OYO’s Battle of the Bulge

OYO is currently the most important startup in India, if not the world.


Maybe not.

For one thing, the budget hospitality startup is currently the great white hope for SoftBank and its $100 billion Vision Fund, the biggest and most influential VC in the world. If SoftBank’s “crown jewel” turns out to be a lump of coal, the fund can all but kiss its chances of raising the second Vision Fund—which is already struggling to get off the ground—goodbye.

For another, OYO is India’s second-largest startup in terms of valuation. If OYO flames out, the seismic repercussions on startup funding in India will reverberate for years.

So why are we discussing this now?

Because OYO is currently facing the unenviable position of having to fight the “Battle of the Bulge”.

History aficionados will recognise the Battle of the Bulge as an iconic “last-stand” battle during World War 2—one last desperate offensive campaign that Germany launched to avert what seemed like inevitable defeat. OYO’s current predicament is something similar. The last year has been annus horribilis for OYO. It saw widely-publicised problems around dissatisfied hotel partners and disgruntled customers culminating in a purge where nearly 20% of the company’s 12,000-strong workforce in India was laid off. There were similar layoffs across its other group entities around the world. OYO now needs to win a last-ditch battle to prevent these eddies from cascading into a deluge that takes the company under.

But OYO has another “bulge” problem—the bulge of the wallet kind. A large part of OYO’s mercurial growth can be attributed to the enormous sums of money raised from its financial backers, most notably SoftBank (which owns nearly 50% of the company). Post the chastening that SoftBank received during the WeWork IPO imbroglio, the halcyon days of bottomless pits of capital were given a quiet burial. Like other SoftBank portfolio firms throughout the world, OYO has discovered that even a seemingly infinite $100 billion fund has limits. Instead, it has been forced to abandon its “grow-at-all-costs” mantra to build a “sustainable path towards profitability”.

The stakes are high. Can OYO conceivably progress towards this holy grail of profitability?

OYO’s recently released audited financials for the year ended March 2019 is a good starting point to help answer this question.

The sum of its parts

The headline numbers make for dire reading.

According to OYO’s latest results, its consolidated revenue stood at $951 million in the year ended March 2019, compared to $211 million in the previous year. While this 4.5X increase in revenue might seem impressive, it pales in comparison with the net loss—a whopping 7X increase to $335 million in the same period, compared to $44 million the prior year. 

These numbers tell us that not only are losses growing much faster than revenue, the net loss as a percentage of revenue is also widening—growing from 25% to 35% over the same period. In an accompanying annual report card, the company further stated that total gross margin fell from 10.7% to 7.1% over this time. Hardly signs of a company on its way to profitability. 

The company’s management, though, sees it differently.

OYO’s executives, led by CEO and founder Ritesh Agarwal, see the company’s business as one that can be broken up into markets in three different phases.

On top of the pile is India, which is both OYO’s largest as well as most mature market. In India, the company claims it is “driving the best gross margins and chasing a path to profitability”.

Then, there are markets like China and Southeast Asia, where the company has already established operations and made substantial investments. These investments have dragged the bottomline down for the year ended March 2019, but are now primed to deliver returns, both in terms of revenue as well as gross margins.

Finally, there is the rest of the world—markets such as the US and Latin America. OYO has been present in these markets for less than a year and is still in the process of setting up operations.

The table below provides a summary of the company’s numbers for the year ended March 2019 across these three markets.

OYO segment-wise numbers for FY19 (Source: Company blog post)

Let us put these numbers to the test.

Starting with India.

Home improvement

According to the company, India’s revenues for the year ended March 2019 totalled $604 million (64% of the total). This is up from $211 million the previous year. So, while India revenues grew nearly 3X year-on-year, losses, on the other hand, went up only marginally—from $50 million to $84 million. To boot, as a percentage of revenue, losses in India was only 14% in the same period, an improvement from the 24% registered the previous year.

Aditya Ghosh, previously the CEO of OYO India and currently a board member, echoed this claim in a press interview. He stated that gross margins in India increased from 10.6% in the year ended March 2018 to 14.7% the following year, “indicating the strength of our business model and a positive correlation between market share and economics”.

All kosher?

Not quite.

First, there is the issue of expense allocations across segments/markets. Burnishing the economics of one segment by shovelling expenses into other segments is almost trivial from an accounting perspective. Several large companies do this routinely to build a narrative that is palatable to their shareholders and the public at large at a particular point in time. 

OYO has a mind-boggling array of no less than 40 subsidiaries across India and the world. It is simple to take, say, ten million dollars from the marketing section and similar sums from other departments such as human resources and move it out from the main Indian entity and account for it in another subsidiary. 

But let’s give OYO the benefit of the doubt for now. Instead, let’s assume we can take these segment-wise numbers at face value.

The topline operating revenue number of $581 million seems mighty impressive. The gross margin of 14.7% (translating to $88 million) is equally so.

Both these numbers are misleading.

Shifting goalposts

Effective 1 April, 2018, OYO changed its accounting methods to recognise what was earlier known as “net realised value” (representing the total flowthrough or gross merchandise value) as revenue. In its filings, the company says that, “Revenue from sale of accommodation services is recognized on gross basis as we gain ‘control’ on stay services before providing it to the customer. We consider ourselves as the ‘Principal’ in arrangement as we assume obligations towards performance of stay services to end customers”.

