Startup Mania Part 1: Valuing Zomato

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).

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.

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

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

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

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.

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.

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.

Valuing an IT company: Mindtree

It's been a while since my last post. Hopefully, I will be more prompt in the future. I decided to pick an IT company for valuation and zeroed in on Mindtree (A random pick. No hidden intellectual curiosity here). I know very little about the company which will reduce if not eliminate my biases in the valuation.

Setting up the Narrative

To be honest, I am no expert on the IT industry. To get a better understanding of the industry, I referred to various sources on the internet. I made the following observations:

1. High Competition - The industry is characterized by high competition as most of the big IT firms are global players. There are no significant barriers to entry as well. Moreover, The IT companies already command a 55% market share in the global outsourcing business according to NASSCOM. Going forward, It will be difficult for the industry as a whole to grab more chunk of the outsourcing business.

2. Diminishing Competitive Advantages- High competition will lead to lower pricing power and put pressure on the margins. Although the average industry operating margins are between 20-25%, I believe that these will begin to decline as labor arbitrage which is a leading competitive advantage of Indian IT industry gradually starts to dry out.

3.Country Risk Exposure- Most Indian IT companies earn a significant portion of their revenues outside India. Thus, they are essentially global corporations which are incorporated in India but have more exposure to country risk of geographies from which they derive their revenues. In the case of Mindtree, 87% of its revenues come from US and Europe.

Incorporating these observations and comparing Mindtree with the competition, My narrative for Mindtree is as follows:

Mindtree is an efficient IT company incorporated in India which primarily derives its revenues from US and Europe. The growth of the company will be constrained due to high competition and diminishing pricing power of the industry in which it operates.

The Number Crunching ( Valuation Model link)

1. Estimating Free Cash Flow to Firm

When I started this valuation, Mindtree had just released their Q2 earnings (I got lucky. Mindtree has a 100% stake in all its subsidiaries. So I took the consolidated numbers without any trouble) . Thus, I updated my annual revenue, depreciation and operating income numbers to Trailing Twelve month numbers. I also had to convert operating leases to debt as these are essentially contractual commitments. Thus, my after tax  operating income after operating lease adjustment is Rs. 7,533.74 Million. Subtracting out the Capex of Rs 3,501 Million and Working Capital of Rs 941 Million, I arrive at FCFF of Rs 2,284 Million.

 

The Capex figure also includes an average price for acquisitions paid by the company. Since acquisitions are an expenditure today to derive benefits in the future, I treat them as Capex and take a normalized number as Mindtree does acquisitions intermittently. ( I couldn't take information for all the acquisitions they have done as the price was not disclosed in some transactions) 

 

Growth Rate in Operating Income and Growth Period

I computed the fundamental growth rate in operating income i.e. a function of how much and how efficiently Mindtree reinvests. With a reinvestment rate of 60% and non-cash ROCE of 31%, the growth rate in operating income is 18.6%.

I use a three stage FCFF model for the company. The high growth period is for 5 years. Although I believe that the competitive advatanges of IT industry in India are fading, I expect them to do so gradually and not overnight.

2. Estimating Cost of Capital 

 

Cost of Debt

 

Cost of Debt- Risk free rate+Company default spread+Country default spread

                    = 5.44%+ 0.70%+ 2.20% = 8.34%

 After Tax Cost of Debt = 8.34%*(1-33.99%) = 5.51%

The risk free rate is arrived at after subtracting out the default spread of 2.20% from the 10 year G sec. Mindtree has a rating of AA, which further entails a spread of 0.70%. Adding on the country default spread of 2.20% (corresponding spread for Baa3 rating, which is the current rating for India), the cost of debt is 8.34% .

Cost of Equity

Cost of Equity- Risk free rate+ beta* ( Equity risk premium ) 

 ERP = implied mature market premium + country risk premium

                      = 5.44%+0.92* ( 6.19%+ 1.40% ) = 12.42%

I derive the cost of equity using CAPM.  I use Aswath Damodaran's global average unlevered beta for computer services firms and adjust it for financial leverage to come up with a beta for 0.92 (Since the D/E is just 1%, the unlevered and levered beta remain the same). The implied equity risk premium for the US is 6.19%. For the country risk premium, I used a location based CRP. Since Mindtree's revenues come from geographies across the globe, I take a weighted average of CRP's across geographies wherein my weights are the TTM  revenues that the company obtains from each location.

Debt and Equity Weights

The debt and equity weights are 1% and 99%. The 1% debt weight is a result of converting operating leases to debt even though it has alomost no debt on the balance sheet.

Thus, my cost of capital for the high growth phase is 12.37%.

