Shapoorji Pallonji Mistry Sr, the son of Pallonji Mistry and heir to the Shapoorji Pallonji group, was furious. No one in Angrezi Bazaar seemed capable enough to fix his electric iron - an coveted item of luxury in those days.

Just when he was about to give up, he came across Meherwan Daruvala, who ran a small electric shop in Angrezi Bazaar, called Wilson Electric Works. Just like Shapoorji, Meherwan too belonged to the enterprising Parsi community of Bombay. Unlike Shapoorji though, Meherwan came from humble means. While the Mistry’s started their business in 1865 and by 1927 were synonymous with the likes of Tata’s, the Daruvala’s were just getting started.

Impressed by Meherwan’s work and abilities, the two soon struck a friendship. That friendship eventually translated into a business relationship when their sons (Pallonji Mistry and Yazdi Daruvala) formalized the partnership by acquiring 51% stake in Wilson Electric Works. It was then, the name ‘Sterling’, from the Mistry’s family investment firm Sterling Investments, was added as a prefix and so birthed the company - Sterling & Wilson Ltd.

That business relationship has survived almost a century across generations of family members and has led to construction of iconic projects like the Taj Mahal hotel in Mumbai (the electric work was done by Sterling & Wilson, constructed by Shapoorji Group and owned by Tatas), the Sultan Qaboos Palace in Oman, the Reserve Bank of India building and the World Trade Center at Cuffe Parade, Mumbai, among others.

In 2019, Sterling and Wilson, demerged and listed its solar EPC business on the National and Bombay Stock Exchanges.

This, is the business of Sterling and Wilson Renewable Energy.

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Part One: Current Business of The Company

Sterling & Wilson Renewable Energy is primarily into the business of setting up large scale renewable energy parks, comprising of mainly solar, wind and battery energy storage systems. The firm, is an engineering, procurement and construction contractor also known as an EPC contractor.

In an EPC business, a company (EPC contractor) is given the responsibility to execute, manage and build a large project. One of the most well known EPC firms in India is Larsen & Tubro, which also happens to be one of the largest EPC companies in the world.

The above graphic highlights various stages of an engineering, procurement & construction (EPC) contract. In some markets, procurement of raw materials function is part of the EPC business and is included in the contract, while in others the client procures and supplies the raw materials.

Another key part of EPC lifecycle is the Operation & Maintenance stage, also known as O&M. Operation & Maintenance is the higher margin, low risk and long sticky revenue business and in most cases is granted to the same company building the project.

The above is a detailed yearly revenue breakup for Sterling and Wilson Renewable Energy from its listing year (2019) to present.

At the heart of it, its a simple business.

But this simple business comes with a myriad of challenges, some of which nearly bankrupted Sterling & Wilson several times.

What are turnarounds?

Before we proceed any further, lets first learn what are turnarounds in investing. To explain turnarounds, here is the legendary Peter Lynch.

As Lynch explains, turnarounds are stocks that went through a tough business phase leading to accumulation of losses, high debt and are most often ignored by the market.

What makes them a turnaround stock, is a trigger - usually an internal change in the way business is performed or a takeover by a new management.

There is a popular market saying, “Turnarounds seldom turn”, which means that most turnarounds fail but when they do succeed they can be humongous wealth generators.

In Indian market there are several recent examples of successful turnaround companies.

Companies like RACL Gear Tech, which was a bankrupt business once, was taken over by a new management, the stock since has returned 20x, or Sangam Renewables which was another failing solar EPC business before being taken over by the giant Waaree - the stock has since returned a massive 175x.

The key questions to ask in turnarounds are:

1. What is the trigger that leads to change in profitability of the business?

2. How close or far away is that trigger?

3. Is the debt on balance sheet manageable?

4. How much of the debt is due in the short to medium term?

5. Is there any real evidence in the company’s financials indicating a turnaround?

In the next sections, we will explore the answer to some of these questions.

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Part Two: The Past & The Present

Before we begin to understand the triggers for the company, we need to explore what went wrong and the events that led to Sterling & Wilson Renewable Energy to where it is today.

The Global Dominance

When Sterling & Wilson Renewable Energy started its operations in 2011, there was a single mission - to become the largest Solar EPC player in the world.

By 2019, right around the time of IPO, Sterling & Wilson succeeded in achieving this mission - but that success came at a cost.

At the time of IPO, the company had projects across almost every major solar geography - Middle East, Africa, Australia, Americas, South East Asia. If there was a large solar project in any part of the world, the company was there to bid for it.

Sometimes even at unfavorable terms.

The demand for solar projects in India was thin, solar and renewables were yet to take off and across the borders in Middle East - the oil kingdom was doling out orders to construct many Gigawatts worth of solar projects vs few Megawatts in India.

Sterling & Wilson was present to bid for all them, even constructing the largest single site solar project in the world, at the time.

Unlike India, which is a Balance of System (BoS) market - where procurement (primary equipment, i.e. solar modules) is the responsibility of the client instead of EPC company.

The contracts Sterling & Wilson was signing on, included everything.

For a fixed contract price - Sterling & Wilson would do everything from procurement of materials to building the required project in very specific time period. This meant that if there were any cost overruns due to delay in construction or increase in price of raw materials etc., the company had to bear all of them from its own pocket, further putting pressure on the tiny single digit EBITDA margins.

Now to Sterling & Wilson’s credit, finishing projects before the due date was a norm in the company and as far as raw materials were concerned - cost of solar PV modules was falling for more than a decade driven by technology advancements, increased demand and giant capacities in China.

Something must have to really go wrong at multiple fronts for the company to incur losses in these projects. You know, like the world would have to shut down, everything would have to come to a standstill, Chinese govt would have to stop granting subsidies to new solar capacities and solar PV module production in China would have to come to a complete halt for several months at a time.

The possibility of all these events occurring at the same time was so miniscule, the company never thought to protect itself from it.

The probability so tiny, such an event would almost never occur.

Almost.

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2020: The World Locks Down

As the pandemic raged across the world in 2020 and most of 2021, Sterling & Wilson found itself in an increasingly tough spot. Unable to work at most sites due to shortage of workers or lockdowns, combined with increasing prices of solar modules and other necessary equipment, the company was forced to concede and call ‘force majeure’ on most of its contracts.

This cancelling of contracts led to a barrage of lawsuits as clients didn’t want to pay up for unfinished work. To Sterling Wilson’s credit, the circumstances under which these contracts were signed in 2019 or before, were suddenly very different in 2021. To their client’s credit, Sterling Wilson should have protected itself better by foreseeing and demanding specific clauses to be enabled in these contracts.

Every EPC business works on very thin margins and as such opts for short term working capital loans to fund itself. When client’s of Sterling Wilson opted not to pay, it had to default on these loans triggering a downward spiral of its credit ratings, which made future borrowing more expensive.

It also increased legal costs for the firm by many folds, as client sued, creditors sued and Sterling Wilson sued them back.

It was the start of rough times for the company.

Between 2019 and financial year ending 2023, the company’s revenues dropped by 75%, from 8240cr in 2019 to just 2015cr. Further, the company went from positive operating margins of 8% to reporting negative margins for the next 10 quarters.

The pandemic had added Sterling & Wilson to its long list of business fatalities.

Amid rising debt, low funds and increasing litigation, the promoters of the company looked to sell 40% stake to shore up funds and found their white knight in Reliance.

On February 9, 2022 Reliance New Energy, a subsidiary of Reliance Industries purchased a 40% stake in Sterling & Wilson at 375/share for a total of ~737.5cr.

2023: There is Light At The End of The Tunnel

In the week of 17th July 2023, Sterling & Wilson’s posted its Q1FY24 results with first indication of positive gross margins. That week, the stock price went up by ~27% with volumes higher than last 658 days.

The market took it as an early signal that maybe the tough phase for the company was ending. The litigation cases were increasingly coming to their closure with the company winning most of them. Lenders were able to agree on terms to refinance loans at higher rates and the troubled legacy order book of the company was increasingly being replaced with domestic orders.

Indian solar market too had drastically changed since 2019. The government’s push for increased solar in total energy output of the country meant that very large orders were now being granted by most public sector undertakings with an overall ambitious goal of reaching 400 GW worth of solar capacity by 2030.

Today *(Oct 2023), the company’s order book comprises of 98% domestic orders - which has always been profitable even during the tough phase from 2019 to 2023.

In its latest quarterly results, the company has achieved profitability on a standalone basis, though remains loss making on a consolidated basis. The losses however have been narrowing.

Most of these losses, stem from the legacy international order book for the company that is still loss making. As the revenue from profitable domestic orders gets increasingly recognized in financial statements, the consolidated financials should also turn profitable.

Even in its international business, the only major new large deal worth over a billion US dollars is for a US govt funded project in Nigeria. It is expected that the deal will be profitable and as such in due course, the international EPC part of the business should also turn profitable on a standalone basis.

With a good understanding of the past and present state, lets now turn our attention towards the current challenges facing the company.

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Part Three: Challenges & Triggers

The main challenge (and its a big one) with the company today is that it is short on funds. As of month ending September 2023, the company had only 55cr in its bank account with total debt at 2,123cr.

That’s a lot of debt!

The past three years of troubled phase and losses have led to accumulation of this debt at pretty high interest rates.

The per quarter interest expense has increased nearly 3 times to now at 64cr. Combine that with the lumpy cash flow nature of the EPC business and shortage of funds in bank and you can see why the company defaulted on its short term loan payment in September 2023.

To shore up liquidity the company and turnaround, the company is focusing on below areas.

1. Fund Raising of 1500cr

   The company will raise 1500cr via equity issue in November 2023 in order to strength its balance sheet. Some of these proceeds will be utilized towards short term debt payment while others would be put towards working capital as the company increasingly bids for large upcoming domestic orders.
   Now, issuance of equity isn’t that great for minority investors like you and me as it leads to dilution of ownership and more shares in the market but without this fund raise and further capital infusion, I doubt the company will remain viable as a going concern.

2. Collect due indemnity payments from promoters

   The promoters of parent company, Sterling & Wilson, owes the company upwards of 400crs which is due in November 2023. The company has asked the promoters to repay earlier so that it can pay back the 135cr amount it defaulted on in Sep 2023.
   These dues relate to the indemnity agreements signed between the three promoters (Mistry’s, Daruvala’s and Reliance) of the company.

3. Focus on a Business Turnaround

   As the company wins increasingly large orders in domestic market, it is also gaining up on efficiencies. Most of these large projects are centered around key geographies which enables the company to deliver more at lower costs as they are able to utilize equipment and personnel much more effectively.

   Further, the company is also focusing on increasing the share of higher margin O&M business by bidding for third party O&M contracts.

4. Optionalities

   Very large orders like those of Nigeria and upcoming ones from promoter Reliance, should bode well for the company in driving revenue, cash flows and ultimately profitability.

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Part Four: Risks & Valuation

Risks

There are several risks in the company as of today, some of these are listed below.

1. Fund Raising: Needless to mention, all future liquidity hopes of Sterling & Wilson Renewable Energy are dependent on the upcoming successful fund raising of 1500cr.

   Any hiccups with this would mean short and medium term issues for the company.

2. Time to Turnaround: As Peter Lynch mentioned in the video earlier, timing with turnaround is of utmost importance. Through the company’s last two quarter’s financial we can devise that margin and profit trajectory are in right direction, the debt alleviation plan remains to be seen.

3. Various Promoters: The company effectively has three promoter groups, the Shapoorji group, the Daruvala’s and Reliance. While Reliance is the largest shareholder, the board chairman remains Khurshed Daruvala. There are six board seats with Reliance being represented by 3 and remaining 3 distributed between Daruvala’s and Mistry’s. When you have too many cooks at the helm, there is always a chance of things going awry.

4. Future Funds: Like all turnaround, here too, the future funding of projects and business earnings depend on current business turning profitable. If the company fails to turn profitable in the next four quarters, it may lose out on the lucrative bidding window of several large PSU projects.

Valuation

The company is valued at the bottom of the pile and as if it was going to fail - which isn’t something out of the ordinary for turnarounds. The stock price has remained in a pretty tight range for most of its listing history.

Technically too, the stock is at its major support zone and any fall in prices below 245 should be worrisome.

Conclusion

“Fast cars and turnarounds are not for the faint hearted”

Time will tell whether Sterling & Wilson’s story that started in the alleys of Angrezi Bazaar in Mumbai will come to an end or will the last three year will be but a small hiccup in an otherwise almost a century old story of the company.

Like all turnarounds, you have to be careful and consider every tiny detail as an investor.

In case of Sterling & Wilson Renewable Energy, there is a light at the end of the tunnel. Today, as an investor you do not know, whether that light is a speeding train hurling towards you or an opening to an oasis.

I hope this write up helped you understand the business of Sterling & Wilson Renewable Energy in a holistic manner. If you enjoyed reading this and have any feedback or insights, please share by leaving a comment below 👇

Leave a comment

Thank you for reading, see you in the next one.

Peace,
Tar

Disclaimer: The information provided in this article is for informational purposes only and should not be construed as investment advice. The analysis and insights presented are based on publicly available information, and while efforts have been made to ensure accuracy, we cannot guarantee the completeness or reliability of the information.

Investing in securities carries inherent risks. This post should not be relied upon as a substitute for independent research or consultation with a qualified financial advisor.

The author of this post and the platform on which it is published do not provide personalized investment recommendations or financial advisory services. Any investment or trading decisions you make based on the information provided in this post are solely at your own risk.

Neither the author nor the platform shall be held responsible or liable for any loss or damage arising directly or indirectly from the use of or reliance on the information contained in this post. Readers are encouraged to conduct their own due diligence and seek professional advice before making any investment decisions.

By accessing and reading this post, you acknowledge and agree to the terms and conditions outlined in this disclaimer.

Armed with an engineering degree from BIT Mesra and an MBA from XLRI Jamshedpur, Rajiv joined Microsoft in 1992 and quickly rose the ranks to become its youngest managing director at the age of 33.

After a stint of 14 years, Rajiv left the comfort and familiarity of Microsoft for the shores of Private Equity.

Yet, that entrepreneurial echo within, nagged him. He wanted something more.

So, in 2008 as a global financial crisis was brewing, Rajiv made his way back home to India. Rajiv’s plan was to hunt for a struggling company (no shortage of those in 2008) and help turn it around into a success.

His search would end in 2009, when he came across ‘Subhiksha Realty Private Limited’. Subhiksha was a small private real estate developer in Mumbai but had an even smaller IT Infra services division within it called - CMS Computers.

Rajiv would convince Blackstone to back him and help purchase CMS Computers from the erstwhile promoters.

Fast forward 14 years, and a change of promoters (Blackstone would later sell entire stake to Barings Private Equity), CMS Info Systems, as its now called, is the leading end to end cash management solutions company operating in India.

The company is debt free, growing its topline by 20% every quarter and boasts return ratios greater than 25% with an EBITDA margin of almost 30%.

This is how the business of CMS Info Systems works.

This article took over 100 hours of research and 10 hours to write. Please consider sharing and subscribing to help support us and grow.

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Current Business of CMS Info Systems

The current business of CMS can be broadly classified into three main categories

1. Cash Management (contributes about 65% to the overall revenue)

2. Managed Services (contributes about 30% to the overall revenue)

3. Technology Solutions (recent but fast growing - contributes about 5% to overall revenue)

Here is detailed explanation of each business line:

ATM Cash Management

This is the bread and butter for CMS and accounts for the largest share of the overall revenue pie. In this segment, CMS helps banks replenish their ATMs with cash as and when required.

The revenue structure is based on a fee per trip along with a fixed yearly fee. CMS has over 72,000+ ATMs across India under its management. Every 1 out of 2 outsourced ATMs in the country is managed by CMS. This is a mature steady line of business and 90% of revenues are annuity based.

CMS has a 46% overall market share in India for ATM Cash Management.

Retail Cash Management

Similar to ATM Cash Management but for retail outlets. CMS here helps retail chains like DMART, Reliance Retail, petrol pumps etc. transfer cash from their outlets to respective banks.

One of technology innovations in this area by CMS is their offering called Cash-X. Via Cash-X, CMS offers retail outlets deposits in their bank accounts as soon as the cash is picked up and reconciled by a CMS pick up van. This enables a retail chain to get access to their cash deposits within hours instead of days.

The revenue structure in this segment is linked to volume along with pick up points, with 70% of total revenues being annuity based.

CMS has a 36% overall market share in India for Retail Cash Management.

Cash In Transit

In this offering, CMS works with banks to transfer cash from one branch to another within a city or across cities.

CMS helps 12,000+ bank branches transfer cash every single day.

Revenue structure is based on 3 to 5 year contracts with 80% revenues being fixed in nature. CMS has a 26% overall market share in India for Cash In Transit services.

Together, the above three business lines (ATM Cash Management, Retail Cash Management and Cash in Transit), form the overall cash management vertical of CMS.

Self developed efficient route technology helps CMS generate industry leading margins of 25%+ for the cash management business. As the number of touchpoints in this line of business expands, so will these margins due to high operating leverage built in to the nature of the business.

