Funding Is A Key Risk for Online Retailers; Conventional Funding Unlikely, Says India Ratings
Online retailers (e-tailers) are exposed to funding risks as their access to easily available private equity (PE) funds gets tighter, says India Ratings and Research (Ind-Ra). Ind-Ra further believes funding through the conventional bank lending route is highly unlikely; consequently they will need to look for specialised institutional investors which have a high risk appetite to avail of bridge finance. E-tailers which were flushed with PE funds up till 2015 have had lesser fortune this year, with muted deals during January-April 2016. The funding concerns have arisen at a time when e-tailers are undergoing a structural transition in their business model, involving considerable capital expenditure.
The agency believes that funding by PEs has slowed down and thus competitive pressure from new players in the e-tailer business may reduce, resulting in higher entry barriers. Thus established players will enjoy the first mover advantages and have limited operating expenses compared to the large capital expenditure (capex) that new entrants in the e-commerce space will need. However the Indian industry is exposed to competition from global players with deep pocket and strong parentage and they will continue to be a challenge.
The funding challenges have come at a stage when the e-tailers are attempting to move out of the deep discounting model to a more sustainable business model, by offering lower discounts, improving efficiencies and focusing on improving loyalty among customers, which requires a considerable investment commitment. As a result the existing players have large planned investments in the value chain namely logistics, payment banking, fulfillment centers and omni channels with a primary focus on improving the active customer base; enhancing customer loyalty and value add services. Additionally, e-tailers are also undergoing structural changes in terms of their business model, especially after the ” government’s guidelines on Foreign Direct Investment (FDI) in E-commerce” , which restricts e-tailers from using FDI funds in the inventory based model. Thus E-tailers are restructuring their business model to operate primarily as a marketplace rather than on the inventory based model. This entails increasing overhead costs on a recurring basis.
The transition to a more sustainable business model, with lower discounts will result in lower cash burn rate; hence the funding requirement is expected to be smaller than was previously seen in the previous rounds of equity raised. However since these players have planned investments in the entire value chain, funding requirements are expected to still be sizeable. In the event of unsuccessful rounds of PE funding in the future, e-tailers with high cash balances may have to use their cash surplus cautiously to fund growth in the short to medium term. This may jeopardise their organic growth and may result in losing market share to global giants. All of which may further impact the e-tailers valuations, which have recently taken a beating, shares of Flipkart India Pvt Ltd and Zomato Media Pvt Ltd were marked down by several investment fund houses. Ind-Ra thus believes that higher investments are imperative to maintain the growth momentum and e-tailers will need to find alternate funding sources.
Ind-Ra’s analysis of the top e-tailers indicates that players are maintaining a considerable amount of unencumbered cash to fund the upcoming planned investments. These constitute funds raised from the previous rounds of PE funding. Ind-Ra believes that home grown e-tailers (dependent on PE infusion without a strong parentage) have sufficient funds for planned investments in CY16, however funding in CY17 will be a challenge, due to the cautious approach of investors in recent times. With muted funding through PEs in CY16 so far, investor appetite seems to have dried up in the e-commerce space, which hit an all-time high in CY15.
Ind-Ra believes that specialised institution investors with primary focus on exponential growth sectors, involving high level of risk will be the target for e-tailers to raise funds. Such funding will only be available at a higher cost. These funds are generally extended on a short term basis, until the next round of PE funding occurs. Ind-Ra believes funding however from such investors will depend upon the ability of the e-tailers to maintain a level of PE confidence by sustaining its prominence and valuation, which seems to heading southward.
We believe that the conventional banking sector will remain out of the lending community for the e-commerce sector in the medium term. Earlier, banks have funded players with working capital loans albeit with lien on cash and current investments. Ind-Ra believes it is unlikely that e-tailers will find takers in the conventional banking community, especially with the backdrop of the absence of material collateral, previous year losses and the lack of visibility of positive cash flows in the near term.
Ind-Ra believes PE activity will remain muted in the foreseeable future, especially after a series of mark down in valuations of e-tailers by investors. Furthermore, the expected US Federal Reserve rate hike, a fragile global recovery and the recent amendment to the India-Mauritius tax treaty may keep global investors away from India, one of the fastest growing e-commerce industries in the world.