enough) means the 2-day promise is potentially toast.

With Control Comes Cost Efficiencies

There are several awesome benefits to having control of the inventory, and a number of them are related to reducing system delivery costs.

Let’s start with a baseline example where the seller handles the shipping process (like how it usually happens on Ebay). Transaction occurs, seller sends the item. Unless the seller is high volume, they likely do not have sweetheart deals with their shipping partner and thus pays retail shipping price, which tends to be high.

Under a dropshipping model, the dropshipping partner can group together the volumes from a large number of merchants, and hence negotiate volume discounts. The same goes for a fulfillment model.

There is one area where fulfillment ends up costing more than the dropshipping model – storage. Under the fulfillment model, the provider needs to build out a lot of warehouses to store the products before they are sold. So the natural question to ask is whether this cost is worth the additional control that you get pre-transaction. And the answer is actually a very resounding yes!

Although storage costs are higher, you get additional cost benefits that you wouldn’t get otherwise under a dropshipping model (and, again, the cost benefits I list below come on top of the tighter control that you would have over delivery timelines).

One of the cost benefits come from the ability to group items. Let’s consider a hypothetical scenario of 5 sellers selling collectively 5 items (or one item each). We will call them A / B / C / D / E. These 5 sellers sell their items to 3 buyers that we will call X / Y / Z. Buyer X purchases an item from A and B. Buyer Y purchases an item from C and D. Z purchases the item from E.

Under our baseline example where the seller handles the shipping, the 5 sellers make a combined 5 shipments. A needs to send their item to X. B also needs to send to X. C and D needs to send to Y. While E needs to send to Z. 5 different shipments.
Under a dropshipping model, we still have 5 shipments, but there will likely be a volume discount since the dropshipping partner will handle the shipping.
Under a fulfillment model, you only have 3 shipments! Since the fulfillment partner has control of the inventory pre- and post-transaction, the fulfillment partner (with an efficient enough process) can group together the items from A and B and put it into a single shipping package before sending it off to X. Same with the packages for Y. The cost advantage of this grouping is low when volumes are low, but likely significantly exceeds the cost of storage when your customers are purchasing with high frequency.

So not only do you have greater control of inventory under a fulfillment model vs other models, you also get the benefits of volume discounts and a more efficient shipping process through package grouping.

Storage Cost Arbitrage

FBA is not free of charge. The cost of using FBA covers not only shipping costs but also storage costs. Although I don’t have concrete numbers to back-up, I believe the storage costs for Amazon are likely lower than that for their merchants because Amazon Warehouses are likely located in non-prime real estate locations and obviously negotiated on a much larger scale. FBA likely embeds a cost arbitrage on the storage side whereby it is cheaper for a merchant to store and ship items via FBA than to store items in-house and then use a dropshipping partner. I don’t have concrete numbers to back this up, but intuitively this makes sense to me and will be a project for some other time in the future.

But it Gets Better – Inventory Commingling

Whereas all the items I listed above are probably still likely fairly well understood, inventory commingling is probably more arcane, but an incredible advantage and this advantage only accrues to the fulfillment model.

What inventory commingling refers to, is the ability to mix ownership of items in storage. For example, you have two sellers that are both selling the same trinket and they both have 10 items each in storage under the fulfillment model. With effective control of the inventory, the platform essentially has 20 trinkets to handle as it wish until it is sold.

Why does this matter?

Because it also magically leads to lower costs! And this is possible because geography comes into play.

Let’s consider the two sellers with 10 trinkets each and consider their geographic distribution. Let’s assume one is located in California and another is located in New York. Under the fulfillment model, the trinkets are pre-shipped for storage at the local fulfillment warehouse. For the Californian seller, this is in California. And for the New York seller, it is in New York.

Now let’s assume there is a buyer in California that happens to buy the trinket but buys it from the New York seller because the price is better (buyers don’t consciously consider where the seller is located as long as it gets to them in the expected timeframe, e.g. 2 days).

