Wednesday, April 22, 2015

Valuations For Hi-Tech Industries - Illustration 1 - BookMyShow.Com

Hi There
For the last 3 years, we have seen hi-tech stocks getting funding like there is no tomorrow, crazy valuations and a sense of deja vu with the 1999-2000 dot com bust. Personally, I find the valuations a bit crazy myself but first things first, let us understand the difference in scenarios prior to the dot-com bust and the current situation.

In the early days of the internet, broadband was a far fetched concept perhaps accessible only to large corporations. It was the world of dialups. Websites had to be made with HTML pages like today but there was not much automation. One had to hire a battery of HTML writers to ensure that pages are put up. The number of internet browsers were limited and so were support infrastructure, security et al. Computers at home were rare and laptops were the privilege of the rich. For the common man, the only way to get internet access was to pay a bomb to the ISPs or go to cybercafes and pay as per usage. All said and done, the technology was absolutely new then [we only have the benefit of hindsight now to say that it was archaic technology!]

All said and done, it was pretty clear that the internet would make the world flat. Suddenly, there was no need to worry about sending letters to loved ones anywhere in the world with postage or courier charges and yet worry whether the mail would reach the person. It set across the culture of instant connect as long as both sides accessed the internet and got the mail.

I won't get too much into the specifics of the technology aspect. There are enough expert views on www to talk about that. Suffice to say that security, access were all limited. This post has got to do more with business models of technology and how human nature stays the same at the core.

Human nature as always is driven by greed and fear when it comes to business and economics. Be it Dutch Tulips or American Housing or Railroads and Utilities, human beings in general are wired to be driven by greed and fear. A vast majority of people got so caught up by this mania of the world getting flat that logic was thrown out of the window to say the least. Almost everybody thought that as long as I have a website and some content out there, I can move on to financial freedom and make good money. Even smart money proved that it was perhaps not very smart. Funding moved in left right and centre to all sorts of technology related businesses without worrying about long term sustainability.

Let us face it, no business can make profits outright - be it brick and mortar business or technology business. Materials need to be procured, a sound operations plan needs to be built in, target customers need to be approached so on and so forth. That is precisely the reason why banks and investment arms exist in the first place. If you want to start a food truck [Im not even getting into a basic restaurant over here], you still need to have that food truck in place. The cuisine needs to be set, people need to be informed about the existence of the food truck. And even then, the food truck can't be making profits from day one. By the time one gets critical mass and the food truck breaks even, it could be at least 2 years.

Likewise, even the e-commerce and hi-tech businesses definitely needed funding to keep themselves going. The main difference then and now is the business ecosystem. In the previous technology boom, getting infrastructure in place itself was a very capital intensive task. What went wrong was the basic sense of how the future revenue model would be. Even if one does not have a clear picture, one needs to know what are things that can be charged for and what can be the potential profit. Nothing was done in this regard. Almost all websites had hazy but crazy projections of revenues and profits purely on the basis of people hooking their eye balls to the internet. It seems outrageous that valuations were done on the basis of number of eye balls, number of hits a website would get - bizarre.

For business its simple: Revenue - Cost = Profit. Some of these costs would be operating costs whilst bulk of costs would be fixed costs to be amortized and recouped over a longer time frame. The music obviously stopped then at some point of time and Darwinian principle of Survival of Fittest kicked in. [Note that it doesn't matter what technology we use, basic human nature and basic economic principles always kick in; technology can be different but the core remains intact]

The BIGGEST BLUNDER in the DOT-COM BUST was that people thought technology itself will be the new way of life and business. What people forget is that TECHNOLOGY IS AN ENABLER - NOT A REPLACEMENT for human beings. Human beings are by nature social beings. They need to interact with people, communicate with near and dear ones. Before the telephone came in, people only had one way and that was through letters. Telephones changed that. So the technology is an enabler to reach out to people. Then came email and it largely reduced the need for conventional post across borders. Key principle - Technology is an enabler.

Also the email and chatrooms brought forth this concept very clearly at that time itself. There are enough likeminded people in the world with whom you can discuss your interests. Earlier, whether you were somewhere in downtown Baltimore in US or in some far fetched suburb in Mumbai or on the beaches of Pattaya, you could struggle to discuss and know more about Origami. You perhaps did not have enough people around to share and discuss ideas about Origami - email, messenger and chatrooms changed that. What it also did was eliminate a lot of biases. People everywhere had some superiority complexes and inferiority complexes regarding different skills, strengths and weaknesses. The dot-com proliferation showed the world that you need not have superiority complex about a lot of things. No matter how smart you think you are, there is at least 1 person who is far superior to you.

Whilst these were positive, the human nature of greed and fear drew valuations way out of the way. It was deja vu Dutch Tulips mania or the Housing Bubble of US. In the hay days of 2006-2007, a pizza delivery boy could double up as a home loan specialist in the US and own a fleet of BMWs and Mercedes cars riding on the housing and mortgage boon. People bought into homes, stocks just to ensure that they are not left out of this boom. After all, in its nascent stages, the segment was clocking almost 15% growth CAGR YoY. The smartly dressed investment bankers decided to superimpose this on the industry and financial sheets. 15% growth in perpetuity.

