Is Walmart chasing a mirage in Flipkart?

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 valuation of nearly $21 billion?

A back-of-the-envelope calculation suggests Flipkart would need to generate an annual net profit of around $2 billion (Rs 13,500 crore at the current exchange rate) to give Walmart a 10 per cent return on its initial investment in the company.

This, in turn, will require Flipkart to become a $100-billion (Rs 670,000 crore) company in terms of revenue within the next few years if it achieves net profit margin similar to that of Walmart at 2.1 per cent. Amazon, too, has a similar net profit margin.

The net margin of the US retail industry (physical) was 3.2 per cent.

On the other hand, physical domestic retailers earn better margins - Future Retail was at 3.3 per cent, while Avenue Supermarts (D-Mart) and Trent were at 5.2 per cent and 5.5 per cent, respectively.

Analysts say it will be a tall order for Flipkart to earn even 2 per cent margin, given that in FY17 it reported revenue of around $3 billion (Rs 19,900 crore) and net loss of $0.84 billion, adjusted for loss on a fair valuation of the derivatives liability, according to a report by Kotak Institutional Equities.

Analysts also say that achieving a top line of $100 billion will not come without additional investment from Walmart in Flipkart, and it will only push the breakeven point further in the future, and negatively affect the US retailer's return on capital employed.

Five-year average return on capital (debt plus shareholders’ equity) was at 11.2 per cent, which has dropped to 8.5 per cent in the past 12 months.

Achieving even half the revenue target seems tough.

“Flipkart could possibly achieve annual revenues of $50 billion in the next 7-8 years, but only if India’s e-commerce remains a two-player game as the company retains half 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 e-commerce market to grow at a compound annual growth rate (CAGR) of 36 per cent (in dollar terms) over the next five years (FY18-23), four times the underlying growth in the retail segment in the country.

According to estimates, this will result in e-commerce penetration levels increasing to 6.2 per cent in FY23 from current levels of 2.1 per cent.

This will require 14-15 per cent CAGR in the 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 past five years at current prices in the domestic currency, according to the Reserve Bank of India data.

Analysts also say 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-thirds of the country’s retail pie of $710 billion.

Of this, e-commerce penetration is just 0.5 per cent, according to JPMorgan.

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) make execution in a profitable manner a significant challenge,” Latika Chopra and Sushruta Mishra of JPMorgan say.

Arvind Singhal of Technopak, however, believes entry barriers remain very high for creating a pan-Indian 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 Walmart’s India bet will finally play out is something that will only unfold in the next few years.

Photograph: Abhishek N Chinnappa/Reuters