Monday, June 29, 2015

Caught in the Big Sale

Sure eTailing is growing by leaps and bounds. But eTailers are booking more losses than profits. Deep discounts and returns are a downward spiral they can’t pull out of  by Vishal Krishna & Abraham C. Mathews

This scene repeats every day. Every morning, trucks loaded with crates of unsold and damaged goods returned by e-commerce companies and other retailers are brought to a 2,00,000 sq. ft. warehouse of Reverse Logistics (RLC) at Tumkur Road in Karnataka. These goods are then cleaned up, refurbished and then sold on RLC’s stores and website

How much of e-commerce sales end up in warehouses? Hitendra Chaturvedi, founder and chief executive officer of GreenDust, says that it could even be upwards of 24 per cent as compared to the international norm of 12 per cent. Large eTail companies such as Flipkart, Snapdeal and Amazon are Chaturvedi’s clients. This is just a little glimpse of the back-end of India’s booming e-commerce industry. And the buzziest, within the sector, is eTailing, or the sale of goods over the Internet.

The e-commerce sector, though miniscule, is rising fast. So fast that all eyes are trained on it. According to a PricewaterhouseCoopers (PwC) 2015 report on e-commerce in India, the sector has grown by 34 per cent CAGR (compound annual growth rate) since 2009 to $16.4 billion in 2014, and is expected to touch $22 billion in 2015. eTailing, which comprises online retail and online marketplaces, is the fastest-growing e-commerce segment; it has grown at a CAGR of around 56 per cent between 2009 and 2014.

PwC pegs the size of the eTail market at $6 billion in 2015 with books, apparel, accessories and electronics constituting around 80 per cent of product distribution and sales. Compared to India’s huge retail industry, which is $550 billion according to Ernst and Young, eTailing is miniscule and will only account for 3 per cent of the trade by 2020. In comparison, the share of eTailing in China today is 8-10 per cent of its retail economy. It’s no wonder that though it is small today, eTailing in India is seen as a goldmine of opportunities.

Despite deep discounting of goods and mounting losses, investors are still keen on investing in eTailing and e-commerce businesses. And so is the valuation of such ventures. Paytm sold a 25 per cent stake to Alibaba Holdings recently for $575 million, valuing the company at $2.4 billion. Broadsheet reports say Snapdeal is in talks with China’s electronic-parts maker Foxconn and Alibaba to sell a 10 per cent stake to them jointly for $500 million, valuing the eTailer at a mind-boggling $5 billion.

But there is something wrong. The simple logic of the rat race between Flipkart, Snapdeal and international competitor Amazon is this: Offering a spectrum of goods at the cheapest prices with easiest terms of delivery and returns to keep your customer base expanding at geometrical progression, and then leveraging the ‘customer real estate’ to get in the next set of investors. This money is used to offer higher discounts. And once the consumer is ‘ensnared’ to eTailing practices, prices will be restored to ‘normal’ levels, and you have a good business going.

What if the investments stop, and with them, the discounts. Plus, there’s a legal minefield lurking with respect to the country’s foreign direct investment (FDI) norms. So is it already a bubble waiting to burst?

Bitten Too Much
The last few years have spawned a variety of entrepreneurs, who plunged into this digital revolution. Both Flipkart and Snapdeal acquired about 10 companies in 12 months, spending $500 million.

Other marketplaces that have raised large sums of money are Urban Ladder, which raised $77 million (Rs 493 crore), Shopclues (Rs 746 crore) and BigBasket (Rs 278 crore). “It is still early days for the e-commerce industry, but the business is no doubt here to stay,” says Sanjeev Aggarwal, co-founder of Helion Ventures.

Unfortunately, acquiring consumers and weaning them away from the normal retailing practices have been expensive business for eTailers because they are compensating the seller for discounts. One estimate put the losses suffered by the big three as follows: Flipkart lost Rs 2.23 for every rupee earned; similarly the loss for Amazon was Rs 1.90, and for Snapdeal, it was Rs 1.72.

What does this add up to? Data acquired by BW|Businessworld from Accounting and Corporate Regulatory Authority (ACRA), Singapore showed that Flipkart suffered a loss of Rs 10,289 crore on a turnover of Rs 29,377 crore in FY14. Losses had doubled from the year before. In FY13, Flipkart’s loss (before taxes) was Rs 5,440 crore on a turnover of Rs 11,631 crore (see Black Hole). Sources say Snapdeal had suffered losses worth Rs 5,300 crore in FY14. Meanwhile Flipkart, Amazon and Snapdeal together have spent Rs 9,774 crore on reverse logistics and discounting in the last financial year to acquire customers, as explained later.

Some believe that the online business models work because there are no rental costs. Remember what killed the organised retail boom in the previous decade? It was discounting and rental costs. Unfortunately, e-commerce has followed the same route today. Though most eTailers do not own physical stores, but Snapdeal, Amazon and Flipkart spend upwards of Rs 350 crore each every year on marketing and advertising to acquire the new real estate called the ‘consumer’. That apart, they are also paying rentals in maintaining warehouses. Last checked, each of the big three maintained at least 10 large warehouses at a huge rental cost.

The vast monies spent to acquire customers through deep discounting remind us of the halcyon days of the brick-and-mortar retail boom between 2003 and 2009. During that period, it is estimated that upwards of $5 billion (Rs 30,000 crore) was pumped in by retailers. Many of them, such as Provogue and Subhiksha, ultimately shut shop because of high-operations cost that included rentals and inventory cost. Others, such as Future Group and RPSG’s Spencer’s Retail, kept afloat by restructuring and incurring heavy debt. Flipkart, Snapdeal and Amazon did not respond to questions raised by BW|Businessworld through email on the challenges they are facing today.

