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Macro challenges likely to weigh on near-term trajectory

Zomato’s earnings delivery in the latest quarter suggested that there were certain growth trade-offs that the company made in its food delivery segment as it focused on meeting the profitability metrics communicated to the shareholders. While our initial impression was that seasonality was the main reason for the sequential deceleration in growth during the Sep quarter, a re-look at some of the management commentaries and industry checks makes us think that growth concerns for the Food Delivery business could in fact be more severe than what the we are anticipating – more so from a near-term perspective. However, a near-term growth blip could provide an interesting entry point for investors to accumulate positions and partake in the long-term value-creation opportunity. We continue to believe that there is immense potential for the food delivery industry to enlarge its consumer base and grow meaningfully bigger over time.

* How long could the softness last? Zomato clocked a QoQ growth of just 3% in Food Delivery GOV during the Sep quarter vs. +10% QoQ in the Jun quarter. Our initial thought was that the growth deceleration was mostly a function of seasonality (absence of IPL and monsoons) with some small additional impact from the discontinuation of the Zomato Pro Plus loyalty programme and increase in delivery fees levied on customers. However, there were a couple of management statements that deserved deeper scrutiny. First, CFO Akshant Goyal’s comment in the earnings call that “We have seen lower app opens in the last quarter as compared to the past, which clearly demonstrates some low intent to spend on a category like ours” and second, Deepinder Goyal’s statement in his letter to shareholders that “I believe there is room for the business to grow much faster than what it is currently trending at. I don’t know if I can attribute this to the macro environment — primarily because I know for a fact that we could have innovated and executed better in the last couple of months.” Read together, these statements seem to indicate that general inflationary pressures are affecting consumers’ willingness to spend, and that is likely weighing on the management’s mind. A dipstick survey conducted by us suggests the softness is likely persisting in the on-going quarter as well. While the company appears to be taking remedial measures to revive growth (refer Exhibit 1 and 2 for examples), we believe macro issues and increase in dine-in consumption (as suggested by managements of Jubilant FoodWorks and Sapphire Foods), could lead to softer 3QFY23, contrary to our earlier assumption of growth acceleration.

* Our optimism built on strong growth potential within existing customer base and foodtech under-penetration: In our recent report we had highlighted that 2.3mn customers of Zomato accounted for c.35% of total order volumes in FY22. These 2.3mn customers are just 5% of the unique annual customers that the company has, which means the balance 95% order just seven times annually or once every 1.5 months. Mining these 95% of customers could be the single biggest driver of growth, scale and, hence, contribution margin for the company. Similarly, we had earlier highlighted that the realistic TAM for food-techs in India by CY25 can be closer to ~150mn individuals, of whom only ~60mn has been penetrated, which also indicates a long runway to growth.

* Management continues to focus on creating long-term growth opportunities: In his latest letter to shareholders, Deepinder Goyal stressed that the company would focus on innovation and execution to drive incremental growth. The company is presently experimenting with multiple new initiatives in its food delivery vertical. These initiatives include Intercity Legends (intercity food delivery), Zomato Instant (food delivery in 10-15 minutes) and an option to order food in vernacular (regional) languages (Hindi, Tamil, Gujarati, Kannada, Bengali, Malayalam, Punjabi, Marathi, Tamil, and Telugu). A media article also suggests the company is working towards improving restaurant partner stickiness on the platform, which, in turn, can support growth. Besides, in the earnings call, the management suggested that it plans to re-launch a revamped version of its loyalty programme in the near term. We believe success of some of these initiatives could generate incremental growth over the medium to long term.

* Multiple levers to profitability improvement but near-term growth investments can limit upside: Zomato reported remarkable improvement in profitability in 2Q with adj. EBITDA loss for the core business (ex-Blinkit) narrowing to INR 0.6bn vs. INR 1.5bn in 1QFY23 (INR 3.1bn in 2QFY22). Importantly, the Food Delivery segment turned profitable (at adj. EBITDA level) on the back of a sharp improvement in contribution margin to 4.5% from 2.8% in 1Q. Over the medium term, the company expects Food Delivery to achieve adj. EBITDA as a % of GOV of 4-5%, as its contribution margin as a % of GOV gradually moves towards 8%. We believe the company has multiple levers to achieve this target, such as 1) further increase in restaurant take-rates, 2) further rationalisation of customer subsidies (delivery charges and discounts), and 3) operating leverage. However, given the near-term growth concerns, margin improvement can be slower than earlier anticipated.

* Deepinder Goyal likely to take over the food delivery operations: We expect Deepinder Goyal to himself fill the leadership vacuum in the food delivery vertical following the exits of other senior executives such as Mohit Gupta (Co-Founder), Rahul Ganjoo (Head of New Businesses) and Siddharth Jhawar (VP, Global Growth). A media article suggests, he will be supported by recent hires Strategy Head, Satyam Mehra (ex-Bain & Capital) and Senior VP, Abhijit Midha (ex-Premji Invest), amongst others.

* Over-hang of pre-IPO investor sell-off is far from over: As of 30 Sep’22, pre-IPO investors (excluding Deepinder Goyal and Info Edge) held more than 32% stake in Zomato. These investors are eligible to trade the shares as the lock-in for them had expired in Jul’22. Some of these investors including Ant Financial (which offloaded around 3% stake today) have made substantial gains as the cost of acquisition was significantly lower for them compared to the current share price of Zomato. We, therefore, believe there could be a steady supply of the company’s shares for sale in the market at regular intervals in the near term. In addition, shares issued to the erstwhile shareholders of Blinkit during its merger with Zomato account for another 6.9% of the total outstanding shares. The lockin as per the terms of transaction for these shares would end after 12 months, i.e., in Aug’23.

* Zomato - a long-term growth story: We remain bullish on the company’s long-term growth 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 continues to be strong with net cash of INR 115bn as of Sep’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 125 (INR 130 earlier). Implied FY26E EV/EBITDA on our TP works out to 66x whereas the stock currently trades at 28x.

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