Simple power of compounding says that one can double an invested principle by a factor of 70/Interest rate. At 15% growth rate, we were talking doubling of home values and business values in 6 years. Obviously that was bizarre. Simple day to day consumption items like milk, juices, bodycare products etc grow 2% to 3% in perpetuity. That is because of economic cycles and the base effect. To double from a small base value of 2 million users to 4 million users is easy. 4 million to 8 million can start getting daunting. These were the socio-economic factors when the previous asset bubbles were built and specifically for the hi-tech boom, the challenge was the overall ecosystem specifically backend stuff that was missing. The music would stop and a crash was imminent.

Now we time travel to current times. The IT ecosystem is much more robust as far as back-end operations are concerned and a large number of people access the internet across different kinds of hardware. Cost of access is marginally low. Jaw dropping valuations are coming through for a lot of hi-tech companies and we clearly can see 2 camps; one that strongly feels that such valuations are justified and the other that feels that it is deja vu 2000.

Let us come specifically to Indian hi-tech companies and also understand a few businesses. I am taking as my first pilot case. Please note that the company is not publicly listed and hence I am using guesstimates to arrive at revenue and expense projections

As with any business, the first thing is to figure out business volume potential

There are about 12000 cinema screens in India and 10% of them are multiplexes set in Metro and Tier1 cities [Business Standard / Economic Times online articles / About Us]

Each multiplex typically has 4 screens with seating capacity of about 250 / screen and 4 shows per day. That gives us about 48 Lakh multiplex tickets potential each day in India. What really is a challenge right now is occupancy [or footfalls as measured in retail terms]. Weekdays sees about 10% occupancy at best overall and 75% occupancy on weekends at liberal levels.

Advantage Bookmyshow: It is independent of these factors; its revenue is based on a fee / ticket. Also cinema tickets are just one of the revenue streams [extremely dominant today] but the same model can be replicated for a number of events like theatre plays, music concerts, sports events etc. Bookmyshow has gained the first mover advantage and gained some traction in this space as well. It is just that compared to actual market potential, these segments have not gained as much compared to mature markets.

Disadvantage Bookmyshow: Due to a variety of reasons, the penetration is far below potential at present. With so many credit/debit card frauds reported almost everyday, a lot of people in general are reluctant to use online portals for making financial transactions. For regular consumption items, there is always the option of Cash/Card on Delivery but that cannot happen with BMS. So although on paper, there is potential to sell upto 2.5 million tickets per day, BMS is just about at 0.5 million tickets per day. Note that this is per day. At a convenience fee of 15 per ticket that still means revenues upwards of 65 million [68 Crores in desi parlance and that too on a cash and carry basis!]

On the brighter side, 68 crores of revenue is fantastic with less than 5% of actual customers using BMS. To scale upto 10% - 20% of new customers is now pretty easy. Since the booking software and code is in place, the core technology remains the same and there will be far greater utilization of staff, resources etc. The business needs about 100 employees across departments to keep this going. The rest can be outsourced. All said and done, there are expenses to take care of and I have outlined my assumptions and projections in the sheet below

Volume / Revenue / Expense Projections 

Without going too much into the sunk costs, as a day to day business, this model earns a healthy margin of 15% pre-tax income and with volume, the bottom-line can be as high as 40%. Hi-tech business unlike brick and mortar business can grow much faster in revenue and expenses will still grow much much slower due to the scalability factor. Classical economic theory tells us that as the market place sees high returns, more players come into the field forcing prices to Marginal Revenue = Marginal Cost. This is another beauty of hi-tech business. It is all about gaining mindshare and many rivals can get crushed just in the acquisition place.

Overall though, the net pre-tax margins won't go below 10% and the market potential is huge. Trade pundits are giving BMS a valuation upwards of 1000 crores at this stage. 1000 crore valuation for a company that rakes in about 70 Crore revenue with 7 crore earnings- seems far stretched. 5 years down the line when volumes to come towards the actual potential, this business will be clocking revenues in excess of 700 crores and PAT of 70 Crores plus. With this kind of money coming in, classical economics says there will be more players coming into the picture.

All in all, a fantastic business to be in with a robust business model. The company is no doubt fabulous and can easily connect with the young population of India. But no matter what way one looks at the business, 1000 crores is a far stretched valuation. Giving it parity with mainstream IT players like TCS or Infosys or HCL Tech, the fair PE multiple is about 30. We know that the earnings will be 70 Crores in 5 years time. With a PE multiple of 30, we get a fair stock price of 210 / Share. Assuming that 10 million shares are outstanding at that point of time, The best case scenario gives the company a valuation of 210 crores.

The other side of the argument is the number of shares outstanding can be far greater than 1 million. I counter that by saying, the greater the number of shares outstanding, lower the EPS and hence price needs to be adjusted accordingly. The fact is that total earnings won't change in a hurry. Allotting more shares does not change the basic facts. The pie remains constant; just that the slice of the pie will chnage.

To summarize, BookMyShow with its Cash and Carry model is bound to succeed. The company seems to have anticipated future needs as well and the backend operations have been secured for now as well as for a good time into the future.

Current Sales / Earnings is about 70 Crores Revenue with 7 Crores Earnings. Business works on Cash n Carry model. Assuming 1 Million Shares outstanding and PE of 30, fair value of the stock will be about 210. So the reported valuation of 1000 crores is grossly overestimated and whilst that is not reason to short when the IPO and initial trading days come in, the counter should follow the steps of parent channels Network 18 and TV18.

Should you buy the IPO: Yes - if the euphoria is good enough. Cash out in early listing gains.

When you buy STOCK, always keep these 2 charts as a guiding principle

Tech valuations are highly subjective but if good old common sense prevails, we will know what is real and what is artificial. In the next valuation exercise, I will take the case of Ola Cabs

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