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Investing, Stocks, Trading  | January 28, 2019

Amazon (AMZN) suffered a major setback in one of the most important regions for the company outside the US. Amazon has been spending massive amounts in India to gain better market share against its rival Flipkart. Besides the online platform, it has invested heavily in local content and digital wallet. Walmart (WMT) gained a majority stake in Flipkart in August 2018 with an investment of $16 billion.

Both Amazon and Flipkart have invested huge amounts to offer attractive deals to customers during the festive season. However, both these online platforms have now been asked to stop selling goods from entities in which they have an equity stake. This reduces the growth potential of Amazon and also puts a question mark on the investments made by the company.

The US administration has also voiced concerns over these regulations as it can lead to huge losses for both Amazon and Walmart.

Massive Investment Spree

Amazon has made a big bet on India with huge investments in online retail, digital wallet, local content, food delivery business, investment in local retailers and more. The company entered this region in 2013 and since then has committed close to $7 billion in investment. A successful online platform in this market would have given Amazon the springboard to make similar growth in South Asia and Southeast Asia.

However, new regulations in this segment will prevent the company from selling goods that are owned by entities in which it has an investment. One of the biggest sellers on Amazon India’s platform is Cloudtail. Amazon has a big stake in this seller which allows the company to ensure the quality of goods and provide adequate discounts during festive seasons.

The main reason behind the aggressive discounts and investments is the growth potential of retailing in this region.

Fig: Price chart of DMart. Source: Yahoo finance

DMart is one of the biggest brick-and-mortar retailers in India with an annual revenue of close to $3 billion. Due to high growth potential, the stock is trading at one of the highest P/E multiples of any brick-and-mortar retailer. The current ttm P/E ratio stands at 109 and market cap of the company is close to $12 billion.

The new regulations will also prevent brands from getting into partnership with Amazon to provide exclusive discounts on the platform. This will substantially reduce the sales of smartphone devices from companies like Xiaomi, Oppo and Huawei which have tried to use a direct online route for their devices to keep the sales costs low.

Besides retail, Amazon has invested $145 million in digital wallet service within this region in 2018 alone. The company was also planning on investing a whopping $500 million in the grocery delivery business. This investment has been delayed due to these regulations. Amazon was also looking to invest INR 25 billion or $350 million to buy a 9.5% stake in Future Retail, a leading local brick-and-mortar retail store chain with over 1,000 stores.

Amazon has been offering Prime membership at INR 999 per year or $15 per year. All the benefits of Prime membership are front-loaded which means customers get similar advantages compared to Prime in other countries. By investing heavily in local content and discounting Prime, the company is looking to gain high loyalty for its subscription business and also build a strong ecosystem of retail, streaming and services.

Wait and Watch

One of the reasons for the new restrictive regulations is the competitive pressure felt by smaller retailers. It should also be noted that there will be national elections in May 2019. Hence, these regulations can see a rollback or modification as a new government gets in office. But the sudden change in regulatory framework also points to the lingering risk for Amazon in international regions.

Amazon has also made an effort in building a vertically integrated platform. This increases the risk for the entire business if a particular segment shows any headwinds. A smaller availability of retail goods on the platform will reduce the attraction of Prime membership and Amazon Pay.

These regulations hurt consumers because of lower competition. If these regulations are maintained it will also reduce any investment in this industry from international companies. Hence we could see more flexible regulations in the future.

Alibaba's Approach

On the other hand, Alibaba (BABA) has shown a more agile approach in this market. Alibaba has invested in a number of local startups which have now reached a significant scale in their respective businesses.

Alibaba has a huge stake in Paytm, a leading digital wallet company in India. Paytm reported an investment of $400 million by Buffett in September 2018 at a massive valuation of $10 billion. Alibaba has made a continuous investment in Paytm over the last few years. This has increased the stake of Alibaba while keeping the overall investment low.

Alibaba has invested in companies like Big Basket which is an online grocery delivery service which is looking to raise funds at $2 billion valuation. Because of the new regulations Amazon would not be able to start a grocery delivery service to compete with Big Basket. We can see that Alibaba’s investment in different startups has prevented a domino effect.

It is too early to say what the final result of this regulation would be. If there are no changes there would be much lower FDI in this region. This is contrary to what most of the government officials have been trying to achieve.

We could see a middle path as the new government takes office after the election. However, there is a high probability that the future outlook of Amazon in this region will not be as bright.

The regulatory risk in international regions is a major headwind for Amazon as it tries to improve its business outside the US. While looking at the growth potential of Amazon in international markets, investors should also note the regulatory setbacks which the company can face in the near future.

Investor Takeaway

Amazon is facing a regulatory backlash in India due to heavy discounts on its retail platform. The company has already invested $7 billion and was in the process of announcing major investments in content, food delivery, and buying a stake in local retail players. This will be delayed at least till the next national elections which will take place in May 2019.

Amazon’s vertically integrated business provides a significant advantage in adding new high growth segments to the company. But it also has higher risk. If one segment faces headwinds, it can lead to lower growth in all other business areas. Investors should carefully access the regulatory risks in international markets while estimating the future growth potential for Amazon.

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