Ep. 48: Three Squirrels: The Nutty World of Chinese D2C Brands

Transcript

[00:00] R: Hey everyone! It’s been a few weeks since we last recorded, but no worries, we are still very much alive and busy, and are working on not one, but two experimental episodes for you in the upcoming few weeks. Meanwhile though, today we have something in the traditional format, where we’re going to deep dive into one company as a way to understand an entire sector and business model in China.
Y: That’s right. Today we’re going to look at direct-to-consumer or D2C brands in China, and highlight one of the early winners of this business model, a company called 3 Squirrels. 3 Squirrels is a story we haven’t seen covered much in English, but which has been the talk of the interwebs this week in China tech, and a story that we think is quite good at demonstrating both the similarities and differences in this really important trend in the US and China.
R: What is 3 Squirrels, you ask? Well it is the Chinese internet snack brand that started off with selling, you guessed it — nuts! Squirrels love nuts, obviously — but now that has made it to scale and now, after its IPO last week on the Shenzhen Stock Exchange, has a market cap of nearly $2Bn.
Y: Like Warby Parker, Dollar Shave Club, Glossier, Kylie Cosmetics, and so many others you probably already use or know, 3 Squirrels began as an internet-only brand. It was founded just 7 years ago in southern China, and now is the largest in its category by revenue, booking just over $1Bn in sales in 2018, and about $60mm in net profits.

[1:43]R: From its humble beginnings of just 5 people in the third-tier city of 芜湖 Wuhu, 3 Squirrels is now a real enterprise of over 3,000 employees, and widely regarded as the number 1 brand in snacking in China. Not bad for a company that’s just 7 years old.
Y: That’s not bad at all for a company that’s raised just $50mm. Just for comparison, although yes, we know, it’s apples to oranges, a company like Warby Parker, now valued at $1.8Bn, has been around for two years longer and has raised about 6 times as much money, and has yet to file for IPO. That’s right, the D2C glasses brand has raised almost $300mm so far.
R: Selling nuts at $3 per bag is different from selling prescription eyewear at $100 per pair, of course, so we are not at all trying to say they are the same. And in fact, 3 Squirrels has made many decisions over the years that really helped lower its capex, but might also be its Achilles’ heel.
Y: But there are a lot of similarities — some of them very intuitive — between how these D2C brands seem to work across the globe, in both the US and China. Those will be our key explorations today. Let’s get started!
R: Yeah. This story is nuts! Totally no pun intended.

[3:37] R: Hi everyone! We are TechBuzz China by Pandaily, powered by the Sinica Podcast Network!
Y: We are a biweekly podcast focused on giving you a peek into what’s buzzing within the tech community in China.
R: We uncover and contextualize unique insights, perspectives and takeaways on headline tech news that don’t always make it into English language coverage. So you can be smarter about the world of China tech. TechBuzz China is a part of Pandaily.com, an English language site that tells you “everything about China’s innovation.” I’m one of your two co-hosts, Rui Ma.
Y: And I’m your other co-host, Ying-Ying Lu. We’d like to acknowledge our partners DealStreetAsia and SupChina, creator of the Sinica Podcast Network! In addition to TechBuzz, you can also find Sinica which covers current affairs, NuVoices and Ta for Ta on women, the business-oriented ChinaEconTalk, and the Caixin-Sinica Business Brief from China’s leading business magazine.

[4:40]R: Speaking of DealStreetAsia, their annual private equity and venture capital conference, Asia PE-VC Summit, is set to take place on the 17th & 18th September this year. Hear from market leaders and experts, and network with the industry’s best over two days in Singapore. To register, follow the link: events.dealstreetasia.com/sg2019/Y: We are also going to be in Beijing and Shanghai the week of October 7-13, 2019, right after Golden Week, for our inaugural invite-only TechBuzz China Investor Trip, so if you are around, tune in for dates and locations of meetups that we plan to have. And finally, as always, if you enjoyed listening to our podcast, please leave us a review on iTunes or whatever other platform you use.

