Ek tha Tiger

Empty vessels make most noise. Still reeling or trying to execute the decision taken such as FDI in retail, FDI in aviation, etc. the government recently announced a plan asking banks to bail out Real estate developers. I cannot but contain my angst on this suggestion by the government.

Why should we use banks money to bail out in-efficient businessmen, who have overleveraged balance sheets and unsold inventory? How should we trust a business which is unwilling to play by market dynamics and is working on inflated prices without giving a valid proposition to the consumer? The following are the reasons for the same:

1.       Higher cost of financing

2.       Higher cost of acquisition

3.       Higher input costs

4.       Market cartelization

5.       Vested interests

6.       Lack of financial discipline

They should all take a lesson from the local vegetable vendor, who also knows that if by the end of a week or a day he has unsold stock they should lower the price and sell off to maintain the cycle of business and cash flow. Innovative accounting such as portraying advances on bookings as Equity too has not helped them in keeping up their cash flows.

Lets take a look at above factors.

Higher cost of financing: This particular factor takes the cake as the cost of financing is not giving any respite and the stock prices of all companies related to interest costs (be it borrowing by businesses and borrowing by consumer who buys these products viz. Real estate, automobiles, etc.) are on a roller-coaster ride. The ever bullish psyche of the real estate industry and the banking (after all they are humans) let them run amok and flush the sector with excessive funds with banks running after developers to take their money. This led to two things:

a.       Value of assets rose significantly

b.      Attracted many a fraudulent players who were not fit to operate

Lot of people made a lot of money, the wise ones stepped aside and the over-enthusiasts, invested in more assets in far-flung places. However, the fundamental factor on which this sector thrives was lost, the User and not the investor was missing. Slowly the first shake-out happened, and the weaker links in the game started breaking away. The over-leveraged factor and unsold and incomplete projects started rising, fraud stories started erupting and a number of companies closed their shutters. The heavy-weights who were able to sell their inventories survived either due to good relations with banks or there comes a time when the creditor has to give in the demands of borrowers to safeguard their money. The ever increasing prices of inventory (developed or launched projects) made in un-affordable for User and hence was supported by investors for some time. However, every investor needs returns, and when their interest depleted with vanishing returns, the funds dried up. At this point, it should have been logical to lower the price and let the market correct, and here lies the missing link.

Higher input costs:

This is the double whammy, with ever increasing input costs and raw material costs due to overall inflation in the economy, this sector got burdened with higher development costs. Hence, putting further pressure on margins.

Also, with MNREGA coming in the labour became a scarce resource and had a better bargaining power, thereby again leading to higher costs at the hands of developers. However, the parallel economy (black money) must have kept the market upbeat and the development has still continued despite drying up of bank funding.

There is difference between cash and per sq. Feet space. There came a time when the latter was considered cash, but unsold space is a cost (interest + Opportunity) and should be cleared to maintain cash flow.

Higher cost of acquisition:

With governments mobilizing land acquisition act for vote banks, the bargaining power of farmers grew. And like the retrospective tax on Vodafone, many developers had to not only pay up farmers for the land already acquired and save their investments. Also, their future investments and plans basis which they has cleared funding became unviable, thereby again hindering their cash flows.

Also, many a small developers who were the followers and not the entrants always entered the markets late on rosy projections and had to cough up higher prices and work on lower margins, thereby further tightening their situation. When the projects became unviable, they shut their shops and ran away with the investors money or are waiting for a bail out

Cartel formation:

The price in an area is beneficial for the other and an unsaid cartel has been formed in many areas. Also, the ever inquisitive nature of buyers is keeping the hope alive. For instance in Gurgaon any good development cannot be found at the buying price of less than INR 8,000 – INR 12000 per sq feet. This is preposterous as an average selling price of a normal 1500 sq. Feet apartment would be about INR 13mn. – INR 18mn. Leveraging about 85% of the price of the apartment comes to about INR 0.12 mn. per month for 20 years. Only a working professional(s) or a DINK couple with a combined salary of more than INR 0.3mn per month will be willing to invest or move in. Else an investor will be willing to invest with a view of rosy return in future. This seems a little unreasonable for the very fact that even 60% of the total available units will be able to find “users” for their developments.

