Where’s the Value? An Inside Look at Walmart’s Flipkart Deal

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Rajat Kumar, COO of ABP Digital, who previously had a leadership role at the Indian e-commerce company Snapdeal and was a consultant at McKinsey, writes in this opinion piece that Walmart’s $16 billion deal to buy online retailer Flipkart says a lot about India’s e-commerce ecosystem.

Walmart’s much-anticipated $16 billion acquisition of Flipkart, India’s top e-commerce retailer, which was announced last week, brings to mind the opening lines from Charles Dickens’ A Tale of Two Cities: “It was the best of times, it was the worst of times; it was the age of wisdom, it was the age of foolishness; it was the epoch of belief, it was the epoch of incredulity; it was the season of light, it was the season of darkness; it was the spring of hope, it was the winter of despair.” The deal is all those things — and more.

Hardly two years ago, Flipkart was being written off in VC circles. Back then growth was slowing, unit economics and profitability remained dreams, the Amazon juggernaut was gaining market share, and markdowns by current investors signalled to the rest of the investing community that the company was overvalued. At the center of it all was Tiger Global, a New York City-based hedge fund that had bet big on Flipkart and was worried about its Indian investments. In 2017 Kalyan Krishnamurthy, who had previously worked as a director at Tiger Global, became Flipkart’s CEO, replacing the founders, Sachin and Binny Bansal. The taps on discounts were opened; the focus on mobile phone sales was sharpened; and that was enough to woo SoftBank Vision Fund, the biggest of the big fish, which invested $2.5 billion.

Now, two blockbuster deals later — first with SoftBank, which provided some relief to Tiger, and the second with Walmart, which provides a profitable exit to SoftBank — things have changed, and how. But apart from ESOPs being liquidated and many millionaires being created, let us remember that little of the valuation will find its way to India. Most of the money will move from Walmart to Tiger Global, SoftBank Vision Fund and Accel, which have invested heavily in Flipkart during the past two years. According to media reports, while Tiger Global will make $3 billion on this deal, both SoftBank Vision Fund and Accel will reap substantial windfalls. Flipkart’s Indian founders and employees will end up with a small slice — perhaps around 10%. How I wish there were a bigger India wealth role in this story, but I guess something is better than nothing. Even 10% of $16 billion is not exactly chump change.

More importantly, let us assess what this transaction could mean for Walmart, for Amazon, for the e-commerce ecosystem, for Indian traders and manufacturers and for consumers.

“Walmart’s sourcing might, combined with Flipkart’s e-commerce prowess, can and should be a global play, not just an India play.”

E-Commerce 101

Before we begin, consider some basic facts about e-commerce in India:

    • E-commerce operates in four broad verticals — electronics (including mobile phones); fashion; household stuff (ranging from furniture to bedsheets to brooms); and fast-moving consumer goods (FMCG). Of these, the most sales value comes from electronics, including mobiles, and the most transactions come from fashion.
    • Despite regulations that specify that retail with overseas funding has to be a marketplace (i.e., it cannot sell its own inventory but should only be a platform for other merchants), no barriers prohibit some suppliers (less than 25% of total business on the platform) from being affiliated with the retailer. WS Retail (for Flipkart) and Cloudtail (for Amazon) are examples. This also helps from a customer perspective since the perception of quality is stronger with such branded suppliers.
    • In a typical retail business, the cost of customer acquisition is measured against the long-term value of a customer (driven by his value per order, number of orders, profit per order, typical number of years before churn). I have never heard any e-commerce discussion in India even mention these metrics. The metric I have heard used most often is gross sales value (GSV) perhaps in the absence of another simple metric in a growth business fueled by discounting and loss leadership. By the way, the way GSV is measured changes from company to company. Firms either use maximum retail price or MRP to measure GSV, or the retailer listing price, but I do not know of any company that uses the actual price charged to a consumer for calculating GSV.
    • Since market leadership is measured in terms of GSV, and funding is dependent on it, it is pertinent to note why GSV is important. GSV stems from a classic marketing and finance model, with the assumption that higher sales automatically mean a larger number of consumers. This, in turn, means a higher mind share as well as a stronger bottom line (with the assumption that products should not be sold at a loss).
    • In a typical VC-led high growth industry, this usually does not hold true, and hence in e-commerce, GSV levers and profitability levers are separate from each other. For example, reducing prices by 10% on a mobile phone can usually ensure that GSV for that phone triples, but clearly, it may make a significant dent in the bottom line with no significant long term gain in consumer mind share. (Also, especially for mobile phones, discounts can lead to trade buys kicking in, where offline retailers pick up discounted stock for later reselling at full rates.) Moreover, GSV does not account for the number of returns, which should not only not be counted in sales done on the platform but can also contribute to significant losses because of free returns, damages and frauds.
    • E-commerce has not yet fully captured the imagination of Indian consumers other than those living in metros and big cities. While orders are shipped to smaller cities, the numbers are not commensurate with the share of population living in these parts of the country.
    • E-commerce prices are much lower than those one would get in, say, a mall. However, barring mobile phones, branded products and FMCG, the prices may still not be able to beat prices of shops in local markets. These shops do not pay rent, do not need high profits for owner sustenance, deal in unbranded goods, and may have innovative ways of avoiding taxes such as GST that ordinary mortals may not be able to imagine. In other words, the second rung of e-commerce penetration in India will be a long-drawn affair, unlike the current phase, and will likely take an omni-channel route.