For the fledgling e-commerce industry, it is probably a case of having bitten off too much, too soon. India promises a market of more than a billion customers; the industry hopes it is just a matter of time before the customer warms up to the idea of using smartphones to shop. Except, India isn’t really the homogenous stereotype as the marketing gurus like to think, where a huge customer base automatically translates into profits.

However, Sachin Bansal, co-founder of Flipkart, believes that the online platform creates so much data that cultural diversity is at the heart of the game. He says that technology, including data analytics, can change the way a region is being served with the help of real data collected from the browsing habits on phones. He is optimistic that the next step is going to be hyper local, and places more emphasis on the growth of mobile shopping.

Ghost Of Back-end Losses
What Sachin Bansal’s optimism hides is the fact that eTailers are paying big time for inventory on behalf of their associate distribution companies. These distribution companies are exclusive to each marketplace. Amazon works with CloudTail and Flipkart works with WS Retail. These companies generate 40 per cent of the deliveries for their eTailers. FDI rules (from 2010) state that not more than 25 per cent can be sourced from an associate company. The rule was scrupulously followed by the now defunct Bharti and Walmart partnership; but the same cannot be said of the eTailers. In the case of Bharti Retail, it sourced only 25 per cent from Walmart’s wholesale business in India — Best Price Cash and Carry.

The inventory costs for eTailers are the root cause of the losses along with discounts. Company sources say that today there is enough evidence of the losses, and it remains a permanent feature of this business. Retail is a cash-burning business and has the lowest margins, say about 4 per cent. Of the 195 million deliveries made, till FY14, by the big three eTailers, 23 per cent of the products were returned, with Rs 6,900 crore borne as the reverse logistics cost by these companies (see Shoddy Shipments and Bleeding Profusely). About 35 to 40 per cent of the total returns were from associate distribution companies, and the rest were from registered sellers. Inventory is maintained for distribution companies and this amounted to Rs 2,462 crore. Two reputed brand heads of big marketers — Puma and Samsung — preferring anonymity told BW|Businessworld that their contracts with Flipkart, Amazon and Snapdeal included a limited return clause. That is, if customers returned products for whatever reason, the vendor will accept only 5 per cent of the returns. The eTailers take the risk for returns above that level.

Now for discounts: an average of 20 per cent is borne by these three e-commerce giants; they pay sellers to make good on discounts. This number rounded up to Rs 7,312 crore in FY14. Now add the returns cost of Rs 2,462 crore to the cost of maintaining discounts at Rs 7,312 crore, and this totals to a whopping Rs 9,774 crore as their losses only from discounting and reverse logistics. Everyone would be happy if new and existing investors keep the money coming and the discounts flowing for the next 15 years. But is that realistic?

Regulatory Warning Signals
There are warning signals. In May, minister of state for commerce and industry Nirmala Sitharaman told the eTail industry that relaxing of FDI rules will not happen till the government’s ‘Make In India’ campaign spurs domestic manufacturing. FDI rules currently put the onus on states to permit foreign investors in retail outlets that sell multiple brands. Most states have so far resisted.

Thus, Amazon is a marketplace in India. However, according to its submissions during a hearing before the Authority of Advance Rulings for Indirect Taxes, in 2012, Amazon said it would provide two types of services in India: A front-end online platform to facilitate merchants, and the second would be to provide logistics support in relation to the goods sold by the merchants. The details are where things get murky. The order at warehouse: Amazon unbundles wholesale packages into individual retail packages, sometimes sorting the packages if the wholesale package includes different items. It then wraps them with required protective material, and bundles products when two or more items are to be sold together. Arguably, going by this, Amazon is more than just a neutral platform. It takes up a much more active role in the sale procedure. Logistics is not limited by the FDI rules, but when combined with the online platform, like a shop-in-shop, for multiple vendors and moving the product through warehouses, it replicates a Central or a Shoppers Stop.

This muddies the companies’ usual rhetoric about being just a marketplace. The point is if there’s ‘transfer of risks and rewards’. R.Muralidharan, senior director for Indirect taxes at Deloitte, says: “If only the companies have contracts that oblige them to take ownership of goods at any point, then it will be difficult to argue that risks and rewards have not been transferred.” Once that is established, tax implications would change and they would fall foul of FDI rules. The Enforcement Directorate has been investigating Flipkart for similar violations since 2012, for its relationship with WS Retail, which sells more than a third of its products. WS Retail was sold to private investors to alienate the ownership from Flipkart’s management. How independent is it really?

“Regulators will ask e-commerce companies to come out with a clear idea of their business; whether they are a technology company, a market place, or a logistics business,” says Ganesh Prasad, partner at law firm Khaitan and Co. He says regulators will go after the tax liability of these companies and not valuations. “Things like the origin of the product and where, in which state, should the tax be collected will need clarity,” adds Prasad.

And then, there is lobbying by brick-and-mortar businesses for a level playing field for raising foreign money. “The current protectionist policies are leading to an imbalance in the market, as the players exploit the gaps in government policies,” says Vikas Agarwal, general manager (India), One Plus, a Chinese electronics company.

