What Zomato investors need to watch out for after the Rs 8,500 Cr QIP

Food and grocery delivery company Zomato’s Rs 8,500 qualified institutional placement (QIP) was met with much enthusiasm amid the exuberance around the company, especially in its quick commerce business Blinkit. 

Motilal Oswal Mutual Fund emerged as the biggest buyer by picking up 21% of the shares that were being issued. ICICI Prudential Mutual Fund, HDFC Mutual Fund, and Kotak Mutual Fund were the other big mutual funds that bought into the QIP. 

Zomato also replaced JSW Steel in the Bombay Stock Exchange’s Sensex, an index that captures the market price of India’s top 30 publicly traded companies, marking a key milestone for India's new-age tech companies. 

But even amid this exuberance, Bengaluru-based advisory firm Capitalmind’s founder and CEO Deepak Shenoy, a prominent voice in the inventor community, asked investors to be cautious about Zomato, saying that the company is already richly valued and that it would need consistent high-level growth to justify its valuation. 

Capitalmind provides services like financial analytics, investment advice and money management services to clients. The SEBI-registered firm manages over Rs 1,300 crore assets under management and they invest in companies through algorithm-enabled tech.

Improved profitability, but keep an eye on EPS

Shenoy said that Zomato’s profitability is likely to improve again significantly in the short term following the QIP as returns from the raised capital, which it would get by investing in fixed income, will likely jump by Rs 500 crore annually.

Zomato’s profits are also largely boosted by other income not core to their business, mostly by investing its excess cash in fixed income assets. Before its acquisition of Paytm Insider, Zomato had a cash balance of over Rs 10,000 crore, from which it has been earning Rs 700 crore annually in fixed income. 

While the company has not disclosed where it has invested all the money in, most of the money has been put in fixed income assets such as debentures and government bonds. 

“So for year one it will look good,” said Shenoy. “I think the earnings growth will come just because of other income. But remember this, I gave you (Zomato) a lot of money, I took some of your shares. Now you are earning interest from your money, which would be about Rs 500 crore,  But you have not done anything more, but still your profits are growing at 35%, so basically the minimum steady state growth to be 35% for it to be a flat company.”

He said that Zomato’s profits should grow at 60% annually long term for its valuation to make sense. 

“Right now, the price-to-earnings (P/E ratio) is roughly 300x earnings today,” said Shenoy. “Earnings from interest income is about Rs 700 crore. That will likely increase by Rs 400 crore because the cash reserves will increase by Rs 8,500 crore because of the QIP.

"Rs 700 crore has gone to Rs 1100 crore just because of the new cash that has come in. It will look like higher profit growth but the earnings per share will not be the same because you have diluted the 3-4% shares, so you are not growing 40%, maybe you are growing 30 or 35%,” he added.

Hit to profitability in the long term

Zomato’s QIP will also help it reduce foreign ownership below 50%, enabling it to own the inventory it sells on its platform. 

India’s foreign direct investment rules restrict the majority foreign-owned companies from having ownership or any control over the inventory, for which companies like Walmart-owned Flipkart and Amazon have come under immense scrutiny in India. 

Currently, Zomato’s Blinkit operates without technically owning the inventory in its books, with other third-party sellers carrying the inventory. If Zomato were to take control over the inventory, it is likely to come with its baggage, impacting profitability. The inventory costs are likely to be more pronounced as quick commerce moves more from fast-moving consumer goods to slower-moving consumer goods like fashion and electronics. 

“In retail operations, a large part of the optimisation processes have a lot of losses in the inventory part of the mechanism,” said Shenoy. “You over-order something and you under-order something else, you will have inventory holding costs. This is not visible on Zomato’s balance sheet because they don’t officially own any of these entities.”

While it is still early days in quick commerce, the Indian government has already reportedly enquired with senior executives of quick commerce companies about the ownership structure of dark stores. Zepto has also been aggressively raising funds from domestic investors, raising a $350 million round led by Motilal Oswal. Both Blinkit and Swiggy Instamart have separate entities operating their dark stores and owning the inventory, whereas Zepto operates under a licensed or franchise model. 

While owning inventory could impact profitability, it also gives Zomato the scope to improve margins and profitability in the long term.

“They (Zomato) need to own the inventory, they cannot make a meaningfully large operation without doing that,” said Shenoy. “Dmart owns its own real estate. You need to own as much of the ecosystem as possible. Dmart generates 8% margins because of that. If you are giving away most of the economics to the guy who owns the inventory then you will be left with 1.5%. I don't think that will be meaningful."