Below, I will discuss the bottom-line impact of the deal on Walmart, which, if one were to go by regulations, should never be a concern since a pure marketplace model as is mandated by regulations is nothing but a technology platform. But by that logic, e-commerce should never have been a loss-making industry in India to begin with, so I would rather base my thoughts on reality rather than on theory.

“How I wish there were a bigger India wealth role in this story, but I guess something is better than nothing.”

Flipkart vs Amazon — and the Value to Walmart

How does Flipkart compare to Amazon in India? Since both companies hold information close to the chest, a broad statement will be inaccurate and inappropriate. Reports suggest that Flipkart leads in GSV over Amazon, while Amazon leads in units sold. Amazon is also believed to have overtaken Flipkart in metros (where the most purchasing power lies).

Flipkart leads in the fashion vertical. Its subsidiaries Myntra and Jabong are completely focused on that industry. Flipkart also leads in mobile phones, which accounts for a significant portion of its total GSV. Moreover, Flipkart has PhonePe, its payments solution, just like Amazon and PayTm have their own solutions. However, Amazon also seems to lead from a consumer share perspective. Reports suggest that Amazon was ahead of Flipkart on browser visits, app downloads and average daily active app users.

So what does Flipkart bring to the table for Walmart (apart from tailwinds about India’s macro story and retail potential, which has been beaten to death)? The implications of gaining leadership in the fashion vertical are that Flipkart has higher bargaining power with suppliers, especially fashion brands. Myntra and Jabong (both owned by Flipkart) are positioned as fashion destinations and not commodity retail destinations. Just this difference in perception automatically means a difference in pricing power.

Fashion prices are not easy to compare across websites, and therefore a price premium can be charged once a consumer starts browsing. For example, what is easier to compare — the price of a Sony Bravia 42-inch television or a sky-blue Arrow full sleeve shirt, size 42 with a specific stripes pattern? Moreover, given the price points, a consumer’s incentive to compare is also lower than in the electronics segment. Hence, fashion is a goldmine from a P&L perspective, if it is done right. If not done right, though, the following costs kick in: Fashion items usually have an unfavorable value-to-shipping cost ratio and also have a higher propensity for return (mismatch in size, color expectations, material expectations, etc). Such return costs are a drag for both the retailer and suppliers.

Moreover, the retailer is stuck with unsold inventory. (Branded fashion deals are usually not done on a marketplace model and there is some level of retailer risk involved.) This imposes a spoilage risk as well as the possibility that unsold inventory may have to be liquidated at a loss. Overall, the Flipkart fashion vertical seems to be doing well, with reports of Myntra looking to break even this year, while maintaining a healthy growth trajectory.

