Description

Summary

 

Meituan Dianping is China’s 2nd largest e-commerce platform in terms of transacting users, focusing on a fresh e-commerce template of local lifestyle services (eg, food delivery, Yelp, TripAdvisor + Booking) and holding clear market leadership in this field. Its business model of taking high frequency services to cross sell low frequency but high margin ones appears to be working. Today, 9-year old Meituan is number 1 in food delivery, hotel OTA, consumer reviews, and group buying. Industry’s organic growth rate is strong due to extremely low online penetration rates. Long runway is gets broadened as new categories get added for cross selling. Meituan’s platform strategy is also unique in building overlapping 2-sided platforms, further benefiting from ownership of China’s main consumer reviews platform (Dianping), which provides a moat in terms of traffic generation and conversion catalyst. CEO has proven to be a strong strategic thinker, fierce competitor and capital allocator along the lines of Amazon. Recent concerns over Alibaba’s acquisition of Meituan’s main rival has resulted in a weak post-IPO performance, though this write-up aims to show why fears over competitive dynamics and BABA’s motivations are misunderstood. I believe that Meituan presents an opportunity to get in on a very well managed compounder that has a long and broadening runway. Current stock price provides ~80% to 100% upside with above-30% rates of revenue compounding and margin expansion to come.

 

Company Overview

 

Meituan Dianping is the result of a 2015 merger between Meituan (“beautiful group”; “group” as in group buying) and Dazhong Dianping (“people’s reviews”).

 

Meituan started out as a group buying company along the lines of Groupon, though its focus has always been on being a platform for local lifestyle services.

 

Dianping is a highly popular consumer reviews service that is sort of like Yelp and TripAdvisor all rolled into one. There is no real competitor to Dianping, just like Yelp and TripAdvisor. Most Chinese check Dianping for discovering restaurants or local services (eg, foot reflexologist or manicurist); Baidu isn’t as popular. In this regard, Dianping is not unlike Amazon as the first port of call for consumers searching for local services instead of via the dominant search engine. This is an important source of moat since customer acquisition cost is much lower, while conversion rates are better.

 

Despite remaining 2 separate apps, the content is the same. Meituan has also stated that it will fold Dianping into Meituan soon to create a single point of traffic and a consistent brand.

 

“Super app” or Everything Store

 

Meituan is often called a “super app” since it provides everything from food delivery to group buying deals, hotel bookings, weekend trips, movie tickets, local services booking (eg, bridal photography), and more recently, bike sharing. The common theme that binds Meituan’s offerings are that they provide users a way to discover and book local lifestyle services, often at a generous discount.

 

The local lifestyle services market similar in size vs conventional goods retail. Meituan noted that the size of the consumer services industry in China was CNY 18.4 tril in 2017 (22.2% of GDP vs 39.1% of GDP for total consumption), though it has defined its immediate addressable market as a CNY 4 tril one. This is huge and Meituan doesn’t have to win it all. Consider the average person’s monthly expenditure on eating out, food delivery, haircuts, gym, travel, etc vs his/her purchases from Amazon or Taobao/Tmall; a 56% allocation to services vs 44% for stuff seems reasonable.

 

Meituan had 382.3 mil annual transacting users as of 3Q18, vs BABA’s 636 mil. This makes Meituan China’s 2nd largest e-commerce platform, serving half of the 800 mil strong online population. Put another way, half of China’s online population orders 1.6 meals per month from Meituan’s food delivery, and the ordering frequency continues to rise.

 

Meituan’s key tool in customer acquisition/demand generation comes from Dianping’s trove of unbiased customer reviews, which also act as the catalyst in closing a transaction on the platform (eg, Amazon reviews often help in the purchase decision). The entire system thus forms a nice closed loop of variety, discovery, reviews, and transaction. If this everything store concept sounds familiar, it is because Meituan’s CEO Wang Xing is an admirer of Amazon.

 

This podcast episode (link) of “Invest Like The Best” discussed how Amazon, Alibaba, Tencent and Meituan are similar in that they are customer aggregation platforms. Products/services that users want are continuously added, piggybacking on the existing user base to add revenue streams that require little incremental customer acquisition cost. The CAC savings thus provide a pricing advantage, while the stacking of products/services create stickiness. Hayden Capital has a good discussion of this and Meituan in its 4Q18 letter to investors (link).

 

Below is a screenshot of Meituan’s app home page (translations in red), which I clicked on to expand the category. 2nd set of screenshots comes from Meituan’s prospectus showing some of the other services offered.

 

 

Using high frequency services to cross sell higher margin, low frequency ones

 

Meituan’s business model is predicated on finding high frequency services like food delivery to cross sell higher margin, but lower frequency ones.

 

For example, a couple living in Shanghai who order food delivery frequently might use Dianping to discover a well-rated karaoke room (KTV) for their upcoming gathering with college pals. The irresistible deals (50% off) available on the reviews page spur the couple to purchase a voucher, thus committing to visiting the store while closing the loop from discovery to monetization.

 

The important points to note from the above example are 1) Dianping as default choice for discovery; 2) deals to create commitment to visit the KTV; and 3) low friction experience that monetizes all within the same page. Point 2 is very important, since Meituan’s proposition to merchants is that it can bring users to the shop. Seeing a good review on Yelp results in a “maybe”, but that becomes a “definitely” when you purchase a voucher. It is always harder to get the consumer to go to a shop, instead of having an item delivered to his house. Thus, attractive deals are the key piece towards monetization.

