India’s Ecommerce Ponzi Scheme Has Started to Unravel

flipkartA spate of newsreports in the recent past clearly show that Indian ecommerce companies are in trouble.

A newsreport on Moneycontrol.com points out: “With an aim to cut costs, struggling e-commerce firm Snapdeal is likely to downsize its team by around 1,300 employee.” This is around one-third of the company’s total workforce of 4,000 employees.

On the other hand, Flipkart has shutdown its courier service and hyperlocal delivery project, less than a year after launching it. There are other examples as well. The question is why are companies doing this? They are trying to cut down their costs and at the same time conserve on all the money they have raised from investors.

Over and above this, investors have made a spate of mark-downs to their investments in these firms. A January 27, 2017, newsreport on Reuters points out that Fidelity Investments has marked down its investment in Flipkart by around 36 per cent. In December 2016, Morgan Stanley, had marked down its investment in Flipkart by 38 per cent.

The Japanese investor Softbank recently marked down the combined value of its shareholding in Ola and Snapdeal by $475 million. What does all this mean? It essentially means that these investors do not accept these ecommerce firms to be as successful as they expected them to be in the past. And given this, they have been writing down the value of their investments.

In a column, I had written early last year I had called Indian ecommerce firms a Ponzi scheme. Of course, this had led to a lot of abuse on the social media and I was told that I do not understand the business model of these firms. I wrote what I did because I understood the business model of these firms. Allow me to explain.

A look at the profit and loss numbers of these firms will tell you that the losses of these firms go up at the same time as their revenue.  Take the case of the market major Flipkart. As a report in the Business Standard points out, for the financial year ending March 31, 2016, the losses of the firm stood at Rs 2,306 crore. The company’s losses for the year ending March 31, 2015, had stood at Rs 1,096 crore. Where did the revenue of the firm stand at? It jumped from Rs 772.5 crore to Rs 1,952 crore, during the same period.

Or take the case of Snapdeal run by Jasper Infotech Private Ltd. A report in the Mint points out that for the financial year ending March 31, 2016, the losses of the firm stood at Rs 3,316 crore. For the financial year ending March 31, 2015, the losses had stood at Rs 1,328 crore. During the same period, the revenue of the firm increased from Rs 933 crore to Rs 1,457 crore.

What sort of a business model is this—where the losses of a company go up at the same time as its revenue? In fact, in case of Snapdeal, the losses have gone up at a much faster rate than its revenue.

What explains this basic disconnect? As Gary Smith writes in Standard Deviations—Flawed Assumptions, Tortured Data and Other Ways to Lie With Statistics: “A dotcom company proved it was a player not by making money, but by spending money, preferably other people’s money… One rationale was to be the first-mover by getting big fast… The idea was that once people believe that your web site is the place to go to buy something, sell something, or learn something, you have a monopoly that can crush competition and reap profits.”

What was true about American dotcoms is also true about Indian ecommerce companies. This isn’t surprising given that many investors in Indian ecommerce firms are American.

I discovered Flipkart one day in 2009. Back then it was simply an online bookstore. It had a reasonably good collection of books. It even had books which bookstores did not. And the deliveries were on time.

What else did one want? Discounts. It had good discounts on offer as well. Hence, out went the bookstore and in came Flipkart. The loyalty was to discounts and nothing more. Sometime later, when other websites like Homeshop18 and even Amazon, started offering higher discounts, I moved to ordering from these websites.

Nevertheless, one did wonder, how would these websites ever get around to making money, given the huge discounts that they offered. The way businesses run traditionally it never makes any sense to sell a product below the cost all the time, because that way the business is never going to make any money.

But these websites did not fit into the traditional way of doing things. At least, that is way they thought. The best way to explain this is through the example of a telephone. As James Evans and Richard L. Schmalensee write in Matchmakers: The New Economics of Multisided Platforms: “A telephone was useless if nobody else had one. Even Bell and Watson started with two. A telephone was more valuable if a user could reach more people.”

The point being that more the number of people who had a telephone, more the number of people who would want to have a telephone. The economists call this the phenomenon of the direct network effect. This essentially means that more the number of people who are connected to any particular network, the more valuable it is to people who are already a part of it.

