One 97 Communications (Paytm) (BUY): Management expects positive FCF generation in 12-18 months; no onerous outcome of regulatory observations

One 97 Communications (Paytm) during its analyst meet yesterday (1st Dec'22) reiterated its continued focus on improving profitability. Management stated that the journey to attain operating profitability (EBITDA before ESOP cost) via consistent margin improvement has exceeded its expectations in the past few quarters. It further emphasised its target to become an FCF-generating company in the next 12-18 months. Management also enhanced clarity around the company's business model by providing additional disclosures with respect to net payment take-rate of 7-9bps, average subscription fee (of Rs100 per month per active device), 2.5-3.5% take-rate on loan sourcing and 0.5-1.5% on collections, etc. Besides, the management pointed at growth drivers in the various business segments and threw light on how it plans to generate free cashflow (FCF). Lastly, clarifications provided around regulatory developments with no onerous outcome provide further comfort. Maintain BUY with an unchanged target price of Rs1,285 based on customer lifetime value methodology. We discuss key takeaways from the analyst day below:

- Ahead of the guided timeline to achieve operating profitability; company to even start generating free cashflow (FCF) in next 12-18 months: Paytm has been delivering better than our expectations as reflected in its operating performance over the past 2-3 quarters. EBITDA (before ESOP) reduced to -(9%) in Q2FY23 from -(39%) in Q2FY22. This gives visibility around the company turning EBITDA-positive (before ESOP cost) ahead of the guided timeline (Q2FY24). In addition, the management is confident about becoming an FCF-generating company (net of capex) in next 12-18 months driven collectively by improved profitability across payment and financial services distribution, cloud, etc.

- Payment processing + subscription revenues on devices = Net payment margin: Through payment processing, Paytm makes a net payment margin of 7-9 bps of GMV. Of this, 3-4bps are earned from UPI transactions and 15-18bps from transactions through other instruments (such as wallet, debit card, credit card, etc). On expectations of faster growth in UPI transactions, management foresees blended margin to stabilise at 5-7bps going ahead. The other margin driver in payment business is subscription revenues earned through device deployment wherein Paytm charges around Rs100 per month per active device. Charges on some high-end devices are higher (up to Rs250 per month). Furthermore, select installations get additional incentives from partner banks, RBI, NABARD, etc. Paytm designs and manufactures the devices through an Indian company in which it has a minority shareholding and which is exclusive to Paytm. This gives Paytm the advantage of being less dependent on other companies and also being more innovative with devices. For example, it is planning to launch a soundbox with card payment acceptance. Paytm takes aggressive depreciation (2 years for soundbox and 3 years for EDC) and expects to generate enough cash in next 12-18 months to fund net capex.

- Lending business margins to trend upward with scale as per management: On disbursement of loans, Paytm makes 2.5% to 3.5% of loan value upfront (net of GST). This is highest in merchant loans followed by personal and then Paytm postpaid loans. In addition to sourcing, it also collects loans for its lending partners mainly through mobile and digital capabilities. Hence by design, the collection cost is very less for it. In collection, the company makes 0.5% to 1.5% of current disbursement value. The take rate looks low as it has been calculated on current disbursement value which has grown significantly wherein collection fee is earned post portfolio closure: typically, 12-14 months for personal and merchant loans, and 3 months for postpaid loans. While majority of the collections happen digitally, the company has a collection force of around 170 people to collect money from defaulted customers of personal and merchant loans. For Paytm Postpaid, given low ticket-size, it does not encourage physical collection mechanism.

- Piloting new products in lending business: Paytm is mainly experimenting on launching 2 new products in the lending business. One is EMI @ POS as now it has a huge base of customers desiring such type of products mainly for lifestyle financing. This could be rolled out over next 10 to 12 months. Secondly, there is a certain set of good customers who have completed few cycles of personal loans and are demanding high ticket-size / high-tenure loans. For this, the company is experimenting slightly high ticket and high tenure product for selected cohort of customers. Apart from lending business, Paytm will focus on stock brokerage offerings in financial services business. Herein, it will target to cross-sell trading products to existing payment customers.

- Strong focus on credit risk management as well: Paytm does not have any kind of FLDG agreement for loans sourced through its platform with its lending partners. Additionally, the company does not select customers and then refer to lenders. White listed customers are selected by lenders bi-annually basis their criteria who are then provided the options of getting the loan from that lender. Based on last exercise of selecting white listed customers conducted during Sep'22, the total number of such customers are around 35mn.

- No plans to become NBFC: Firstly, the management sees more benefits from its current business model wherein it earns fees on sourcing and collection of total disbursements. This is different from NBFC model wherein most of the income is earned on outstanding book with interest rate and credit risk. Secondly, it does not desire to become another large NBFC within the financial service space wherein it would have to compete with other big players whereas in current business model it works with the same players as partners which benefits both parties.