 

Meituan’s formula of improving wallet-share and number of transactions among its users appears to be working, as can be seen from the cohort graph below. Number of transactions refers to annual transactions. Transactions are across all categories.

 

 

Further evidence of the model working can be seen from the series of tables below. Gross transaction value (GTV), user count, average transactions per user, and merchant count all posted strong growth despite clear trends in falling sales & marketing expenses as a percentage of revenue and rising take rates. These trends also suggest good pricing power.

 

Meituan reported gross margins of 16.6% for food delivery and 90.6% for “in-store, hotel & travel” in 3Q18. As such, cross selling has a disproportionate impact on the bottom line.

 

Based on GTV, Meituan sold $61.63 of “in-store, hotel & travel” (“in-store” henceforth) per $100 of food delivery in 3Q18. The corresponding ratio in 3Q17 was 0.84 to 1. The deterioration was in part due to a 54.4% growth in food delivery (takes time for cross selling to kick in; see cohort graph above) and weaker consumer confidence given China’s economic slowdown (these are consumer discretionary services). Ctrip’s weak guidance is consistent with this hypothesis. Guess competition from BABA might be a factor too, though it is not as if this is something new. As such, consumer confidence was probably the swing factor here.  

 

If correct, then a normalized ratio should be somewhere in between (ie, ~0.73 to 1). Furthermore, this ratio can improve as Meituan ads more categories of services to its slate.

 

Online marketing/transactions channel for local services merchants

 

On the merchants’ side, Meituan’s value proposition is even stronger. Meituan’s ability to aggregate users means that it is the go-to platform for local services merchants who want to sell or market online. While BABA’s newly formed Local Services Company (combination of Ele.me + Koubei; more on this later) is a competitor, Meituan has a significant lead in food delivery, clear market leadership in in-store deals, as well as the killer tool of Dianping reviews. Meituan is thus the easier choice if traffic is what a merchant wants.

 

Furthermore, users are increasingly spending more of their time online; merchants wanting to get noticed simply have to meet them there. However, local services merchants tend to lack an online presence. This is not due to mom and pop shops being unaware of the Internet (it is 2019 after all); rather, there is little economic sense in creating/maintaining a website for the local pizza parlour. Even if one were created, online traffic is likely to be woeful due to lack of resources to pursue techniques like SEO, SEM or social media marketing. For the more digitally savvy of this bunch, a Facebook profile often serves as their web presence. In China, they have WeChat. But how does one pull the marketing triggers with discount campaigns or find users when they are hungry AND in the area? Therefore, a Meituan profile is much more effective in helping our pizza parlour reach a hungry 20-something with a taste for Italian fare when he is browsing Meituan/Dianping for food choices within 200m from his location outside Plaza 66 (Shanghai mall).

 

Wang Xing also pointed out that contribution margins in local services are very different from selling physical goods online. For example, a merchant is unlikely to do deep discounts selling basketballs on Taobao, since fixed costs (eg, rent, staffing) are a very small component of the overall cost structure. As such, the basketball seller can wait.

 

It is very different for local services; fixed costs are a huge percentage of total cost. Time matters too, since capacity utilization determines profitability (think airlines). A typical restaurant’s food costs are ~25% and it gets worse for a gym, which has minimal variable costs. As such, incremental gross profits matter a lot to local services merchants. This was why Wang Xing started out with a Groupon model, since 1) it uses deep discounts to generate demand for unused capacity; 2) group vs single deal is better for soaking capacity up; and 3) it is an easy to understand marketing format.

 

Group buying remains popular in China today and merchants have become more sophisticated in terms of pricing some services as loss leaders with group deals to bring customers into the door for the up-sell. As such, Meituan’s market leadership in group buying makes it a key tool in the local services merchant’s marketing playbook.

 

Key Business Segments

 

Group buying + Local services

 

Meituan was one of the earliest group buying companies in China, having started in 2010 based on Wang Xing’s observation that the Groupon format works well for local services merchants to market online.

 

The path to dominance wasn’t an easy one as China went through a phase during 2011 when there were more than 5,000 Groupon clones fighting it out in the market. Meituan won the war (more on this later) and is the clear market leader in group buying today.

 

Group buying remains popular in China because 1) consumers want value; and 2) population density makes it easier to make the minimum participation for a deal to happen. If still in doubt, consider the case study of Pinduoduo; it is essentially group buying.

 

Since 2012, Meituan has also relaxed the format of group deals. A group deal can now be always on, with very low minimum participants, if the merchant so chooses. Merchants can also run straight discounts without a group deal format, which are just as helpful in bringing committed traffic through the door.

 

Deals close the loop for Meituan’s efforts in marketing offline merchants, which is something that Yelp lacks. Deals allow Meituan to monetize Dianping’s reviews by allowing the customer to “buy now” at a great price. Do note that customers can also make online appointments/reservations (eg, Open Table style) or secure a spot in the restaurant queue during peak hours without buying deals.

 

While one might think of this as a high margin business, Meituan does it differently from Groupon. Meituan started with the idea of using low take rates to lure merchants onto its platform. To ensure that merchants chose Meituan over its 5,000+ competitors back in the day, Meituan also set up local sales teams to sell merchants on its platform and help them craft group deals (process includes coming up with photographs, pricing of discounts, and marketing slogans). While the group buying war is over, Meituan has maintained its 30,000-strong on-the-ground sales force (link) to continue adding merchants to its platform. It is easy for the same sales person pitching a hotel on restaurant group deals and wedding banquet discounts to pitch OTA services too. This was how Meituan built its supply in smaller hotels and overtook Ctrip to become the largest hotel OTA in China. Operating leverage at work.