Flipkart’s lead in the mobile market also has significant implications. For one thing, mobile phones are highly amenable to online purchase through e-commerce platforms. They are high value, have high demand, are not bulky and perhaps cost Rs 40 (or $0.75) to ship. Moreover, a consumer who wants to compare multiple models side by side in peace may take two or three visits before making up his mind (and hence would hate pushy salespeople in a physical store). For these reasons, mobile phones were one of the first few items to show significant traction on e-commerce and take significant share from offline retail. Even today, most searches in e-commerce are about mobile phones, which are a significant symbol of identity, especially for Indian youth.

Flipkart is a leading destination for phones in India — be it the deals it has with Motorola or Xiaomi (which Amazon has slowly tried to wrestle into), or just the sheer number of exclusive launches it does in a year. It is now an indispensable site for manufacturers to list their phones. And with the high volume comes high bargaining power on margins. In addition, a lead in mobile phones market share automatically means an entry into a high-turnover segment with further scope to gain share versus offline retail.

“E-commerce has not yet fully captured the imagination of Indian consumers other than those living in metros and big cities.”

The downside, however, is that mobile phones are a double-edged sword; they usually do not make money. In fact, they are loss leaders for e-commerce. Prices are easy to compare and hence there is a simple downward spiral to woo the consumers, even at a loss. The margins are way lower than in fashion, and usually hover around 7% to 10%. While shipping costs are low, losses on account of fraud or returns can be gigantic. And if platforms want exclusive deals with manufacturers, they have to provide sell out targets (usually guaranteed) to gain that exclusivity. This means that the loss on account of unsold inventory may potentially hit the retailer rather than the manufacturer.

In summary, once the Flipkart deal goes through, Walmart will inherit a business that is a leader in both high-margin business (fashion) and high-GSV business (phones). Still, the latter may continue to remain a bigger drain on the bottom line than the former, despite providing a cushion in the vanity metric of GSV.

Did Walmart Overpay?

Much ink has been spilled discussing the $16 billion acquisition price, so it is worth discussing if the valuation was correct. In my view, beauty lies in the eyes of the beholder. From a pure RoI perspective, the valuation may not appear to be justified. However, one must note that most technology businesses have much of their value embedded in terminal value, or in cash flows that appear after a 15-year to 20-year horizon. The exponential growth curve in a growing market makes it very tough to accurately model the right value in such cases. As a result, most venture capitalists speak in terms of revenue multiples rather than EBITDA multiples. The only concern that Walmart may have is how improving unit economics (especially on the electronics side) will impact growth and consequently the value embedded in terminal value.

The bigger question is whether Walmart had a choice: Could it have invested its war chest in India and hoped to reach Flipkart levels organically, choosing the path that Amazon chose earlier? Perhaps it could have, provided it had technology and e-commerce expertise, but the company has not been able to convincingly demonstrate this elsewhere. (For example, Walmart’s plan to collaborate with Bharti to build its retail presence in India did not take off as planned, so perhaps it remains wary of organic plays in India, especially with regulation stacked against it.) Moreover, in such a scenario, it would have to be wary of SoftBank pumping in more money into Flipkart to counter Walmart, or prepping it for listing and using the funds to crush Walmart India before it could gain a proper toehold.

In the medium term, Walmart may be able to do some smart moves with Flipkart. I am sure it has built these factors into its valuation — and if it has not, it should have. Walmart and Flipkart will have better bargaining power with suppliers (imagine the global might of both U.S. and India volumes while negotiating rates with Chinese suppliers). Walmart could also apply its e-commerce lessons from Flipkart and implement them in the U.S and other global plays (Jet.com, etc). I imagine this would have a much greater bearing on Walmart’s thinking than a pure India play. After all, few companies globally have been able to withstand Amazon’s onslaught, as Walmart knows from previous experience. Walmart’s sourcing might, combined with Flipkart’s e-commerce prowess, can and should be a global play, not just an India play.

“Even today, most searches in e-commerce are about mobile phones, which are a significant symbol of identity, especially for Indian youth.”

Implications for Indian Retail

Let’s face it — Indian manufacturing and retail are inefficient. The warped ratio of real estate rents to product value, inefficient transportation and infrastructure, or the sheer number of intermediaries, make the final consumer price way higher than it should ideally be, considering the purchasing power of average Indians. Of course, high tax rates on sales worsen the situation, offset by rampant tax evasion. Having said that, I do not see any immediate implications for the retail sector, except for a tailwind-driven, slow erosion of sales towards e-commerce.

