IPO Review : Zomato IPO – Invest or avoid?

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If there’s talk in the stock markets today, it’s devoted to the upcoming Zomato IPO, which aims to mop up Rs 9,375 crore. Unlike the crop of recent private equity investor backed companies doing IPOs, this isn’t primarily an offer for sale. Zomato gets a whopping Rs 9,000 crore to deploy into its business mainly through a fresh issue of shares. Only one investor, Info Edge, will offload a Rs 375 crore stake. At the upper end of the price band of Rs 72-76, the post-offer market cap of listed Zomato will be around Rs 60,000 crore.

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This IPO has got the market hooked by the sheer novelty of its business and the complete absence of any profitability both in the past and foreseeable future. So should you buy into the hype or dismiss it?

The business

Zomato needs little introduction. The company operates mainly in the food-delivery business, linking restaurants and customers through its app. The company earns its revenues in the following ways:

  • Commissions that a restaurant pays Zomato. This commission is a proportion of the order value. Higher the order value, the higher the commission earned. This is the primary revenue source, making up about 88-90% of its revenue.  
  • Advertisements that restaurants feature on Zomato’s platform. This accounts for about 15-20% of the total revenue.
  • Subscription fee from Zomato’s Pro membership plan. This holds a minor share in revenues at less than 5%.
  • B2B business of supplying restaurants with inputs restaurants needed such as vegetables and other food products.

The story

Zomato’s appeal lies in its ability to proxy an item of consumption that is undeniably taking up an increasing share of the Indian consumer’s wallet – eating out. App-based businesses like Zomato also derive their growth prospects from the young, affluent, digitally savvy and upwardly mobile working demographic. Listed consumption plays whether in FMCGs, durables or restaurants and hotels do not offer such a focused play on this demographic. 

Zomato is a fundamentally tech-enabled business, making it scalable and adaptable to changing market scenarios. It operates in an almost duopolistic market. Apart from Swiggy, other players have folded up or been bought out by either Zomato or Swiggy. It taps into a growing consumer spending segment, and one that is in a nascent stage. According to the offer document, of the population with access to the internet only about 9% currently use food delivery apps, leaving room for expansion. It offers a better play on food services and dining out than current listed players who are limited to traditional QSR and restaurant chains, which are hamstrung by high fixed and available costs. 

Tech-enabled businesses such as Zomato tend to be evaluated purely on their ability to grow their customers and topline, and to build a network effect that makes it near-impossible for users to leave the platform. Let’s see how Zomato fares on these metrics.

#1 Customer growth

Zomato’s growth depends on how many users it attracts to its platform, how well it is able to retain these customers, and how much these customers spend. On all three fronts, Zomato has made good progress over the past 4 years. 

The number of active users – i.e., devices with which there has been at least one visit to the app – has grown to an average of 32.1 million per month in FY21, from  29.3 million hit in FY-19, and well above the 13.8 million in FY-18 (based on DRHP numbers). But visits don’t amount to much if they don’t convert into transactions. Zomato though has managed to grow conversions at a fair pace too. Its monthly transacting users climbed to 6.8 million in FY-21 against the 5.6 million in FY-19. Going by the trends in these numbers, Zomato is getting better at converting visits into transactions.

Zomato uses various forms of marketing to attract users. One major avenue is digital marketing and content marketing (such as user reviews of restaurants). The funds raised in the IPO, along with funds the company already has, give it an enormous war chest to double down on marketing and to acquire users.

Zomato has indicated that about 68% of its customers came through the organic (i.e., not from paid marketing) route in FY-21. This suggests that the company’s efforts in building brand awareness are paying off and the network effect of its customer base is lending more strength to its brand. It therefore may be able to divert some spend into pushing more discounts and promotions to improve transaction volumes. Restaurants too have their own promotional offers, which can spur volumes.