 

Food delivery

 

Meituan started food delivery in 2013, before its merger with Dianping in January 2015. Today, Meituan has a 60% market share in food delivery vs 36% for Ele.me.

What is more impressive was how this market share evolved. Below is a table from a business school case study on Meituan (purchase on HBR; link). Meituan started with 27.6% in 2014 while Ele.me started with 30.6%. BABA acquired Koubei and pumped Taodiandian’s food delivery business into Ele.me subsequently. Ele.me also acquired Baidu Waimai after Baidu decided to exit this business in August 2017 (link). So Ele.me added 31% of market share to its 2014 share of 30.6% along the way for a grand total of 61.6%, but the tables have flipped today with Meituan showing 60% and Ele.me showing 36%.

 

 

Meituan’s strategy of blanketing lower tier cities for food delivery early on helped because the F&B business is highly competitive and has short business lifespans. Competition for restaurants in Tier 1 cities is high and scoring an exclusive doesn’t count for much when the restaurant goes belly up a year later. Things are more stable in lower tier cities and the competition didn’t prioritize them. Meituan was thus able to get a good headstart here, scoring exclusives by promising lower take rates and/or more marketing exposure on the app. Lower tier cities’ food delivery operations were thus profitable, with the profits being driven to Meituan’s fight in Tier 1 cities. This article (link) gives a very good overview of the dynamics around the food delivery business in China.

 

Today, Meituan continues to lead in lower tier cities with near-monopoly positions in some of them (local sales team helps). It is more evenly matched in Tier 1 cities. Lower tier cities are profitable while the company is nearing breakeven in Tier 1 cities.

 

Meituan mainly uses dedicated full-time (vs crowdsourced) delivery fleets since this avoids the problem of facing a labour crunch during peak hours or when the weather is bad. Merchants can choose their own delivery option and most crowdsource via Dada Daojia (part-owned by JD; link) but delivery times are less reliable due to waiting for the job to be accepted. This results in longer expected delivery times being shown for such merchants (not good) so most end up choosing Meituan’s fleet. Nonetheless, crowdsourced fleets are necessary during unexpected demand surges.  

 

Meituan’s fleets are outsourced to fleet management companies (“delivery partners” in the prospectus). Delivery men are mostly full-time employees but paid per order delivered to incentivize them to move fast. Various sources put the all-in delivery fee at around CNY 5.20 per order for higher tier cities, with the split at around 10:90 (fleet company gets 10%; delivery man gets 90% or ~CNY 4.70 per order). With the average delivery man doing more than 40 orders a day (good pay but tough life; see video link), the fleet company can make about CNY 7,000 per delivery man, per year. This easily covers the cost of the bike, which sells for around USD 300 – 400 brand new at wholesale prices in China and lasts more than a year.

 

Using fleet management companies helps Meituan scale faster while not dealing with the details. It also removes any balance sheet burden. No operating leases to account for and no need to adjust for depreciation. Meituan is already charging users for delivery (~half of cost) with the expectation that this eventually becomes a 100% flow-through cost to the user.

 

One last interesting point relates to how Meituan is starting to change F&B operations in China. Wang Xing mentioned that the most successful merchants on Taoabo are not those with large existing offline retail stores, but those who adapted to the infrastructure-light approach. As such, he believes that the same will be the case for Meituan. This is starting to happen, as delivery-only kitchens have emerged (video link; 5:30 min onwards). The bargaining power is very much tilted in Meituan’s favour when it comes to these delivery-only kitchens.

 

Hotel OTA

 

Meituan has become the largest hotel OTA in China by room nights in the short period of time it entered this field (started in 2013). Note that when Meituan says it is bigger than Ctrip, it is referring to the Ctrip brand, instead of the Ctrip family (including Qunar and Elong). Table below shows the market share evolution. “Company 1” is Ctrip, while 2 and 3 are Qunar and Elong.

 

 

A lot of the edge came from securing a strong supply of hard to reach small hotels with Meituan’s 30,000-strong local sales force. Take rates for such hotels tend to be better too. Very reminiscent of Booking.com’s early days in Europe.

 

 

Unsurprisingly, BKNG is an investor in Meituan and has plugged its Agoda inventory into Meituan to be sold on the super app.

 

Ctrip CEO, Jane Sun, likes to dismiss Meituan as gaining share only via subsidies (link and various transcripts). However, the numbers speak for themselves. Ctrip’s 3Q18 sales & marketing expenses were 29.3% of net revenue, while Meituan’s were 24.2%. Given how a typical CNY 5 coupon for Meituan’s food delivery eats up 79% of revenue (14% take rate * CNY 45 average GTV per food delivery order), and that food delivery is 58.6% of revenue, it is hard to look at these figures and think that Meituan is subsidizing more than Ctrip in its hotel business. This metric also demonstrates Meituan’s success in cross selling.

 

Reviews

 

As mentioned, Dianping is the default consumer reviews service like Yelp or TripAdvisor. Network effects are very strong in this business.