Banking Automation Solutions

CMS helps banks automate their banking functions via ATMs. If you have ever used an ATM that both accepts and dispenses cash - it is an example of a banking automation. Similarly, ATMs that help you change card pins, print passbooks, deposit cheques etc. are examples of banking automation.

In this business line, revenues are linked to sale of banking automation services along with a 7 to 10 year maintenance revenue contract.

Sale and Maintenance of ATMs

CMS also engages in sales as well as routine maintenance and repair of new and existing ATMs. To participate in the ‘Make in India’ movement, CMS has also recently set up an ATM manufacturing plant in Chennai, India.

Card Personalization Services

Anytime a bank issues a credit or debit card, it has the customer name and other details on it. This is usually outsourced by banks to authorized vendors like CMS.

Card personalization is a very tiny part of overall revenue for CMS.

Brown Label ATMs

Brown Label ATMs refer to those ATMs that are owned (by a bank) but operated by a third party service provider like CMS. Usually banks float tender offers and require the third party to purchase and maintain a brown label ATM on their behalf.

In exchange, the banks pays a yearly fee to the third party service provider.

This is a capex intensive business area and as such CMS tends to participate very selectively. It has a target of setting up less than 1,000 Brown Label ATMs per year and is happy to cede market share to other competitors.

The above four business lines, together form the managed services vertical of the business - which generates about 30% of the overall revenue pie.

Overall EBITDA margins for managed services tend to stay below 20%.

Remote Monitoring

This is the most exciting and rapidly growing business segment for CMS today. Via remote monitoring, CMS enables banks to leverage sensors, cameras and other software based automations to effectively govern the security of their ATM sites.

In a simplified manner of speaking, CMS is automating the job of security guards at ATMs. A typical bank spends about Rs 45,000 per month to provide round the clock security for each ATM site. Via CMS remote monitoring offering, banks can achieve the same (if not more efficient security) at less than Rs 10,000 per month.

CMS is also able to provide this service at scale by monitoring all ATM locations from a central site, there by further reducing the cost.

The remote monitoring business is rapidly growing, with revenues scaling from 0 to 100cr in less than 12 months.

CMS envisions providing the remote monitoring solution to retail chains, gold loan branches, NBFCs etc.

Being a software and fixed recurring revenue business, margins are also north of 40% in this segment.

Security Software Solutions (CMS Algo OTC)

This is an ATM access security software service. Whenever an ATM needs to be unlocked to add or remove cash, a bank needs to verify the person performing that service is legit.

Via CMS’s Algo OTC software, a bank can perform this service remotely and in an automated fashion. CMS also helps the banks meet any new RBI guidelines by updating the software on the fly to be compliant in real time.

Multi Vendor ATM Software Management Solution

Another offering by CMS is Algo MVS - which enables banks to upgrade and maintain the software on their ATMs irrespective of which vendors they purchased the ATM from.

In both CMS Algo OTC and Multi Vendor Software Solution, CMS is a market leader in India.

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Industry Analysis

Global Landscape

In mature economies like US and Europe, cash management is a consolidated oligopoly industry with the top two players owning more than 90% market share.

The biggest names worldwide are the likes of NCR Corporation, Brinks Incorporated, Loomis AB and Diebold Nixdorf. All these four companies have been around for a while, with NCR being the oldest and the largest among them, having been incorporated in 1884.

While revenue from cash management still contributes to a large chunk of the overall pie for all of them, all four players have, in recent years, shown a tendency to move towards more software-oriented solutions - similar to what CMS has been building for the domestic market in India.

While the global players are 5x larger in size than CMS, their margins are at best less than half of what CMS is able to deliver.

CMS is also growing much faster (~20% quarterly growth rate) than its global peers, who, being much larger and in more mature markets, average at a single-digit growth rate.

Domestic Industry Landscape

While globally, the industry is consolidated and oligopolistic, in India, there are a large number of international as well as domestic players competing in various sub-segments of the market.

Post demonetization, this market has been consolidating at a rapid pace, and existing players are either conceding market share, exiting parts of their business, or leaving the industry all together.

CMS has been able to leverage its strong debt-free balance sheet to take advantage of the consolidation in the industry. The playbook for CMS has been to buy an existing competitor at a slump sale valuation, leverage its relationships with banking customers, and up sell them the new offering as a package in addition to the existing services. Banks, too, prefer to give their business to one large player instead of several smaller ones.

This strategy has enabled CMS to grow faster than any of its competitors and increase its overall market share. Buying cheap and scaling rapidly also lead to high return ratios for the company.

Apart from CMS, the other Indian listed competitors include AGS Transact Technologies, SIS Securities Limited and Radiant Cash Management Services.

Porter 5 Force Analysis

In order to cement our understanding of this industry, here is a Porter's Five Forces analysis of CMS Info System’s business model.

Few things are evident from this analysis.

1. CMS Info Systems has some pricing power for its services but they also tend to be largely dependent on regulation and its customer’s willingness to pay. Regulation so far has been favorable for CMS and banks are willing to pay for quality services especially if a vendor can offer end-to-end integrated platform like CMS. This is reflected in the rapidly growing margins trajectory - with EBITDA margins increasing from mid teens to almost 30% today.

2. Another observation is the increasing number of competitors opting to exit the market and overall market share being consolidated among the larger players. This is also partly driven by regulation - the regulator has over the years increased compliance. Example of these include the requirement to upgrade all ATMs to a cassette swap instead of traditional locker based, live tracking of all cash vans and timelines to reconcile cash. This increasing cost of compliance is driving smaller players out of the industry and acting favorably for larger players, like CMS.

3. Finally, the threat of substitute from a shift towards digital payments is real and ever growing. UPI has been a great differentiator and enabler for India to move towards a more digitized payment system. However, this move hasn’t impacted the cash usage in the economy. Cash in Circulation - a metric used by RBI to describe cash usage has essentially increased at an annual rate of 5.33%.

   

   This increase in cash usage is not just across rural and semi urban areas but even within developed metros. In-fact, the state of Karnataka has the highest ATM replenishment rate at Rs 1.73cr per ATM per year across India!

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It is clear from the above analysis, that CMS is witnessing tailwinds in its business driven largely by increasing pace of industry consolidation - leading to operating leverage kicking in. While the threat of digital payment looms, in the short to medium term, the use of cash seems to be stable and persistent in the economy.

Financial Analysis of the Company

CMS boasts of healthy, fast-growing financials. The 3-year sales CAGR has been 11%, while profits in the same timeframe have grown by 31%.

The margin profile has accelerated in recent years. CMS has gone from earning 17% EBITDA margins in 2019 to 28% in 2023. The main reasons for this growth have been operating leverage along with an increased share and growth of higher-margin businesses like software solutions.

A minor area of concern within the financials is the large share of intangible assets when compared to the overall fixed asset pie. Total intangible assets (goodwill, etc.) accounted for more than 50% of the total assets in 2019. However, this figure has sharply reduced and is now at 25% as of March 2023.

Valuations

Overall, at 18x trailing twelve-month earnings and 10x EVEBITDA, the company seems reasonably priced given the backdrop of an accelerating growth rate and increasing margin profile.

The company also boasts a 25% dividend payout ratio and a debt-free balance sheet with over ~1400 crore in reserves.

The management has guided for a doubling of the topline by 2025 and an immediate yearly growth rate of 18%.

So far, they have been ahead of their target goals.

Risks and Growth Triggers

Risks

There are three main key risks for CMS Info Systems:

1. Market Structure Risk

   CMS largely derives its business from the use of cash in India's economy. Given the adoption and focus from the government to digitize the economy, there is an increased risk to the business.

   While the use of cash may not decrease in the next 5 to 10 years, the same cannot be stated with a high degree of certainty for the following 10 years.

2. Regulatory Risk

   The company operates in a highly regulated industry. Any adverse regulatory changes can quickly erase margins and hinder growth.

   RBI, so far, has been pushing for stricter compliance and supporting the formalization and growth of the cash management industry.

   However, governments and policies can be unpredictable, and they tend to change every few years.

3. Promoter Risk

   The promoter for CMS is a large private equity fund - Barings. The PE fund has been liquidating their stake in the company, and all PE funds have an exit timeline.

   There may be a risk of increased share supply, which could keep the share price down or in range for an extended period.

Growth Triggers

There are several growth triggers for CMS playing out today, I will highlight the three main ones:

1. Increasing pace of consolidation in the Industry

   As mentioned earlier throughout this article, the industry in which CMS operates is undergoing rapid consolidation. CMS, being a leader in the industry, stands to benefit from this change, leading to a higher market share.

2. Scaling up of New Business Verticals

   CMS has been successful in rapidly scaling up new business verticals like remote monitoring, which has reached a revenue run rate of 100 crore within 12 months.

3. Incubation of New Business Lines

   Constant innovation combined with the luxury of a strong balance sheet allows CMS to incubate new business lines. The latest business incubation is focused on cash collections - an area that is largely unorganized but crucial to the business of a bank.

   ---

   Below is an excerpt on cash collections business from the CMS Investor Day.

   “In the collection space in India, the focus has been primarily on lending money rather than collecting money. Our idea was to create a business model that addresses this gap by leveraging three key elements. Firstly, there are numerous small, semi-organized or unorganized collection agencies in the country, but none of them have achieved scale or operate nationwide. Secondly, the collections value chain encompasses technology, contact centers, and customer outreach, each handled by different companies. Lastly, there is a lack of a comprehensive solution that combines all these aspects. This interested us the most, as banks seek partners who prioritize reputation management and brand integrity. Currently, we are in the incubation phase, assembling a team and hiring experienced leaders from the industry. Our focus in the upcoming year will be on piloting and investing in the business, working with large NBFCs and exploring partnerships with additional organizations. This year will serve as a pilot period to evaluate the scalability and success of our approach.”

   Rajiv Kaul, CMS Investor Day, May 2023

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Conclusion

In my view, CMS Info Systems is a company undergoing metamorphosis. The business is transitioning itself from a cash management company to a business solutions company for financial institutions.

The company is run by able and proven management, available at reasonable valuations and exhibiting accelerated growth.

There are terminal risks to the business due to increased digitization of money but these terminal risks seem to be more than a decade away. Cash in India is sticky, as evident from RBI’s data.

The business also is pushing to transform itself by incubating new revenue lines that are agnostic to the form of money.

I hope this write up helped you understand the business of CMS Info Systems in a holistic manner. If you enjoyed reading this and have any feedback or insights, please share by leaving a comment below 👇

Leave a comment

Thank you for reading, see you in the next one.

Peace,
Tar

Disclaimer: The information provided in this article is for informational purposes only and should not be construed as investment advice. The analysis and insights presented are based on publicly available information, and while efforts have been made to ensure accuracy, we cannot guarantee the completeness or reliability of the information.

Investing in securities carries inherent risks. This post should not be relied upon as a substitute for independent research or consultation with a qualified financial advisor.

The author of this post and the platform on which it is published do not provide personalized investment recommendations or financial advisory services. Any investment or trading decisions you make based on the information provided in this post are solely at your own risk.

Neither the author nor the platform shall be held responsible or liable for any loss or damage arising directly or indirectly from the use of or reliance on the information contained in this post. Readers are encouraged to conduct their own due diligence and seek professional advice before making any investment decisions.

By accessing and reading this post, you acknowledge and agree to the terms and conditions outlined in this disclaimer.

You probably consumed MCC today, in the form of medicine, food or even cosmetics. Microcrystalline Cellulose, which in its raw form looks like a white powder, is derived from wood pulp and serve as a excipient in medicines, binding agent in food and stabilizer in cosmetics.

Think of it as a naturally occurring packaging material that is non harmful to humans.

So why is an investment newsletter talking about some weird powdery packaging material? Well, that’s to do with the business we will be exploring today.

Sigachi Industries is a 33 year old family run business that is one of the leading global suppliers of Microcrystalline Cellulose. The business publicly listed itself among much fanfare in Nov 2021 with listing day gains of over ~250%.

The stock price has since corrected by over ~50% and now hovers at ~INR 315/share, as of this writing.

Like most families, this business too is complicated with a lot of pros and cons. It is also undergoing a significant transformation of itself, something it has exceled at in the recent past, just before its public listing.

Through this write up, we will explore the global microcrystalline cellulose industry, get introduced to the various players operating in the local as well as the global market, explore the current financial and growth triggers of Sigachi and also look at several red flags of the company.

By the end of this article, you should be well versed with the business, that is, Sigachi Industries.

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Global Micro Crystalline Industry

The global micro crystalline industry can be segregated into two major type of players - giant established corporations and everyone else. MCC as a product finds its primary application in pharmaceutical industry, which accounts for a lion’s share of the demand - currently around ~70%.

The finished product is also low value, commoditized, as such the pharma giants and other large corporations tend to stick to a single supplier of the product to ensure quality control.

Since the product is low value in nature, the producers of MCC find it relatively easier to pass on any price hikes and raw material related inflationary costs pressures. As such the margins tend to remain stable for everyone involved in the entire value chain.

The supply of MCC product always outpaces the demand due to its commoditized nature and a simple manufacturing process.

Further, regional players have a consolidated market share for their respective geographies. For example, DuPont is the primary supplier to majority of innovator pharma companies in North America and Sigachi being an outside company limits itself to generic pharma companies.

Finally, there are two major changes ongoing in the industry.

First is the shift of manufacturing from high cost locations to low cost locations like Thailand. Being a low value and thin margin product, it has become increasingly challenging for suppliers to keep manufacturing MCC in high cost geographies like US and EU.

This is evident by two facts

1. Sigachi and every other MCC manufacturer in the world, sources its raw materials from a high cost geography, refines and manufactures MCC in a low cost country and then sells its back to a high cost geography

2. Companies like DuPont (the worlds largest supplier of high grade MCC) setting up manufacturing facilities across Thailand

Second major change in the industry is the onset of ‘value added’ MCC products. The manufacturers have started producing various purity grades and types of MCC depending on the end customer usage, in order to differentiate themselves.

A value added product also helps the producer make higher margins and garner a larger wallet share from the customer.

Now that we have understood the industry Sigachi operates in, lets explore the company in detail.

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Current Revenue Profile of Sigachi Industries

Sigachi has been growing its revenues at an approx. CAGR of ~20% for the last six years. The company used to do ~100cr of sales in 2018 and should be able to close this year will net sales of more than ~300cr.

Further the company’s operating margin profile has increased from ~12% to now stable at ~20% per year.

The main boost in margins have come from the R&D push by the company. It has over the years refined its manufacturing process and has been able to produce more with less raw materials, thereby saving costs and increasing margins.

Topline growth is aided by the company really sweating its assets. Sigachi has an asset turnover of ~1.2x, which is really healthy for an asset heavy manufacturing company.

The company is primarily an export oriented firm, with exports representing ~75% of its topline and rest accounting for domestic sales. Primary customers of the company are large distributors of MCC and other pharma and food ingredients.

The company has three manufacturing plants spread across Gujarat and Hyderabad, with all three of them are running at above 95% capacity.

Owing to high capacity utilization, the company is expanding its manufacturing capacity by over ~50%. New capacities will come online mid 2023 and early 2024.

The company boasts healthy return ratios, with both return on equity and capital employed exceeding ~25%.

So on paper, Sigachi looks like a great company. It has a large export oriented customer base, new capacities coming online, high demand for its product, great margin profile and a fast growing topline.

But when we look a little bit deeper, several red flags start to emerge. Lets explore them in detail.

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Financial Shenanigans

Red Flag #1 🚩

The Company doesn’t own its own IP

Just before Sigachi was about to IPO, the company sold all of its trademarks, brand names and even the name ‘Sigachi’ to its owners, for a measly sum of Rs 2.4 lakhs.

In return, for the privilege of using the name Sigachi along with other trademarks and brand names, the company is set to pay 1% of sales as royalty to the promoters starting 2025.

Further, this royalty agreement is only valid till 2035, post which if the promoters choose, they can reset the agreement or even bar the company from using the trademarks and any other intellectual property again.

Below is the excerpt from their IPO document that calls out this clause in detail.

Red Flag #2 🚩

The Incentive for the Promoters reside in the topline growth and not the bottom line

As a minority shareholder, your incentive to invest in the company for the long haul is a essentially a bet that the company will grow its bottom line, i.e., profit after tax. As a company makes larger profits, these profits eventually should make way to your bank account in the form of dividends.

Companies do well over time when both promoters and minority shareholders’ incentives are in sync. This is not the case with Sigachi.

Since the promoters incentive are clearly at the topline growth (owing to the 1% royalty agreement we spoke about earlier), the company has been ‘diworsifying’ into various ancillary businesses.

So far in its limited history of being a public listed company, Sigachi has

1. Hired consultants and then cancelled plans to open an ethanol factory

2. Launched a nutritional premix product range via taking a lease on a premix manufacturing plant

3. In process of launching a OTC healthcare segment and investing to build a domestic distribution network in India

All of the above are not related to its core business, i.e. making cellulose based excipient products.

Meanwhile, the debtor days for the company have increased from 77 days to now 88 days with receivables (credit sales) accounting for over ~25% of the overall sales.

Red Flag #3 🚩

A whole lot of related party transactions

Apart from the upcoming royalty payments to the promoters, the company has been leasing properties from its owners.

