This article takes a look at the world of online-to-offline (O2O) commerce in China and analyses the future investment opportunities that this phenomenon provides. The item is written by Ashley Hsu, a senior investment analyst at Mirae Asset Global Investments, the Asia-headquartered firm which oversees a total of $73.45 billion in client assets. The editors of this publication are very pleased to share these insights with readers and invite responses. As ever, this publication doesn’t necessarily endorse all the views expressed.

Improvements in technology and the spread of Internet connectivity throughout China has led to a substantial growth in the number of Chinese Internet users over the past two years. In 2014 alone, the total number of Internet users in China reached 648 million (iResearch2014), including 560 million mobile Internet users at an annual growth rate of 11.4 per cent.

This development has significantly boosted the amount of e-commerce taking place in the country. In fact, the Chinese Internet economy topped RMB858 billion ($138 billion) in 2014 (iResearch2015), up 51 per cent from a year ago. The fast adoption of mobile devices in China definitely helped to give a boost to the online economy in 2013-2014.

It is fair to say that China’s Internet industry is no longer at an early phase. However, what is new and under-penetrated is online-to-offline (O2O) service commerce. With the Chinese Internet space moving beyond the simple connecting of disparate information, entertainment offerings, and purchases of physical goods to veritably connecting services to users.

One of the main areas to benefit from this phenomenon is the local lifestyle O2O market. In 2014 the local lifestyle O2O market was valued at RMB235 billion, growing over 36 per cent for the year (iResearch2014). Amidst this promising market, conventional O2O models can be found in online travel agent companies like Ctrip and Qunar, Chinese versions of Priceline and Kayak that offer the added value proposition of connecting people with airline and hotel booking services.

Then there are real estate website companies like Soufun and Leju, connecting online users to offline real estate developers and agents. In effect, O2O development is occurring within the innovation segment that generally consists of verticals that have not yet been subject to the forces of disruption brought on by the Internet, as manufacturing and traditional retail sectors have already experienced. Food and beverages, healthcare goods and medical services, general beauty and household services, along with local transportation are examples of key innovation segments that occupy meaningful market sizes.

In China, the new wave of services offered are within labour-intensive verticals, such as transportation (Kuaidi and Didi Dache are the Chinese versions of Uber-like car hailing companies), home services (58Home), entertainment ticketing, food delivery, catering, and much more. The industry gross merchandise value (GMV) of local lifestyle services – commingling online and offline – is an estimated total RMB4.7 trillion in 2013, rising 13.3 per cent year-over-year (iResearch2014), while the China O2O market size has been gaining share on the back of a structural step-change in users’ mindshare toward online services. The China O2O market size recorded RMB170 billion ($27 billion) in 2013, up 45 per cent year-over-year, and is expected to reach RMB455 billion in 2017, growing at a robust four-year 27.6 per cent compound annual growth rate (iResearch2014). Despite this brisk pace of growth, the penetration in the whole local lifestyle service market is still in the single digits.

An example of successful, countrywide O2O is demonstrated through analysis of taxi apps. Kuaidi Taxi, a private company partially invested by Alibaba Group Holdings, is a taxi-hailing smartphone app which shows the real-time locations of taxis and allows users to hire cabs via its application. The company covered over 261 cities in China by March 2014. The number of daily transactions topped 6.23 million, 20.7 times larger than a year ago (source: chinainternetwatch.com).

On a smaller scale, KungFu Bear (in Chinese) is a typical example of a start-up O2O company in Beijing. The company offers massage and physical therapy services at your designated location. The entire order flow happens through the firm's app, starting from showing a list of massage therapists with basic information such as location, years of experience of the therapist, historical reviews, and service price. Users then are able to secure a booking and complete their payment using Tenpay in just a few clicks.

After a decade of rapid progress and development, China’s leading Internet companies are hungry for new levers of growth, which is an evident consequence of investments and spending. As such, during the past few years we have seen intensive strategic investments by Alibaba, Tencent and Baidu. For example, Alibaba invested $1.3 billion in Autonavi, a leading provider of digital map content and navigation solutions in China (source: Bloomberg).

As an extension of natural consumer behaviour, O2O is a clear catalyst for the increasing usage of mobile payments, which is expected to become a frequently used payment instrument in China. With that in mind, and while developing the O2O market, the Internet giants are also closely eyeing the mobile payment market as such consumption habits continue to expand their share within the Internet economy.

As we have seen, Chinese consumers are no longer solely using the Internet to search for information, but are now seeking to connect online through mobile to offline products and services, marking the advent of the O2O market. O2O is now making its way into segments that have previously been untouched by innovation, such as food and beverages, housing, transport, and general beauty and household services.

Looking ahead, it is this migration of internet giants into the O2O market combined with the opportunities presented by key innovation segments, driven by the fragmentation of the services market and China’s per capital income growth, which makes O2O a justifiable investment theme to play in the years ahead.