Under the seller direct shipping model and dropshipping model, the trinket essentially needs to go from New York to California in a very short period of time. That is costly. A bit cheaper with volume discount under the dropshipping model but still costly. Under the fulfillment model, inventory is commingled. The fulfillment partner can send the trinket from California instead! The shorter distance means not only lower cost, but the time to do that delivery is also shorter. I believe this is a key reason why Amazon Fulfillment is starting to gain enough scale to do same-day delivery.

Of course, over time this process will lead to a geographic imbalance of inventory, but that is easily remedied by shipping the excess inventory from New York to California in our above example. But wouldn’t that negate the cost benefit eventually? No, because this rebalancing process can be done over time on a longer timeframe. Shipping and item from New York to California by train over a week is much cheaper than having to airfreight it overnight to stick to a 2 day delivery promise.

Sorcery!

The Competitive Advantage that is Hard to Copy – It’s All Because of Working Capital

Given all of the advantages I listed above, it’s shocking (to me) that fulfillment isn’t more of a priority for both traditional retailers like Walmart as well as other global ecommerce platforms. JD does this in China, but Alibaba is barely starting to explore this angle. Same with Mercadolibre in Latin America.

Competitors like Walmart and other retailers that don’t offer fulfillment likely don’t realize that fulfillment has a massive first mover advantage on the supply side, not just the goodwill that you accrue with buyers on the demand side. And this is all because of working capital.

Retailers generally have low margins and managing cash flows are a particular challenge because inventory days are quite high and business is seasonal. A retailer like Macy’s or JC Penney has to turn cash into inventory months in advance and then will have to spend months to turn that back into cash. In short, working capital is high, and working capital can both be life blood and poison.

In a world without fulfillment, ecommerce is a fantastic channel for managing working capital. It brings additional customers without much additional working capital. For example, consider a small local merchant with a physical store in San Francisco. The store already has inventory. That inventory can be listed on Ebay or a Shopify page, and when it sells, you just ship whatever inventory you already have in the store.

We can also consider another example where the merchant is purely online. One set of inventory, but that one set of inventory can be listed across Ebay, Shopify, Alibaba, Mercadolibre, Amazon, etc. One set of inventory, many sales channel. Effectively, we can create shadow/duplicate inventory in an online world. Of course, the merchant would have an issue if all of the items sold at once, but that doesn’t usually happen.

But the whole equation changes when fulfillment comes into play. Because that inventory is now under a non-neutral platform’s control (and not necessarily the seller’s control). With that inventory sitting in a specific non-seller-controlled warehouse, it becomes much harder to duplicate inventory online across a number of websites. In effect, the inventory held in storage becomes captive to that specific platform. And since working capital is a very hard problem for retailers, it limits their ability to sell across a large number of online channels. This creates incredible lock-in, and I think this advantage is largely glossed over by the mainstream media and investor crowd that assume that a well-funded competitor like Walmart can just walk in and fulfillment. Walmart may be able to build out a fulfillment network, but good luck convincing merchants to hold inventory in both a Walmart warehouse as well as an Amazon warehouse. 2x more inventory = 2x bigger inventory management problem and more cash required.

Conclusion

Fulfillment is clearly beneficial on the demand side, but has a lot of supply side advantages as well. It all comes from the ability to control the inventory. That control helps reduce shipping times, which is what consumers are most focused on, but also significantly reduces costs for the entire system.

More importantly, I believe fulfillment has first mover advantages and creates lock-in because merchants have limited ability to fund working capital. The first player to offer fulfillment effectively ups the working capital requirement on subsequent fulfillment competitors. The bar goes up and becomes that much higher.

Bitcoin and Cryptocurrencies – The Mother of All Bubbles

Two months ago I wrote The Bitcoin “Penny Stock”, detailing what I believed were the conditions that created Bitcoin’s incredible run through September. Although the piece sounded cautious given Bitcoin’s 30-40x 1 year return up until that point, I noted that the prevailing conditions allowed far more than that, perhaps another 50-100x. I highly recommend reviewing that piece since I continue to believe those conditions remain true.

