Investing In New-Age Businesses
Out of the Rs 1.3 lakh crore raised via IPOs throughout the year 2021, roughly 33 per cent of it was cumulatively raised by eight new-age companies such as Paytm, Zomato, Nykaa, PB Fintech, Car Trade, Fino Payments Bank, Nazara Technologies and Easy Trip. Does this indicate that it’s a red carpet walk for all new-age companies? It may seem so but as Armaan Madhani and Shreya Chaware point out, investors need to study a slew of factors before parking their funds in this space
The year 2021 was a blockbuster year for the Indian primary capital markets! During the calendar year, a whopping 63 companies launched initial public offerings (IPOs) and collectively raised a record-breaking sum of approximately Rs 1.3 lakh crore. Likewise, the Indian secondary markets soared high like an eagle, witnessing an exceptional bull run. Equity benchmark indices oftentimes recorded fresh all-time highs over the first nine months of the year. Over the last three months, Indian markets witnessed a pullback from the higher levels on account of weak global cues, spiralling inflation, switch in major central bank policies to a hawkish stance and the discovery and dissemination of the new Omicron variant of the corona virus across the globe.
Despite the stock markets witnessing a correction over the past couple of months, the IPO market persists to remain buoyant and unfettered. As many as 11 companies came up with their IPOs in December 2021, making it one of the busiest months for the primary capital markets. In fact, 2021 will be marked as a monumental year in the history of the Indian capital markets because we witnessed several prominent new-age businesses getting listed on the bourses. Out of the Rs 1.3 lakh crore raised via IPOs throughout the year, roughly 33 per cent of it was cumulatively raised by eight new-age companies.
These comprise of Paytm (Rs 18,300 crore), Zomato (Rs 9,375 crore), Nykaa (Rs 5,352 crore), PB Fintech (Rs 5,625 crore), Car Trade (Rs 2,998 crore), Fino Payments Bank (Rs 1,200 crore), Nazara Technologies (Rs 583 crore) and Easy Trip (Rs 510 crore). IPOs of these new-age companies were received with open arms by investors across the board and saw ample oversubscription. Listing of these companies was a mixed bag. Nykaa, Zomato and Nazara Technologies debuted with phenomenal gains on the bourses. Meanwhile, Paytm and Car Trade were the laggards of the pack, tumbling dramatically on the listing day. We feel that this is just the beginning and it’s only going to get better from here on.
2021 has been a harbinger for the brighter prospects of value unlocking that lies ahead for new-age businesses and its founders who are in quest for substantial incremental capital to grow, scale and fulfil their visions. As per an article in Fortune India, a total of 108 companies from the new economy sector with a valuation of USD 435 billion are IPO-ready. Hence, as responsible retail investors it is our duty to evaluate these new-age companies with fresh eyes, be cognizant of their unconventional business models and look beyond the accounting numbers to truly appreciate scalability, execution and corporate governance.
New-Age Businesses
Change is inevitable and it causes disruption on a major scale. To quote respected technologist and business leader Steven Sinofsky, “Disruption is a critical element of the evolution of technology – from the positive and negative aspects of disruption a typical pattern emerges, as new technologies come to the market and subsequently take hold.” In the same way, as these new-age internet-enabled companies scale up their operations rapidly, they are disrupting traditional companies with the fundamental manner in which businesses and consumers interact with each other. New-age companies are predominantly digital and focus on building an asset-light business from the get go.
An asset-light strategy involves transferring capabilities such as people, process and technology to ‘better owners’ in order to enable companies to transition fixed costs to a variable cost structure and facilitate a shift of resources that allows a focus on core capabilities. It reduces capital intensity and attendant investment risk while allowing brands to achieve scale rapidly without the exorbitant start-up losses. It also aids to reduce complexity, furnishes agility to create new revenue streams, fosters innovation and assists to drive a higher return on capital.
New-age companies concentrate their financial and human resources to self-generate intangible assets (e.g. software, technology platform) as compared to traditional businesses which acquire fixed or tangible assets. As the book ‘Capitalism without Capital’ accurately notes, “Physical assets can only be in one place at one time. Intangible assets, by contrast, can usually be used over and over, in multiple places at the same time.” By virtue of these intangible assets, new-age companies enjoy the benefit of very low marginal costs while replicating their offering across different geographies with a heterogeneous target consumer base.
This has enabled technology giants such as Google, Amazon, Facebook, Netflix and Tencent to acquire the requisite competitive edge to thrive and flourish in highly competitive markets worldwide. New-age Indian companies are also following suit. For example, Paytm launched a QR-based smart phone payment in Canada called PayPay in a joint venture between Soft Bank and Yahoo Japan. Swiggy smoothly forayed into Latin America, which is one of the hottest emerging regions for technology adoption. Ola has launched its services in Australia, New Zealand and the UK.
Success Factors for Exponential Growth
There are 44 companies listed on the Indian exchanges which are more than 100 years old, out of which only two companies – Tata Steel and ITC – have a market capitalisation of over Rs 1 trillion. Juxtapose this with Paytm, Zomato and Nykaa which have only been in existence for 21, 11 and 9 years, respectively, but have managed to debut on the bourses with a market capitalisation of over Rs 1 trillion. New-age companies have found success in exceptional high-speed growth in revenues. Tencent, Google and Netflix since their listing on the exchanges 16 years ago have seen revenue growth at CAGR of 46 per cent, 29 per cent and 28 per cent, respectively.
