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Is online retail the next bubble waiting to pop?

High valuations could make most online firms go belly up, warn experts

Swati Garg  |  Kolkata 

Internet retailing is sizzling, with big bucks chasing a flood of hawking everything from coupons to laptops. Yet, experts warn that not only are valuations too high, but that most of these firms will ultimately go belly up.

Online retail in India is on fire. Just switch on the television in the evenings and you will see signs of this trend—a wave of advertisements during prime time from like Snapdeal and Flipkart blanketing the airwaves.

That’s because these e-tailing sites have been pumped with cash for expansion, and there’s now a frantic race afoot to try and scale up as quickly as possible. What makes these ads eerily familiar is residual memory of a similar kind of spending-spree that took place not so long ago by who now occupy real estate in the great internet graveyard. In the US, companies like pets.com and etoys.com were harbingers of the next great revolution in e-commerce, their valuations reaching astronomical heights, only to quietly collapse and expire in a few years.

Could the same thing happen here?

Sky high valuations
It is still early days for e-tailing in India, but Flipkart, India’s closest version of Amazon is currently valued at a staggering $1 billion (Rs 5,300 crore). Snapdeal.com, a company less than two years old that resembles US-based Groupon raised $40 million at a valuation of $100 million (Rs 530 crore) in July, over and above the $12 million that company raised in January.

Other players who have bagged similarly lucrative deals include fashion and lifestyle players Fashion and You (which raised $40 million in November at valuations of $200 million) and sports gear website Myntra (which raised $40 million at similar valuations). These are simply the most visible players, with an avalanche of others already bagging lucrative deals or waiting in the wings to do so.

According to an Avendus report released in November, in the first 10 months of 2011, investments totalling $829 million were made in the sector. The total number of deals doubled from 33 in 2010 to 66 in 2011.

Mahesh MurthyYet, many investors, especially those with a visceral memory of the 2000 internet bubble say that it is easy to find gaping holes in the fairytale. Mahesh Murthy, co-founder of Seedfund, a Venture Capital firm, is a leading skeptic of the boom, his outlook based on issues of accountancy, and a thorough mismatch between toplines, sales, margins and valuations. “How can a company with toplines of Rs 50 crore raise money at a valuation of $1 billion? The valuations have a ratio of 1:100 vis-à-vis sales to market cap. The company is yet to break even. The valuations, then, to my mind, are insane,” Murthy, founding partner, Seedfund said. Seedfund is an early stage venture capital fund.

ONLINE RETAIL’S BIG GUNS
Name of 
Company
Amount 
Raised*
Date Private Equity
Partner
Current
Valuation*
Flipkart  20.00

Jun ‘11

Tiger Global 1,000.00
Snapdeal 12

40

Jan ‘11

Jul ‘11

Nexus Venture 
Partner
Bessemer
100
Fashion 
and You
8
40

Dec ‘10
Nov ‘11

Sequoia Capita
Norwest Venture
partners, Intel
Capital
200
Naaptol 7
25

Aug ‘11
Oct ‘11

Cannan Partners
New Enterprise 
Associates

Not 
known

*figures in $million                                        Source: Industry

The trend, says Murthy, is being driven by the ‘Greater Fools Theory’. “The belief is that in a year or two some other Greater Fool will come by and pay an even higher price for it. That's all there is to it—no fundamentals, no other financial logic,” Murthy said.

While Flipkart declined to comment on the valuation aspect, the company said that it currently has sales of Rs 2.5 crores a day. “We currently ship about 30,000 orders daily. Our revenues have gone up from Rs 50 crore in 2010-11 to Rs 500 crores this year. We expect to reach our target of $1 billion in revenues much sooner than our 2015 target,” said Flipkart founder and CEO, Sachin Bansal.

Yet, despite the growth in sales, the margins are still weak enough to translate into a bubble according to Deepak Shenoy, founder MarketVision, and financial writer. The logic goes something like this: to justify a $1 billion valuation, the company needs Rs 1,000 crore in toplines at a minimum 5 per cent margin. “Any company which is valued at $1 billion now, should expect a listing at $2 billion. To justify this, the company should have toplines of at least Rs 2,000 crore. The fact that this is some way off means another internet bubble,” explains Shenoy.