Defending these eTailing practices, Sachin Bansal of Flipkart, said on the side lines of a press conference: “The business has seen phenomenal growth. The capital raised, so far is being used to better technology and offer the best to the customer.” Bansal’s counterpart at Snapdeal, Kunal Bahl, agrees with him on the growth of the business. “The younger generation’s propensity to shop online is clear, for the future, and smartphones are a great way to engage with them.” But both agree that regulation was something that all e-commerce companies had to cope with and were struggling to seek clarity in the long-run.

The tax issue too is being debated vehemently by the state of Karnataka. Last year, local tax authorities stopped sellers from trading, especially Amazon, from warehouses operated and managed by eTailers. The tax authorities’ case was that eTailers should collect tax on behalf of sellers. The eTailing companies, on the other hand, did not want to follow such direction because it would bring them in direct conflict with FDI regulations, which does not allow multi-brand retailing. The status quo continues to this day with no settlement in sight.

Long-term Value
Regulatory hassles have not dissuaded investors. In fact, there is a glut of foreign money chasing a few e-tailers. The Russians (DST Global), the Americans (Tiger Global), the Japanese (Softbank), and the Chinese (Alibaba) are on the prowl. Every acquisition has been at an eye-popping valuation. So far, Rs 9,774 crore has been spent on servicing 36 million regular consumers, and the industry will need a further Rs 27,000 crore to acquire 100 million regular customers by 2018. The target for the VCs has always been the number of consumers their ‘investee’ companies can acquire and not the number of sellers who came on board. Flipkart, Amazon and Snapdeal have only 10 per cent of their total 1,00,000 registered sellers, as regular merchants.

“It is quite possible that the liquidity in the global funds, and the promise of the Indian eTail story is driving the prices up to unreasonable levels,” says Aviral Jain of valuation firm American Appraisal, a division of Duff & Phelps. “The premise of e-commerce valuations in the US is customer loyalty, says Jain. In India, however, the challenge is that the loyalty is absent and survival until consolidation is the key, he says. In India we are loyal to prices, thus making discounts de rigueur.


With extensive experience in e-commerce industry and related investments, Shinoj Koshy, partner, Luthra & Luthra, says:  “E-commerce players are not in the business of handing out discounts. What they are interested in is altering consumer behaviour by weaning customers from traditional brick-and-mortar outlets. Once a habit has been formed, then discounts will get rationalised and services are likely to come at cost. An indication of what is to come is paid services at Flipkart First and Amazon Prime.”

Investors’ Waiting Game
“That the customer is going online is true. But like any retail business, it requires capital to sustain operations,” says Vinay Parekh, CFO and co-founder of He says the industry needs long-term capital to build trust with consumers and offer the best services. Big Basket delivers grocery in six cities to 20 million customers every year. Perhaps, they are the only ones who have not spent heavily on acquiring customers. Paytm, which has harboured an ambition of making it big in eTail, plans to bring on board a hundred thousand sellers by end of the  year, and bring in one million Chinese sellers.

“These goods, ordered on our app or website go to our delivery centres and do not remain in there for long,” says Amit Lakhotia, general manager of Paytm wallet. He adds the opportunity to bring Alibaba’s merchants was enormous and could supplement the revenues garnered from the online wallet business. Logically, everyone is betting on the fickle smartphone user. However, the average Indian (600 million Indians under age 40) is still not using the smartphone for regular transactions.

Not being able to acquire customers is beginning to glow in the darkness. These companies do not generate cash from operations, which is the lifeline of a company. The accounts filings with the Registrar of Companies, in India, show serious losses. The trio of Flipkart, Amazon India and Snapdeal posted losses totalling Rs 1,300 crore (Amazon Rs 320 crore, Snapdeal Rs 264 crore and Flipkart Rs 716 crore) in 2013-14. Can one of the three rivals afford to turn off the discount tap without losing their market share?

On the other hand, a synchronised move to do away with discounts, when they have a firm control of the market, is sure to earn the censure of the Competition Commission of India.

Will Investors Stay?
The eTailers are at the mercy of investors who have different timelines for closing their funds. Most of them will begin exiting by 2018 and the top two Indian eTailers must create a sustainable business by then. The total share capital of Flipkart was $3.2 billion (Rs 20,000 crore) and it has already eroded by Rs 10,288 crore. Flipkart has not been generating cash from its operations and its negative cash flow stands at Rs 592 crore. Similarly, Snapdeal too has not been generating cash, and carries on its shoulders a negative cash flow of Rs 300 crore on the Rs 6,000 crore it has raised so far.

When fresh money stops coming, do these home grown eTailers have the fundamentals to remain afloat? Or will they become victims of a fire sale by investors offloading to private equity funds, who usually take long-term bets. Private equity seems to be the only option. Flipkart registered in Singapore has 148 investors. Many of them are pension funds of Xerox Corp, ConAgra, Rio Tinto and Shell. Seeing Flipkart’s downward spiral, how long will they wait before exiting?

Sanchit Vir Gogia, CEO of Greyhound Knowledge Group, says most investments were made between 2013 and 2014; so funds may want to exit before 2018-19, since VC fund cycles last only for five years. Institutional investors look for an exit by either selling back to the promoter,  or to another investor or to the public through an initial public offering (IPO). An Indian IPO looks remote when there are no profits on the horizon. Making new investors pay more than the current valuation could be a tough ask.

That is when things get tricky. Devangshu Dutta, CEO of Third Eyesight, a retail consultancy, says that these businesses, like any retail business, will not make money in the short run, but like steel or infrastructure businesses, these would take a 15-year cycle to make money. India’s home grown eTail companies are expectedly worried because by committing $2 billion to their India foray, Amazon has neutralised the advantage Flipkart built over the last five years. Today, they compete as equals.

