Investing in India's B2B Potential

Anurag:

Hello, everyone, and welcome to Matrix Moments. I'm Anurag and I'm part of the B2B investments team. Today we will be discussing about the opportunity for B2B in 2023 and beyond, that just still continues to excite us as exciting as it was a couple of years back. What are some of the key fundamentals that a good B2B business need to have to kind of make it big. What are some of the pitfalls that founders should be aware of especially in that 10 to infinity journey and finally to wrap up we’ll wrap it up with certain thoughts on which sectors, which trends in B2B are things that we’re most excited about. Today with me I have Sudipto who leads our B2B and deep tech investments. He has very closely followed this space for the last 7 plus years and have invested in companies like Vegrow, Captain Fresh, FarMart, Bijnis among others. Welcome, Sudipto.

Sudipto:

Thanks, Anurag. First of all welcome to the B2B team at Matrix. As you know we’re big believers of B2B in India and when we say B2B it’s across coal manufacturing, agriculture, exports, logistics supply chain and distribution businesses, anything that’s real GDP and sort of enables the core sectors in India to either produce more efficiently for India or for the world that's B2B for us. And we’re big believers of this sector right from 2015-16 and have been fortunate to invest in more than ten companies including companies like OfBusiness which is the largest company in B2B in the country and multiple other category leaders which we just mentioned about. So, yes, super bullish and great to be doing the B2B marketplaces podcast again after 18 months.

Anurag:

So clearly we’re big believers in the B2B space and we’ve actually put our money where our mouth is so our intentions can't be doubted out here. In fact I remember you and Nitisha doing a bunch of series of podcasts last year wherein on why that was the correct time to build B2B. So there were multiple tailwinds that were present at that time so the whole internet penetration due to Jio revolution, GST, de-mo, UPI leading to MSME digitization and formalization in that economy. The whole China plus one global shift which happened, the push from government for manufacturing sector, PLIs etc which actually give a lot of impetus to the Indian manufacturing sector. However things are substantially changed from that time around and they’ve taken a turn for the worse so to speak. There are weakening macroeconomic global conditions, there are mass lay-offs across industries, across geographies that we see, there are corporate governance issues which have started coming up now. So with all of these headwinds how do you actually look the B2B here, are you still as bullish, has something changed in our world in our point of view how do you things done today?

Sudipto:

First of all great question and I ask this question a lot on has our stance in B2B changed. Actually we’re more bullish today on B2B than we were 18 months back. All the things that you said are actually true and I’ll address most of the questions that you raised but on an overall macro point we’re still continuing to be very bullish on B2B. So now let’s take your question and break it into three parts. First is on the macro and 18 months back we spoke about a bunch of macro tailwinds, digitization, formalization, China plus one, Make in India government push, all of them are still true. Actually in certain cases some of these tailwinds have accelerated, if we look at the last 18 months there is more digital penetration today than it was in 2021. There is more formalization, more digital payments, better logistics infrastructure today, ONDC coming up which was not there in 2021. If I talk about government push in incentives in the last 12 months there has been significant push on PLIs and DLIs for core manufacturing sectors and multiple companies across EVs, auto, electronics manufacturing, ODMs, semi-conductor fabless design companies, they’ve all gotten significant government push, funding and incentives. And the China plus one story as we all know actually has continued to grow deeper and deeper where everyone in the West across sectors are looking for supply chain partners outside of China and India is definitely emerging as a geography from where they want to import goods from. So if I look at macro actually over the last 18 months the macro for Indian companies for B2B has improved, so that’s one. Second if I look at our portfolio companies over the last 18 months there is an economic slowdown in terms of funding, valuation etc but if I look at real numbers under the hood companies have continued to execute and grow faster and they have navigated themselves towards profitability. So if I look at companies like OfBusiness they do tens of millions of dollars of PAT every month. There are companies like ZippMat, FarMart, which are EBITDA profitable. There are companies like VeGrow and Captain Fresh which have not only grown but significantly expanded their take rakes and contribution margins where today their take rakes are above 20 percent, contribution margins are closer to double digits. So overall both in terms of growth and profitability at least what we see from our portfolio companies they’ve executed really well. Then third you spoke about obviously a funding winter, corporate governance and a lot of noise in the ecosystem. I think those statements are true, I think over the past 18-20 months there were a lot of companies that got funded which did not add a lot of value or there were corporate governance issues which as we go through a bear cycle sort of there’ll be natural course of action taken, some companies will survive, some companies will pivot to profitability. But overall as a ecosystem I think we’re in a much better place and if I look ten years out I think the overall trend line and thesis that significant value will be created in core GDP sectors in India that continues to be true. And I know I’ve told you this before we’re a country of the Tatas, the Ambanis, the Adanis which are all in some shape and form core B2B companies either actually doing manufacturing or solving for distribution or some shape and form so continue to be super bullish.