Since September, Bitcoin has more than doubled from $3.5k to nearly $11k. Bitcoin is all the rage now, even more so than before as evidenced by media, institutional, and retail attention.

Bubblish? Very likely, but this bubble will be unlike any other bubble in history for one very simple reason – Bitcoin (and crypto) are global assets, and this will be the first global bubble in history.

Consider the list of previous bubbles: US residential property, European peripheral residential property (e.g. Spain), dotcoms and telecoms in the late 90s, Japanese real estate and equities in the 80s, etc.These were massive bubbles. But despite their size, they were localized in nature. The vast majority of people buying US real estate were Americans. The vast majority of people speculating on Spanish real estate were Spaniards. The vast majority of people speculating in dotcoms were Americans. This is because the assets were localized and regulations made it hard to invest cross-border. This limited the amount of speculative capital that could flow into the assets. This is largely untrue of Bitcoin and cryptocurrencies. The amount of speculative capital that can flow into Bitcoin is larger than any other pool of capital observed in history. Bitcoin speculators are/can be from every country. With that in mind, why should we be surprised by $400 billion of crypto assets that have likely decoupled from reality? If the whole world is in on this, the hockey stick likely hasn’t even turned upwards.

In the 90s, Microsoft alone was valued at $800 billion. The combine value of dotcoms was probably greater than $10 trillion. And that was fueled largely just by American money.

There is no parallel for what is happening. Be amazed, and perhaps be greedy while you can, but be scared. This could be the first true global bubble.

The Bitcoin “Penny Stock”

For almost a decade, Bitcoin has periodically captured the attention of the public. Sometimes for its technological potential, sometimes as an object of ridicule, but often times for its boom / bust cycles that have fueled the limitless imaginations of speculators.

Since the start of this year, Bitcoin and alt-coins have once again captured the attention of the public.

market-price-(usd)

Not only has Bitcoin risen dramatically in price, potentially minting hundreds of millionaires and possibly a few discrete billionaires, the blockchain, alt-coins, and ICOs appear to be carrying us at light-speed into a radically democratized and de-centralized future.

I’m not here to speak to the technological appeal of blockchains — for which there are many — as there are many more qualified minds that can do that better than I can.

However, I do have news for you:

Bitcoin’s meteoric rise in price year-to-date has more to do with the technicals and conditions normally found in penny stocks than likely any long-term fundamental factors.

Before you immediately dismiss the rest of this post because you suspect my argument is for lower prices, I will be upfront and tell you that that is not the case. I have no particular view on whether cryptocurrencies will go up or down. My goal is simply to discuss what I believe has been the primary driver of upward momentum and leave it for the reader to assess whether these conditions will continue favorably or potentially reverse. Having observed the rise of many penny stocks, I have seen few that don’t eventually come crashing back down in dramatic fashion when the conditions that made the rise possible cease to persist.

The Anatomy of a Penny Stock Shooting Star

Most penny stocks never amount to anything. But occasionally, a few rise and rise and rise in dramatic fashion. Sometimes up to thousands of percents within a few days or months.

For example:

HGEN CVSI

Every penny stock shooting star begins with a similar set of conditions: Limited information, micro market capitalizations, and extremely low liquidity.

All of these factors come together to maximize the chance that a / any penny stock can be easily manipulated to trade on everything but fundamentals.

Fundamentals are usually the enemy of penny stocks since most of these have no long-term successful business models. What they might have are seductive stories – potential to change the world, potential to transform society, and the most seductive story of all, the potential to make you very rich very quickly. Limited information creates the right environment to nurture these stories because whatever information you can get becomes definitive. The siren song these stocks sing are already powerful in and of itself, but even more so when there are no other credible voices of caution.