[5:29] R:Today’s episode is brought to you by The Transpacific Experiment: How China and California Collaborate and Compete for Our Future, a new book out on August 13th by Matt Sheehan, a former journalist in China and current non-resident fellow at the Paulson Institute’s think tank, MacroPolo. Matt is one of the smartest and most thoughtful voices on US-China topics and this book is going to tell you things you never knew about how intertwined China and California are, and how that’s playing out in people’s lives here on the ground, in tech, entertainment, real estate, and other key industries. If you’re in the Bay Area, see if you can make our Tuesday, August 13th evening event with the Asia Society. If you can’t, you’ll definitely want to pre-order this book on Amazon. Go to our transcript at pandaily.com for links to the event or to order the book, or follow Matt on Twitter at @mattsheehan88!

[6:36] Y: So, as we’ve already introduced, 3 Squirrels is a top-selling snack brand in China.
R: And just how big is the snack market in China? Not super clear. We got a lot of confusing estimates, but if you believe Chinese media, then it’s either over $70Bn in revenue, over 10% bigger than the food delivery business, and on par with the US market size, or as much as $400Bn, according to one report by state-owned media Xinhuanet.
Y: That’s still within a magnitude of difference. On the other hand, you have websites like Statista, which are usually very reliable, saying that the market is less than $8Bn, which is like one-tenth of every other estimate we’ve seen in Chinese, and also doesn’t really jive with our personal experience.
R: Yeah, because at $8Bn, that means the average Chinese person is only snacking $5 per annum, and if we know Chinese people, it’s that Chinese people like to snack. Chinese people like to eat in general, but snacking is a big part of the culture.

[7:44] Y:And maybe that’s where the difference in the estimates are coming from. Maybe some items that Chinese people consider to be snacks aren’t categorized properly in other estimates. For example, chicken feet. That’s both a common appetizer and a snack that people buy to just eat in between meals, like a cookie or something.
R: Yeah, one top brand — but just one brand — sold $130mm worth of preserved spicy chicken feet last year. Just that one snack. OK, so, that does make the $70Bn revenue number much more believable. Someone tell Statista they need to include more than cookies and potato chips in their numbers.
Y: OK, so snacking in China is an enormous market. But more than that, it’s also highly fragmented. The top 3 players combined account for less than 4% of total revenues.
R: No surprise there. While there are large food brands in China, they are generally state-owned and slow-moving, and the private enterprises in processed foods, especially snacks, simply haven’t been around long enough to really gain a dominant market share, with very few exceptions, like in ramen or certain beverage types.

[9:02] Y: Which is why the founder and CEO 章燎原 dove head first into this category.
R: Well, yes and no. He did have nine years of experience in the industry before he started 3 Squirrels, so it wasn’t like he had an epiphany one day, hey, how about I sell some nuts?
Y: That’s true. Actually, it was pretty much all he knew. That’s because compared to most of the other entrepreneurs that we’ve covered on TechBuzz, Zhang has a decidedly unprivileged, unremarkable past. In fact, all we know is that he went to a vocational school, and that by his own words, he was a bum before the age of 26, having done everything from being a street vendor, operating a motorcycle taxi, selling video CDs, for those of you who remember what those are, and basically having no fixed profession.
R: It was in 2003, by a pure stroke of luck, that he was hired into a nut firm — wait that sounds weird — a firm that sold nuts, I mean. Actually, it didn’t even sell all nuts, it was known for selling a specific local Anhui provincial variety of walnuts. Zhang was hired to do sales, and his life changed drastically for the better. He found that — guess what? — he was pretty good at selling nuts! And pretty soon he was promoted to regional sales director, and then managing director.

[10:45] Y: In 2011, he built the company’s first online brand — 壳壳果 — which had some sales records and made him famous, at least in the e-commerce community at the time. He was convinced that it could be a much bigger opportunity and tried to get the company to invest further in e-commerce. Unfortunately, he did not succeed.
R: Fortunately, you mean. Because he believed so fervently that the internet was a distribution channel that one should pursue at all costs, he quit and started 3 Squirrels. I know right? Who would have thought? Sell food over the internet? That’s crazy!
Y: We can be sarcastic all we want now, but actually, it wasn’t always so obvious at the time. Sure, Taobao was a big deal but even the largest businesses at the time were just raking in a few million dollars a year. Maybe a few were in the low eight digits. But no one was building unicorns solely off of selling online.
R: Zhang, however, felt that he had to get into e-commerce no matter what. More specifically, he felt that e-commerce was going to accelerate the birth of completely new brands. I don’t know about you, but that’s pretty insightful.

