Of tall charts, taller claims and gross margins

In 2016, OYO did away with its practice of partial inventories and minimum guarantees and moved to a new model where it picked up 100% of inventory in the hotels it partnered with. It also ventured into greenfield projects setting up hotels of its own (christened “Townhouse”).

Claims of the company

In April 2016, OYO founder and CEO Ritesh Agarwal claimed that the company hit unit-level profitability, an amazing claim considering that OYO’s net takes rate had only just turned positive. He later even claimed that they have positive net margins saying “last year in March, we announced that we had gotten into a net transaction profit, which means that for every Rs 100 we sell, we were making Rs 100-plus.

Our gross margin has been 25% and net margin is at 16%”. Agarwal might believe that a positive take rate is the same as a positive net margin but there is an enormous difference.

The former indicates that the company has a positive top-line and the latter that the company has a positive bottom-line. One would think that a positive top-line or positive revenue is the only kind of revenue there is but clearly like OYO showed until March 2016, that can hardly be taken for granted.

While it might seem that the company has progressed remarkably in this period, a lot of these supposed gains are ephemeral. The dip in the company’s loss from Rs 496 crore ($70.9 million) to Rs 330 ($47.2 million) is almost completely due to the doing away of the minimum guarantee losses (Rs 141 crore for FY 16) while the increase in the accounting top-line is the result of the positive take rates.

Is it really helping?

But isn’t a positive take rate a sign that OYO has a meaningful business model?

Not really. If anything, it is the minimum expectation for any company that operates a marketplace model. By itself, it can’t guarantee a positive or meaningful gross margin. OYO’s 15% net take rate implies that for every Rs 100 ($1.43) that flows through its marketplace, it gets to keep Rs 15 ($0.21) for itself as its gross revenue. But this revenue doesn’t come for free.

There are a number of operating expenses heads that are incurred to deliver this service. These need to be subtracted from the topline to arrive at the gross margin. More importantly, it is now standard practice to subtract all expenses related to marketing and promotions from this number. For instance, MakeMyTrip recently reported a sharp fall in revenue from the hotel’s segment at $76 million in the last quarter, down 43% from $134 million in the corresponding quarter last year.

By that measure, the sum of operating expenses of Rs 56 crore ($8 million) and sales promotion expenses of Rs 76 crore ($10 million) far exceeds OYO’s total operating revenue of Rs 76 crore for the last reported FY. This is only half the work done. From this gross margin figure, expenses related to salaries and other expenses need to be further provisioned for which means that company-level profitability is a long way off.

Lack of profitability?

Is this lack of profitability a problem with hotels in India?

Not quite. For FY 17-18, the Taj Group of hotels reported a topline of Rs 4,165 crore ($596 million) with an EBITDA margin of 18% and a net profit of Rs 101 crore ($14.4 million). Up 129% year-on-year.

The problem is with OYO’s choice of the segment.

Agarwal claims that OYO has more than 90% market share of branded hotels in India. But even if this is true, the hotel segment it operates in is in at the low end of the spectrum.

Unlike the likes of the Taj or the Marriott group who operate luxury and premium hotels with high margins, OYO’s hotels operate at an ARR (average room rate) of Rs 1,500 ($21) per night. A take rate or commission of 15% means that OYO’s net revenue per hotel room per night is Rs 225 or just $3.

The company would need to sell millions of room nights a month for this number to count for anything, and more importantly, would need to find a way to sell it profitably, which is a daunting challenge given the razor-thin margin. Also, there is an investment involved to standardize hotel rooms to the standard that OYO espouses to offer as part of its brand promise.

It is still moot if these investments can be recouped if room rates are as low as these. This is a choke point. Investments can’t be too high as that would require higher realized rates, but the segment is such that rates can’t be higher than this.