Below are the few excerpts from the IPO Document.

Below are some of the properties controlled by the promoter and used by the company on a rental basis.

The company’s corporate office, manufacturing plant, guest houses all are owned by the promoters and the rent on these seem abnormally high.

Further, the company’s rental expense has increased by ~25% just in last year!

The are more red flags like abnormally high promoter remuneration, non-independence of audit committee, but I sense that you get the gist!

Lets now explore some of the growth triggers and current valuations of the company.

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Growth Triggers

Sigachi has two main growth triggers ahead

1. A 50% increase in capacity that should disproportionately aid in topline growth

2. Launch of Croscarmellose Sodium or CCS as a new product

We spoke about the capex growth trigger earlier in this write up, lets explore a bit about croscarmellose sodium or CCS.

CCS is a high value, high margin product that is also in high demand by the pharma industry. It is used as a disintegrant in medicines to ensure the API in the medicine gets digested at the right time when its in the body.

This would be a new product for Sigachi and it aims to leverage its existing customer relationships to sell this higher margin product in addition to MCC.

In my view this product can easily help Sigachi maintain or even extend its margins from ~20% to ~25% range in the short term.

Valuations

At the current stock price of Rs ~315 per share, the market is assigning a 10% earnings growth to Sigachi.

This seems low for a company that will expand its manufacturing capacity in near term and introduce a higher margin product. The company is also able to easily pass on higher raw material and related costs to end customer, there by giving us confidence that a ~20% operating margin profile will stay.

Technically the stock looks strong and has so far managed to stay well above its immediate support of Rs ~240 per share.

Maybe the market doesn’t like the long laundry list of related party transactions and royalty agreements along with the ‘diworsification’ into unrelated segments.

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Conclusion

Sigachi Industries, as per me, is a typical case of a good business run by a greedy promoter. The company is minority shareholder un-friendly but at the same time has lot of earnings trigger.

Given the misplaced promoter incentives, its anybody’s guess whether the topline growth will ever translate into bottom line for the company.

I will be a trader of the stock and not an investor.

I hope this write up helped you understand the business of Sigachi Industries in a holistic manner. If you enjoyed reading this and have any feedback or insights, please share by leaving a comment below 👇

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Thank you for reading, see you in the next one.

Peace,
Tar

Disclaimer: The information provided in this article is for informational purposes only and should not be construed as investment advice. The analysis and insights presented are based on publicly available information, and while efforts have been made to ensure accuracy, we cannot guarantee the completeness or reliability of the information.

Investing in securities carries inherent risks. This post should not be relied upon as a substitute for independent research or consultation with a qualified financial advisor.

The author of this post and the platform on which it is published do not provide personalized investment recommendations or financial advisory services. Any investment or trading decisions you make based on the information provided in this post are solely at your own risk.

Neither the author nor the platform shall be held responsible or liable for any loss or damage arising directly or indirectly from the use of or reliance on the information contained in this post. Readers are encouraged to conduct their own due diligence and seek professional advice before making any investment decisions.

By accessing and reading this post, you acknowledge and agree to the terms and conditions outlined in this disclaimer.

It was a tough job.

Less than 5% of India’s population at the time travelled by air and a miniscule percentage of that availed services of an airport lounge. For a price conscious country, longue services at the airport were a luxury limited only to business class travelers. Debit and credit cards were possessed by a few and even fewer were aware about the free airport lounge perks as part of their card service.

However, things were changing.

Since 2008, air passengers in India have increased at a CAGR of 11.64%. In absolute terms, this means that more than 200 Million Indian passengers will travel by air in 2022 vs less than 50 Million that used to in 2008.

More airports in India were opting to build a lounge and banks were issuing more debit and credit cards with airport longue perks. The international airport lounge aggregator at the time, Priority Pass, had a very small presence in India and considered India to be a very small market not worth investing in.

There was a clear vacuum in the market for an India focused lounge aggregator that helped connect lounge operators at airports with customers of card issuing companies availing lounge perks.

So in April of 2008, Liberatha left her job at Plaza Premium Lounge and registered ‘Believe Tradelink Private Limited’ with registrar of companies in New Delhi.

Fifteen years later, in 2022, Believe Tradelink Private Limited would IPO as Dreamfolks Services Limited and become the largest lounge and airport service aggregator of India.

This is how the business of Dreamfolks works.

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Current Business of Dreamfolks

Dreamfolks business is simple.

In its IPO document, it describes itself as an ‘airport service aggregator platform’. In simple terms, the company is the middle man that helps airport service operators (like lounges, food and beverage stores, spa chains, meet and assist operators etc.) seamlessly provide services to customers that are leveraging their credit or debit card perks at the airport to avail such services.

The below visualization is an example of a really simplified version of their service.

In real world, there are millions of passengers and tens of banks, corporate clients etc. issuing cards with airport service perks and tens of lounge and airport service operators in India. Dreamfolks finds its use in facilitating business through all of them in a seamless fashion.

A more comprehensive version of Dreamfolks services is show below.

As evident from the above visualizations, there is indeed a need for a middle man that can work with banks, card networks and service providers to facilitate business.

However, there are no ‘network effects’ or ‘proprietary technology’ at play here. Anyone with little bit of capital and inclination to replicate Dreamfolks business can do so without any headwinds.

Lets explore this a bit in detail.

Industry Structure for Airport Service Aggregator

To explore the industry structure in depth, we will be leveraging the Porter’s Five Force Model. The model will help us understand the business of Dreamfolks, its competitive advantages (if any) and current industry structure in depth.

If you’re unfamiliar with Porter’s five forces, you may read the below Twitter thread to familiarize yourself.

Dreamfolks Porters Five Force Analysis

Below is a detailed five force analysis for the industry Dreamfolks operates in.

Few things are evident from this analysis.

1. Dreamfolks does not have any bargaining power with either its suppliers (airport services) or its buyers (card issuing companies). As such the margin profile for Dreamfolks is razor thin. The company works on a single digit EBITDA margin spread and has indicated in various interviews that margin gap between the price it has to pay to lounge operators vs the price it charges to card companies cannot exceed 15%.

2. Further, Dreamfolks does not have any leverage to increase its commission or margin spread rates. On both sides of its business (airport service and card issuing companies) the market is highly concentrated.

3. Though the barriers to entry are less, so far no one has challenged Dreamfolks business. It has so far operated and continued to gain market share without any competitor resisting. Apart from Dreamfolks, the only other lounge aggregator that operates in India is Priority Pass. Priority Pass has largely ignored the business in India as the market was too small but in future, if it gets aggressive, it wont take much for it to regain market share from Dreamfolks.

4. Dreamfolks technology stack is off the shelf and can be replicated easily. This is evident by the expenses and staff that company keeps to upkeep its technology stack. For the year ending 2022, technology spend by the company was Rs 79 lakhs and only 12 out of the 60 people it employs, were full time technology developers.

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Its clear from the above analysis that instead of being a ‘platform technology business’ like the company has so far advertised itself, it is a low margin commodity technology business without any barriers to entry that is thriving because of the absence of any real competitors in the space it operates.

Having said that, it doesn’t mean that this is a bad business or doesn’t have any future growth triggers. The company has been investing in building new lines of revenue growth, some of which we will explore in the next segment.

Revenue Profile & Growth Triggers for the Company

The current revenue profile of Dreamfolks is 95% lounge service fee and 5% fee related to other airport services like food & beverages, meet and assist, airport transfers etc. The company has 60% market share of all lounge traffic and 99% market share of all lounge traffic paid for by cards.

All 60+ lounges spread across India are part of its portfolio with about 12 lounges exclusively catering to Dreamfolks and not its competitors like Priority Pass. However, these 12 lounges are in non metro and tier 2 cities that do not attract much footfall. The top lounges in the country (based in Delhi, Mumbai and Bengaluru) do not have any exclusive arrangements and are free to cater to both Dreamfolks and its competitors like Priority Pass.

There are several growth triggers for the company both in the short, medium and long term. Some of these are explored below.

Increase in overall air passenger traffic and passengers availing lounge access

The biggest growth trigger for the company is the continued increase in air passenger traffic within India. About 8% of existing air passenger traffic avails a lounge access and as more air passenger increases in India, the more the number of passengers availing lounge services, there by aiding Dreamfolks to expand its topline growth.

To aid in increase air passenger traffic, Government of India has launched UDAN scheme which is focused on building air travel access to Tier 2 and 3 cities there by allowing more citizens of India esp. in non economic zones to travel by air.

This bodes well for Dreamfolks, whose revenue growth is tied at hip to increase in domestic air travel.

Railway Lounge Access

Another area of growth for the company is access to lounges at railway stations. Dreamfolks currently has 8 railway lounges in its portfolio and is expected to enroll more as Indian Railways get modernized.

Though at nascent stages, this revenue line has a lot of potential for future growth.

Foray into South East Asia and Middle East Markets

Dreamfolks has saturated the Indian airport lounge market. For it to grow fast, it needs to expand overseas into South East Asian and Middle Eastern markets. While the company has presence in most countries via partnerships with local lounge operators, it does not have any tie ups with banks and card issuing companies of these countries.

At present, Dreamfolks only makes money whenever an Indian card holder avails access to an international lounge at one of the overseas location partnering with Dreamfolks. As such, the percentage of overall revenue that Dreamfolks generate with overseas operations is miniscule.

To fix this, company has begun exploring partnerships with banks and card issuing companies in local geographies.

Ancillary businesses like loyalty program management

Another promising area of growth for Dreamfolks is foray into loyalty management programs for corporates and organizations. While the company doesn’t have any active offerings at the moment, it has expressed a desire to build such offerings in near future.

Clients other than Card Issuers opting to provide lounge perks

In its intention to diversify client base from banks and card networks, Dreamfolks is now partnering with corporate clients, telecoms and online travel agencies.

For example, Vodafone Idea’s highest tier postpaid plan allows its customers to avail 4 free international or domestic lounge access. Dreamfolks is the servicing agent behind that perk.

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Risks to the Company

MDR rate changes by RBI

The biggest risk to the business of Dreamfolks is RBI reducing MDR or Merchant Discount Rates. Merchant Discount Rate is charged by card issuing companies every time you transact with a debit or credit card. The fee generated from MDR is what powers the perks (lounge access, cashback etc.) provided by card companies to its customers.

RBI until very recently has been focused on reducing costs of digital transactions including card based transactions. In its recent discussion paper, dated Aug 2022, RBI has expressed a desire to reduce these rates even further.

While the policy is only at discussion stage at present, if and when RBI reduces MDR in India, it is expected that card issuing companies will lower the perks available on its cards. Since majority of Dreamfolks business is based on lounge perks being availed by debit and credit card customers, any reduction in said perks will significantly impact the overall revenues of the company.

Competitor like Priority Pass getting aggressive and willing to work with a lower margin rate than Dreamfolks

The second big risk to Dreamfolks business is its competitors like Priority Pass (who have so far overlooked India) getting aggressive in gaining market share and willing to work at a lower margin rate than Dreamfolks. Since banks and end customers do not care which backend service (Dreamfolks or Priority Pass) helps in availing lounge access, Dreamfolks may lose a significant chunk of its revenue in such a scenario.

Priority Pass already has a tie up with Kotak Bank to provide lounge access to its highest tier customers.

Collison Group, the owner of Priority Pass also recently boosted its India leadership by announcing a dedicated country head, a first for the company. Sumit Prakash, an industry veteran will now lead the India & South Asia business for Priority Pass.

The company has also launched a dedicated India focused service for airport lounges.

High Working Capital and Lack of Financial Controls

Dreamfolks until 2021, didn’t have a Chief Financial Officer. It hired one in late 2021 as it prepared for IPO. There have been several instances when Dreamfolks as a Private Limited company failed to file its financial statements properly with the Registrar of the Company. Even in its maiden conference call in Nov 2022, the company’s CFO found it hard to explain simple details on working capital cycle and receivable vs payable days to investors. Further, the company’s CFO is paid just 30 lakhs in annual salary vs more than 3 crores, the company’s CMD (Liberatha) draws annually. This mismatch in pay for top management (other than promoters) highlights the lack of quality talent available to the company.

The company also has more than 50% of its net sales as receivables and while receivables as a percentage of sales is expected to reduce over time, the company has written off bad debts every year in the three year financial documents it has provided at the time of IPO. Moreover, the provision for bad debts by the company remains awfully low and is not in accordance with the previous years bad debt trend.

In my view the company lacks appropriate financial controls and needs to invest in this area to appropriately represent its financials.

Inability to tie up with overseas card issuing banks and Competition from established aggregators in international market

The company’s foray into international markets will only start contributing to topline meaningfully if and when it is able to tie up with overseas card issuing companies. Any challenges to tie up with said companies will hamper any growth in overseas market.

Further, there are established players like Priority Pass, Lounge Buddy and Dragon Pass that already operate in the international market. These players have strong relationships with both banks and lounge operators and it is expected that Dreamfolks will face a lot of competition to break its competitors hold in these markets.

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Valuation

The company’s valuations at the time of writing this article are okay and not necessarily a bargain. The company is expected to publish an EPS of ~10 for the year ending March 2023, which puts its current PE at 37.

The main trigger for growth remains the growth of domestic air passenger. The company in my view is a proxy for air passenger growth in India.

The company has low fixed and operating costs. With just 60 employees and low technology spends, the company can generate a faster than normal growth in bottom line as topline continues to expand. However, since the delta between the rates charged by Dreamfolks to banks and card issuing companies vs the amount it has to pay to lounge operators is fixed at 15%, I do not expect a high double digit EBITDA margin growth.

Being an asset light business, the company has high asset turnover, which in turn helps it to generate more than 20% ROCE even with single digit EBITDA margins.

Conclusion

In my view, Dreamfolks is a decent business that is available at ‘okayish’ valuations today.

There are issues with the company with regards to its financial controls and regulatory overhang on merchant discount rates.

However, it fits as an excellent proxy for an investor looking to add some exposure to the growth of aviation sector in India.

For an investor in this company, the key metrics to track are

1. Growth of passengers availing access to an airport lounge

2. RBI decision and policy feel on Merchant Discount Rates

3. Company’s ability to build new engines of revenue growth (Railway Lounges, Loyalty Programs, International Business etc.)

I hope this write up helped you understand the business of Dreamfolks in a holistic manner. If you enjoyed reading this and have any feedback or insights, please share by leaving a comment below 👇

Leave a comment

Thank you for reading, see you in the next one.

Peace,
Tar

Disclaimer: The information provided in this article is for informational purposes only and should not be construed as investment advice. The analysis and insights presented are based on publicly available information, and while efforts have been made to ensure accuracy, we cannot guarantee the completeness or reliability of the information.

Investing in securities carries inherent risks. This post should not be relied upon as a substitute for independent research or consultation with a qualified financial advisor.

The author of this post and the platform on which it is published do not provide personalized investment recommendations or financial advisory services. Any investment or trading decisions you make based on the information provided in this post are solely at your own risk.

Neither the author nor the platform shall be held responsible or liable for any loss or damage arising directly or indirectly from the use of or reliance on the information contained in this post. Readers are encouraged to conduct their own due diligence and seek professional advice before making any investment decisions.

By accessing and reading this post, you acknowledge and agree to the terms and conditions outlined in this disclaimer.

It is for this reason, banks have over the years tried to categorize and formulate risk in the form of credit scores or rudimentary human driven processes and questionaries that can some how help them identify ‘true risk’ associated with grant of a loan.

These primitive methodologies designed in late 1980s are still prevalent around the world and used by major financial institutions to disburse trillions of dollars in loans.

All this in the age where your social media feed is decided by an algorithm.

Why can’t the same technology that drives your social media feed be used to improve the process of determining risk associated with grant of individual loans?

Three folks at Google in 2012 asked the same question and decided to start a company to solve this very problem. Ten years later, their company is valued at over $10 Billion.

This is the story of Upstart.

Before we proceed, please consider sharing this write up with your friends or on your social media.
My aim, through these write ups, is to reach out to as many people as I can, so that they can make informed financial decisions.

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Part One: What is Upstart? 🤖

Upstart is an ‘AI’ driven credit lending platform.

If you are a professional data science practitioner like me, you know Artificial Intelligence does not exist. When companies like Upstart advertise themselves as AI driven, what they really mean is that they have several proprietary machine learning algorithms working together to execute a certain task.

In case of Upstart, its the combination of several machine learning models that work together to help identify and define true risk.

True risk in case of lending is identifying the probability of default on a loan.

Therefore, Upstart is a Machine Learning driven platform that helps identify true risk and leverages this proprietary technology to helps banks offer more loans at reduced risk when compared to other traditional models like credit scores.

The Heart of Upstart ❤️

At the heart of Upstart, lives its machine learning driven risk model.

To develop a successful machine learning model, you need three things:

1. Data Variables: Think of these as your columns in a spreadsheet with each column defining a characteristic of a borrower, i.e. education, income levels, age, number of dependents etc.

   In 2014, Upstart started with 32 of these variables, today it has over 1600 and this count is only going to increase from here.

2. Data Count: The above variables mean nothing if there is no actual data present for them. Think of data count as rows in a spreadsheet. The larger the number of rows, the more data Upstart models can consume and more accurate they can become.