Take the case of app-based cab services. When they launched, they offered rock bottom rates. This was done to attract customers. Once customers came on board, it was easy to attract more and more drivers on to the network as well. And over a period of time, the price of these app based services has gone up.

Of course, it is not easy as I make it sound. But that is the basic logic. Then there are apps which deliver food from restaurants. They also offered discounts initially in order to build a critical mass of customers to be able to attract good restaurants on the platform.

As economist John Kay writes in Everlasting Last Bulbs—How Economics Illuminates the World: “The company that is first to create the largest network denies access to competitors and establishes an unassailable monopoly…Connectedness is vital, and it is best to be connected to the largest network.”

So, the ecommerce game is centred around building a monopoly and cashing in on it. As Ray Fisman and Tim Sullivan write in The Inner Lives of Markets in the context of network externality: “The bigger a company gets, the more valuable it is to each successive customer, there’s a huge premium on expanding your customer base.”

And this explains the discount led model. In case of Flipkart, the discount led model was first offered on books to build a critical mass of customers, and then the company gradually got into selling many other products. The hope was that once the consumer was comfortable buying books from the website, he would become comfortable buying other products as well, over a period of time. The logic worked on the supply side as well, as more and more vendors got comfortable selling online, more vendors came in.

Of course, the discount led model leads to losses. Hence, any company following this model, needs money from investors to keep running. And this is where the structure of Indian ecommerce companies becomes similar to that of a Ponzi scheme.

A Ponzi scheme is essentially a financial fraud in which investment is solicited by offering very high returns. The investment of the first lot of investors is redeemed by using the money brought in by the second lot. The investment of the second lot of investors is redeemed by using the money brought in by the third lot and so on.

The scheme continues up until the money being brought in by the new investors is greater than the money being redeemed to the old investors. The moment the money that needs to be redeemed becomes greater than the fresh money coming in, the scheme collapses.  How does this apply in case of Indian e-commerce companies?

Indian ecommerce companies have managed to survive because of investors bringing in fresh money into the scheme at regular intervals. It is worth mentioning here that every time investors bring in more money, they bring it in at a higher valuation. This essentially means that the price at which shares of the company are sold to the investors are higher than they were the last time around. This increases the market capitalization of the company.

This increase in market capitalization comes about because the company has managed to increase its revenue. As long as the money being brought in by the investors keeps subsidising the losses being accumulated by the e-commerce firms, these firms will keep running. The moment this changes, the firms will start to shut-down. The structure of the Indian e-commerce companies is that of a classic Ponzi scheme.

Nevertheless, as we have seen earlier in this column, this increase in revenue typically comes at the losses increasing as well. This is a fact that investors of these firms have started to realise as well. And that is why they have marked down the value of their investments.

An investor who is marking down his investment is unlikely to invest more money into the firm. If he actually goes about investing more money in the firm, then he is likely to do it at a much lower valuation. Given this, the Indian Ecommerce Ponzi scheme is now unravelling. The trouble is that everyone wants to be build a monopoly. But everyone cannot be a monopoly.

As Smith writes in the context of the American dotcom bubble: “The problem is that, even if it is possible to monopolize something, there were thousands of dotcom companies and there isn’t room for thousands of monopolies. Of the thousands of companies trying to get big fast, very few can ever be monopolies.”

This basic logic applies to the Indian ecommerce as well. And given this, if fresh investor  money stops coming into these firms, as it has in many cases, these companies will soon start going bust.

To conclude, it’s time we got ready for the ecommerce bloodbath.

The column was originally published on Equitymaster on February 15, 2017

Paytm Karo! Will Govt End Up Building a Private Monopoly?

paytm_logo
One company which has benefited tremendously from the process of demonetisation initiated by the Narendra Modi government has been Paytm. In fact, recently, the annual party speech video of the company, in which an overexcited Paytm CEO Vijay Shekhar Sharma can be seen speaking to his employees (to put it very mildly), went viral. The attitude of Sharma in the video did not go down well with whosoever saw it.

Indeed, the rise and rise of Paytm is worrying, simply because government actions are helping build a private monopoly in the finance sector. I had first written about this in the Vivek Kaul Letter, but given the importance of this issue, I am writing this for the Diary readers as well.