- Commerce and cloud businesses are beneficiaries of Paytm app traffic: In cloud business, apart from providing cloud-based and advertising / marketing services to merchants, it also earns fee by distributing co-branded credit cards. Credit cards give Paytm upfront distribution revenue and lifetime usage fee based on spends per card. Currently it has ~300k cumulative active cards as of Sep'22 with average retail spend per active card being Rs22-24k per month with both showing healthy growth (in Oct'22, it activated around 48k new cards). Due to multiplicity usage of Paytm, credit card activation is as high as 90% on Paytm platform. In commerce business, Paytm helps merchants sell their tickets, gift vouchers and deals, etc. This business is run with cash profitability as it has ~6% take rate on commerce GMV (this was Rs20.21bn in Q2FY23).

- Building / expanding the platform and payment processing charges are the key costs: Within platform, the two key costs are building it, which means hiring more manpower and expanding existing platform which means marketing/sales that are directly driven by revenue opportunity in market. Cost of building platform was Rs2.01bn in Q2FY23 and management expects 10-15% YoY increase in current base, unless it enters new business, which is very unlikely over the near to medium term. Expanding platform cost was Rs3.09bn in Q2FY23 (Rs1.37bn in marketing and Rs1.72bn in sales cost). Marketing cost tends to be volatile as company has provided sponsorship for certain sports events. The company would continue investments in sales and marketing, however, it believes that it will improve profitability despite that.

As far as payment processing charges are concerned, management believes that it will trend downwards as percentage of GMV mainly because of: 1) higher UPI mix, and 2) routing and rate optimisation. However, from Q3FY23 onwards, postpaid charges will be reported in payment processing charges (earlier reported under Promotional cashback and incentives). While this might increase payment processing charges a bit, however, the impact on contribution margin will be nil.

- ESOP charges to be at around Rs10bn-14bn run-rate until FY25, post which it will start trending downwards: Management gave clear expected ESOP charges going ahead based on currently issued ESOPs. It expects the same to around Rs7.5bn / Rs14.1bn / Rs10.bn / Rs4.4bn / Rs1.4bn in H2FY23 / FY24/ FY25/ FY26/ FY27, respectively. Consequently, total number of diluted shares stands at around 695mn. We are building in Rs10-18bn ESOP charges from FY23E till FY26E indicating upside risks.

- Large TAM in every segment is key growth driver for Paytm: Despite strong digital adoption, management believes that it is still early days as there are only 250mn registered UPI users and 10mn total devices. Furthermore, Paytm also believes that India could have potential of 100mn merchant entities and more than 500mn payment customers in near term. It plans to keep on helping merchants in expanding their businesses by offering coupons, deals, marketing and loyalty which will in turn create more revenue & profit for its commerce business. Bank Partnerships for selling their products is another area wherein it sees great opportunity. FASTag and Co-branded credit card are already a success, and EMI aggregation on PG, remittance among others could be next. Lastly, in financial services, it will focus on growing loan and stock brokerage offerings.

- No major negative business impact of regulation is expected: Recently, Paytm has been engaged with regulators on three fronts. 1) Ban on customer on-boarding on Paytm Payment Bank (PPBL) due to RBI audit: there are no onerous findings as they are related to strengthening operating processes like KYC, etc. and IT sharing activities between Paytm and PPBL, 2) Ban on online merchant on-boarding for 100% subsidiary, Paytm Payment Services Ltd (PPSL). Herein, RBI has asked PPSL to seek necessary approval for past downward investment from the company into PPSL, to comply with FDI guidelines and then resubmit payment aggregator (PA) license within 120 calendar days. This is expected to have no material impact on its business and revenue as it can continue to on-board new offline merchants and offer them payment services. Similarly, PPSL can continue to do business with existing online merchants, and 3) Digital lending guidelines: As far as this regulatory interference is concerned, Paytm did not have to make any changes to its existing processes because of the same.

- No immediate plans for mergers and acquisitions: While Paytm currently has high cash reserves of around Rs92bn as of Sep'22, yet, it does not plan to do any mergers and acquisitions. This is mainly due to the fact that the company is currently focused on growing profitably and secondly, it believes in growing organically as it allows to understand the business and leverage technology expertise in a better manner. Apart from that, currently, company does not plan to do any buy back of shares.

- Key Risks: 1) Slower than anticipated scale up in financial services revenue, 2) Pressure on take rate in lending business, and 3) slower GMV growth.

Shares of One 97 Communications Limited was last trading in BSE at Rs. 501.50 as compared to the previous close of Rs. 481.65. The total number of shares traded during the day was 640805 in over 15967 trades.

The stock hit an intraday high of Rs. 504.80 and intraday low of 485.15. The net turnover during the day was Rs. 319180886.00.

Source : Equity Bulls

Keywords

PayTM INE982J01020 Internet DigitalPayment One97Communications ICICISecurities