March 13, 2015 2 Comments
There has been an incredible, unprecedented rise over the past year in the sentiment around the consumer mobile and internet space in India. There are now several private companies in the ecosystem valued in the billions of dollars and a slew of new deep pocketed global investors active in India ready to invest tens or hundreds of millions of dollars into relatively young companies. 2014 saw tech VC/PE investment of over $5B, more than double of any prior year on record. 2015 so far appears to be on pace to beat that high watermark.
Having been active as an investor in India for the past several years and having seen the ecosystem and many companies negotiate both ups and downs of investor sentiment, this is a very interesting time. Every week I speak with multiple potential investors – usually those looking from afar or just entering India – who are brimming with optimism, and I speak with many others – usually those who have been on the ground for a while – who privately voice that we are in some form of a frenzy or bubble.
Here I capture some thoughts looking at both sides – the bull case as well as the key risks around investing in growth stage consumer mobile/Internet companies in India in the current environment.
There is a strong Bull Case…
- Digital platforms at scale: Mobile Internet has unleashed digital platforms of massive scale in India. There are over 200M unique Internet users in India today, likely to cross 500M in five years. Most of those 500M users will access the web primarily over mobile. When you have hundreds of millions of users with a connected device on their person, the platforms and services you can create are endless. With 175M+ mobile internet users, 200M+ internet users, 900M+ mobile users and 150M+ social media users, India’s digital economy has reached critical mass, and continues to grow faster than most other large markets. For the foreseeable future, India will be second only to China in the sheer scale of digital platforms.
- China benchmarks: For India, China provides a direct upside benchmark of a buzzing Internet ecosystem at scale in a large emerging market. The Alibaba IPO was arguably a major trigger for the ongoing consumer Internet investment boom in India. China has 30+ Billion dollar consumer digital companies, which are cumulatively worth over $500B on the public markets. In China, almost every large vertical and model – eCommercce, social, search, gaming, classifieds, mapping, payments, portals, travel, real estate, jobs, taxi – has seen billion dollar outcomes. And the Chinese Internet market still has a long runway ahead of it.
India, by contrast, currently has just three public Internet companies with a total worth of under $4B, and only a handful of Billion dollar private companies (even after the funding frenzy of the last twelve months). Given the fact that India has a population similar to that of China, is now reportedly growing at least as fast as China, and has a political dispensation perceived to be business-friendly, most investors agree that this gap represents a large opportunity for value creation in India. Purely based on this macro comparison basis, we should expect to see many more ‘unicorns’ coming out of the Indian consumer digital space.
- Global product companies from India: The other leg of the India tech story is the emergence of global product companies being built out of India. Given India’s deep entrepreneurial and technical talent pool, a large itinerant base of global Indians, and lack of linguistic barriers, India is well positioned to create an Israel-like ecosystem of startups that builds locally but sells globally. There are already examples set by companies such as Vizury, Zomato, Druva & Freshdesk, and this trend will only accelerate over time as cities such as Bangalore develop into startup and innovation hubs rivaling Silicon Valley.
- Network effects and betting on the winner: Many consumer Internet segments have a strong network effect, and thus have a strong winner-take-most dynamic. Segment-leading Internet companies in India have had relatively high historical survivability, and have generally demonstrated ability to maintain market position through tenacity. Therefore in many cases, investors believe they can’t go wrong when investing in a market leader, even if they understand well that they are entering at a very high price well ahead of current traction. Given the large long term potential and network effects, market leaders in many segments should still fetch outsized returns over the long term.
- Local winners: Unlike the first wave of the Internet (search, portals, news, social), most emerging/growth segments in the consumer space (eCommerce, taxi/transportation, real estate, food, local deliveries, local merchants/services) have a strong offline or local component. Local well-run companies are better positioned than their global counterparts to address the unique nuances of building large offline operations in the Indian market
- Internet/Mobile eating up industries: Entire industries are being created or disrupted by consumer tech companies. Take the retail, travel, taxi/transportation and food industries today. Over time, this will extend to many other spaces such as education, healthcare, real estate, local services, automotive and others. In fact in India, the opportunity for technology led industry disruption is perhaps higher than in many developed economies. India may leapfrog a generation of companies given limited penetration of organized offline businesses across these industries, e.g. eCommerce in India is in the process of leap-frogging traditional organized retail, which remains relatively small in proportion to the economy. Other sectors such as transportation, real estate and travel may also see Internet companies emerge as bigger value creators than first generation offline companies
…But many challenges to be overcome
Where there is opportunity, there are challenges. And challenges continue to be aplenty in the India consumer digital space. However, the good news is that many of these question the “when”, not the “if” about the opportunity, and the smart ones will figure their way around.
- Low Monetization: India has the unique dichotomy of extremely large user numbers and extremely low monetization per user. India’s average per capita income is still barely above sustenance level (~$1500), leaving very little disposable spend per capita. Take the digital ad market for instance. Digital ad market in India is around $600M/year. At 200M Internet users, this implies a digital ad spend of about $3/user/year. The analogous figure for China is about $50/user/year. For the US it is over $200. For sure this represents room for upside. However, the Indian digital ad market, while growing rapidly, is not yet growing meaningfully faster than user base growth, i.e. ad monetization per user is only growing at a moderate pace. The wide differential in monetization levels holds across other sectors with direct monetization, including eCommerce and travel. E.g. in the relatively mature online travel space, for India’s leading OTA, net monthly revenues are estimated to be $0.4 per MUV, while the same figure for China is around $1, and for the US around $18. These gaps will converge, albeit over a period of several years (or decades).
