Will Indian tech companies ever be profitable?

Perhaps the top question venture capitalists have asked Indian tech companies in the last 2 years is about their profitability potential. In view of the discount-driven growth strategy of some leading internet companies, it is certainly a question worth asking.

 

While we have heard rhetorical arguments on both sides of the issue (“we will be profitable before the year is out”, “online businesses are fundamentally a scam”) the question of long-term profitability of Indian technology companies merits a more nuanced and detailed look.

 

Here are my two cents:

 

1. Is India fundamentally a low-profit economy?

 

The consumer and services sectors of the Indian economy are highly profitable, fast growing and have provided an excellent return on capital.

"There is nothing fundamentally wrong with the Indian market that would prevent a well-run company from being profitable."

(Source: NSE data)

 

The chart above shows the performance of public companies in these sectors compared with global benchmarks. It clearly shows that the Indian consumer/business customer is not only buying more and more every year (18% annualized revenue growth) but is also paying a price that substantially exceeds the cost of providing the goods and services - resulting in roughly 20% post-tax profit for the providers. 

In that sense, there is nothing fundamentally wrong with the Indian market that would prevent a well-run company from being profitable.

In fact, it can be argued that Indian companies have potential to be more profitable than those in developed markets precisely because it is harder to build an organized business in India. There are high barriers to scale, and those companies that cross the hump generate super-normal returns because there is so little competition at that scale.

 

2. Does technology adoption reduce profitability?

 

Technology makes businesses more, not less efficient. As a new generation of tech-enabled companies replaces the above incumbents in both scale and efficiency, there is a reason to believe they will deliver better - not worse - profitability and return on capital.

 

  • Even two years ago, a TaxiForSure cab was utilized roughly twice as much as a regular taxi, and that utilization has only increased in the intervening period.
  • A merchant on an online marketplace generates additional business without investing substantially in real estate and inventory.
  • Big Basket gets rid of its fresh inventory in less than a day, on average.

 

Sure, prices may go down as software “eats” the old way of doing business, but with corresponding reductions in cost and/or capital required.

There is a fair question to be asked: who benefits most from these efficiency gains? The platform or the provider? Maybe all the gains from the 2x taxi utilization are being shared between the driver and the consumer, and all the gains from the lower inventory holding in grocery are being passed to the consumer.

We will come to these questions, but there is no denying the fact that technology has generated an additional surplus even in the “high-friction” Indian context.

 

3. So then why are internet companies unprofitable?

 

Several prominent internet companies have remained unprofitable so far for three key reasons:

 

  1. Discounting as a strategy to change customer behavior (from offline to online purchase)
  2. Investing in systems and processes that are profitable only at scale (e.g. delivery and payments infrastructure)
  3. Intense competition to secure market share in a very attractive market

Arguably we are already past the point where a) and b) above are relevant.

 

"Big Basket and Bookmyshow, never played the discount game: the value proposition (for BB) and network effects (for BMS) were strong enough to attract and retain users"

 

India’s internet economy has grown so dramatically over the last 5 years that consumers no longer need an incentive to continue to buy online.

Wherever the category has matured and clear winners emerged, discounting has given way to market pricing, and the gains have accrued to the platform and not only to the providers.

Big Basket and Bookmyshow, leaders by far in their categories, never played the discount game: the value proposition (for BB) and network effects (for BMS) were strong enough to attract and retain users.

Swiggy (and later Zomato) consistently ate away at Food Panda’s market share despite the latter’s discount-led business model.

Also, we are already at a scale where delivery and payments don’t need in-house investments and are available at a small variable cost to all - as demonstrated by companies like PayTM and Delhivery. Of course, newer companies in underpenetrated tech sectors may have to similarly spend till they reach scale, but both of these expense heads reduce significantly with growth.

 

4. Where are the high-margin startups?

 

Sectors like horizontal e-commerce have obviously gone through intense competition that has resulted in continuing massive losses, but by no means is that a pervasive phenomenon across sectors. 

 

My thesis continues to be that pockets of high profitability can be found in markets that require a combination of technology, local market understanding and execution intensity that deters hyper-competition.

 

I share some examples below:

 

Jeff Bezos recently wrote a tweet that generated massive interest:

 

 

If they were not modest, media-shy entrepreneurs, the founders of India’s largest grocery e-commerce company may have made that call. Big Basket enjoys high gross margin in a commodity category by optimizing sourcing, using data analytics to identify private-label opportunities and continually striving towards a larger basket size.

 

Livspace, the online interior design startup, takes control of the entire supply chain that pulls together Italian designers, Thai manufacturers, and Indian installers, and as a result, generates very high profitability all the while maintaining a positive cash cycle.

 

Zefo is attempting to disrupt the traditional classifieds business model in used household goods space by taking more aspects of the supply chain in-house (pickup, touch-ups, and pricing). Because they fully monetize the seller’s need for convenience and the buyer’s need for quality assurance, their margins have consistently topped their own projections.