 

Dianping’s reviews are Meituan’s customer acquisition tool. Food delivery and in-store deals are how Meituan monetizes this traffic. Post-transaction, users leave a review, which expands the depth of Dianping’s trove. There is a positive feedback loop here.

 

There isn’t much difference in the way Meituan or BABA’s Koubei (“word of mouth” in Chinese) operate in terms of local services, though Koubei doesn’t do group deals (one less marketing tool) and its quantity of reviews for most stores are far less than Dianping’s. Reviews on Koubei tend to come from transactions that took place on it, while Dianping’s are a combination of organic (ie, TripAdvisor/Yelp) and transactions-led. Given the winner-takes-all nature of consumer reviews, Dianping has a stronger word of mouth.

 

Wang Xing mentioned that Meituan will focus on China (huge market at nascent stage) during the IPO press conference, but he also pointed out that he will close some of the gaps in international reviews (video link). “Gap” in this instance means beefing up Dianping’s proposition as a TripAdvisor to the Chinese.

 

Many Chinese already use Dianping as their overseas guide vs TripAdvisor. This explains why one doesn’t see a lot of Chinese reviews on TRIP despite the ubiquitous Chinese tourist. Below are some screenshots of the TRIP app vs Dianping on Bangkok’s Siam Ocean World attraction. Notice 1) the richer formatting and information available on Dianping; 2) more monetization options on Dianping; 3) Dianping has half of TRIP’s number of reviews, despite Chinese tourists making up less than 1/3 of global tourism; and 4) positioning of reviewer’s photos/videos within the review makes more sense than requiring user to scroll up to find the shark video referenced.

 

TripAdvisor

 

Dianping

 

Thus, while I like TRIP and have owned it before, they will probably find it hard to gain traction over Dianping with Chinese tourists. Attractions looking to monetize Chinese tourists flows will also engage with Dianping. If one has a bull case on TRIP, one should consider Meituan since it closes the monetization loop very well and has the equivalent trove of reviews targeting one of the fastest growing tourism markets in the world.

 

Marketing services for merchants

 

Given the pressing need to fill capacity, merchants are highly motivated to score a more prominent placement in Meituan’s app. This is where Meituan’s “online marketing services” come in. Today, online marketing services only make up 17.5% of Meituan’s food delivery and in-store/hotel revenues. The runway is huge, considering BABA’s equivalent “customer management” revenue came in at 145.9% higher than its reported commission revenue. True that BABA doesn’t charge commissions for Taobao but adjusting for this still puts customer management revenue at ~109% of total hypothetical commission revenue.

 

Not hard to imagine stronger demand for Meituan’s merchant marketing services too, given the dynamics around high contribution margin from incremental sales.

 

Furthermore, Meituan’s pricing on such performance ads can improve if its data allows for more relevant matching between user and merchant.

 

Merchant services

 

Meituan is the largest player in China’s nascent restaurant management software market today due to its system’s ability to integrate offline and online transactions (via Meituan). This is another example of cross-selling on the merchant side of Meituan’s platform.

 

Meituan also provides a supply chain solution (“Kuailv”) that bundles raw material orders from smaller restaurants so that it can get a better price from wholesalers, to be delivered more cost effectively via Meituan’s network of riders (operating leverage). This looks like a US Foods/Sysco format. Also sets Meituan up to be an aggregator of F&B establishments, which allows for interesting business models on the wholesale side.

 

Merchant churn rates are greatly reduced with these mission critical services.

 

As mentioned during the 3Q18 earnings call, 10% of Meituan’s active merchants base use at least one of its merchant services. This area looks promising.   

 

Bike share

 

The market was dumbfounded when Meituan acquired bike sharing firm, Mobike, for USD 2.7 bil in April 2018 (link). How Meituan was going to justify the price when a 30-min ride only earns CNY 1 was hard to imagine.

 

Meituan revealed its strategy in January 2019 by announcing that they will be shutting the Mobike app and mini program down. Users just need to open their Meituan app to scan to unlock the bikes.

 

Thus, Meituan is buying a high frequency business here to get new users, reduce churn in existing ones, and increase overall usage frequency. Bike sharing also allows Meituan to gather much more detailed location data on users. Recommendations and marketing can thus be more relevant.

 

The operating numbers don’t look terrible. According to Meituan’s prospectus, Mobike had 48.1 mil active users, 7.1 mil active bikes (each bike supports ~7 users, which Wang Xing said can be improved upon) and over 1.0 bil rides completed from Jan – Apr 18 (62.4 annual rides per active user; high frequency enough).

 

I do have a harder time figuring out how the price paid works out assuming Meituan cross sells new users acquired via Mobike. However, there are other considerations as mentioned above. The price might make sense if Meituan achieves them, though it is harder to quantify.

 

Ride hailing

 

Meituan entered ride hailing in 2017. Doing so made sense, since users in higher tier cities will notice an option to hail a ride to the store on the merchant’s page on Meituan. This is thus a natural cross sell.

 

However, Didi Chuxing felt threatened and got aggressive in the retaliation. Partly as a result, Didi reported a net loss of CNY 10.8 bil in 2018, of which CNY 11.3 bil came from driver subsidies. This coming from the Uber-slayer which commands a >90% market share suggests Didi takes the threat seriously.

 

Nonetheless, Meituan’s ride hailing roll-out was slow and deliberate, since it wasn’t getting a good return on capital here. It mentioned in its prospectus that it doesn’t foresee further expansion in ride hailing unless the economics improve. Thus, management cares about capital allocation and doesn’t just pursue growth blindly.