Over time, though, I see this situation as one of which both small retailers and big players like Future Retail (Big Bazaar) should be wary. Apart from both Amazon and Flipkart developing the significant (and automated) warehousing infrastructure that has worked so well in the U.S., and which has a role to play in the Indian context, I imagine that Flipkart under Walmart may test some omni-channel possibilities as well (despite regulatory hurdles), especially seeing the success of DMart and the reach of Big Bazaar. It would also be much better positioned than Future Retail and DMart to open physical stores in smaller towns — purely as a window to e-commerce as well as a means to ease the returns process.

A point that is often missed is that for the first time, all the leading players in Indian retail are strategic players and not VC driven start-ups. This means that the VC pressure that often accompanies a funded start-up to show growth will be replaced by logical, long-term horizon decisions. Be it Flipkart, Amazon, Big Bazaar or DMart, I now foresee a lot more real value creation for consumers, rather than a primarily discount-led play that is nothing but a transfer of value from one player to another. To that extent, I foresee that losses will stabilize, suppliers will be squeezed (beware small manufacturers), and loyalty programs and customer data will play a key role in market share battles. I personally look forward to enjoying the replicas of Cola wars all over again.

I have mixed feelings about what Walmart’s Flipkart deal shows about India’s regulatory direction. Despite clear mandates about not allowing foreign capital in retail unless it is a pure platform play, we now have a situation where Indian e-commerce is pretty much being run on foreign strategic capital. Both Walmart and Amazon have their own store brands as well, and at least in spirit, cannot be called pure platform plays. I would have loved to see an Alibaba being created and sustained in India. It seems, though, that Indian regulations are not geared towards creating homegrown behemoths in the internet age.

China has done a great job in this regard, by not allowing foreign players in internet-driven sectors, thus ensuring the rise of Chinese internet giants such as Alibaba, Baidu and Tencent. Without similar protection, basic economics dictate that established overseas players with deeper pockets will always win an internet platform battle, since by its very nature, the internet is geared towards promoting global monopolies or duopolies. Cases in point: Google, Uber, Amazon, Facebook, AirBnB, etc.

“In summary, once the Flipkart deal goes through, Walmart will inherit a business that is a leader in both high-margin business (fashion) and high-GSV business (phones).”

I have two final comments about the role of capital. No player (even a Big Bazaar) was able to create this kind of scale with Indian capital, so is Indian capital slow to react? Why would a Flipkart even get a chance to rise with both Reliance and Future Retail already present in the market?

My view is that, in general, the Indian mind is not focused on innovation. The education system based on a “repeat after me” style of teaching; the societal mindset which looks down upon a young person doing a summer job in a TGIF or McDonalds; the parental pressure to do a “job” rather than experiment with passion — all these ways of thinking carry forward in a typical Indian work environment. The result is that innovation has limited (or no) budgets allocated; the boss is always right; and no middle manager would want to be in a situation where, despite a grand vision and a potential payoff of billions, the risk of failure can be attributed to him. So, unfortunately, I do not believe that traditional Indian capital is geared towards a 20-year horizon. (I mark Reliance Jio as an exception — but that is a story for another day.)

The big takeaway from the present deal is that deep pockets win. This is a maxim that has been demonstrated over and over again, especially in B2C technology plays. A certain disdain for capital efficiency, a focus on gaining share and a relentless focus on killing competition define today’s leading companies. Flipkart would have been in the news for very different reasons had it not been for the timely fund infusion by SoftBank in 2017. Growth had stalled, the annual burn was high and unit economics were unsustainable. And yet, as part of the strategy of Lee Fixel of Tiger Global and Kalyan Krishnamurthy, Flipkart doubled down on not ceding market share to Amazon, whatever the capital burn. This in turn caught Softbank’s eye (whose earlier investment in Snapdeal was not working to its expectations).

As a result, Flipkart is now touted as a poster child of Indian start-ups. The critical question in today’s age, which may require some rewriting of textbooks, is: What comes first, the business plan or the capital? Walmart’s Flipkart deal suggests it is the latter.

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