Yesterday, I was looking at one of the research reports of Zomato prepared by IIFL, shared by a dear friend.
In consumer tech-driven companies like this one, one feature which stands out is capital intensity – cost of market entry is so high that even market leaders lose money for several years before eventually turning profitable, if at all. This presents a bit of a dilemma for the typical market investor as his/her standard proxy tools, viz. Net Profits, Free cash flow per share become irrelevant since these would remain non-existent for several years in a row, may not come by as well!!
This is where innovative investors turn to new proxies like Gross Merchandise Value (GMV), EBITDA, Average Order Value (AOV), Revenue per order (ROV) and EBITDAM (M represents marketing – Do you really believe marketing costs will go away?) and tie it back to the standard valuation tools – and voila, you can rationalize your investments!!
While some of these tech-driven companies would achieve economies of scale and may eventually become profitable, however there are inherent risks in the variables being considered.
# First is the “symmetry risk”, which stems from the fact that the not all variables are considered equal. The only comparable variable in the true sense is cash flows. After all, even Being profitable is hardly the evidence of a good business.
The moment you compare proxy variables like GMV, AOV, ROV, EBITDA, EBITDAM, the likelihood of comparing apples to apples diminishes. Can you compare negative EBITDA of Zomato for the year ended March 2020 of -84% with UBER which showed a negative EBITDA margin of -70%?
What about Interest, Taxes, Depreciation and Amortization expenses? UBER by the way had a consolidated debt of USD 5.7 billion as of December 2019. How would it pay the I, D, T & A, viz. Interest, Taxes, Depreciation and Amortization?
Zomato’s EBITDA is being assumed to grow from current -84% in 2020 to a positive 25% by 2030, with assumptions like Revenue growing at a CAGR of 27% YoY over the next 10 years, Fixed costs as a % of revenue dropping from 90% in FY2019 to 21% by FY2030, Zomato Pro growing at an exponential rate of 45% CAGR over the next 5 years, Management executing the business flawlessly, no more pandemics/pandemic like situations occurring, duopoly playing out in favour of Zomato.
# This is where second risk, i.e., Assumption risk comes into play. After proxy valuations begin to stick, we begin to treat them as fact. For instance, we might divide companies’ market capitalization by its customer base and decide that a customer is worth $X, or AOV would increase continuously. However, we should relook at the cash flows that are likely to come from that customer and then determine if the overall valuation makes sense. With assumptions of Zomato’s weighted average cost of capital (WACC) of 13%, the overall food-tech space poised to grow exponentially, Zomato could be valued at USD 7 billion, according to the IIFL report, while it has already achieved a unicorn status.
Becoming too comfortable with the proxy and its assumptions can be dangerous. After all, someone has rightly said:
Revenue is Vanity; Profit is Sanity; Cash Flow is Reality
Eye opener basic facts.
I don’t think this company will ever show positive bottom line.
Hi Vikash, Good post. I agree completely that these businesses have high optional value. Investing in them is either playing the greater fool theory or betting in a casino. We don’t know whether they will survive long enough to be cash flow accretive. Investors who depend on cash flows should be prepared to sit aside and watch these opportunities pass by without getting consumed by greed.
Or perhaps the world of business and investing is changing, old paradigm no longer applies to the new-age businesses, we don’t know what the future holds and what kind of businesses will thrive in the future.
We dont know what the future holds.