Late last year, Morgan Stanley marked down the valuation of Indian internet “unicorn” Flipkart by 38%, taking it to a low of $5.54 billion compared to the peak $15.5 billion it stood at in 2015. This was the fourth consecutive markdown by the New York-based global financial services firm. Even as the media was full of reports of Sachin and Binny Bansal (the unrelated cofounders of Flipkart) attempting to secure funding from larger firms – Walmart was rumored to be interested – India’s leading e-commerce site sprang a surprise: In early April, it announced fresh funding at a post-transaction valuation of $11.6 billion. Executive chairman Sachin Bansal, who had described the valuation markdowns from Morgan Stanley and others including U.S.-based Vanguard, Fidelity and Valic as “a very uninformed opinion,” stood vindicated.

“This deal helps Flipkart secure some strategic investors who can bring technology and operational expertise, something much needed to solidify its market leadership,” says Sandy Shen, research director at Gartner. “This is different from the previous rounds of mostly financial investors. So Flipkart is getting more than just the funding.”

More than the valuation, it’s the credentials of the strategic investors who have come in that matter. The biggest slice of the $1.4 billion investment is $700 million from Chinese tech giant Tencent. EBay will invest $500 million. But it is also selling its local operations to Flipkart for $200 million. Microsoft brings up the rear with $200 million. “Today we entered into strategic agreements with three of the world’s biggest tech companies who join us as partners in our Indian e-commerce journey,” said group CEO Binny Bansal in an email to employees.

Amazon vs. Flipkart

The battle-lines are being drawn in India’s e-commerce arena. On one side is Amazon. During a visit to India, CEO Jeff Bezos said that the company plans to invest an additional $3 billion in its operations in the country to take its outlay in India to over $5 billion. On the other are Flipkart and its backers. Tencent is the largest company by market cap on the Hong Kong stock exchange. Last year, it overtook e-commerce rival Alibaba. The San Jose-based eBay may have given up its India dreams; it will be a part of Flipkart but operate as an independent company. It helps that eBay India will report to Flipkart CEO Kalyan Krishnamurthy, who came to the firm from eBay Asia-Pacific. And Microsoft, which already has a deal with Flipkart for the latter to use its Azure cloud platform, is adding fertilizer for possible future growth in business.

The deal comes at a time when the internet space in India — including e-commerce — is undergoing a major shakeout. EBay, which tried to add muscle after its acquisition of fellow e-tailer in 2005, is seeing the flip side of takeovers today. Online marketplace ShopClues, which was planning a Nasdaq IPO later this year, has had to push back plans after a cofounder alleged fraud against the rest of the team. Image messaging firm Snapchat, fresh from a successful $3.4 billion IPO in the U.S., is being blackballed in India because of a reported statement by its CEO that he doesn’t “want to expand into poor countries like India and Spain.” (The allegation was made in a lawsuit filed by a former employee in a U.S. court; the company has denied it.) The CEO of homestay platform Stayzilla is out on bail after nearly a month in jail on charges of fraud filed by its vendor Jigsaw Solutions. Jigsaw owner Radha Shekhar has written to New Delhi politicians – including the prime minister — saying that Stayzilla should be investigated “instead of letting them take cover behind the startup ecosystem.”

“The real challenge for large Indian companies like Flipkart and Ola is that India’s capital markets aren’t as large and mature as those in the U.S.” –Kartik Hosanagar

List of Casualties

Then there is online marketplace Snapdeal, facing a financial crisis and being pushed by SoftBank, a Japanese telecommunications and Internet company with major technology-related investments, into a merger with Flipkart. (SoftBank holds a 35% stake in Jasper Infotech, Snapdeal’s parent.)

An email to employees by Snapdeal cofounders Kunal Bahl and Rohit Bansal captures all that is wrong with e-commerce in India today: “Over the past two-three years, with all the capital coming into this market, our entire industry, including ourselves, started making mistakes. We started growing our business much before the right economic model and market fit was figured out… [Today] we are combining teams, reducing layers, eliminating non-core projects and strengthening the focus on profitable growth. Let’s remember: GMV (gross merchandise volume) is vanity. Profit is sanity.”

