Interest rates are low and, hence, there is enough appetite in the market for IPOs of tech-related plays right now, says a technology analyst
Seize the moment appears to be the mantra for investors these days. After all, what explains the euphoria behind food delivery firm Zomato Ltd’s initial public offering (IPO). Its valuation was already expensive at around 12 times estimated FY23 revenue. Yet, the book-built part of the loss-making firm’s IPO was subscribed about 38 times, with investors banking on a listing at a $10 billion valuation.
Other internet firms are lining up their IPOs, too, to take advantage of the frenzy on the Street. The pipeline of tech-related companies is robust and includes firms such as Paytm, PolicyBazaar, Nykaa and MobiKwik.
What explains the current exuberance for internet IPOs? There are three major factors driving the excitement around these firms. The most obvious is that global liquidity remains high, with central banks continuing to stay accommodative with their monetary policies. Higher the liquidity, greater the risk tolerance, and an increasing number of investors who are willing to bet on loss-making firms. “Interest rates are low and, hence, there is enough appetite in the market for IPOs of tech-related plays right now," said Bhavin Shah, a former technology analyst and founder of Sameeksha Capital, a portfolio management services firm.
Second, there is a heightened FOMO (fear of missing out) factor at play. Hope springs eternal that these Indian internet companies would eventually be success stories like Google, Facebook and Netflix, and investors don’t want to miss out.
Third, the Chinese government is going after its tech companies, and a part of the incremental flows are moving towards countries such as India and Indonesia. “While it is a relatively new phenomenon, this could be a structural shift," said an analyst at a multinational brokerage firm, requesting anonymity.
But these factors that are driving the flood of investments are fraught with risks. “Investors should note that when the Fed starts raising rates, valuations of tech companies are likely to materially correct. Right now, everyone is just going with the momentum," said the analyst.
“People draw parallels with Google, Facebook and Amazon, but note that these businesses pretty much own their entire space and, hence, the economics are different. One has to assess whether a tech firm would be able to dominate its market or would have to share the space with one or more other players," said Shah.
In the past few years, the Indian market has risen on many hope-based trades. While earnings have continued to disappoint, investors kept falling back on hopes that things will get better in the future. Internet stocks take the hope trade to another level altogether as investors don’t even need to worry about inconvenient truths such as losses or cash burn in the near term. It’s all about the great potential in the long term, based on the growth of internet companies in China and in the US.
“While the market potential is huge in India, one must be careful in drawing parallels with China because at similar levels of per capita income, India has not grown as fast as China and, hence, may take longer to achieve the same milestone of per capita income," points out Shah.
The other big hope that investors are riding has a name called ‘adjacencies’ or what some refer to as ‘optionality’. “Optionality-related to future use cases is a critical component of the internet business model. Learning from the likes of global companies such as Meituan suggests that one use case (e.g. food delivery, payments) can often be used as a hook to cross-sell/upsell other use cases/services. For instance, nearly 85% of first-time users come to the Meituan app to scout for food delivery. Interestingly, >50% of users who stayed on the platform for three years buy all the top-5 selling services on the platform," ICICI Securities Ltd said in a note.
Zomato isn’t worth $10 billion in the eyes of some investors simply because of the prospects of its food delivery business. These investors are also betting that it will offer its millions of users other ‘adjacent’ services such as grocery. Whether these adjacent services add value or cause more cash burn is, of course, not something to worry about now.
“Ultimately, for any business, valuation is a function of discounting future cash flows, and for many tech startups, the visibility on this is too far into the future, sometimes even with a disclosure that these companies may never make profits," said Darshan Rathod, co-founder, Acumen M&A Advisors.
“From a cash-flow valuation perspective, one can tweak assumptions to justify anything. For example, what may look overvalued can look undervalued if one assumes entire future growth to materialize in, say, 10 years instead of 20 years. Often, this subtle thing gets overlooked in the hyped-up environment," added Shah.
To be sure, while there is a general exuberance about tech IPOs, companies with better profitability are the biggest beneficiaries. Companies with positive unit economics or ones that are near Ebitda-breakeven are fetching better valuations.
“We don’t see all companies benefit equally and expect companies with good business models/moats to maintain traction. Bigger tech companies would also look to acquire companies having complementary offerings. We also see struggling companies shutting down as focus starts moving towards unit economics," said BofA analysts in a report.
Investors, therefore, need to be aware of the high risk of failure of some ventures. Many tech firms that were well-funded earlier are almost forgotten now. “Jabong is a classic case. At one point, it was negotiating a valuation of $1.2 billion for itself, and its owners had to eventually settle for a $70 million price just a year later. And this list is long. But no one wants to talk about negative bets; as humans, we’re wired to display only our wins, not losses," Rathod said.