Nykaa, Paytm and long-term investing

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During Moneycontrol’s Samvat 2078 panel discussion, Dalal Street veteran Ramesh Damani recalled, in the spirit of levity, the Bollywood song Tujhe Dekha Toh Yeh Jaana Sanam to describe his emotion towards Avenue Supermarts, the owner of retail chain DMart. It was apt, for Avenue Supermarts has consistently conquered new peaks since its listing in March 2017 despite its high valuation.

From its IPO price of Rs 299, the stock is up 17x at Rs 5,080 on November 12. At the current price, the stock is trading at FY22 P/E multiple of 185x commanding a market cap of Rs 3.29 lakh crore. So, while Damani might have sung in levity, investor affection is deep-rooted and for good reason.

Nykaa CEO Falguni Nayar learnt these two things from Uday Kotak

DMart’s business model was spot-on, when every other entrepreneur in modern retail was struggling to profitably crack the tremendous opportunity in the biggest consumer market after the US and China. The impeccable execution and measured expansion ensured that investors had no reason to complain. As the track record improved, even the skeptics on valuation hopped on to the bandwagon and took the stock higher and higher. The magic happened because DMart was created by a stock market wizard who with able management built a business that every investor craved to own.

Nykaa has now served the same recipe. A bang-on business model, that has successfully tapped into the white space of organized beauty retail in India. A digital business that is highly scalable, across other product segments, and across other geographies. Again, a promoter who understands investor expectation supremely well, having been on the other side of the game for the longest time and is determined not to do anything that does not make “economic sense” in an environment where profit and growth is an either-or for most entrepreneurs. If the stock market has fallen in love with the ‘queen of beauty’, it’s understandable.

Exclusive interview: Nykaa CEO Falguni Nayar

What seems hard to justify though is the valuation for Nykaa. Just like it has been hard to justify DMart’s valuation. In a strategy note in October, Kotak Institutional Equities calculated that the market expects Avenue Supermarts valuation to be Rs 70 lakh crore by 2050 (when India’s GDP per capita will reach that of China’s current GDP per capita of $11,000), assuming that the weighted average cost of capital is 11 percent.

If the cost of capital is assumed to be 12 percent, the market’s expectation of DMart’s valuation, Kotak analysts said, would be Rs 90 lakh crore. The top 10 Chinese retailing companies currently have a combined market cap of $1 trillion (Rs 75 lakh crore). This not only assumes over 6 percent per capita income growth but flawless and significantly superior execution by the management to ensure it gathers a bigger slice of the market for itself.

Unlike DMart, the big plus Nykaa has is that its online business is highly scalable and has a high chance of evolving into a winner-take-all. With an omni-channel approach, off-line will feed into online and propel growth. The beauty and personal care space is large at $18 billion (pre-Covid) and the growth narrative is rosy considering the large youth segment keen to spend on looking good, plus the rising aspiration in smaller cities and towns. Nykaa is the leader here and has perfected the business model that blends in both offline and online.

Here comes the clincher: the management’s decision to go beyond beauty into fashion. This is what has added even more power to the Nykaa story as fashion is an even bigger market at $83 billion (pre-Covid). This is notwithstanding the fact that fashion is a tougher business with lower gross margins, and highly fragmented with an already established online leader and plethora of multi-brand retailers.

But, what the addition of the fashion vertical has done is shown the way in terms of future potential by expanding the total addressable market for the company, which is a key assumption analysts use to extrapolate into the future. That’s also the beauty of these digital businesses–there are what you call ‘optionalities’ or opportunities that are available to be chosen and exploited in the future but are not obligatory.

Net-net, Nykaa is beautiful. Great management, great business model, growth on its side, and there is a scarcity of such businesses in the market that is craving for digital-driven businesses. Till this sentiment continues, it’s hard to argue with the market on valuation. But we also know from past experience that high valuation beyond a point can lead to significant correction and underperformance even in top-quality companies – think Infosys in 2000.

Nykaa’s paltry profits of FY21 at Rs 27 crore is already down to nothing (Rs 1.2 crore) this quarter, although revenue increased 47 percent on a y-o-y basis and 8 percent on a sequential basis. Most importantly, its overall m-cap in excess of 1 lakh crore assumes that it already almost owns the entire beauty and personal care space which as mentioned earlier is $18 billion (Rs 1.35 lakh crore), when its FY21 GMV was $540 million (Rs 4,050 crore) and actual revenue was Rs 2,400 crore. Sure, the market value of an industry can be higher than the size of the industry depending on future growth and profitability of the business, but in Nykaa’s case, despite the phenomenal strength in its business, the discounting seems far out into the future.

Paytm – karo ya baro?

On November 10, the day that Nykaa listed with a bumper valuation, One97 Communications, the owner of Paytm, barely managed to cross full subscription with its IPO. The largest IPO in Indian history, with an offer for sale of Rs 10,000 crore and Rs 8,000 crore of fresh equity was subscribed 1.89x, with the reserved portion for non-institutional investors subscribed only 24 percent.

350 Paytm employees set to become millionaires after IPO launch

Unlike Nykaa, Paytm does not have a distinctive or proven business model, it is operating in a space that now has no entry barriers, because of UPI. Despite such fragility, Paytm had the audacity to launch such a huge IPO chiefly to offer an exit to existing investors. The fact that the market has shown restraint in its reception means we are still not in a euphoric zone.

A euphoric market is when dabba companies get dhamaka valuation! One could however argue that the prevailing valuation Paytm has got is dhamaka for what it brings to the table, and that would not be far from the truth either. Considering the weak fundamentals, a significant correction may not come as a surprise especially if overall market sentiment turns bearish. That brings me to my next point.

The promise of ‘long-term’

Investors generally have one hiding ground for all mistakes: long-term. Whatever kind of investor you are, when you buy a stock and it goes south, you invariably end up being a long-term investor in the stock! This of course is largely because of loss-aversion. As humans we prefer to avoid losses, and this fear of taking a hit causes us to prolong our position even when we may not be convinced about the stock anymore, and there may be alternate opportunities to profit from.

Strangely, these days, I see analysts increasingly advising ‘long-term’ as ‘safe’ to invest in stocks that are momentum-driven, including the internet businesses that are now in vogue. Long-term does not eliminate risk. On the contrary, when things are hugely sentiment-driven, and you do not want to miss out on the momentum, short-term may be the best approach, with a very clear idea of when to cut and run, because some things only get worse in the long-term.