“We saw these valuations in 1999-2000 as well. The reason this is a bubble is because customer acquisition is being done at the cost of selling below cost price,” said K Vaitheeswaran, founder and CEO, Indiaplaza, an e-retailer, founded in 1998, and a survivor from the first boom.

According to other industry insiders, the reason for these valuations is to be found in the supposed future prospects that the industry has. India currently has 100 million internet users of which 7 million are online buyers. These numbers are expected to grow to 500 million and 50 million respectively, in the next 5 years. “But just because the customer base will grow does not mean that customer behaviour will change in the way an e-commerce company expects it to. The theory of future potential is heretofore unproved,” Vaitheeswaran explained.

Creative accounting
There is another, more insidious problem that people like Murthy have with e-commerce firms. “Shady accountancy methods are being adopted by some of the new bunch of e-commerce companies,” said Murthy. The main problem here is that discounts are amortised as capital expenditures.

Shenoy explains the concept: Suppose an item is priced at Rs 100 and sold at Rs 70 at a discount of 30 per cent—ideally, the Rs 30 which is discounted should be written-off as expenditure in the year of the sale itself.

Instead, the practice is to amortise this cost as a capital expenditure to be written off in three years in tranches of Rs 10 each year. The justification is that this is a loyalty expenditure that will pay dividends in later years. “This means that the balance sheet gets inflated,” Shenoy explained.

Accountants stand by Shenoy’s view. According to Jamil Khetri, executive director, KPMG, capitalisation of expenditure is permitted but the question is which expenditures can be capitalised. “Accounting standard-26, does not allow the amortisation of capital expenditure just on grounds that the benefit of the cost will be reaped in a few years, because consumer behaviour is unpredictable,” Khetri explained.

However, Business Standard was unable to ascertain if any of the companies mentioned in this story followed this practice.

Game of scales
The first sign of an upcoming bloodbath is the shutting down of operations of Taggle.com, the much talked about daily deal site that raised $8.75 million. Here is an extract of the note that the company posted on its website:

“…the current market conditions have many e-commerce players selling products at below cost price to lure users. The only way to sustain the business at this time is to get into a price war and burn a lot of investor money and try to outdo competition in a ‘Last Man Standing’ game. This practice goes against our philosophy of building a sustainable and profitable company.” Over the past 12 months, at least half a dozen websites have shut shop.

This, in a nutshell, is the herculean challenge that will face e-tailing sites in the next few years. Therefore, in many ways, the key question is not so much whether companies like Flipkart are overvalued or not, but how many will in fact be able to survive the mad scramble to scale. “For every company that survives, ten will fail within the next year and a half,” said Gaurav Kachroo, CEO, Deals and You. “The survivors will be the ones who are able to build brands, service consumers and set up a backend”, says Manu Agarwal, founder & CEO, Naaptol. Naaptol, for example, has set aside $1 million a month on value chain and backend expansion.

Deep pockets mean a better ability to hang in what becomes a process of attrition. According to another leading player, for any company to survive, it is essential that the company is able to raise at least $50 million in the first three years to build infrastructure and platform capabilities. Moreover, in the case of Flipkart for instance, an early mover advantage and its understanding of the unique aspects of India’s logistics and supply chain terrain could convince global behemoth Amazon that it would rather absorb Flipkart for a pile of cash than start from scratch here.

This isn’t 2000
If 2011 was the year of euphoria, 2012 will be the year when valuations are normalised, says Prashanth Prakash, Partner, Accel India Venture Fund, which has injected $20 million into companies over the past few years. “First, one cannot compare the leaders with the rest, because the leader will any day be valued much higher. Also, I admit that a lot of inflation in valuations happened because of euphoria, but one can expect a normalisation to be the trend this year,” Prakash said.

Despite this normalisation, Prakash says that the second coming of e-commerce in India is the real thing and not a bubble. In the next 3 to 4 years, the early stage-focused private equity (PE) player will invest $140 million of which 40 per cent is estimated to be in internet based companies.

Sanjiv Bhikchandani, who launched India’s leading internet job portal Naukri around a decade ago, adds that there is one big difference between today and ten years ago. “The difference this time around is that there are 100 million internet users as opposed to the 4 million internet users that India had in 1999-2000. If the companies are able to scale well, and execute keeping in mind a road to profitability we should see some winners this time around.”

The trick as always is for investors to pick the winners from the losers before it’s too late.

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First Published: Thu, January 12 2012. 00:16 IST
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