Dear Investors,
The following chart depicts our returns viz BSE 500 TRI.
In this memo we will be discussing the journey of new age tech private companies going public. Prescient founders have spent a reasonable amount of time working with both Public and Private companies to understand and appreciate the nuances. In this memo we will be covering the key differentiators that determine how Public markets value companies differently and how private companies might stack up adversely on those.
Capital Allocation
Capital allocation is a nuanced topic that even large established companies get wrong. A wrong capital allocation call takes easily 4-5 years to fix and turn around.
New age tech companies that got listed in the last 2-3 years frequently compromise capital allocation for chasing revenue growth and valuation.
A significant amount of capital is misdirected to enter into related/unrelated businesses categories. Sometimes excess liquidity is sucked into making large acquisitions. Case in point is the acquisition of Blinkit by Zomato.
Best to consider capital as a thing that is easier to disburse/allocation but something which is very very difficult to retrace if gone wrong.
Good capital allocators are far and few. Behaviourally, good capital allocators have neutral relationships with markets/investors as they do not need external capital. Their businesses have a return of capital at par or higher with the growth of their businesses.
For some of the startups which have already raised large amounts of capital, a good way to start looking at capital allocation is to:
Work with 30-40 % of the funds available. Assume the balance never got raised.
For future projects/growth expansion, start looking at things that can payback capital max in 3-4 years, i.e. improve the incremental return on capital employed (ROCE) of your business to 25-33%. Over time, the combined businesses ROCE will start looking better.
Shelf projects that have a longer payback period as they are balance sheet traps and would rarely return capital, forget generating returns.
The buck for capital allocation stops with the MD/CEO, not with the consultants and bankers or anyone else. Have seen enough examples where both old age and new age management pass the buck to consultants and focus solely on growth.
In the longer run, your capital allocation is the one size fits all barometer of your competitive advantage. We have a transformer company in our portfolio which me and my partner have been closely tracking for more than a decade now. For reference, Transformers are a low on tech, medium growth sector that is full of capital misallocation minefields. The company has a 10 year ROCE of ~ 15% while the next best player will be close to a zero ROCE. During the same decade, the company has reinvested only ~ 100 cr of its internal accruals in (only 1/6 of its cash earnings) to generate a cash profit of nearly 600 cr. Needless to say, the company has converted ~Rs 250/share of retained earnings during this period to ~ INR 5000 of share price appreciation. Each rupee of retained earnings has been amplified by 20x in market cap over the decade.
Behaviorally what we have learnt from this management, something which can be replicated:
No forward or future guidance, razor sharp focus on delivering good profitable growth
The management feels responsible to return capital as dividend and buyback to the shareholders.
They call a spade a spade, in good times they are modest in their outlook and in bad times they give you to the worst case scenario.
They always and always look to preserve their balance sheet.
Sustainable cash flow profitability is the only thing that matters
We have seen a few new age founders boast on social media that they are the only PAT profitable startup or a few file their DRHPs after only 1-2 quarters of PAT/EBITDA profitability. Per seasoned public market investors, all this is white noise. One should always remember this phrase: Revenue is vanity, Profit is sanity and Cash Flow is reality.
Examples of companies like Zomato and Policybazaar had/have a cash generating business which can arguably grow for the near/mid term at a high growth rate. There was/is no need to grow into unrelated businesses and turn their back on cash flow profitability.
It has been observed that some companies have gotten listed on the back of 1-2 quarters of only P&L profitability. This is kinda silly as those doing this are ill advised. For a lot of these companies a reduction in operating cost (mainly marketing burn) during the COVID lockdown turned the business from red to black for a short while. Seasoned public market investors can catch this and carry a wrong perception about a management that stays for a while.
Other public market investors like MFs, Insurance companies are eager to get in but are impatient for results too. They often need to see a business turn to black within 2-3 quarters of listing. This is true for seasoned tech markets like the US too. During their last correction in the markets, stock prices of the businesses that were in red bore the maximum brunt.
In Banking/NBFC especially, being PAT profitable has no meaning. One can be PAT profitable and be running a book that accrues NPAs at 5% of amount lent. Consider a Debt to Equity of 10:1, this implies you are eroding 50 % of your net-worth.
