A detailed analysis of the business fundamentals of food service industry and Zomato followed with its discounted cash flow analysis


In 1994, when the first pizza was delivered online through the Pizza-hut website, no one would have guessed it would be an industry worth billions of dollars. Fast-forward 27 years and the likes of DoorDash, UberEats, Meitshu, Deliveroo, Zomato, Swiggy, Foodpanda, GrubHub, Postmates, Domino's, you-name-it are riding bikes across the nook and corner of our planet delivering great food for hungry customers.

Photo by abillion on Unsplash


As a marketplace aggregator, the business model of these companies is similar. It is the unique adaptation according to each market that  would determines the pioneer of this industry.

In our very first of company analysis, we present the valuation of an Indian food-delivery service Zomato. Zomato is a great homegrown brand and is currently on the way to IPO on the Indian bourses. In the essay below, we analyse how Zomato has already reached 523+ cities of India and is now adopting a vertically-integrated ecosystem strategy on its road to profitability. So, grab a cuppa before we go!

Beginnings

Zomato started as a food-listing company in 2008 when its founders Deepinder Singh and Pankaj Chaddah put out restaurant menus on the internal portals of Bain and Company. This idea struck when they saw a long queue of people just to see the menu and then joining another line for ordering. It was a problem that needed to be solved in the post Internet era.

Since then, the company has come a long way and now has 350,174 listed restaurant partners on its platform. Zomato and Swiggy together employ 440,000 delivery partners, which is more workforce than the number of employees at Department of Post, India. 

Zomato now has aspirations to become India's largest food aggregator - a role which would arguably bring the Internet company at the center of the food service industry worth $670 billion. To make things interesting, 90% of this market is unorganised and the other 10% in which Zomato operates is riddled with brutal competition, fickle customer loyalty and low value orders which are unique to Indian market.

Source: Zomato


Zomato recently was adjudged as the best Indian brand in customer satisfaction and customer advocacy during the pandemic, ahead of its competition Swiggy and Amazon. While the second wave of Corona was wreaking havoc, Zomato continued operations so that customers can get their fav food, gig workers can generate income and restaurant owners stay in business. 

We valued Zomato at $1.1. billion through the Discounted Cash Flow approach. The last valuation of Zomato was at $5.4 billion in Feb'21.

Why discounted cash flow?

When a company is being listed on the Street, it undergoes a metamorphosis of sorts. It becomes accountable to the common shareholders in the execution of its stated strategy and hence, subject to the swings of Mr. Market. Keeping an eye (or two) on profitability would become as important, if not more than growth.

Markets also measure the performance of a share by looking at the increase in value which is a function of the free cash flow it generates. Besides in an absence of a domestic peer in an unorganised food service industry, discounted cash flow is one of the best ways to understand the theoretical underpinnings on which Zomato's business model is based.

An estimation of free cash flows and profitability would allow us to project the road to sustainability, not only for Zomato, but for the industry as a whole. 

We have tried to build the story out in public to have conversations on the right building blocks of the Internet company, and the valuation might not be sacrosanct, but it offers a playbook for sustainability; even though imprecise, but directionally accurate.

The food-operator playbook

Zomato's platform is a one-stop solution across all the different stakeholders - be it farmers, restaurant owners, delivery partners and customers. Customers order their favourite food from the restaurants listed in the app which are assigned by the app to be delivered by the delivery partners. Some of the restaurant partners also use its procurement division, Hyperpure to access farm produce from the farmers.

The broad categorisation of its business lines are:

Source: Publicly available data, Samkhya analysis

As a super-app for food, Zomato has combined the business models of Yelp, OpenTable and Doordash - with an optimism that India's growing population would buy more smartphones which would bring greater Internet penetration. This would lead to increased organisation of food service and delivery industry, thereby giving it economies of scale and scope. 

Its competition Swiggy, does not have restaurant discovery and booking and a procurement business yet but is doubling down on the hyper-retail grocery and food delivery business with an intent to capture more market than Zomato.