 

This is not to say, of course, that the startups above have found it easy to generate high margins. They all operate operations-heavy businesses that are hard to execute and even harder to scale. But it is this very friction that, once overcome, widens the profit gap between them and their offline competitors. Additionally, the supply chains of their respective industries are so India-specific, that it is hard to transplant a global business model and win merely on the back of capital.

 

“VCs love to fund the fixed burn of such startups, for profitability is a matter of arithmetic progression from that point. ”

 

It is also important to state that none of these companies generates a net profit today, and that’s okay. They are all investing in building their product and organization for scale. As long as each unit they sell contributes to the bottom line, and contributes enough to turn a profit at a reasonable scale, we may yet see the glorious black in the bottom line. VCs love to fund the fixed burn of such startups, for profitability is a matter of arithmetic progression from that point.

 

5. How do I find these mythical beasts?

 

My partners and I have certain hypotheses on the kind of startups likely to turn a profit within our fund life and are actively seeking such investment opportunities. One or more of the following traits in your startup will make our profit radar light up:

 

  • Solves an India-specific problem:

“X of India” businesses have never been a good idea, because sooner or later the X comes around to compete with you, and often bleeds you by throwing money at the problem. Instead, a company trying to solve problems unique to India, have a distinct advantage. Such problems are everywhere - whether they involve building applications and services for the next 20% of the population, or in making Indian supply chains more efficient.

 

  • Leverages India’s cost advantages:

Indian enterprise services companies have always enjoyed an arbitrage in development cost. For product startups that result in the increased ability to iterate and with less capital - effectively more shots at goal. In addition, the (relatively recent) success of the remote sales model extends this cost advantage to sales and marketing as well.

 

  • Leverages 3rd party infrastructure:

We love startups that run trains on rails built by other people. This dramatically reduces the scale required for profitability and often reduces execution complexity as well. In India, such infrastructure is being created both by private entities in payment, logistics, and location, and also increasingly as a public good by the government in the form of Aadhaar, UPI, and the GST Network.

 

  • Is disproportionately valued by a niche:

The startups that race to profitability are often those that exploit gaps in the market - find a niche that highly values your product and is willing to pay a high price for it. The mass market may never pay that price, but the niche may help kickstart the virtuous cycle of network effects and economies of scale.

 

If you run such a startup, we would love to learn more about it. Till then, here’s to the next decade of profitable startups in India!

  • Sri Ram Pemmasani

    Interesting points here Ritesh. However a few notes

    1. I agree with your inference that India is at least as good a market for profitability as US. However, extending that argument to modern Indian startups needs to be taken with a pinch of salt. Along with the market, profitability is also based on the kind of model you chose and what precedence you have set with your past strategies including discounting(paradigm shifts that point to “unless there is a discount, i wont buy online”). I believe the business models of many continue to be hazy if not outright shitty and the collateral damage of past ghosts will continue to haunt them.

    2. Technology surely creates efficiency but that should be evident from the adaption. As long as you do not charge for the cost to serve, one can never say people have taken to that technology. Say an Uber driver does 12 trips a day and a regular cab guy does 8 and the gross receipts are the same because of the pricing difference, then do we still say that it led to better utilization. Was it the technology or subsidy that led to it

    3. While I do get, some investments make sense only at scale, a big factor people forget in India is the shadow economy. BB has to contend with local Kirana that pays no tax(IT or ST), has no regard for labour norms, runs it out of his house(so no rent), very low overheads(no IIT/IIM/HBS) folks, deals in cash(no MDR) etc and has a local connect. I am not saying BB cannot beat them, but these factors have to be considered which are often overlooked. Also while GMs may be high for BB, it is easy to underestimate the huge investment that led to the GMs being low(warehouses/supply chain, delivery infrastructure) or the cost to get revenue(marketing, merchandizing etc)

    Data Points: BB Salary 91 cr. Rev 563 cr in 15-16(16% of rev) – Overheads
    BB Stock purchase slightly higher than rev(170 cr) – Negative GM in 14-15
    Rev grew 3X from 14-15 and losses more than 4X. While it cannot be concluded that their efficiency did not get better, but i assume the GMs might not have improved remarkably

    Would love to learn your thoughts

  • Karan Jindal

    Great article! My wife runs a international healthy food delivery brand http://www.zoe.menu operating at 20% net margin and doing healthy revenues in 95 countries. Do check it out.

  • Resham Chhabra

    While the question “Will Indian tech companies ever be profitable?” is rhetorical and has many aspects and variables, this particular piece is quite impressive backed with enough numbers and stats. Good read.

  • Karthik Rajeshwaran

    Hi Ritesh,

    If you view it thru the lens of whether an Indian consumer has the propensity to pay then you probably end up with a diff answer. The switching costs are low unless there is a significant differential over the offline choices available.

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