Anurag:

That's good to hear and actually it plays out in the numbers that we see in the macro economy as well. Despite all the headwinds and everything we still see a 5.1 percent growth year on year in the India’s industry index of production which is a direct indicator of how growth and factory output is happening. So I think that's a very clear indicator. And in fact this is something which we’ve also seen across multiple downturn cycles as we grow that macros actually put pressure on key operating metrics and it’s only the companies which have strong fundamentals who survive through them and they not just survive they actually expand to take up the place which has been vacated by companies which probably didn’t have those strong fundamentals which were out there. But that begs the question in this current environment and with B2B as a very specific example what are those current fundamentals, what are those key characteristics that would enable a B2B company to actually become big, to have that big opportunity in such a scenario going forward.

Sudipto:

See, the fundamentals have not changed, whatever the fundamentals were 18 months back it’s still the same. So if you remember in the last set of podcasts that we did in B2B marketplaces we identified 3-4 different things. One, if you're building in B2B please build vertical B2B marketplaces because every supply chain in B2B is different. So that's one and it still continues to be true. Second, we spoke about the supply fragmentation so if supply is fragmented and unbranded then marketplace is all the value because the buyer does not know if they can trust the supplier and they start trusting the marketplace, the marketplace creates value. So if you're building a B2B marketplace company please build in areas where the supply is fragmented. However in areas where the supply is consolidated, branded and there is sort of IP in the production process there you should build a core manufacturing or a core agritech company instead of building a distribution company. So figure out where the value is in the supply chain, fragmented supply value is with the marketplace, IP driven consolidated supply value is in the production. And focus on the right place to build for a particular supply chain. Third, B2B is as much a balance sheet company as a P&L company so ensuring that, a, you're raising having a strong balance sheet raising debt your cost of capital is cheaper and ensuring that you have a tight monitoring sort of processes the ensure that collections, receivables, working capital, these are under control is extremely critical. I would say those were key to building a B2B company 18 months back, they still continue to be the key to building a good B2B company. Take a vertical, figure out across the supply chain where do you want to play, in production or in distribution. Then have a very strong balance sheet with low cost of capital and extremely strong collection and receivable processes. If you do that it’s a strong solid B2B company.

Now let me take a step back and instead of just talking about features and characteristics like let’s talk about what’s a great business. In the end a great business is a business that has MOT, a defensibility, generates very high ROCE which is return on capital employed and throws out a lot of cash. So even like all these characteristics are so that you can build a business with an n state where you have a strong MOT, you have high quality ROCE and you start throwing a lot of cash and that's the goal that founders should think about that when they’re building in the n state will these three things be true or not.

Anurag:

Got it. That's actually a very interesting point because the general perception in the industry is that B2B doesn’t have either of these three, they don’t – there is no real MOT in the B2B industry, margins are wafer thin, working capital is something which is probably best left undiscussed and unsaid out there and that's the general perception. So maybe it’s worthwhile going deep into each one of these to understand some of these better, maybe let’s start with MOT. What according to you are key MOTs in the B2B industry that founders can actually look to build upon on and carry on from there.

Sudipto:

Sure. I think typically when you look at B2B supply chains if you're doing say commoditized manufacturing you're producing kurtis that thousand other factories are doing you actually don’t have MOT. Or you're doing a trading business where you're taking a commodity from ten sellers and selling it to 15 buyers you don’t have a MOT because you can have another kurti factory the next day and you will be irrelevant and you can have another trading partner that which flourishes the next day and you start becoming irrelevant that is why you don’t have MOTs which actually shows in ROCE and cash flows which we’ll talk about later. And that's what most people talk about. But fundamentally if I take a step back and think about MOTs and defensibilities across the B2B supply chain there are lot of areas where you can create true MOTs. Let me give you a few examples, right, maybe the first thing that comes to my mind is if you're building a marketplace with a lot of fragmented supply and lot of fragmented demand your ability to sort of map and match and take the right product from supply to demand is itself a MOT. So that is matchmaking MOT and in any company in any marketplace whether lot of SKUs, fragmented supply, fragmented demand the underlying marketplace actually figures out which product to show to which buyer and then sell it to that buyer, so that's one MOT. Second in perishable supply chains with a lot of wastage and dump ability to manage a supply chain where you procure at scale then you grade different products, then you figure out the right buyer for a particular grade of product and then transport it efficiently with logistics is the MOT where you can reduce in an industry where wastage is 20-25 percent you can bring it below 5 percent and you create economic value. Third, in say commodities, steel, agri etc the MOT is actually an ability to underwrite your customer and expand outside of your core geography. It’s very easy to do trading in your own geography where you know the end customer which is where you underwrite because of relationship. But to build a pan India network where you can underwrite hundreds and thousands of SMEs and have a low cost of capital because of a strong balance sheet is the MOT. Fourth MOT is if you're taking Indian products to the world you go to the West, you go to US, you go to Europe, they want to do China plus one but they don’t have a trusted brand out of India. You build a brand, trusted brand out of India by consistently delivering good quality products on time again and again and again and 3-4 years down the line that consistency becomes brand and the brand is a MOT. And probably, fifth, the final one, is just in core IP and manufacturing or agriculture. You create a process of producing good quality products either on the farm or on the factory that's proprietary to you and you create because of that you're able to create an end product which is significantly different from the rest of the market and you have that capability that's a MOT. And these are 4-5 on the top of my head so there are multiple different MOTs but you have to take a step back and while building the company think harder on am I building capabilities in the company today that differentiates me from the rest of the competition and no amount of capital or a new company can displace those capabilities built. And you know, we spoke a lot about the macro tailwinds factors, the reason all of that is important is because those MOTs are possible to be built today because of those tailwinds. Because of digitization and so many SMEs adopting tech you can create a marketplace with lot of supply, lot of demand and create liquidity. Because of China plus one you can go to the West and create a brand for India. Because of digital penetration you can do credit, because of the PLI schemes that significant push from the government on core sectors in India you can do innovation in manufacturing. So a lot of the macro that we talk about is enabling founders to build businesses through strong MOTs in defensibility which is very different from a commoditized manufacturing or a B2B trading platform which does not have MOTs.

Anurag:

So it’s clear that there are MOTs it’s just not there is a one size fits all kind of a thing. You need to take a step back, you need to identify the kind of business that you are in and then find the appropriate MOT and then build capabilities for it. Got it, so that's clear. Let’s probably move to the second one that you called out which was ROCE so if you can explain for our viewers what is ROCE, why is it important and more importantly how do MOTs play into those.

Sudipto:

I think ROCE when you look at a business especially in B2B the single most important metric to see is ROCE or return on capital employed and I’ll give a very simple definition it which is very intuitive. So return on capital employed is what is the return or the profits you make on the capital that you’ve employed into the business, it’s as simple as that. So let’s take a 100 rupees, if you want a 4 rupee return you would probably put that money in a savings bank account. You want 5, 6, 7 you move to fixed deposit, you want 8,10 you take a little bit of risk with a few risky bonds. Anywhere between 10-15 you essentially put money in the share market. If you want more than 15 percent return on your money that's when you go and do a business otherwise why are you taking the risk of building a business. And return on capital employed is if you invest 100 rupees how much money can you get out of the business. So if you look at most companies out there and most traders or intermediaries out there they will all operate between the 15-25 percent ROCE. If it’s less than that it does not make any sense to build a business. If it’s more than that then everybody would want to be in that business and then sort of there would be competition and your ROCE will start reducing. So that's what is return on capital employed. But the question as founders or as investors when you do think is on the new business that we are creating, why can’t we have better ROCE than the market, can you generate 25, 30, 40 percent ROCE and what that does is that makes a great company. Like if you invest 100 and if you can get 40 out of it that's a great business and that will also show in the next question on sort of cash flows but that's why ROCE is important.

Anurag:

But just before moving to cash flows a natural question which comes up is at the early stage most of the companies will not be profitable then how do you even go about calculating ROCE, right are proxies that you can use, how do you then say whether it’s a good company or not at that early stage when probably returns are just not there.