Micro market capitalizations further nurture this environment because it usually keeps professionals away. By virtue of having a small market cap, it is nearly impossible to make meaningful amounts of money for the professionals (e.g. shorting), and thus many that could see through the risks of penny stocks are not engaged. Retail investors also popularly assume that many long-term winner once began as penny stocks:

Investors who have fallen into the trap of the first fallacy believe Wal-Mart, Microsoft and many other large companies were once penny stocks that have appreciated to high dollar values. Many investors make this mistake because they are looking at the “adjusted stock price,” which takes into account all stock splits. By taking a look at both Microsoft and Wal-Mart, you can see that the respective prices on their first days of trading were $21 and $16.50, even though the prices adjusted for splits was about eight cents and one cent, respectively. Rather than starting at a low market price, these companies actually started high, continually rising until they needed to be split.

-Investopedia, The Lowdown on Penny Stocks

But the most important one of all – low liquidity. It is through low liquidity that penny stocks gain their immense volatility. As money pours in (or out), low liquidity guarantees that trades will easily move penny stocks like a leaf-blower through a forest floor.

Why Some Penny Stocks Soar While Others Languish and are Simply Forgotten

Many retail investors have limited ability (or perhaps desire) to conduct research on companies. Many retail investors are simply chartists. But to become a shooting star, penny stocks need a story. Although the most seductive story of all is always the same – you can be rich very quickly – even speculators usually demand a story that has some semblance of fundamental long-term potential.

Because of that, many penny stock shooting stars begin with a sponsor that formulates this story and sells it to potential speculators. These sponsors are the ones that get the flywheel going. Story formulation is not the hard part, but how do you convince speculators that there is potentially a lot of money to be made? The easiest way is to show that a lot of money has already been created, but don’t just sit there or you will miss out on all the rest! By targeting low liquidity penny stocks, a sponsor can buy a meaningful amount of stock initially, which drives up the price because of the low liquidity. This creates the initial gains that will eventually draw in other speculators. Once the flywheel is in full motion, the sponsor will quietly sell down the initial purchase at a handsome gain, leaving speculative followers with the aftermath.

This is known as pump-and-dump:

The same scheme can be perpetrated by anyone with access to an online trading account and the ability to convince other investors to buy a stock that is supposedly ready to take off. The schemer can get the action going by buying heavily into a stock that trades on low volume, which usually pumps up the price. The price action induces other investors to buy heavily, pumping the share price even higher. At any point when the schemer feels the buying pressure is ready to fall off, he can dump his shares for a big profit.

-Investopedia, Pump and Dump

Regardless of how sophisticated you are with the markets, I’m quite certain most people know that pump-and-dumps never end well (unless you are the sponsor or a speculator that recognizes a pump-and-dump for what it is and are able to get out in time).

Drawing Parallels to Bitcoin

So what are the parallels to Bitcoin and alt-coins? Simple, all the conditions that make penny stocks potential vehicles for speculation have been present in Bitcoin and alt-coins.

Firstly, Bitcoins and alt-coins are new areas driven by technology that has not matured and continues to evolve. This creates an environment that is a vacuum for information that is necessary to judge the long-term fundamentals of the asset class. In addition, the amount of technical knowledge needed to understand cryptocurrencies mean that a small subset of people can establish themselves as the de-facto experts on the future and possibilities of cryptocurrencies. Regardless of whether these expert opinions are well-placed or not, they formulate and control the story and overwhelmingly the story has been about the potential for cryptocurrencies to change everything – your life, your finances, government, everything.

Cryptocurrencies in the aggregate recently accumulated a market cap of >$160bn, certainly not micro cap under any definition. However, we should view that in light of the 30-40x growth within the past year. We need to consider the market cap before the rise, and even as recently as October of last year, the aggregate market cap of all cryptocurrencies according to Coinmarketcap.com was as low as $13bn.

Cryptocurrency Market Cap

And as with penny stocks, the most important factor of all – low liquidity. I cannot overstate how important this factor is for understanding why Bitcoin and cryptocurrencies began a sudden rise less than a year ago.

