Summary
Grubhub’s third-quarter earnings were a wake-up call to current industry conditions of intense competition, causing the stock to drop 43%.
Since then, the stock has rallied 44% off the lows.
In this article, I look at why the stock dropped and what has changed since earnings.
I discuss several combinations of industry players and speculate on which is most likely.
Grubhub’s (GRUB) third-quarter earnings were a wake-up call. Investors were forced to face the reality that the food order and delivery market has become ultra-competitive and that Grubhub was no longer the market leader in the US. The company dramatically lowered its guidance for the fourth quarter to revenues of $315-$335 million and EBITDA of $15-$25 million, versus analyst estimates of $387 million and $79 million. The change in guidance, competitive positioning and strategy was so significant that management released a shareholder letter to communicate its views on the industry and Grubhub’s positioning going forward. As a result, Grubhub’s stock dropped from $58 to $33, a 43% drop.
Remarkably, though, Grubhub’s stock has regained much of that ground over the past two months, rallying back to $49. Its stock has risen 48% from the post-earnings low. So what has changed, if anything, to cause this increase? Or is the increase simply due to the market adjusting to an overreaction following the third-quarter results?
First, I look at the points management made in its shareholder letter that caused the stock to drop. Second, I’ll speculate on whether these factors have changed since earnings to justify the recent rally in the stock.
1. Growth Slowing and Diners Becoming More Promiscuous
Management was clear in the letter that “supply innovations in online takeout have been played out and growth is slowing and returning to a more normal longer-term state which we believe will settle in the low double digits”. Further, management detailed that diners are “becoming more promiscuous” in terms of ordering on other competing online platforms.
It’s unlikely that either of these factors has changed since earnings.
2. Delivery is Not Profitable
Management was clear that they did not expect delivery to ever generate profits. They wrote:
In 2015, we added delivery capabilities to enable restaurants that didn’t have delivery to join our platform. We did this as a means to an end – we knew it would be valuable to have those restaurants on the platform. But we didn’t then, and still don’t believe now, that a company can generate significant profits on just the logistics component of the business. It is a commodity and there are significant variable costs that are hard to leverage even with technology and scale. Extremely large delivery/logistics companies can generate slim margins, but only because of the hub and spoke efficiencies they gain at substantial scale. The point-to-point nature of our business mostly eliminates that aspect of operating leverage.
This dynamic is unlikely to have changed and, if anything, Grubhub’s competitors have continued exploring ways to leverage the delivery network, with Uber (UBER) eyeing courier services for retail orders in New York and DoorDash (DOORD) opening delivery-only “ghost” kitchens in San Francisco and other markets.
3. All of the Profits Generated by Small to Medium Sized Restaurants in the Marketplace
Grubhub was clear in the shareholder letter that large restaurant chains are not driving profitability. It wrote:
That said, the biggest enterprise brands don’t need Grubhub to bring them new diners in the same way independents and small chains do because they spend billions a year on developing their own brands. What they need most is a driver to take the food to their diners. And, as we just noted, that isn’t cheap, or particularly scalable…
What is profitable is the marketplace business, and in particular, the marketplace business for small and medium sized restaurants. It wrote:
There is real economic value to a small-medium sized business that doesn’t have the expertise or resources to generate online demand for their stores. Bringing them millions of active diners matters a lot. Expertise in digital marketing matters a lot. Technological savvy and product optimization matters a lot. And all of this is incredibly scalable. This is a vast majority of our marketplace business – over 80% of our orders are generated by small-medium-sized businesses.
This is why our continual focus on partnerships with independents and small chains has been a successful strategy. And this is why Grubhub is fundamentally profitable and sustainable.
This dynamic is what has powered Grubhub’s profitability over the middle part of the decade – marketplace orders to small- and mid-sized restaurants that are either pick-up or self-delivered by the restaurant. Grubhub has benefited from this dynamic, particularly in New York City, which is dominated by small to mid-sized restaurants and is dense enough for diners to pick up orders themselves or restaurants to employ a staff to self-deliver. These characteristics are not present in any other market in the country, at least not to this degree. Grubhub may be used to the local diner in mid-town Manhattan with its own delivery crew, and surely makes a lot of profit off that customer, but that customer is unique to New York.
This is a large reason why Grubhub has been bested by competitors in most cities outside of its core Northeast markets, particularly more suburban cities and cities with a higher portion of national chain restaurants. In these markets only the pizza stores typically have delivery. By offering delivery, Uber Eats and DoorDash found a way into these markets, and they haven’t looked back since.