Add to this the fact that direct monetization is harder in India outside of areas where the consumer is already used to paying for a good or service offline, or where online services provide a large discount to alternatives (e.g. travel, eCommerce, local commerce). Sectors such as digital music, gaming, consumer/SMB SaaS have created large winners in markets such as China and the US. However, in India, digital content, virtual goods, software subscriptions have so far been relatively hard to get customers to pay for, and companies in these spaces will take longer to get to scale.
Companies and investors must thus look for models with direct monetization where possible, and/or be geared to build slowly as the market expands.
- Challenging unit economics and high burn rates: I look at local marketplace businesses across geographies, and India has by far the toughest unit economics of all markets I look at. Monetization levels per customer are low, but costs are often not proportionately low owing to systemic inefficiencies. Customer acquisition is expensive (relative to ticket sizes) given the highly crowded environment and inefficient acquisition channels. Real Contribution Margins for many high growth businesses are negative, even in their steady state localities or segments. Discounts and aggressive competition push the unit economics further into the red. Many businesses, including several of the large ones, seem to perpetually be in ‘investing’ mode (known less charitably as selling 100 Rupee notes for 90 Rupees).
While in many cases investing ahead of the curve is a necessity to build the market and stay ahead of competition, companies and investors need to have a very clear view of how they will/can get to positive unit economics. Not all companies and segments will be able to make that transition.
- China analogs not directly applicable to India: The Chinese internet economy is arguably one of a kind, the scale and vibrancy of which may remain unparalleled for a long time to come. Indian Internet may not mirror what has happened in China. There are several reasons for this. Everyone is familiar with statutory constraints on foreign entrants in China, which created a natural walled garden and a facilitating environment for the hyper growth of local companies. An equally important but less appreciated difference is that traditional media and distribution are not as developed in China as they are in India. E.g. India has a well-developed ecosystem of hundreds of private TV channels, print media, radio, local entertainment etc, while in China, the Internet forms the predominant channel to access information, entertainment, communication, commerce etc, especially for the younger population. Lastly, China’s per capita income is about 3.5x that of India. But for many relevant consumer discretionary segments the gap is much larger, as the ratio of disposable incomes is much more skewed than the ratio of incomes.
- Diminishing returns: While the Internet user base in India is on track to get to 500M users in a few years, it is important to realize the hurdles associated with engaging and viably monetizing the incremental users getting online. The incremental users will predominantly be those with significantly lower spending power than current Internet users. Many of these users will be based out in the hinterland and may have needs very different from what many current services offer.
Many vertical marketplaces getting funded today dispense products or services that are applicable to a relatively small subset of today’s online user base, let alone the next 300M Internet users. Business plans and investment theses need to appropriately bake this in.
- Valuations: It is no secret that current valuations in the consumer internet market in India are priced for perfection. Any global or local macro event, or a couple of adverse ecsosystem situations can send the party into a tailspin. India has gone through these cycles before, as has rest of the world.
Many growth stage investment cases today must necessarily rest on the “Greater investor theory”. At current pricing levels, many growth stage investments can only be justified based on aggressive growth investors purchasing the asset at some point in the future. Many companies will not in the next 5-7 years reach anywhere close to a level of baseline profitability where exit at a fundamentals-driven valuation would provide a reasonable return to investors getting in now. So exits must be timed during a future period when the music is on and there is a high appetite for assets of larger size than today.
- Macro view and Hot Money: The current rally in tech investing got triggered primarily after the change of political dispensation in India (along with the massive Alibaba IPO), with the new establishment viewed widely as business friendly and growth oriented. This has triggered an inflow of large amounts of capital from various geographies and sources that see India as a bright spot in a world that is largely slowing down. These cycles unfortunately tend to be ephemeral. Hot money is always on the lookout for the next Brazil, Turkey or Indonesia. Interestingly, the last such upcycle lasted till as recently as 2011, when the global macro view on India was incredibly positive, there was a positive vibe on Indian political dispensation and its reformist credentials. All that changed rather quickly in 2012.
Companies must at all times have a plan of action for an environment where they may not be able to raise sufficient money to fund tens of millions of dollars in monthly burn.
- Last but not least, Talent Shortage: Anyone who has invested in or run a company in India is familiar with the level of talent crunch the country is currently going through. There just aren’t enough engineers, salespersons, product managers, CXOs, data scientists to execute against all the opportunity. Capital is abundant, and so is entrepreneurial talent. But there just aren’t enough skilled folks to do all the work! The well-funded will fight fierce and pricy talent wars, while many others will be forced to drop off the radar. While VC funding may have grown 2.5X in a year, talent availability in India will grow linearly at best. This may be the prime supply side constraint to the growth of many startups.
So is this a good time to invest in the consumer digital space in India, especially at the later stages? Well, as always, there are no blanket right or wrong answers. Outcomes will vary by company, sector, specific situation and level of preparedness.