There are the long-term hopefuls. “Global investors will back these companies, and will bailout existing funds, because India is the largest consumption market,” says Ganesh Prasad of Khaitan and Company. The investors may lead yet another large round of funding, he says.
“When you have the money, raise funds,” says Aviral Jain of American Appraisal. But what if your business model itself is flawed? Then the next round of funding becomes difficult. One will have to wait and see if the investors blink. Warren Buffett put it thus: “Only when the tide goes out, do you discover who has been swimming naked.”  

Saturday, June 27, 2015

Carmakers launch peer-to-peer vehicle sharing

Three of the world’s biggest carmakers have jumped into peer-to-peer vehicle sharing, as the automobile industry scrambles to stay relevant in the age of Uber and BlaBlaCar.
Within hours of each other, FordGeneral Motors and BMW announced Airbnb-style schemes on Wednesday – with each manufacturer claiming to be the first to let car owners earn money by renting out their new vehicles to other drivers.

“Society and the automotive industry are undergoing radical change,” said Peter Schwarzenbauer, member of the BMW board for the British brands Mini and Rolls-Royce.The moves are part of established companies’ attempts to respond to the changing tastes of so-called millennials. Motor industry executives are watching with alarm as consumer-focused sectors are disrupted by new entrants encouraging individuals to share goods and services with each other.
From next year, BMW will allow customers buying a Mini to choose to rent out their cars via DriveNow, an existing scheme run by the German carmaker. The option will initially be available in the US and later in DriveNow cities such as London.
BMW announced the scheme just as Opel, General Motors’ European marque, said it would offer “car sharing for everyone”. Opel CarUnity will allow drivers to rent out their cars – say, to their Facebook friends – via a dedicated Opel app for smartphones and tablet computers.
Ford has also launched a six-month pilot scheme to allow 12,000 customers in and around London who have bought cars through its financial services arm to rent out their vehicles, using easyCar Club, an online peer-to-peer platform. The pilot will also run in six cities in the US, in collaboration with Getaround, another platform.
In each case, a portion of the fee paid by the person renting the car goes to the vehicle owner, with the remainder passing to the manufacturer, partly to cover insurance.
A number of platforms have sprung up offering vehicle-sharing models, such as RenteCarlo, whose users have shared Maseratis, Porches and Audi R8s. Other services, such as BlaBlaCar, a French car pooling service pairing motorists with passengers, threaten to further undermine the concept of car ownership.

He added that GM was looking at how to deliver the “good parts” of the experience – the freedom to travel wherever with whomever – but on a “sharing model”.Dan Ammann, president of GM, last month outlined the dilemma for city-dwellers who rarely use their cars. “It’s the last thing you should do because you buy this asset, it depreciates fairly rapidly, you use it 3 per cent of the time, and you pay a vast amount of money to park it for the other 97 per cent of the time,” he said in an interview with the Financial Times.

There have been apocalyptic warnings that the rise of car sharing will decimate carmakers’ revenues, at a time when investment needs are increasing because of environmental regulations. But the biggest risk is in not adapting to new trends, said Philippe Houchois, analyst at UBS.
“I think car manufacturers are rapidly waking up to the fact that part of their current and future clientele are not interested in owning cars any more,” he added.
The more cars get used – ie shared – the faster they wear and need to be replaced
- Philippe Houchois, analyst at UBS
“However, demand for personal transport in cars continues to increase. The more cars get used – ie shared – the faster they wear and need to be replaced. So pooling and sharing isn’t necessarily negative, unless one fails to get involved.”
The other benefit for manufacturers is they can introduce young consumers to their products.
“It would be really neat it we could introduce them to the vehicles early on and, when the time comes to buy a car, they look favourably upon us,” said David McClelland, vice-president of marketing at Ford Credit.

