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ESOP cost no longer one-off post approval of new policy

Zomato’s shareholders have approved Employee Stock Option Plan 2024 (ESOP 2024) that would enable grant of ~183mn stock options to its group employees. The dilution impact for existing shareholders on a fully diluted basis would be c.2%. While we had already trimmed our reported earnings forecasts (refer 4QFY24 results note) to factor in the ESOP 2024 costs, we were yet to factor in the impact in our valuations assuming them to be a one-off expense (ESOP 2021 was essentially a reward for senior management for successfully taking the company public). However, the formulation of a new policy suggests ESOP costs should be treated as a regular business expense as they are likely to recur in future. So we change our valuation methodology for Zomato to PER from the multiples-driven SOTP approach earlier to better capture the impact of ESOP cost on valuations. Our TP for Zomato falls to INR 230 (from INR 250 earlier) as we assign a target EPS multiple of 75x and roll-forward TP to Sep’25. We maintain BUY.

* ESOPs help attract and retain high quality talent… In the 4QFY24 shareholders’ letter, Zomato’s management had mentioned that ESOPs were important “to create a ‘founder mindset’ amongst senior employees, which ultimately drives the right outcomes for longterm shareholder value creation”. We concur with this view because ESOPs help attract and retain high quality talent, as the employee’s personal success directly gets linked to the company’s performance.

* …but ESOP grant should be linked to measurable performance-based outcomes: The ESOP 2024 policy entails that ESOP will be granted at face value as the strike price, which effectively means the exercise price for employees will be INR 1 per equity share. The fair value at the time of issuance, however, would be close to the market price at the time of the grant, as per IND AS 102. This leaves an impression that the new ESOP grant will be at a deeply discounted price, without any measurable performance-linked outcomes. That runs the risk of the new ESOP policy being considered unfair by some shareholders as they would be the ones taking a meaningful hit on their earnings in the medium term. Hence, we feel that Zomato should publicly lay out a formal policy where eligibility and criterion for grant of ESOPs is clearly defined and linked to certain measurable performance parameters such as GOV growth, Revenue growth, EBITDA growth, FCFF growth, PAT growth, return ratios or total shareholder returns.

* Factor in ESOP costs as a regular business expense: After studying the impact of the new ESOP policy, we believe investors should, henceforth, treat ESOP costs as regular business expense as they are likely to be recurring in the foreseeable future. While it’s difficult to determine the exact P&L impact due to uncertainty related to grant criteria, grant date, fair value on the date of grant and the vesting schedule, we believe Zomato’s management would be prudent enough to ensure that the total employee costs as a % of adjusted revenue doesn’t shoot up from current levels. In fact, we believe the company will grant ESOPs in a manner that would ensure total employee expense as a % of adjusted revenue would continue to fall YoY. Accordingly, we forecast employee cost as % of adjusted revenue to fall to 8.6% by FY27 vs. 12.3% in FY24.

* Change valuation methodology and revise down TP to INR 230: We broadly maintain our estimates our GOV/Revenue/EBITDA/PAT forecasts over FY25-27. We, however, change our valuation methodology to PER from the multiples-driven SOTP approach earlier to better capture the impact of ESOPs on valuations. We assign a target multiple of 75x on Zomato’s Sep’26 EPS to derive a revised TP of INR 230 (vs. INR 250 earlier). Despite the revision, the stock continues to be one of our preferred picks in the listed Internet space as we believe it is well positioned to benefit from robust industry tailwinds for the hyperlocal delivery businesses. Its balance sheet also remains strong with net cash of INR 122bn as of Mar’24 (INR 120bn in Dec’23). We maintain ‘BUY’

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