Grubhub: A Structurally Challenged Business Model

Summary

Grubhub’s unit economics are significantly deteriorating.

GRUB lacks a competitive moat amid deteriorating industry dynamics.

Not do I see much of a case for a takeout at current valuations.

I am not buying this dip.

Following the pullback in the aftermath of its Q3 results, Grubhub (GRUB) valuations may appeal on revenue-based multiples such as EV/Revenue. However, I would caution against “buying the dip” here. It is unclear to me if the business model is viable, even in the long run. To be clear, I do not think Grubhub’s misfortunes are entirely of its own doing; its quarterly industry commentary pointed toward secular challenges across the industry, which I believe is reflective of the challenges of operating in food delivery. I see little reason for a multiple re-rating from here; nor do I see an acquisition scenario materializing at the $197/active diner implied by current valuations.

(Re-)Setting Expectations

If I could surmise GRUB’s Q3 results, it would be that the growth outlook and forward profitability are becoming significantly challenged. The reset of 2020 expectations was shocking – adjusted EBITDA is now projected to reach “at least” $100mn, which is far below the already weak 2019E guidance.

Source: Grubhub Historical Company Reports

As its shareholder letter lays out, the disappointing numbers were down to a number of issues, most of which seem to be secular rather than one-off.. Firstly, deteriorating new customer dynamics, with newer diners trending worse than prior cohorts on frequency, loyalty, and retention. This ties in with management’s commentary on deteriorating industry dynamics in the shareholder letter, with increased industry-wide competition leading to bleak growth prospects (“low double- digits growth”).

What we concluded is that the supply innovations in online takeout have been played out and annual growth is slowing and returning to a more normal longer-term state which we believe will settle in the low double digits, except that there are multiple players all competing for the same new diners and order growth.

With competitive intensity on the rise, GRUB has identified restaurant inventory and diner loyalty as key areas of focus. Management is looking to build supply by onboarding more non-partnered restaurants on its platform, aiming to more than double the number available by 2020.

Meanwhile, to differentiate itself and address the deterioration in new diner retention, the company plans to utilize its industry-low fees and direct point-of-sale integrations to support its loyalty push. Supporting this initiative is the strong diner rewards numbers through Perks:

The Perks program, which we talked a lot about last earnings call, is already very exciting. Over 20% of our diners are redeeming loyalty rewards right now. Restaurants have given away over $70 million so far this year on our platform to diners.

The key implication here is that delivery economics are materially worsening as companies’ investment needs escalate. Amid a deteriorating industry backdrop, GRUB simply does not have an economic moat to shied itself from the race. The company is investing in building out its sales team to expand supply (by adding more restaurants onto the platform) while simultaneously being engaged in a subsidy war with well-funded competitors such as UberEats to build loyalty.

Getting Worse Before It Gets Better

The issue with the food delivery investment case comes down to unit economics – with supply (delivery apps) proliferating, there simply does not seem to be any discernible network effects or first-mover advantages for incumbents to build on. Here’s a particularly damning chart for Grubhub:

Source: Fortune

The quote below, from the same Fortune article, frames the food delivery state of play quite well, in my view:

Market leaders in the on-demand delivery industry can change in an instant, says Pandya. Companies like DoorDash and Uber Eats constantly track sales performance and make daily tweaks—releasing new promotions, switching marketing strategies, targeting specific audiences—all of which could have major impact on the following day’s results.

If the food business seems like a difficult, overcrowded proposition, food delivery might be even worse – there has been little evidence that well-funded market leaders have been able to build in any switching costs into their business model. This applies to both diners (demand side) and restaurants (supply side). Restaurants have shown little interest in going exclusive with any one platform, and are instead, signing up with multiple delivery platforms to maximize customer leads. There are, after all, no upfront costs in signing up.

GrubHub sits in a particularly precarious position. It competes with both extremely well-funded industry participants with a huge captive ecosystem (Amazon, Uber) as well as leaner startups (Postmates, Doordash).

The key to the GRUB bull case lies in the total addressable market (also known as TAM”) argument, which has some credence. The sheer size of the overall food delivery market, coupled with the high purchase frequency means the market opportunity is vast (GRUB believes the number is $200bn/yr, as specified in its shareholder letter).

But we have seen this movie before, with the likes of online travel etc. The key to profitable growth (industry-wide consolidation and rationalization) is well-known but the time and incentive required for such a consolidation to materialize is the key question. There has been little sign of industry discipline thus far, and by GRUB’s admission in its shareholder letter, things are getting worse.

We have to balance our view of the long-term with the realities of the current environment we are operating in. While our competitors continue to spend aggressively, swallowing steep losses in the process.

Pondering the M&A Runway

Historically, the GRUB growth strategy has leaned heavily on an acquisitive streak. In the last few years, the company has splurged on Eat24, Restaurant on the Run, Delivered Dish, DiningIn, and LABite, among others. The question now, however, is what next? The food delivery M&A landscape seems exhausted, with little in the way of remaining acquisition targets of scale.

Source: CBInsights

Given the absence of network effects exhibited by GrubHub’s business thus far, I struggle to see the case for GRUB to be an acquisition target down the line. At an EV of ~$197/active diner today, the price to acquire GrubHub’s users is still exceptionally pricey. With little in the way of an economic moat, I see little reason why the likes of Uber, for example, would buyout GRUB for a premium, instead of simply building out a network organically.

EV (As at 2nd Dec)4.13B
Active Diners (Q3 ’19)21M
EV/Active Diners$196.7

Source: GRUB shareholder letter, Seeking Alpha, Own Est

Pricey GRUB

Incorporating the implications from the latest quarterly update, I believe Grubhub has room to move lower. I hold a price target of $22 on the stock, based on a 20x EBITDA multiple to account for the increased investment requirements, though the bulls are getting the benefit of doubt here considering this is still notably above many Internet peers. The EBITDA multiple could well compress lower if bulls lose faith in the TAM-based investment case.

Adj. EBITDA (Fwd)$110
(NYSE:X) Valuation Multiple20.0x
(=) Implied Enterprise Value$2,200
(-) Debt(493)
(+) Cash & Equivalents458
(=) Implied Equity Value$2165
(÷) Diluted Shares97
Fair Value per Share$22

Source: Own Est, Company Filings

Final Take

Grubhub’s recent fall from grace highlights the hazards of TAM-based investing – by ignoring the underlying unit economics, bulls seem to have underestimated the level of investments needed to generate sales, and the level of competitive intensity within the low-moat food delivery business. Though the third quarter was a timely reality check, I am still decidedly cautious on the stock. Industry dynamics, for instance, has deteriorated, with management’s bearish outlook leading me to question the sustainability of the business model and Grubhub’s ability to maintain share.

Looking ahead, the competitive outlook could get a lot worse. Competitors have shown little interest in maintaining discipline, while continuing to invest heavily in technology and fulfillment, and funding subsidy-driven losses across the value chain (from diner to restaurant). I would not be buying the GRUB dip anytime soon, given the heightened execution risk as management navigates an intensely competitive space.

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