Is Nykaa a Falling Knife?

When popular stocks find no takers, their stock prices move sharply southwards. Then, they are labelled as falling knives. Investors believe that buying such stocks is akin to ruining their portfolio.

I often find the 'falling knife' questions on stocks in my mailbag.

The latest ones are on the stock of Nykaa, listed as FSN E-Commerce Ventures.

The stock has fallen like nine pins in recent months. Even a generous bonus issue did not stop the slide. In fact, the selling pressure has accelerated in the days following the bonus issue.

Just a year back Nykaa was nothing less than a market favourite.

The stock listed in 2021 at sky high valuations. No one batted an eyelid even when the valuation multiple crossed three digits and stayed there.

On the contrary, investors clamoured to the uniqueness of the business model and its projected growth.

Nykaa was among the first to retail beauty products online in India. At a time when physical distribution of such products was a huge challenge, Nykaa made beauty shopping a fingertip activity.

But now Nykaa's core proposition of being a multi-brand platform is at risk. The company currently makes a big chunk of its revenue from brand advertisement. But Nykaa is no longer the only platform for such beauty brands.

Several deep pocketed competitors in the beauty and skin care segment are cannibalising Nykaa's share. The Tata group is the latest to plan what it calls a beauty tech venture.

So, Nykaa's share of ad revenue is at grave risk. Apart from losing ads, Nykaa's existence as a multi-brand platform is itself at risk over the longer term.

Intense competition requires players to forego profits and offer massive discounts to stave off competition and retain customers. Therefore, a meaningful increase in Nykaa's profitability is ruled out for now.

A foray into fashion and other verticals can only temporarily solve the margin problem. Plus, they need heavy cash investments. Nykaa plans to add 25-30 retail stores per annum.

So, its future performance depends on its ability to leverage its brand image without compromising profits. Capex on new stores and spending on acquiring brands will continue to be a drain on cashflows.

Understandably, investors have realised the mistake in valuing Nykaa for perpetual high growth. The stock has halved in the past twelve months.

Nykaa is, of course, not the only stock bearing the brunt of investor agony.

Zomato is down 58%.

Paytm is down 64%.

Policy Bazaar has crashed 74% from its 52-week highs.

In the US, Amazon, Netflix and Meta have shed a whopping 40-70% of their market value this year.

So, the question is whether all the top growth stocks in India will become falling knives in a market downturn.

More importantly, what should investors do to identify and avoid such potential value destroyers.

Of course, new age tech stocks cannot always be valued based on earnings. Balance sheet assets are out of question as most of the assets are digital or intellectual property.

So, high risk investors and hedge fund managers follow what they call 'Rule of 40' to evaluate the growth-return prospects of such businesses.

The 40% rule is that the company's growth rate and your profit should add up to 40%.

So, if you are growing at 20%, you should be generating a profit of 20%.

If you are growing at 40%, even generating 0% profit is acceptable.

If you are growing at 50%, even losing 10% should be pardonable. If you are doing better than the 40% rule, that's awesome.

When applied sensibly the Rule of 40 offers early-stage investors a quick check on the health of the new tech companies versus their growth.

Yet, one must understand that such business could see extreme volatility from time to time. They have several drawbacks versus steady, high cash businesses.

• Limited revenue visibility
• Sharp volatility in margins and cashflows
• Growth dependant on capex, discounts or ad spends

Therefore, a sharp correction in valuations should not come as a surprise. The sharp correction in valuations was both necessary and meaningful.

Now whether Nykaa will continue to be a falling knife will depend on the management's ability to offer earnings visibility.

Though Nykaa remains a relatively high-risk bet, investors keeping a close watch on its financials and valuations could consider a contrarian bet.

As Seth Klarman says, be contrarian with a calculator. You need both. The calculator is to prevent junk.

Warm regards,

Tanushree Banerjee
Editor, StockSelect
Equitymaster Agora Research Private Limited (Research Analyst)