   Upstart has over 9 Million+ of these data points and all of these come from the actual real world data Upstart gathers from the loans that originate from its platform.

3. Learning Algorithms: The final piece of our puzzle is a learning algorithm. A learning algorithm is bunch of coded instructions that over time modifies itself to learn from the data supplied to it and gets better at the task required from it.

   In Upstart’s case, the main job of a learning algorithm is to predict the probability of default for a loan.

   In 2014 Upstart started with two basic learning algorithms. Today it has over 16 different models that feed into each other trying to predict everything from probability of prepayment, default, income fraud, identity fraud and interest rate optimization.

This is where things get exciting.

This part of the article is very important to understand the competitive advantages of Upstart later, so please bear with me if it gets too technical.

In the domain of machine learning, there are two main types of learning concepts - supervised learning and unsupervised learning.

Think of supervised learning as a teacher teaching you in a class. You’re given very specific instructions to follow and your job is to follow them as accurately as you can.

Unsupervised learning is when that teacher doesn’t give you any instructions whatsoever but instead tells you what the answer should be. Your job is to figure out the instructions required to arrive at the answer accurately.

The way unsupervised learning works is the algorithm learns from previous ‘experiences’ and gets better at the job required from it automatically.

I will let the below video help you understand how unsupervised learning works in real life. In the video there are two unsupervised learning algorithms competing against each other in the game of hide and seek.

Both algorithms job is simple, one has to get better at hiding and other at seeking. Watch till the end to understand how dramatically these algorithms can improve themselves without any additional input.

The learning algorithms and data Upstart collects from its platform are its biggest competitive advantages. Over the years, Upstart has been busy trying to remove all human elements from these learning algorithms while making sure they stay true to their purpose - to identify true risk.

“We are in the process of removing all human based involvement in decision making. There is still a lot of work to be done and until 2016 we were just building the foundations of our model. We are trying to automate every corner of our codebase that isn’t machine driven today and we are confident that over time we will be able to achieve that.” - Paul Gu, Co-founder and SVP, Upstart

What started as a simple binary classification model is now a combination of several automated learning algorithms that feed off from the real world credit data and make each other better.

Over time the improvement in the output of these algorithms at Upstart will be more dramatic than any financial analyst at Wall Street can predict today.

This inbuilt competitive advantage is also evident in Upstart’s business flywheel shown below.

More Data → More Sophisticated Models → Higher Approvals of Loans

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The Problem to Solve 🧮

Upstart’s mission is to ‘enable effortless credit based on true risk’.

Four in five Americans have never defaulted on a loan yet almost 50% of them have credit scores that wouldn’t qualify them for a low interest rate loan. This gap in lending is the problem Upstart is trying to solve.

By leveraging data and machine learning techniques Upstart can more efficiently estimate ‘true risk’ than traditional models ever can. Upstart’s model lead to a 75% reduction in loss rates for banks while increasing the conversion rates by 10x.

By estimating risk better, Upstart’s bank partners can disburse more loans at much lower risk profiles, while consumers can avail these loans at cheaper interest rates.
A win-win scenario for everyone.

Upstart, in essence, has built a better mouse trap - one which banks can use to approve more loans while controlling their risk and driving default rates lower.

How Upstart makes Money? 🪙

Upstart is a two sided platform - on one side they market and create a funnel of prospective loan seekers via their website Upstart.com and on the other hand they have 40+ bank partners that can either choose to underwrite these loans directly from the Upstart’s website or opt in to create a white label solution of Upstart’s platform for their own customers.

Upstart makes money primarily three ways.

1. Referral Fee: This is usually 3 to 4% of the loan value charged to banks whenever a successful loan transaction is made via Upstart’s platform.

   This segment makes up for majority of Upstart’s revenue, representing over 94% of Q4 FY21’s revenue.

2. Platform Fee: This is a fixed dollar fee per loan charged to banks for the privilege of using Upstart’s platform

3. Servicing Fee: This represents a fee collected from banks or institutional partners to service the loan i.e. collections, reporting etc. This usually represents 0.5% to 1% of loan value.

Upstart does not charge any fees to consumers. This revenue model works well as bank partners only pay to Upstart if they are using the platform while consumers do not pay anything.

A logical question to ask here now would be as to who is underwriting these loans?
The answer is - its a mixed equation.

When Upstart enters into a product category they usually underwrite a small percentage of loans (2%) to get the ball rolling. Majority of loans are underwritten by its 40+ bank partners which have the privilege to later sell these loans to Upstart’s 100+ institutional investors like Goldman Sachs, JP Morgan and Morgan Stanley.

Upstart doesn’t want to take any credit risk on its balance sheet and doesn’t want to compete with banks either. It’s goal is to help banks adopt technology and seek Upstart as their primary lending technology partner.

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Part Two: Financials, Risks and Valuations 📈

Financials 🏦

Upstart’s revenues have grow at a blistering pace since its public listing. Revenue each quarter has increased in triple digit percentage when compared to previous year.

Q4 of 2020 for example, Upstart did around $87 Million in topline. The same quarter in 2021, topline was $305 Million representing a 252% year over year increase.

The primary driver behind this revenue growth is the increase in the loan transaction volume on Upstart’s platform. Transaction volumes in Q4’21 were up by ~230% when compared to Q4’20.

As Upstart gains more recognition and becomes a brand, these transaction volumes should increase further.

While the topline is increasing, bottom line too is showing signs of improvement. Upstart’s contribution margin has been increasing from mid 30’s to now 52 percentage points for the latest quarter.

Contribution margin represents how much money Upstart makes from the transaction volume on its platform.

Risks 🚩

Lending is a Cyclical Industry
The biggest risk to Upstart’s revenue projections is that it works in a cyclical industry that is bound to follow the ebbs and flows of the larger economic outlook.

When economy is thriving, credit and lending demand is sky high and banks feel comfortable in underwriting a larger portion of loans. When economy is in a recession, credit demand is at its lows and banks tend to be more risk averse.

Since, Upstart’s revenues are directly linked to loan transaction volume on its platform, its revenue will take a hit whenever the state of the economy turns. With inflation running sky high in US and Federal Bank increasing interest rates, it is possible that US economic growth slows down to an extent in the near term.

Concentration of Loan Book

While Upstart has 40+ banking partners on its network, a majority of loans originating from Upstart are underwritten by a single bank, Cross River Bank. While the dependency on Cross River Bank has reduced over the years from 83% of all loans underwritten in 2017 to 60% of all loans underwritten in 2020, it still represents a large chuck on their loan underwriting volume. If Cross River Bank were to pull back tomorrow, it would represent a sudden liquidity crunch on Upstart’s platform.

Upstart has been onboarding other small and medium sized banks (their target area) to improve liquidity and reduce dependency on any single banking partner. A typical bank partner onboarding process for Upstart takes anywhere between six to fifteen months, so going from 40 to a 100 banking partners will take some time.

Concentration on Customer Acquisition Funnel

While Upstart has been trying to market itself and establish a standalone brand name, a major chunk of its customer funnel comes from a single source - Credit Karma, a loan aggregator website.

The concerning part is that even though Upstart has increased its marketing budget by several times in the last three years, the percentage of customers acquired via Credit Karma and dependency on it has increased from 28% in 2017 to almost 60% in 2020.

While this is not of immediate concern, if Credit Karma were to shut down tomorrow, Upstart would lose a part of its major customer acquisition funnel. This dependency highlights the importance for Upstart to build and control its own customer funnel and establish itself as a brand.

Valuation and Earnings Triggers 💰

Earnings Triggers 📊

Until recently Upstart was a single product company and was present only in the market of personal loans.

They are now slowly expanding into other lending verticals namely - Auto Lending, Small and Medium Scale Business Lending and Mortgage Lending.

Each vertical has a larger market than personal loan business. To me, Upstart’s foray into personal loans was just a proving ground and having built a successful business there, they can blitzscale the learnings from personal loan business and apply to scale up auto, business lending and mortgage businesses.

Auto Lending is the first market they are targeting for 2022 and this is our first major earnings trigger.

From the capital they raised from IPO, Upstart acquired Prodigy Software, a provider of cloud based automotive retail software to auto dealerships. Upstart later rebranded Prodigy Software to Upstart Auto.

“While Amazon and Shopify have modernized the online shopping experience, the auto industry has been left behind. Upstart is on a path to reduce the cost of auto financing, and we can accelerate this opportunity with a modern multi-channel purchase experience.” - Dave Girouard, CEO, Upstart

Leveraging Upstart Auto, Upstart wants to help dealers in US manage and sell cars while also providing auto financing options through the Upstart platform. Their target for 2022 is $1.5 Billion in transaction volume from Upstart Auto.

Upstart Auto has already started showing signs of taking off. Earlier this month, in March 2022, world’s largest car manufacturer Volkswagen, announced its partnership with Upstart to modernized its dealerships by leveraging the Upstart Auto Retail platform.

“When we started working with Upstart Auto Retail, they were an up-and-coming startup in the digital retail space. We chose them because other platforms simply did not meet our needs. Having worked with them now for so long, it has been nothing but a success story,” stated Josh Lever of Platinum Volkswagen.

“They worked with me at the dealer level and took our dealership’s needs into consideration. I cannot thank the team enough for developing such a robust product around what dealers need today.”

The Mortgage and Small and Medium Business Lending are much bigger markets than Auto, Upstart has a target of 2023 to launch viable products for the same.

Valuations 💸

Upstart’s market cap has been no stranger to volatility. Having IPO at $20 a share in December 2020 at a $2 Billion valuation, Upstart saw its share price climb to $400 at its peak valuing it at $33 Billion.

Valuations have since cooled off and entered a realm of reality. Upstart today, as of writing this article is valued at ~$10 Billion which is a 7x NTM Price to Sales multiple.

In my view this valuation is much more reasonable but doesn’t represent a bargain with a margin of safety.

In the spirit of full disclosure, I do have a position in the company at $78 per share and I will look to slowly increase my position as and when the share price presents a reasonable value.

Part Three: Conclusion 🏁

I believe Upstart to be one of the true FinTech companies of our generation. The leadership team is strong, mission motivated and they have clearly build a product that helps all the users on its platform.

The opportunity and market size is large enough for Upstart to become a $100 Billion player and still not represent a large percentage of the market. Their technology is hard to replace with high barriers to entry and applications around the world.

Being a professional data science practitioner who loves finance, its exciting for me to see a company leveraging and applying the great parts of machine learning and cutting edge developments in this field to the world of finance.

What do you think about Upstart? Let me know in the comments below.

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Thank you for reading, see you in the next one.

Peace,
Tar

Disclaimer: The information provided in this article is for informational purposes only and should not be construed as investment advice. The analysis and insights presented are based on publicly available information, and while efforts have been made to ensure accuracy, we cannot guarantee the completeness or reliability of the information.

Investing in securities carries inherent risks. This post should not be relied upon as a substitute for independent research or consultation with a qualified financial advisor.

The author of this post and the platform on which it is published do not provide personalized investment recommendations or financial advisory services. Any investment or trading decisions you make based on the information provided in this post are solely at your own risk.

Neither the author nor the platform shall be held responsible or liable for any loss or damage arising directly or indirectly from the use of or reliance on the information contained in this post. Readers are encouraged to conduct their own due diligence and seek professional advice before making any investment decisions.

By accessing and reading this post, you acknowledge and agree to the terms and conditions outlined in this disclaimer.

News headlines are filled with the collapse of Lehman Brothers and the onset of the Great Financial Crisis. Stock markets around the world have tanked anywhere between 40 to 70% from their last peak, made earlier in 2007. Economic outlook all over the world is grim and money seems to be running on short supply.

It’s against this backdrop, a young Sahil Barua is brainstorming various business ideas from his dorm room in IIM Bangalore. As the economic conditions throughout 2008 deteriorated, so did his hopes to launch a start up.

He closes the lid on his business plans and takes a job as a management consultant with Bain & Co. Little does Sahil know at the time that he will meet his future co-founders at Bain and three years later in 2011, they will together lay the foundation for what will become a $3 Billion logistics company.

This is the story of Delhivery.

Before we proceed, please consider sharing this write up with your friends or on your social media.
My aim, through these write ups, is to reach out to as many people as I can, so that they can make informed financial decisions.

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Part One: From Hyper Local to eCommerce 🚚

Delhivery started as a hyperlocal food delivery service in New Delhi.

In 2011, restaurants were increasingly being introduced to the power of internet and while Zomato was helping them coming online, food delivery was still managed by individual restaurants.

There was money to be made in streamlining food deliveries and so Sahil along with his colleague Suraj Saharan quit their consulting jobs with Bain and started Delhivery.

What started as a successful hyperlocal food delivery service quickly pivoted to building a logistics firm for eCommerce.

The main motivation to pivot was the scale of opportunity and absence of anyone else trying to optimize logistics for eCommerce. Traditional players were accustomed to delivering documents, pre paid orders and movement of freight where as in eCommerce, there is usually a two way logistics channel - business to customer and then customer to business.

The latter is usually return orders and cash collected from customer in case of cash on delivery, which were 90%+ eCommerce deliveries at the time. None of the existing logistics players were accustomed to this new way of delivering goods and their network built and optimized for old logistics industry would take a complete rebuild from the ground up to cater to this new segment.

This was an area ripe for opportunity for Delhivery. They could build a new logistics company that was designed from the ground up for eCommerce - and so they did.

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Traditional Logistics vs Delhivery

Traditional logistics players work on a Hub and Spoke Model.

Deliveries collected from various places are sent to a central distribution and sorting hub for further processing. The hub then further sends these packages to smaller sorting facilities until they are sent to delivery centers responsible for each delivery area.

This model is slow and works well when time isn’t of the essence.

Delhivery follows a point to point model. Each facility in this model acts as its own hub and sorting facility. This allows Delhivery to pick up packages from anywhere and directly send it to the nearest sorting facility which further processes it directly to the facility closest to delivery destination.

This model is fast and with a lot of help from technology Delhivery is able to reduce the delivery time from a few weeks to a one or two days.

The model works even faster when number of nodes in the network increase significantly.

Below is an illustration of the Delhivery Logistics Mesh Network.

As illustrated above, Delhivery has a mesh network on a scale unlike anyone else in India. In a city like Mumbai, where eCommerce deliveries are high, they can simply add more nodes and meet the demand. Where as in Tier 3 cities where eCommerce deliveries are considerably less compared to Mumbai, they can make do with a fewer nodes.

For a traditional player following a hub and spoke model, this agility in enhancing the network doesn’t work as they have to incur considerable spend to introduce a new hub in the model.

This is Delhivery’s competitive advantage #1.

A Lot of help from Technology

On the face of it, Delhivery looks like a logistics company, but as you peel through the layers, you will discover almost every single aspect of their logistics network is operated via their proprietary technology stack.

In Delhivery’s case, they like to build the technology first and logistics later.

The company has over 80 proprietary self developed applications that work together to help Delhivery deliver millions of packages every year. Delhivery further goes ahead and collects data points on each of these deliveries. Machine Learning optimized algorithms continuously consume these datapoints and work tirelessly behind the scenes to optimize this logistics network even further.

This is the same playbook Amazon has used over the years to help it become the largest, fastest and most reliable logistics company in the world.

Delhivery’s logistics technology is so successful, that they are now exposing it as a SaaS offering to other enterprises and customers.

Excerpt from their DRHP ⤵️

“We intend to externalize our logistics operating system as a platform and a SaaS offering by enabling other logistics service provider, logistics-tech companies, and enterprise and developer partners, in India and globally.”

This SaaS offering on its own can be a significant pie of their revenue a couple years down the road.

Test for their technology prowess came in during the Covid lockdown in March 2020.

In March 2020, when India announced a completed lockdown, the logistics industry came to a definitive halt. Ten days later when the country selectively reopened, Delhivery by leveraging its ‘Logistics OS’ was able to selectively activate 8300 pin codes for essential delivery and re-establish operations overnight simply by looking at unstructured data (announcements by local, state and national authorities).

An example of the applications developed on their technology stack is Orion, the application they use for Truckload Freight Management. Delhivery being an asset light firm, owns a tiny portion of delivery fleet (less than 8%), rest of it is either leased or sourced via Orion.

Orion helps match demand from shippers with suppliers of truckload capacity in real time. The application was primarily built to help Delhivery source delivery fleet from its network partners, but now has an added optionality of being launched as a standalone SaaS based offering for other large logistics companies.

Deeply integrated technology is Delhivery’s competitive advantage #2.

Why own an asset when you can lease it?

Logistics by its very nature is an asset heavy, upfront capex driven business.

A typical logistics company requires warehouses, distribution centers, fulfilment centers, staff to deliver and manage packages, delivery fleet and capital to run the business. All this before even it can begin to deliver its first order.

It should come as no surprise then, that more than 95% of logistics industry in India is fragmented and made up of small business owners running a logistics service at a very small scale.

For example, 85% of Road Transport companies in India own less than 20 trucks that drive on an average less than 300 kms a day. 90% of warehouses in India are smaller than 10,000 sq feet in size.

These small businesses cannot become mid to large scale companies unless there is technology to help them vastly increase their logistics network via partnerships with larger companies.

