Thread by @finshots

Understanding Zomato's Unit economics and figuring out why it's the key to a profitable future. A thread🧵

Unit economics (in this instance) means measuring business performance by comparing the revenues and costs involved in processing a single order. And if you want to understand what that means, consider the example below.

Each time you place an order, you pay a certain sum to Zomato (less of all discounts). Zomato then takes a cut and they promptly transfer what’s left to restaurants. It's an oversimplification, but it will have to do for now

At this point, you have to see what Zomato spends to fulfill this order. If they can ferry an order by spending ₹10 and make ₹11 via commissions and delivery charges, then it has positive unit economics.

This isn't the same as saying the company is profitable. Because bear in mind, we've not included fixed costs, including sales and advertisement expenses. This just involves costs and commissions associated with fulfilling one order. That's it.

Unfortunately, for the longest time, Zomato simply didn’t have this bit sorted. They couldn’t make break-even here.

However, that changed during the pandemic. And to see how that happened, you may have to look at a metric called the average order value (AOV).

The average order value, as the name indicates, is the average value of any order placed on the app. So if you have 3 orders with values ₹200, ₹300, and ₹400. The average order value, in this case, is ₹300.

But here’s the catch — If the average order value keeps climbing, then Zomato has a better chance of breaking even and perhaps turning a profit on each order.

The logic here is simple — Zomato spends pretty much the same kind of money ferrying a ₹100 order and a ₹500 order i.e. the costs more or less remain the same. But they make more money from the ₹500 order, by virtue of claiming a commission on the total order value.

A 20% commission on ₹100 tallies up to ₹20. On an order value of ₹500, the commission jumps to ₹100. You can see how the 2nd transaction is a more profitable enterprise & if customers routinely seek more expensive orders, then you will witness an uptick in average order value

This is the path to profitability and during the course of the pandemic, that is precisely what transpired. First, the average order value started shooting up. We saw premium restaurants start showing up on Zomato and families ordering in large numbers.

There were also people who took up the mantle and order for multiple members in the same household. Put together, the average order value rose — from ₹264 for the period between March and June 2019, to about ₹400 during the last 3 months of 2020.

And this meant Zomato had finally figured out the unit economics problem. At least for the time being.

And we say that because, at the turn of 2021, people were already adjusting to the new normal.

And while the company still boasted positive unit economics, the average order value had declined — possibly indicating that it may be harder for Zomato to make a sizeable profit on each order while also trying to court new business.

Why is any of this important, you ask? Because analysts were skeptical if this business would ever break even at the unit level. The implication being that if Zomato failed to boast positive unit economics, they may never become profitable.

However, considering they've shown that they could figure out the unit economics problem, they have a path to profitability. Although, you have to wait and see if they can keep doing this while still growing at an exponential rate and justifying their valuation.

If you want to read a full review of the IPO and why Zomato has a gargantuan task ahead of it to justify the price they're seeking please read this article finshots.in/markets/the-zo…