Stable growth assumptions

I assume that the firm will enter into stable growth in Year 10. My assumptions for stable growth period are as follows:

1. Growth Rate: I assume that the growth rate for the firm in perpetuity will be equal to the risk free rate of 5.44%.

2. Cost of Capital: The beta for the stock is 0.92. The debt and equity weights will converge to industry average weights of 16.07% and 83.93%. Therefore, my cost of capital in perpetuity is 11.31%.

3. Return on Capital: I have assumed a ROCE of 16.31%. I expect Mindtree to generate an excess return in perpetuity as the business in which they operate has an average spread of 15% between return of capital and cost of capital globally. Since I believe they will not be a major player in the market, I give them an excess return of only 5%. I am also assuming that the dwindling competitive advantage of labor arbitrage in India will also get offset by cost advantages in other geographies (Philippines and Poland are fast becoming favorable outsourcing destinations). However, I am pretty unsure about this number and do try to bring in that uncertainty in the Monte Carlo simulation .

Estimating Value of Firm and Equity

Discounting the free cash flows for the next 10 years gives a firm value of Rs 1,07,194 Million. Subtracting out the debt of Rs 806 Million and adding on the cash and liquid investments of Rs 4,834 Million gives the free cash flow to equity holders of Rs 1,11,222 Million. Dividing by number of shares outstanding of 83.83 Million, the value per share is Rs 1326.76.

Factoring in the uncertainty

1. Market Implied Variables: Using Goal Seek, I set my value equal to the market price and backed out two key drivers of my valuation i.e. fundamental growth rate in the high growth phase and the ROCE in perpetuity. The market implied fundamental growth rate is 20.90% and ROCE in perpetuity is 24.22%. Although I believe that growth rate of 20.90% is plausible, I believe that implied ROCE is too high in perpetuity as growing competition will bring that number down.

2. Monte Carlo Simulation: To factor in changes in my assumptions, I did a Monte Carlo simulation wherein I gave a uniform distribution to the growth rate in high growth phase and a triangular distribution to ROCE in perpetuity. After 1,000,000 trials, the median value per share is Rs. 1350.53.

Bottom line 

Given my narrative and numbers, Mindtree is overvalued. I will be looking forward to the next earnings report for revaluing Mindtree again and to check for any changes in my narrative.

Valuation Model Link

Pre IPO Valuation of Indigo: Time to be an Air-aholic?

Finally, the most awaited IPO in the Indian aviation industry was filed on 30th June 2015. Interglobe Aviation Limited plans to raise at least $400 million from the offering, giving the company a value of around $4 billion (according to media reports citing bankers ). I was curious as to how much the company was worth ( hence the freak part in valuation freak ) and decided to estimate the value of  the firm bearing in mind that the $4 billion value estimated by the investment bankers would be more of pricing rather than a valuation.

The Discounted Cash Flow Valuation:
Any Discounted Cash Flow Valuation can be broken down into four parts:

1. Estimating Expected Cash Flows
2. Estimating the Growth Rate in those cash flows
3. How risky are the cash flows? ( The discount rate )
4.When does the firm achieve Stable growth? ( Terminal Value )

Estimating Expected Cash Flows 

Building the Narrative
Before estimating cash flows, I tried to get a sense of the global airline industry. And it is not pretty. Globally, airlines have been consistently been generating returns below their cost of capital. According to a Mckinsey study for International Air Transport Association,Since 2000 the Return on Capital of the industry has been consistently below its Cost of Capital, thus consistently destroying value.

The Indian Airline industry fares worse then the Global airline industry. However, Indigo Airlines has been able to buck this trend. Being the only Indian airline company to consistently deliver positive earnings year and year, Indigo airlines has been able to enhance value by leveraging on suppliers for sweeter deals and ensuring low maintenance costs. Thus, my narrative for Indigo airlines is as follows:

Indigo is a highly efficient, young low cost carrier operating in the Indian Airline industry. A high market share and rising competition will make it difficult for the company to sustain high growth for a longer period. Being in a business where it is difficult to generate excess returns, Indigo would only be able to cover its costs in perpetuity.

Estimating Free Cash Flow to the Firm
I use a normalized operating margin to come up with the operating income for the base year. Since airline margins are highly correlated with oil prices, a normalized margin averages out this cost volatility. I also have to adjust the operating income for operating lease adjustment ( by converting operating leases to debt.). Thus, my adjusted after tax operating income for the base year is Rs. 14039 Million. Subtracting out Net Capex ( Capex- Depreciation ) of Rs. 8057 Million and Net Working Capital of Rs.7664 Million, I arrive at a negative FCFF of  Rs. 1683 Million for the base year.

Estimating Growth Rate and Growth Period
I use the fundamental growth rate to come up for the growth rate in operating income i.e.

