Zomato and the Unit Economics Problem

We are finally back.

After 2 gruelling weeks dealing with the effects of Covid, it feels so good to be writing this newsletter again. We are all doing fine and we have had enough time to rest and cope these past few days. Also, I want to thank each kind soul that wrote to us offering help. Thank you for your blessings and your wishes. We are forever indebted to you. And while we’ve been extremely lucky to come out the other side, relatively unscathed, we know that others around us haven’t had the same kind of luck. My heart goes out to each person that’s lost a loved one during this pandemic. I hope you’ll come out of this stronger.

It isn't easy getting back to this daily routine when there's so much agony all around us. But this newsletter is probably the only thing that's keeping us sane here at Finshots. So with this little introduction out of the way, we will just dive into today’s big story. Zomato is finally going public and the Draft Red Herring Prospectus — detailing the company’s financials and business prospects, is now out there for the world to see. And since there’s absolutely no way we will be able to cover everything inside the prospectus, we will focus on just one thing - Unit Economics. Basically, trying to see if Zomato has finally found a way to fulfil an order without spending more money than it earns.

The Story

The Red Herring Prospectus is a strange document. The regulator mandates companies to list their prospectus in the hope that potential investors seeking to buy a company’s stock would have more clarity on the pitfalls of investing in the IPO. However, the document itself is dense and can often rival a company’s marketing brochure.

Zomato’s prospectus, however, is pretty transparent for the most part. There’s some very useful information and potential investors seeking to participate in the IPO could get a lot out of it. That being said, we still need to look at some of the lofty claims made in the document with a healthy dose of scepticism.

The most significant claim being that the company’s unit economics have now improved. That Zomato now makes more money on each order compared to the money they spend fulfilling that order.

This is all the more surprising considering several important metrics took a beating as the pandemic induced lockdown disrupted operations last year. For instance, there was a visible dip in gross order value (GOV), there were fewer active users on the platform and even fewer transacting users. Gross order value i.e. Total monetary value of all orders (including taxes and customer delivery charges) tanked — from ~₹2680 crores during January and March 2020, to about ₹1093 crores for the period between April and June 2020 — at the height of the 1st wave of the pandemic.

Transacting users meanwhile also suffered the same fate. Between March 2019 and March 2020, you had an average of 1 crore monthly transacting users on the platform. However, after Covid, between March 2020 and December 2020 — there were only 58 lakh monthly transacting users on average.

So you have to ask, what explains the seeming disparity here — How can Zomato boast positive unit economics when also posting a dismal set of numbers elsewhere.

Well, there’s a lot of nuance here. So let’s break it down one at a time.

Sure, the average MTU (Monthly Transacting Users), declining for instance is cause for concern. But here’s the thing — The average was calculated over a period of 9 months between March 2020 and December 2020. During the first few months, this number tanked precipitously because of the general paranoia surrounding Covid. Nobody was transacting on the platform. It was an aberration. And you know what happens to averages when you have a few extreme values in the mix. They affect the value considerably and it doesn’t paint a fair picture. Bottom line — Transacting users have seen a decline but it isn’t as bad as the numbers project.

The gross order value meanwhile did tank between April and June 2020. But by the end of the year i.e. between October and December 2020, Zomato was already recording its highest number ever — ₹2980 crores during the last 2 months of 2020. Bottom line — Gross order value was back to pre-covid level with some improvement on top. So these numbers aren’t bad per se.

Besides, unit economics has nothing to do with these values. It doesn’t matter if the company has 1 user or a million different users. The unit here refers to a single order. And if the company can ferry this one order by spending ₹10 while earning ₹11, from that same order, then it has positive unit economics.

In fact, the only number affecting this metric is the average order value (AOV).

The logic here is simple— Zomato spends pretty much the same kind of money ferrying a ₹100 order and a ₹500 order. The costs more or less remain the same. But they make more money from the ₹500 order, by virtue of claiming a commission on the total order value, thus making it a more profitable enterprise. So if customers start transacting on the platform seeking more expensive orders, then you will witness an uptick in average order value. The increase in average order value in turn will help Zomato improve the unit economics. This is the path to profitability. And Zomato claims that it has cracked the code.

