By Upasna Kakroo

In the last decade, India has made a name for itself as a tech player. But that reputation, however well-deserved, belies important limitations – and these are having a big effect on the development of online commerce.

For a start, Internet penetration is still very low, with only 8.4% of the population online. Then there is India’s great size, unpredictable logistics and creaky transport. Bricks-and-mortar retailers, many of whom have cultivated rich and long-lasting relationships with their customers, offer tough competition. And finally, 90% of all retail transactions are conducted in cash; online works best with plastic or electronic money. No wonder, then, that e-commerce accounts for less 1% of total retail sales (compared to more than 4% in Brazil).

And yet…. the opportunity is just too alluring to ignore. Eighty percent of current Internet users say they are planning to shop online in the near future, for reasons as varied as convenience and privacy (for items like lingerie). Moreover, India’s online retailers are making progress. The e-commerce market has grown an average of 34% a year since 2005 and will continue

to grow briskly for the foreseeable future, reaching $2 billion in sales by 2015. By then, it is estimated that India will have 38 million active online shoppers.

In a country of 1.3 billion people, that is still a drop in the bucket. But by any standard, 38 million is an appetizingly big drop. Money is talking, too: In 2011, investors poured $305 million into Indian e-commerce.

E-commerce on the moveSo far, online companies have built the business by playing to the natural strengths of the channel: focusing on younger and more affluent consumers; offering aggressive pricing; and emphasizing speed and convenience.

One category, travel, stands head and shoulders above the rest. Nearly a third of India’s travel is now booked online, accounting for $7 billion of the $23 billion

E-commerce in India: Early birds, expensive worms

Consumer and Shopper InsightsJuly 2012

USD millions

SOURCE: Euromonitor, McKinsey

Exhibit 1:E-commerce sales, by year and rate of growth

Internet retail in India

SOURCE: Euromonitor; McKinsey

2,054

1,355

930

543

302108

2005

+34% p.a.

201513110907

Low Internet penetration and high infrastructure barriers are hobbling — but not crippling — online shopping.

market. Two local players dominate -- MakemyTrip (48% market share) and Yatra (30%). In one subcategory, train reservations, 40% of bookings are made online, thanks to the popularity of Indian Railways’ IRCTC site. The online travel market is ideally suited to Indian conditions, because tickets can be downloaded, and thus the sector does not have to deal with the transport and logistical problems that loom so large for other products.

Outside travel, the most popular categories are similar to those seen elsewhere, such as mobile phones, books, computer hardware and consumer electronics. Apparel has, however, been slow to take off. Indian consumers like to feel and try on before they buy, and bespoke tailoring is common.

As befits a young and fast-growing sector, the e-commerce market is fragmented, with a large number of players competing in a multitude of formats. There are e-tailers like Flipkart, Infibeam and Letsbuy; online channels of established retail chains like Next and Shoppers Stop; niche players like Perfume2order and Caratlane; and deal aggregators like Snapdeal and Crazeal. In addition, a number of big players in the appliance and electrical goods sectors have built dedicated online storefronts. These are increasingly supported by social networking features, from Facebook pages to user forums and loyalty schemes. Finally, there is third-party e-commerce. Indiatimes Shopping, for example, runs customer support for a global phone company; the phones are delivered straight from the manufacturer. Single-brand outlets, however, may struggle for position, because bargain-hunting Indian consumers (and that means just about everyone) prefer multi-brand channels that allow them to compare prices and product features.

At the moment, Indian consumers are getting the better bargain in e-commerce. Consider online bookselling. An analysis in Forbes magazine found that in an effort to build market share and loyalty, many online retailers are selling at close to break-even or even at a slight loss – essentially transferring what would have been their profit margins to consumers. This is obviously not a lasting business model.

Price wars between online players have been harsh, and some early entrants have already been forced out. “Everybody is in a cut-throat price,” Rutvik Doshi told the Economic Times. “If other players are selling a product at 85 rupees when the cost itself is 100 rupees, it is clearly not sustainable.” He should know: Doshi was CEO of Taggle, an online group-buying site that shut its virtual doors late last year.

Consolidation across the sector is inevitable, particularly as operational excellence becomes more important. Ravi Adusumalli, managing partner at Saif Partners, a Delhi-based private-equity firm, predicts, “One or two companies will survive in each segment; others will either fail or get acquired.”

Pay now, deliver later?Much of the investment flowing into the sector is going into logistics, as retailers work to improve service and to extend their reach beyond the Tier 1 cities (ie, Bombay, Delhi, Madras, Calcutta, Hyderabad, and Bangalore). Flipkart, for example, India’s largest online bookseller, plans to build 18 additional warehouses (it now has seven) and 25 more delivery centers (up from 35). A number of e-tailers are also setting up their own logistics operations. It will be particularly interesting to see how Amazon does, and how its entrance shapes the market. The American e-commerce giant recently entered the Indian e-commerce space with junglee.com, a platform from which consumers can buy a range of products, from diapers to beard trimmers, from thousands of outlets, both on- and offline. The seller, not Amazon, handles the money.

Which brings us to the other big challenge: payment. Eight out of ten online purchases made in India today are cash-on-delivery. This is a very expensive for e-tailers and the lack of a requirement to pay up-front encourages awkward consumer habits. K Vaitheeswaran, who

SOURCE: Nielsen, McKinsey

Millions of users

Exhibit 2:Debit card and credit card users

0

50

100

150

200

250

06-072005-06

Debit cards

Credit cards

2010-1109-1008-0907-08

in 1999 founded Indiaplaza.com, a multi-category online store, estimates that 45% of products ordered online are rejected at the point of delivery. That is clearly not sustainable, either.

The problem is that Indian consumers are chary of plastic and electronic cash. Fewer than 1% of Indians use credit cards, and that percentage has not been growing much. The hopeful news is that debit cards are close to becoming mainstream, with more than 200 million in circulation (see Exhibit 2). The low cost

and high convenience of online retail may help to expand card ownership further; consumers have a reason to experiment with non-cash shopping. But there is a lot of confidence-building to be done: A large percentage (40% and up) of Indians say they are worried about cyber-security.

E-commerce encapsulates many of the economic dynamics of 21st-century India. The potential is huge and the wit and energy of the entrepreneurs in the sector is impressive. But the promise is being

suppressed by distinctly 20th-century problems, such as bad roads.

Online commerce in India is destined to grow, both in revenues and geographic reach. Certainly, there is money to be made. But the shakeout is going to be brutal, too. This is no market for widows and orphans.

http://csi.mckinsey.com

Upasna Kakroo is a senior research analyst in McKinsey’s Gurgaon office.