 

Didi has since bumped into regulatory woes and is laying off 15% of its workforce in 2019 (link). It is also facing competition from Ant Financial backed Hello TransTech (used to be Hello Bike), which grew via targeting lower tier cities.

 

Depending on how this turns out, Meituan can either get back into the competition or simply auction or partner for that ride hailing button in its app (capital light but earns a commission). Either way works cos of user aggregation.

 

Management

 

“Little Jack Ma” + Shadows of Bezos

 

Wang Xing keeps a low profile and isn’t a household name yet. But the Chinese public is starting to learn more about him as Meituan gets bigger. His nickname in Chinese tech media is “little Jack Ma”. This is not undeserved, as the man combines the best of Jack Ma’s strategic thinking, Pony Ma’s product insights and Jeff Bezos’ competitiveness.

 

Meituan’s execution of its cross selling strategy in the new field of services e-commerce and how it emerged victorious in its many battles for market leadership showcases Wang Xing’s strategic thinking. His VC backers like Neil Shen (Sequoia China) and Kathy Xu (Capital Today) also share this view.

 

It requires a good deal of product design insights to cram that many features/businesses into a mobile app, and cross-sell new categories (huge hurdle in initial user buy-in) to fickle/impatient mobile users. The only other super app that has done well so far is WeChat.

 

Finally, the above discussion about how Meituan broke into new categories by grabbing the number 1 spot from behind shows that there is an “Amazon is coming for you” pattern here. It is not easy fighting off 5,000 VC-backed clones (not luck), displacing the top OTA with all the network effects in place, and successfully fending off rivals throwing prodigious amounts of money to grab share (Ele.me in food delivery).

 

Most people who have interacted with Wang Xing often share that he is a deep and logical thinker who is also a learning machine. Wang Xing’s 2 earlier startups had limited success, but he parlayed the lessons into his Meituan with good results.

 

The man is also very willing to experiment and fail, echoing Bezos’ views on this topic (link). In a biography of Wang Xing, the author (who had access to Wang and his team) pointed out that Wang Xing sets aside time every day to read about and try new product features from startups in the US and China, testing out the more interesting ones inside his startups. This video of a Q&A session (in Chinese) with university students gives viewers a sense of Wang Xing’s willingness around experimentation (link; 21 min to 27 min segment).

 

Last but not least, Wang Xing has integrity. This interview (link; very good read; Google Translate it) by Kathy Xu (very successful VC behind Capital Today) highlighted how Wang Xing’s competitors during the “War of a Thousand Groupon Clones” told Xu that all group buying companies inflated their metrics for funding, but Wang Xing didn’t. Most group buying companies inflated the “original price” of their deals to make the discounts look awesome to fool the user into buying; Meituan never did so. These things carry more weight when coming from competitors.

 

“War of a Thousand Groupon Clones”

 

Fatigued readers can skip this part but how management took on 5,000 competitors and won gives a sense of the strategy, execution and competitive tactics behind the team.

 

A year after Meituan was started, the Chinese startup scene caught “Groupon fever” and saw thousands of Groupon clones emerge, backed by prodigious amounts of venture capital. Remember that this was at the peak of Groupon’s popularity before its IPO. Many of these entrepreneurs wanted to copy the concept, spend on growth, and then do a quick flip via an IPO. As such, there were more than 5,000 group buying companies in China at its peak in 2011. To make matters worse, Groupon entered China with a joint venture with Tencent. The arena was impossibly competitive, and the competition was brutal/unscrupulous, as documented by Lee Kai-Fu in his recent book, “AI Superpowers” (Lee invested in Meituan and naturally speaks well of it, but the book is a good read; link).

 

Meituan might have been early, but that didn’t count for much. It wasn’t the best capitalized group buying company. It was also never number 1 till much later. Regardless, it managed to outlast the competition and win the war with a differentiated strategy.

 

Meituan stood out for putting the user first. It gave users a 7-day refund period in case they changed their minds. Importantly, Meituan allowed users to roll their vouchers over into new ones if they expired without being used. Most group buying companies wouldn’t do so, since this was 100% gross margin. These moves bought goodwill.

 

On the merchants side, Meituan hired good salespeople who were trained to know their customers inside out (eg, the shop owner’s wife calls the shots). The salespeople also won by helping merchants craft attractive deals to customers. This sales team remains today and is the pillar behind Meituan’s efforts in adding offline merchants to its platform.

 

Merchants preferred Meituan because it paid them faster than the competition and did so with an automated process. Bad experiences with group buying companies going bust (merchants fulfilled the service but didn’t get paid) made Meituan’s payment terms stand out.

 

In terms of tech, Meituan was able to track every single deal online in its IT system vs disparate spreadsheets stored on local hard disks for competitors. Sales people could snap a photo of contracts signed and upload it to the server to be available immediately to both Meituan and merchant. Merchants could also access real time analytics from Meituan (competition didn’t offer this). These things might seem unimpressive today, but Meituan was doing so since 2011.   

 

As for marketing, Meituan eschewed offline marketing (eg, posters in lifts or buses) that the competition favoured since it reasoned that it was selling online; marketing should thus be online. Meituan pursued word of mouth marketing since it was the most effective; it gave users a CNY 10 voucher if their friends bought a deal. Cost effective with high marketing ROI.