India’s ecommerce groups target online grocery shoppers

On a sweltering Delhi morning, the 30,000 square foot warehouse of Big Basket, an Indian online grocery store, is a hive of activity. Workers with hand-held computers read incoming orders for packaged foods, personal care products, cleaning supplies, and fresh produce, then pack the items into red delivery crates.
Each order is divided into several parts and assigned to multiple “pickers”, who grab and pack stock from the aisles — such as personal care or products or packaged foods — that they know intimately. Big Basket found this was much more efficient than having a single “picker” collect all items for an individual order from separate parts of the warehouse.
So far, these calculations seem to be paying off. With operations in six of India’s biggest cities — and starting in two more in the coming months — Big Basket is the biggest player in India’s most promising yet challenging ecommerce category: grocery retailing.“Every five or 10 minutes are calculated,” says Sanjeev Khanna, who heads the company’s operations in India’s national capital region.
Globally, buying groceries online has not boomed, except in the UK. But in India, most consumers are still at the mercy of small mom-and-pop shops with limited or erratic supplies, while corporate grocery retailing has been stunted by expensive real estate and restrictions on foreign direct investment.
Chief executive Hari Menon, who co-founded Big Basket in 2011, believes that the promise of a greater choice of products, and convenience, will drive a faster pick-up of online grocery shopping in India than has been seen in other markets.
“Potentially, this business itself can be close to a $20bn business in 2020,” Mr Menon says. “Organised retail is only 15 per cent of overall retail here. Rental costs are really high, and that is really impacting business. The whole model looks very suspect. Online companies will go after these modern trade customers, who are mostly likely to shift.”
I want [groceries delivered] the same day or the next day. I don’t want my potatoes coming three days later
- Pragya Singh, Technopak vice-president
Big Basket has raised $61m from private equity funds Ascent Capital, Helion Ventures, Zodius and US-based Bessemer Venture Partners and is valued at about $275m. It says it has an estimated 500,000 active customers and that revenues are growing by 12 to 16 per cent each month.
After collecting revenues of $33m last year — when it was present in just five cities — it is projecting income of $126m in the financial year to March 2016 and $295m the following year.
Others also sense opportunity. Competition to entice Indian consumers to shop for groceries online is heating up, albeit with different business models. Many of the fledgling players in the space are effectively localised, on-demand delivery services, which develop relationships to source goods from existing brick-and-mortar corporate retailers such Metro Cash & Carry, the German wholesaler; HyperCity, a chain owned by India’s Raheja Group, and More Stores, part of the Aditya Birla Group’s retail operations.
Chart: Retail growth in India's big cities
Localbanya, which started operations in Mumbai three years ago, operates in five cities, as does Zopnow, based in Bangalore. Investors such as Sequoia Capital, Saif Capital Partners, and Tiger Capital Partners are also backing other young on-demand grocery delivery services such as Pepper Tap and Grofers These use mobile phone apps to link consumers to local stores, including independent mom-and-pop shops, and handle deliveries for online orders.
In recent years, Indian consumers have grown increasingly comfortable with shopping online, snapping up books, electronics and other non-perishables from India’s three large marketplaces — Flipkart, Snapdeal and Amazon — with a clutch of smaller and specialised rivals, such as PayTM, also battling for market supremacy.
But with nearly 67 per cent of Indian retail spending still going towards food and groceries, analysts and investors see a huge potential for companies that can cater to urban dwellers who are short on time, and want a greater choice of products than typically available at mom-and-pop stores, traditionally known as kiranas.
“Kiranas might be everywhere but will they have some Italian herbs, sundried tomatoes, or extra virgin olive oil that a premium category consumer might want?” says Pragya Singh, a vice-president with Technopak, a New Delhi-based retail consultancy. “If you can offer urban Indian consumers the products they might not have access to, you can actually make a customer very loyal.”
Chart: Retail consumption across key categories
But if potential rewards are high, so are the challenges. Online groceries require complex logistics, including local supply chains that must be developed city-by-city, with a reliable system that ensures rapid deliveries within precise time windows.
“Customers for groceries have a much quicker fulfilment need than in other categories,” says Ms Singh. “I want it the same day or the next day. I don’t want my potatoes coming three days later.”
Big Basket, India’s only egrocery developing its own integrated back-end supply chain from scratch, believes the battle for customer loyalty — and market share — can be won through the reliable supply of high-quality fruit and vegetables to finicky customers, short on time to pick over produce themselves.
Says Mr Khanna: “If you can give customers confidence in your fruit and vegetables, that is your winning edge”.

Technology conceives the inconceivable

A funny thing happened on the way to the internet of things. Many of the “things” got a mind of their own. They also started to be produced in surprising new ways, often at much lower cost, and mutate into forms few anticipated.
Technology revolutions have a habit of unfolding in unexpected ways. The more foundational the underlying change, the harder it is to anticipate where it will eventually lead. Yes, the internal combustion engine brought cars and car companies but it also brought booming suburbs, hypermarkets and road rage.
The internet of things feels like one of those technology revolutions. It was founded on the idea that when inanimate objects, from lightbulbs to complex industrial equipment, are connected to the internet interesting new things will become possible. The expected benefits include being able to control objects more easily. It also increases the ability to lease things out, with payments tied to actual usage, turning the provision of physical goods into a service industry.
But the predictable, linear development this implies — an orderly progression that adds value to existing assets and new revenue streams to existing businesses — is not the way technology revolutions normally play out.
For a start, some of the hoped-for benefits have been slow to arrive. True, this is a long-term, highly complex change that will creep slowly into many areas of business and life, from the way cities operate to industrial, home and personal settings. In a report this week, the McKinsey Global Institute predicted that the applications of this technology would be worth $11tn a year by 2025, equivalent to 11 per cent of the global economy by that point.
A second seminal tech change will stem from the spread of artificial intelligence, which will make it easier to design and control complex ecosystems of objects
But McKinsey also pointed out that there was a lag in the effects of this technology, similar to the productivity lag that followed the wave of corporate IT automation that started in the 1980s. It takes time for companies to learn how to manage new technologies and for the new business models to emerge.
Part of the problem results from sheer complexity. Some 40 per cent of the benefits from the internet of things depend on deep integration of different systems, according to McKinsey. Also, the world is already awash with data, little of which is actually used. Simply adding equipment to pile up more information will not guarantee a return, says Michael Chui, a partner at the professional services firm.
Eventually big companies should start to see a return from their investments. But, as the rise of the internet in the 1990s showed, the bigger impact from a wave of new technology may come from a direction that is not anticipated by the incumbents. The world-changing applications made possible by the new technology platform cannot be imagined at the outset.
Some signs of the more disruptive changes that could lie ahead with the internet of things were on display this week at the Solid conference in San Francisco, produced by O’Reilly Media.
As the rise of the internet in the 1990s showed, the bigger impact from a wave of new technology may come from a direction that is not anticipated by the incumbents
As the name suggests, this was a celebration of the physical in a tech industry whose biggest recent fortunes have come from the dematerialised: software and data. The exhibits included a “pop-up factory” to make electronics on the fly and a part-3D printed car designed to be built in small local “microfactories”. Much of the discussion was of synthetic biology that will take manufacturing down to the microscopic level and merge the inorganic with the organic.
Behind the disruption lie three technologies that are on a collision course, according to Mickey McManus, a researcher at design software company Autodesk.
Extending internet connectivity to the physical world is only part of the story. A second seminal tech change will stem from the spread of artificial intelligence, which will make it easier to design and control complex ecosystems of objects, as well as put a higher level of intelligence into the individual “things” themselves. The third leg of the revolution, says Mr McManus, is digital manufacturing exemplified by 3D printing, which could present an alternative to some forms of mass-market production.
Taken together, he hints at the types of changes that could result: three students in a dorm room could start a car company; a distributed social network might replace a factory; or objects may disassemble and reassemble themselves as needs change.
If there is as much value to be extracted from the internet of things as McKinsey anticipates, there will be a plenty of new wealth to spread around. But the most interesting implications are still barely imaginable.

