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E-tailing Valuations: Smart Investing Or Russian Roulette

Published on Mon, Oct 26,2015 | 18:00, Updated at Mon, Oct 26 at 18:06Source : 

By: Tanwir Shirolkar, Partner, Sudit K. Parekh & Co

E-tailing (online retail) in India started many years ago in 1999 with Indiaplaza, one of India’s first e-tailing companies. However, the sector has witnessed renewed growth since 2009 with companies witnessing high revenue growth and fetching sky high valuations. Over the years, some significant developments have caught the attention of investors.

Several factors have led to strong growth and will continue to lead to impressive growth in e-commerce, primarily driven by e-tailing. Some of the key factors contributing to the sector’s success are the adoption of a deep-discount model, increasing internet penetration, rise in smartphone users, improved logistics infrastructure and the introduction of the cash-on-delivery mode of payment.

The Indian e-commerce sector, which includes e-tailing, online travel, digital payments, etc. was approximately USD 3.8 billion in 2009 and is estimated to be about USD 20 billion as of financial year (FY) 2015. The share of e-tailing in this pie is low at about USD 7 billion (approximately 35%), while the sector is dominated by the online travel market worth approximately USD 9.4 billion (approximately 47% of the sector). The e-tailing segment has grown at an impressive compounded annual growth rate of 56% during 2009-14 and is expected to be the major catalyst for future growth. In fact, it is expected that the share of e-tailing will be over 50% by FY 2020.

With changing lifestyles and growing income levels of the Indian population, it is believed that the Indian e-commerce market is at an inflection point and is poised for fabulous growth. However, this will depend on how the key growth drivers are exploited further. Besides those mentioned earlier, better telecom infrastructure, a simplified and clear regulatory environment, higher adoption of online payment channels by consumers, and a better overall consumer experience will be factors that will decide the future trajectory of this sector.

India’s unique challenges
Compared to the current Indian e-commerce market of USD 20 billion, China’s e-commerce market is around USD 200 billion while that of USA is around USD 675 billion, only suggesting the immense growth potential of the Indian market.

While there are significant growth opportunities here, comparing India with other countries would not be entirely correct as the Indian economy has its own set of challenges:

Logistics is still a big challenge
Managing logistics in India is a daunting challenge with various issues being encountered while fulfilling the delivery of the goods. Road infrastructure is still in the developmental stage, which adversely affects the time taken to deliver products. There are thousands of small towns that are not easily accessible, and these towns are where the real growth of the e-commerce industry lies. Pin code mapping in India is not very accurate and there is little standardisation in the way postal addresses are written across the country.

The economics of cash on delivery
Most consumers in India (almost 60%) prefer cash as the mode of payment, compared to about 30% in China and about 2% in USA. Cash is the preferred payment mode in India due to the low penetration of credit cards, lack of trust in online transactions, and the high failure rate of payment gateways in India. Unlike electronic payments, manual cash collection is laborious, risky, and expensive. As a result, this increases the transaction cost for the seller. Therefore, while the introduction of the cash-on-delivery option was the game changer that triggered massive growth in e-tailing, it is not a cheap option for e-tailing companies due to the costs associated with it.

Source: "Percentage of Individuals using the Internet 2000-2013", International Telecommunications Union (Geneva)

India has 352 million internet users – the third highest in the world. However, the penetration level is very low when compared with advanced countries. As a percentage of the entire population, India’s penetration stands at 19.19% (2014 figures), while countries such as USA (86.75%) and UK (89.90%) are far ahead in terms of internet penetration. However, according to the Internet and Mobile Association of India, the number of online users in India will rise to more than half a billion by 2018.

Other challenges
Other challenges unique to the Indian economy include the lack of investment in improving telecom infrastructure, poor network coverage, delayed rollout of 4G, and lack of digital literacy and consumer awareness in rural areas.

Furthermore, certain regulatory restrictions on foreign investments in inventory-based e-commerce also play a dampening role in meeting funding requirements, especially when the business is capital intensive, requiring heavy investments in technology, logistics, distribution, etc.  
Deals in the e-tailing  market
Recent deals
Flipkart and Snapdeal are the two largest Indian e-tail companies that have garnered a lot of investor attention in the recent past. Flipkart has raised over USD 3.5 billion in 10 rounds of funding; the latest round of investment being USD 700 million in July 2015, which was at an estimated valuation of USD 15 billion. Snapdeal on the other hand, has raised almost USD 1.7 billion, including the recent funding of USD 500 million at an estimated valuation of over USD 5 billion.

Source: Public sources

Note: Assumed that Debt and Cash are insignificant in Enterprise Value (EV) as no data is available

Flipkart’s valuation over the last three years has grown at a combined annual growth rate of ~150% whereas the company’s Gross Merchandise Value (GMV) has grown at ~250%. Similarly, Snapdeal’s valuation over the past three years has grown by ~130%, while its GMV has grown by ~460%. There is a correlation between valuation and the GMV. Flipkart’s valuation in May 2015 was approximately USD 15 billion and GMV was USD 4.5 billion – this means the valuation is now only a little over three times the GMV, while it was much higher (~15 times) in 2011. With the GMV projected to grow to USD 8 billion, this multiple is set to become lower. Similarly, Snapdeal’s GMV multiple has come down from nearly 20 times in 2012 to under two in FY 2015. In the early days, the expectation of growth was high, hence the higher GMV multiple.

How are valuations done?
These fundings could have happened at EV/GMV multiples. GMV is the total value of the products sold by the company. However, the key thing to note here is that both these entities are currently making losses and are not likely to make any profits in the near future. So the big question is: how does one value e-tail companies that are achieving stupendous growth in sales but making huge losses? Traditionally, companies have been valued on their profitability or ability to generate sustainable cash flows to shareholders. However, these methods may not be apt when considering the stage in which these companies are operating.

Why are valuations so high for loss-making companies?
The e-commerce market in India is expected to be more than USD 300 billion by 2030 according to a Goldman Sachs report. Now, every e-commerce company wants to have a large pie of this future market. Hence, the major players (Flipkart, Snapdeal, Amazon, etc.) in the e-tailing sector are focusing on garnering maximum market share. They are roping in customers with heavy discounts, aggressive marketing and business promotion in a way that the very behaviour of a consumer wanting to physically feel the product can be replaced with the convenience with which the products can be ordered online. These companies normally have a longer gestation period and hence investors focus more on the top line in the growth stage of the company. Once the industry and company falls in the mature stage, the focus shifts to the bottom line i.e. profit making or cash-generating capacity.

The way forward
Valuation multiples normally follow a downward trend once the companies move from the super-growth stage to the growth stage and finally to the mature stage. For example, Amazon Inc. initially fetched a high EV/GMV multiple of 20x which has now come to ~1-1.5x. This is in line with what we are witnessing/may witness in India. However, it may not be entirely correct to compare Indian players with major players like Amazon Inc. and Alibaba that are operating in different economies.

The story for India may differ compared to developed economies as there are various challenges unique to the Indian economy. The roadmap to profitability for e-tailing companies is yet to be thought upon by the industry. The huge amounts of cash burned in offering discounts and promotions may not result in any customer loyalty as customers may always choose the player offering the product at the lowest price. The idea of “last man standing” appears to be the theme of the moment as investors continue to pump in huge amounts of money into these firms.

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