Fundamental Growth Rate in Operating Income =  Reinvestment Rate * Non Cash ROC

The computed Reinvestment Rate as of 31st Dec 2014 is 111.9% which is (Net Capex+ Net Working Capital) as a percentage of after tax operating income. The Non Cash Return on Capital Employed as of 31st Dec 2014 is 24.59%. A high reinvestment rate and a high ROC enable the company to have a growth rate of 27.54% for the high growth period.

Length of High Growth Period 

Since Indigo is in the growth phase of its life cycle, I use a Three Stage FCFF Model. The length of the high growth phase is taken to be 3 years. I am implicitly assuming that Indigo's highest market share of 32% and increasing competition by new entrants in the market like AirAsia and Tata Vistara will make it difficult for the company to grow at such a fast pace in the future. I am also factoring in the increasing price wars in the Indian airline industry which will result in higher revenues but will put pressure on the margins. After 3 years, I assume that the growth rate would linearly decline to the economy growth rate of 5.60% in perpetuity.

Cost of Capital
My cost of capital for the high growth phase is 9.29%. The components of cost of capital are as follows:
 

Cost of Debt- Risk free rate+Company default spread+Country default spread
                    = 5.60%+ 1.20%+ 2.20% = 9.00%
 After Tax Cost of Debt = 9.00%*(1-33.99%) = 5.94%

The risk free rate is arrived by subtracting the default spread of 2.20% ( the spread for Baa3 rating which is the current local currency debt rating for India ) embedded in the 10 year G sec yield on the day of this valuation i.e. 7.80%. The company default spread is 1.20% on account of synthetic rating of A- which I compute using Aswath Damodaran's synthetic rating table. 

Market Weight for Debt- The Book Value of Debt as per the balance sheet is Rs. 40028 Million. To come up with a total debt number, I convert operating leases to debt as these are essentially contractual obligations. Converting the operating leases at a pre-tax cost of debt gives me a total debt value of Rs 75465 Million. I subtract out the Rs 11656 Million, the amount by which the company plans to reduce its debt through the IPO offering to arrive at a debt value of Rs 63809 million.

Cost of Equity- Risk free rate+ beta* ( Equity risk premium ) 

 ERP = implied mature market premium + country risk premium

                      = 5.60%+1.30* ( 5.81%+ 3.43% ) = 17.61%

I use CAPM to estimate the required return for stockholders. To come up with a levered beta for Indigo, I use a bottom up beta of 0.64 which is the global average unlevered beta of airline firms. I then relever the beta by the market D/E of 1.56 to get a levered beta of 1.30. For the ERP, I compute an implied equity risk premium for the US which is 5.81%. I add a country risk premium component for India of 3.43% ( CRP= country default spread * (Standard deviation of Indian Equities/ Standard deviation of Indian bonds ). Thus, my equity risk premium for India is 9.25%.

Market Weights for Equity
Coming up with a market value of equity was the tricky part. I used some patch work here. Across news stories, analysts estimate the IPO to raise at least $400 Million. I converted this estimate into Rupees to come up with my market value of equity which is Rs 25200 Million.

Stable Growth (Terminal Value)
I assume that the firm will go into a stable growth phase after Year 10. My assumptions for stable growth period are as follows:

1. Growth Rate- The growth rate in perpetuity is set equal to the risk free rate ( which is my long term economy growth rate ).

2. Cost of Capital
a) Beta- The beta of the stock will converge to the market beta of 1.

b) Debt and Equity Weights- The debt and equity weights converge to global industry average weights of 51 and 49%. Thus, the cost of capital linearly increases to 10.48% in perpetuity.

3. The Return on Capital- I have assumed that the company's ROC will be equal to its cost of capital in perpetuity.

Estimating Value of Firm and Equity
Discounting the Free Cash Flows for the next 10 years along with the terminal value at the cost of capital gives a Firm Value of Rs. 344226 Million . Subtracting out the market value of debt and value of employee stock options and adding on cash and liquid investments gives an equity value of Rs 307709 Million.

Factoring in the uncertainty: Monte Carlo Simulation
To incorporate changes in my assumptions, I did a Monte Carlo simulation wherein I assumed a uniform distribution for growth rate in operating income and normal distribution for return on capital. After 1,000,000 trials, the median value for equity is Rs. 291340 Million.

Conclusion

Buying into the IPO would be playing the pricing game rather than investing. Given my narrative, I will be comfortable with an equity value of Rs 300000 million.  However, I will have to adjust a key piece in my valuation i.e. market value of equity ( which is based on investment banker's estimates ) once the IPO hits the market and then do a post IPO valuation to take an investment decision.

Link to Valuation spreadsheet