Hence, comes in the question about the lowering of prices to adjust to market reality. Given the fact that is not happening, these apartments are being rented out as that is more affordable for the user. This gives the owner a return of about 2.5% per annum, which in no way is anything to rave about. Hence, it becomes more affordable to rent out rather than own a house.

However, working on ever enthusiastic attitude of rising real estate prices, this leads to a systemic risk and hence leads to creation of cartels so as to not sell below a particular price and safeguard the interests of few on the cost of many.

Vested interests:

It is not un-common to find vested interests that do not have any association to the business whatsoever but their commandment does not let the developed lower the prices. It is as similar to having a non-executive investor in the company with a majority stake who though does have any knowledge of the business but wishes for the best returns as comparable to an e-commerce industry these days. These vested interests invest or park their surplus (not necessarily on the books income) and are looking for returns till they do not need the money. These interests too discourage the developers to offload the inventory due to the returns expected by these ghost investors and the higher costs as mentioned above

No Financial discipline:

This is in inherent nature and not a followed diktat. More money in this sector saw instead of better products, fancy cars, customized holidays, designer clothing and designer homes for the owners entering the houses of the developers. Anticipation of income has seen kins of these businesses driving the fanciest of cars and splurging like there’s no tomorrow.

A financial discipline is most necessary while conducting any business. Cash flows should be utilized towards bringing efficiency in the business rather than adding cars to the fleet. Lack of this has dwindled many developers into bankruptcy and reeling under pressure. Also, this business has transformed into show business, with the success being measured by the fleet of cars and the labels one wears. A Sales manager of a real estate (infrastructure they call it now) I met recently speaks in Millions and drives a fancy car, but a little probe  left me bewildered that his income is levered about 70%. A fancy car and a designer lable helps him in selling at a higher price. This is what I call the Iceland effect, where its just the money in the economy playing a role and no one knows how to value the asset. It is speculation and not efficient buying and selling which is driving the industry. And once speculation takes the charge, its always best for retail investors or users to stay put till the market corrects.

Also, there is no mechanism to hedge the risks against such kind of markets in India.

Most of the points mentioned above are common for other sectors reeling under the pressure, however, that does not mean that we will keep bailing out everyone. What steps were taken for the recent airline which almost has shut down (however not so delayed) should be kept in mind and the market should be allowed to take its call. Else, the NPA's will rise and tax payers money will be lost.

Banks however, should consider the risk of losing the money in one scenario atleast as they are lending to the developers to build and on the other side financing the borrowers and investors to buy at an inflated rate.  The unsold inventory is piling up as the investor is not attracted at the returns anymore and the User finds it too expensive. Hence, It should be left to the markets to decide who shuts the shops or corrects the price rather than “bail – out” the developers so they can carry the farce and create another bubble.

Seems all the hard work and reforms (read good reforms) are being let go off by the government. And I am but forced to draw an analogy with the recent hit movie by showman of Bollywood “Ek Tha Tiger” and the recent spate of disappearing tigers in India. The same is the state of reforms which are disappearing and are being replaced by these “suggestions” by the government.

Fables of E-Commerce

After the Facebook fallout and a nearly disastrous IPO (the trading price as and when I write this is about $33.10), I am but not amazed at the E-Commerce revolution in India. From services like 24 hours alcohol and beverages supply to Shoes and fashion clothing at “unbelievable” discounts is something which I can’t digest. This unprecedented growth followed by mindless stake buys by the biggest names in the PE industry is giving shape to a new story. Though I agree that the big brother push (PE’s, Bankers and policies) is required to germinate a solid foundation for any industry, however, the economics are astounding and make me wonder how the firms are surviving.