Source: publicly available data

Zomato's ecosystem strategy is to be a player across all ends of spectrum and use data in India's unorganised food sector as a differentiating factor. Its delivery partners would help it establish control over the value chain and use the farm produce, restaurant and customer usage data to build its own verticalized businesses.

While the unorganised food market present a challenge and a blessing, and is ripe for an overall integrated platform, it is the unsustainable nature of food delivery - its anchor business that puts a question mark on the entire strategy, one that might have a domino effect on other businesses, Covid headwinds notwithstanding.

Food delivery in India which accounts for 87% of Zomato's revenue has a very low order per value in comparison to global peers), a characteristic which sets it apart from other markets. Also, the rider cost per order is  high as a percentage of revenue. Resulting in a unit economics which makes going profitable a distant dream in India.

Source: Goldman Sachs 


The average order value is low (~50% of China) in comparison to its global peers, the rider cost is 90% of the revenue. As a result, the cash burn per order is highest for India.

Now, Zomato has turned unit economics positive during Covid. Yes, the gross order value has increased which has made net contribution positive, but it remains to be seen if it comes with greater revenues.

Source: Zomato

Covid has led a societal shift in India, where the single, working professionals who had come from tier II / III cities have returned to their homes, as remote working becomes common. Below is a figure showing the demographic shift in Zomato's red herring prospectus.

Source: Zomato

This shift would alter spending patterns on online food as the meals-for-two or three would translate to higher GOV but reduced meals-for-one  would lead to lower volumes and plateaued growth. It is this higher GOV  from meals for two which reflects in a better unit economics. Though the jury is still out if it going to be a consistent change in the market.

Also, the sustained high-growth period that Zomato and Swiggy have enjoyed in the past 2 years has exhausted its runway. The metros are saturated with Swiggy and Zomato delivery and new growth is going to come from increased orders (including groceries) in existing cities and new orders from Tier II and III towns.

So, while the growth seems to stabilise as the industry matures and also prepares itself for more competition with the entry of Amazon, the scope to improve unit economics and become sustainable becomes critical for the business. Fortunately, it still has a lever which is being used beautifully by its international peers.

Enter 'Route optimisation'

India as a country has one of the highest route density in the world. The number of people residing in small clusters across the 500+ cities presents a chance to improve Zomato's delivery cost per-order. Route optimisation would allow Zomato to increased value per order, more orders per route and also increased frequency of orders.

Zomato is already taking steps towards this:

  • Groceries - Including hyper-local grocery delivery (talks of investing in Grofers)
  • Dark kitchens - partnerships with restaurant chains like Haldirams, Adigas & Sarvana Bhawan to build dark kitchens and provide delivery to adjacent areas
  • Micro-fulfillment centers - use existing stores to increase fulfilment efficiency and enable same-day delivery; no distribution center investment

Having dark kitchens and micro fulfillment centers strengthen merchant partnerships and improve delivery efficiency.

Source: LEK analysis

This signals an evolution of its food delivery model from point-to-point delivery to a hub-and-spoke model. For a customer, it reduces the wait time for orders while Zomato increases its utilisation by increasing number of orders per delivery.

Source: Samkhya


Summary

  • Zomato is an Indian food delivery app now with four businesses: The company aspires to become a food operator by catering to farmers, restaurants and customers.
  • Food delivery still forms 88% of its revenue. The other sources are: Hyperpure (4%), platform services (8%).
  • Zomato has a revenue of ~$365 million (FY20) with 350,174 active restaurant listings across 526 cities in India
  • As a strategic focus, Zomato is withdrawing from other markets and would solely focus in India
  • We value Zomato at $1.1 billion on a discounted cash flow (Operating Profit) approach
  • While the top cities have almost exhausted the growth runway, next phase of growth to come from tier II cities even as competition tightens with Amazon entering the ring.
  • Zomato is using vertical integration to increase profitability and ecoosystem control of an unstructured food market in India
  • Its future success also depends on the 3 other businesses which are still open to competition. It has adopted the playbooks of Doordash, Yelp and Open Table though the fundamental unit economics is different than US and Chinese markets.
  • Zomato's investors include Fidelity Management, Tiger Global, Bow Wave Capital Management, Dragoneer Investments, Luxor Capital, Mirae Asset amongst others

Valuation: our DCF model estimates Zomato at $1.1 billion through discounted cash flow method, which is 3x of its EV/2020 revenue.

