After blockbuster listings, India’s start-up favourites are currently down anywhere between 50% and 75%. The sheer quantum of fall and underperformance can be tempting to buy into. But here’s some conventional investing wisdom - just because something has fallen a lot, doesn’t mean it has fallen enough.
One such stock is Nykaa, which, with a 65% decline since listing, has been making its investors feel like they've been hit with a ton of bricks. But even after this massive fall, the stock still seems overvalued, with more room for the downside. The Pink Friday Sale for Nykaa’s stock to be in your cart might just be further away.
Nykaa is a great business. It has not just been able to capture a large set of loyal customers, but also able to successfully monetise and grow this base. Over the last three years, it has managed to crack two significant markets (beauty and fashion) and has seen it's GMV (Gross Merchandise Value) grow 4x.
There are several things it has done right, which made it a favourite for both consumers and investors (VCs, not the ones who bought after them). However, despite the attractive confluence of strong business and high growth, its valuations seem too high to be bought into, at this point.
It is trading at 5x EV/Sales and 57x EV/EBITDA on our FY25E forecasts, which assume a Sales CAGR of 25% and EBITDA CAGR of 50%.
Why are we calling these numbers high?
1. Inventory-led models deserve a discount
Nykaa operates like a traditional store, but online. It purchases goods, displays them on its website, and allows users to purchase them. Fairly simple.
In the process, because of its scale, Nykaa is able to buy in bulk, get better rates, offer discounts, and even get access to authentic products in a market tainted by counterfeits. The attractive price and quality make it gain immense customer loyalty.
But, this is what is called an inventory-led model, which makes everything linear and boring. The larger Nykaa grows, the more goods it will have to buy and hoard, blocking working capital.
Moreover, the more it sells, the more its profit since all it earns is a margin on the products sold.
This business is not-so-sexy when you compare it to a platform business. Look at Amazon. It doesn’t buy stuff. It just creates a place for sellers to list their products and fulfil orders from sellers. And it charges sellers for all the sales they make.
Amazon’s revenue is directly linked to the number of goods sold on the platform. But its costs are not. After all, the seller is making, buying, storing and selling.
Valuation comparison across inventory and platform plays*
*Based on trailing twelve-month numbers. Inventory-led, Platform-led
💡 Naturally, platform players should get a higher valuation compared to inventory-led models. However, despite Nykaa’s 85% linkage to inventory, it trades at valuations which are closer to platform players than inventory players.
2. Competition is getting stiff
Other than price and quality, Nykaa’s success can also be attributed to the fact that it had a first-mover advantage when it launched back in 2012. It quickly became the go-to brand for beauty and personal care (BPC).
The dominance ensured that it got a lion’s share of advertising money, which makes up about 10% of Nykaa’s net sales value. However, competition is getting intense - Amazon and Flipkart are heavily investing to ramp up their BPC category, and online stores like AJIO, Myntra and Tata Cliq Palette are well-funded and gaining share in BPC.
With this, Nykaa faces a few threats:
Budgets for advertisers will now get split across a larger pie, affecting the current monopoly that Nykaa has
Ad revenues are non-linear, unlike the inventory-led revenue for most of Nykaa’s BPC operations. Any impact here will thus also have a disproportionate impact on the bottom line
Nykaa’s dependence on ad revenue for profitability in BPC is pretty high. Rs. 310 crore in ad revenue in 9MFY23, in an overall profit pool of Rs. 185 crore shows how ads are a large profit-contributor
💡 With a threat to continued momentum in profits, valuations are likely to have a tough time sticking up at the already sky-high levels.
3. Fashion is cool, but also brutal
Nykaa’s name-to-fame came from the BPC segment, and its presence in Fashion is yet fairly nascent. Although this is a marketplace game, which we earlier favoured, other dynamics aren’t the most favourable!
Nykaa’s fashion segment faces competition from well-established players like Myntra, AJIO and Tata Cliq Palette, who have larger customer bases, higher traffic and more spending power
The business is not EBITDA positive, which anyway is tough to achieve in fashion given competitive intensity, high advertising and promotional spending, discounts, and high fulfilment costs.
Moreover, with D2C firms increasingly eager to move offline and customers expecting more physical storefronts to experience items, Nykaa will need to reinvest gains to sustain growth in the lower ROE offline model, while putting already low margins under strain.
💡 While Nykaa is making significant progress on the marketplace model in Fashion, profitability in the business is highly questionable, which may restrict the amount of re-rating it fetches.
What’s the downside then?
We did a DCF-based valuation on Nykaa, which fetched us a price of Rs. 100 per share.
A price of Rs. 100 per share would imply that Nykaa trades at a valuation of 3.7x EV/Sales and 43x EV/EBITDA. Why does this sound fair?
The valuation moves away from platform plays, and comes closer to inventory-led models, as it should
The valuations are based on an estimated 25% revenue CAGR and 50% EBITDA CAGR over the next two years. An implied valuation of 43x EV/EBITDA for that growth seems to leave some room for downside risk on earnings
A 30% discount from current levels would be able to better accommodate for risks and consequent perils of competitive intensity and/or the questionable potential profit from the Fashion business than current levels
The Rs. 100 fair value, of course can be subject to higher risk factors, which Nykaa hasn’t failed to offer to investors. Its bonus issuance right before the end of the lock-in period, hasn’t left a good taste amongst investors.
That behind, we’d declare it a Pink Friday Sale for the stock when we see a 30% discount!