On the Zomato IPO

The general opinion on Indian businesses has swayed towards the positive side of things ever since Zomato went for a public listing. Reporting on the topic has maintained that the prospect of a start-up business going public on a stock exchange is a big deal. I cannot get myself to agree that the endgame of owning a business is to see it go public. For starters, a public company has to do a lot of compliance related administrative work while also risking its stocks to be subject to buying & selling sprees. The general opinion is that the ownership of the company is being traded and that the general public can remain invested in the economy they’re a part of.

This statement makes a great leap forward, a la Mao. What is traded on the exchange is a security. The statement that securities of a company are being traded on the exchange is true. To say that all securities give part ownership of a company is incomplete at best. I must take a step back into accounting and the fundamental accounting equation & a few accounting concepts here. A business is a fictional entity. A business does not exist as itself. It manifests in activities of exchange. Business needs capital. How the capital is tied to the income of the business would classify it as either a liability or equity. Liability has to be paid back no matter what and enjoys some seniority over the equity in terms of the security of the capital. Such contracts give the business legitimacy of existence, and hence become the securities it issues. Any such contract where a business gets capital necessitates that a balancing entry be made on the other side of the accounting equation since the assets a business owns went up.

Shares or stocks are synonymous with the stock exchange. This is where Zomato comes back in. I do not get the mass hysteria surrounding this business. In their IPO filing, one thing stood out. Nearly all of the equity ownership of the investors was in a particular kind of security. This was under a CCPS security. CCPS stands for “Compulsorily Convertible Preferred Stock”. The last two words stand out for me – preferred stock. Just because it says stock doesn’t make it common stocks. Preferred stocks are ingenious at best, when used in moderation, and perverse if taken to the extreme. To issue common stock, existing shareholder’s equity ownership decreases and so does their voting right, assuming all stocks are of the same class & have the same number of votes to them. The other way out was to take on debt. To take on more and more capital with a liability means that the number of compulsory payments keep going up. To dilute equity means that one loses property rights & the subsequent power to make capital allocation decisions. The solution was to issue an instrument that was called stock with no voting right, but the benefit was that this security was in a senior position to common stock. This brings us to the seniority of securities – a general rule is that liabilities are senior to the equity securities. In this way, preferred stocks offer a company the opportunity to raise capital without upsetting the property rights of the common stockholders.

The ingeniousness of preferred stocks is precisely this. To the untrained eye, the company hasn’t taken on a mountain of debt to fund its operations because preferred stock is accounted for as equity. Several complications pile up once we take note of the accounting events. Dividends are paid to the equity holders from the net income of the company. The net income is when there’s no one else to pay but the owners themselves – who can choose to reinvest the capital, which would become retained earnings, or free cash flows in case it’s a subsidiary business in a conglomerate. Interest payments come before the net income in the calculations. They come after the point where EBITDA is written down. Gross revenue, operating earnings, EBITDA, EBIT, PAT or net income. This point would become salient once we understand the true nature of preferred stock. Before going ahead, I must confess – I learnt this from the great Ben Graham from his magnum opus “Security Analysis” (1940 edition).

Debt or stock, either way one invests into a company. It could be any security, that’s immaterial. The minute money is exchanged for the prospect of greater future cash flows, it can qualify as an investment or speculation. The distinction is discussed in another article of mine. For now, let’s stick to investing as the term. In preferred stock vs debt, say a bond, there is hardly any fundamental difference save for the semantics & the subsequent reporting in financial statements. In both the securities, the holder does not have a decision on the capital allocation. Yet, debt is senior to the preferred stock instrument as a security. To call it preferred stock, as elaborated, is just to keep the balance sheet clean but the true nature of the security reveals no difference between a preferred stock & a bond. In what is called reformulation of financial statements, Ben Graham suggests that preferred stocks be grouped with debt & not be valued as common stock.

This turns Zomato from being a great Indian business to a great Indian ticking time bomb. As was the case with the Mortgage-Backed Security in 2008 or the railroad bond in 1893, the CCPS has the potential to quickly become that instrument that can bring down the whole of the ecosystem due to its excessive use. Preferred stocks offer a company to raise capital without disturbing the holders of common stocks. When a company is going public, it just needs to sell an equity instrument over the exchange. It could even be a class-B common stock with a fraction of the voting rights of the Class-A stock. From what I can recall, the total common stock holdings in Zomato are about ₹3.1 lakh. The enterprise market value of the company is roughly around ₹99,000 crores. To say that aside from the 3.1 lakh rupees the rest debt is a whole lot scarier than saying that in a company of nearly ₹99,000 crores is almost entirely taking on debt sounds like an absolutely crazy idea. And in honesty, it is crazy to a degree. Why would so many investors be ready to pour in so much capital in exchange for quasi-debt in a company? Does it signal that they have confidence in it? Or is it just everyone thinking they found lightning in a bottle for a dirt-cheap price?

I cannot get myself to be excited about a business situation where something which is a good idea in moderation has been taken to the extreme. I would say that buying Zomato securities is a speculative action and not an investment at all as the company has never exhibited a tendency to come close to making money. Reducing losses does not indicate a trend of eventual profits in a company where the variable cost is high. Companies often brag about positive unit economics and that they’ve made money in every transaction. This manipulation of accounts to paint a distorted picture is for another time but for now, I’ll leave it here.

To paraphrase Mark Baum/Steve Eisman, Zomato is confusing preferred stock for genius. And the general opinion has to be on the overly exuberant side. If history has said anything, a mania is always followed by a panic & a crash. Not a question of if, just when.

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