A third force seems to be emerging to challenge Amazon and Flipkart. The SoftBank Group is in talks to put in between $1.2 billion and $1.5 billion in electronics payments provider Paytm, making it one of the largest shareholders in the fintech startup. “The deal could increase Paytm’s valuation to $7 billion-$9 billion,” reports Mint business daily. “SoftBank’s potential investment in Paytm and another $1 billion bet on Flipkart is likely to make its chief Masayoshi Son the toughest competitor Bezos will ever have faced in India,” notes The Economic Times. “There are two parallel deals expected in 2017 that could define the way the Indian e-commerce sector moves for at least the next three years.” Alibaba of China is an investor in Paytm e-commerce.

In this expansion and consolidation process, a lot of questions are being asked. Is it too early for e-commerce to take root in India? Is brick-and-mortar retail going to dominate for many more years to come? Does India need a different e-commerce model? Is “capital dumping” at the core of the problem?

Capital Dumping

Take capital dumping first. The three prominent voices against capital dumping are Flipkart’s Sachin Bansal, ride services firm Ola cofounder Bhavish Aggarwal, and Vani Kola, managing director of Kalaari Capital, a venture capital (VC) major. Their demand: the government should stop foreign funding of their rivals (like Amazon and Uber) and create a level playing field. “What we need to do is what China did [15 years ago] and tell the world we need your capital, but we don’t need your companies,” said Bansal at a meeting in Bangalore. Added Aggarwal: “The real fight is on capital, not innovation. The markets are being distorted by capital.”

“We support free flow of capital that is not only good for customers, but also helps create jobs [and] develop infrastructure, aids the growth of small businesses, and facilitates India’s economic development,” says Amit Agarwal, senior vice president and country head, Amazon India. He has no comment on Flipkart’s capital harvesting. “As a company we are customer focused and not competition obsessed,” he adds.

“All e-tailers are desperately trying to get out of this vicious cycle [of discounts]. This is not a sustainable business model.” –Ashis Mishra

“Personally, I don’t buy the capital dumping arguments,” says Kartik Hosanagar, Wharton professor of operations, information and decisions. “Small retailers who got crushed by venture-funded startups like Flipkart could have claimed capital dumping back then. Local companies have access to private equity markets and can technically raise lots of capital there if they can convince investors of their long-term potential. The real challenge for large Indian companies like Flipkart and Ola is that India’s capital markets aren’t as large and mature as those in the U.S. So Indian players will find it hard to raise the mammoth funds needed to compete with Western counterparts who commit billions of dollars to India. The solution isn’t to block investment by Western companies, but ask how we can address the capital market challenges faced by private companies.”

Adds venture capitalist Mahesh Murthy in a post on LinkedIn: “Of course, the same level playing fields were not deemed necessary by the same VCs when Big Bazaar [a brick-and-mortar retailer] petitioned the government for them against Myntra [an online fashion store] and Flipkart, and when small shopkeepers asked for protection against Snapdeal.”

Whether the dumping argument will itself be dumped, one thing is clear: The era of massive discounts in order to grow business has to come to an end. According to Mint, financial 2015-2016 (year ended March) saw Amazon record revenues of Rs2,275 crore (about $350 million) with a loss of Rs3,572 crore ($550 million). Flipkart wasn’t much better. It had revenues of Rs1,952 crore ($300 million) and a loss of Rs2,306 crore ($350 million). “As a company policy we do not comment on financials” says Agarwal. “That being said, we have seen a healthy growth in India. In 2016 we have grown over 100% year-on-year despite demonetization and other headwinds. For Amazon, India is one of the highest priority investments.” (Flipkart did not respond to Knowledge at Wharton’s queries.)

“All e-tailers are desperately trying to get out of this vicious cycle,” says Ashis Mishra, professor of marketing at the Indian Institute of Management Bangalore. “This is not a sustainable business model.”