Sudipto:

Which is fair, ROCE is obviously [0:17:59] [Inaudible] by capital employed but in early stages you don’t have operating profit so the proxy that we use is take CM2 which is the net contribution margin and so typically if you look at capital investment in a B2B company most of it typically is actually in working capital, sometimes you will have CapEx but in most marketplaces you won't. In manufacturing sector probably you will have some CapEx. And on trades you will start making contribution margin very soon, if you're not CM2 profitable anyways you should not be doing a B2B business. So the proxy that we take is your CM2 into number of times you rotate that capital which means if you were 2 percent CM2 and you have a 30 days of working capital which means you invest 100 rupees in working capital and every 30 days you make essentially 2 rupees which means you rotate it 12 times a year that’s 24 percent ROCE. That's a proxy and the proxy is because with scale in most B2B businesses the CM2 and the EBITDA bridge actually shrinks and in the initial stages you can take CM2 as a proxy. So if you're 2 percent CM2 business you should at least be thinking of rotating the capital 12-18 times. If you're a 5 percent CM2 business then it’s okay if you rotate it 6 times which means you have a 60 day working capital cycle and you’re 30 percent plus ROCE. If you can get to 10 percent margin you can still live with a much longer working capital cycle but the proxy to look at an early stage is CM2 and number of times you're turning the CM2.

Anurag:

So I think that is clear on how do we look at profitability, however let’s go probably one step deeper as well and I’d heard this someplace wherein it kind of called out that revenue is vanity, profit is sanity but cash is the king. And I truly believe that because the ultimate objective of any business should be to get positive operating cash flows that you can kind of get in the business. However what we’ve seen is a large number of companies may be EBITDA positive but similar to what you just called out because of the working capital cycles etc there is no real cash coming into the company. So how do we look at it, what are the views around it?

Sudipto:

So first I’ll take a more macro view to this, so the value of a business is discounted future cash flow. So businesses are valued on cash flows not on revenue, not on EBITDA. So the sole purpose of a business is to throw cash, is to generate cash. And if you look at public markets you will see that typically B2C companies have much better EBIDA multiples than B2B companies, why, because B2C companies convert their EBITDA to cash flow much better than most B2B companies do. So when somebody is valuing your company and looking at a company’s cash flows there are all sort of EBIDA and profit margins. We’re thinking of two things, one, can this margin sustain over a period of time and two of that EBITDA that is generated how much of that can be converted to cash flow. And if you can fix these two things from an investors mindset there’s nothing called B2C or B2B we’re essentially underwriting the future cash flows of the company. Now if you think about margins any business that has MOT over a period of time can defend margins which is why MOT becomes extremely important. If you're able to do something because of your MOT then no one else can then you’ll always enjoy a position to command your own sort of pricing which will translate into your ability to defend your margins which is predictability of margins or EBITDA for a period of time. Now EBITDA to cash flow, so what happens is in a lot of software companies or B2C companies they operated negative working capital which means I get paid today for the subscription of a year’s fee over the next 12 months. So I get cash first and then the revenues are actually accounted for. In B2B the revenue is accounted today but you get cash 30 days, 60 days, 90 days later because of working capital and that creates a stress where you're creating EBITDA but you're not getting the cash. And second if you have to grow the more you grow the more working capital grows. So a significant portion of the EBITDA has to grow into the working capital. That's where ROCE becomes extremely important, what is ROCE, it is the return on capital employed. So if you have 100 rupees you make 20. Now if you have to grow by 20 percent you can invest this 20 back into the business and you grow by 20 percent. If you have to grow by 10 percent you will keep a little bit of cash to yourself and cash flow will start showing. If you have to grow 40 percent but your ROCE is 20 which mean you’ll become negative cash flow. So although you're making money you have to invest more money to grow than you're generating out of your core business. So if you have a very high ROCE company even in B2B if you can make 5-6 percent of EBITDA if you can turn that say eight times a year that's a 40 percent [0:23:03] [Inaudible] so 35-40 percent ROCE business which means you can sustainably grow that business 40 percent year on year and still be sort of cash flow neutral or cash flow positive. So absolutely B2B company, any company, needs to generate cash flow in the future for it to become valuable that cash flow needs to be defendable. So if you have high MOTs then the margins become defendable and if you have very strong ROCE then you start generating cash out of it. So as a founder think hard about where are my MOTs that can create defensibility of EBITDA and margin, what new value am I adding that I can have ROCE better than everyone else and then automatically the ROCE will start translating into cash flows.

Anurag:

It’s good to know that unlike market perception if you have the correct set of MOTs you can actually make a profitable and cashflow positive business in B2B as well. But let’s just switch tracks for a bit. So we were talking about how do we build a big business, what are some of the key fundamentals that a good B2B business should have but what we’ve seen is companies actually do quite well in going from their 0-1, 1-10 journey but things start to break when they start expanding from the 10-infinity journey. So what are some of those things that we have learnt basis our experience with our portfolio companies, the market etc on things which actually break in the journeys for 10-infinity and what can founders do to kind of ensure that it doesn’t break and they’re able to scale up.