[11:59] Y: Looking back, it was right around then that investors began to seriously look into investing in what was then called 淘品牌, or Taobao brands, the Chinese version of direct to consumer or D2C brands. So Zhang had the right idea, and the right timing.
R: He wasn’t the only one who had that insight though. There was a whole generation of entrepreneurs who were convinced of the same opportunity and jumped in around the same time. However, most of that cohort has not survived. If you ask Zhang, it had everything to do with which vertical they chose.
Y: Clothing, for example, was a popular choice, but so difficult to standardize, and the trends were always changing. Everyday household items were easy to standardize, but had stiff competition from offline brands. If P&G wanted to, they could probably destroy you very easily, Zhang reasoned. In Zhang’s eyes, it’s never wise to go into a vertical where there is already a huge and tech-savvy enterprise who can devour you at any moment, like a Uniqlo for casual fashion, for example.
R: Back in 2012, however, there was no extremely dominant offline snack brand that also had the capability to move quickly into e-commerce. There was actually an offline snack store called 来伊份 Laiyifen that I used to hit up all the time, and has continued to be a top 10 player, but it didn’t make a big push into e-commerce, at least not when it mattered, and so that left 3 Squirrels with an opportunity to not just survive but thrive.

[13:38] Y:By the way, because of how Zhang grew into the space, because industry behemoth Laiyifen at the time did not take him to be serious competition, Zhang is extremely vigilant of any potential competitors. If anyone has a product that is growing quickly, he doesn’t care how small the base is, he will go in and copy you, and he will beat you on price.
R: In the beginning, though, Zhang wasn’t thinking so far. In fact, he had only 3 goals: 1) pick a good name for the company, 2) provide a good user experience and 3) … could you guess what 3 is? If you were a new consumer brand, especially one that was 100% digital, what is the most important sales metric for you?
Y: The most important vanity sales metric, you mean. Well, in the US it would be the holiday season, and maybe Black Friday stands out as a disproportionately large indicator of success. But in China, that would absolutely be November 11 of every year, or Single’s Day, Alibaba’s giant e-commerce festival, which we covered in detail in Episode 29.
R: But let’s back up a little here. Zhang quit and started 3 Squirrels in the beginning of 2012, quickly raising $1.5mm in Series A funding led by IDG. At the time, his post money valuation was just $5.6mm. Yes you heard that right, that was his full Series A. This was before the concept of unicorns burst onto the scene and people like Softbank came to play. The good old days.

[15:19] Y: With this money, Zhang went to work. One of his nicknames is 松鼠老爹, or Squirrel Dad, which is totally cute, on-brand and makes sense. Another one though, is “Chief Brainwashing Officer,” 首席洗脑官, which is not on-brand but might be more accurate. After all, it’s widely acknowledged that 3 Squirrels’ success is in large part due to his genius for brainwashing — I mean … marketing.
R: No surprise there. As we’ve also seen in the US with respect to direct-to-consumer brands, lots of these founders don’t have a traditional tech or even e-commerce background. That’s because most of these businesses, as one would expect, is low on tech, high on operations, and highest on marketing.
Y: This might, by the way, explain 3 Squirrels’ obsession with intellectual property. Over the years, it’s accumulated over 1400 trademarks — covering not just the brand overall but each one of its 3 cartoon squirrel brand ambassadors — and also 300 patents.

