A Zomato 2022 Update: Value, Pricing and the Gap

 On July 21, 2021, I valued Zomato just ahead of its initial public offering at about ₹41 per share. The market clearly had a very different view, as the stock premiered at ₹74  per share and soared into the stratosphere, peaking at ₹169
per share in late 2021. The last few months have been rocky, as the
price has been marked down, partly in response to disappointing results
from the company, and partly because of macro developments. At close of
trading on July 26, 2022, the stock was trading at ₹41.65
per share, and the mood and momentum that worked in its favor for most
of 2021 had turned against the company. In this post, I will begin with a
quick review of my 2021 valuation, then move on to the price action in
2021 and 2022 and then update my valuation to reflect the company’s
current numbers. 

My IPO Valuation

I
valued Zomato, soon after it filed its prospectus for its initial
public offering, in July 2021. The details of that valuation are in this post,
but to cut a long story short, I argued that an investment on Zomato
was a joint bet on India (that economic growth would bring more
discretionary income to its people), on Indian eating habits (that
Indians would eat out at restaurants more than they have in the past)
and on the company (that its business model and first move advantages
would give it a dominant market share of the food delivery market). I
summarized my valuation in a picture:

I
valued the company at close to ₹41, and note that this valuation
incorporates the proceeds from the IPO and adjusts the share count for
the offering. I argued then that notwithstanding the potential growth in
the market, and Zomato’s advantageous positioning, it was being over
priced for its IPO, at ₹76 per share.

In
response to the pushback that I got from those who disagreed with my
valuation, with half arguing that I was being way too optimistic about
the future and the other half that I was ignoring the potential for
growth overseas and in new businesses, I followed up with a second post, where I let readers choose their own story line for Zomato, and came up with a table that linked stories to values:

Using
my test of whether a valuation story is possible (the weakest test),
plausible (a stronger test) and probable (the acid test), I posited that
you could justify a value per share for Zomato of ₹40 – ₹50,
per share, with plausible stories, but that valuations that were much
higher required pushing the limits of plausible narratives. 

The Pricing Game

One
reason that I enjoy valuing a company just ahead of its market debut is
that there is no market price to bias your analysis; in my experience,
the market price operates as magnet, drawing intrinsic valuations
towards it. The downside is that without a market price acting as an
anchor, your valuations can easily come unmoored from reality. No matter
what, having a valuation in hand makes the first day of trading much
more interesting, as you wait for the market to pass its own judgment on
the stock’s pricing, though that judgment reflects more a pricing game
than a value estimate.

Staying with
the theme that it is demand and supply, mood and momentum that determine
what happens to a company’s stock in  first few months of trading, the
buzz that accompanied Zomato’s listing and its standing as one of the
first new age Indian companies to go public, spilled over into the first
day of trading, as the stock soared 51% over its offering price of ₹76, and rose as high as ₹137
during the trading day. That opening day glow lasted for the rest of
2021, abetted by easy access to risk capital, and the stock maintained
its lofty pricing. If you are tempted to attribute the price performance
to good news from the company, its earnings reports continued to report
escalating losses and one of its co-founders quit in September 2021. 

Updating the fundamentals

Though some have suggested
that price dropping to my value is vindication of my valuation, I am
not part of that group for three reasons. First, it seems skewed to
celebrate only your successes and not your failures, and it behooves me
to let you know that I also valued Paytm at close to ₹2000 per share, and the stock is currently trading at ₹713. Second, even if nothing in my valuation has changed, the value per share of ₹41
per share was as of July 2021, and if it is a fair assessment, the
expected intrinsic value per share in July 2022 should be roughly 11.5%
higher (i.e., grow at the cost of equity), yielding about ₹46 in
July 2022. Finally, the company and the market have changed in the year
since I last valued it, and to make a fair judgment today, the company
will have to be revalued.

Company Fundamentals

In
the year since my IPO valuation, there have been four quarterly reports
from the company, in addition to news stories about governance and the
company’s legal challenges,  and there is a mix of good and bad news in
them. 

    On the good news front,
the food delivery market in India has continued to grow over the last
year, and Zomato has been able to maintain its market share. In fact,
there are signs that the market is consolidating with Zomato and Swiggy
controlling 90% of the market share of restaurant deliveries. As a
consequence, Zomato’s gross order value and revenues have both jumped
over the course of the last year:

In
addition, the substantial cash that Zomato raised on its IPO is
providing it with a cash and liquidity cushion, with cash and short term
investments jumping from ₹15,000 in March 2021 to ₹68746
(including short term investments) in March 2022. Since Zomato is a
young, money-losing company, and the likelihood of failure acts as a
drag on value, this will benefit the company, since it provides not only
a cushion for the firm but also eliminates dependence on external
capital for the next few years.

