May 28, 2006

Used Cars in China: Part 2 – It’s going to take more than TurtleWax to make used car portals shine in China

Filed under: Automotive — Administrator @ 8:44 pm

Last week’s note titled “America’s experience with interest rates, leasing, and auctions” discussed the history of used cars in the United States, concluding that the main driver of used car proliferation in America was interest rates; and until China experiences a similar shift in rates/consumer demand the used car industry will remain uninspiring.

This week, we’re shifting gears from drivers to models, specifically Internet related models. Before I get too far ahead of myself, I wanted to warn you, I’m not all that jazzed up about the prospects of the online used car space in China. I used to be full throttle psyched (like 3 months ago) but now the deeper I dig the more I’m convinced that the numbers/demand can’t support a web-based used car offering in China.

Don’t get me wrong, I want to believe in this used car dream more than anyone (I have a storage room filled with bumper stickers in Chinese reading “honk if you’ve been used”); but sometimes reality bites, and in this case, well, I’m looking for Winona Ryder. What concerns me is that there seems to be a tsunami of euphoria flooding China, touting the riches to be gained in this business. And, I can understand why, or rather where it comes from (queue Meg Whitman’s entrance, spot light on eBay Motors). To the causal observer (yes, I am one of those) eBay Motors’ numbers are staggering – the preverbal “smoking gun” of comparable business models…or are they?!

So, let’s get on with it – show me revenues:

According to Solomon Smith Barney, eBay Motors accounted for about 30% of eBay’s total gross merchandise sales (GMS) in 2003 (up from 12% in 2001); incredible still is the fact that eBay Motors went live around 2000. And talk about potential, eBay Motors estimated penetration rate is about 1.8% of the total US$350bn addressable market (or a GMS run rate of about US$6.5bn). Casually flashing these figures around a boardroom would stimulate the bluest of the blue bloods to roll up their pants and River Dance around the room.

“Cool. We’re going into the used car business,” yelps the bean counter in the corner holding his tortoiseshell rimmed glasses (by the way, I wear tortoiseshell glasses) in one hand and a Texas Instruments BA II Plus calculator in the other, “let’s buy some more servers…”

Kansas City Sidestep (KCS) anyone? Yeah, well, for all the gloss, in some ways, eBay Motors is a KCS. No need to make this complicated with loads of details but there are some downers dulling eBay Motors fine turtle wax finish.

An obvious one is eBay’s so called “take Rate”, or rather the percentage of money eBay makes off merchandise (GMS) transactions – essentially, revenue. According to eBay’s 2003 annual report, the average non-motor GMS take rate is about 8.5%, or more than two times eBay’s estimated 3.5% take rate from motor related GMS. If we make some adjustment to eBay Motors’ GMS, taking into account its lower take rate, Motors contribution to eBay’s total transaction based revenue drops from about 30% to about 11%.

But let’s not be too harsh – an 11% revenue contribution from any one category (or product) is solid, yet this is only 11% of total transaction related revenue, eBay also has payment related revenue (and this is a point I’m hijacking from Solomon Smith Barney as I overlooked it, too). Payments in 2003 accounted for 22% to 23% of eBay’s total revenue whereas auction related transactions accounted for the balance, 78% to 77% – following this line of reasoning and adjusting for payments, it seems like eBay Motors contributed less than 10% to eBay’s consolidated revenues.

Oh, silly me, I forgot to mention, 20% of eBay Motors GMS comes from non-auto related auctions, such as motorcycles and recreational vehicles (RVs); yeah, you got it, further eroding Motors contribution. Ouch! Does anyone have a flashlight? It’s getting a little dark in here…

…perhaps, a little too dark, a little too hardcore on the rev erosion front for my liking. And, yeah, I know it is hard to argue with the numbers but I’m comfortable believing motor related revenues account for somewhere between 11% and 15% of eBay’s total consolidated revenue.

And margins? Well, even at 50% I think the river dancing in the boardroom has stopped, but if you insist we can use the cocktail napkin approach to come up with something – eBay doesn’t report margins on individual categories so we need to get a little creative by pulling some numbers from comparable companies: (1) eBay reported a 2003 Earning Before Tax (EBT) margin of 30.6% – very healthy (queue river dancing) – yet it would be unreasonable to assume eBay Motors generated anything close to these margins as eBay Motors’ pricing scheme is fixed; (2) on average franchised and independent car dealers earn margins of around 5.5% to 11.6% on new and used cars (source: NADA 2006); (3) China based job listing site generated margins 13% to 21% between 2003 and 2005; and (4) auction houses, such as Manheim, report margin anywhere between 4.5% to 7.0% (by our best estimates from available data).

Back of the napkin estimate – I think it might be safe to assume EBT margins come in between 5% and 10% (though, Solomon guesstimates eBay Motors contributes to less than 5% of eBay’s net profit). Okay, not supermarket margins, but not eBay margins either; and certainly not enough to sustain a China-based start-up where the market is desperately underdeveloped. And what’s more, margins would be seemingly lower than eBay Motors as, most likely, the China venture would be a listing service (or classified service) rather than an auction platform where a business can demand a listing fee and a percentage of the money generated from the auction.

Show me infrastructure and inventory…

Putting margins and revenues aside, and turning our focus to infrastructure expenditure, the picture for our start-up friends (or even those a bit more entrenched) doesn’t improve much. Imagine, if you will, the amount of cash required to build-out a platform similar to that of eBay’s (circa 2000) – even in China, it would be massive. How so?

First, eBay Motors had the luxury of leveraging (arguably) the best web-based auction platform in the world – a tweak here, a tweak there, plug this into that thing over there and you are ready to go. Second, eBay has an installed registered user base of 10 million people. Third, mucho brand value and substantial marketing dollars. Fourth, tried and trusted features, such as proxy bidding, the Feedback Forum, “SafeHarbor” trust and safety services, to name a few. And finally, perhaps most importantly, strategic partnerships and acquisitions which not only provided inventory and traffic, but installed eBay Motors securely aloft the competition.