The gross value of orders placed has grown at an annual rate of 33% over the past 2 years. If FY-18 numbers from the DRHP are considered, the 3-year CAGR in order value works out to a good 92%. Zomato’s commissions depend entirely on the amount customers spend, so higher spends translate into higher revenues.

Next, the average order value (i.e., the average per-order spend) has also moved higher to Rs 395 in the March 2021 quarter against the Rs 286 in the year-ago quarter.

The rising trend in average order values can be explained by customers ordering from more premium restaurants and by an increasing number of ‘family’ orders – that is, when a single order is placed for multiple people instead of only a single person. This helps improve margins Zomato makes on an order. The cost of delivery per order is fixed - it costs the same to deliver an order for, say, Rs 100 and an order for Rs 1,000. But the commission netted on the latter will be higher. The company has also expanded its restaurant network rapidly to now cover 1.48 lakh restaurants. It has expanded geographically into 525 cities.

#2 Improving unit economics

Zomato has a long way to go to turn an accounting profit, but it has managed to improve what it retains per order. In FY-20, the company was losing Rs 30.5 for every order it fulfilled. But thanks in part to higher average order values, plus higher commission drawn from restaurants and lower spends on discounts, the company managed to make a gain of Rs 20.5 per order in FY-21.

Note here that the customer delivery charge goes to the delivery partner and not Zomato. These costs do not include marketing and other support costs. Even so, the numbers above indicate three things: One, Zomato has in FY21 able to wrangle a higher commission out of its restaurant partners. An expanding user base could put the company in a better bargaining position in this respect.  

Two, the company has been able to keep transaction volumes and value going despite shelling out lower discounts. It has been able to push restaurants into footing part of the bill for discounting. Three, the company is able to get customers to pay separately for delivery, a positive development suggesting that customers do see a value proposition in the service. This again helps bring Zomato’s own costs down.

These changes have helped Zomato’s EBIDTA losses shrink from Rs 2,158 crore in FY-19 to Rs 342 core in FY-21. This is primarily on account of lower spending on advertising and costs incurred on delivery agents and other third-party support entities.

#3 Diversification

Zomato’s core proposition is in the delivery service. But the company has tried to diversify away from this one segment to reduce concentration and tap other revenue streams.  

One avenue that appears to have started well is its B2B segment, through which it supplies ingredients such as vegetables, meats, groceries, packaging and so on to restaurants. This segment also saw lower impact from the pandemic than the delivery business. The company reduces the cost of this input supply service from the restaurant’s order value commissions that restaurants owe it, which allows restaurants to fund their working capital cycle a tad more efficiently. This may improve the value proposition offered by Zomato to its restaurant partners, which has so far been a bone of contention. The segment was launched in 2019 and now accounts for about a tenth of sales. 

Zomato after launching and shuttering its own grocery delivery services Zomato Markets during the pandemic, is set to acquire a stake of 9.25% and 9.27% in two Grofers entities, for their groceries’ delivery business and B2B warehousing and trading business. 

#4 Funding strength

Zomato has already raised Rs 6,608 crore last year from a clutch of PE investors. It is now raising Rs 9,000 crore through the IPO. Both give it the firepower to continue spending on customer acquisition and engagement, through heavier discounting and marketing. The company also intends to use 75% of the issue proceeds to fund inorganic growth. This cash pile holds Zomato in good stead for the coming years, even if a global rate rise or stimulus reversal shuts off the flood of abundant funding. 

To put everything explained up to this point in a nutshell – Zomato is seeing strong growth in its customer base and its customers are spending more. It has managed to control costs enough to improve the economics of each order and brought down losses. It has begun diversifying into related avenues to tap more opportunities. And most importantly, built up a cash reserve to fund future operations and expansion plans.

The Risks

#1 Competition

Zomato, despite diversification plans, is still heavily dependent on the online food delivery space. It needs to acquire and retain customers, and push them to spend more from existing markets if it has to grow. Its city-strength is matched by Swiggy. Its international diversification has not taken off. Amazon, with its deep pockets and India focus and delivery strength, is set to enter the same food delivery space. All this means stiff competition for Zomato for its existing user base.  

