My partner Yin Ming recently wrote an article about internet finance, which is actually one form of the much-discussed "Internet+". In this article, I want to share some of our observations and thoughts on another form of "Internet+".

Let's start with a picture.

First, when a group's informatization level exceeds a critical point, an application may explode, bringing efficiency gains. I won't elaborate on this.

Second, when some members of a group improve their efficiency, it forces the rest to quickly raise their informatization level. When some taxi drivers started using Didi and Kuaidi, other taxi drivers' relative efficiency dropped, forcing them to buy smartphones.

Third, the explosion of one application can also promote the explosion of another. If it weren't for Ele.me and Meituan Waimai's efforts in 2014, small restaurant owners wouldn't have learned to use smartphones so quickly, and Meicai's explosion might have been delayed. Note: Meicai is a mobile e-commerce platform for fresh produce serving small and medium restaurants. Launched in 2014, its 2015 sales are expected to reach 1.5 to 2 billion RMB, and it has raised over 1 billion RMB since inception (including Blue Lake Capital's Series A of over $10 million). Essentially, Meicai uses smartphones to transform the restaurant supply chain: restaurant owners order via smartphones, suppliers bid via smartphones, and truck drivers receive dispatch instructions via smartphones.

The larger the network, the greater the value of each node—this proposition applies not only to social networks but also to the entire internet. Android, WeChat, Didi Kuaidi, Meituan-Dianping, Ele.me—these new nodes have pushed mobile internet into the next stage, gradually transforming the supply chains of traditional industries worth tens of trillions.

Currently, the core of China's various commodity circulation is the various "wholesale markets." They play positive roles in pricing, matching transactions, improving commodity liquidity, and reducing transaction costs. However, through observation, we have found that many forms of wholesale markets have incurable inefficiencies, existing in a "suboptimal stable state," and there are opportunities to use information technology and capital to transform them. We have studied various characteristics of wholesale markets. Let's discuss two of them.

Characteristic 1: Accelerating Non-Standard Product Transaction Matching

Agricultural wholesale markets are a typical platform for matching non-standard products. It sounds inefficient: agricultural products are displayed in wholesale markets, which must lead to high spoilage. Why do buyers have to go to wholesale markets instead of locking in long-term supply from farms or cooperatives? Because farms and cooperatives cannot guarantee stable supply quality and quantity due to planting seasons, climate, pests, and other factors. Each batch may be different, and even within the same batch, quality may be uneven. Agricultural wholesale markets concentrate more sellers, allowing buyers to "see to believe," select on-site, and transact in cash.

This seems like an unsolvable problem. How can smartphones solve it? Observing domestic and international markets, we found that the answer lies not in "technology" but in "scale."

In fact, even before the internet era, American consumers had abandoned farmers' markets for chain supermarkets; the restaurant industry had also abandoned wholesale markets, relying mainly on 50 large "broad-line" Food Service companies, 16,000 small "narrow-line" Food Service companies (each serving an average of 40 restaurants), and some Cash and Carry (warehouse stores). The "broad-line" segment is highly concentrated: the top three (Sysco, USFood, PFGC) account for 70%; Sysco is twice the size of the second and three times the third, with obvious economies of scale. The EBITDA of the broad-line segment (7.2%) is more than double that of the third-place PFGC (2.8%), and per-SKU revenue, per-customer value, and per-warehouse capacity are all significantly higher than PFGC.

In China, due to geography, policy, and other reasons, supply is too fragmented and unstable, and the circulation sector lacks the soil for scale, with almost no "broad-line" Food Service companies.

So where is the opportunity for smartphones? We believe the opportunity lies in using mobile e-commerce to first solve the "scaling" problem on the demand side, quickly integrating the procurement scale of small restaurants, then moving from sales-area wholesale markets to production-area wholesale markets, and gradually extending to the source. Huge procurement scale can give circulation companies more accurate information on upstream agricultural output and quality, forcing producers to improve yield forecasting and grade differentiation, thereby increasing supply stability and reducing the number of times goods are displayed and moved. Additionally, integration in the circulation sector can improve logistics efficiency and, in the long run, promote the construction of cold chain logistics systems, further improving circulation efficiency.

When there is huge scale, the fragmented upstream becomes an opportunity. Sysco and PFGC both offer hundreds of thousands of SKUs but have only a few thousand suppliers (and likely with significant overlap). In China, in the future, it's possible that one SKU could have thousands of suppliers bidding daily via smartphones.

Characteristic 2: Pricing

When many buyers and sellers gather, market liquidity promotes price discovery and serves a pricing function.

Blue Lake once researched the flower market in Yunnan. Sellers are usually flower farmers and brokers from the production area, while buyers are usually wholesalers from the sales area. Demand for fresh flowers fluctuates greatly; a holiday or even a large event can significantly affect prices. However, because flower cultivation is not easy to scale, farmers have limited capacity (only a dozen to a few dozen bunches per day), and unsold flowers are wasted, so "selling at a reasonable price" greatly impacts farmers' income.

We found that sellers (flower farmers) mainly adjust prices quickly based on daily market sentiment (inquiries and sales speed). The extreme form of this is the "auction." In fact, in the Netherlands and Japan, the vast majority of fresh cut flowers were once sold through live auctions. In situations where face-to-face transactions are necessary and both supply and demand are fragmented, this pricing mechanism is relatively efficient. The buyers we surveyed generally felt that "market prices are relatively transparent." But the drawbacks are obvious—it doesn't fully leverage demand's guidance for production planning, and on-site transaction costs are high.