A vast total addressable market (TAM) i.e. large opportunity size is a key success factor for exponential growth of new-age digital companies. Amazon, Google and Microsoft have all crossed the much coveted USD 1 trillion in valuation by focusing on opportunities on a global scale. Product-market fit is also paramount as it defines target consumer base and gives birth to the company’s communication and marketing strategy by exhibiting that there are consumers out there who are being underserved and their product offering is necessary. History is replete with scores of companies which have failed because they misunderstood product-market fit. Another salient success factor is widespread and robust distribution reach both online as well as offline, empowering the company to provide the best possible service to consumers.
Unit economics refers to an analysis of a specific business model’s revenues and costs in relation to an individual unit of its product or service offering. For Zomato, the unit is ‘delivery’. Once it is established that every single delivery is profitable, only then it makes sense to aggressively execute more and more deliveries. For example, Zomato’s unit economics turned profitable in FY21 with a positive contribution of Rs 19 per order versus negative contribution of Rs 33 in FY20. Therefore, new-age companies which are initially loss-making generate hefty profits once they achieve substantial scale of operations with favourable unit economics as operating and financial leverage kicks in.
India: All Set for the Digital Era
Over the last two decades in the US, there has been a noteworthy value migration from physical to digital. During this time span, new-age companies such as Amazon, Apple, Google, Facebook and Netflix have outperformed venerable traditional companies such as Walmart, Coca Cola and General Electric by a huge margin. Along the same lines, let’s consider China in the last decade. The new-age companies have grown by 17 times as against only threefold growth in old economy sectors. Currently, new-age companies form a mammoth 60 per cent of the country’s market capitalisation as compared to 20 per cent a decade ago.
As per a report by Goldman Sachs titled, ‘Indian Equities: Digital Transformation as Private Goes Public’, it expects IPOs of digital new-age companies to drive market capitalisation expansion in the years ahead. The report says that around 150 private firms could list over the next 2-3 years, adding USD 400 billion to the market capitalisation. The authors of the report argue that the Indian market is dominated by old-economy sectors with listing age of Indian companies exceeding 20 years. The inclusion of new economy stocks could take the share of these stocks to 16 per cent from 5 per cent. Since these stocks trade at far higher valuation and have potential for faster growth, India’s market capitalisation will expand to USD 5 trillion by 2024, making it the fifth-largest market.
How to Evaluate New-Age Business IPOs?
The world of investing has transformed tremendously from when Benjamin Graham wrote ‘Intelligent Investor’ in 1949, in which he elucidated investment in value stocks with sufficient margin of safety to the current situation where high growth start-ups are being valued based on future growth potential. The IPO pipeline for 2022 is hot with several new-age digital companies such as Mobikwik, Oyo, Delhivery, Flipkart and Byju’s. Conventional ways of evaluating IPOs would not be sufficient as one needs to rely on different metrics. To start with, the primary thing to internalise is that these new-age companies bear significantly larger risks, since they are valued based on assumption that they will evolve to become larger businesses in the future.
But considering the current times, while we all look at a company like Amazon, which wasn’t profitable for a very long time but still created enormous wealth for shareholders, and hope that we get to become rich by finding the next Amazon, the truth that lies beneath is that for every one Amazon there are thousands of such companies that never made it. The chances of being able to pick that one winning company that will go in line with our desired expectations and also be profitable are relatively low. Some of the parameters that must be studied while evaluating new agebusiness IPOs are as follows:
• Type of IPO : Investors should know whether the fresh IPO being launched is an offer for sale (OFS) or generating fresh equity. Fresh issuance is better than offer for sale, as in the latter case the existing investors sell their shares. Issue size which has a big chunk of OFS is not considered to be a good sign.
• Equity Dilution : While evaluating an IPO, it is important to note down how much equity dilution has taken place. Are the start-ups really self-sustaining or are they repeatedly raising fresh capital is an important aspect to be seen. This implies that founders diluting their equity stakes excessively may not be a good sign.
• Business Model : Having a thorough study of the business model is one of the crucial steps of evaluation. One must understand exactly what the start-up is doing and is it likely to make a disruption in the segment it operates. It is also important to study the relevance of the business model in the coming years. It can be summed up in three main aspects, which need to be touched upon while studying the business model, namely, competitive positioning, past track record and path to profitability.
• Capex or Opex: New-age companies generally work with an asset-light model – their need for spending money on technology upgrades, research and development, hiring employees and ad-spends lead to higher operating expenditure. Whether it is capex or opex, the viable start-ups will be the ones that are reducing their capital or operating expenditure. Digital companies use human capital to selfgenerate intangible assets such as software or technology platforms, which generate revenue and profit. Such intangible assets do not find a place in the balance-sheet. Instead, the human capital gets fully expensed in the income statement as employee cost, thereby leaving no distinction between capex and opex. The cost of creating software or technology platform is high in the initial years. Hence, these companies tend to show high optical accounting losses in their formative years.