    On the bad news front, the take rate, i.e., the slice of gross order value (GOV) that Zomato keeps has dropped substantially over the last year,
reflecting increased competition in the market, higher delivery costs
and Zomato’s entry into newer markets (like grocery delivery) with lower
revenue sharing. In addition, the growth has come in fits and starts,
and given Zomato’s active acquisition strategy, it is not clear how much
of the revenue growth is organic and how much is acquired. Not
surprisingly, the company’s losses have ballooned over the last year:

    On the still-to-be-decided front,
Zomato has continued on a strategy of acquiring small companies to
advance its growth agenda, and while many of these acquisitions have
been small, its most recent acquisition of Blinkit has raised questions
about whether this growth is coming at a reasonable cost. (Again, the
contention from management that this is a capital-light company that
growth with little investment is not true, since these acquisitions are
its true cap ex, making it a capital intensive firm.)  The potential conflicts of interest in this acquisition,
with a Zomato co-founder’s spouse operating as the CEO of Blinkit, also
add to the questions. Even if the Blinkit acquisition pans out, it is
an open question whether Zomato can continue to deliver growth
effectively and efficiently through this acquisition-driven strategy,
using its own shares as currency, especially as it scales up. In
addition, Zomato is also building a portfolio of equity positions, which
do not show up as part of operating assets, and the founders
rationalize this behavior by arguing that these are “the building blocks
for a robust quick-commerce business in India, and will accelerate
digitisation and growth of  the food and restaurant industry which
accelerates our core food business ” (from the 2022 Q4 shareholder discussion).
Even if we accept this argument for minority holdings, it will add to
the complexity in the firm and make investors and traders more wary,
especially in periods of uncertainty.

The Macro Factors

    When
I valued Zomato in July 2021, the markets (in India and globally) were
in the midst of a boom, with abundant supply of risk capital and
optimism about economic growth, pushing up the prices of tech companies,
generally, and the youngest, most money-losing tech companies,
specifically. Those circumstances no longer hold, with two big
developments in global markets, both of which I have talked about in
previous posts

1. Inflation returns: Inflation is back in almost every part of the globe, and has unsettled markets. In this post, from May 2022,
   I noted that financial assets (stocks, bonds) lose value when inflation
   is higher than expected, and that a decade of low and stable inflation
   has left investors exposed and vulnerable. The effects of inflation show
   up first as higher risk free rates, across currencies, and next in higher risk premiums, with both equity risk premiums and default spreads rising. In a follow-up post a couple of weeks later,
   I looked inflation’s effects on individual companies and argued that
   less-risky companies with pricing power and high gross margins would be
   less exposed than riskier, money-losing companies. (I will leave it to
   you to judge where Zomato falls on this continuum.)
2. Risk Capital flees: In a post at the start of this month,
   I looked at how the retreat of risk capital, i.e., capital invested in
   the riskiest assets (from venture capital invested in start ups to
   investments in the riskiest collectibles) was playing out in higher
   equity risk premiums in mature markets, and in a later post a few days
   later, even bigger increases in equity risk premiums in emerging markets. As a company with the bulk of its business in India, Zomato again is more exposed to these developments.

A
higher equity risk premium for India (9.08% in July 2022, compared to
6.85% in July 2021) and a higher riskfree rate in rupees (4.78% in July
2022, compared to 4.25% in July 2021) conspire to push up the cost of
capital for Zomato (and other Indian companies) by about 1.5-2% from my
IPO valuation.

A Zomato Revaluation

Incorporating
the updated financials for Zomato (with the doubling of revenues in
conjunction with larger operating losses) and the higher cost of
capital, from macro developments, I revalued Zomato on July 26, 2022:

Download spreadsheet with valuation (and DIY)

Note
that my core story for the company has not changed, but its Blinkit
acquisition suggests that Zomato is planning a substantial foray into
the grocery delivery business (pushing up the total market size
currently and in the future), albeit at the expense of a smaller slice
of revenues and a smaller market share. The value per share has dropped
from ₹40.79 to ₹35.32
per share, with much of the value change from last year is coming from
macroeconomic developments, manifested in a higher cost of capital. For
this value to be generated, the company will need to stop paying lip
service to contribution margins and adjusted EBITDA, and work on
reducing growth in its cost of goods sold.

An Action Plan

    So,
what now? As with my valuation last year, let me emphasize that this is
not the valuation of Zomato, but is my valuation and it will inform my
decisions on the company. I have a story for Zomato, and valuation
inputs that reflect that story, but I could be wrong on both fronts, and
as I did last year, I tried to capture these uncertainties in a Monte
Carlo simulation:

Oracle Crystal Ball used for simulations

Allowing
for the wide ranges of estimates that you can have on the total market
for food (restaurant and grocery) delivery in India in 2032 and the
uncertainties about Zomato’s share of that market and its operating
margins, you get a range of values. The median value of ₹34.12 is close to the base case value of ₹35.32, not surprising since the input distributions were centered on my base case input values, and at its current stock price (₹41.65
on July 26), the stock is still at the 70th percentile. That said a few
more weeks like the last two will push the price below my median value,
and if it does, I would buy Zomato, as part of a diversified portfolio
(and not as a stand alone investment).