This shifting of goal posts means what was earlier considered revenue is now considered as “gross margin”.

If you strip away these cosmetic changes, the numbers are underwhelming. Even this $88 million figure is inflated. It doesn’t provision for commissions paid to selling agents such as online travel agent MakeMyTrip, which amounts to $26 million and needs to be netted out to get an accurate picture of the company’s true topline.

But optics aside, is this just a matter of semantics? After all, you can call it “net operating revenue” or “gross margin” or even “take rate” (which is what this number actually represents for a marketplace like OYO) but the fact is that this number has gone up from 10% of GMV to nearly 15%.

For a company like OYO that has historically had even negative take rates, a 15% figure definitely counts for laudable progress.

But there are three questions that need to be asked about this number.

A tale of three questions

First, what was the cost of getting to this figure?

As of March 2019, OYO had approximately 180,000 rooms in India, adding 10,000 rooms every month at that point in time. Over the course of that year, OYO’s employee base in India went from 2,000 to more than 8,000 people. This scale of staff growth was required to onboard new hotels and manage operations at this scale. It is not a coincidence that this 4X growth in staffing mirrors the 4X growth in revenue. It shows that despite wanting to be perceived as a tech startup, OYO is closer to a traditional hospitality company, where there is a linear dependency on staff and infrastructure. 

Second, is this number sustainable?

To combat the natural limits of a hospitality business, by its own admission, OYO cut corners galore. Salespeople oversold OYO to hotel partners and once the hotels were on-boarded, hidden charges and opaque fees became commonplace. 

On top of that, the monthly fees guaranteed to hotels were not paid in time or at all, in many cases. The plethora of complaints from disgruntled hotel partners, both in the press as well as in courts of law, bear adequate testimony to these practices. Purely from a revenue perspective though, all of this helped grow OYO’s margins. So, rather than hurt the company’s book, at least temporarily, this helped OYO report better numbers. 

The problem, however, is that disgruntled hotel partners fought back, refusing to honor room bookings and flouting OYO’s standards when it came to hotel amenities and maintenance. This vicious circle breaks OYO’s fundamental brand promise of predictable and standardised budget hotel rooms. The recent round of mass layoffs has led to further uncertainty among both hotel partners and potential customers.

Finally, is this number enough?

Despite progressing from 10% to 15%, OYO’s bottomline for India was negative for the year ended March 2019. The net loss bottomline of $84 million is almost as much as the company’s actual topline, implying that even at this high take rate, the company was losing one dollar for every dollar it earned. There is little prospect of this take rate improving from 15% and if anything, is likely to go down once OYO perforce calls a halt to the practices it adopted to increase margins. The natural limit of the take rate for a budget hotel offering is likely to be in the 10-12% range at best.

At sea overseas

All of this means that contrary to the company’s claims, OYO is still far from positive unit economics/gross margins in India, and despite improved numbers, it is unlikely to progress closer to profitability from this point on.

Then there is China.

OYO’s financials show that China contributed nearly 75% of its losses in the year ended March 2019. The company claims these losses were a result of entering a new market and involved “front-loading of setup costs and manpower investments while the revenue trails resulted in higher losses in the beginning.”

But here’s the catch.

As of March 2019, OYO’s presence in China was neither early nor front-loaded.

The company entered China in November 2017, and in less than a year, built a base of over 50,000 rooms. In March 2019, Aditya Ghosh said, “We actually treat both India and China as our two home markets. China actually exceeds India in the sheer number of rooms that it has today”.

In an interview in August 2018, Agarwal claimed that OYO was already the number two hotel chain in Shenzhen, the fastest growing market in China. He also claimed that the China operations generated significant cash and they were “at an asset-level profit within two months of its launch”.

Given these statements, the claim that the losses in China were due to entering a new market that was in a “development and investment mode” rings hollow.

What is striking is that the litany of adverse press reports emanating from China and other international markets like Japan and the US follow an eerily similar script to the complaints by hotel partners and customers in India. Lure hotels promising minimum guarantees, renege on these commitments, provide a sub-par experience for customers. A familiar playbook that has few positives.

Factor in fears around how the Coronavirus epidemic is likely to severely affect OYO’s China business and it is all but guaranteed that the company is destined to lose money heavily in that market for the immediate future.

So if both the Indian as well as international markets are far from profitability, is OYO destined to lose the Battle of the Bulge?

There is a silver lining. And it comes from an unlikely source.

As we had previously reported, OYO’s recent $1.5 billion fund raise was led by SoftBank and Ritesh Agarwal himself. Agarwal took a loan of $2 billion to finance this investment and provide a partial exit to investors like Sequoia and Lightspeed (The perverse incentives of that secondary deal make for a story in itself but one for another day). Agarwal’s $2 billion loan was personally guaranteed by Masayoshi Son, SoftBank’s mercurial founder. 

In another world, this move by SoftBank’s founder to issue a guarantee to a founder of a SoftBank-backed portfolio firm to invest into the same SoftBank-backed portfolio firm, might have invited censure. It could have been perceived as unethical, if not outrightly illegal. But in our world, this is apparently business as usual. Given this personal guarantee, Masa has a vested interest to make sure that not only does OYO stay afloat but that Agarwal repays the loan by selling this stake at some point within the next few years.

So whether OYO is currently the most important startup in the world or not, it is certainly the most important startup for Masa. And in the final analysis, that is all it probably needs to win the battle.

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