As they note in the prospectus —

AOV is a function of the price of food at restaurants and the number of people the food is being ordered for. Everything else being equal, the AOVs are higher for orders from premium restaurants. Our AOV has increased steadily over the last seven quarters.

And it’s true. The average order value has in fact been rising — from ₹264 for the period between March and June 2019, to about ₹400 during the last 3 months of 2020. That means the average customer on Zomato is now spending more money than he/she used to.

But why?

Well,  let’s start by looking at the price of food. If there is any reason to suspect that the food prices may have been on a rise these past two years, then we could explain with some confidence why the average order value has been on the up. But it’s a bit hard to believe that food prices would increase drastically over a period of 20 odd months unless it’s being deliberately inflated. Does that mean the restaurants are somehow colluding?

Of course not.

Is Zomato inflating the price?

Well, that’s a bit difficult to answer.

Because Zomato will tell you that they have no influence on pricing. But that is only partially true. When Zomato charges a service fee from restaurants they’re indirectly affecting the listing price. If Zomato were seeking a higher commission, then it’s quite possible food prices across the board would rise in tandem. So one possible explanation is that Zomato is now taking a higher cut thereby forcing restaurants to up their price. This explanation is further supported by the fact that Zomato now operates in a space where there’s only one clear competitor — Swiggy. So it isn’t far-fetched to assume that they would have significant pricing power. However, at a time when restaurants were actively fighting back against aggregators like Zomato, it’s quite unlikely the company would have had the leeway to push commissions disproportionately.

This means we have to find another explanation. Perhaps one where prices rise because of a fundamental shift in industry dynamics. Now bear in mind, we saw the pandemic wreak havoc last year. And if you were a keen observer, you’d have seen a distinct change in listing patterns. We saw premium restaurants pivot to deliveries and takeaways for the first time ever. As people refused to frequent restaurants, these high-end restaurants had no choice but to list their offerings on apps like Zomato. And as such, people now had the luxury to order high-value items from these outlets, and price patterns across the app witnessed a shift. As the company noted in an interview with the LiveMint last year —

“With more premium restaurants, i.e. restaurants where a meal for two may cost ₹1500 and above, now opening up to online delivery, a larger number of affluent consumers are embracing online ordering. Overall spends on such premium restaurants have grown by over 25% over pre-covid levels.”

Outside of this, there was also a change in Zomato’s customer demographic. You know who’s likely to order from Zomato — It’s the lone bachelor living in an urban center with little incentive to cook. These were the original loyalists — people like myself. However, as Covid induced lockdowns became commonplace, the bachelors migrated home and a very different set of consumers started exerting their influence — families. As Zomato noted in an interview back in September 2020 — “Orders with meals for 3 or more persons have recovered well and are higher than even pre-covid levels currently”

Meaning, you could partly explain the uptick in average order value by showing how each order now contained multiple dishes meant for different people. Now there are some who would look at this and say that the newfound riches may not last. Families will go back to cooking. Bachelors will return and the average order value will tank. But remember what we already noted — By December 2020, the gross order value was already back to pre-covid level with a distinct improvement. And yet, they were still profitable delivering each order. Granted it wasn’t as profitable as it used to be during the early days of the 1st wave, but they were still boasting positive unit economics.

And yes, we know that these trends could reverse as they compete for market share. And we also know they still aren't profitable at the aggregate level. When you are trying to work out the unit economics you don’t include the fixed costs and the marketing expense. When you add those numbers you’ll see Zomato is still an unprofitable enterprise. And the effects of the pandemic will probably have an impact on the top line as well.

But it’s still progress. And even if you think that the company will go back to its loss-making ways once the pandemic fades from view, you still have to be optimistic looking at the numbers. Here’s an Indian startup that changed the way we eat. It made our lives better during the pandemic and now they’re at the cusp of going public with profitable unit economics.

You have to be rooting for Zomato, no?

….

Well, we don’t know about you. But we are and hopefully, the positive unit economics sustain even as the company starts navigating through another crisis as the deadly second wave unfolds across the country.

Until then…

Don't forget to share this story with anybody who loves Zomato. Links to Whatsapp, Twitter and LinkedIn

Also, we will be writing another story on the IPO covering all the other details (including valuation) when the listing day approaches.