In early December 2016, around three weeks after demonetisation was announced, I had to run an errand and ended up paying Rs 650 in cash. But before I paid the merchant in cash, I had a very interesting conversation with him, which is worth recounting here.

“You don’t have Paytm?” I asked, hoping that I could simply transfer money to him through Paytm and in the process save on my cash reserves.

“Yes, I do,” he replied, much to my surprise.

So, I immediately downloaded the app on my phone and activated it. I already had a Paytm account given that I had been using it to pay for my Uber rides. But I hadn’t used to pay for anything else before.

Once, I had downloaded Paytm, I asked for the merchant’s mobile number, which I needed to enter into the app, in order to transfer money to him.

He didn’t give me his mobile number and instead suggested why don’t I just scan and pay him. He felt that would be much easier. For the uninitiated, merchants who accept Paytm, have a code. This code is typically a part of a large sticker that has been pasted on to a wall in the merchant’s shop. The app allows you to scan this code and the payment gets made to the merchant’s account. (This like when it comes to technology needs to be tried in order to be properly understood).

I decided to scan and pay him. When I tried to do that, the payment didn’t go through. This was a little surprising, given that there was no reason for the payment to fail. I had money in my Paytm account and I was using the app properly.

It took me a few seconds to realise that the merchant did not have the Paytm app but had Freecharge instead. I pointed this out to him. His reply was very interesting. He said: “Haan mere paas Freecharge ka Paytm hai (I have Freecharge’s Paytm).”

This was a classic example of a brand representing the entire category. Dear Reader, I am sure, you would have heard of similar examples earlier as well. Like “Amul ka Cadbury (Amul’s Cadbury)” or “HDFC ka LIC (HDFC’s LIC, meaning HDFC’s insurance,” or  simply “Xerox (meaning photocopy)”. Along similar lines, in the mind of the merchant, Paytm stood for the entire category of mobile wallets.

This isn’t surprising given that Paytm has been one of the biggest gainers in the aftermath of demonetisation of Rs 500 and Rs 1,000, by the Narendra Modi government. As the company said in a statement on November 29, 2016: “Paytm has registered a strong surge in online recharges on its platform post the government’s move… As millions of new consumers tried online recharges for the first time, Paytm has registered over 35 million online recharges in the last few days.”

A major reason for this huge jump was because a picture of the prime minister Narendra Modi appeared in a Paytm advertisement. Also, the fact that the Paytm is the main sponsor of Indian cricket gives them a sort of legitimacy that other wallets don’t have. Over and above this, for a period of close to two months people were short on cash.

But there is a basic problem with Paytm and other mobile wallets. As I found out, they don’t talk to each other. There is no inter-wallet clearing mechanism. Like in case of credit or debit cards I can use a credit or debit card from one bank on a point of sale machine from another bank. Hence, my HDFC debit card can be used on an ICICI Bank point of sale machine. This makes the entire system of consumer payments extremely easy given that the card and the machine need not be from the same bank.

The same logic doesn’t hold in case of mobile wallets. If I am on Freecharge I cannot use the app to pay someone who is on Paytm. To pay him or her, I also need to be on Paytm. While, technology wise this is hardly a problem because all I need to do is download the Paytm app. Nevertheless, the way digital economics work, we may end up creating a monopoly in the financial space in the form of Paytm.  And any monopoly, government or private, is never good for the simple reason that monopolies rarely think about the customer. This is primarily because there is no competition that can make them think about the customer.

Before we go any further, we need to understand the concept of network effect. The best way to explain this is through the example of a telephone. As James Evans and Richard L. Schmalensee write in Matchmakers: The New Economics of Multisided Platforms: “A telephone was useless if nobody else had one. Even Bell and Watson started with two. A telephone was more valuable if a user could reach more people.”

The point being that more the number of people who had a telephone, more the number of people who would want to have a telephone. The economists call this the phenomenon of the direct network effect. This essentially means that more the number of people who are connected to any particular network, the more valuable it is to people who are already a part of it.

