Home >Markets >Ipo >What Zomato IPO has in common with the humble telephone

The initial public offering of the food delivery company Zomato is currently the talk of the town. The company plans to raise around 9,375 crore through the IPO at a price band of between 72 and Rs76 apiece. Given this, the market capitalization of the company is expected to be around 60,000 crore.

Many investors can’t seem to get their head around the idea of a company that has been making losses over the past several years being valued at such a high price. In fact, the expected market capitalization of Zomato is higher than hotel companies like Indian Hotels and EIH, which are 17,625 crore and 7,307 crore, respectively. It is also more than Jubilant FoodWorks, which has the franchisee for Domino’s in India and has a market capitalization of 40,895 crore.

Take a look at the following chart. It plots the total income and losses of Zomato over the last few years.

Zomato income and loss
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Zomato income and loss

The above chart makes for interesting reading. As the income of Zomato went up between 2017-18 to 2019-20, so did its losses. In simple terms, this doesn’t seem like much of a business model where income and losses go up simultaneously. In 2020-21, the income fell, but the losses fell faster than the drop in income.

So, what does this tell us? It tells us that the company has survived despite making huge losses of more than 4,300 crore in the past four years. How is that possible? Venture capitalists have been funding Zomato up until now.

Why would anyone fund a loss-making company? This is where things get interesting. Ecommerce companies have what is known as a network externality. What is network externality? Let’s take the example of the humble land-line telephone invented by Alexander Graham Bell in 1876 to understand this concept.

Graham Bell made the first telephone call to his assistant Thomas Watson. As David Evans and Richard Schmalensee write in Matchmakers: The New Economics of Multisided Platforms: “A telephone was useless if nobody else had one. Even Bell and Watson started with two. A telephone was more valuable if a user could reach more people."

If the telephone had stayed as a medium of communication between Graham Bell and Watson, it would have been a largely useless invention. Hence, the more people who ended up using the telephone, the greater its value became.

As Evans and Schmalensee write: “The more people connected to a network, the more valuable that network is to each person who is part of it." Economists refer to this as network externality. It is called an externality simply because even one more person joining the network impacts everyone else.

Given this, the success of the telephone depended on building a critical mass of subscribers. The more the number of subscribers the telephone reached, the more the number of newer subscribers would want to own one and more its value would increase for everyone who owned one. That’s network externality.

There are two sides to the network externality equation. First, let’s take the example of Google and the fact that everyone can use it for free. As Ray Fisman and Tim Sullivan write in The Inner Lives of Markets: “Why, for example, does Google let you search the web for free, even though maintaining its primacy in the search engine market costs the company a fortune in R&D (and) computing infrastructure."

The fact that anyone can use Google for free is one side of the equation. What is the other side? The more people who use Google, the more viable its business model gets. As Fisman and Sullivan point out: “A bigger user base allows Google to extract ever-higher revenues from the other side of the market—the advertisers, who pay for search listings."

Or take a company like Uber. The more prospective cab users who download the app, the greater the incentive for cab drivers to associate with the company.

Similarly, when it comes to a food delivery company like Zomato, it needs both restaurants and prospective consumers to be using its app to be a viable product. The more consumers who order food using the app, the more the restaurants would like to associate with Zomato and vice versa. This is how it works.

This is as basic as network externality gets. But there is a little more to it. Economists studying businesses with network effects over the years realized the importance of the first-mover advantage.

As Evans and Schmalensee write: “Network effects meant that one firm, or standard, would control the market since bigger was always better in the eyes of consumers. These were, therefore, winner-take-all markets." Given this, the economists concluded that “if you wanted to be the winner who took all, you had better start first and keep your lead."

When venture capitalists fund businesses with network effects, the idea is to help them build a market share quickly and worry about making money later. This is precisely the logic followed by Zomato and every company which has network externality at its heart.

As Fisman and Sullivan write: “The bigger a company gets, the more valuable it is to each successive customer, there’s a huge premium on expanding your customer base. As a result, platforms may want to set prices lower than businesses that sell unnetworked products."

To build a large customer base, such companies offer huge discounts initially. These discounts lead to a lot of cash burn, which leads to huge losses during the initial years.

As Tim Harford writes in Fifty Things That Made the Modern Economy: “That’s why Uber and its rivals – Didi Chuxing in China, Grab in Southeast Asia, Ola in India – have invested massively in subsidizing rides and giving credits to new customers: they wanted to get big first."

Zomato is also doing the same thing by getting more and more people to download the app and order food using it. This is why it has made huge losses over the years. The venture capital firms that have invested in Zomato have done so in the hope that the company will capture a large chunk of the food delivery market over the years, and that’s when it will rake in all the money. Or they might simply sell out their stake to other investors who buy this story, even before it plays out.

The trouble is until that happens, Zomato and every such firm need a continuous flow of money to keep funding its losses. Of the around 9,375 crore that Zomato plans to raise through the IPO, 9,000 crore will go towards what it calls the core growth areas. These are a) customer and user acquisition, b) delivery infrastructure, and c) technology infrastructure. So, the cash burn in trying to expand its customer base is likely to continue.

The question is whether Zomato can keep reducing its losses as it keeps increasing its sales in the years to come. It did that in 2020-21. But that’s just one year and a year impacted by the covid pandemic. Will a significant number of people keep ordering food online even after discounts go out of the picture or are gradually reduced? That’s the question. The good part is that the food delivery market is dominated by just two companies (the other one being Swiggy). Hence, there is very little competition.

In the short term, the stock price might of Zomato might go up post-listing, given the huge amount of money that is chasing stocks these days and given the considerable investor interest in this IPO.

But in the long-term, whether the Zomato stock does well depends on how well the firm’s business model works out. Uber explained this risk very well in its IPO prospectus, where it said: “We have incurred significant losses since inception, including in the US and other major markets. We expect our operating expenses to increase significantly in the foreseeable future, and we may not achieve profitability."

The point is not every company ends up controlling a significant portion of the market.

Some even fall by the wayside. Remember Snapdeal?

Vivek Kaul is the author of Bad Money.

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