Instagram unfiltered

Large, square photos of a towering redwood forest, a yacht at sunset and a carefully crafted cup of coffee adorn the walls of Kevin Systrom’s office. At one time, these beautifully shot pictures might have hung in an art gallery. Now they are everyday Instagram, plucked from filtered feeds found in an app on a smartphone.
In the scrappy, ever-expanding Facebook campus where Instagram is based in Silicon Valley, and where everyone has just moved desks and few have changed out of their gym clothes, the pristine office of its co-founder and chief executive is a corner that is forever fashionable. Systrom strides in to find me waiting at his white oval marble table. Wearing a khaki mac, pale blue striped shirt and black sneakers with patent toes, he is more carefully dressed than his boss Mark Zuckerberg, who was responsible for turning the hoodie into a geek icon. Yet, however stylish his outfit, he still lacks the gloss of the last photo he posted on Instagram.

Systrom’s Instagram feed shows him posing with designer Karl Lagerfeld, snapping a hasty selfie with chef Jamie Oliver and a view looking down on the Oscars audience. When we meet, he is excited that Hillary Clinton has just joined, posting a picture of her red, white and blue pantsuits.
“It is cool to see that the fashion world has really taken to Instagram but, again, it is one of the many examples of many communities: whether you are a chef, a skateboarder, a surfer, a skier,” he says. This week, Instagram announced a new way to discover these communities on the app, curating collections such as “extreme sports” and “towering rocks” and making it easier to find people to follow. “There are funny examples — nail art communities, for example,” Systrom says. He does not follow nail art on Instagram personally, he adds, examining his unremarkable man nails.
Amount Facebook paid for Instagram
Instagram’s business is only just beginning to reveal itself. Bought by Facebook in 2012 for $1bn, when it had just 13 employees, it escaped the frenzy of fundraising rounds which have brought copious press attention to rivals including Twitter and Snapchat. Nor has it had to rush to take advertising. Now, five years after it was founded and three years after it was acquired, it is ready to go full throttle into generating revenue. Its relationships with other industries, where people are passionate about photographing and filtering images of meals, outfits and scenery, should help grow advertising sales.
Sarah Phillips was one of the first to use Instagram for her business, grabbing the handles @food and @baking. The trim 61-year-old learnt about the app from her daughter, who has the handle @newyorkcity. (The same handle cannot be used by another Instagrammer.) She immediately knew it would be a hit. “People say a picture is worth a thousand words but I think it is worth billions,” she says. “It is technology plus art merged together, hence its popularity.”
©Kevin Systrom
Phillips is an early adopter, starting the subscription-based in 2000, where she posts recipes and pictures of food that she raves are full of “colour, nourishment, fun and joy”. Instagram has helped build her business, striking deals worth thousands of dollars to promote food brands such as Kraft, Unilever and Starbucks in her feed, and helping her network with the other food industry Instagrammers.
She is one of thousands who say Instagram has changed their business. Elsewhere in food, chefs are paying more attention to plating meals and cafés say foods such as avocado on toast have soared in popularity because of their looks, not their taste.
In fashion, models often gather at the end of a catwalk show, posing so Instagrammers can snap them. A model’s follower count is considered when she auditions for work and draws up contracts.
Singer Rihanna is preparing to launch an album with a teaser on Instagram, Mario Götze put his first photo with the World Cup trophy on Instagram and Katie Meyler, a non-profit founder honoured by Time magazine’s Person of the Year 2014, used the app to promote her work fighting Ebola in Liberia.
Kristina Webb, a 19-year old New Zealander, has built a full-time job on Instagram. Her colourful, Disney-like pictures appeal to Instagram’s huge teenage base — and she can now afford to employ her sister, a former accountant.

Last time she came to the US, she posted asking if any of her followers (1.7 million on her business account, 600,000 on her personal one) wanted to meet up in a mall in Santa Monica. The next day, she found 300 fans waiting for her, screaming and brandishing signs, and an angry manager confused about the fuss. “It was the most surreal moment for me. On Instagram it is a number, but getting to see them in real life was the overwhelming part. Knowing I had impacted their lives,” she says.“It is sort of my perfect job because at the end of the day, Instagram is what I used to do in my spare time when I got home from school or home from my part-time jobs,” she says. She sells her work on posters and phone cases, has a book deal with HarperCollins and is planning a 20-city book tour in the US this year.

