Zomato: Zomato a no-brainer for a long-term investor, but a challenge for short-term investors: Abhay Agarwal
The Zomato IPO will be tricky isn’t it?
We have been looking at companies that are using digital technology, digital models and Zomato is right at the forefront of technology meeting in consumer space. It is a name that everybody is very familiar with. Unlike some of the other names which are more in financial services like CDSL and Angel Broking which have done extremely well. Zomato is a consumer product company and the more we look at it, the more we believe it will reward the long-term shareholders. But anybody who is looking at a quick flip or a quick bet may get some money but since the IPO is not really cheap in terms of valuations though the market size is very large, we are looking at a very broad target market which is valued at close to $250 billion.
If you take half the food consumption market in India, then Zomato and Swiggy are just scratching the surface there. If a five-year view is taken and if you believe that as an investor, Indian consumption habits will change with millennials and GenZ ordering more and spending more on digital platforms then Zomato looks like a no brainer for a long term investor. But for the short term investor, it may be a challenge.
On one side, there is the argument that Zomato is not making profit right now and is burning cash and on the other side, there is the talk of the runway of growth and the terminal value of these kinds of companies. You have analysed some of the other successful business models globally. What is your view?
The company is making losses and that is why it is very difficult for investors to get an answer on it using the traditional valuation matrix. At the same time, these are tech services businesses that write off their entire investment. They do not invest in plants and machineries. A manufacturing company would be depreciating its plant and machinery over 15-20 years and showing a PAT. Here you are writing off every investment that you make pretty much in the same year. So the PAT looks negative. But it is more of an optical thing and the flip side is that with no big depreciation in future years and as the gross order value increases, the average order value (AOV) increases, the number of users increases the company will become tremendously profitable and we have seen that.
I do not want to compare exact names but companies like Facebook or even Twitter now or some of the other global giants all became profitably very fast once they hit a certain size and that is where the target market size allows Zomato to grow over the next five years because its earnings are driven by three matrix — one is the number of active users; the second is how many times in a month do they order and the third thing is average order value. If these three things grow together or even two of them grow together, then we are looking at an exponential growth in the top line. A large part of that top line will flow into the bottom line because the cost structure is such that assuming a standard tech rate of about 20% and limited cost you become very profitable suddenly. So as a long-term investor, I would look at that and some of these companies like Doordash Grubhub. Even in China, the closet proxy is Meituan-Dianping. They are valued high because they have shown the growth path they can get into.
A lot of people do not believe yet that in India also, it is possible. We believe that with a median age of 29 years, the youngest population in the world, we are headed in that direction. I do not think the next generation is going to cook 90% of their meals at home. As these things change, profitability will kick in and taking a long term view we see Zomato at par with any global company in the same space.
How does the unit economics really work? Since the earnings are not there, does the growth which the companies are clocking in terms of acquisition of customers indicate the kind of returns or how does one gauge the potential returns over five-seven years?
You asked about unit economics and that is a good way to look at it on a minute basis. The earnings are driven by average order value (AOV) and the AOV of the company has gone up in Covid time because lesser number of people were ordering larger ticket sizes. The AOV which used to be around Rs 240 jumped to almost Rs 400 as of March 21 and the number of users came down.
The AOV is a very important number because it allows the company to earn the commission. The take rate of 22% which the company makes, is linked to the average order value. The higher the average order value, assuming the same take rate, the company makes more money per order. Right now, the revenue for the company from Rs 400 AOV is about Rs 90. Now that Rs 90 covers the cost of delivery. As you do more and more deliveries, the cost per delivery comes down.
We have seen cost per delivery fall from Rs 65 to about Rs 48 and as they do more and more deliveries, that cost will come down further. Then the revenue per order also covers the discounts that other than the partner restaurants Zomato itself gives. In Covid time, they really brought down the discounts from Rs 20 odd to Rs 8.
The third thing is the variable cost which are the marketing expenses. For the first time, Zomato showed an order level contribution of Rs 20 per order. Now whether this will sustain or the AOV will come down as the market opens up and more people order, go back to office and start ordering cheaper meals because the delivery cost being the same, there is a school of thought that says if AOV comes down, then the company will start losing money per order.
That may happen in the short term but in other countries, we have seen that the order value is quite sticky. Once it goes up, people order more and more rather than less and less. With the five-year view you have to also build in the food price inflation. There is a normal escalation of order value that goes up. Plus, Zomato has only 148,000 restaurants in its network, which is the lowest in the world. I will compare that to China’s Meituan-Dianping which has 68 lakh restaurants. Assuming that we keep moving in the same direction, in 5 to 7 years’ time, Zomato will quadruple its gross order value.
If gross order value goes up from Rs 12,000 crore to 60,000 crore, the company will be making a very reasonable amount of profit on that. Once you take that perspective backwards and this business also has a very high terminal value, even if you stop at 5 year or 7 years or 10 years beyond that, the terminal value is still very high. So even if you do a discounted cash flow (DCF) calculation backwards, the opportunity looks pretty sizable.
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