Price-to-imagination for PE? Raamdeo lists out pitfalls of dealing with digital stocks

NEW DELHI: Market veteran Raamdeo Agrawal says many companies in the dot-com bubble phase added to their names and got benefited valuation-wise. Today, he fears a similar trend to emerge wherein 30-40 year aged old economy companies would call themselves to ride the digital wave.

Be careful, he advised.

Speaking at Motilal Oswal Global Partner Summit, Agrawal said there were no earnings in the dot-com bubble, but only the scaling up of valuations. “When such stocks finally crashed, there was nothing to hold on to, as there were no earnings and so no value buying emerging,” he said.

In that context, Agrawal said digital companies that could potentially reward investors in their listed journey would be the ones that would not only manage to scale up the top line, but also improve their Ebitda margins.

Digital companies, he said, are not financially leveraged, as they are fuelled by private equity money. They are needed to work only on the operating leverage, he said.

“You need to be king in understanding. You need to know where is the fixed cost that could be leveraged. If you have scaled 100 times, but have no fixed cost to leverage, I won’t see it as successful scaling. You will see a lot of companies which will scale up but would not have effective operating leverage and eventually die,” he said.

Raamdeo is often heard saying that every bull market sees a sector that takes the center of gravity — the eye of the storm — which creates immense wealth for investors.

Asked whether digital companies could be the ones leading this bull run, he said, “At the beginning of a bull market, you should not be able to see it. If you are able to see it, that is not going to be that sector!,” he said.

Agrawal said Bangalore is full of unicorns, with 25 unicorns right now and 150 others likely to emerge in the next five years. So there is much to be excited about, he said. Besides, he believes some of the domestic unicorns will also tap into the global value chain.

“Since there is no profit, what we have got is price-to-imagination, where no price is right — a $40 billion is just a number as there is no E (earnings). That’s the most comfortable part of it!,” he said sarcastically.

The market veteran said investors of loss-making digital companies will keep giving money as long as times are good. “But eventually when they will get to know that these jokers cannot make money, they will stop money flow,” he said.

Agrawal said he has seen the evolution of valuing digital companies in the US. Amazon, he said, initially had a very thin profit or no profit.

“Its P&L was negative, but cash flows were positive. People see whether incrementally the company would be profitable. There are very few guys that can successfully do blitz-scaling. You can scale the company’s size from 1 to 100 times, but you can also lose billions of dollars,” he said.

“Blitz-scaling in digital companies is something when your marginal cost is literally zero. Your marginal cost may not be zero when you are sub-scale. When your turnover is say $1 billion, your marginal cost could be 30-40 per cent of revenues. When the business grows from $1 billion to $5billion, that marginal cost comes down to 10 per cent. So the operating margin which was minus 5 per cent would become plus 25 per cent. And then you see at some level, a lot of things come together, and you see 40-50 per cent Ebitda margin,” he said.

But who are those companies which will scale up the topline but also scale up the Ebitda margin, he asked.

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