Is Walmart chasing a mirage in Flipkart with the $16-billion acquisition?

Flipkart will need $2 bn annual profit to make Walmart investment viable, which will mean yearly revenue of $100 bn

Is Walmart chasing a mirage by acquiring Flipkart at a total valuation of nearly $21 billion? A back of the envelope calculation suggests that Flipkart would need to generate an annual net profit of around $2 billion (Rs 135 billion at the current exchange rate) for Walmart to get a 10 per cent return on its initial investment in the company.

This will require Flipkart to become a $100-billion (Rs 6,700 billion) company in terms of revenues within the next few years, given it achieves a net profit margin similar to that of Walmart’s, at 2.1 per cent. Amazon.com too has a similar net profit margin.

The corresponding net profit margin for the US retail industry (offline) was 3.2 per cent. On the other hand, Indian physical retailers hit higher. Future Retail earned a net margin of 3.3 per cent, whereas margins of Avenue Supermarts (DMart) and Trent were at 5.2 per cent and 5.5 per cent.

Analysts say it will be a tall order for Flipkart to earn such a margin, given that in FY17 it reported a revenue of around $3 billion (Rs 199 billion) and a net loss of $0.84 billion, adjusted for loss on fair valuation of derivatives liability, according to a report by Kotak Institutional Equity.

Analysts also said that achieving a top line of $100 billion will require additional investment from Walmart in Flipkart, which will only push the breakeven point further in the future, and negatively impact the US retailer’s return on capital employed. Walmart earned 8.5 per cent on its capital (debt plus shareholders' equity) during the last 12 months, down from its five-year average of 11.2 per cent.

Achieving even half the revenue target seems tough. “Flipkart could possibly achieve annual revenues of $50 billion in the next seven-eight years but only if India’s e-commerce remains a two-player game as the company retains half of the industry’s pie. But as the market expands, competition will only intensify given low entry-barriers in the e-commerce space,” says G Chokkalingam, founder & MD, Equinomics Research & Advisory.

He expects competition to largely come from category-specialist e-tailers given the technology talent in India and the culture of entrepreneurship in the country.

India’s e-commerce industry clocked revenues of around $16 billion during 2017, according to estimates by retail consultancy Technopak Advisors.

Walmart expects the market to grow at a compounded annual growth rate of 36 per over (in dollar terms) the next five years (FY18-23E), 4x the underlying growth in total of the retail segment in the country. This will result in e-commerce penetration levels increasing to 6.2 per cent in FY23E from current levels of 2.1 per cent.

This will require 14-15 per cent compounded annual growth rate (CAGR) in domestic retail industry in rupee terms given historical average currency depreciation of around 5 per cent. In comparison, India's consumption expenditure (or private final consumption expenditure) grew at a CAGR of 11.9 per cent in the last five years at current prices in domestic currency, according to figures by the Reserve Bank of India.

Analysts also say that Flipkart will have to enter the food and grocery space to achieve the scale that would satisfy Walmart. According to estimates by Technopak, food and grocery accounts for nearly two-third of the country’s total retail pie of $710 billion with e-commerce penetration of just 0.5 per cent, as per JPMorgan.

The growth in this space, however, comes with heightened competition and much lower margins than Flipkart’s current forte – mobile phones, consumer electronics and fashion (through Myntra and Jabong). “Though FMCG is a repeat purchase business implying opportunity to consistently tap into a sizeable part of the consumer’s wallet, lower margins and competition from millions of mom-n-pop stores (with location/delivery advantage) makes execution in a profitable manner a significant challenge,” write Latika Chopra and Sushruta Mishra of JPMorgan, in a report.

Arvind Singhal of Technopak, however, believes that entry barriers remain very high for creating a pan-India giant in e-commerce. “Moreover, Walmart is a global retail giant with deep pockets to bankroll incremental investment by Flipkart to maintain its current market share and enter new segments like grocery.”

Yet, there is a line of caution. “Alibaba.com and Reliance Retail have the financial muscle to make large in-roads into the Indian e-commerce space. To retain its turf, incumbents will need to make large incremental investments,” he adds.

That applies to Walmart as well as other e-commerce players. How will Walmart’s India bet finally play out is something that will only unfold in the next few years.