So what role can the internet play? Again, integrating scale. Observing Japanese, European, and American markets, we found that due to demand-side integration brought by e-commerce, pre-ordering and contract trading have become mainstream. In Japan, over the past decade, the proportion of fresh cut flowers sold through auctions has dropped from 70% to 30%. Flower farmers actually prefer long-term stable buyers and don't want to worry daily about their flowers rotting unsold in the wholesale market. So if someone can purchase stably over the long term, they are willing to prioritize meeting their quality standards and supply them first when production is insufficient.

Another example is B2B auction of used cars. Retail-savvy car dealers (buyers) need to go to car source areas (usually first-tier cities) to find familiar models and years, while collection-savvy dealers, 4S shops, and rental companies (sellers) need to quickly digest inventory to free up capital and purchase quotas. Beijing's Huaxiang market's pricing method is basically to quote a high price first, then slowly adjust through bargaining.

Mobile internet is rapidly changing this industry. Before founding Blue Lake, I invested in a startup called "Youxinpai" (yes, the one behind the "shang shang shang shang" ads for Youxin Used Cars; at the time they only targeted small B, but now they also do retail to C). They used smart mobile devices to achieve low-cost and standardized inspection, quickly integrating supply, then used smart devices for online electronic auctions, greatly improving liquidity and price discovery efficiency. Their transaction volume has now reached 10-20 billion and is still growing rapidly.

Characteristic 3: Increasing Product Variety and Speeding Up "Product Search"

Auto parts cities and hardware cities are typical. These two types of products share a common demand characteristic: urgency. Auto repair shops have anxious waiting customers, and construction teams and factories have anxious workers waiting to start. These are unplanned procurement needs, and the product variety is enormous, ranging from hundreds of thousands to millions, making it difficult for a single supplier to stock everything.

These wholesale markets offer buyers a rich selection, but they also have many problems. First, although the wholesale market is large, it's a motley crew without a "master index" of products. When product types reach hundreds of thousands, finding an uncommon, hard-to-describe item is extremely difficult. The current solution relies mainly on the "living index" in the minds of small wholesalers, who "transfer goods" among themselves to meet customer needs. They generally know which peers to contact for certain goods, then inquire via phone, QQ, WeChat, etc. Additionally, due to unstable demand, it's hard for both sides to form stable supply-demand relationships. This leads to generally low integrity among market participants, with passing off inferior goods and shortchanging being the norm.

It seems that "rich selection" and "reliability" can't coexist... Let's imagine: if a company had enough money to build a huge central warehouse stocked with hundreds of thousands of products, could it meet customers' "rich selection" needs on the basis of "reliability"? The answer is yes. In fact, there are such companies in the US, like NAPA and Grainger, with sales in the tens of billions of dollars. They achieve "complete, fast, and reliable" by building multiple levels of warehouses of different sizes. Smaller companies survive by choosing a niche category and offering even more complete inventory than these giants.

We have a theory called the "Blue Lake Efficient Frontier" that can describe this market situation. Let's take the hardware industry as an example and draw a diagram:

Business forms on the efficiency frontier can survive; those inside the frontier are in the "death zone" and will be eliminated by the market.

You might be getting impatient: it sounds like the internet has no role, let alone smartphones. Don't worry, Blue Lake Capital believes that the internet and smartphones can not only add a point or two on the "Blue Lake Efficient Frontier" but also shift the frontier. See the diagram below:

When the efficiency curve shifts right, broad-line wholesalers and wholesale markets enter the death zone. Why?

First, the internet makes it easy for users to search, making product discovery easier. E-commerce has also matured the social logistics system, expanding suppliers' service radius and increasing competition. Mobile internet may be even more important; it can integrate supply-side product and inventory information and improve service response capabilities. When Blue Lake Capital surveyed auto parts cities and hardware cities, we saw small merchants using WeChat to provide consultation and quotes to customers, and also using WeChat groups to "transfer goods" among themselves. Mobile internet has already increased information flow speed in a rough way.

To meet the internet challenge, Grainger, the largest hardware wholesaler in the US, increased its inventory SKUs from less than 100,000 to 600,000 between 2005 and 2013, and e-commerce now accounts for one-third of sales, making it the 15th largest e-commerce company globally.

We see Grainger striving to move along with the efficiency curve. However, this approach of relying on massive owned inventory is not the only answer. At the other end of the efficiency curve, there's a Japanese company called "Misumi" that claims to offer 10 million SKUs with delivery in 1-3 days, but it barely relies on owned inventory. Through over a decade of rapid growth, it has reached sales of $1.8 billion and a market cap close to $4 billion.

In fact, wholesale markets have many other characteristics, such as cross-selling, providing one-stop shopping convenience, and offering infrastructure (like payment and transfer certification). Due to space limitations, we'll discuss these another time. Interested readers can follow our public account "Blue Lake Capital". Additionally, Blue Lake Capital will soon hold small "B2B Supply Chain Salons" in Beijing, Shanghai, and Guangzhou to discuss various opportunities and issues. Interested readers can find registration links on the WeChat public account "Blue Lake Capital".

Finally, as usual, some advice for entrepreneurs:

  • First, deeply understand the needs of the supply and demand sides in the industry chain, understand the inefficiencies in the existing supply chain, and design your product and business model accordingly. Don't simply think that "mobile internetization," ordering via phone, or completing a so-called "payment loop" will make you more efficient than the small merchants in wholesale markets.
  • Second, don't simply rely on short SKUs to drive sales. Take time to think: where does your service sit on the "Blue Lake Efficient Frontier" diagram? How can you fully leverage mobile internet advantages to shift the curve and push existing players into the death zone? Is your business model the ultimate form, or could a better model push you into the death zone?

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About Blue Lake Capital

Blue Lake Capital is a new generation research-driven venture capital fund, primarily investing in early-stage internet companies. The first fund is $200 million, with investment amounts ranging from $1 million to $15 million.

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