[17:09]R: I know that foreign companies are always complaining about IP protection in China, and they have every reason to, but the truth of it is that Chinese companies steal from and infringe upon each other all the time as well. Zhang and team obviously were well aware of that, and filed their first trademark application before the product even went live. In a commoditized industry where your brand can be everything, 3 Squirrels was relentlessly aggressive about protecting it.
Y: But also before you get super excited about the vast 3 Squirrels patent portfolio — know that patent law in China is quite different from that in the US, and so it can be a bit of a vanity metric, like many other things in China. For example, some of 3 Squirrels’ patents include cookie recipes and packaging design for its stuffed animals of its company mascots. We aren’t IP experts at all here, but those don’t sound like novel inventions to us.
R: Anyway … still on the brand here. For whatever reason, people just loved the 3 Squirrels brand. In 2013, one year after its founding, 徐新 Xu Xin, whose English name is Kathy, founder of Capital Today, led the company’s Series B.
Y: Kathy is probably the most famous Chinese female VC, and we’ve talked about her in several episodes before, first mentioning her in episode 2, and she is known as the queen of consumer investment. According to Kathy, she only took a few hours to decide to invest, and one of the main reasons was that she immediately fell in love with the name, which she felt was super important to the brand.
R: I think now is a good time to explain the 3 squirrels branding a little bit more. So basically, the brand mainly revolves around 3 very very cute cartoon squirrels, 2 boy squirrels and 1 girl squirrel, each with a name and a different personality. They look and act like children, and they call you — the customers — their owners, 主人.

[19:16] Y: Westerners may find this weird, or creepy, but basically the squirrels say they’re here to serve you, their owners slash masters, and that they seek to belong to you. It’s all part of the Chinese 萌文化, or “cutesy” culture where everything is infantilized.
R: Trust us, it’s really difficult to translate these things cross-culturally. For example, one of their popular taglines is “求包养,” which is supposed to convey something like “up for adoption,” but can also mean “seeking sugar daddy / sugar mommy” under a different context. Yeaaah. Difficult to translate.
Y: Anyway, you just have to trust us that this was a big hit with Chinese consumers and that they basically found these squirrels irresistible. Because just 65 days after launch, 3 Squirrels had already reached No. 1 in its category, and by November of 2012, on its very first Single’s Day campaign, it racked up over $1MM in sales.
R: But it wasn’t just great cutesy branding that propelled 3 Squirrels to success. As Kathy explains it, there were two other obvious trends at the time that 3 Squirrels was capitalizing on that also convinced her to invest. The first one was consumption upgrade in the snack space, whereby Chinese consumers were both rich enough and health and quality conscious enough that they were buying fancy imported nuts instead of the dollar-pack of sunflower seeds on the street.

[20:49] Y: The second was the fact that Alibaba was heavily pushing Tmall, its B2C platform, diverting substantial amounts of traffic from Taobao, its C2C product. This, she thought, was an obvious window of opportunity, a 风口. By the way, what a way to hedge her bets. She was one of the earliest and biggest investors in JD, and if you guys will remember, Tmall was a direct reaction to threats like JD, who never went the C2C route and was B2C from the very beginning.
R: OK, so 3 Squirrels had a genius brand and great market timing. Did it have any weaknesses?
Y: Obviously. For one, one of the main reasons that it was able to grow so quickly was that it didn’t bother to set up its own supply chain, and was instead just buying product from white-label suppliers and slapping on its own brand. This remains its biggest PR and I would argue existential crisis, that it’s constantly in the news for food safety issues.
R: Yup, it’s not good when people are finding pieces of unidentifiable plastic and worms and mold in your bags of nuts. Another weakness is that it’s highly dependent on Tmall, although that’s less of an issue than before. But in the beginning, nearly 80% of its sales came from the site. Now, it’s still at about half.

[22:19] Y:Channel diversification is indeed an issue, and we’ll go into that in detail later, but also, product diversification was even more urgent. While 3 Squirrels continued to hit Single’s Day records for its category on Alibaba’s platforms every year, as early as 2017, this particular metric was slowing down.
R: In fact, the growth for 2017 Single’s Day was less than 5%, which was worrying, because this day had traditionally accounted for something like one-tenth of 3 Squirrels’ annual sales, and if you’ll remember, was one of their most important sales targets.
Y: Luckily, remember how Zhang always felt that no space was too small to go after as long as it was fast growing? Somewhere in 2016 he saw the opportunity for cakes, a segment that attracted a bunch of venture funding, and got into that in a big way. So today, cakes account for over 20% of the company’s sales, and nuts are just over half.
R: OK, but these points seem to strengthen rather than weaken the 3 Squirrels story. So they were dependent on Tmall, they diversified their channels. They were dependent on nuts. They began selling cakes.

