With E-Commerce firms reaching stratospheric valuations and the day of reckoning arriving sooner than they estimated, I decided to take the plunge and value startups in this 3 part valuation series. Going against the conventional wisdom of "Don't go out looking for trouble, let trouble find you", I will be venturing into the dark space of complexity and uncertainty in the hope of being slightly more right than the next person valuing these companies.
Defining the Industry
Zomato is broadly classified in the food ordering business or essentially a food tech startup. While that is true, it is essentially operating in the online advertising space as 99% of Zomato's revenues come from paid advertising by restaurants. To get a sense of online advertising market in India, I did a google search and got my hands on eMarketer's estimates:
As of 2016, The size of Indian online advertising market was $933 Million (Rs. 59.86 Billion or 12.6% of total media ad spending). Zomato's revenues for FY 2015 are Rs. 788.35 Million which gives it a market share of just 1.32% (bearing in mind that the market is total online advertising market and not specifically restaurant advertising).
4. Acquisition Spree: To break into new markets, The company has acquired 8 companies since 2014 with the most notable of them being the acquisition of Urbanspoon for $55 Million.
1. Revenues:
Given the above inputs along with debt and equity weights of 1.30% and 98.70%, I arrive at a cost of capital of 14.61% for the company.
1. Growth Rate: I have assumed a growth rate in perpetuity equal to the risk free rate i.e. 5.22%
2. Cost of Capital: As Zomato transitions to a stable growth phase, the debt and equity weights will converge to industry average weights of 22.51% and 77.49%. Therefore, the cost of capital will decline from 14.61% to 13.16% in perpetuity. I am also implicitly assuming that the synthetic rating for the company will transition from D to Baa3 in perpetuity (which is the current sovereign rating) as the company starts making money.
Value of Firm and Equity
To come up with valuation for the whole company, I looked at the list of subsidiaries for the company. As per regulatory filings, Zomato has 28 subsidiaries with 100% ownership and 49% in a Joint Venture (Zomato Media WLL). I took the Book Value of each subsidiary and multiplied it by the average sector Price to Book ratio to get a market value. In the case of JV, I took 49% of the Market Value as Zomato owns only 49%. Thus, the market value of subsidiaries is Rs 29145.49 Million.
Adding the value of subsidiaries and cash and liquid assets (Rs 1,772 Million) to Value of operating assets gives the value of equity as Rs 31,350.77 Million. In dollar terms, the value of equity is $470.16 Million.
Bottomline
Defining the Industry
Zomato is broadly classified in the food ordering business or essentially a food tech startup. While that is true, it is essentially operating in the online advertising space as 99% of Zomato's revenues come from paid advertising by restaurants. To get a sense of online advertising market in India, I did a google search and got my hands on eMarketer's estimates:
As of 2016, The size of Indian online advertising market was $933 Million (Rs. 59.86 Billion or 12.6% of total media ad spending). Zomato's revenues for FY 2015 are Rs. 788.35 Million which gives it a market share of just 1.32% (bearing in mind that the market is total online advertising market and not specifically restaurant advertising).
I have summarized my key observations regarding the company and the industry below:
1. High Competition, No Barriers to Entry: Although competitors like FoodPanda, Swiggy are present in the market, they are primarily competing in food ordering and delivering space with Zomato. The bad thing is that nothing stops another firm (Yelp is a strong contender) from entering into the Indian market and competing with the company in the advertising space. Other competitors include online search engines like Google as well social media companies like Facebook and Twitter who derive a substantial portion of revenues from online advertising.
2. Employee Benefit Expenses are a problem: Employee expenses constitute a major portion of expenses which is attributable to what I like to call the "Ivy League Curse" i.e. the curse of hiring only from Top Tier institutions. The problem further aggravates because it brings a Catch 22 for the company: fire employees and get negative publicity and employee morale goes for a toss or capping or reducing existing salaries which reduces employee motivation as well. Either way, economic sense has to prevail over the long term.
3. Low Conversion Rate: 70000 restaurants are listed on Zomato. However, the paid listings are just 6% i.e. only 4200 restaurants actually pay Zomato for listing space. This shows a vast untapped potential but also raises questions about the restaurant owners being motivated enough to actually go for paid listings. Speaking of E-Commerce industry as a whole, it is not easy to raise prices when the next folk doing the same business is ready to lose money (as Flipkart found out ).
4. Acquisition Spree: To break into new markets, The company has acquired 8 companies since 2014 with the most notable of them being the acquisition of Urbanspoon for $55 Million.
5. Market Share is a Zero Sum Game: Inspite of the VC bandwagon, the industry narrative is not going to be "and they all lived happily ever after". Most of the startups never make it and it will be a carnage with only few winners standing tall at the end.
Considering the industry life cycle and company specific factors, My narrative for Zomato is as follows:
Zomato is an online advertising company working in an industry with high competition and low barriers to entry.
Putting down the Numbers
The company isn't making any money, it doesn't plan to make money atleast in the near future. Therefore, I had to use the information that I have and make a crucial judgement call: what will Zomato be like 10 years down the line?