On another front, restaurants are fighting back against the commissions they are charged and the discounts they are pushed into funding, either by removing themselves from Zomato’s app or by getting their own delivery systems in place; steps on this front have already been taken. 

All this boils down to one thing – an increase in advertising and promotional offers and heavier cash burn. While Zomato will have the firepower to burn cash at a higher rate post-offer, such reversals will impact per-delivery economics. Zomato may also have to scale back on commissions it charges from restaurants. Improvement on the EBIDTA front, therefore, could be pushed back. Topline growth could also come under pressure. The company already operates on a negative operating cash flow basis. This situation can simply prolong.

#2 Uncertainty

Predicting the company’s growth trajectory is hard because of the many moving variables influencing it. The inorganic route to growth where Zomato experiments with unrelated lines of business, like grocery delivery, creates more uncertainty on this front. Zomato has failed on acquisitions in the past both globally and locally. 

Acquisitions may entail heavy spending that pushes back the path to profitability on its core business. Should it acquire a bigger stake in Grofers, for example, it could mean heavier spending to compete with the Tata-backed Big Basket or Reliance Industries’ own delivery business. 

Third, as we are already seeing in the Indian ecommerce space (where the domestic trade lobby has made life tough for overseas players) there can also be regulatory setbacks should the local restaurant or hotel industry push back. This can be either in the form of tighter controls on foreign funding, regulations to reduce the abuse of leadership positions or even regulations that target discounting efforts or payment systems that can increase customer inconvenience and reduce engagement.

#3 Losses

By the conventional yardsticks used by equity investors, Zomato wouldn’t make it to any ‘quality’ shortlist. It is loss-making at both the EBITDA and net level and will continue to remain so for the foreseeable future. Normal valuation metrics do not apply here. 

With Zomato-like companies, unlike your usual stock investments, you are not paying for a share of earnings or its ability to compound in the foreseeable future. Instead, you’re paying for a slice of a fast-growing business in a growing consumer segment that you didn’t have access to in the listed space until now, in the hope that the investor fancy for such ‘new-age’ business models will hold up.

#4 Liquidity

Stock valuations, and particularly valuations of cash-burning start-ups, have been powered by generous funding by global private investors in recent years, who have had access to ultra-cheap money thanks to near zero rates in the developed markets. Current market conditions are also conducive to Zomato making a successful offer. 

But if this liquidity were to dry up, as central banks across the world scale back the money they are pushing into their economies or interest rates were to rise (the US Fed has already indicated it will eventually hike rates), narratives justifying valuations for EBIDTA-negative businesses could change. Should private investors and public markets revert to conventional investing - preferring viable, profit-making companies - Zomato-like companies could find funding hard to come by.

What should you do?

There is no way to value the company using conventional metrics, nor can this offer be viewed from a valuation perspective. Comparing valuations of overseas players may not be right as they operate in very different markets. 

So, should you go for the Zomato IPO? Unless you're willing to think like a PE investor, it is best you sit this IPO out. But if you're able to tick all the following boxes, you can give the IPO a shot.

  • You’re willing to take a very high risk. Given that Zomato is loss-making and will remain so, you need a high-risk capacity to bet that topline growth will continue to stay strong and that the market continues to be content with such growth without earnings.
  • You’re willing to set aside textbook metrics and tried-and-tested wisdom to assess a stock’s quality and growth prospects. The aim is solely to snag an opportunity where there is no listed alternative. Zomato is among the few options to play the tech-driven disruption opportunity in India (do note here that you have access to many similar tech-enabled businesses with a clearer path to profitability in the global markets which are now quite accessible. Betting on Nasdaq 100 or FAANG funds in India can also give you a more diversified exposure to such disruptive stocks).
  • You're able to gauge the impact of the company's moves, spotting any materialization of risks, whether it is acquisitions failing, competition hurting or funding drying up, and able to figure when customer acquisition and topline growth can continue to hold.
  • You're able to exit when the going is good - in other words, before the promise that drives interest in the stock peters out.
  • You have other stocks in your portfolio that can absorb the loss that may arise from this Zomato IPO bet. If you’re looking to subscribe to the offer or buy it post-offer, it’s best you keep such allocation to about 5-7% of your stock portfolio. This is precisely how private equity investors view their start-up bets – they back multiple ideas and business models in the hope that a few that deliver astronomical growth will make up for the many that fold up along the way.