Loic Gouzer, 34, a specialist at Christie’s, realised the power of Instagram when a flyer he designed to promote an edgy modern art sale, “If I Live I’ll See You Tuesday”, in New York was rejected by “some suit somewhere in management”. He published the image on Instagram as he felt there were “no laws” and he could develop his own voice and relationship with his followers. It has helped attract collectors to his shows and artists clamour to be featured in his feed.
“The time from when a painting is shown in a gallery to the moment it gets some kind of credibility used to take two, three, five, 10 years,” he says. “Now you don’t even finish the work and someone in a studio somewhere is taking a photo and two minutes later a guy is seeing it and buying it.”
Monthly active users
But there are signs the dynamics of the Insta-economy may already be changing. Sarah Phillips is organising a meeting of fellow food Instagrammers to try to create some standards for brands who she says often “want something for nothing”.
“Why should I advertise for a big food company for nothing? I think there’s going to be a shake-up in how to monetise on Instagram,” she says, adding that some now approach her offering as little as $100 per photo or even just free products. “It is not that I like turning away money. It is outrageous. And if I start taking these jobs it will drive the whole business down,” she says.
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Systrom may be in his early thirties but he speaks like he is feeling his age. Pointing to his office door, he refers to the employees as the “young folks out there”. Outside, fresh-faced men and women sit and stand at rows of desks, peering over laptops. The open-plan office has the perks expected in tech (free snacks galore) — but a fun “gravity” room, arranged so that photos can be taken to make it look as if a person is flying, has been removed to make room for more staff.
21 minutes
Average daily use
He describes how different his own teenagehood — spent playing the game “Snake” on his Nokia — was to that of the flocks of teens on Instagram. When asked what has changed in Silicon Valley since he started there in 2006, he focuses on age. “There are a lot more companies with a lot younger people,” he says. “It is just like 23-year-olds are starting companies and they are scaling really quickly.”
Systrom started Instagram with co-founder Mike Krieger, who leads the technical side, at the grand old age of 26. Instagram was one of a few real overnight sensations, with 25,000 downloads on its first day. When it was bought by Facebook a year and a half later, it had 27 million active users.
©Annie Tritt
Chris Sacca, an early Instagram investor, says Systrom did not pitch hard when talking to investors. “Kevin always knew that Instagram would be huge. He never tried to convince any of us,” he says. Beforehand, Systrom had a typical career for a wannabe entrepreneur: studying management science and engineering at Stanford, working at Google and the start-up Odeo, which turned into Twitter. But it was his life before tech that prepared him to create a new way of posting photos online.
Systrom grew up in Massachusetts, with a mother who worked in marketing, a father in human resources and a sister. He studied computer science at an independent high school near Boston, skied and worked at a local radio station.
Studying in Florence during college, he took a photography class in which a teacher pushed him to try a plastic camera and add chemicals to the developing solutions to achieve interesting effects. “That changed my life. I mean, you know, the discovery of square-format, filtered photos. I mean, that’s it, right?” he says, gesturing at the plus-sized Instagram photos on the wall.
Skipping over years, he describes how he did the same with Photoshop, “without all the hard work of a dark room”, then made it an easy “tap on an iPhone” by programming the algorithm of a filter.
He never considered becoming a photographer because he was “never that good at it”. “I just like to try to take good photos on Instagram and people are like, ‘Why don’t you take photos every single day?’ Because I’m not that good, I’m trying my best.”
It is creating a record of the world, a history of the world . . . and I think that is beautiful. I don’t think that is narcissistic
- Kevin Systrom
Instead, Systrom thrived where art meets technology. He bets if you “zoom back to high school”, where he was president of the photography club, and asked peers what kind of start-up he would found, they would predict it would be about art, photography and connecting people.
But it wasn’t just the square format and flattering filters that helped Instagram beat many other photo apps. It was also the “asymmetric follow model”, where people can follow others without them following — or friending — them back, he says. “Not many people were doing that with photos. Photos were seen as the most private type of content and Instagram really flipped that on its head and said photos can be really public.”
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Critics worry that this public face displayed on Instagram is creating a narcissistic generation who use the app to depict a vision of a life they may not actually live. The selfie has become the ultimate symbol of self-promotion. Systrom’s feed shows he, too, is fond of a selfie. “I’m like my own selfie stick,” Systrom jokes, unfurling his arms. “I’m 6ft 5in, can you see me?” But he rejects the idea his app is simply lifestyle porn, where, for example, people are so concerned with presenting every meal to their friends, they leave the food to go cold.
©Kevin Systrom
“I’ve never woken up and thought, man, we live in a narcissistic generation,” he says. “I think it is creating a record of the world, a history of the world, people’s emotions, people’s expressions and I think that is beautiful. I don’t think that is narcissistic.”
Systrom likes how teens’ Instagram feeds show them growing up. One young man, who was 13 when he met him at an early gathering of Instagrammers, is now 18 and using the app to promote his music. Self-portraits existed before the smartphone, he says, but it “took a really long time”.
“I think, like, this is not an Instagram thing, this is a societal thing. People wear certain clothes to give off a certain image, people drive certain cars, live in certain homes, work in certain jobs or titles. It is a human thing. I think you’re just seeing humanity play out on a massive scale through images on Instagram,” he says.
Instagram has humanity, now it needs money. Systrom must now get a slice of the proceeds already being made on the platform, by creating adverts that will be embraced by Instagram lovers.