[23:38] Y:Yes and no, because here is where the story converges a little bit with what we see in the US, and that is for a brand like 3 Squirrels, at more than a billion dollars in sales, they’ve hit a sort of bottleneck with their online operations, at least in the segment that they are targeting, which is still very value and price driven.
R: Yes, and also, don’t forget, the entire Chinese internet ecosystem has changed. Selling online is no longer novel, and is an important part of any business strategy. So while we don’t know the full details, it is likely that for 3 Squirrels, customer acquisition costs online has become high enough relative to lifetime value that in addition to expanding their product offering, they are also seeking growth … offline.
Y: Not so curiously, we are seeing the exact same playbook in China and the US, and with both trends arising at roughly the same time too. US direct-to-consumer eyewear brand Warby Parker was perhaps the earliest to open up offline stores, doing so back in 2013 just 3 years after their founding, but you could argue that they were more compelled to do so because of the nature of their products, eyeglasses that are best tried on in a showroom before purchase. They’re up to something like 100 stores now, apparently.
R: For the snack industry, the dynamics are different but also favorable. According to Zhang, there are several distinct advantages about operating offline that makes it very attractive. For one, their offline gross margins exceed 40%, which is much higher than their online store margins, those are generally below 30%, and are some of the lowest in the industry.

[25:28] Y:Yup. One reason is that price comparison is difficult. Meaning that you can’t just easily jump in between multiple snack stores and check each one’s price on imported hazelnuts like you could do online with a simple search.
R: Even more important than that, in your online store, you tend to have best-seller products, or 爆款, that you use for promotional purposes and so must discount, resulting in even lower margins. In your online store, customers can see how many ratings, and sometimes, depending on the store, the actual number of purchases, a specific product has. This might further distort your sales as people just go for the bestselling or most reviewed items. In an offline store, of course, that would not be nearly as obvious and so the distribution of sales is probably not so skewed towards just a few popular things.
Y: Then there’s the fact that one can buy very little at a time, at a much higher frequency, and without added delivery costs. Online sales have a pretty fixed delivery cost which means that each order needs to reach a certain dollar amount in order for it to be financially viable. Offline purchases have no such threshold. Want to buy just one ounce of macadamia nuts? Go ahead. You want to do that online? Yes you can but the additional shipping costs would make it a very bad deal.
R: But despite all their intentions about expanding offline, at the end of 2018, 3 Squirrels only has 53 offline stores. Definitely no Luckin Coffee, for sure. For comparison, competitors such as 良品铺子 Liangpinpuzi, which began as an offline brand, have over 2,000 locations.

[27:12] Y:And these offline brands are not taking the fight lying down, either. They have also gotten into the internet game by partnering with multiple food delivery giants. All in all, it’s really pretty similar to what we are seeing in the US, with certain types of retail stores dying but others thriving and taking their place, and just more and more integration of online and offline. For retail in both the US and China, it might be less of an apocalypse and more of an evolution.
R: One last thing that we found that was pretty universally echoed across both the US and China for D2C brands was the fact that consumers are no longer content to be passive, but instead want to be active participants in the brand experience. 71% of US users want to share experiences with new products they discover, and also far more likely to make a purchase based on the recommendation of an influencer they follow. Which all means that word-of-mouth and influencer marketing is supremely important. And creating a delightful user experience that is easily shareable.
Y: What’s an example of that you ask? Apparently, 3 Squirrels will go the extra mile to delight their customers for example including an additional bag for your shells, and a wet wipe for you to use afterwards. For Zhang, the customer is so supreme that he actually considers “fans” to be as much a part of 3 Squirrels as his employees.
R: No surprise there, if you look at their marketing strategy. First of all, they have a ton of product placements in all the hottest TV shows, whether as the snack itself, or sometimes in the form of the 3 squirrels.

