Letter # 57

Malcolm Gladwell has an interesting start to his book, Outliers. He argues that “I did it by myself” kind of explanations to success don’t usually work. Most of them are invariably beneficiaries of hidden advantages, extraordinary opportunities and cultural legacies that enable them to learn, work hard and make sense of the world in ways others cannot.

Take hockey teams in Canada for example. Here, 40% of the national players are born in the first quarter of a calendar and only 10% in the last. What gives? No, it isn’t astrology. It’s simply that the eligibility cut-off for age-class hockey is January 1. So, someone who is born on January 2 would compete with younger kids, sometimes almost a year younger. At that level, 12 months can make a huge difference. As levels advance, it then leads to a self-fulfilling prophecy–you start getting more games, better facilities and the benefit compounds in your favour by the time you reach the national stage.

I was reminded of Outliers earlier this week as many brokerages presented their views on the upcoming (and quite hot, might I add) IPO of the home-grown online Beauty and Personal Care (BPC) champion Nykaa. As Spark Capital succinctly put it (and I paraphrase) over the last decade, a lot of factors have aligned to create a conducive runway for growth for Nykaa i.e., the rapid penetration of smart phones, affordability of data, adoption of digital commerce, evolution of logistics ecosystem and Covid-led digital adoption. Nevertheless, Nykaa got multiple things right–the category and channel (there weren’t many players in online BPC space), solved the right consumer problem (counterfeits and lack of foreign brands sans distribution) and did so without burning a lot of cash.

The consensus opinion from most reports appears to be along these lines: (a) it is a great business; (b) in a nascent industry with a massive runway; (c) it has cracked it in a way that competition never would be able to… and that too; (d) without burning cash.

Consequently, it deserves to be valued quite close to stratosphere. Nykaa last raised capital in May 2020 at the valuation of USD1.2bn. One year later, by March 2021, news reports ⁽¹⁾ had started pegging IPO valuation at USD3.5bn. By June 2021 ⁽²⁾ that rose to USD4.5bn. Most recently, one brokerage report suggested a one-year forward target of cUSD9bn.

I think that as Nykaa’s business model has benefitted from the ecosystem that evolved, its valuations have benefitted from the gush of liquidity fuelled through by historically low interest rates. And, whereas reams of pages are being dedicated to the business model, a discourse on how secondary market shareholders should value such businesses seems missing (publishing absolute valuations may not be permitted under law, the methodology to value it still is).

The venture capital model runs on probability rather than cash flows. A 10% probability of 50x returns over five years implies 33% CAGR… that math is easy. For secondary markets: (a) cash flows; and (b) its timing, take precedence. In developed economies, investments in new-age, hyper growth, cash burning businesses are treated akin to an investment in an ultra-high duration bond (a cash flow stream that will probably generate high cash flow after a long period). So long as interest rates stay very low, secondary investors happily match their ultra long-term liabilities with investments in equity of such businesses. The moment interest rates rise above a certain threshold, these equity investments become untenable to fund. And, without continuous funding, the ‘probability’ of future cash flows dwindles.

I employ similar model that a brokerage might have used to arrive at the USD9bn valuation, albeit with 2 minor changes–one, I increase cost of capital by 2%, and two, I lower terminal growth by 2% (both are quite conceivable and within the realms of possibility). With these changes, the valuation falls to USD5bn, down 44% from the suggested USD9bn. Also, important to point out that the terminal growth rate kicks in after assuming that the annual FCF increases from negative USD10mn currently to over USD2bn over the next two decades (yes, two decades is the explicit forecast period).

“Look at the mess the US economy and the Fed balance sheet is in,” you might say. “Why would the interest rates ever rise?” The short answer is, because economic activity is rising due to liquidity, not necessarily due to productivity gains. Also, a large part of supply disruptions may be permanent. And… it has happened before!

Richard Nixon was inaugurated in 1969 and despite widespread belief of being ‘fiscally conservative’, he turned out to be one with “liberal ideas”. He continued to fund the war, increased social welfare spending, ran large budget deficits and supported income policy.

In 1971, he broke away from the gold standard, which devalued the USD. He fired the then Fed chair McChesney and installed Burns, and leaned heavily on him to keep rates low. “We will take the inflation, if necessary, but we can’t take unemployment,” said Nixon, recalls Burns in his book Secret of the temple.

Initially, the Fed in the 1970s kept seeing inflation as driven by high crude oil prices (and therefore “transitory”, which also saw mankind invent the term ‘core inflation’). Eventually, US had both–high inflation and high unemployment. By 1973, inflation doubled to 8.8%, on its way to 12% later in the decade. It eventually took a new fed chair Volcker in 1979 to raise interest rates to double digits, which put the economy in recession.

Milton Friedman, later, eloquently said it in his book Money Mischief, “inflation is always and everywhere a monetary phenomenon.” To summarize, something will eventually give in and interest rates will rise. May not be now, not next quarter, but soon enough. And once that cycle starts playing out, a lot of business models will become questionable. With that, valuations of all such businesses will be questioned.

Nykaa has created a phenomenal business out of hardly any investment. Even if evolution of the ecosystem benefitted the company, one must credit it for getting almost everything right. Regardless of that, the question of valuation is still one for secondary investors. Nykaa will do phenomenally well if it were to grow annual FCF from negative USD10mn to over USD2bn over the next two decades (as that broking house seems to believe). Even if that happens, minuscule changes in assumptions lead to dramatically lower valuations.

Given the frenzy surrounding the IPO market in general and Nykaa in particular, ours would likely come off as a minority opinion. I am aware of that. Nevertheless, over the short term, following central banks helps make money; over the long term, macros need to fall in order. And, whereas macros for Nykaa might turn out to be just fine, those of several economies leave a lot to be desired. Sadly, that has an equal (if not higher) bearing on the valuation of these businesses than the macros of these companies themselves.

After reading this, while scratching your head, if your question for me is, “dude… I just want to make money on listing pop; will I?” I would do you one better and ask this in return, “if there is a huge runway ahead and the company isn’t burning cash, why the IPO in the first place?”

Notes:
(1) nykaa ipo: ETtech IPO Watch | How Nykaa’s valuation, cap table have evolved over the years – The Economic Times (indiatimes.com)
(2) Nykaa looks to list at $4.5 billion valuation (livemint.com)
This letter was originally published here: No Such Thing As A Free Meal, Or … Free Make-Up, Apparently! (cnbctv18.com)

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