Systrom slips in his boldest claim: Instagram is probably monetising faster than any other social network, ‘period’
Usually careful with his words — except when joking — Systrom surprises when he casually slips in the boldest claim of the interview: Instagram is probably monetising more quickly than any other social network, “period”.
It is bold because the start-up has been only dabbling in advertising since it showed its first advert — of a gold Michael Kors watch on a table set for high tea — 18 months ago. Few Instagram users regularly see ads and it only allowed users to click through to a company’s website in March this year.
“Initially, we took it pretty slowly because we wanted to make sure everyone understood we were going to monetise,” Systrom says. Now Instagrammers are comfortable with ads on the platform, so “our intent is certainly to go very quickly right now”.
He attributes this ability to accelerate now to Instagram’s owner, Facebook, the first to master social media advertising. Facebook is an “engine for serving ads” that can power Instagram, he says.
Facebook’s algorithms can use detailed targeting to help marketers reach their audience. A retailer can choose, for example, to show adverts to women aged 25 to 35, who like tennis and share attributes with other customers.
Systrom is also learning an important lesson from the parent company: advertisers do not want to be forced to learn their craft from scratch for every new platform. Facebook flailed in its first ventures on to Madison Avenue, when it tried to reinvent ads without understanding advertisers’ desire to measure and compare different media. It changed tack and is now one of the more popular digital media companies.
“I think one thing that most technology companies will learn over time with advertising is the way to be really successful in the advertising business is not to try to be too unique,” he says.
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That Systrom praises Facebook for speeding along Instagram’s advertising business is a vindication of the original logic for the acquisition. Instagram was the first child in what Facebook now dubs its “family of apps”. The deal has formed the model for subsequent acquisitions such as last year’s purchase of messaging app WhatsApp.
In this model, the acquired start-up’s founders are given significant independence but offered a list of what Facebook can help them with: from hiring, to server space, to advertising. Rich Wong at Accel Partners, an early funder of Facebook, says the company had “guts” to buy Instagram. “People thought it was crazy at the time but that was prescient, in retrospect, addressing mobile users plus the younger demographic,” he says.
He dislikes being compared to his boss, Mark Zuckerberg. ‘We are just two very different people’
But Instagram’s success has also led to questions about whether they sold too early and for too little. At $1bn, it was much cheaper than the $22bn Zuckerberg spent on WhatsApp just two years later. Then, $1bn was a lot of money; now, there are about 80 so-called “unicorns”, start-ups that have been valued at more than $1bn, and the largest boast valuations of $11bn (Pinterest), $15bn (Snapchat) and $40bn (Uber).
John Lilly at Greylock Capital, which closed a deal to invest in Instagram just days before the acquisition, says Instagram could have become a “big, durable company”. But he adds: “My guess is it wouldn’t be all that different if it had stayed independent. It had significant scale before the acquisition. I think Kevin having collaborators in Zuckerberg and Mike Schroepfer [Facebook’s chief technology officer] and Sheryl [Sandberg] has been transformative to him.”
Systrom seems most on edge when I ask about his relationship with Zuckerberg. Throughout, he has been spinning the rotating leather chair next to him, first with his foot, then pulling it nearer and turning it from side to side with his hand. The spinning gets more fidgety when the topic turns to Zuckerberg.
“I see him every week, not always talking about Instagram stuff. I’m on the management team at Facebook so I also help with managing in general,” he says. “We have dinners, not every week, that would be a lie . . . ”
When pressed on where they have dinner — Facebook canteen, home or fancy Silicon Valley restaurant — he shrugs: “It totally depends.”
©Kevin Systrom
“But yeah, we have a close relationship and I think one that is fairly productive. So it’s good,” he concludes.
I try lightening the mood with an attempt at a joke about Zuckerberg’s lack of dress sense. Systrom demurs but smiles, “I don’t know. I mean, everyone has their own thing. He reads like a book a week, I wish I did that.”
He clearly dislikes being compared to his boss. “I guess my point is everyone has their thing but it makes sense that I love aesthetics, I love the craft, I love the product based on those communities that have really taken to Instagram,” he says. “I think to try to compare us is hard because we are just two very different people but that is what makes Instagram and Facebook together so cool.”
Facebook also helps insulate Instagram from fears about a technology bubble bursting. Valuations are soaring and even prominent venture capitalists and entrepreneurs are publicly questioning whether some start-ups could be overvalued.
Systrom doesn’t worry about a tech bubble because “our single investor is Facebook” and their business is “healthy” (generating a plump $4.7bn of adjusted earnings last year). But he realises the cycle affects everyone here — he just doesn’t know where we are in it.
“There are issues with technology right now. Technology companies, everyone is growing really, really quickly but I think that will work itself out in the long run. I’m not concerned about the long-term prospects of technology,” he says. The future for social media will include more video, wearables and virtual reality, he predicts. Instagram already offers video and Facebook is challenging YouTube’s dominance but: “I don’t think anyone has figured out video.”
And his own future? Many wonder if Systrom will stay in the job. Even when Instagram develops a solid business, Systrom will still be a leader of a corner of Facebook’s empire, not a public company chief executive. Maybe he’ll be tempted to start out on his own again.
In reality, he sees more than just tuxedo-wearing in his future. Refusing to name a timeline, he says he is revelling in the opportunities to launch new Instagram apps, such as Layout, to arrange photos, and Hyperlapse, which speeds up videos to a comic pace.
“Building a business is something I really believe in. I didn’t start it because I felt it was a good idea for an app, I started it with Mike because we felt we could build an amazing business around, like, connecting people through images,” he says. “It is just awesome, right?”