Let’s put it this way - Zomato is burning cash to acquire customers, engage and encourage them to spend more on eating out, and buy out other companies. As an IPO investor, you will be funding that cash burn. If that’s something you’re willing to do, like a PE investor would, in order to participate in a novel business no matter the risks, go ahead and subscribe. If you value profitability or at least visibility of profitability, then avoid this IPO. 

With inputs from N V Chandrachoodamani

Please note that this review does not take into consideration the possibility of listing gains.

General Disclosures & Disclaimers

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11 thoughts on “IPO Review : Zomato IPO – Invest or avoid?”

  1. Superb review Bhavana & Team. I always wonder in our country when any matrix about % of penetration of food delivery, number of users using internet %… gives 2 scenarios thoughts as follows
    (1) Enormous untapped potential if I see comparison with US China ( brighter days ahead ) – optimism
    (2) Our sheer population and economic development … puts a big risk in terms of time involved in break even and probability of success by sheer maturity of economy – pessimism

    The early investors players in the game wins ….. cap moves to the lower in the chain . Ofcourse in this scenario practically all is fresh issue which is good to note and no OFS

    Interesting scenario… I never imagined when I first ordered through zomato may around ~ 3 to 4 years back this the potential valuation of food delivery app !!

    1. Bhavana Acharya

      Thanks, sir! We’d be a bit wary of comparisons with US and China in terms of penetration levels or spends because the markets are very different. While the internet-enabled market is large, the proportion that will spend on online ordering from restaurants is much smaller. So banking on development and rising income is a very long-term game. In the meantime, in the next few years, it will go to how much more Zomato can capture of the existing market, and push into spending more. But yes, it’s great to see new businesses aim at listing in our markets 🙂 – thanks, Bhavana

  2. One thing to note is that these delivery businesses generate enormous amounts of packaging trash, consume lots of petrol. So ESG folks would probably stay away too and not fund eco-unfriendly business.

    1. Bhavana Acharya

      Zomato’s somewhat trying to address that by using bicycles as part of their delivery fleet, trying to offset carbon footprint through environmental projects, and trying to use all-EV vehicles in 10 years’ time. Some restaurants also try to use environment-friendly packaging. But yes, waste generation is a problem…but this exists in many fields, not just in the food delivery business. Even FMCG packaging, for example, can be waste generating when they use individual wrapping for their teas or biscuits etc. So it’s a tough debate. – thanks, Bhavana

  3. Thanx Bhavna, for a comprehensive analysis. Purely as a hypothetical exercise, at what price band, if any, would this have been an attractive valuation, in your opinion? Thanx again, Anil

    1. Bhavana Acharya

      Valuation itself, in the normal sense of profitability, growth in earnings, cash flows is not possible because there’s only topline growth right now. As we said, there are far too many moving variables to correctly peg whether the company will even turn EBITDA positive, leave the net level. So even metrics such as EV/EBITDA and the like would be difficult to use. So the approach is to ignore the ‘reasonable valuation’ tag altogether because it won’t apply here. That’s why we said the approach needs to be like a PE investor and look at growth differently. – thanks, Bhavana

  4. Bhavna, superb analysis. This is the best review and the most nuanced one at that of which I have come across and there have been quite a few.
    The topic is a difficult one & you folks have given really grounded, well supported advice. Thank you and I look forward to Primeinvestor content with anticipation as always. Three cheers !!

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