My approach is based on following platform of ideas:

1)     The customer acquisition (fabrication)

2)     Big Discounts – myth or a short-lived opportunity

3)      Huge money being pumped (again the FB story wherein an asset is being tossed after a good story at a fat price on someone else’s balance sheet)

I will focus on the Fashion/ Clothing/ Households products etc. in this blog. Though I know the potential for services is huge, however, the big push is in the E-tailing industry and this blog essentially focuses on perils of the same.

Lets start by focusing on why will I buy a particular brand?

a.      It gels with my persona

b.     It augments my persona

c.     It is value for money (again to augment my persona)

d.     I trust the brand

The value offered by a brand is exactly the price is comes for, this I learnt from a renowned professor during my one off interaction at a seminar. And I kind of stick to this story, i.e. the price I pay at the start of a season is always high due to the exclusivity offered. As the season progresses, the value of the product or a style always diminishes and finally goes on a discount, unless it becomes like a Tote from Gucci or the signature LV bag. The economics works like this, a brand always tries to unlock its investment and at least 50% of the target return in the first few weeks of a season of say 4 months. Post this; whatever the stock left is either bundled with the new marketing campaign or sold off slowly at a discount starting from 10% or more, again depending upon the brand strength. Eventually when the product or SKU reaches the clearance stage, it is the eccentric sizes/ colors/defected pieces which are left on the shelf.  However, a brand which sells at a discount from Day 1 or tries to sell eventually becomes a discounted brand, it not only loses its sheen for the false volumes it generates, but also dies out with time. For e.g. Cantabil, Reebok and numerous others opened up factory outlets and were on sale 12 months a year in the recent past. A brand usually goes on sale to either clear out its inventory or unlock the value to generate cash in order to meet its expenses. We did witness that most of the brands went up on sale last year during slowdown, in order to meet their expense and debt obligation and also to give some momentum to its products off the shelf.

The E-commerce revolution in India, as they say is on the customer acquisition spree, thereby luring the customer with mindless discounts. I know websites where the high end brands are being offered at more than 50% discounts in addition to the margins the websites selling them are making, thereby further reducing the cost of procurement. The following are the circumstances which can make this happen:

1)      These brands are not original – However, these websites guarantee the authenticity of the brands and will be tangled in litigation issues if they are doing so and sooner or later someone will notice.

2)      There are export product lots which do not meet company’s specifications and are auctioned or sold off to clear the inventory (If this is the case then the products mentioned on the websites should clearly mention Export surplus)

3)      The discounts are coming out of the company’s budgets to promote their website and acquire more and more customers. However, the basic premise of any such e-commerce portal is the range and the ease of purchase. These services can easily be replicated and the basic premise is built on a discount price platform. Therefore, once the website stops offering discounts, the customers will move elsewhere.

4)      The brands are selling off the products to clear out their inventory. In this situation the brand in question is either a sub standard discounted brand or has a nincompoop manager who though generating volumes is moving towards the black hole of discounted brand. This will not be sustainable in the long run, as the lower rung brand which offers less exclusivity and will be low on margins will cease to exist or the high margin brands with continuous discounts will lose its sheen. In either case, the traffic of customers will lose owing to less exclusive brands being offered and bread and butter will be less exclusive low margin products being offered on discounts, which is neither profitable and will commoditize its business soon . Eitherways, again there will be another change of hands for equity to continue the mindless bargains or there will be corners cut in terms of products being offered, thereby yet again making the model unsustainable.

There is a free hand given by the stakeholders and management to acquire as many customers and add to the bottom-line, while adjusting the profits. These stakes will eventually be offloaded to some other PE, Bank or listed, thereby de-risking own portfolio and offloading on someone else’s books. People argue with the case of Amazon, however, Amazon offered discount on books by bridging the gap between the publishers and readers, thereby biting away the margins in between.  There were no exclusive publisher stores and its different story with brands. Though Amazon expanded to other categories as well, however, the core offering is reflected on margins made on books.