• Financials : Having seen most of the digital IPO’s being loss-making, conventional valuation or profitability metrics cannot be run. A good revenue growth can be witnessed in new-age IPOs but they still incur losses owing to substantial spending towards advertisement, promotions and employees, etc. These companies should be evaluated with a different perspective such as understanding the sector, strategy and future growth prospects.
• User Growth : This has become an important parameter to be studied not just to determine if the business is a leader in its space, but also to study the market expansion. This number can be easily fudged by a business, especially in a market like India where the internet and smart phone penetration is almost 500 million people and a significant percentage of the population that earns an annualised income of less than USD 2,000. For example, if a business provides enough economic incentives in the form of freebies or cash-backs, it is possible to have scores of consumers signing up to use their application and who can then be counted as ‘users’ to show growth. Such user growth is artificial, tends to slow down the business and generally does not help in building business sustainability in the long run. Hence, investors should be able to separate the wheat from the chaff, knowing whether the user base of any new-age business is real or forged.
• Future Prospects : Eventually, as the Indian market grows, some industries will outperform others. It will be fair to assume that as the years go by, Indians will buy more products digitally. The potential that the target market beholds to expand is a wild card. If a business in any category is growing fast, the opportunities in that segment will help it significantly. If you observe, private market investors have their bets mostly on sectors and industries that have the potential to expand manifold. The probability of succeeding is more when investing in stocks that are trending. A company remaining as a leader in the market is easier to call as against a company which is yet to become a leader. Being a market leader gives a business a significant valuation premium, which increases its ability to raise more capital, which in turn increases its chances of succeeding and remaining the leader.
Owing to Reliance Jio and the pandemic which accelerated digital adoption, India is one of the fastest growing nations when it comes to internet and smart phone usage. Also, initiatives by the Indian government such as Aadhaar, eKYC, Digilocker and Jan Dhan have all been clinical triggers for widespread financial inclusion and digitisation. Not to forget the ingenious financial innovation of Unified Payment Interface (UPI), enabling peer-to-peer interbank transfers at zero cost. All these have set up a conducive digital ecosystem, which will accelerate the growth of new-age businesses, making it easier for them to onboard new customers who have even been outside the reach of traditional enterprises in an instant.
Market regulator Securities and Exchange Board of India (SEBI) has also relaxed its regulations to permit listing of loss-making companies as well. Ergo, India is all set for the imminent digital era. To quote an excerpt from an article by Prateek Pant, ED and CBO, White Oak Capital Management, “India has a population of 1.4 billion people with almost 750 million 4G connections. However, online buyers or transactors are in the range of 120- 150 million only. This is likely to rise to 300-500 million buyers over the next 3-5 years as digital payment penetration rises. This growth will have multiple implications for not only new-age technology companies but also for the disrupted (traditional) companies. It is possible that new-age technology might see faster penetration in India.”
Risks and Challenges
When it comes to analysing the risks and challenges before investing into new-age business, the dotcom bubble qualifies to be a suitable example fitting here. The dotcom bubble was an asset valuation bubble that occurred in the 1990s. It led to a recession caused by highly speculative investments in internet-based businesses. The bubble burst in early 2000 after investors realised many of these companies had business models that weren’t viable. The growth opportunity that new-age companies present is exciting. However, it is also important to bear in mind the risks and challenges involved. The wealth creation study recently published by Motilal Oswal identifies and thoroughly explains some key risks and challenges involved while investing in new-age business. Here is a quick summary of the same:
1. Survival Bias : Survival bias is a framework from behavioural finance. Survival bias is the tendency for failed companies to be excluded from performance studies because they no longer exist. It is the logical error of concentrating on people or things that made it past some selection process and overlooking those that did not, typically because of their lack of visibility. It is extremely important that the new-age company an investor invests in survives over the long-term.
2. Hype Factor : IPOs of Nykaa, Zomato, Car Trade and Policybazaar were oversubscribed 82, 38, 20 and 17 times, respectively. If the number of times the recent IPOs of new-age companies have gotten oversubscribed is any indication, there are early signs of hype or market frenzy. The digital hype is at two levels. First is at the business capability of the companies and second in their valuations.
3. Criticality of Contribution : Hyper growth of new-age companies is explainable only so long as unit economics is favourable. The bottom-line of unit economics is contribution i.e. revenue minus all variable costs. Any misstatement of expenses could have severe repercussion on the company’s profitability and consequently their stock price.
Conclusion
India is currently working at per capita GDP of USD 2,000 and while making its way up to USD 4,000, the opportunity for technology-first new-age businesses to capture incremental growth will significantly be more than traditional businesses. New-age businesses in India are enabled by favourable demographics, an excellent frictionless payment ecosystem and burgeoning internet penetration. However, one must keep in mind that great reward is often accompanied with great risk. The time taken by a new-age business to reach the desired level of scale may be longer and could negatively impact market expectations, especially the ones relying on high potential future growth. A sensible investment strategy for retail investors would be to allocate a small portion of their portfolio to new-age businesses.