Will Alibaba Ever Become a Big Threat to Amazon?

With the planned Alibaba IPO, more U.S. consumers will no doubt become more familiar with China's largest e-commerce player. This should be a little disconcerting for Amazon (NASDAQ: AMZN  ) investors because of Alibaba's popularity outside the U.S. Amazon has developed a reputation of cutting product prices to the bone--but Alibaba is no stranger to such practices either.

Mark William, a William and Blair analyst who regularly tracks products sold at Amazon, told Y-Charts in April that there were a number of items on Alibaba's merchant website, AliExpress.com, that were selling at huge discounts compared to similar products at Amazon and Wal-Mart (NYSE: WMT  ) . For instance, a KitchenAid Classic 4.5QT Standard Mixer was selling at $299.00 on both Amazon and Wal-Mart, but just $199.18 at AliExpress. A Keurig Q10 Coffee Maker sold at $99.00 in Wal-Mart, and $95.44 at Amazon, but only $45.58 on AliExpress.

AliExpress concentrates on selling very low-priced, mostly lower quality products, some of which overlap with products sold by Amazon and Wal-Mart. Currently, few U.S. consumers are aware of AliExpress, let alone do their shopping there. But with the planned Alibaba IPO, this could change very fast, and Alibaba could soon become a household name in America.

Although the merchandise on AliExpress is mostly lower quality, more U.S. shoppers are likely to start visiting the site hunting for bargain deals. Low price retailers such as Wal-Mart might face more competition from AliExpress in the future.

But Amazon is not likely to relinquish its position as the dominant online seller, as we shall see below.

Different frugal model
Alibaba can afford to offer such low prices because it operates a very different model from Amazon's. Alibaba does not do any fulfillment of its own, but simply acts as a go-between or marketplace for online buyers and sellers who do their own fulfillment. Alibaba is therefore simply an interface where buyers and sellers meet and do business. Alibaba also sells advertising space for merchants who would like be featured higher on Alibaba searches.

This is in stark contrast to Amazon, where third-party sellers account for only 40% of the company's revenue, and the rest mainly comes from direct sales by the online giant. Amazon invests very heavily in large warehouses and fulfillment centers. Amazon has been investing heavily in infrastructure to support its expanding business in countries such as Italy and Spain. That's the biggest reason why the company's international profits have been shrinking -- and pulling down the company's overall profitability as well.

Amazon Operating Margin by Geography

Source: Beyond Devices

The downside of Alibaba's revenue model is that it generates considerably lower revenue. This is perhaps because many people would prefer the convenience of shopping with Amazon instead of Alibaba because it delivers the merchandise for them, whereas they would have to do their own shipping arrangements if they were to shop at Alibaba. The upside is that Alibaba's revenue model generates a much higher transactional value than Amazon's. Alibaba makes $0.43 for every dollar in sales, while Amazon earns just $0.01 for every dollar in sales.

Amazon vs. Alibaba Revenue & Operating Income

Note: Figures in Millions of Dollars. Source: Beyond Devices

How Alibaba's low prices can benefit Amazon
But, the availability of cheap products on Alibaba can also work in Amazon's favor. Mark Miller told Y-Charts that the heightened promotional activity at GNC, a leading vitamins and supplement retailer, had been creating arbitrage opportunities where people bought products cheaply on GNC's website, and then sold them on Amazon. According to Mr. Miller, there were only 460 GNC SKUs on Amazon in 2012, but 1,270 SKUs in 2014.

Such huge price differences such as the ones I have illustrated above are not likely to exist for long once Alibaba becomes well known to Amazon third-party sellers. It will be relatively easy for them to buy goods cheaply on Alibaba and sell them on Amazon, which will in turn increase demand and drive the prices up. Such trading activity would earn Amazon more revenue through the normal fees it charges third-party sellers.

Alibaba might, however, pose a bigger threat for a company like Wal-Mart, whose online sales make up just 2% of the company's overall sales. But even here, the impact will probably not be big enough to cause a noticeable dent on the giant retailer's top line.

Foolish bottom line
The Alibaba IPO is likely to lead to the Chinese e-commerce giant becoming better known to the average American. But Alibaba mainly sells lower quality products than what you would typically find on Amazon or Wal-Mart. This might mean less competition for the two retailers.

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