Fashion and clothing is a different ball game altogether. There is plethora of businesses and websites, which have closed their shops or lowered their offerings substantially, like The Private sales, Fetise, etc. Once the cash runs out or the money from stake sale or equity of owners dries up, a company should and will have to focus on bottom-line or atleast EBITDA. Else, the money thrown in will go in a bottom-less pit, with cash being pumped in through reselling of stake until someone realizes it is a loss making proposition. The same happened with Facebook and Real estate bubbles, wherein an underlying asset is being tossed from one balance sheet to other, not because of value addition but just because the interest rates are low and there is excess money being pumped in the economy.  With the slowdown in the Indian economy, growing penetration of Internet and online banking, over leveraged balance sheets of conventional companies and huge cash piles of unutilized cash has prompted a flurry in this sector (e-commerce). Everyone wants a piece of the pie and after the news of Instagram being sold off at $1bn, thinking theirs might be the next big revolution.

However, the financial model is not so easy as it seems to be. The Cash on deliver model (or COD as they call it), which is another convenience factor, is indeed a twin edged sword.

1)      It not only leads to a lag in collection and cost in terms of keeping a tab on collection, but also adds to the pressure of cost of inventory. This is due to the reason that, as opposed to the start of e-commerce business wherein the products were delivered only when a certain number of sales were achieved by the seller, the websites are purchasing the inventory and storing it in the warehouse, thereby further increasing the costs and reducing the margins.

2)      For e.g. A product worth INR 5000 is sold on a COD model and the margin on the product is 15% i.e. INR 750(to make it simplified, let us assume there is no cost of logistics). The collection agency will take a minimum of 15 – 30 days to transfer the money from the date of sale. If everything goes normal and the product is satisfactory, the margin is reduced by INR 42.5, 46, 50 and 53; given interest rates are 12%, 13%, 14% or 15% respectively.

3)      Add to the above the cost of rent of warehouse, labour, electricity, water, etc. and the margins are pressurized further.  

4)      The cost of discounts as added, not by the bargaining power, but though marketing budgets may also be another deterring factor to the fundamental business sense.
T
T   Things were different when the sites were procuring their merchandize based on number of orders from their clients, however, with setting up of infrastructure to expand, more and more costs are being added, while competition is further squeezing the margins.  

A sustained business model cannot be built on discounts offered. Websites have to steer clear of being as only discount driven sites to offering exclusive products. There is no ‘Points of differentiation’ being offered by these neo-sites apart from convenience, which also have inherent flaws in terms of wrong products being shipped (these are initial hiccups though and can be overcome in the long terms with better backend integration). However, still I would wait and see how sustainable and scalable the model is after a couple of years to eventually believe in the e-commerce story. Till then, enjoy the mindless discounts at the expense of others while I do the same. 

Darling of Investors OR Greed of few

Whether it is successful or not is yet to be seen, however, the $16bn. IPO of Facebook ($18.4bn, if the underwriters exercise their IPO option at the listing price) will set example of many more similar entrepreneurial ventures monetizing their creations. Whether sales of $3.8bn, last year justifies this price or not is yet to be formalized. The model around which the story is doing rounds is the Advertising sales (well wasn’t this the model that Mr. Zuckerberg loathed while creating this asset.)

Whether this is just the lack of companies to invest in and monetize by the hungry investment bankers and the PE industry or whether ‘someone’ saw ‘some’ intrinsic business value based on an excellent business model is yet to be seen.

The total money supply of USD is set to cross $9 trn., and the US economy has slowed down considerably since 2008, with its GDP growth and job market just barely justifying the money or fiscal stimulus being pumped in or was pumped in. There is no manufacturing or infrastructure growth which will justify the amount of money being pumped in. The consumption pattern has shown a declining rate, the government is hell bent on keeping the interest rates at its lowest till atleast 2014 so as to kickstart the biggest consumer economy in the world. This, they hope will kickstart the investment climate and grease the wheels of the economy so that it starts moving again. However, job growth data is not sending any positive signals and the business climate remains uncertain owing to Euro crisis. Grexit (Greece Exit) is all but inevitable. Austerity measures are not helping either the economy of the politics of any country. Spain is soon slipping down (the fresh issue of bonds last Thursday is proof enough of falling investor confidence).