 

Cost consciousness was ingrained in the business. Wang Xing justified every spending decision by ROI. Was very willing to spend big as long as the ROI behind it was strong (good capital allocation).

 

Meituan’s frugality conserved capital. Management pointed out ~mid-2011 that the group buying capital cycle would turn because the number of competitors and their staff had risen 10x in a year, while industry GTV only rose 120%. Investors would end up disappointed and stop funding new competitors soon. This turned out to be true by the end of the year. At that point, Meituan charged out of the gates to grab share with its strong balance sheet, ending up as the market leader.

 

This is a highly summarized version of how Meituan won the “War of a Thousand Groupon Clones”.  Considered together with how Meituan started behind but won the food delivery and hotel OTA industries in such short order, Chinese tech firms ought to worry whenever Meituan comes for them. Just like Amazon.  

 

Senior management team

 

While most people think of Wang Xing when talking about Meituan, his core management team is very capable too. Guys like Mu Rongjun, Wang Huiwen and Gan Jiawei pull their own weight. Many have stuck with him since his first startup. This is similar to Alibaba in that Jack Ma gets all the attention, but his core team is strong.

 

As a bit of trivia, Bytedance CEO Zhang Yiming used to work under Wang Xing in his second startup, Fanfou. Both also grew up in Fujian province. Zhang left after Fanfou (China’s most popular Twitter clone at that time; link) was suspended in June 2009 over politically-sensitive posts regarding Uighur-majority Xinjiang. Zhang and Wang remain buddies today.

 

Take rates and margins

 

Take rates

 

Take rates for local services tend to be higher than goods e-commerce as a result of their huge variance in experience, making them harder to sell online. An analogy will be OTAs getting higher take rates for hotels (rooms are not all the same) vs air tickets (a seat is a seat). The higher commission is compensation for working the harder sale.

 

Meituan’s take rate for food delivery was raised to ~20% (link) in January 2019 while in-store take rates appear to be unchanged at around 10%. Tmall’s take rates are 2% - 5% (depending on category).

 

CLSA did a small survey of merchants and found a 25% take rate to be the upper limit for food delivery. Makes sense, since this can’t exceed rent + labour cost saved.

There is thus room to increase take rates, but probably more so in the in-store area.

 

Margin expansion

 

Gross margins for in-store is high (90.6%). Food delivery’s 3Q18 gross margins of 16.6% might look woeful, but this is changing.

 

Gross margins for food delivery should expand with the Jan 2019 increase in take rates for food delivery to ~20%. This compares favourably to Meituan’s reported 14% food delivery take rate for 3Q18, which was an average for the quarter (own estimate puts the quarter-end take rate at around 16% to 18%).

 

Meituan has also started levying a small delivery fee on users since 3Q18 of around CNY 2.50 per order. Considering that delivery cost in a Tier 1 or 2 city is slightly more than CNY 5, and that delivery forms the bulk of cost of revenue, having the customer pay for half of this goes a long way in expanding gross margins.

 

To get a sense of the outcome based on 3Q18 numbers, assume the same CNY 45 in average food delivery GTV and a 19% take rate + CNY 2.50 in delivery fees per order; food delivery gross margins can expand to ~68%. Group-wide gross margin rises from 24.0% to 56.9% (or 73.4% if “new initiatives” segment is excluded).

 

Next, assuming operating expenses stay the same (reasonable), operating margin rises from negative 17.7% to +22.5% (or 32.9%, excluding “new initiatives”).

 

These numbers are much closer to BABA’s Core Commerce margins and rightly so, since Meituan is a large e-commerce marketplace too. Furthermore, the above scenarios assume Meituan still subsidizes half the delivery fees and under-monetizes its merchant advertising business.

 

Competition from Alibaba

 

BABA’s Local Services Company

 

BABA took 100% control of Ele.me (food delivery) in 2018 and merged it with Koubei (in-store) to create “Local Services Company” (LSC). LSC is meant to be BABA’s vehicle for taking on the huge O2O (online to offline) market.

 

However, Meituan co-founder Wang Huiwen (no relation to Wang Xing; they were college mates from Tsinghua) pointed out during an interview with 36kr in 2018 that BABA simply copied Meituan’s entire playbook for Ele.me, Koubei and the subsequent move to merge them for the cross-sell. Ironic, considering Jack Ma’s famous quote: “You should learn from your competitor but never copy. Copy, and you die.” (link).

 

Regardless, given the same playbook and BABA’s reputation/execution/capital, the market got concerned and pushed Meituan’s stock price lower.

 

Why is BABA doing this?

 

For starters, the services e-commerce market is a huge one. Given the number of major players in goods e-commerce (BABA, JD, PDD), there is room for more.

 

The Chinese tech media generally understands BABA’s motivations by pointing out that it bought Ele.me for its 30-min delivery capabilities. This is very important to fulfil fresh food/grocery deliveries under New Retail. As long as the fleet pays for itself doing food delivery, BABA’s stacking of fresh food/grocery deliveries during non-peak periods will improve the unit economics of New Retail. In-store services can also be packaged with the offline activities within New Retail.

 

In short, LSC is to complement New Retail.

 

Furthermore, BABA has bundled Ele.me into its “88 VIP” membership (link). Thus, while food delivery is an important vertical, it is a complementary but secondary business to the core retail piece (similar dynamics to the perks in Amazon Prime).