[28:57] Y:They also have a ton of Weibo-based campaigns where you are entered into drawings for free products and hongbaos if you retweet the brand. And Zhang is obsessive over the brand’s social media presence. He claims that he rarely goes to business dinners; anything and everything he needs to learn about his business he can do so by combing through social media and what customers say about his products.
R: That’s not a bad strategy. In the US, over one-third of users believe that sharing about the brand in their social media is a requirement for brands they are loyal to. It seems that Chinese users feel the same. And what’s more, many of them want to feel like they have impact on the brands they are loyal to by being in regular dialogue with the brand over social media.
Y: Remember how in TechBuzz Episode 41 on Ruhann 如涵, the recently IPO’ed platform for influencers we talked about how super influencer Zhang Dayi 张大奕, the Kylie Jenner of China, sources her newest fashion ideas from her fans? Well, 3 Squirrels is doing that as well, and in this way, is able to shorten their new product development to just a few months, by asking and listening to their fans about what they want in advance of pushing out new items.
R: Of course, this is by no means something that is unique to 3 Squirrels, but still, color us impressed that you can find most of these insights in a 2015 interview of Zhang Liaoyuan. That’s pretty early. Alright, I think that’s enough about squirrels and nuts for today. Why don’t you summarize for us what we learned today, Ying-Ying?

[30:37] Y:Today we talked about 3 Squirrels, the leading snack food brand in China that just went IPO in Shenzhen at a P/E ratio of 23 times and is now worth almost $2Bn. It was founded seven years ago by an entrepreneur named Zhang Liaoyuan, who despite not being well-educated, really saw the opportunity at the time to accelerate the creation of a whole new consumer brand using e-commerce channels, specifically, Tmall, Alibaba’s B2C platform and the world’s 7th most trafficked e-commerce website.
R: That’s right. Zhang had been nearly a decade in the nuts business and decided that without a large offline incumbent to threaten him, he had a good chance of taking a piece of the highly fragmented Chinese snack market, which has annual revenues in the tens of billions of dollars.
Y: He made sure to give the company a great name — 3 Squirrels — and trademarked the heck out of it. Then using funding he raised from funds such as IDG and Capital Today, Zhang focused on making record sales every year on Single’s Day, Alibaba’s annual Shopping Festival. This he did for seven years in a row, finally hitting $100mm last year.
R: Hey, Zhang is an ambitious guy. He’s never hid the fact that from the beginning, he’s wanted to build a company that lasts 100 years and gets into the Fortune 500. But in order to chase quick and cheap growth, he chose to not own his own supply chain and instead relies on third-party suppliers, making the brand synonymous with “poor food safety” in many consumers’ eyes.

[32:17] Y:Still, that doesn’t erase the fact that he used his remarkably accurate intuitions about using social media marketing to build a massive direct-to-consumer business that is still growing, and profitable. There are certainly many lessons to be learned here and many parallels we can draw to US retail.
R: Yes, its expansion into offline stores being one of them. We have also seen many D2C brands do here in the US, such as Warby Parker, the eyewear brand. We will see how that works out for players in both countries, but our guess is that for many product categories, having offline stores can greatly enhance and complement their online sales.
Y: I didn’t think snacks were the most obvious category for that, but Zhang gave some compelling reasons for it. Still, he’ll run into plenty of competition. I mean, unlike here in the US, there are actually a lot of snack stores in China. There’s a chain just selling duck necks, for example.
R: I know! That’s nuts! I just wanted to say that one last time. What did you think guys, did you get any more insight into the Chinese D2C brand business this week? Tweet at us and let us know what you thought of the episode!

[33:39] Y:Alright, that’s all for this week folks! Thanks for listening. As a reminder, our episodes will now be available every other Friday instead of Wednesdays. We really enjoyed putting this together, and we are always open to any comments or suggestions. You can find us on twitter at thepandaily, at techbuzzchina, and my personal Twitter account is GINYGINY.
R: And my Twitter is spelled RUIMA. TechBuzz China by Pandaily is powered by the Sinica Podcast Network. Pandaily.com is an English language site that tells you “everything about China’s innovation.” Our producers are Shaw Wan and Kaiser Kuo. Our interns are Wang Menglu and Mindy Xu. Thank you for listening!