Let’s take a look at Bitcoin trading volumes over the last 6 months (via data.bitcoinity.org):

6m Bitcoin Volume.jpg

We can observe a few spikes here and there, but overall the volumes have been fairly steady. Do note that volumes rose significantly as the recent sell-off intensified in August / September.

But the more informative chart is to see what volumes have done over the past year – you will be shocked:

Bitcoin 2 Year Volume

Volumes absolutely collapsed between December and January. In fact, liquidity nearly entirely dried up.

Where did the liquidity declines come from? Cutting the data another way, we can see which exchanges were responsible for most of the trading over the past two years: BTCChina, Huobi, and OKCoin. These three exchanges were responsible for close to 90% of all Bitcoin trading over the past 2 years, but suddenly the entire volumes of all three exchanges evaporated at the end of last year.

Bitcoin Volume by Exchange

The drop in volumes was due largely to Chinese regulations tightening up the trading of cryptocurrencies. Coindesk featured an interesting article highlighting this dynamic earlier in the year.

Due to the significant decline of Bitcoin trading volume earlier this year, I believe it is clear that Bitcoin’s low liquidity created conditions that are normally only observable in penny stocks. This low liquidity likely allowed well-meaning technologists and venture capitals that are true believers of cryptocurrencies to inadvertently act like sponsors akin to those of penny stock schemes. The buying of cryptocurrencies into extremely thin liquidity created the initial 5x-10x gains that would later bring masses of retail speculators.

Do All Shooting Stars Eventually Burn Out?

Here’s the thing – with penny stocks, the rise usually comes to an end because the sponsor sells out at the top. The sponsor considers when s/he has maximized the number of speculators (or prey depending on how you look at it) that can get pulled in and then will sell out at the top. Sponsors always have an endgame of getting out before the crowd finds out.

I have no doubts that given the extremely low liquidity in cryptocurrencies today, that if the large cryptocurrency wallets (and yes, there are a number of wallets out there are are very massive in size) were to cash out, downside volatility would be as dramatic as the rise we have seen year to date.

The question is how many of the early “investors” in cryptocurrencies believe enough in the long term to not be concerned about volatility and therefore feel compelled to go back into cash / government-issued currency? If Bitcoins and alt-coins were truly only in the hands of true believers, low liquidity could mean that we continue to see these cryptocurrencies appreciate 50x or 100x or even more from here.

The question is, again, are cryptocurrencies in the hands of true believers?

One anchor that many investors / speculators in Bitcoin fixate on is that the number of Bitcoins that will ever be in existence is fixed (currently growing at a small rate but total that will ever be mined is fixed). Yes – this is true, and perhaps one reason why Bitcoin should appreciate relative to the growing stock of government-issued currency. But 30-40x in 9 months? That’s only possible not because the stock of Bitcoins is fixed, but because the tradable float of Bitcoin has been declining. Just ask yourself how many cryptocurrency investors you’ve heard say that they will buy and sit on it and never sell – these coins are locked away and in effect reduce the tradable float. The tradable float is declining every day.

When will this locked up float suddenly come back to exchanges? That will be a terrible moment.

As I mentioned at the beginning, I’ll leave it up to readers to decide on the direction of prices. I have no view. What I have a view on is that Bitcoin and alt-coins have increasingly become like penny stocks.

I’ll close with a quote from Fred Wilson, a celebrated Venture Capitalist:

I know a lot of people who are true believers in crypto and have made fortunes in it. They are â€œall inâ€ on crypto and have much of their net worth (all in some cases) invested in this sector. I worry about them and this post is aimed at them and others like them. It is fine to be a true believer and being all in on crypto has made them a lot of money. But preservation of capital is about diversification and I think and hope that they will take some money off the table, pay the taxes, and invest it elsewhere.

-Fred Wilson,Â Diversification (aka How to Survive a Crash)

Beware – even the faith of the true believers may waiver.