Here is another example.  As Niraj Dawar writes in Tilt – Shifting Your Strategy from -Products to Customers For those who want to be a part of a social network, it makes sense to congregate where everybody else is hanging out. There is only one village square on the Internet, and it is run by Facebook. Being on a different square from everyone else doesn’t get you anywhere—you just miss the party.”

I am on Facebook because everyone else is on Facebook. When was the last time you heard of Google Plus? Economist Paul Oyer makes a similar point in Everything I Ever Needed to Know about Economics I Learned from Online Dating: “The rise of the internet has made network externalities more apparent and more important in many ways…Perhaps the best example of the idea is Facebook. Essentially, the only reason anyone uses Facebook is because other people use Facebook. Each person who signs up for Facebook makes Facebook a little more valuable for everybody else. That is the entire secret of Facebook’s success—it has a lot of subscribers.”

The more the number of people on a particular network, the more the number of people who want to join it and the more valuable it becomes for those already on the network. At the same time, as one company gets bigger, it also leads to a situation where the competitors get driven out of the market.

As economist John Kay writes in Everlasting Last Bulbs—How Economics Illuminates the World: “The company that is first to create the largest network denies access to competitors and establishes an unassailable monopoly…Connectedness is vital, and it is best to be connected to the largest network.”

This explains the rise of Facebook and how it killed competitors like Myspace, Orkut and Google Plus. Or how Google killed the likes of Ask Jeeves, Alta Vista and many more. In fact, search engines like MSN and Yahoo, which have survived are barely used in comparison to Google.

So, the digital game is centred around building a monopoly and cashing in on it. As Ray Fisman and Tim Sullivan write in The Inner Lives of Markets in the context of network externality: “The bigger a company gets, the more valuable it is to each successive customer, there’s a huge premium on expanding your customer base.”

An important part of this monopoly is to ensure that the app or the website, does not talk to other apps and websites. To talk to someone on Facebook, you need to be on Facebook as well. To talk to someone on Twitter, you need to be on Twitter as well.

Along similar lines, to pay someone on Paytm, you need to be on Paytm as well.

But that is not the case with other forms of communication or making payment. Take the case of the mobile phone. Calls made from a phone connection issued by one company are not limited to only those connections issued by the same company.

As Kay writes: “The world telephone system consists of many operators, large and small. Most provide service in a particular geographical area, and connect each other call’s through negotiated access agreements.”

The same stands true for ATMs as well. Payments can be made across banks. “Today, a network of clearing and correspondent agreements ensures that you can make a payment through your local bank to anyone in the world,” writes Kay. You can withdraw money from an ATM of one bank using a card from another bank.

But this is something that is not possible in case of the web based messaging services. You cannot send a message from Facebook to LinkedIn, for example. Like you cannot make a payment from Paytm to Freecharge or any of the other wallets.

The mobile wallets need to be like email. As American writer Kevin Maney once told me:  “Email is technology’s cockroach: Everyone hates it but we also can’t kill it. We can’t kill it because it’s the only communications tool since the telephone that is universal. As company walls and national borders break down in cyberspace, email is the only way we can share ideas and digital matter with nearly anyone, anywhere.”

This is how mobile payment apps need to work. They need to talk to each other. This becomes even more important once we take into account the fact that prime minister Narendra Modi already has a dream of India moving towards a cashless society.

As he said in the November 2016 edition of the mann ki baat programme: “The great task that the country wants to accomplish today is the realisation of our dream of a ‘Cashless Society’. It is true that a hundred percent cashless society is not possible. But why should India not make a beginning in creating a ‘less-cash society’? Once we embark on our journey to create a ‘less-cash society’, the goal of ‘cashless society’ will not remain very far.”

In the process of moving towards a cashless society, we shouldn’t be creating private monopolies like Paytm, in the field of finance. The only way to counter this is to get mobile wallets to talk to each other.

I am not a technology guy, so I really don’t have an answer for how this can be implemented. Nevertheless, the government’s unified payment interface works across banks. We also have the Immediate Payment Service (IMPS) system which can be used for transferring money from one bank account to another bank account with a different bank, almost immediately.

Something similar needs to be developed for the mobile wallet companies as well. This would mean the involvement of the Reserve Bank of India. It would also mean developing similar standards and a clearing mechanism around which mobile wallet companies can work.