Delhivery through its technology solutions found a way to effectively build and run a marketplace for this vast network of small scale untapped capacity of truck fleets and warehouses throughout India.

Most of this demand in this marketplace today is from Delhivery itself.

Excerpt from their DRHP ⤵️

“Our systems function as a managed marketplaces that match partner capacity with Delhivery internal and third-party client demand based on partners’ service quality ratings and pricing.

This approach has enabled us to quickly expand to geographically dispersed locations, optimize loads, improve our cost structure and maintain flexibility in handling seasonal demands while incurring minimal fixed costs and capital expenditures.”

Delhivery’s motto is to invest in critical infrastructure while leveraging everything else via its network partners.

Delhivery owns a little assets of its own but leases a lot of them.

The company effectively has 12.42 Million sq. ft of logistics space available to it throughout India that cover over 17,045 pin codes which are serviced by its self owned and partner contracted fleet of trucks delivering over a billion packages weighing almost a million tonnes for its 21,000+ customers.

Pretty big and noteworthy numbers for a company started less than a decade ago.

This ability to scale up its logistics network without having to burn a lot of cash is Delhivery’s competitive advantage #3.

Partner and Automate

The little assets Delhivery does own on its own are highly automated. Take for example, their Gateways - which are the largest logistics facilities forming the core of their network.

Gateways are the big nodes in their mesh logistics network that handle all types of packages and perform majority of the tasks. The entire delivery network functions as fast as Gateways can. It is for this reason Delhivery has invested heavily into automating every single aspect of their Gateway functions that can be automated.

Packages are sorted automatically as soon as they arrive to a Gateway, with some Gateways being completely automated, capable of handling upto 32,000 shipments per hour.

Partnerships are another area where Delhivery has started to excel. In order to grow operations across border and stabilize Indian revenues, the company has entered into strategic alliances with FedEx and Aramex.

Any packages coming through the FedEx or Aramex networks to India will be delivered via Delhivery through its domestics logistics set up. Similarly any packages originating out of India to International destinations on Delhivery network will be serviced by FedEx and Aramex.

Apart from FedEx and Aramex, Delhivery already has a partnership with UPS which they entered into in 2019.

This ability to struck partnerships with strongest global players, helps Delhivery expand its network without any additional costs and is its competitive advantage #4.

Before we move on to financials, above is the brief timeline of Delhivery since its incorporation in 2011.

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Part Two: All About Money 🪙💰

Revenues

70% of FY21 revenue for Delhivery, or 2,550cr out of 3,635cr was from express shipment of deliveries for other eCommerce websites.

The rest 30% of revenue is divided between Part Truck Load (11%), Supply Chain Services (11%), Full Truck Load (6%) and Cross Border Delivery Services (3%).

Needless to mention an overwhelming majority of this revenue pie is linked to growth of eCommerce in India. Delhivery acknowledges and mentions this as one of their key risks in their DRHP.

Excerpt from their DRHP ⤵️

“Although we continue to diversify our customer base, e-commerce customers contribute a majority of our shipment volume. Accordingly, our business and growth are highly correlated with the growth of the eCommerce industry and more generally, commerce, in India.”

Delhivery is slowly diversifying into other industry verticals like shipment of customer electronics, consumer durables, FMCG, healthcare, lifestyle, automobiles and manufacturing.

Overtime the dependency on eCommerce should go down but I doubt it will ever be less than 50% of the overall revenue pie.

Reducing Losses and Increasing Income

Like most start ups, Delhivery is a loss making company. Unlike most start ups though, Delhivery has a clear path to profitability as their revenues are growing at a CAGR of 44% while losses are reducing.

The two main top expenses for the company are

1. Freight Handling and Servicing (76% of Revenue)

2. Employee Benefit Expenses (16% of Revenue)

As the company’s operations expand and volumes increase, operating leverage should play out and help reduce the freight handling expenses to a more manageable extent.

The employee benefit expenses however, are here to stay and may even increase in future as the company attracts and tries to retain more technological talent.

Increasing income and reducing losses, made Delhivery cash positive for the first time in 2021.

The losses might be reducing but make no mistake, this will never be a high Gross Margin business unless optionalities like their SaaS based offering for ‘Logistics OS’ playout and starts contributing to a significant chunk of revenue.

Debt

As of June 20, 2021 Delhivery had about ~342cr of long term and short term debt on its books. Much of this will be repaid from some of the proceeds from IPO.

Customer Concentration

A key area of risk for Delhivery is the customer concentration. An average of ~45% of revenue comes from just five customers.

Delhivery does not disclose the name of these customers but it is safe to assume some of these five customers are largest eCommerce companies in India like Flipkart, Myntra, Amazon etc.

Most of these large eCommerce players are investing in logistics capability of their own and only hire Delhivery when their own internal logistics systems are running at full capacity. As such as and when the logistical prowess of these eCommerce companies increases, their dependency on Delhivery should reduce and as such Delhivery’s revenues from these customers.

To counteract this revenue concentration risk, Delhivery has set its sights on a different kind of customer - the D2C (Direct to Customer) companies. These are your mom and pop small internet businesses that do not have the scale to invest in logistics of their own but want to primarily sell their products on the internet.

Delhivery onboards these customers and provides them with the logistics capability for them to conduct their business online. As of FY 21, some 675 out of 21,000 customers Delhivery caters to, were D2C companies.

D2C is kind of going through its own renaissance in India and is expected to grow faster than traditional large scale eCommerce.

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Part Three: Valuations and About The IPO

Objectives of IPO Offer

The company is raising 3750cr in its IPO via issuing fresh equity. Out of this 3750cr, 2500cr will be used for organic growth - expanding the current logistics network and upgrading and improving its ‘Logistics OS’ proprietary technology stack.

The remaining 1250cr will be used to fund acquisitions and other inorganic growth opportunities.

Majority of the company is owned by venture and private equity funds, with original founders collectively owning less than ~8% of the entire company.

The DRHP currently does not indicate how much these VC and PE funds wants to offload their stake in the IPO.

Valuations
Updated on 11th May 2022

Delhivery finally launched its IPO today seeking a market cap of 35,000cr at the upper band of the IPO price range of Rs 462 to Rs 487 per share.

This valuation target, by any stretch of imagination is towards the extreme end.

To give you some perspective, you can buy most of the listed profitable logistics companies in India for 35,000cr or you can buy a single loss making Delhivery.

The pre IPO financing round for Delhivery pegged its valuations at 22,500cr (~$3 Billion) just a few months back, so even with that in mind its quite a formidable ask to list oneself at 35,000cr market cap.

While Delhivery has a great business that one day maybe can recreate what the likes of FedEx did for America in 1980s, today the price is too high to take that gamble.

As with all the other IPOs, I will follow my rule and wait for six to twelve months before taking a call to invest.

Conclusion

Logistics is a high barrier capex heavy sector and Delhivery through the use of its own proprietary technology stack has enabled itself to raise these barriers to entry even further.

In my opinion, Delhivery is a good proxy bet to play the growth of eCommerce industry in India.

After my deep dive on Nykaa, this was the second company, I personally really enjoyed reading in depth and writing about.

I hope your experience was the same.

Thank you for reading, see you in the next one.

Peace,
Tar

Disclaimer: The information provided in this article is for informational purposes only and should not be construed as investment advice. The analysis and insights presented are based on publicly available information, and while efforts have been made to ensure accuracy, we cannot guarantee the completeness or reliability of the information.

Investing in securities carries inherent risks. This post should not be relied upon as a substitute for independent research or consultation with a qualified financial advisor.

The author of this post and the platform on which it is published do not provide personalized investment recommendations or financial advisory services. Any investment or trading decisions you make based on the information provided in this post are solely at your own risk.

Neither the author nor the platform shall be held responsible or liable for any loss or damage arising directly or indirectly from the use of or reliance on the information contained in this post. Readers are encouraged to conduct their own due diligence and seek professional advice before making any investment decisions.

By accessing and reading this post, you acknowledge and agree to the terms and conditions outlined in this disclaimer.

From its humble roots of selling bicycles in 1956 Ludhiana Punjab, to becoming the world’s largest two wheeler company is an extraordinary feat. Maintaining the momentum, protecting its market share and setting sights towards ‘Future of Mobility’ is something special.

Yet this giant, that sells its products in over 40 countries globally, has manufacturing capacity of over 9 million units annually and churns out a new two wheeler every few seconds from one of its eight production plants spread across India, Bangladesh and Colombia, is valued for about ~1x Sales.

This is my attempt to find out - Why?

Before we proceed, please consider sharing this write up with your friends or on your social media.
My aim, through these write ups, is to reach out to as many people as I can, so that they can make informed financial decisions.

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I won’t bore you with the history of Hero, there is more than enough material to read on the internet and if you’re from India, chances are you probably already know about it, as Hero is a household name.

Instead, this write up is focused on the journey of Hero, since the dissolving of its joint venture with Honda, steps taken to rebuild the R&D foundation and what the next decade may look like for the company.

Part One: The Big Set Back

December 2010
Business news headlines around India are reporting Hero Honda’s 33% jump in sales for the month and Hero’s stock is on an upwards trajectory, rewarding its shareholders a ~40% increase in share price that year, out beating the market index by a wide margin.

Yet the atmosphere in the board room, at Hero Honda’s headquarters in New Delhi is not pleasant. What the world doesn’t know yet, is that in less than 15 days, the joint venture between Hero and Honda Motors will dissolve.

Hero’s partnership with Honda was a pivotal moment in its history. The two companies formed a joint venture in 1983 to produce motorcycles for the domestic market. Honda was to supply Hero with R&D while Hero would work on scaling up manufacturing. The arrangement worked well and their partnership, soon catapulted HeroHonda to become the largest two wheeler company in the world by early 1990s.

By 2010, the same partnership was hindering growth for Hero. Honda was never completely forthcoming with the R&D and used it as a leash to control the ambitions of Hero. The initial agreement with Honda, also meant that Hero wasn’t allowed to scale up its export business beyond the boundaries of India and had limited presence in Bangladesh, Nepal and Sri Lanka - tiny markets at the time.

Meanwhile at its home base, in India, competition was brewing from every nook and corner - Bajaj, TVS and Eicher Motors were foraying into premium models and wanted to gain market share from Hero. To add to this competition, user preferences were migrating from motorcycles to automatic scooters, an area dominated by Honda Motors with their Activa offering.

Breaking up with Honda was the logical choice - a tough one but the only way out if Hero wanted to become a global brand.

When two parties agreed to dissolve their partnership, an agreement was formed that Honda would continue to supply R&D and engine designs to Hero till 2014. Honda would later back out of this agreement as Hero forayed into scooters.

The culmination of these events led to the decline of Hero’s market share in the two wheeler space - particularly in the premium category. Hero Honda Karzima used to rule the premium segment of the market, but by mid 2015’s offerings from Bajaj (Pulsar), Eicher (Royal Enfield) and TVS (Apache) took the top spot. Hero instead chose to double down on its entry level offerings, an area its still the leader in today.

Part Two: Hunt for Growth Begins

2016 to 2021
2016 was the year when Hero started to lay the foundation for its future growth. It launched a new R&D center in Jaipur, India followed by another one in Germany.

The same year Hero would invest and become the largest investor in a little known electric vehicle upstart from Bengaluru called Ather Energy.

Over the last five years from 2016 to 2021, Hero has been busy breaking the shackles of its past.

It has forayed into international markets - now supplying its products in over 40 countries globally, eight of which are growing substantially. It has also reworked its mission statement, setting its sights on the ‘Future of Mobility’, not limiting itself to just two wheelers.

Hero’s goal is to produce and sell another 100 million vehicles in the coming decade (Hero has sold 100 million two wheelers since its inception).

Meanwhile back at home in India, headwinds would grow stronger for Hero.

The last five years haven’t been kind to the auto industry - first came demonetization in Nov of 2016, followed by NBFC crisis of 2018, followed by transition to BS-VI transmission norms in 2019 and then finally the pandemic of 2020.

Most of its peers were impacted, but Hero felt the burden more. A major chunk of Hero’s sales comes from entry level motorcycles targeted at the rural segment of India. Hero distributes these motorcycles via 6000 touchpoints spread across the nation. No other auto manufacturer in India has such a wide distribution network.

While most of its peers have reported sales CAGR of anywhere between 4 to 11% for the last 5 years, Hero’s sales have grown at mere 2%. The main reason behind this deviation is the presence of its competitors in the premium segment.

In auto industry, the only way to protect your margins is to have a balance of entry and premium products. Entry level products lets you build scale while premium products help you in pricing power and delivering better margins. Sway too much on either side and you either risk losing your margins or not have enough demand to implement economies of scale in your business. Since Hero product mix sways too much on entry level side, it has scale but not as much pricing power.

Hero is fixing this by offering more premium variations to its existing products.

Splendor Canvas is an example of such an offering. The investment in R&D has also started to yield results - helping Hero launch more premium products with its Xpulse and Xtreme range. Competition remains tough in this category with names like TVS and Bajaj dominating the market share.

Another step taken by Hero to further alleviate the margin pressure is to implement a company wide cost savings program called - Leap. Leap was implemented in 2014 and has over the years helped Hero cut through the headwinds amid an inflation in commodity prices. Hero today saves enough money today, to delay the price hikes on its products and thus help protect its market share within the entry level segment.

The same Leap program has helped Hero maintain an operating profit margin of above 12%, even in the toughest of years.

You would imagine, five years of headwinds would have depleted the financials of an auto company - but not Hero. Hero Moto Corp financials today are envy of its peers. The balance sheet has negligible debt and cash reserves of over $2 Billion. The main business of Hero still throws up almost half a billion dollars worth of Free Cash Flow every single year, three times more money than Hero plans to spend annually.

The only piece missing in this puzzle is growth. Let’s explore where the growth for Hero will come from.

Part Three: Racing Ahead

Exports

Hero’s strategy with exports is two fold - first it helps the company produce and sell more of what its already good at - entry level motorcycles, and second it helps offset some of the sales erosion that may take place in India on account of transition to electric vehicles.

While a Hero motorcycle can be found in over 40 countries globally, only eight of them account for the lion’s share of the export business. Within these, Bangladesh, Mexico, Colombia and Nigeria are the fastest growing markets. The single thing common between these four - they are all immune to EV adoption, at least in the short term.

Take for example Nigeria, where Hero sells an entry level bike named Hunter. Electrification of a country like Nigeria is far away, motorbikes are still the primary form of transport in the country, referred to as ‘taxis’ by the locals. Hero developed Hunter from the ground up for the Nigerian market. Its designed to carry a heavy load, is durable and beats existing products on mileage - thereby allowing a Nigerian ‘taxi’ driver to earn more.

This is an example on how Hero is catering to a global market by designing and selling products suited for each individual geography.

To grow its exports fast, Hero has borrowed a page out of the playbook of its erstwhile partner - Honda. When Hero enters a new market, it does so in partnership with an established local distributor. This way, Hero doesn’t have to spend a lot of money on building a distribution network in each country and can focus on building products instead. Such a model has worked well for Hero in each of its fastest growing markets - Mexico, Nigeria, Bangladesh and Colombia.

Hero has a target of 15% sales volume from its export business by 2025.

Premiumization

When it comes to selling premium models, there is no brand more iconic than Harley Davidson. Hero has a partnership with Harley to manufacture, market and sell products under the Harley Davidson brand in India. These products will be targeted at the highest end of the market allowing Hero better margins and maybe some room to gain market share in this category.

Today’s Hero’s market share in premium category is at a mere 1.6%.

The company is further beefing up its product portfolio in the 160cc to 200cc category with its XPulse and Xtreme range. It plans to launch one new product in this segment, every year for the next four years.

Making progress is this category is important for Hero - this is the most EV immune part of the two wheeler market and allows Hero to improve its operating margins to above 20%.

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Spare Parts

Hero started selling motorcycle components in 2013 under the brand ‘Hero Genuine Parts’. In 2014 this business was making 1800cr in revenue every year, today it makes over 3200cr ever year and is growing at double digits (even during the pandemic).
Hero plans to have 10% of annual revenue from this line of business by 2025.

Spare Parts are a lucrative and very high margin business for any OEM, Hero has further enhanced the margins in this area by backwards integrating into manufacturing these parts on its own. Today over 25% of spare parts are produced in house by Hero, rest outsourced to ancillary companies.

Making over half a billion dollars a year just doing spare parts sales is no easy feat.

Electric Vehicles

Final part of this growth puzzle is Electric Vehicles. Hero has been ahead of its peers in embracing the transition to EVs. Its first investment in EV space was Ather Energy (~38% stake today). Another big leg up came with the partnership with Gogoro, a Taiwanese based company that has championed battery swap and go technology for two wheelers. Finally, Hero is also developing its own EVs two wheelers in house, with first one to launch in March of 2022.

To an outsider, this approach to electric vehicles may look messy - too many fingers in too many jars type approach, but there is a method to this madness.

Whenever a new technology enters the market, it is imperative to test out multiple approaches in order to assess which technology works for which segment of the population. Just like today, everyone doesn’t buy entry level motorcycles, tomorrow everyone may not choose to buy a standardized electric scooter that tops out at 65km/hr.

