For several months this year, Chinese smartphone app Car8 delivered carwash services to users in Beijing for the low price of 10 yuan ($1.57), a hefty discount on the usual 20 yuan to 30 yuan price.

The cost to Car8 for each carwash was 17 yuan, but the hope was to build a base of loyal customers and then to be able to phase out the discounts.

But in July, Car8 folded—as have scores of similar apps in recent weeks—after it ran out of cash and failed to raise more funds. "You need a huge user base to cover the costs of operating the business," said Car8 founder Liu Qiang.

The failure of Car8 reflects the shakeout that is hitting one of the hottest segments of China's booming startup scene. Dubbed online-to-offline, or O2O for short, these businesses offer online booking of services as diverse as manicures, food delivery and taxi rides—similar to what is known as on-demand services in the U.S.

But while the lure of such services in the U.S. is largely convenience, in China, it is bargains. A Subway tuna sandwich and drink on food-delivery app Ele.me, costs nine yuan including delivery, versus 31 yuan at the nearest Subway shop. A karaoke room can be reserved on group-discount site Meituan at just 58 yuan for eight hours of singing, a 90% discount off the original 560 yuan price.

In most cases, when apps connect users to brick-and-mortar services, the merchant gets paid full price, while the app covers the difference, often with venture-capital funds that until recently were pouring into Chinese startups. The huge bargains made O2O apps a feature of life for many Chinese. On an average Friday, Beijing news editor Yu Xi, 25 years old, says she uses phone apps to hail a ride to her office, order dumplings for lunch and coffee during the afternoon, and hunt for deals for dinner and a movie.

In a McKinsey & Co. survey in February, 71% of Chinese online consumers reported that they use O2O apps.

But the recent Chinese stock-market swings and increasing concerns over slow economic growth have made venture capitalists nervous about the high rate at which O2O startups have been burning through cash, and some investors are pulling the plug.

Venture-capital firm Gobi Partners Inc., which has invested in apps across sectors including real estate, auto repair and food delivery, estimates that 30% to 40% of O2O startups have shut down in the past few months. Ken Xu, a partner at the firm, said roughly half the money such startups raise has been used for subsidies to attract consumers.

Lists of dozens of failed O2O startups are circulating in Chinese media. Websites of the companies named carry error messages or notices announcing that services have been suspended.

To be sure, for a number of apps and businesses that still have funding, what is an unprofitable business model now still holds promise well beyond China's larger cities. Meituan.com, a leading competitor, expects to raise more than $2 billion in its current round of funding, valuing the company at more than $10 billion, said Wang Huiwen, a vice president at the startup.

China's deep-pocketed Internet companies—Alibaba Group Holding Ltd., Baidu Inc. and Tencent Holdings Ltd.—have all staked claims in the sector and continue to see great potential for growth.

"In terms of the market that hasn't been grabbed yet, it's a blue ocean," said Zeng Liang, Baidu's vice president in charge of its group-buying platform Nuomi. Baidu, too, has spent on subsidies, Mr. Zeng said, but the search company also draws on user-behavior data and its own mapping tool to make better recommendations to users.

Baidu has invested in apps for dining, delivery and entertainment services and estimates the total value of the O2O market at 10 trillion yuan this year. It expects the market to double in four to five years, and plans to invest more than $3.2 billion in services apps over three years.

Alibaba and its financial affiliate said in June they were investing nearly $1 billion in Koubei, a food-delivery platform. Alibaba's vice chairman, Joe Tsai, said Alibaba's payment platform, Alipay, as well as its shopping service Taobao give it an advantage.

"We have natural traffic entry points," he said.

Tencent's strategy has been to back "high-frequency" apps, such as ride sharing and food delivery, via minority stakes, which lets it keep some distance from the heavy spending on discounts, according to the company.

A weeding-out process seems to be under way to identify the apps with the most sustainable business ideas.

A Shenzhen car-repair app, Xiuyang, attracted more than 120 repair shops to its platform, but ran through one million yuan, or one-third of its initial capital, on discounts and promotions in just three months. Its co-founder Liu Le said that in Shenzhen alone, more than 15 mobile apps offer car-repair and maintenance services. "They all give huge discounts," he said. The app folded in late August.

"What we're seeing is that the smaller ones are failing, while some of the bigger ones are holding up," said Jixun Foo, a managing partner at GGV Capital, which invests in ventures in the U.S. and China.

But eventually, even the best-funded apps must turn a profit to survive.

Tencent-backed Ele.me—whose name means "Are you hungry?"—has backed off subsidizing sharp discounts in recent months, a spokesman said. Instead it is striking discount deals with restaurants to make sure the apps still offer lower prices, the spokesman said.

Wang Bowen, a 23-year-old gadget dealer in Shenzhen, used to get more than half off on his Ele.me orders, a significant incentive when the app didn't have many restaurants to choose from. Recently, he paid 35 yuan for a 38 yuan meal of steamed chicken and rice from a Chinese fast-food chain. Despite the small discount, Ele.me was still his preferred service because of the range of restaurants on its platform.

"It's not so cheap anymore, but I still use it because it's so convenient," he said.

Write to Gillian Wong at gillian.wong@wsj.com, Laurie Burkitt at laurie.burkitt@wsj.com and Juro Osawa at juro.osawa@wsj.com

 

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(END) Dow Jones Newswires

October 04, 2015 20:55 ET (00:55 GMT)

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