Large total addressable market (TAM) doesn’t mean anything
As aptly stated by Pulak Prasad, TAM based investing in a company is detrimental to returns. A promoter’s over emphasis around TAM therefore is meaningless.
Conventional sectors like steel, oil and gas, branded food, apparel, and shoes that have large TAMs are the most crazily competitive sectors and to our understanding have very low profitability pools.
Usually it has been seen that large TAMs attract competition and over time reduces the returns profile of the sector
What matters is the ability of a company to define, safeguard and improve its profit pool over a long period of time.
Further, TAM does not tell us which firms in the sector will turn out to be profitable. Take the case of Nykaa, an e-commerce company which sells beauty and fashion products. It was such a sought after stock when it was listed due to a lack of understanding around its presumably endless addressable market. Overtime, the investors figured out that this is a business which can be easily replicated and has no real moats surrounding it.
On the flip side, consider the case of AIA engineering that makes high grade abrasion and corrosion resistant castings that are used in mining/cement/quarry. Back in 2013, we decided not to invest in the company due to mature/stagnant market shares and exposure to low volume growth sectors. The company has surprised us. The company was founded by a metallurgist (from IIT Kanpur) and has innovated through product engineering. The company has found ways to reduce corrosion/abrasion of their products and reduce downtime for the grinding applications. This has helped them command higher prices for their products. As against our expectations of low single digit profit growth, during the last 10 years the company’s PAT has grown at a CAGR of ~18% and it has improved its ROCE profile from ~ 20% to ~ 25%. The stock price during the same period is up >10x.
ESOPs/Related Party Transactions
While dealing with public markets, founders should remember that markets have a long term memory. They reward professional conduct, but remember any misgovernance for a long time.
Preferential allocation to founders in the form of ESOPs, or pref shares has been a common practice before the listing of a company.
While the transactions may look commercially right, they often are a huge burden on the minority shareholders, when items such as ESOPs are vested and cause dilution. Public markets usually encourage grant of ESOPs to promoters/staff, but the same cannot dilute minority shareholders by >2-3%.
Some startups also merge their promoter group entities right before their IPOs. This is sometimes done to boost promoter shareholding in the merged entity.
Also under scrutiny has been the dealings of a company getting listed with family/friends and associated group entities.
Dealing with related parties as vendors or investing in them for strategic P&L benefit, is also short sighted. The opacity of commercial dealing with related parties is often seen as a sign of misgovernance.
Companies such as TCS, Infosys in their early growth stages in 2000 set new standards of disclosures and clean governance, which became the hallmark for other IT companies and listed universe by and large. The same is expected of the current lot of tech companies.
Stepping off the fundraise rollercoaster
Markets reward patient and honest communication by founders. Narratives like “Markets do not understand the disruption my business is creating or will have to be taught more about my business's potential” are futile.
Behaviorally pitching to public markets is different from pitching to private markets.
In private markets money is raised at steep valuations by creating a pitch around the disruptor, winner takes all, or the first mover advantage theme. Large portions of capital are cornered to eliminate or dissuade competition.
In public markets it is the other way round. Money is not a zero sum game. Money is available for investing in, for example, a sick company, a challenger, a leader and/or the disruptor in the same sector. Sometimes the best returns are made in investing in a sick business that shows signs of a turnaround. So it is very very difficult to make a pitch to corner all the capital available. Founders who come to terms with this reality that are a drop in an ocean, are more likely to succeed.
New age founders would find it easy if they consider markets as a source of infinite capital if they take time to make markets understand their businesses potential, its differentiation, any risk and cyclicality in your business and the efforts you as a management are making to improve the return profile of your business.
Overemphasis on hiring CVs
Lots of listed startups make a stack of awesome CVs and forget their people cost.
Hiring talent, integrating them with the company’s vision and then making them execute above their potential are painstakingly difficult tasks. Hoarding of CVs at the senior level, with often overlapping roles, no clear direction and incentives often leads to high attrition, which is not considered favourably by markets.
Good tech companies hire good C-minus leaders and then use their leverage to grow and ace execution. This truly creates operating leverage.