Zomato has four (five if Grofers deal goes through) business lines. These business lines would have different growth, cost and profitability structures especially at the initial growth years. With limited visibility to these cost structures, a Sum-of-The-Parts (SOTP) valuation might not be accurate. 

Hence, we have followed a top-down approach of estimating the growth of the food service & delivery industry. The food service industry is witnessing increased competition as Amazon foods is waiting to enter Indian market and there is an outside chance of of a Reliance-Facebook app to compete in retail - food & grocery delivery).

Currently, the market is equally divided between Zomato and Swiggy with ~45% of food delivery share. This may come down to 35-40% for Zomato especially as Amazon has an established supply chain in Tier II cities where maximum growth is going to come from.

The overall food delivery market is expected to be at $12 billion by FY25. Considering Zomato' share of 35-40% in the market, at a 25% take rate, Zomato's estimated revenue would be approx. $1.1 billion in FY25. 

Our estimates suggest that by keeping current spend of sales and advertising, Zomato can break even in FY24 with an EBITDA margins of ~15%.

Source: Samkhya Valuation Platform


Source: Samkhya Valuation Platform


At a cost of capital of 15.3% using CAPM method,  the enterprise value of Zomato is at ₹ 82.32 billion or $1.1 billion.

At an FY20 EV/Sales, that leads to 3x sales. This is at a huge discount to its the current trading multiple of global peers like Doordash. To give a perspective, Doordash's revenue in FY20 stood at $2.9 billion (vs. $365 million for Zomato). Doordash's average order value is $31 unlike Zomato's at $3 - $4.

Risks

1. Depreciation and amortization expenses: which accounts for capitalized software and website-app development costs account for 7.5% in FY21. This reflects the changing scenario in a pandemic where software needs to be constantly updated.

Source: Zomato

2. Customer acquisition costs (CAC): Historically, the customer acquisition cost of Zomato has been high as % of revenues. With increased competition and growth since lowing down, CAC may rise higher than pre-Covid levels, thereby increasing the timeline to profitability.

3. Outsourced support cost: Zomato measures its delivery cost and payments to delivery partners through outsourced support cost. Chances are with new cities and towns, these costs might increase though there is a scope for route utilisation leading to reduced costs.

Source: Zomato


Tying it all together

​No one invests on a number. We all need a story to invest. - Daniel Kahneman

While a $1.1 billion is a muted valuation, especially since Zomato's last valuation was at $5.4 billion in private markets, the outlook is overall conservative. Seven of its shareholders including CEO Deepinder Goyal have cashed out $319 million of shares before the listing. The stakeholders who partially exited from Zomato include Alipay, Nexus Sunlight Fund, Sequoia Capital, Blume Ventures, Deepinder Goyal and Pankaj Chaddah (ex-founder). 

While we can debate on the valuation as its not sacrosanct - as Aswath Damodaran says, an IPO is a pricing game. And IPO is priced in two ways:

  1. Venture Capital pricing: Zomato has raised $250 million in Feb'21 at a valuation of $5.4 billion (~15x times its sales). 
  2. Peer pricing: In the absence of a domestic listed peer, we compare Zomato to international food delivery companies. On an average, Doordash, Grubhub, Deliveroo are trading currently at 18x of sales.

It's a high chance that market would be euphoric and welcoming to the first of the Indian Internet startups making its way to the Dalal Street. Zomato has a positive brand recall and is seen as a cheerleader for providing employment and vaccination for its delivery staff during Covid along with having a capital-light tech product. The positive brand perception leads to a higher stock-price than the previous EV/sales of 15x. It'll be an interesting watch on the D-day! 

Do you think the valuation of Zomato would be different? What assumptions would you change? Drop in your comments below.​

This report is a discussion on the business fundamentals of Zomato as it goes to IPO and is not a business advise. It contains company financials based on publicly available information. Samkhya did not receive any compensation from Zomato for the report. This report is not investment advice or an endorsement of any securities. Please read our T&C.