Hero’s approach to electric vehicles is to test out what works in the market by making product options available for every segment of the population.

Ather 450X for example is a premium electric vehicle, capable of fast charging and reaching speeds of upto 80km/hr. Gogoro’s SmartScooter can reach upwards of 100km/hr. and is center around battery swap and go technology that mimics the experience of refueling.

While very little is known about Hero’s own electric vehicle scooter, the glimpses provided by Dr. Munjal (CEO of HeroMotoCorp) shows that its capable of fast charging and is designed to keep affordability in mind.

Hero is taking the same approach to electric vehicles as the auto industry has taken to motorbikes in the past. Motorcycles come in three categories - Entry (100-125cc), Deluxe (125-150cc) and finally Premium Segment (150cc and above). Electric Scooters too seem to be transitioning to that segmentation - affordable (Hero’s own EV) , premium (Ather) and swap & go (Gogoro).

Hero plans to launch two electric vehicles in 2022 and thereafter one new electric vehicle every single year till 2030. Out of the total capex of 10,000cr, Hero plans to spend in the coming decade, 50% is reserved for development of EV products.

If you want me to do a deep dive into Gogoro and Electric Scooter space in India, please leave a comment.

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Part Four: Feet on Ground, Eyes at Sky

Investment Thesis
In my view, the worst is already baked in to the valuations of Hero today. The headwinds of last five years couple with slow growth has led market to discount what the future and near term holds for Hero Moto Corp.

I foresee a strong case of rerating for Hero in 2022 as the company transitions to launch more electric scooters and build its product catalogue for EVs. Couple that with strong double digit earnings growth driven by exports, rebound in domestic sales and a growing ancillary business - and you have a good investment thesis.

Everything that could go wrong, seems to be already baked into the price, implying a high margin of safety for future revaluation.

Risks

This isn’t to say that there are no risks to the company. There are a growing breed of upstarts in India that are scaling up and launching new electric scooters. Backed by Private Equity giants they have a single mission - to electrify India by 2025. The two major ones to watch out for are Ola Electric and Simple Energy.

There are other ones too but they all lack scale. To succeed in any kind of hardware business, especially in the business of making two wheelers you need scale.

The only two upstarts focusing on implementing scale today are Ola (10 Million annual capacity) and Simple Energy (12.5 Million annual capacity).

The good news is, reaching scale needs time and Hero doesn’t have any shortage of its own funds to deploy in this war for EV market share.

Another major risk, I see in Hero today is cannibalizing its own sales. A EV scooter sold by Hero will be counted as a substitute purchase - an existing customer of Hero who was supposed to buy a bike may now buy a electric scooter from them. So increase in sales of electric vehicles may mean an equivalent decrease in sales of motorcycles for Hero. While for the likes of Ola, a sale is a sale, it is not competing against its own existing products.

A higher than expected slowdown in entry level segment due to this transition to EVs is another major risk for the company as entry level bikes are its bread and butter.

There are a bunch more smaller risks and anti-thesis in the company - I sourced a couple from the community at Twitter - leaving a few of them for you in the segment below.

Risks and Anti Thesis Pointers sourced from Twitter

Thank you to everyone who contributed, sorry I wasn’t able to include them all. If you want to read the entire thread all possible risks within Hero, you may access via below link.

Hero Anti Thesis Pointers

Few good ones, are highlighted below.

Conclusion

The entire investing case in Hero today can be summed up in a single line - can a value bet of today become a growth bet of tomorrow?

Going by their history, the events that led up to valuations of today and incremental earnings triggers of next 5 years - I certainly think so.

Thank you for reading, see you in the next one.

Peace,
Tar

Disclaimer: The information provided in this article is for informational purposes only and should not be construed as investment advice. The analysis and insights presented are based on publicly available information, and while efforts have been made to ensure accuracy, we cannot guarantee the completeness or reliability of the information.

Investing in securities carries inherent risks. This post should not be relied upon as a substitute for independent research or consultation with a qualified financial advisor.

The author of this post and the platform on which it is published do not provide personalized investment recommendations or financial advisory services. Any investment or trading decisions you make based on the information provided in this post are solely at your own risk.

Neither the author nor the platform shall be held responsible or liable for any loss or damage arising directly or indirectly from the use of or reliance on the information contained in this post. Readers are encouraged to conduct their own due diligence and seek professional advice before making any investment decisions.

By accessing and reading this post, you acknowledge and agree to the terms and conditions outlined in this disclaimer.

Yet this company, that started in a small office in Chennai on Oct 13th 2010, has paved the foundation for Indian SaaS industry - a $10 Billion per year industry that is growing at ~40% CAGR and represents a ~5% market share of the global SaaS market.

Pretty impressive figures for something that didn’t exist a decade ago.

This, is the story of Freshworks and the Indian SaaS revolution.

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This deep dive is divided into the following parts:

1. Overview of the Global and Indian SaaS Industry

2. A Brief History of Freshworks

3. Product Offerings of Freshworks

4. Profile of Key People at Freshworks

5. Analysis of Competitive Landscape

6. Analysis of Financial Statements

7. Valuations

8. Conclusion and My Take

1. Overview of the Global and Indian SaaS Industry

Traditionally software was built to order. Multinational corporations would either hire their own IT teams or outsource the development requirements to a third party. The software would be built once as per requirements and then ‘shipped’ upon completion.

As companies evolved and initial requirements changed, this software would quickly become outdated and the whole cycle would repeat again - with new requirements, new software orders to third parties and new shipping dates.

As you would assume, this entire process was expensive, rigid and relied on user requirements remaining static.

In a fast moving dynamic world, software development process needed to disrupt itself with something that could scale with a company’s evolution, remain dynamic, could get frequently updated with the latest and greatest technology, and was available for cheap.

This change came with the advent of cloud computing and particularly with the commercialization of Amazon Web Services (AWS). AWS made it incredibly cheap for anyone in the world to start their own technology company without worrying about the associated hardware costs. Anyone from any part of the world, could now ‘rent’ computing power on any scale and start building their own software company.

This simple change led to the birth of an entire industry we now call Software as a Service (SaaS).

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Global SaaS Market

Globally, the SaaS market today is worth around ~$200 Billion and is expected to grow to ~$500 Billion by 2025 at a CAGR of ~20%.

The main drivers behind this growth is the increased adoption of SaaS products, especially by the small and medium scale businesses. Most giant software corporations do not create targeted products for this segment of the industry primarily due to the small sales ticket size. A large order worth a few million is worth more and easier to manage compared to thousands of orders worth a few hundred bucks a month.

This is the area where most new SaaS companies globally are thriving - selling software products to small and medium scale businesses.

Another key area of growth is the increased adoption of SaaS products by large enterprises. Traditionally these companies used to build their own software in-house and almost never purchase much less subscribe to software products. This trend is now changing - with enterprises more inclined to buy ‘off the shelve’ software products than build something on their own.

Today, anyone can start a company with traditional functions including HR, Marketing, Finance, Operations and Logistics by entirely using software that is available off the shelf. A new business today doesn’t need to make any large investments into setting up a traditional technology team.

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Indian SaaS Market

Indian SaaS companies were just a couple of ‘upstarts’ in 2010s - far and few existed and a large number of them didn’t make a lot of money. Today, that landscape has changed entirely - over 30 Indian SaaS companies make $10 Million in Annual Recurring Revenue and together Indian SaaS market is expected to reach ~$20 Billion by next year (2022), representing a 9% market share of the global SaaS market.

Indian companies are leaping up market share from global counter parts due to large in-built competitive advantages.

Building a SaaS company in India has lot of associated advantages:

1. There is a lot of good, cheap and skilled engineering talent available
   (it costs 85% less to hire an entry level developer in India compared to US)

2. There is a large ecosystem of venture capital and start up funding available (mostly driven by domestic venture funds and seed funds established by early founders of SaaS and successful start ups)

3. Successful Indian SaaS companies are leaders in their field and have found customers globally
   (Postman created the industry for API Management, Freshworks serves 200K clients and Kissflow’s products are used in over 150+ countries)

The products from Indian SaaS companies are also increasingly finding acceptance among the top tier enterprises - Druva (a cyber security SaaS company), for example, serves more than 50 of the top Fortune 500 clients in the world.

Here is another metric to highlight the above point - more than 70% of revenue for all Indian SaaS companies comes from outside India.

India is increasingly producing top quality software for the world and is doing it at an incredible speed.

This fast growth is shown in Revenue metrics of these companies as well. Only a single SaaS company made over $100 Million in Annual Revenue, 5 years ago. Today more than 5 Indian SaaS start ups have cross that milestone.

The time taken to achieve these ARR milestones are also significantly shorter for Indian companies than their US counter parts.

This is an incredibly exciting space and if you want me to do a deep dive into Indian SaaS companies and their future potential along with various investment opportunities available, then please leave a comment.

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2. A Brief History of Freshworks

Freshworks is a company that wasn’t supposed to win. When the company started in late 2010, SaaS globally was still in its infancy and didn’t exit in India.

Freshworks is one of the original Indian SaaS companies that laid the foundation stone of the industry.

Right from inception, Girish Mathrubootham, founder and CEO of Freshworks, was told that his company will not succeed. Here is an extract from the S-1 where he states this in his opening remarks.

The idea of Freshworks came from a message board on Hacker News - ZenDesk (an old established CRM company) was raising its prices by 300% and many of its small and medium scale customers were unhappy. This was the lighting moment for Girish, he knew there was a market for cheap CRM software that caters to mainly small and medium scale businesses. Being in India and surrounded by tech talent, he could easily build such a product and maybe market it to customers globally - and so Freshdesk was born.

The company believes in ‘Dreaming in Increments’ - accomplishing small incremental goals that are larger than the previous ones. Right from day one, Girish and team has focused on product led growth - designing products that are advanced, well built, easy to use and available for cheap. It is this product led growth that enabled it to become a global company from inception - first few customers of Freshdesk were from four different continents.

From its initial CRM product (Freshdesk), the company now operates and offers software for a wide variety of business needs, ranging from:

1. Customer Experience (Freshdesk)

2. IT Service Management (Freshservice)

3. Sales and Marketing (Freshsales)

4. Developer Platform (Freshworks Neo)

Two out of these four products (Freshdesk and Freshservice) already generate over $100 Million in ARR and are used by more than 50,000 customers globally.

Not bad for a company that wasn’t supposed to win.

3. Product Offerings of Freshworks

Each of Freshworks products has several tiers of subscriptions plans ranging from free to enterprise. This helps the company attract a wide variety of users (mainly small and medium scale businesses) ranging from a fresh startup to an established enterprise.

Freshdesk is the one of the main product offerings of the company. Freshdesk is designed to help businesses enhance and cater to their customers experience by providing omni channel support.

Businesses use Freshdesk to interact with their customers and respond to customer service request. If you have ever contacted a customer support over apps like Swiggy etc., that customer support interaction and interface is powered via products like Freshdesk.

Below image depicts the pricing and subscription tiers for Freshdesk. As with most SaaS companies, the offerings increase along with the subscription tier.

Competitors of Freshdesk include companies like Salesforce, Monday.com and Zendesk.

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Freshservice is the second main product offering from Freshworks. Unlike Freshdesk, which is targeted at managing customer experience and relationship, Freshservice is targeted to help organizations managed their employee productivity and increase technology throughput.

By leveraging Freshservice, a company can allow its employees to reach out to service desk efficiently, resolve service issues, enable non tech functions like HR and Legal to provide support services and lastly enable tech teams to organize and collaborate on projects by using the inbuilt project management capabilities.

Similar to Freshdesk, Freshservice too has various subscription plans, designed to attract businesses of all scale.

Here is a snapshot of how all of the above fits into Freshservice product suite.

Main competitors of Freshservice include companies like Atlassian and Service Now.

Both Freshdesk and Freshservice combined generate more than $200 Million in Annual Recurring Revenue for the company. They essentially represent the bulk of company’s revenue.

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Freshsales is the company’s product offering for sales force and marketing automation. It is designed to help a business boost productivity of its sales teams, enable them with generating quick leads and provide insights into data from previous and ongoing sales.

Leveraging Freshsales suite, a business can design and work with various marketing campaigns while integrating the results with their salesforce.

Here is a snapshot of how Freshsales suite looks like.

Freshsales too has various subscription tiers to enable its adoption across all categories of customers.

The final products offering from Freshworks stable is called Freshworks Neo. Freshworks Neo is a developer platform that enables customers of Freshworks to build solutions for themselves using low code development and third party service integrations.

Customers can leverage the Marketplace available on the Neo platform to integrate 1100+ free and paid applications ranging from categories like bots, reporting, analytics, messaging, e-commerce, etc.

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Customer Insights

As of June 30, 2021, Freshworks has more than 52,500 paying customers spread across 120 countries around the world.

Out of these 52K customers,

• There are over 13,000 that spend more than $5,000 per year

• There are 1164 customers that spend more than $50,000 per year

More than 18% of Freshworks customers purchase two or more of its products. Such customers represent 45% of the overall ARR.

The above chart shows how much each customer cohort spends and contributes to the yearly $300 Million recurring revenue. Notice, how the more recent customers end up spending more, indicating that Freshworks is able to target and onboard more enterprise clients with larger spending budgets.

Freshworks is also increasing its ARR to a more diversified client base - no single customer accounts for more than 1% of ARR and top 10 customers combined represent less than 5% of the total ARR.

Here are some of the marquee customers of Freshworks.

4. Profile of Key People at Freshworks

Executive Compensation

Girish was paid $10.7 Million as compensation in 2020, the bulk of which came in the form of stock awards ($10.25 Million worth) and rest as base salary ($331K).

Tyler was paid $14.4 Million as compensation in 2020, the bulk of which came in the form of stock awards ($14.08 Million worth) and rest as base salary ($278K).

Jose was paid $14.35 Million as compensation in 2020, the bulk of which came in the form of stock awards ($14.17 Million worth) and rest as base salary ($87K).

Going forward, key employees including the leadership team will continue to be paid a large part of their compensation in the form of stock awards. Investors should account and build in future dilution of equity while valuing the company.

5. Analysis of Competitive Landscape

Freshworks is part of a highly competitive industry. There are more than 630+ CRM and IT Service management software available in the market. Each of these try to distinguish itself in term of offerings, subscription prices, capabilities or target market.

Only a handful of them survive and gather enough market share to become profitable in the long run.

The intensity of competition is increasing, vendors like Salesforce that were originally focused on enterprise customers have now released a strip down version of their software to target small and medium scale businesses.

Eventually this industry should undergo a lot of consolidation as it matures.

Porter’s 5 Force Analysis

If I were to run a Porter’s five force analysis on this industry it would come out to something like this.

Threat of New Entrants: Medium

Anyone in the world can start a SaaS based company providing the tools Freshworks does, but to gather momentum is hard to achieve and as such I would rate the threat of any new entrants as medium.

Threat of Substitutes: Medium

Its not easy for a customer of Freshworks to change and migrate to another product overnight, as such the threat of substitute is medium. Customers do tend to migrate but only when the alternative showcases large advantages.

Bargaining Power of Buyers: High

Customers in this industry are spoiled for choice, they get to pick and choose whatever software they want and companies usually hand out large discounts to attract customers.

Bargaining Power of Suppliers: Low

The supply side of the industry is standardized and as such there isn’t any bargaining power of suppliers.

Rivalry Among Existing Competitors: High

Every competitor in this industry is fighting to attract the next customer. Participants usually spend a significant percentage of their revenues in sales and marketing to retain and attract new customers. As such the intensity of competition is really high.

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Growth At All Costs

Since this industry is relatively new, the only way to differentiate the winners from the losers is growth. Participants that grow well, are rewarded high valuation multiples.

Freshworks most recent quarterly revenue was $88.3 Million and is growing at 126%. That figure seems high until you realize that Monday.com which has similar quarterly revenue is growing at 300%+. Part of the reason for high growth for both these companies is low base.

Companies like Zendesk (Freshworks closest competitor in terms of offerings) and HubSpot are growing at 64% and 90% respectively, but have considerable higher revenues than Freshworks (HubSpot generates 3.5x Freshworks quarterly revenue and Zendesk generates 3.6x Freshworks quarterly revenue).

As mentioned earlier, the margins in this business are very small - mostly cause of increased competition in the industry. Bulk of earnings are spent towards upfront cost of software development and customer acquisition costs.

Even though negative (-4%), Freshworks has one of the more respectable margins for a company its size in this space. Primary reason for this is Freshworks major development costs are in India while majority of its revenue is generated in North America.

As of June 2021, 88% of Freshworks employees were based in India while 42% of its revenue was generated from customers in North America.

As long as Freshworks keeps growing its customer base and increasing the portion of customers spending more than $5,000 in ARR, it should be able to capitalize on this competitive advantage and generate higher margins than its competitors.

6. Analysis of Financial Statements

Income Statement

In its latest quarter, June 2021, Freshworks generated $88.34 Million in Sales with stable gross margins of ~79%. This represents a YoY sales growth rate of ~55%.

Bulk of this revenue though goes towards selling and marketing expenses, with Selling and Administrative Expenses totaling around ~65% of its latest quarterly revenue.

