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Zomato IPO Analysis by GSN Invest

Disclaimer: This is an educational exercise. Please conduct your own diligence or consult an investment advisor before taking any investment decision.


Understanding three sided market placesb


Zomato operates in a three sided market pace with the customers, delivery partners, and restaurant partners all linked to the Zomato platform. Customers order via the app and pay for food+delivery+tips+ packaging, Zomato pays the payment for food & packaging to the restaurant partner after subtracting its commissions, and pays its delivery partner the delivery fee and tips (plus any surplus fee from its end). It keeps the commissions and the advertising fee from the restaurant partner for itself.


Here's a visual representation to help you understand this better.


Before we dive deeper into this, let us understand the benefits of a three sided market place vs a two sided one - and why one may be preferable to the other.


Why three sided market places beat two sided market places


Consider for example what Zomato would look like if it was a two sided market place - You had the restaurants all added on the app and customers could come online and book food via the app. Zomato would then send this order to the restaurant, and it would be the restaurant's responsibility to deliver the food. For a traditional cash flow loving investor like myself (rough translation: boomer) this is a brilliant model - because the costs are extremely low (build and maintain the technology platform) and the returns are uncapped - you can add a restaurant to the platform with very little additional effort - pure operating leverage in action!




The downside for this however, is that it isn't defensible against a competitor who adds the third side. Something similar happened in the west, where Grubhub - traditionally operating as a two sided market place, was forced to pivot when Doordash entered with delivery drivers offering a far more compelling proposition to the restaurants and a far more reliable experience for end customers. Long story short - three sided market places are generally less profitable, but the food delivery space will almost always move to this structure given the inherent benefits of the three sided market.


With the basics covered, lets dig a bit deeper into Zomato's numbers and see how they have been doing.


Operating Performance




The firm has had phenomenal growth with both its restaurant and transacting users through FY20. FY21 has seen a massive decline - dven by the impact of the COVID pandemic on both the food service industry (restaurant closure) as well as personal propensity to consume (safety concerns). Zomato's increased focus on profitability - driving up both comissions and delivery charges is also expected to be one of the factors driving a fall in order volumes (more on this later!) The growth in users, restaurants, and orders is a wonderful virtuous cycle that has the potential to become a firm's strongest moat. Let us understand this in detail below.

Moat & Path to Profit


The most critical cost in the food delivery business - is the recurring cost that will sustain - that you will have to bear every time you service a customer - the fulfillment cost. While other cost like the advertisement and employee costs gain more prominence especially in the early days when you have to burn a lot to build a decent platform to attract customers, and then burn some more to get customers to your platform - if you've built a farily good and sticky platform these costs shouldn't bother you in the long run.



What will matter therefore is how much you can crush fulfillment cost - because that will allow you to offer the most attractive proposition to both the customer and the restaurant without burning VC money.


The most sustainable way to lower fulfillment cost is to gain scale- with more deliveries driving up utilization and consequently driving down prices. The virtuous cycle that a market place like Zomato creates therefore - via its structured content, driving more customers, driving more restaurants, driving more orders - is both the biggest moat and the best shot at achieving profitability for a three sided marketplace.


Now that we have understood the sector, the operating performance and the moats, lets go straight to the meat of the matter - profits and how Zomato can reach them.


Key Financials


Three very important trends become clear the moment we chart out some key financials -

1. The competitive intensity in the industry continues to stay high as the take rate of the firm continues to be pushed downwards

2. The firm is making a conscious effort to move towards profitability by slashing its advertisement & promotion expenses and trying to reign in its employee costs

3. The combination of these two factors is almost certain to have a detrimental impact on market share


A deep dive into the unit economics makes the picture even clearer - the higher delivery charges and commissions and lower discounts are driving away lower value purchases from the platform. While this will be the eventual trend given the INR 50+ cost per delivery, in all likelihood competitors like Swiggy, Dunzo, and Amazon would be more than happy to gnaw away market share. Amazon, the newest entrant in the space and the one with the deepest pockets, and Swiggy the market leader in the space who recently raised a new round would be most likely contenders to gain share at the expense of Zomato.



Closing comments


So where does that leave us? While a firm making a focused shift towards profitability is always good to see, in this case it doesn't seem to be organic or market driven - but rather a top down target driven shift (possibly pre IPO focussed?)- sacrificing market share to get there.


This means there are two broad paths the firm can take post IPO - continue on the profitability trajectory - lose some share in the bargain - and weaken the virtuous loop that we discussed above, as other competitors attract more customers. Alternately, it could pivot away from profitability and focus on retaining and growing share again.


Investors are likely to be displeased with both outcomes given the story that has been pitched in the IPO.


While the Indian food delivery space holds great promise, how much of the value generated in the space will be captured by the marketplaces, which marketplace will emerge as the winner amongst the lot, and when would the sector be stable enough to generate clean cash flows isn't clear to us yet.


The IPO pricing is unlikely to give us sufficient margin of safety to factor in the uncertainty that Zomato faces. So we'll wish them luck on their journey ahead, and wait for a stronger insurance play that may come out of the Naukri stable next.


That's it from our side. Until next time.

Stay home.🏠 Stay masked. 😷 Stay safe. 🛡️

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