Sudipto:

So in most companies the places where we’ve seen things break are more on the balance sheet side of things and not the P&L side of things. If you're not making contribution margin profit in your 1-10 journey you will anyways not make it in the 10-infinity journey. But a lot of companies actually have a strong P&L, it breaks on the balance sheet because as I mentioned it’s a heavy working capital business and doing collections is not easy. So having the right set of processes to enable collections happening on time and keeping a tight check on the balance sheet I think that's one where we’ve seen things break a lot. Second, having the right processes and tech to manage people at scale and that's where a lot of corporate governance issues come too because you don’t have the right monitoring and incentivizing mechanism for the entire organization. So, A, building a very strong n-minus-one team with high integrity and capability and then, B, managing a very large sales force on the field team using tech and ensuring their productivity I think that's where a lot of companies break. So if I had to pick two I think one would be ensuring that the balance sheet is fine and, two, managing people at scale and having the right set of processes. I think those are the two areas where we’ve seen companies break.

Anurag:

Let’s deep dive into the last point that you made especially around corporate governance and managing teams at scale etc and this is of course a very topical point. I mean there are multiple companies where corporate governance have been put into question especially the level at which it should have been for companies of that size etc. So how do we look at corporate governance, is it important at very early stages, how do we progress in corporate governance parlance also as we move forward in the journey for companies. So how does that happen, how do we move it?

Sudipto:

Well, as Sanjeev Bikhchandani says, “Corporate governance starts with the mind of the founder”. So that we obviously can't change where founders – so if a founder wants to do fraud there will be fraud and you can't save it. But there are lot of instances where the founder is well intentioned and they want to do the right thing but still corporate governance in the company breaks. And at least the way we’ve seen we can solve it in companies is, a, for the founder to be cognizant of this fact and put right people and processes in place from day one to ensure that things are in place. Now what do I mean by that? Having somebody to head finance very early on in your journey, getting a right strong CFO reporting to the board at the right time at the beginning of your 10-infinity journey. Having tech led processes for underwriting, incentivizing people on collections not on sales and in general having an ethos and culture in a company where anything that is unscrupulous is not tolerated can be seen from day 1 in the company and I think once you get all the right people in place put the right processes in place as a board also I think as investors also it’s our job and duty to ensure that some of these best practices incorporated in the company I think the probability and chances of sort of fraud and misreporting goes down over a period of time. For example our best founders do internal audits of their company on their own, it’s not an external audit, it’s not a stat audit, it’s an internal audit which is the health check of the company. That also informs the founders if something is broken, right, so getting all of these pieces in place, hire good FC then CFO, ensure that there are right tech enabled processes to monitor the business, incentivizing people on the right metrics, having internal audit to know about any issues before they actually come up and both the founder and boards thinking about it I think will ensure that even the edge cases where corporate governance is breaking because we were not aware of it that stops happening.

Anurag:

Got it, clear. So essentially good intentions and having processes in place to get those early warning signals are the key to having good corporate governance. I think that’s great, just to wrap things up and how do we now think of B2B investments are you planning on making more B2B investments in the next six months or the year to come?

Sudipto:

If we were not planning to make more investments we would have not have had you. So as I mentioned in the beginning we continue to be bullish, I think if I look at the run rate over the last 3-4 years we have been consistently making 2-4 investments every year. In fact in the first half of this year we’ve already made 2 investments in B2B so we continue to look to invest more and more in B2B, I think the slight change is we have traditionally invested more in B2B marketplaces and distribution place which we’ll continue to do but now we’re increasingly seeing more opportunities in the production side of B2B which is core manufacturing say an ODM or EMS player for electronics manufacturing. Or in core agri tech where you essentially take a farm and significantly increase the yield or create a new form of seed that has much better yield than traditionally out there. So there are new pockets that we see, so if I look at B2B on the first wave we invested a lot in India distribution business, companies like OfBusiness and FarMart and Bijinis. Then we said we’ll invest in companies that take Indian products to the world, companies like Captain Fresh and Zimcart and Sourcewiz etc. Now we’ll continue to invest in both India and global distribution businesses but the focus will also shift a little bit into investing in core businesses which manufacture or produce goods and have an IP which sort of differentiates them from every other product. The rest of it I think warrants a different podcast but continue to be extremely bullish on B2B and look forward to making many more investments going forward.

Anurag:

Sure. And that brings us to the end of our podcast. Thanks, Sudipto, for your insights and thanks for tuning in.

Sudipto:

Thank you.

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