This trend is typical of the industry, as intensity of competition is high and everyone is competing for a limited set of customers.

This results in very low income ratios and margins. While Gross Margins were ~78%, Operating Margins for latest quarter are -7.3% and Net Income and EPS both being in negative territory as well.

I do not expect Freshworks to start generating profit any time soon since its very much in its growth phase and as such while valuing the company, the focus should be entirely on its growth and its ability to increase its market share.

Balance Sheet

The company has enough cash on its books to meet any its debt obligations ($240 Million worth of debt). Its generating enough revenue to meet its growth requirements and the recent IPO proceeds will help it accelerate its growth further.

Total Assets stood at ~$380 Million vs Total Liabilities of $191.72 Million for the most recent quarter (June, 2021).

Cash Flow Statement

The company is Cash Flow from Operations positive - cash generated by the company is enough to meet its needs and incremental revenue goes towards future growth.

Since majority of revenue goes towards selling and marketing costs, the cash flow from operations can significantly improve as and when the company starts to limit spending in that bucket. The current Op. Margin of ~-7.7% should climb to high double digits whenever that happens. The company however, needs to ensure that this doesn’t happen at the cost of growth.

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7. Valuations

Freshworks debuted on Nasdaq on 22nd Sep 2021 via direct listing. The price on that day closed at $47.55 per share. As of writing this article, Freshworks ($FRSH) latest closing price is $42.27 per share which gives it a market cap of $11.9 Billion.

At current market cap, Freshworks is valued at nearly ~40 times its yearly revenue, Price to Sales multiple of 38.6.

Its closest competitor, Zendesk, is valued at roughly ~13 times Price to Sales. At current stock price, Freshworks seem to be overvalued and doesn’t leave much margin of safety in its price even for a fast growing SaaS company.

8. Conclusion and My Take

Listing of Freshworks represents a significant milestone for the Indian SaaS industry. From its infancy the industry has grown to compete with global giants in less than a decade.

Just like every other Indian SaaS company, Freshworks too has significant competitive advantages given the low employee and operating costs, while developing products for global consumers.

At current price, Freshworks is a pass for me and will remain in my watchlist. The only comfort in current valuation is the high growth in revenue. I will observe the company’s performance for next few quarters to check if it can retain its current revenue growth rates and evaluate the investment case again.

If you’re still reading this, then thank you very much.

Writing deep dives like these require lot of research and effort and if you like what I write, please consider sharing this write up with your friends or on your social media.

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Thank you for reading.
Until next time.

Peace,
Tar

Disclaimer: The information provided in this article is for informational purposes only and should not be construed as investment advice. The analysis and insights presented are based on publicly available information, and while efforts have been made to ensure accuracy, we cannot guarantee the completeness or reliability of the information.

Investing in securities carries inherent risks. This post should not be relied upon as a substitute for independent research or consultation with a qualified financial advisor.

The author of this post and the platform on which it is published do not provide personalized investment recommendations or financial advisory services. Any investment or trading decisions you make based on the information provided in this post are solely at your own risk.

Neither the author nor the platform shall be held responsible or liable for any loss or damage arising directly or indirectly from the use of or reliance on the information contained in this post. Readers are encouraged to conduct their own due diligence and seek professional advice before making any investment decisions.

By accessing and reading this post, you acknowledge and agree to the terms and conditions outlined in this disclaimer.

As you set out for Ithaka
hope your road is a long one,
full of adventure, full of discovery.

These are the first few lines to the poem ‘Ithaka’ written by C.P Cavafy.
This is the poem, then shared by the daughter of founder and CEO, Falguni Nayar, that led to the birth of Nykaa.

The poem talks about how the journey of a thousand miles is more important than the destination. It’s this sentiment that Falguni Nayar’s Nykaa imbibes in itself.
The company has never tried to rush growth, it has taken its time experimenting with itself and faced challenges head on as they come.

In the process, Falguni Nayar and team has been able to create a business from ground up that is resilient, growing fast, is profitable and primarily caters to the needs of an overlooked category and segment of our economy - women.

In this deep dive we will explore the business of Nykaa. I will take you through

1. The Background of the Promoters - Nayar Family

2. Outlook of the Industry Nykaa Operates In

3. Nykaa’s Business and its fit in Indian Market

4. Financials of the Company

5. Details about its IPO

6. Risks and Competitors

7. Conclusion and a few final words

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The Background of the Promoters

Nykaa is promoted by the Nayar family - Sanjay Nayar, Falguni Nayar and their two children - Anchit Nayar and Adwaita Nayar.
Together the family owns about 54.25% of the entire company and will continue to own above 51% stake, post its IPO.

Sanjay Nayar is the Chairman and CEO of the Indian arm of the private equity giant, KKR.
Falguni Nayar was the Managing Director at Kotak Mahindra Investment Banking, leading the team that took various companies public.
Anchit Nayar was a Vice President at Morgan Stanley Equity Research and
Adwaita Nayar has worked with several consulting and investment banking giants.

Out of four, three members of the family work with Nykaa full time.

Falguni Nayar is the CEO of the entire Nykaa and all its subsidiaries.
Anchit Nayar is the CEO of the e-Commerce and Beauty arm of Nykaa.
Adwaita Nayar is the CEO of new businesses and Nykaa Fashion.

Beauty and Personal Care Industry

Nykaa operates in a segment of the retail industry known as BPC or Beauty and Personal Care. This segment is part of the discretionary retail industry in India, which is set to reach Rs 31 Trillion by 2025.

Fashion and BPC combined, accounts for 35% of the total discretionary retail pie. This is a large enough market for Nykaa to foray into and grow further.

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Before Nykaa started in 2012, India’s BPC industry was fragmented. There was a clear divide in the industry. On one hand you had these hi-retail luxury stores that were present far and few in Tier 1 cities or at airports catering to only the elite, and on the other hand you had customers in Tier 2 and 3 cities buying from small stores that had a limited selection of products available to choose from.

There was a clear gap in the options available to the target consumer - women, esp. the ones residing in Tier 2 and Tier 3 cities and towns across India. In 2012, online commerce had just started a few years earlier but was laded with fake products being sold or just like the small stores, didn’t have everything a customer wanted.

This unaddressed gap in the industry is where Falguni Nayar saw opportunity.

In 2016, 89% of India’s retail market was unorganized. By 2019, various reforms like GST, decrease in internet data costs due to Jio effect and improved logistics infrastructure due to increase in ecommerce penetration helped organized retail gain the share to 15% of total pie (an increase of four percentage points in three years).

2020 was a transformational year for internet economy and organized retail.
Today, organized retail is almost 20% of the entire market and growing fast.

Indian retail industry is estimated to grow at a CAGR of 11% till 2025.

Of this, the BPC segment will grow faster at a CAGR of 12%+. Share of unorganized retail is reducing in this segment from 77% in 2016 to 70% in 2020.

Within the BPC segment, the online growth is much faster at 30%+ CAGR with a long runway ahead. The penetration of online BPC sales in India stands at 6% compared to almost 35% in China and 20% in US.

Two major factors that are helping the online markets grow faster than the industry are - trust and large catalogue of products.
BPC as a category demands trust on the genuineness of the products being sold to the customer. Customers also want different products and SKUs available. By its nature cosmetic products have a long tail (large variety).

High prevalence of counterfeit goods sold by small stores and unavailability of every single product that a customer may demand, is hurting their growth and diverting the sales to online platforms like Nykaa.

This is reflected in the data as well, which clearly shows that demand from Tier 2+ cities is growing much faster than demand from Metro and Tier 1 cities.

India Fashion Market

The other market that Nykaa is foraying into is Fashion. Here too, similar forces, of the move away from unorganized retail to organized retail is helping the company. Organized retail share of the overall market was 29% in 2016, this share jumped to 38% in 2019 and is growing fast.

Shift of demand from offline to online is providing tailwinds for companies like Nykaa. Online fashion sector grew at a CAGR of 25% in last four years, Covid has accelerated this growth further.

India’s online fashion penetration is still only 8% compared to 40% in China and 35% in US, indicating that there is a lot of room for further growth.

The growth in both these segments of retail industry - Beauty and Personal Care, Apparel and Fashion - means Nykaa has a giant Target Addressable Market of USD 152 Billion to chase after in the next 5 years.

It’s this increasing size of the market that has attracted players like Amazon, Flipkart, Paytm Mall and vertical online platforms like Myntra, Purplle and Myglamm - all of which directly compete with Nykaa to get a share of this growing market.

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Nykaa’s Business

Nykaa is an omni-channel vertical e-commerce company, i.e., the company has presence both offline and online and only sells products in a single category, unlike e-commerce companies like Flipkart and Amazon that sell everything.

It is this focus at verticalization that gave Nykaa its edge. Today, Nykaa is the undisputed market leader in Beauty and Personal Care products across India.
It started in 2012 with this category as it was relatively easy to disrupt it and most competitors weren’t focusing at building a vertical e-commerce company.

Margins are easy to protect in Beauty and Personal Care products given cosmetics have the highest mark up of any consumer product in the world. This mark up and wiggle room in the margin of its products meant, Nykaa, could experiment and build a company from ground up while not incurring heavy losses.

This is also the reason why Nykaa didn’t have to raise a lot of money from private investors (it has raised less than ~$350 Million) and the equity dilution isn’t as much as other startup businesses that are going public (Nayar Family and founders still holds 54% of equity compared to less than 5% for companies like Zomato and PolicyBazaar).

When Amazon was taking shape, Jeff Bezos used a similar playbook. He started Amazon as an online book store as it was easier to manage and ship books online - books weren’t perishable items and most books come in standard sizes. Once he had built the infrastructure required for shipping books, he could easily start selling and shipping other items. Today, couple of decades later, Amazon sells everything.

Nykaa in a way is following the same path that Amazon once charted upon. What began as an omnichannel beauty and personal care business is now slowly morphing into a lifestyle platform.

Nykaa’s entry into fashion and apparel is a step towards this direction.

The Big Moat

Nykaa’s biggest moat isn’t its platform or the network of offline stores or even its brand, its something else entirely, something that even its closest competitors do not excel at - content.

At the heart of its business, Nykaa, is a content generating machine.

The company uses a wide variety of ways to generate content and has deployed technologies to tailormade and personalize this content for its users.

Below are a few ways Nykaa creates content for its users.

Nykaa, today, excels at two major changes happening within e-commerce industry - social commerce and live stream commerce.

Nykaa Network is the company’s social media platform, where users can talk about everything related to beauty and fashion. A quick glance at the platform and you will notice it looks very similar to any other social media platform - except users can directly buy products while navigating the platform.

This is very similar to what shopping on Instagram is like.

Here is an example of what shopping experience on Nykaa Network is like. I expect the company to scale this feature going forward.

While nascent in its offering, this example shows how far ahead the company is able to see and adapt with the changing industry dynamics.

Another area where the company excels, with regards to content creation, is the ability to harness the collective power of influencers to drive sales via live stream commerce.

Nykaa has a network of 1363 influencers (as of 31st March 2021) - the largest such network for online beauty and personal care sector in India. These influencers interact with their followers and recommend items for purchase. Nykaa in return pays these influencers commission for the amount of sales they bring.

This type of commerce is already huge in China and has transformed the online shopping experience. Taobao Live, is an app by Alibaba, that helps influencers sell products while live streaming. Last year it sold Gross Merchandise Value worth over USD 70 Billion.

Here is a video that explains this phenomenon in detail.

Nykaa is at the beginning of this journey in India - make up and apparel being the easiest of merchandise to sell via live stream.

This content helps Nykaa create a networking effect for its products which in turn drive loyalty among its customers as the whole experience is aimed at personalization.

An example of the depth of customer loyalty is Nykaa Prive, the loyalty program of Nykaa, which has more than 2 Million (20 lakh) members.

Private Label Business

Another chapter, Nykaa has borrowed from Amazon’s playbook is the private label business. Amazon has several of its own private label brands (like Amazon Basics, Solimo) that it sells on its website.

Amazon does this by harnessing the user search and demand data to identify gaps in the product catalogues and sell them at a price point that generates the maximum demand. It’s a data driven approach to introducing and selling products.

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Nykaa has too, replicated this entire flow. It’s able to leverage user data from its platform to introduce products that are very likely to succeed with the end customer. Over the years, Nykaa has launched several private label businesses like Nykaa Cosmetics (in 2015), followed by Nykaa Naturals, Wanderlust, Nykaa Hair, Nykd, Nykaa KK Beauty (a partnership between Nykaa and Katrina Kaif) and Masaba by Nykaa (a partnership between Nykaa and Masaba Gupta).

Private labels have much higher margin for Nykaa and since Nykaa outsources the manufacturing of these products, it doesn’t have to incur large capital expenditure to set up these brand. I expect Nykaa to launch many more private labels in the coming years.

Going Omnichannel

Through its online platform, Nykaa today delivers to more than 24,800 pin-codes, which together represents ~86% of all serviceable pin-codes in India.
Further, the company has presence in 38 cities via its 73 offline stores that run in various formats ranging from full scale luxury stores to small kiosks in malls and shopping centers.

The purpose of these offline stores are two fold

1. First, is to sell products to customers who wish to buy in person rather than online

2. Second and more importantly, educate and build brand presence for its customers

Nykaa employs 273 beauty advisors in these offline stores who spend time educating the customers on different products.

This omnichannel presence helps the company provide a wholistic experience to its customers. No matter what format a customer may want to shop, Nykaa is there for them.

Despite this omnichannel presence, Nykaa generates the highest sales per sq. ft. of revenue amongst its peers.

Going forward, I expect these stores to morph into a lifestyle experience store selling BPC products alongside Nykaa’s Fashion and Apparel catalogue.

Optionality

If you double the number of experiments you do per year you’re going to double your inventiveness - Jeff Bezos

Nykaa has built a platform, now it has the luxury to experiment with it and build new lines of businesses. The great part about these experiments is that, none of them require large capital expenditures and Nykaa can change and adapt with them quite nimbly.

Here are few experiments that Nykaa is running on its platform as of 2021:

Nykaa Man
Nykaa Man is targeted at, you guessed it, Men. The company operates this business via a separate app and website. There are several categories of products offered ranging from gadgets, tech accessories, personal care, fashion, health and even nutrition.

The Global Store
The Global Store is Nykaa’s offering to buy luxury foreign brands from overseas retailers. These brands usually do not have a presence in India either in offline or online segment and their partnership with Nykaa is the only way customers can buy them in India.

Nykaa Pro
Nykaa Pro is a membership program for beauty professional and make up artists around the country. There are several beauty and personal brands in the world that are ‘Professional Only’. Members of Nykaa Pro can order these brands from Nykaa and also get the relevant expert training along with educational content to help them in their professional journey.

SuperStore
SuperStore is Nykaa’s entry into B2B segment. Via SuperStore, Nykaa wants to sell BPC products to select offline and local retailers. Nykaa’s foray into this segment makes sense as the company’s logistic and warehouse capability has reached a stage where it can effectively supply products to other retail chains.

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Nykaa’s Financials

Unit Economics

What makes Nykaa stand out amongst the Indian start up community, is that Nykaa is unit economic positive. It makes a profit on every order it ships via its platform. This profit should grow further as business scales and costs of additional business via the platform reduces dramatically.

Nykaa makes a profit of about ~Rs 250 to Rs 300 per average order value of ~Rs 2000, in the BPC Category.

Per unit economics for Nykaa Fashion aren’t clear yet as its relatively new. The fashion and apparel business is ramping up fast though and should significantly contribute towards revenues and unit economics in FY22.

Sales and CAGR

Nykaa has compounded it’s annual sales at an unbelievable CAGR of 84% per year since 2017. This growth wasn’t even impacted to a large extent in FY20 and business recovered very soon post the aftermath of Covid.

Nykaa works on an inventory led model - it buys the products from various suppliers and brands globally based on the demand and then sells the product to customer via its platform. In each transaction, Nykaa acts as the direct seller unlike at Amazon where the customer is purchasing an item from a third party seller.

Bulk of Nykaa’s revenue (~90%) comes from this channel. Any discounts and promotions by specific brands is passed on directly to the consumer and doesn’t effect Nykaa’s bottom line.

The other ~10% of revenue is split between rendering marketing support to brands, commissions from the limited number of third party brands who sell on Nykaa’s platform and the delivery and shipping fees charged to the customers.

Profit and Margins

The gross margin for the business remain steady at a little over 40%, while EBITDA margins are inching higher from -23% in FY17 to ~6.6% in FY21.

The company closed FY21 as its first year of PAT breakeven.

Cash Flow

The company’s cash flow from operations has significantly improved from a negative Rs 997 million in FY17 to a positive Rs 1498 million in FY21.

There is significant operating leverage built into the business and as the company scales further, this should increase disproportionately.

In FY21, Nykaa turned both Cash Flow from Operations and Free Cash Flow positive - a rarity among e-commerce companies.

Debt

The company’s net debt to equity ratio has reduced at an accelerated pace, as it has raised substantial cash via recent funding rounds.

Net Debt to Equity ratio declined to a negative (0.1) in FY21, indicating that the company has more cash on its books than debt.

