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Profitability levers can offset impact of growth challenges

Our recent channel checks suggest sequential food delivery GOV growth is likely to remain muted for the third consecutive time in Mar-Q. Key factors affecting growth include continued inflationary pressures, growing share of dining-out and focus on profitability improvement (to support growth investments in adjacencies such as Blinkit and Hyperpure). In fact, relaunch of the ‘Gold’ loyalty membership and closure of operations in 225 cities suggest the company sees high long-term value creation potential by mining high-quality customers (those whose ordering frequency is very high), rather than investing in expanding the long-tail of customers ordering infrequently. While on the one hand this strategy could have an adverse impact on the near-term MTU trend (amidst weak macros), on the other hand it could accelerate profitability expansion. Recent developments also suggest 1) improvement in restaurant take-rates, and 2) decline in delivery cost could be much better than earlier anticipated, leading to accelerated profitability. Therefore, while we now forecast Zomato’s food delivery segment to grow at a CAGR of c.21% over FY23-27 vs. the earlier estimate of ~25%, contribution margin (as % of GOV) could reach ~7% by FY27 vs. FY34 expected earlier. Our 15-year DCF-driven valuation remains unchanged, as the impact of growth moderation will be broadly offset by better profitability.

* We moderate medium-term growth expectations in food delivery: While the launch of ‘Gold’ membership should help Zomato regain some of the market share it had lost in the last two reported quarters, we believe sequential expansion of MTUs and order volume in Mar-Q could be a challenge. Factors that could impact order volume growth include absence of ‘Gold’ membership in January, Navaratri festivities in late March, and lower calendar days in Mar-Q. Even sustaining AOV could be a challenge in Mar-Q due to the high base of Dec-Q and ‘zero delivery fees’ collected on Gold orders. That said, we expect sequential recovery in Jun-Q due to IPL seasonality and the low base effect. From a medium-term perspective however, we now expect Zomato to report CAGR growth of c.21% over FY23-27 (roughly 1.5x of the expected growth for organised food services market) due to its growing focus on high-quality growth and the fact that penetration of the online channel in the organised food services market is already quite high at ~33%, meaning incremental gains could be slower than in the past.

* Margin improvement in food delivery segment likely to accelerate despite Gold impact: Our channel checks suggest Swiggy’s take-rates for its restaurant partners on average are relatively higher than that of Zomato by ~200bps, a gap that Zomato is now attempting to narrow. The recent hike in commission rates for several restaurant partners was perhaps a step in this direction (refer media report). In addition, the company has been focussing on increasing ad income from restaurant partners. We, therefore, expect restaurant take-rates for Zomato to improve sequentially in Mar-Q. The company could also see delivery cost efficiencies amidst stable fuel prices and improvement in delivery partner utilisation. Both these factors together are likely to offset the adverse impact of ‘zero delivery fees’ and ‘no-delay guarantee benefit’ on Gold orders, leading to at least stable contribution margin in Mar-Q on a QoQ basis. Further, re-pricing of Gold membership and/or rationalisation of its benefits, closure of operations in 225 lossmaking cities, and scale benefits should help the company accelerate profitability improvement over the next few quarters. Accordingly, we now forecast faster improvement in contribution margin (7.0% in FY27 versus earlier est. of 6.2%) as well as adj. EBITDA margin (3.5% in FY27 versus earlier est. of 3.1%) despite factoring in slower GOV growth.

* Incremental benefit of investments in quick commerce likely higher than that in food delivery: We believe Swiggy and Zomato are increasingly committing themselves to making incremental investments in quick commerce instead of the food delivery segment. This is likely because: quick commerce offers a much bigger TAM; current penetration levels in quick commerce are significantly lower compared to food delivery within their relevant TAM; competitive intensity has slowed down in quick commerce, which gives incumbents room to build scale moats; and the expectation that the life cycle value of the incremental transacting user in quick commerce could be significantly better than in food delivery at the current stage.

* Incremental benefit of investments in quick commerce likely higher than that in food delivery: We believe Swiggy and Zomato are increasingly committing themselves to making incremental investments in quick commerce instead of the food delivery segment. This is likely because: quick commerce offers a much bigger TAM; current penetration levels in quick commerce are significantly lower compared to food delivery within their relevant TAM; competitive intensity has slowed down in quick commerce, which gives incumbents room to build scale moats; and the expectation that the life cycle value of the incremental transacting user in quick commerce could be significantly better than in food delivery at the current stage.

* Continue to expect strong GOV growth and profitability improvement in Blinkit: We expect Blinkit to continue to report strong sequential GOV growth of low-teens in Mar-Q as the business is relatively nascent and is skewed towards essential/non-discretionary spend. Growth would likely be volume driven as AOVs are likely to shrink due to the company’s focus on enhancing the customer experience and expanding the transacting base. We also expect both contribution margin and adj. EBITDA margin to increase due to improvement in take-rates (because of better product commissions and ad income), slowing competitive intensity, and delivery partner related cost efficiencies. However, adj. EBITDA is unlikely to break even in the near term as we expect new store additions (management plans to grow dark-store count by ~30-40% over the next 12 months) to partially offset improvements in existing store profitability.

* Zomato remains a long-term story: We continue to remain bullish on the company’s longterm prospects in the hyperlocal delivery space as we believe it is well positioned to benefit from robust industry tailwinds such as improving tech penetration and rising income share of digitally native millennials / GenZ. Balance sheet also remains robust with net cash of INR 113bn as of Dec’22. We continue to value the consolidated business using a 15-year DCF (WACC of 13% and Tg of 6%) to arrive at a Dec’23 FV for Zomato of INR 100. At CMP, the stock trades at ~24x FY27E PER while our TP implies 49x FY27 PER.

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