Should You Invest In Paytm's IPO?

Paytm’s hotly-anticipated initial public offering (IPO) has created a frenzy in the grey markets and the media. The company plans to raise about Rs. 8300 crores, while existing shareholders, including the founder Vijay Shekhar Sharma, plan to offload shares worth another Rs. 8300 crores. According to reports, Paytm expects to command a valuation of $25-$30 billion in the IPO. Its current revenues are around $500 Million, which implies a price-to-sales (P/S) ratio of 50.

Are these valuations justified? Should an investor put money into the IPO? We have analysed its core businesses to answer these questions.

Payments Business

A fin-tech start-up must get the distribution right, before the incumbent gets the technology right. Paytm was right in this sweet spot in the 2015 to 2016 period. It was fin-tech start-up whose user base had grown exponentially after demonetisation. A first mover advantage and a closed payment environment (digital wallets), ensured strong network effects – a venture capitalist (VC)’s wet dream. All of this was happening right in the middle of the start-up funding boom in India. In a zero interest rate environment, VC’s were funding everything in sight. India, with its upwardly mobile masses who had been introduced to cheap smart-phones and free 3G internet right then, was a hotspot of investment activity.

Fast forward to 2021, the Unified Payments Interface (UPI), a free payment mechanism, dominates the payments ecosystem. Paytm’s strongest competitive advantage was quite short lived. Digital wallets’ transaction volumes have been dwarfed by UPI transaction volumes. The government has pushed for zero transaction charges on UPI transactions with merchants, to incentivise digital payments adoption.

Paytm, which was once the leader in the digital payments space, has now been displaced to the third position in terms of UPI transaction volumes. Late entrants like PhonePe and Google Pay, have quickly gained the top positions.

Paytm’s payments business’ revenue depends on the take rate and the Gross Merchandise Value (GMV) processed through its platform. The take rate is the percentage of commission it charges the merchant. The gross merchandise value refers to the transaction value. For instance, if you pay a merchant Rs. 100 (GMV) through your Paytm wallet and the take rate is 1%, the merchant will receive Rs. 99, while Paytm receives Rs. 1 for facilitating the transaction. However, according to the Draft Red Herring Prospectus, Paytm’s overall take rate has gone lower because of the higher percentage of UPI transactions through the app. Merchants also prefer payments through UPI as the transactions have zero frictional costs.

Under these circumstances, Paytm has to compete with other payments providers to gain more market share. Most of these providers have their own super apps for merchants resulting in a very competitive environment. Google Pay, PhonePe and Amazon Pay are owned by large American corporations who can continue subsidizing losses for their Indian subsidiaries. With the IPO and the Chinese government’s virtual takeover of Ant Financial (its largest backer), Paytm might not have the luxury of perennially burning cash to gain more users.

Lending & Financial Services Business

Paytm has been relatively conservative in its approach towards lending. Rather than lending money itself, it has partnered up with various financial institutions. These financial institutions extend credit through the Paytm app, while using Paytm’s data to underwrite loans and price the risks. However, lending continues to be a competitive space.

Multiple digital start-ups have partnered up with non-banking financial institution(NBFCs) to lend to the same target audiences as Paytm – small merchants, consumers, businesses in tier 3 & 4 cities etc. Traditional banks continue to make strategic investments into start-ups or apply for NBFC licenses to make riskier loans. Lending is a commodity business where interest rates play a crucial role in enticing customers. It remains to be seen if Paytm can develop any advantage over its competitors using its high penetration.

Paytm’s mutual fund distributorship business has emerged as one of the largest players in the country. By selling direct funds, Paytm has been unable to monetise the business despite the scale. Paytm even launched SIP schemes for amounts as low as Rs. 100. However, it was not economical for AMCs to process a large volume of small-value SIPs. Some asset management companies (AMC) soon reverted back to the original SIP amounts. Similarly, in the stock-broking business it competes with well-established competitors like Zerodha, which has a sticky customer base. It is unlikely that customers would undertake the hassle of switching stockbrokers or using multiple brokers, unless offered a very strong incentive to do so.

Commerce Business

The commerce business includes the ticketing, entertainment, travel and other businesses where Paytm charges a transaction fee for the merchants and/or a convenience fee from the consumers. The business has been badly hit by the pandemic. However, the past data shows that the revenues were falling even before Covid struck.

According to the 2018 annual report, the segment’s revenues shot up in FY 18 to Rs. 1735 crores from Rs. 61 crores in FY17. The revenue fell to Rs. 1064 in FY19. This figure continued to fall further in FY20, and the company has clocked in around Rs. 500 crores in commerce revenue for FY21. While Covid might have catalysed the revenue de-growth, the data clearly shows that commerce revenues had begun falling even before Covid struck. Such observations do raise concerns about the longer term sustainability of Paytm’s revenue streams.

With Paytm’s current cash burn rate, it is quite probable that Paytm will continue raising money even after the IPO to fund its growth - leading to equity dilution. With equity dilution, even if the company turns profitable somewhere in the future, shareholders might not be able to reap the rewards of the profitability.

In a contrasting scenario, let’s assume that Paytm focuses solely on becoming profitable. In order to become profitable, it will have to cut back on its expansion plans. With the rising pressure to lower losses, the company has already tried doing this. The company was clocking in almost 100% revenue growth rates in 2019 in the payments business. The growth immediately slowed down to 12% for FY20 and 10% for FY21. The drop in growth rate coincided with a drop in marketing expenses. For FY19, the company spent 3400 crores on marketing, 1400 crores in FY20 and Rs. 532 crores in FY21.

These observations indicate that much of Paytm’s growth came from burning cash and offering incentives to customers to transact on its platform. If it is to focus on profitability, it might have to cut down expenses further, resulting in lower growth in the future, putting the “high-growth” story in jeopardy.

In the annual general meeting (AGM) on June 30 2021, Paytm had asked for shareholder approval to subscribe to 15% p.a. debentures issued by VSS Investco - a company fully owned by Vijay Shekhar Sharma. The money will be used to buy a majority stake in Raheja QBE Insurance, while the minority stake will be bought by Paytm directly. Why would Paytm fund the CEO’s private stake? Shareholder funds could have been used to buy QBE directly.

Ant Financial – the Chinese financial giant has been an investor in Paytm since 2015. While both parties deny any claim of Ant’s influence on Paytm, there have been multiple reports indicating Ant’s strong influence on Paytm. Paytm has also copied some products like interest free post-paid credit facility which has strong resemblances to Ant Financial’s Huabei. Paytm seems to a strategic investment in India rather than a purely financial investment. Recently, Ant had its own run-ins with the authoritarian Chinese government. The Chinese government has forced an overhaul, with more supervision and oversight on Ant Financial’s activities, which might limit Paytm’s funding in the future.

Despite the halo around Paytm, it pays to be logical and stay within one’s circle of competence. If measured by conventional yardsticks, its valuations are lofty without much margin for error. Paytm’s high valuations stem from expectations of exponential revenue growth in the future. However, Paytm has still not demonstrated that it can do so in a sustainable manner.

With the reduction in marketing expenditure, Paytm’s payments business’ growth rate has dropped to a fraction of its earlier growth rates. If an investor wants to invest in the financial space, private banks should be the first choice. They are absolutely entrenched in the system and have demonstrated sustainable profitability for decades. Those who wish to invest in Paytm simply because Berkshire Hathway has bought a stake in it should realise that the Paytm investment represents around 0.0008% of Berskhire’s net worth.

At the current valuation, Paytm does not seem to offer much in terms of upside. Unless one has a deep positive insight into the business model, investing in Paytm can certainly wait till it builds a self-sustaining business model.