The first three are obvious and need little explanation, but the fourth (trusted features) and fifth (partnerships & acquisitions) are worth a bit more discussion:

Number Four: Trusted Features

eBay’s reputation as a “SafeHarbor” was widely accepted by its users, but vehicles (with their high sticker prices) were entirely different beasts all together – users needed sophisticated tools to protect themselves against fraud. Okay, so now you are scratching your head, thinking, isn’t this guy a bit hypocritical? Hasn’t he compared certification with a Kansas City Shuffle? Well, I’m not changing my tune – in fact, the following further supports my “certification is a hoax” campaign. (Where’s that damn soapbox? Ah, found it…)

In 2001, eBay formed a partnership with Saturn Motors (a subsidiary of General Motors targeted at women) whereby an eBay member selling a car could bring the vehicle to one of four hundred Saturn dealerships across America and get the damn thing “Certified” for a US$99 fee. It was a good attempt at resolving the trust problem (and a move I would have totally championed if I was heading up eBay Motors back in 2000) but very few people got their cars certified. In fact, the service really should have targeted those out-of-state buyers (people who could not physically inspect the car). I’ve spoken with several eBay Motors employees and asked for the number of cars “Certified” – each time I get same response, a hand-full (shuffle, shuffle, shuffle…).

And then, in 2002, eBay got smart and said “gosh, certification as a concept is a good idea, but members aren’t buying into it, we need to do more.” Enter eBay’s Assurance Program for Vehicles – the Program provided coverage to buyers and sellers alike and consisted of four main features: Limited Warranty (coverage for 1month or 1000 miles), Purchase Insurance (up to US$20,000), Payment Protection (Fast Deposit and and Mobile Vehicle Inspection (in 2004, eBay canceled the Saturn partnership and hooked up with SGS Automotive Service, who could perform inspections a member’s home or office).

A solid four point protection program that covered pre and post-transaction services; and thus distinguishing eBay from the crowd. Furthermore, eBay Motors, as the market leader, had the leverage and wallet to cobbled together this Assurance Program. And while relatively easy for eBay to do this in America, a China base operator would have one hell of a time replicated these services for any number of reasons, but specifically because the necessary service providers don’t quite exist (or rather, those that do exist are either too expensive, not web-enabled, or restricted by regulations).

Number Five: Partnerships and Acquisitions

I’m seriously feeling this flavor (partnerships and acquisitions) big time – meaning that this was perhaps one of the most important steps eBay Motors took in establishing itself as a leader in online used car market. To recap, we know eBay Motors had access to premium IT and a unique/active membership base (eBay was a marketplace, true as the north star) but what eBay Motors didn’t have was vehicle inventory and established relationships with the largest group of used car buyers, franchised and independent car dealers (NADA reported that 76% of all used car sales involved dealers in 2005).

Here is a timeline detailing what eBay did to fill their inventory/partnership gap:

In 1999, Kruse International was acquired for about US$17m. Kruse companies conduct auctions, perform appraisal services and auctioneering training for classic car auctions in various locations in the United States and internationally.

In 2000, eBay entered into a marketing and services agreement with and purchased a less than 5% equity interest in AutoTrader (an automotive related web portal backed by Cox Enterprises, Manheim Auctions, and Trader Publishing Company). Under the terms of the marketing and services agreement, eBay developed the co-branded eBay Motors site and AutoTrader referred customers desiring an auction pricing format to the co-branded site in exchange for a referral fee. Also, eBay committed to incur $US32mn in marketing and promotion of the service and additional related services offered by AutoTrader over the 3.5-year term of the agreement (source: eBay annual report, 2001).

The significant of this relationship can not be overstated as it connected eBay’s trading community of 10mn buyers and sellers with AutoTrader’s 5mn unique monthly visitors and more than 40,000 participating auto dealers and 250,000 private sellers that provide the 1.5mn used vehicles offered for sale on AutoTrader.

In 2003, eBay acquired certain assets of Texas-based CARad, a leader in online auction management services for car dealers. CARad’s technology gave car dealers a simplified way to list and manage more vehicle auctions on eBay Motors. That same year, eBay Motors also forged a strategic relationship with Kelley Blue Book to become its exclusive auction-style partner.

Gosh, what does this all mean?

I guess it all depends on your risk appetite, right? Do you like investing in sure things, making intelligent high risk/reward bets, or simply blowing out your brains with a piss poor investment! Because at the end of the day, we all know the truth, eBay Motors (or some business model derivative) can not be independently replicated in China (given the existing environment) without the support of a sugar daddy. But if you disagree, well, here is a water gun (this is a family site)…

What eBay Motors demonstrates is that it is possible to make this model work if you bring to the table enough scale, traffic, technical support, comprehensive Assurance Program, and quality inventory. Though would we expect anything less from a US$50bn global Internet company? And yet, is eBay Motors a leader or rather a loss leader for eBay?

I don’t get the feeling eBay Motors would be a viable entity in its own right without the support (economies of scale) of eBay’s other categories. Or rather, I don’t expect eBay Motors, as a separate, independent entity, would be able to command anywhere near eBay’s un-adjusted FY06 PE of 45x (eBay is priced a little richer than the industry average PE of 41x – source Morningstar).

And, if you buy into this thought process (I’m intentionally excluding potential advertising revenue), then you’re sure to agree that there is no way on this green earth that a China-base used car web portal has the resources or traction to scale/survive independent of a cash-rich parent company with an existing inventory of quality used cars which are not only regularly replenished but also locally available.

To be continued…

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