Nykaa has been in the news in recent times for not so good reasons. That the shares have got pummelled from India’s own dotcom bubble type frenzy for stock like Nykaa is just one part of it. What has also caught attention is the issue of bonus shares by Nykaa closer to lock-in expiry for certain large investors and when stock is trading closer to all-time lows. This has raised concerns on corporate governance at Nykaa, making many wonder whether this was just a plain attempt to ‘manage the stock price.’ While bonus shares and stock splits add zero fundamental value to a stock, they play their part in positively influencing near-term share price movements for various reasons. This ideally should not be the focus of a management trying to create long-term value for shareholders, and hence reflects poorly on Nykaa.
With Nykaa now trading close to its IPO price of ₹187.50 (adjusted for bonus issue) a year on, and 55 per cent below its peak price of ₹428.95, it might be tempting for investors to give the stock a second chance. Especially if one felt they had missed this bus, considering the fact that the IPO was oversubscribed a massive 81 times. However, the case to stay away from the stock remains intact for reasons mentioned below.
Growth at a cost
Nykaa offers customers a diverse portfolio of beauty and personal care products (BPC), and fashion products via its online and offline platforms. While it is primarily a digital native e-commerce company with majority of revenue from its online platform, it is building its business around providing customers an omnichannel experience (online and physical format stores).
BPC is still the main segment, accounting for around 87 per cent of revenue. Fashion and other minor segments account for the rest. BPC segment functions on full-fledged retail model i.e. it sources, buys/manages inventory and sells products. Fashion segment functions more on the lines of a market place model, directly linking sellers with buyers via its platform, for which it gets a commission on products sold.
The company has also been expanding its portfolio with its own branded products (better margins) in both BPC and Fashion. It has also been investing in physical store formats to provide a more seamless experience for customers. Further, it has been tying up with partners to take its business to international locations. Some of these new initiatives, however interesting they might be, are small to make an impact for now.
In recent times, the company has delivered quite well in terms of revenue growth. In FY22, revenue grew by 55 per cent to ₹3,774 crore and in Q2 FY23 it grew 39 per cent Y-o-Y to ₹1,230 crore. Some of the underlying metrics too were quit good, with customers for its BPC business growing by 31 per cent and showing good momentum.
This growth has, however, not translated into better returns at the bottom line. A ₹1,334 crore increase in revenue in FY22, translated into a net profit decline by ₹20 crore to ₹41 crore in this period.
Similarly in Q2 FY23, a ₹345-crore increase in revenue resulted in a mere ₹4 crore increase in net profit to ₹5.2 crore. While company saw Y-o-Y improvement in EBITDA margin to 5 per cent (vs 3 per cent a year ago), gains were given up in below-the-line costs in terms of higher depreciation, interest and amortisation expenses incurred to expand fulfilment warehouses and physical retail stores.
While an argument can be made that these are investments for growth, the counter to this is that what will be the actual growth when these investments taper off? There is high probability that growth, while it can remain good, will taper post investment phase as seen from the experience of e-commerce companies globally.
Valuation
A core inherent aspect of retail business is that it is a low-margin business. The largest e-commerce retailer in the world, Amazon, operates with EBIT margin (e-commerce business alone; excludes AWS/cloud computing business) of just 2-3 per cent. If companies with such high scale and volumes have EBIT/PAT margin in the low single digits, it is hard to justify any substantially higher margin for Nykaa in the future.
Even if one assumes a highly optimistic scenario of Nykaa repeating its FY22 revenue growth of 39 per cent for the next three years upto FY25, and is able to scale up its PAT margin from current 0.4 to 4 per cent (quite a challenging task), it implies that it is today trading at an unpalatable PE of around 135 times FY25 EPS. It also needs to be noted that this growth and profitability has to be achieved in the midst of competition. Thus, at current levels, a lot of optimism is baked in, while leaving no margin of safety for risks that can play out. While Nykaa meeting or beating optimistic expectations is not impossible, the risk vs reward is unfavourable at this valuation.