Total debt for the company stood at Rs 1,875 million in FY21 compared to Rs 2,256 in FY19 (a reduction of ~17%).

About The IPO

Nykaa filed its draft prospectus with the regulator on 3rd Aug 2021. The company will publicly list in India on both NSE and BSE.

The date of actual listing and IPO is unknown as of writing this article.

Current Shareholding Structure

As mentioned earlier, promoters of the company (the Nayar family) together holds 54% stake in the entire company.

Some other noteworthy investors in the company include Sunil Kant Munjal of Hero Group, venture funds like TPG Growth, Steadview Capital and Lighthouse India and late stage funds like Fidelity.

Here is the list of shareholders that will be selling part of their stake in the company upon listing.

Major Milestones

Below are some of the major milestones of the company mapped in the form of a timeline.

What will the proceeds of IPO be used for?

The company plans to use bulk of its proceeds for enhancing its brand visibility and repaying a significant portion of its debt.

The company will also be using Rs 350 Million from the IPO to set up new retail stores for Nykaa Fashion. These stores will be about 75,000 square feet each and will be set up over the next three years till FY24.

All of these stores will be taken on a lease basis and the company does not own any of its existing stores.

This is a clear indication that the company expects to ramp up its fashion business significantly and sees it as the driver for major growth for the next 5 years.

Risks

Regulations

The biggest risk to Nykaa today is the impending regulation by Ministry of Consumer Affairs. All e-commerce platform companies are under scrutiny for selling private labels merchandize and as per draft regulations, Govt of India is mulling the option of banning platforms ability to sell any private label goods.

If this regulation is passed, it will hamper Nykaa’s investment into its own private label brands and result in some headwinds for the company. The company owns a portfolio of 13 private label brands as of 2021.

This regulation is still very much under development, so we do not know if and when it may be passed into law. The best way to tackle this risk is to keep a close eye on any new developments, esp. if you’re thinking of investing in the company.

Increasing Competition

The second biggest risk is the increased competition from new vertical e-commerce players. Both start ups and established companies are entering Nykaa’s turf and challenging it’s market share.

Myntra was the latest to announce its foray into Beauty and Product Category.
Then there are startups like Purplle, who have been trying to compete with Nykaa since the beginning.

Even though Purplle started before Nykaa, it has lost market share and struggled to keep up with Nykaa’s pace.

Though entry of these new players mean increased competition, I believe Nykaa will still be able to protect its market share, thanks to its content moat we discussed earlier.
Nykaa is more than a platform to its customers today, it’s a platform built on their trust.

Valuations

This part was added to article on 26th Oct 2021 after Nykaa released its IPO Date and share price range.

Nykaa has finally released its IPO Date (28th Oct 2021) along with the share price range. At upper limit of Rs 1125 /share, Nykaa will be valued at 22.6 times its FY21 Sales with a market cap of Rs 55,500cr.

This is certainly a very high valuation for a company that did Rs 2452cr in sales last year, and I believe its being priced as such due to the excessive demand for this IPO.

Having said that, Nykaa’s 3 year Revenue CAGR is 61.89%, exceptional by any metric.

There is no doubt in my mind that the topline (sales) for this business will continue to grow well in future, I am not so sure about its bottom line (profit). Falguni Nayar in her interviews, has made it clear that the business’s focus is not on generating profit but acquiring more customers in the medium term.

To accomplish this, Nykaa is foraying into Middle East and European markets and setting goals to becoming an international company.

Here is an interview where CEO speaks about the business and its valuations.

Personally, I will not be applying for the IPO and will be an admirer of the business model from afar but not an investor at these valuations.

An inherent part of my investing philosophy is margin of safety and I do not believe that these valuations provide enough margin of safety for my investment.

Conclusion

Nykaa’s IPO represents a significant milestone for the Indian start up ecosystem. Successful e-commerce companies are rare, a profitable omnichannel retail platform is even rarer.

What excites me about Nykaa is the captain of this company - Falguni Nayar - and if I choose to invest, it will be because of my bet on her ability to turn this ship and chart the journey of Nykaa to its Ithaka.

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I have little doubt on the future success of this business - there will be challenges along the way, but going by its history - Nykaa knows a thing or two on how to tackle them.

See you in the next one.

Peace,
Tar

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Mr. Yashish Dahiya is an impatient man. In one of the interviews with The Ken, he narrated a story of how while in college he used to run home to Noida every Friday and back to college on a Monday morning (both 30kms in one direction) as he found public buses too slow for his liking.

Mr. Dahiya, is also persistent and doesn't give up easy - he is one of the few people in the world who has completed the grueling Ironman triathlon - an intense race that consists of swimming, bicycle ride and a marathon all raced in that order - widely considered one of the most difficult one-day sporting events in the world.
It’s these qualities of impatience, persistence and continuously improving oneself that can be found in the business of PolicyBazaar or PBFinTech, the name of the parent company applying for IPO.

Like most successful start ups - Facebook, Google, Amazon, Apple - PolicyBazaar has a history of reinventing itself and going through several evolutions to get to where it is today.

In this deep dive, I will take you through the journey of PolicyBazaar. We will explore its beginnings, understand some of the failed projects and hurdles it faced along the way, how does it fit into the insurance industry in present day and try to chart a map of the many possible paths it may take in future.

The Beginnings

PolicyBazaar started in June 2008 as an insurance aggregator.

That's a fancy word for stating that it had a website which looked like a form, where a prospective customer could key in their details. These details would then be sent to a call center run by PolicyBazaar, where an employee would call back the prospective customer, understand their requirements and pass on the lead to an insurance company. This insurance company would then try to sell an insurance policy to the customer and if the sale was made, PolicyBazaar would get commission for generating a lead.

This is how their website looked like on July 6th 2008.

As you can observe it was a barebones operation and a very simple solution to an otherwise complicated and an unsolved problem that the insurance industry was facing - the problem of quality data.

Insurance runs on data

As the quality and granularity of data increases, Insurance companies can assess risk behind an insurance policy better and offer that policy at more subsidized rates. PolicyBazaar was created to solve this problem of data - the call center employees at PolicyBazaar were tasked with capturing higher quality and more granular data of customers than a commission based insurance agent would do. As the customers of PolicyBazaar grew, so did this data and with that the importance of PolicyBazaar in the insurance ecosystem.

The most valuable asset today of PolicyBazaar isn't its website, the office buildings it leases, the trademarks or its partnerships with the various insurance companies - it is this data that PolicyBazaar has captured over the years since its inception.

This data helps the company work with its insurance partners and create policies that are suited for a specific need and segment of customers. It is also this quality of data that enables it to pass on discounts from insurance companies in the form of lower premiums to its customers.

In the business of Insurance - data and the quality of data is everything. By solving the problem of generating and storing quality data - PolicyBazaar solved many problems with one platform.

In its DRHP, PolicyBazaar, like every other platform company today, is quick to mention this flywheel - the infinite loop of solving problems both on consumer and insurer side - all via data. It is this flywheel and first mover advantage, that enabled PolicyBazaar to capture 90% market share of the digital insurance segment in India.

Better data leads to lower claims which leads to insurance provider providing same policy at lower rates to PolicyBazaar's customer. Lower policy rates attracts more customers to the platform which leads to further aggregation of data and so on and so forth.

Its a forever loop that runs on data.

The stuff FinTech Dreams are made of

A lot has changed since 2008 when PolicyBazaar was first founded, it has launched new products, transformed itself from a simple insurance price comparison website to a web aggregator of insurance policies, forayed into credit and loans business via PaisaBazaar, started and shut operations for a health insurance aggregator (DocPrime) to now (in June 2021) securing an insurance broking license for itself from IRDAI (Insurance Regulatory and Development Authority of India) which allows it to sell life and general insurance polices offline in addition to the online business.

PolicyBazaar doesn’t carry any credit risk on its books nor does it underwrite any insurance on its own. It acts as a broker between customers and other insurance providers, helping its customers with a variety of insurance related services.

Below is a brief history of PolicyBazaar as a company presented in the form of a timeline.

PolicyBazaar's ambitions from here are growing.

The firm is raising more capital through its IPO than it has raised in all of the previous funding rounds from a dozen private investors put together.

The total IPO size is around ~ $810 Million which is a combination of fresh issue and offer for sale from existing investors. Of this total ~ $810 Million, around $500 Million is fresh issue. To put this in context, the start up has raised about $716 Million since its inception in 2008, it has only used about $50 Million of that money.

The company still has about ~$250 Million of cash on its books.
This existing cash combined with the fresh issue for $500 Million from IPO and some debt will give the company roughly about ~$1 Billion of capital, to deploy in new areas of growth.

PolicyBazaar's DRHP lays out this growth plan in exquisite detail.
Broadly the growth plans can be clubbed into five board categories.

1. Build an Offline Presence

2. Go after Small and Medium Scale Enterprises and Build Corporate Clientele

3. Build new offerings including a health tech platform

4. Pursue International Expansion

5. Venture into neo-lending via PaisaBazaar

Lets explore them in detail.

Building an Offline Presence and Onboarding Corporate Clients

The bulk of capital raised via IPO will be utilized by PolicyBazaar to build an offline presence. This is a strategic and important move on part of the company. Even today, India's insurance industry is only 10% Digital and 90% Offline. PolicyBazaar already has 90% market share of the digital segment.
To grow further it needs to capture the offline segment otherwise the company risks becoming a large fish in a very small pond.

The company aims to set up 200 physical retail outlets across the country in all city tiers by end of Fiscal 2024. Today, it has less than 15 physical stores. So in the next 3 years, PolicyBazaar is looking to grow its physical stores by almost 14 times to arrive at a total of 215.

These stores will provide service to end customers in local languages and develop a network of sales staff that can sell insurance policies to end customers, help them process claims and provide support whenever required.

In a sense PolicyBazaar is moving away from its digital roots to become an omni channel insurance and credit platform.

This move helps PolicyBazaar increase its customer base and start catering to small and medium scale companies as well as to other corporates. In the corporate and business segment, average premium value per policy is higher, there by allowing PolicyBazaar to capture a larger pie of the overall business. Having secured an insurance broker license, it can now also foray into providing group health insurance for these corporate customers - a market valued at Rs 25,000 crore per year.

An example of corporate insurance is Acko providing Health and Accident Care coverage to delivery partners of Zomato. PolicyBazaar can follow the same model and provide insurance coverage to delivery partners of Swiggy, Delhivery, Dunzo etc.

Having disrupted the online segment, the company is preparing to disrupt the offline segment.

This growth won't be easy though. There are dozens of new age startups along with traditional players already in this segment and each has their own war chest prepared to go after this market.

Of all the new age competitors in this space, the moves of Digit, Paytm and Acko are the ones PolicyBazaar will be watching out for.

New Offerings - A Health Tech Insurance Platform

As mentioned earlier, corporate health insurance is an yearly 25,000 crore market which remains largely run by traditional insurance providers. PolicyBazaar new broking license allows it to go after this segment and most likely we will hear about an acquisition announcement maybe just a few months after listing of the company.

The company's DRHP points to this specific acquisition target in detail.

This segment of market will be a significant addition to its customer base and should serve the second lever for growth along with the increasing offline presence. India's Plum Insurance is the neo age start up in this space and if I have to speculate - this can be PolicyBazaar's target mentioned in its DRHP.

It will be interesting to see if PolicyBazaar is able to scale up this segment of business successfully after the acquisition. It tried to venture into this space with an earlier venture called DocPrime - which was eventually shut and sold off as it was burning more cash than it was generating.

Pursue International Expansion

Growth area number three for PolicyBazaar is expanding its services internationally. The company currently has a small presence in Dubai and UAE. Part of proceeds from IPO will be used to scale up its business in Middle East along with foraying into South East Asia.

South East Asia is a very competitive market though with Chinese companies like ZhongAn and PingAn already having tie ups with existing local players.

The intent to go after this market shows the seriousness and development curve of PolicyBazaar. Its no longer is an Indian insurance start up - it wants to become a global FinTech giant and is taking its first steps to move in that direction.

PaisaBazaar - Neo Lending

PaisaBazaar accounts for about ~30% of revenue pie for PolicyBazaar. Its the platform developed to help customers avail loans. If you have ever applied for a loan in India you know how cumbersome the entire process is - endless trails of documents and constant back and forth dilutes the entire experience.

PaisaBazaar was launched to change that. Just like with its PolicyBazaar platform, the company has leveraged data to build this platform too. Customers usually come to PaisaBazaar to avail the free credit report and in process provide valuable data to the company for free. The company then uses this data to target customers for various offers in segments like - credit cards, personal loans, home loans, business loans and micro loans.

For a home loan for example, the company provides document pick up service and one representative for the customer to talk and work with during the entire loan application process.

Small steps like these, to improve the overall customer experience helps PolicyBazaar retain a customer to cross sell products later.

Using data, PaisaBazaar was able to come with with innovative products like credit card backed by Fixed Deposit and a Step Up Credit Card - for users with no previous credit history. All of these innovations are possible only via the use of data which lets PolicyBazaar understand which set of customers posses more risk compared to others.

PaisaBazaar now wants to use this data to repeat its success of credit card with loans. There is a large segment on Indian population that doesn't have access to credit because they are underbanked. PaisaBazaar wants to change that and help meet unfulfilled credit needs of customers across geographies and income levels.

Industry Trends - Bite Sized and Niche Insurance

Insurance industry around the world is moving away from traditional insurance policies towards a new concept of Bite Sized Insurance. These are small ticket insurance policies that cover very specific risks. For example, ZhongAn - the Chinese Insurance giant derives a bulk of its revenue by offering ecommerce shipment insurance to its customers.

Under the policy, if for whatsoever reason the customer receives a broken or incorrect ecommerce shipment, they are protected for the value of the product and get a full refund from the insurance company. The company today has 400 Million customers and has sold over 10 Billion policies.

Another segment that is on the rise is niche insurance, for example, pet insurance policies.

These are policies that aren't provided by traditional insurance companies and are only possible via the data collected by Insurance Tech companies.

I expect PolicyBazaar to eventually foray into these segments as well, mostly cause its competitors already have. Ola for example provides ride insurance policy in collaboration with Acko. Toffee Insurance, provides cycle theft insurance and fitness insurance policies. Digit too has come out with home content insurance, targeted at people who are living on rent and want to protect their belonging but not the structure of the house.

Insurance Industry in India

Penetration of insurance in India is abysmally low.

Only about 28% of Indian Adults are covered under life insurance as opposed to 92% of the population in US. Even in Health Insurance, only 34% of Indians are covered as opposed to 100% of population in France.
Property insurance is non existent - when was the last time you heard someone taking a home insurance policy along with their house purchase?

The only two segments of insurance that seem to be doing well are - crop (27%) and motor insurance (81%) - both mandated by government regulation.

As of FY20, India's insurance industry was worth $102 Billion (measured in Total Premium) and this expected to grow to $520 Billion by FY30. This represents an overall industry growth rate of 17.8% per year.

Within this, Life Insurance is growing at a faster rate (18.8% CAGR) compared to Health Insurance (15.3% CAGR) and General Insurance (13.5% CAGR).

There is a lot of scope and opportunity for all players to grow in the industry as insurance remains highly underpenetrated throughout the country.

Risks to PolicyBazaar

The grass in PolicyBazaar's garden is not all green. There are lot of risks associated with the company as well. The biggest of them is its insurance partners leaving the platform.

Today, PolicyBazaar has 51 insurance partners that it works with and the company doesn't have any exclusive or binding contracts with these partners. At any point in time, these partners may choose to leave the platform and chart their own route.

This recently happened with HDFC Ergo and LIC pulling its products from the platform. Limited players in India have license to conduct insurance business in India - if PolicyBazaar loses a major chunk of the big ones - it will lose its ability to deliver products to its customers.

The contribution of revenues from four largest partners was 30.82%, 35.11% and 32.81% for 2019, 2020 and 2021 respectively.

The company however has so far helped its existing partners increase the total premium transacted on its platform at a CAGR of 42% in last three years. With foray into offline segment, this growth rate should inch higher for the next three years.

Another area of risk for the business is the excessive financial regulation. IRDAI is a very strict regulator and any mishap by the company in this segment can attract large fines from the regulator. Cyber crime is also a bigger headache for the company as it has sensitive financial and insurance related data of its customers.

Being a financial business, it is closely linked with growth in the economy. Any events that hamper this growth will adversely effect the business too.
Covid and the RBI Moratorium, for example, reduced PaisaBazaar's revenues drastically in Fiscal 2021 as lending partners weren't able to issue new loans at the same rate as before.

Closing Notes

Based on the history of PolicyBazaar, previous growth rates and where the entire insurance industry is heading, I am quite confident that this business will continue to grow and march forward. Their foray into international geographies along with offline segment marks the beginning of a major milestone for the company.
What PolicyBazaar has achieved since its inception is maybe just a fraction of what it aims to and could achieve in future.

Just like its founder, Mr. Yashish Dahiya, this business is impatient, persistent and bent on continuously reinventing itself to grow further.

Sources
PolicyBazaar DRHP
Insurance Tech Report by Boston Consulting Group
My Notes

See you in the next one.
Tar