 

Thus, LSC is not exactly a profit center for BABA.

 

Alibaba is not the Crocodile in the Yangtze

 

“EBay is a shark in the ocean. We are a crocodile in the Yangtze River. If we Fight in the ocean, we will lose. But if we fight in the river, we will win.” – Jack Ma

 

The above quote summed up how BABA won EBay. It even formed the title of a documentary on BABA’s founding story, launched right before BABA’s IPO (link).

 

While BABA might be the bigger company (CNY 54.2 bil in 3Q18 China Core Commerce revenue vs CNY 19.1 bil for Meituan), Meituan is the clear leader in local services and food delivery. As such, Meituan owns the network and infrastructure advantage when it comes to its own turf; Meituan is the crocodile in the Yangtze this time.

 

Doesn’t help that BABA has been against hiring local sales teams in favour of the light touch it prefers. Below is a snippet from BABA’s 2Q16 earnings call (dated 27 Oct 15). BABA might be right, but my view is that Meituan’s local sales team has been a key tool in offline merchant acquisition since services merchants require a fair bit of handholding and selling.

 

Piyush Mubayi, Goldman Sachs

The second question is about O2O space. And I wanted to know if you could share with us your Koubei strategy, mostly because it's emerged as an area of high level of cash spend. And we wanted to know whether you'd go down that path or you'd leverage your very deep customer presence in SME relationships. Thank you.

Joe Tsai, Alibaba

I'll address the O2O question. The O2O market is huge. It's about a $1 trillion market in China. And so at first sight we think that this is a space that can accommodate several very significant players. It's not a winner-take-all kind of market.

So in terms of the investment that you're asking, what kind of cash spend, what kind of investments, we see a very aggressive and competitive market right now. But the place people are spending money on is user acquisition, rebates to customers that come to use their services. But that's where Alibaba with our unrivaled mobile leadership has an advantage.

If you look at the mobile Taobao app and also the Alipay app, these are two of the largest apps in China with users coming in to engage in commerce transactions every day. And those two apps are providing a great entry point for our Koubei service.

So the places where we are going to spend money in terms of investment might not be what you think. We think that there are other areas, such as merchant acquisition and things like that, where you need to be very innovative. And building out a huge sales force on that front is not the way to go. So we hope to run the Koubei business as a light business and as an innovative business. Thanks.

 

It’s not about the money

 

Ele.me’s co-founder, Mark Zhang, did an interview with Chinese tech publication 36kr shortly after BABA’s acquisition of it. Zhang was candid in saying that food delivery is no longer a game of throwing capital behind discounts. Ele.me spent CNY 2 bil from its June 2017 funding round to wrest market share from Meituan but failed. Zhang attributed this to Meituan’s broader food delivery vendor selection, ability to offer in-store and Dianping’s reviews (ie, the super app concept works).

 

Zhang also noted that consumers are habituated to their preferred platforms and are suspicious of too-cheap food delivery (food safety is a concern in China).

 

But Zhang concluded by saying that he thinks being part of the BABA ecosystem might work.

 

Shortly thereafter, BABA announced a “summer battle” in July 2018 to spend CNY 3 bil in a single quarter to raise Ele.me’s market share from 36% to 50% (link). This was the opening salvo of BABA’s newly appointed CEO for Ele.me. The timing was also in part to disrupt Meituan’s IPO process.

 

3Q18 came and went. Meituan reduced sales & marketing expenses as a percentage of revenue and raised its take rate. But it managed to grow food delivery GTV by +17.3% QoQ (+89% annualized), users by +7.1 QoQ (+31.6% annualized) and transactions per user by +6.0% QoQ (+26.2% annualized).

 

Meituan also had this to say during the 3Q18 earnings call:

 

Shaohui Chen, Meituan Dianping - VP, Corporate Development

I will take the questions about subsidy. We have observed that the other player in the market has maintained a much higher subsidy level on the food delivery starting from this summer, about three times higher than ours.

But at the same time, the significant investments, many [of these] small portion of their overall consumer behavior, particularly those price-sensitive consumer groups, which we are not very concerned about. Because we have been focused more on the quality growth rather than just using investment subsidy to grow the volume.

We think this market already gets into a stage that fewer subsidy is not the most effective way and to build your competitive advantages. So we have been very careful in evaluating the competitive environment and also invest when we see there is value when the ROI can achieve the -- meet our requirements. So we are open-minded to invest only when we see the invest can generate high-quality consumers groups or high-quality orders on our platform.

So we have been able to see that our market share can [continue to play] and is very clearly in position even when other player is subsidizing heavily. And at the same time, we are able to continue to improve our overall unit economics.

 

Guess Ele.me’s new CEO should have listened to his predecessor.

 

App design and process flows matter

 

BABA likes to talk up its massive e-commerce traffic from Taobao and Tmall, hinting at strengths in cross-selling Ele.me or Koubei. However, notifications on the Taobao app tends to be related to the core goods e-commerce business, not services. The Koubei button is also positioned on the 2nd page, not first. An extra swipe to another page on real-estate scarce mobile phones demands too much friction; and these 3 actions (open-swipe-click) only gets the user to opening the Koubei page within the Taobao app vs 1 step to open the Meituan app.

 

Consider again Meituan’s super app design. If the point is to cross-sell in-store by making them easy to discover, BABA’s unnecessary friction is detrimental. To be fair, it is not that BABA doesn’t get it, but more of the Taobao app being designed to sell Taobao/Tmall stuff. BABA is trying to have its cake and eat it, but app design matters greatly in this discovery-to-cross-selling business model.