To get some perspective of competition, I looked at the market share of largest players by revenue:
Clearly, Google accounts for more than two-thirds of the online advertising market in India followed by Justdial. Facebook and Twitter alongwith Zomato have less than 5% of the current market. With online advertising being Google's strong suite, I don't see it losing market share to the smaller players. I believe the rest of the positions in the Top 5 will be up for grabs.
To get some perspective of competition, I looked at the market share of largest players by revenue:
Clearly, Google accounts for more than two-thirds of the online advertising market in India followed by Justdial. Facebook and Twitter alongwith Zomato have less than 5% of the current market. With online advertising being Google's strong suite, I don't see it losing market share to the smaller players. I believe the rest of the positions in the Top 5 will be up for grabs.
1. Revenues:
I assume that total Indian advertising market to be worth $17.37 Billion in 10 years from now. Furthermore, Drawing on insights from developed markets like the US, I assume that the digital advertising spending to grow as a proportion of total advertising spending and will be 30% in 10 years i.e. Rs 334 Billion.
To come up with Zomato's revenues, I set them a target revenue of Rs 33.4 Billion in year 10, which means I am assuming a 10% market share for the company in Year 10. I am implicitly assuming that Zomato will be able to carve out a niche in the online advertising market i.e. restaurant advertising.
2. Margins:
The company currently has an operating margin of -78.88% (adjusted for operating leases). If the company has to survive, it has to start making money atleast sometime in the future. I have assumed a pre-tax margin of 12.04% in Year 10, which is the average operating margin for advertising firms globally. With Venture Capitalist's patience running thin, Zomato will have to focus on margins sooner than later.
3.Reinvestment:
I have assumed a sales to capital ratio of 3.28 to come up with my reinvestment numbers i.e. the average sales to capital ratio for advertising firms globally. Given my reinvestment assumption, the implied ROIC for the company in year 10 is 17.62%.
4. Cost of Capital
4. Cost of Capital
Cost of Debt
Risk free rate+Company default spread+Country default spread
= 5.22%+ 12.00%+ 2.44% = 19.66%
After Tax Cost of Debt = 19.66%*(1-33.99%) = 12.98%
Cost of Equity
Risk free rate+ beta* ( Equity risk premium )
ERP = implied mature market premium + country risk premium
= 5.44%+0.95* ( 6.48%+ 3.40% ) = 14.63%
Given the above inputs along with debt and equity weights of 1.30% and 98.70%, I arrive at a cost of capital of 14.61% for the company.
Stable Growth Assumptions
2. Cost of Capital: As Zomato transitions to a stable growth phase, the debt and equity weights will converge to industry average weights of 22.51% and 77.49%. Therefore, the cost of capital will decline from 14.61% to 13.16% in perpetuity. I am also implicitly assuming that the synthetic rating for the company will transition from D to Baa3 in perpetuity (which is the current sovereign rating) as the company starts making money.
Value of Firm and Equity
Discounting the future cash flows at the cost of capital gives a firm value of Rs 499.76 Million (Value of operating assets). Subtracting out the debt of Rs 67 Million, I arrive at a value of equity of Rs 432.6 Million. This is the value of Zomato's India Operations as I have used standalone numbers all along.
Adding the value of subsidiaries and cash and liquid assets (Rs 1,772 Million) to Value of operating assets gives the value of equity as Rs 31,350.77 Million. In dollar terms, the value of equity is $470.16 Million.
What if?
To account for variations in my assumptions, I used the following sensitivity tools:
1. Scenario Analysis
I use three scenarios: Base Case, Optimistic and Pessimistic to capture changes in key variations and subsequent effects on value:
Given my assumptions of these 3 scenarios, the value of the company can either be $437 Million, $470 Million or $523 Million. Here is the bad news: In none of the scenarios, the value even comes close to a billion dollars! Given my assumptions and narrative, I find it hard to believe that the company is, in VC parlance, a Unicorn.
2.Monte Carlo Simulation
I use simulation to capture variation in my assumption about operating margins, I use a triangular distribution for the same. After 1,000,000 simulations, the average value of equity is Rs 31,344.74 Million and at a 95% confidence interval, the range is from Rs 26,929.18 Million to Rs 35,675.94 Million i.e. $403 Million to $535 Million.
Bottomline
Given the company's nature of business and my narrative, It is hard to buy into the Unicorn argument. The real question will be how does Zomato solve the margin problem? I will not be surprised if in a couple of years down the line the firm is acquired by bigger players like Google or a possible new entrant in the market (Yelp) and gets priced on the basis of number of users. However, The road of increasing value would indeed be a treacherous one. In other words, "Winter is Coming".
Valuation Model Link
Note: Please do not consider any content on this blog as an investment recommendation or advice. At the time of posting of this article, I do not have any financial interest in the company being analyzed. The views contained in this blog are my personal views.
Valuation Model Link
Note: Please do not consider any content on this blog as an investment recommendation or advice. At the time of posting of this article, I do not have any financial interest in the company being analyzed. The views contained in this blog are my personal views.