Here’s where we stand now in terms of market share in the major cities as of October 2019 (Source: CBNC):
As you can see, Grubhub has basically lost the leadership position outside of New York, Chicago, Philadelphia and Boston. And these markets are now likely very saturated and do not offer much growth potential.
This leaves Grubhub in a challenging position, which has not changed since the earnings announcement.
So What Has Changed to Trigger the 48% Rally?
So why the 48% rally, then, if the dynamics management outlined above haven’t changed? I have two theories.
The WeWork Effect
First, I think some investors hope that WeWork’s (WE) troubles have caused private companies generally to become more profit-focused. SoftBank (OTCPK:SFTBY) (OTCPK:SFTBF), a part owner of DoorDash, has reportedly urged its portfolio companies to focus on a path to profitability. The hope is that Uber Eats, DoorDash and Postmates (POSTM) will be pressured to reduce their losses by reducing customer incentives or raising prices.
While there may be some truth to this, I think it’s likely not the end of the story. DoorDash, Uber Eats and Postmates gained their market share positions in food delivery by being willing to invest and it seems unlikely that they would put the brakes on investment now and cede their gains. While some may retrench from certain markets where they are not well positioned, others may increase investment in markets that they see as strategic. This poses a particular risk for Grubhub as its New York market is by far its best and most profitable market, and it would be a devastating loss if Grubhub lost significant market share there. And we know that Uber obviously has a strong driver presence in New York and is exploring retail deliveries as well, and may invest in improving its food market share as well.
Industry Consolidation
Second, I think investors are looking ahead to inevitable M&A in the sector. In fact, consolidation has already begun as DoorDash acquired Square’s (SQ) Caviar in August. The idea here, and what I suspect has driven most of Grubhub’s rally, is the idea that Grubhub is a takeover target.
The theory seems logical. Grubhub’s market value is $4.4 billion, much smaller than Uber’s $51 billion market cap or the $12.6 billion valuation that DoorDash recently raised money at in May. Theoretically, Grubhub or Postmates, which last raised capital in September at a $2.4 billion valuation, could fairly easily be swallowed by Uber or DoorDash.
The problem is that Grubhub, despite its relatively low valuation, would be difficult for DoorDash to acquire because it is public. DoorDash would almost certainly need to use its stock to make an acquisition as large as Grubhub. That would lead to a shareholder vote by Grubhub shareholders to approve the acquisition. That has two problems. First, DoorDash is not public and issuing shares to all of Grubhub shareholders would require it to go public at the same time. Second, Grubhub’s shareholders would have little way of valuing DoorDash shares and the market would likely find the $12.6 billion valuation that DoorDash last raised at to be too high, requiring DoorDash to reduce its valuation. As a result, this deal is very unlikely.
That leaves Uber. While Uber is public, a potential acquisition by Uber raises other issues. Uber’s stock is down over 35% from its highs, and much more from its peak private valuations. That could cause Uber to hesitate to issue its stock to acquire Grubhub. Moreover, Grubhub already operates two brands, Grubhub and Seamless, so any deal would mean Uber Eats would be operating three food delivery brands nationwide. If Uber were to change branding on Grubhub and Seamless to Uber Eats, it would presumably lose significant brand value, particularly with Seamless in New York. Nevertheless, this deal is a possibility.
The other side of the coin is that there may be industry consolidation that does not involve Grubhub. This seems more likely in my opinion, particularly a deal between DoorDash and Postmates because both are private companies and would not require new valuations or public company shareholder votes. A combination of DoorDash and Postmates would instantly solidify top market positions in the Southern US markets and West Coast and provide a spring board for launching offensives in Chicago, Philadelphia and Boston. An Uber acquisition of Postmates could also make sense. The deal has a few things going for it: Postmates is likely a willing seller, the deal would be smaller than a Grubhub acquisition, and it wouldn’t require a public shareholder vote and would thus be much quicker.
Conclusion
Grubhub is losing market share and profitability as large and well-funded competitors Uber, DoorDash (over $2 billion raised to-date) and Postmates (over $900 million raised) reduce industry-wide profitability. Investors were faced with this reality after the third-quarter results, and the stock slumped 43%. Now investors have bid the stock up 48% from its lows on the hope of a take-out by an industry player. While industry consolidation is likely, GRUB’s status as a public company and DoorDash’s high valuation makes an acquisition by DoorDash very unlikely. The simplest deal would be a combination of DoorDash and Postmates, which would lead to substantial downside in Grubhub’s stock. As such, I am short the stock and expect the stock to give back its recent rally if Grubhub is not acquired.