Of course, the venture capitalists funding the mobile wallet companies won’t like it, given that each one of them wants to become a private monopoly and cash in on it.

Postscript: The merchant I talk about at the beginning of this column, seems to have learnt his lesson. The next time I went to him in early January 2017, he had the Paytm payment mechanism in place.

The column was originally published in Equitymaster on January 30, 2017

What if Google goes paid?

googleA few weeks back a friend during the course of a conversation asked, “What if Google goes paid?”.  “I will pay for it,” pat came my response, even before he could finish asking his question.

As a freelance writer, who has ambitions of writing more books in the years to come, Google is a huge source of information for me. Research papers, data (Indian as well as international), news (both old and new, Indian as well as international) and so on, keep me going.

At least that is how I use Google on most days. But there are other uses as well. People use it to find out restaurants, electricians, plumbers, and so on. The uses of Google for an individual who has access to internet (either through a smart phone or through a computer) are simply way too many to put down in a 600-700 word column.

So, the question is will people pay to subscribe to Google, if it ever decides to go paid i.e. only those who pay a certain amount of money every month or every year, will be allowed to access it. While this sounds like an interesting question to ask, it is not the right question to ask.

Or so I figured out, after the conversation I was having with my friend came to an end. The right question to ask is will Google ever become a paid website, instead of asking will you pay for it, if it becomes one.

Before I go any further, it is important to explain the concept of network externality in economics, which applies in this case. This is a situation where one person’s purchase of a good or a service, makes it more valuable for other prospective consumers.

Take the case of a telephone (or a mobile phone). If only one person is on the network, it is essentially useless. For it to be of any use, at least two people need to be on it. Of course, if only two people are on it, then it is not financially viable. So the network needs to attain a certain size.

Or take the case of a social networking site like Facebook. I am on Facebook because most of my friends and people I may want to be friends with in the future, are on Facebook.

This, also explains why Orkut, lost out to Facebook, and ultimately had to shutdown. There just weren’t enough people on it, for it to continue attracting more people. Everyone had moved on to Facebook. This also explains why Google Plus never really took off. Most people were happy being on Facebook and did not move to Google Plus.

As Ray Fisman and Tim Sullivan write in The Inner Lives of Markets in the context of network externality: “The bigger a company gets, the more valuable it is to each successive customer, there’s a huge premium on expanding your customer base.” Now look at this in the context of Google. It fits the bill totally.

As Fisman and Sullivan write: “Why, for example, does Google let you search the web for free, even though maintaining its primacy in the search engine market costs the company a fortune in R&D [and] computing infrastructure.”

The answer lies in the fact that more users that Google has, the more viable its business model gets. As Fisman and Sullivan point out: “A bigger user base allows Google to extract ever-higher revenues from the other side of the market—the advertisers, who pay for search listings.”

Hence, Google is free because that is the only way to ensure that it will continue to have the kind of following that it does. And if it is in that situation, it can continue to charge advertisers a good amount of money. The fact that Google is free, ensures that its business model continues running. Given this, it is highly unlikely that in the near future, Google will ever turn paid.

Not, at least, till its current business model keeps running.