No Fundamental Problem

“Does India need a different model: I don’t think so,” counters Hosanagar. “There is no fundamental problem with the e-commerce market in India. The case for e-commerce is strong. First, urban areas have traffic congestion issues and high real estate costs, making e-commerce attractive. Smaller towns don’t offer great product selection. The issue in India has been twofold. First, in their intense battle for marketshare, all companies have discounted too aggressively, and that isn’t sustainable in the long run. Second, investors like SoftBank and Tiger Global created a bit of a frenzy by over-investing at unreasonable valuations. These created the current issues and not any supply-demand fundamentals. I imagine all this will get sorted out in the next couple of years.”

Others see problems that will take longer to resolve. “India’s online retail market is at an early stage and is lagging compared to many other markets in volume and maturity,” says Shen. “Given the not-so-well-established retail infrastructure, e-commerce is an efficiency channel for merchants to reach out to a wide audience and scale up quickly. As more businesses are moving to the digital channel in a way to follow their customers, e-commerce will see high growth down the road.” She lists some shortcomings of the market: “Some key challenges: User behavior takes time to establish for online shopping (currently more limited to the elite group); product/brand choice ranges are not great; logistics can be difficult in rural and remote areas; and digital payment is not widely established, though demonetization and Aadhaar (the universal biometric identity card) will move this forward quickly.”

“India has a multiple economy — that of the metros and big cities, smaller towns and rural area,” says Mishra, who has worked on retail atmospherics and retail consumer behavior. “E-tail in metros and big cities may establish itself after reasonable consolidation in the next two-three years. Smaller towns are just having a taste of modern retailing. Online is catching up; still, it may take five-10 years to be a major force under favorable conditions. In the rural areas, no business model is available yet.”

Is trust an issue? “The quality of brands has never been a problem with online retailing,” says Mishra. “Most customers are net savvy and they can search and figure out the quality. However, lack of trust is significant in terms of accuracy of the order, timely delivery, condition [of the goods delivered], ease of cancellation of order and ease of returns. The cash-on-delivery logistics for high-value items, even for lower-value items in smaller towns, is not developed adequately. The order cycle gets elongated unduly as a result. So, both the parties find it is difficult to trust each other.”

In the U.S., Amazon was set up in 1994; it went online in 1995. It began by selling books. It took two decades to overtake Walmart in market capitalization – considered a measure of future earnings potential. But the difference between the U.S. and India is that brick-and-mortar retail has yet to come of age in India. In the U.S., stores are closing down (“Are Retailers Facing a Coming ‘Tsunami’?”). Now, in India, both those eras are overlapping.

Avenue Supermarts – the owner of the D-Mart retail chain brand – had an IPO in India in March. The shares listed on March 21 at over 100% the IPO price, giving it a valuation higher than all the retail stocks in the country put together. The next player is the Future Group; the market cap of all its listed entities add up to Rs25,000 crore. D-Mart is more than double that.

“This deal helps Flipkart secure some strategic investors who can bring technology and operational expertise.” –Sandy Shen

D-Mart is among the most expensive global retail stocks (brick-and-mortar), with the price/earnings (P/E) ratio for fiscal 2018 and 2019 at around 56 times and 42 times respectively, according to brokerage firm JP Morgan. Walmart’s P/E ratio is about 17.

“The world over, in developed markets including the U.S., physical retail commands over 93% share of modern retail,” says a Future Group spokesperson. “Even in the remaining 7%, more than half is captured through omnichannel operations of physical retailers. Physical retail continues to be the dominant and the most cost efficient channel in India by a huge margin.” Adds Binny Bansal: “E-commerce accounts for less than 2% of all retail in India, and the potential for online retail alone is about $100 billion.”

That’s a $100 billion cake waiting to be cut. Small wonder that Flipkart’s Big Billion Day sale last year and Amazon’s Great Indian Festival earlier this year were so successful.

“The question isn’t physical or virtual retail,” says a Future Group spokesperson. “Today, as consumers, we live a seamless life, and retailing, too, will be a seamless experience. Like major physical retailers, we have built significant digital interfaces. From conducting major sales events on Twitter, to a full-fledged digital wallet, Future Pay, from omni-channel portals to a large social media presence, we are transforming into a store-led digital organization.” Adds Amazon’s Agarwal: “We believe there is room for multiple formats, players and most importantly, for innovation.”