The point of the above ‘Gyaan’ is just to highlight the fact that given the circumstances, the investor climate and the business climate is not conducive for any business to flourish, leave alone expand. And to be honest every banker (this particular profession is off late getting enough bad publicity like the lawyers always dread) needs a company which is a darling of investors, so that they can churn out as much fees as possible. ‘Facebook is just the right answer’. In one of the books by Michael Lewis, I read that during the famous crisis post the ‘Honeymoon’ era of growth i.e. early 2000’s till 2007, Iceland, which was essentially a fisherman’s economy and had no experience whatsoever in Investment banking soon started acquiring Banks and Football clubs. This was fuelled by the cheap money supplied due to their credit rating enhanced by the European union, which led to excessive real estate boom. As neither had they had access to such kind of money, nor they had the experience of handling such money, they started transferring the same assets at inflated price on each other’s balance sheet. So imagine an asset (say land) having underlying value to INR 100, being sold for INR 120, then the same being floated around with a story and little value addition at INR 140, and so on. The value of the asset is increasing due to the increase in money supply in the economy and not because its creating any value.

Now compare this scenario to the IPO in question, there is no set emphatic and innovative structure of revenue which the company has to offer apart from advertising (which essentially was uncool for facebook to start with). Once, just to please their investors, the company throws the towel for advertisement, it might cheese off its users. However, that is still a big question mark. Also, other similar IPO’s in the past like Groupon are reeling under pressure and are trading lower than their IPO level prices (Is this a cautionary note). However, Facebook is clearly a different value proposition and first of its kind to hit the bourses, so it remains to be seen what will be its plight (pun intended)

So, is it creative PR and false stories and bankers and PE managers who don’t want to miss the bus who artificially inflated its price tag? There is immense pressure on the financial industry to perform, as most the fund managers have barely made any returns on their portflio’s since the last crisis. So was this a herd following (carefully crafted) to ‘create’ an asset with no underlying revenue model. A 107 times is trailing 12-month earnings and about 26 times its revenue in 12 –month as on March 31. This is no joke, no one gets that kind of valuation. Apple inc. with a super-cool product line which is a hit amongst the hoi - polloi and oozes the oomph factor amongst consumers and investors alike has a valuation at about 4.5 times its revenues and a PE ratio of about 12.93. It might not be an accurate comparison; however, we are speaking of valuation unheard of (or maybe heard off during the dotcom bust). But are we trying to ignore the signals of 2000 – 2001. Fine, it has a user base of 900mn users, but ‘how’ do they monetize it. 

I want to compare Facebook to Central park (which is also a social networking platform), where approximate users every year are about 38mn. This is immense, but how do you monetize Central park visitors. Yes, the park is maintained through probably government funds, donations and park fees, etc. however, once you start advertising all over the park and charge customers, imagine you’re spoiling the beauty of it.

Probably Facebook should be nationalized and be maintained out of government funds pooled in by various governments depending on their country user base, as definitely its become a massive force which is beneficial in more ways I can think of. In the past mass movements like aggregation or start of revolution in Libya and other North African and Middle east countries started though Facebook, following which governments of various countries have stopped Facebook access, due to the danger it poses on creating a domino effect. However, in all the above cases the reason has been more socialist than capitalist. The opening day did not offer any respite, the opening day could not break the $40 mark, when the IPO price was $38. Fine the signals were wrong, Spain is under pressure, there are talks of Grexit. However, if the investors saw such a strong underlying intrinsic value in FB (as they famously address it) why did not it show on its opening day price levels? It seems like everyone has their eyes shut to the fact that because no one knows what lies in the FB story, so it must be good, as everyone’s buying it.

However, one fact that cannot be ignored is that this kind of money will open up doors to innovation in the social media and ecommerce space. We will see more innovative offerings in future, however, if this company fails to charm its investors, the reverse domino effect might start and before anyone knows the stock will be dumped and moved on upon. That will again lead to a logjam and another set of bust which swarmed the world markets in 2000 – 2001. There should be caution and only the slightest hints and consumers and investors will flee to the next best alternative.