The column originally appeared in the Bangalore Mirror on August 3, 2016

Why Facebook liked WhatsApp

 facebook-logoVivek Kaul 

The messaging company WhatsApp was recently bought by Facebook for a whopping $19 billion. The owners of the start-up will receive $4 billion in cash, $12 billion in Facebook stock and the remaining $ 3 billion in the form of restricted stock units, which will vest over the next four years.
In rupee terms, Facebook paid close to Rs 1,18,000 crore (assuming one dollar is worth Rs 62.2) for Whats-App, a company with just 45 employees. This amount is greater than the individual budgets of most ministries of the Indian government for the next financial year, except the defence and the finance ministries.
So what is it that made Facebook pay so much money for WhatsApp?
Lets compare this with Instagram, a company that Facebook acquired in 2012 for a billion dollars. Interestingly, Instagram had just 13 employees, when it was acquired. Why did Facebook a billion dollars for a company with just 13 employees and 19 times more for another company with just 45 employees?
Computer scientist and philosopher has an explanation for it in his book
Who Owns the Future? As he writes “When it was sold to Facebook for a billion dollars in 2012, Instagram employed only thirteen people…Instagram isn’t worth a billion dollars just because those thirteen employees are extraordinary. Instead, its value comes from the millions of users who contribute to their network without being paid for it. Networks need a great number of people to participate in them to generate significant value. But when they do, only a small number of people get paid.”
In the above paragraph replace Instagram with WhatsApp and the logic stays the same. As of the end of 2013, WhatsApp had around 400 million users worldwide. So Facebook was essentially paying to acquire the number of people who used the messaging service rather than the knowledge and the technological prowess of the people who ran it.
But wouldn’t it be cheaper for Facebook to just build a similar application? In fact, it wouldn’t take much effort on the part of Facebook to develop a similar and even a better application than WhatsApp. So why pay so much money for it?
In fact, WhatsApp like Facebook and Twitter before it is a classical example of what economists like to call a network externality. This is a situation where demand for a product creates more demand for the product.
As economist Paul Oyer writes in his new book
 “A product has a network externality if one added user makes the product valuable to other users…The rise of the internet has made network externalities more apparent and more important in many ways…Perhaps the best example of the idea is Facebook. Essentially, the only reason anyone uses Facebook is because other people use Facebook. Each person who signs up for Facebook makes Facebook a little more valuable for everybody else. That is the entire secret of Facebook’s success—it has a lot of subscribers.”
Again, replace Facebook with WhatsApp in the above paragraph and the logic stays the same. What made WhatsApp very valuable is the fact that it has close to 400 million users. Hence, even though Facebook can create a similar application at a much lower price, it can’t get 400 million people to use it.
Take the case of Google, which launched Google+ a few years back to take on Facebook. The experts felt that Google+ was a better product and some of them even went ahead and predicted that people would now move on from Facebook to Google+. But that did not happen.
As Niraj Dawar writes in
Tilt – Shifting Your Strategy from Products to Customers “For those who want to be a part of a social network, it makes sense to congregate where everybody else is hanging out. There is only one village square on the Internet, and it is run by Facebook. Being on a different square from everyone else doesn’t get you anywhere—you just miss the party.”
This was the main reason why people did not move from Facebook to Google+, even though it may have been the better product. “Google + may offer features such as greater privacy or group video chat,” writes Dawar, but it fails to “create the positive feedback loop, because it makes sense for everybody to be where everybody else already is.”
So even though Google+ was believed to be superior to Facebook, the users continued to stay put with Facebook. As Oyer puts it “Google+ has signed up many users, but it has not put any real dent in Facebook’s dominance. Nobody is going to switch to Google+ from Facebook unless most of her friends do, too, and it seems very unlikely that whole groups of friends will act in a coordinated fashion to move from one social network to another.”
Given this, even though Facebook could have launched a better version of an application on its own, there was no guarantee that people would start using it. Chances were that they would have continued to use WhatsApp. And that explains why Facebook paid a bomb for it.
Also, in a way Facebook was just buying out prospective competition. Many youngsters have their parents and family, as friends on Facebook. This obviously limits the frankness of the conversation that they can have with their “real” friends.
This has led to teenagers preferring to use messaging services like WhatsApp rather than Facebook. In fact, in a recent earnings call Facebook admitted that teens were spending lesser time on its service and were fleeing to messaging applications like WhatsApp WeChat etc. Mark Zuckerberg, the chairman of Facebook, believes that kids are fleeing the format because parents spam their walls with inspirational quotes and tagging them in photographs which they really do not want their friends to see.
Another explanation on why teenagers are fleeing Facebook was offered to me by a friend who has worked extensively in the technology industry in the United States. When it comes to technology, Facebook is not a light app, like the chat sights. There is a newsfeed comprising of various kinds of data and there is always a chance that things get lost to your intended audience under large piles of such data. Also, it might need more memory, something that the lowest priced smartphones, which the kids are likely to use ave may not have.
Due to all these reasons Facebook paid $19 billion for WhatsApp.

The article originally appeared in the Mutual Fund Insight magazine dated April 2014

 (Vivek Kaul is the author of Easy Money. He can be reached at [email protected]. He would like to thank Somnath Daripa for providing some excellent thoughts on the topic)