Initial public offerings of Indian new-age tech companies are coming thick and fast. This time it’s Paytm’s Rs 18,300 crore IPO, the largest ever in India to date which will hit the street after Diwali. The offer consists of a Rs 8,300 crore fresh issue of shares and an offer for sale of up to Rs 10,000 crore by existing investors like Albibaba’s Antfin (Netherlands) Holding BV and Alibaba.com Singapore ECommerce, Softbank’s and SAIF Partners, including Founder snd CEO, MD, and Chairman of One97 Communications Vijay Shekhar Sharma.

Paytm’s management said in the pre-IPO call with analysts that it builds its new financial services, payments, commerce and cloud businesses to generate profits. This seems to have enthused the anchor investors who bid for the company’s Rs 8,235 crore anchor allotment.

As a result nearly 45% of the company’s Rs 18,300-crore IPO is already subscribed. The remaining approximately Rs 10,000 crore is what will be available for bidding. Out of this, up to 10%, i.e. Rs 1,000 crore will be available for retail investors, and up to 15% or Rs 1,500 crore for the high net worth quota, and the rest for institutional buyers.

The issue is priced at nearly 48 times One97 Communications’ FY21 revenues. There is no other similar listed company in India; when we look at the US, PayPal which has a comparable business model,  is valued at around 10 times its trailing twelve-month revenues. The company’s GMV spiked in the quarter ended September 2021 at Rs 1.96 lakh crore. To get a sense of the recent spike in GMV, at the end of FY21, Paytm’s GMV was Rs 4.7 lakh crore.

The company operates through One97 Communications, which acts as a holding company for Paytm’s various businesses which include payments and a payments bank, ticket booking, internet gaming, e-commerce, financial services (including Paytm Money, general and life insurance businesses), among others. Vijay Shekhar Sharma fashions Paytm as an “agent of change” that will bring financial inclusion to millions of Indians.

But investors need to bet on something more than sentiment and optimism. Is Paytm’s high valuation ask justified, based on its business and its future prospects?

Not yet profitable, but losses reduce considerably

The complexity of Paytm’s business operations makes it difficult to take headline numbers like number of users, loans disbursed or even number of merchants to drill down the company’s unit economics or its revenues. But as a whole, One97 Communications has not yet made profits, although losses have come down a lot over the past three years.

One97 Communications’ revenues come from payment services to consumers and merchants, commerce services, cloud services, and other (which includes financial services).

The company seems focused on reducing its marketing and promotional expenses over the past few years. This effort coincided with a drop in revenues over the past three years as well. But the company’s losses also declined, which shows that the company’s businesses are now at an inflection point.

The expected future rise in this GMV, which will in turn lead to a spike in Paytm’s revenues. This as a result will lead to profits at which its growth will be highly profitable. That is what seems to be one of the contributing factors in Paytm’s expensive valuations.

Focused action on marketing and promotional costs

The falling costs of acquiring new businesses, be it fee income on distribution of loans, or its postpaid or buy now pay later lending product, its broking services including mutual funds, insurance businesses, among others, will eventually lead to profits at higher volumes of transactions.

This phenomenon helped Paytm’s consolidated cash flow from operations turn positive in Q1FY22. This is an important metric, despite this being achieved at a higher revenue level than Q1FY21 because the company is able to generate cash at the operating level through its various businesses.

The company’s focus on monetising its extensive payments networks through various use cases over the internet led to a direct fall in marketing and promotion expenses. This led to the company being able to cover its variable costs and eke out a contribution margin over its revenues.

At the end of Q1FY22, the company’s contribution margin spiked to 27.4%. This shows that the company’s efforts to monetise its platform by setting up adjacent businesses - like wealth management, stockbroking, insurance, gaming, ticket booking, among others - are paying off.

But the question is whether as the company’s scale rises from around 337 million customers, if the company will produce super normal profits. Investors looking to bid for the company’s shares will be paying a high price for a business that hopes its future scale will produce those profits.

In conclusion, investors should also pay attention to the complex nature of the various subsidiaries and associate companies that One97 Communications has, in order to enter various payments offerings. 

In many businesses, the company does not have a majority stake. For example, in Paytm Payments Bank, and the general insurance and life insurance JVs, founder Vijay Shekhar Sharma holds a majority stake. So, not all the incremental profits will accrue to One97 Communications.

It’s not a risk factor per se, but this complex structure means that when consolidated financials are presented, the profits of those businesses will not entirely accrue to Paytm’s consolidated entity. Some kind of clarity of the future plans for this structure and the future listing trajectory of these businesses would help.

For now, investors’ need to weigh the hefty price they are paying against the company’s expectations of how its business will grow in the future. In a way, that future growth is the price Paytm is asking for in its share issue now.