Almost exactly a decade ago, organised retail was the toast of the capital markets in India. Led by 'let's dream big' business leaders, organised retail was touted as the opportunity to make investors and entrepreneurs rich overnight. After all, a massive middle class, rising income and aspiration levels, and increasing urbanisation offered a heady mix. Add to that the mouth-watering stories of wealth creation by large retailers in other markets - predominantly USA - and anyone who even dared to express doubt about the potential of organised retail would have been consigned to the duh club.
The story lasted for a few years till 2008 with easy capital funding and loss-making expansion - after all, growth was important, profits could come later! A rapid shrink in capital availability ensured that capital-dependent 'loss-hiding' companies were unable to sustain their businesses. Market capitalisation of the top player dropped to 10 per cent or so of the peak. Today, the organised retail business continues to struggle with fewer players, more sedate growth and average profitability. The zing has now moved to e-commerce!
E-commerce: the next big thing for India
Google the words 'e-commerce' and 'India', and the search will throw up many colourful charts and graphs depicting everything from India's low but rapidly rising smartphone adoption, the low penetration of the Internet (only for now; it will rapidly increase in the future) and the immense potential for e-commerce, in particular, mobile commerce. All of this is probably correct and will eventually turn to reality in the future.
Venture funds and PE funds have poured money into anything that can be remotely called a business-to-consumer (B2C) e-commerce opportunity. In a few years, several companies have managed to reach valuations of billions of dollars - and therein lies the nub.
If these valuations were backed by profits, there would have been no cause for complaint. However, in the lingo that managers are now fond of using, costs become 'investments', and therefore losses are to be ignored, since these are caused by 'investments' in building the future and growth. The largest of companies continue to bleed, with the bleed increasing with increasing size. This bleed is indicative of a business that will sustain only when capital is freely available with it.
Financial markets: the first and the biggest e-commerce business
A business is about finding clients, receiving orders, fulfilling orders and receiving payments for the goods/services delivered. A business where all this can be done on a computer - without the need for a physical interaction - would be a great example of e-commerce. Share trading is one such example (in fact, most financial services are). A client can be 'sourced' from web advertising. The account can be opened electronically, information about what to buy or sell can be exchanged without personal meetings, and transactions of shares and money can be conducted fully electronically - in other words, a business with little or no cost in terms of storage, logistics, collections, returns of goods, etc.
Has Internet trading taken off? More than 50 per cent of the volume on the NSE is now executed without 'dealer' interaction with clients - through algorithms, Internet or mobile trading. What has this done for the financials of the service provider? Over the past decade, the revenues of the brokerage industry have remained flat or perhaps shrunk despite an exponential increase in volumes. Concentration of client volumes has happened. Despite this, most brokerages are not making significant money from agency business. Instead, money is largely made by funding clients and earning interest on the funding.
The learning: High volume, scalable businesses do not necessarily earn economic returns on capital unless the product is sharply distinguishable. Commoditised businesses (that include businesses that are simply selling other people's products) are not necessarily going to generate economic returns for investors.
Where is the moat?
A fundamental tenet of investing is to look for companies that operate with a 'moat' around them. A moat is something that prevents competition from quickly catching up. It could be the nature of brands, regulatory requirements (as in pharma companies) or even the network effect (for example, in telecom or trading exchanges).
E-commerce platform providers are usually distributors of products manufactured by others (in the 'marketplace' model that most companies in India follow). In this model, the key challenge is to handle logistics and client experience - refunds, returns, promptness and correctness of delivery. These challenges exist because the logistics in India are still underdeveloped. As logistics improve, most companies will look alike to the consumer. E-commerce companies will have to find newer means to find and retain customers. Even now, a survey reveals that over 70 per cent of the customers who shop online do so because of the discounts on offer. Once discounts vanish, will online shopping still retain its charm?
In the dot-com days, much was made of the fact that 'horizontal' websites like Yahoo! or Rediff would be the entry point for visitors to other websites. The value of Yahoo! as a 'gateway' was supposed to be high. That was the moat. Time has proven this concept irrelevant, with search engines removing the need to have horizontals. Already there are specialist websites for travel, jobs, marriages, furniture, show booking, etc. As a market segment becomes large, vertically focused sites develop that can offer the prospective client greater value. The need for a horizontal marketplace may not stand the test of time.
Not all institutional investors represent 'smart money'
'Smart money' chased organised retail for a decade before realising that without profits there was no point in funding the business. With easy money available, a new mall came up whenever an earlier one showed signs of breaking-even, delaying the break-even of the incumbent. A business that was supposed to turn profitable over three-five years did not turn profitable even a decade later. Now with institutional funding less easily available, survivors are slowly putting together the pieces to make a profitable business model. However, if enthusiasm around e-commerce turns out to be true, this could be a body blow to organised retail - profits may again be 'postponed'. After all, customers are not necessarily increasing spend, just using a new channel for their purchases. Smart money does not look so smart after all.
The same is likely to happen with e-retail. After the tsumani of money leaves the market, some survivors will remain who offer real value to clients. And they will, perhaps, eventually make economic returns. Current valuations are a result of the 'herding behaviour' set by an incestuous club of investors who do not have a market to benchmark against. These will eventually correct. For now, the only way to participate in the game is to dream up your own pet B2C idea and convince a VC to fund it.
Anand Tandon is an independent analyst.
This column appeared in the April 2015 issue of Wealth Insight.