Should you subscribe to Zomato IPO?

Long term investors can wait a while before taking a bite of online restaurant aggregator and food delivery service - Zomato. The offer will raise ₹9,350 crore (₹ 9,000 crore will be fresh issue and ₹350 crore secondary offer) and will value Zomato at a market capitalisation of around Rs 58,000 crore. The company plans to utilize 75 per cent of the proceeds of the offer to fund organic and inorganic growth initiatives and balance for general corporate purposes.

Participating in the IPO may be tempting given the brand's high visibility and it being India’s first unicorn to hit the capital markets. However, the IPO pricing appears to leave very little money on the table for long term investors with the valuation at a market capitalisation to operating revenue of 29 times and EV/operating revenue of 23 times based on FY21 numbers. Given its consistent cash burn, market capitalisation to revenue would be a more reliable metric.

Business and prospects

Zomato’s core business is that of a technology platform that connects customers, restaurant partners and delivery partners. Customers use its platform to search and discover restaurants, read and write customer reviews and view and upload photos, order food delivery, book a table and make payments while dining out at restaurants. The company wants to build its business across four revenue streams – Food delivery, Dining out, Hyperpure (supplying raw materials to restaurants) and Zomato pro (customer loyalty program). At present, food delivery is the primary contributor to topline. The revenue model here is based on a commission (known as the take rate) that Zomato retains out of the gross order value (GOV) made by a customer to a restaurant on the Zomato platform. In FY21 the company made around ₹62 per order on its platform (excluding delivery charge billed to customer which is fully paid out to delivery partners). Its average order value (AOV), which is basically GOV/number of orders, increased by 37 per cent in Q4FY21 (over Q4 FY20) to ₹395. At the same time its GOV decreased by 15 per cent in FY21 (entire decline cannot be attributed to pandemic/lockdowns as it also resulted in structural shift to ecommerce adoption).

The value proposition for customers from Zomato is that of convenience and variety of offerings, and that for restaurants is discovery and sales . According to consulting company RedSeer, Zomato is one of the leading food services platforms in terms of value of food sold. The company has presence in 525 cities in India and has around 150,000 active food delivery restaurants on its platform.

Financials

Zomato reported operating revenues of ₹1,994 crore in FY21, down by around 23 per cent over FY20. The company attributes the decline to covid related disruption in FY21. However the extent of decline is still of concern, as after the initial lockdown last year and gradual reopening post that, app-based digital platforms saw significant structural benefits as more people embraced digitization. For example US listed food delivery company Door Dash saw its revenues in covid impacted CY2020 grow by 226 per cent. Zomato has been EBITDA and cash flow negative in recent years including FY21. EBITDA margin for FY21 was at negative 15 per cent.

Valuation

While there are many expert opinions on how tech platforms like Zomato must not be valued based on traditional fundamental metrics, valuations do matter for investor returns even in new-age tech companies with large growth potential. For instance, if the most successful ecommerce company of all time – Amazon, which has given CAGR returns of 34 per cent in the last 10 years, was instead trading at 29 times Market cap/sales in 2011, the CAGR returns to its investors would have been just 7 per cent. If UBER was priced at 29 times revenue at the time of its IPO in 2019, 2 year CAGR returns for investors would be a negative 47 per cent. Sure there have been companies like Facebook that listed at around 25 times revenue in 2012 and has given CAGR of 29 per cent since, but then Facebook was cash flow positive and had an adjusted net profit margin of 27 per cent at the time of listing vs Zomato’s negative 25 per cent (adjusted net profit). Even US food delivery peer Door Dash is less expensively priced. Also, the companies mentioned above are market leaders by a big margin versus competitors. Zomato does not have such an advantage, with both Zomato and Swiggy neck to neck in terms of market share (both at 45-50 per cent as per recent report by CLSA). Deep pocketed Amazon is also gradually expanding in this space in India and is a competitive threat to Zomato.

Zomato's cash burn, still unproven path to profitability, competitive threats and frenemy relationship with National Restaurant Association of India are all hurdles in the path of value creation from the IPO pricing level. That the company's preferred route to growth also includes inorganic growth, with acquisitions such as stake in Grofers also enhances execution risks and potential distractions to management from core business.

On multiple facets, Zomato has been a key player in revolutionizing the food industry in India. While it has decent prospects for its business to succeed, value creation for investors in the IPO may hinge on the entry valuation, which is steep.

Investors interested in the stock must look for more clear trends on company’s revenue in coming quarters. This apart, progress in reducing cash burn and clear path to profitability must also be assessed. Increase in GOV and stable to increasing AOV are essential to gain confidence in future profitability. If there is progress on these fronts, a valuation of EV/Revenue (trailing) of around 8-9 times might be levels reasonable enough to enter with a long term perspective.