 

BABA’s incremental margins don’t support a war with Meituan

 

Finally, does BABA really want to stretch its finances to go after Meituan? BABA’s incremental operating margin for calendar 4Q18 was 16.6%, far from the headline 39.3% figure and 48.0% reported for FYE18 (Mar 2018). Do note that 16.6% in incremental margins probably includes a heavy mix of BABA’s good ol’ e-commerce operating margins, which were 55% before venturing into New Retail. Assuming New Retail accounts for 50% of Core Commerce revenue (likely to be much lower), its operating margins will work out to negative 23%. A lower New Retail mix makes it much more unprofitable. And it is capital intensive. But it is BABA’s priority.

 

Consider too that other priority areas like cloud and international expansion are important consumers of capital; BABA can’t really afford to put its money where its mouth is when it comes to Meituan.

 

To win a 50% market share in Meituan’s turf means spending at least as much in terms of sales & marketing. The true spending required is likely higher since Meituan has network effects and cross buying habits by users. Meituan spent CNY 4.6 bil on sales & marketing in 3Q18; this would have shaved another 4.5% off BABA’s already thin 4Q18 16.6% incremental operating margins (gets worse if we compare like-for-like 3Q18 numbers).

 

BABA’s CEO, Daniel Zhang, is an accountant by training and a rational guy. He certainly understands how the numbers work. He has heavy demands on his capital for his priority areas. Local services might be important, but it mainly pertains to the fresh food/grocery delivery piece to complement New Retail. 16.6% incremental operating margins will result in headline figure converging towards it if the trajectory doesn’t stop; what will BABA’s Core Commerce multiple be if that happens? BABA is unlikely to go nuts fighting Meituan.

 

Also explains why Ele.me followed Meituan when it raised food delivery take rates to 20% in January, as well as levying CNY 2.50 delivery fees on users. A determined competitor will never do that.

 

Valuation

 

As worked out under the section on “Margin Expansion”, operating margin is likely to hit 22.5% (or 32.9% if “New Initiatives” are excluded). Assume that “New Initiatives” is a necessary cost for this business model. Consensus estimates of revenue growth is above 40% p.a. for the next 2 years. Not a stretch to pay 20x EBIT for this. Thus, 20x of adjusted operating margin works out to a 4.5x EV/sales multiple. Or HKD 568.6 bil market cap (HKD 103.50/share) on consensus FY19 revenue of CNY 95 bil. This represents an ~80% upside from today’s prices.

 

Long runway that gets broadened with new cross selling categories means revenue can compound above-30% for some time.

 

Note that the 4.5x EV/sales multiple is not very different from the ~5.5x the market is ascribing to BABA’s Core Commerce segment. Much lower than PDD’s ~7.5x multiple, though PDD’s growth rate is higher.

 

Why is this Cheap?

 

- Local services e-commerce is a new template that isn’t well understood, especially outside of China

- Meituan’s business model of cross selling high margin, low frequency services onto high frequency ones is not well understood

- Many still think of Meituan as a food delivery company or a group buying one

- Market and sell side analysts think BABA is going to focus its balance sheet towards wresting the market from Meituan

 

Risks

 

- BABA somehow shifts food delivery/in-store services/hotel OTA to the top of its priorities and goes all-in with Meituan, disregarding how a 12% incremental operating margin is going to sit with investors

- Key man risk. A lot still depends on Wang Xing, though his team is capable.

- Lock-up expiration ~mid-March 2019. Xiaomi’s lock-up expiration saw its shares getting dumped. China Tower’s didn’t. Depending on your trading views, you can scale into the position if you like. Nothing useful to add from me when it comes to trading.

- Cash burn is NOT an issue. Wang Xing’s first business ran out of cash and he has learnt well. Meituan’s negative working capital is ~65% of revenue. At 40% growth rate, this covers 3Q18 operating loss of CNY 3.4 bil (some of this is non-cash) by 1.5x; similar to Amazon’s cash flow dynamics. Even without negative working capital, Meituan’s CNY 59.6 bil in cash and short-term investments can cover 4.5 years of operating losses. Throw in margin expansion underway (but not yet on the financial statements), cash burn is not an issue.

 

Conclusion

 

Thanks for reading this long post. Felt the details are necessary since Meituan isn’t well understood outside China. Competition from BABA is real, but the market is pricing in something significantly more than what BABA will probably execute. Last but not least, Meituan’s operating margins are on their way to hit half of BABA’s Core Commerce’s ones, while revenues are also half of BABA’s upon adjustments. But Meituan’s current enterprise value of USD 30.4 bil vs BABA’s Core Commerce’s ~USD 240 bil is too wide a gap. Even at ¼ BABA’s level (half operating margins * half revenue), Meituan should still be a double from here.

Catalyst

- Continued expansion into new categories and execution on existing ones. International expansion for Dianping along the lines of TripAdvisor helps.

- Margin expansion (already underway)

- Realization that BABA will prove to be a rational competitor and that local services is not exactly its priority

- Macro clouds lifting on Chinese equities

- Further inflows from MSCI inclusion (reported mid-Feb 2019; link). This resulted in a nice surge but might have follow-on effects. Macro clouds lifting on China might also result in heavier China allocations, which will lift Meituan indirectly.