Sunday, June 7, 2015

Why the e-commerce bubble will end badly

Over the last few days, there has been a lot of buzz about how  e-com valuations are justified are not.

E-com market is getting increasingly consolidated: Not so long ago, there were more than 4-5 players and another 4-5 up and coming players waiting in the wings in each space.  Most of them have come down to 2-3 goliaths each of whom have at least raised $ 100 MM.  And, every VC in town is on a wild goose chase to get onto one of these giant bandwagons.

Risks are getting aggregated and getting shifted to one, two larger players in each vertical: Given that most of the larger players are now an amalgamation of at least 2-3 players each of whom have gone through a hypergrowth with little or no profitability to show for, I am pretty sure that there are likely to be significant risks that have been thus far swept under the table.

Near 100% usage of price discounting as the only enduring " mouse trap" :  Ask a lay customer and the first thing that he equates e-commerce with is "discounts". So much so, in conference calls, industry chieftains have come on board claiming that the price at which a few e-commerce companies buy from them is higher than what they sell to the customer at.

Law of diminishing returns is already kicking in and kicking in fairly fast: If the early phase of e commerce was about scaling up revenues rapidly without worrying about profitability (2009-10). The next wave was about compromising margins even further to acquire new customers  (2011-2014). The current wave is about building features/new additions  without worrying about if they would ever result in revenues at all. Case in point, being's great, new feature  or olx/quikr's ever increasing list of features. I do not have the latest data, but I would be surprised if has annualized revenues of Rs. 10 Cr. or if olx/quikr have revenues in excess of Rs. 75-100 Cr. (given that more than $ 200 MM of money has gone into each).  I am so sure, that each extra $ 1 is resulting in an ever decreasing contribution to the topline. I am told, these days, the valuation is ascribed to the number of downloads of the mobile app.

Rapidly diminishing stake and skin in the game : An offshoot of  all of the above, is the little stake that the founders are left with after  all these rounds of funding. With salaries that are benchmarked to best in class, a cash burn and a single digit shareholding, I cannot see why this would'nt translate into a combustible mix of "heads we win, tails you lose" type of behaviour that charactertized all the previous bubbles caused by excessse. As charlie munger would say, "incentives matter a lot - infact, they are the only ones that matter" 

Of course, public memory is so short that we fail to recognize that less than 30 % of the capital deployed in the private equity boom between 2006-2012 has been returned and the rest will probably never get returned. And these were into profitable, real businesses that had real cash flows and profits to show for.

 Assumption about liquidity wave increasing/stable: Read an off-hand remark by a famous VC here. This reminds me of the infamous chuck prince statement in 2007  -  read it here.  We all know what happened barely a year later - Uncle sam had to step in to prevent citi from collapsing and chuck prince was fired for reckless risk taking.

What happens in a consolidated market is that whenever cracks appear, they tend to spread fairly quickly. In a fragmented and free market, a disruption in one player is filled in by another one soon - if you cannot get your vegetables from your neighbourhood vendor, you can always get it from another one. However, if BPCL runs out of gasoline, there are only two more left standing - IOCL and HPCL. And the resulting run on them will be so much that they will also get squeezed out soon enough. However, in a market with very many players, this load gets taken over across a large spectrum, significantly cushioning the impact.

Given all of the above - low alignment with stakeholders, incentives aligned towards reckless risk taking and a consolidated market with no focus on profitability, it's only a matter of time before we see a big shrink in valuations - much like what happened with sub prime or in the dot bomb bubble in 2000.

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