Shares of Walmart (NYSE:WMT) fell 3% on May 9, after the retailer announced that it would acquire a 77% stake in Indian e-commerce company Flipkart for $16 billion. The remaining stake would be held by other investors -- including co-founder Binny Bansal, investment firm Tiger Global, Tencent, and Microsoft.
Japanese tech giant SoftBank (NASDAQOTH:SFTBY) was also a major Flipkart investor, but it sold that stake -- which it originally acquired for $2.5 billion -- to Walmart for $4 billion. SoftBank CEO Masayoshi Son accidentally pre-announced the deal before Walmart, forcing the retailer to confirm it.
On the surface, Walmart's takeover of Flipkart, the biggest e-commerce player in India, seems like the right move. India is a major e-commerce growth market, thanks to rising income levels and internet penetration rates.
Morgan Stanley expects over 50% of India's internet users to buy products online by 2026 -- up from just 14% in 2016. Walmart expects online shopping in India to rise 36% annually over the next five years. So why do investors seem to hate this acquisition? Let's examine the four most likely reasons.
1. Walmart overpaid
Flipkart's revenue rose 29% last year to $3 billion, but that marked a slowdown from its 50% growth in 2016. Its net losses widened by 68% to $1.3 billion. Therefore, Walmart's $16 billion bid, which values Flipkart at nearly $21 billion, values the unprofitable company at about seven times last year's sales.
To put that into perspective, Amazon (NASDAQ:AMZN), a profitable company that posted 31% sales growth in 2017, trades at about 4 times trailing sales. Walmart's bid also dwarfs the $5 billion Amazon committed to its Indian expansion two years ago.
Amazon was also reportedly interested in buying Flipkart, but it likely backed off for two reasons -- it realized Walmart's bid was too high, and the combination of Flipkart and Amazon could have attracted regulatory scrutiny.
2. Walmart inherits Flipkart's war with Amazon
Flipkart's share of the Indian e-commerce market grew from 31.5% to 35.7% between 2016 and 2017, according to Bloomberg Intelligence and Euromonitor Passport. But during the same period, Amazon's share grew from 24.5% to 27.7%.
Both internet retailers were growing at the expense of shrinking rivals like Jasper Infotech and Rocket Internet. But as more smaller players get wiped out, Walmart will need to deal with Amazon head-on -- and that could result in even steeper losses for Flipkart.
3. Get ready for a big earnings dip
Walmart expects the Flipkart deal to reduce its EPS by $0.25-$0.30 this year, if it closes during the end of the second quarter. The deal could also reduce Walmart's earnings by $0.60 next year.
This means that Walmart originally expected its earnings to rise 10% (at the midpoint) this year, while analysts expected another 8% growth next year. But after the Flipkart deal, Walmart now expects 4% earnings growth this year (at the midpoint, assuming a $0.30 reduction), followed by less than 2% growth in 2020.
Those numbers aren't disastrous, but they make the stock more expensive. The stock previously traded at 17 times the midpoint of this year's earnings, but it now trades at 18 times this year's post-Flipkart estimate.
4. Walmart had other options
Up until now, Walmart only had a minor presence in India with 20 superstores under its Best Price banner. By acquiring Flipkart, Walmart dove straight into the deep end.
That strategy was unusual for Walmart, which took a more prudent approach in China. Its main online strategy in China, where it operates over 440 stores, is to expand with online retailer JD.com and tech giant Tencent to tether shoppers to their shared ecosystem.
Instead of gobbling up Flipkart, Walmart could have partnered with smaller companies that were being marginalized by Flipkart and Amazon. Or it could have increased its investment in Flipkart -- as its other investors did -- without assuming total control.
Should investors be worried?
I understand why investors are wary of the Flipkart deal, since Walmart's rising expenditures on e-commerce growth, renovations, and wage hikes throttled its earnings growth in recent quarters. I also think pressure from Amazon forced Walmart to overpay.
Nonetheless, I believe buying Flipkart was necessary, since Walmart needs higher-growth overseas markets to offset the slower growth of its U.S. stores. Walmart's $16 billion takeover might weigh down its earnings over the next two years, but with any luck the investment will pay off over the long term -- as long as Flipkart keeps Amazon at bay.