GrubHub: A Proper Valuation

| About: GrubHub Inc. (GRUB)

Summary

GRUB looks highly overvalued on TTM metrics, but this is likely not the correct way to evaluate the stock.

A better method involves the long-term growth potential and profitability measures the company can realize.

Based on what it can achieve within a few years, GrubHub looks quite inexpensive.

Investors are also provided substantial margin of safety from the fact that GRUB is already profitable in key markets, which limits downside.

Introduction

Most value investors suffer from 'sticker-shock' when they see a fast-growing internet company like GrubHub (NYSE:GRUB). They see the very high multiples and immediately pass over the company. In fact, many notable value investors have come out and claimed that the so-called FANG stocks are overvalued, and that tech is in a major bubble. They are reminded of the excesses of the dot-com bubble and at first glance, many of the similarities are certainly present. The high multiples, low profits, and excessive optimism are there in part. Yet, the analogy is really only applicable in certain cases, and one has to be careful not to generalize. In fact, it is entirely irrelevant in many cases.

Some of today's internet companies have proven business models, benefit from strong network effects, and can achieve dramatic scale at no incremental capital investment. Many of these companies appear overvalued based on traditional metrics, because they are spending heavily to expand their competitive moats. So, while the TTM numbers are not inspiring, using them exclusively is NOT the right way to value a company like this.

The correct way, in my view, involves a multi-step process. First, one should start by understanding the business model, seeing if there are barriers to entry, and determining if they can be maintained. Then, one has to look further out and determine what the earnings will be several years in the future. GrubHub is a textbook example of this. While it looks expensive now, I believe it has key advantages that will allow it to scale and dramatically increase its profitability several years in the future.

Based on that view, I think GrubHub is quite undervalued. GRUB generates revenues by charging a take rate on orders facilitated through its orders. Profitability is currently depressed because the company is spending aggressively on marketing efforts, R&D, and other growth initiatives. Yet, this is actually a very high-margin business once the business scales (and scale does not require heavy capital investment). In this article, I will walk through how to think about the company's competitive advantages, its market opportunity, and what its margins and take rate can potentially be. Once these levels are realized, I believe GRUB will be worth substantially more than its current market price.

Discussion of Barriers to Entry

At first glance, barriers to entry appear to be minimal. There are no substantial regulatory restrictions. No substantial capital is required, as the service is delivered through a website and mobile application (which require relatively little capital to build and maintain). A first mover advantage also does not appear to be particularly meaningful. GrubHub's service completely dominates those of some competitors, such as Delivery.com or Foodler, in terms of unique visitors and views per visitor. These were both founded the same year as GrubHub, in 2004. Meanwhile, Eat24, a competitor acquired by Yelp (NYSE:YELP), has gained the second largest market share, despite being founded in 2007.

However, there is one key barrier to entry: scale. Scale is the primary obstacle preventing new entrants in this fast growing and highly profitable space. In order for the platform's value proposition to be worthwhile, it needs to be sufficiently large enough to offer users a good selection to order food from. This is only possible through sufficient scale. For the customer, there is a very simple reason to belong to a restaurant aggregation platform, as it can only serve to increase order flow. Moreover, it also allows restaurants free advertising, so the benefits of listing on a platform far outweigh any costs (which are none at the moment; the company transfers restaurant information to its platform on its own).

In the future, if online ordering becomes increasingly ubiquitous, the larger companies will be able to demand additional benefits from restaurants, in the form of higher fees or exclusivity (i.e., a restaurant that lists on GrubHub may only list there). Naturally, this is another case in favor of achieving scale. One might make the counter-argument that if GrubHub's commissions become egregiously high, restaurants will switch to alternative platforms or abandon them altogether.

This is unlikely, simply because GrubHub and comparable services provide independent restaurants too much exposure. In an NPR report on the matter, a number of small NYC restaurant owners discussed how they were willing to tolerate commission increases because GrubHub gave them business that would otherwise have been unattainable. One café owner talks about receiving orders from the building of prominent Wall Street firms, located in buildings where he would never have been able to slip in a menu and get orders.

With regards to scale, the company's service is substantially larger than those of its competitors. With nearly triple the site visitors and views, and nearly nine times the 2014 revenue of its second largest competitor, Eat24, GrubHub is the dominant firm in this space. Since Yelp does not break down revenues by segment, I am presenting 2014 revenue, which was calculated based on Yelp's acquisition price of Eat24.

A virtuous cycle exists in this industry: the companies that achieve scale realize the largest revenues, which result in more funds for marketing and website development, which result in greater monetization, which results in larger revenues, and so on. All the while, user habits are becoming 'stickier', and users have no incentive to switch to a competing platform. As such, it becomes difficult for subscale firms to compete with the largest scale one. It also ensures a more stable business model, with revenues being recurring in nature.

Additionally, the spending that GrubHub devotes to the marketing side will also not be recurring in nature. Once customers are created and a market matures, the company can lessen its efforts there and focus on other areas. Consequently, this also leads to substantial operating leverage. In many ways, this contributes to a 'winner-take-all' dynamic is somewhat reminiscent of social media and search, which are all dominated by one firm [Facebook (NASDAQ:FB), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), respectively]. Therefore, barriers to entry are in fact substantial.

Last-Mile Delivery

GrubHub is expanding its economic scope to include a delivery service. As part of this offering, the company aims to actually deliver food to diners (so-called "last-mile delivery"), in addition to serving as the platform for connecting diners and restaurants. This particular space is less concentrated, and GrubHub has no particular dominance here. However, the implementation of a delivery service could help GrubHub penetrate other markets and could actually prove complementary to its existing business. For instance, the company could expand its website to incorporate orders from merchants that typically do not deliver (grocery stores, liquor stores, etc.), and use its last-mile delivery service for the physical delivery.

The company's management views this line of business as a necessary complement to help grow the existing service. In last-mile delivery, the company faces intense competition. These competitors, in addition to local firms, include Postmates, Delivery Dudes, DoorDash, OrderUp [acquired by Groupon (NASDAQ:GRPN)], and Caviar. Postmates's delivery services expand beyond food and total deliveries have surpassed 2 million, and it has signed deals with Chipotle (NYSE:CMG) and McDonald's (NYSE:MCD).

The delivery service industry has notably seen the entrance of Amazon (NASDAQ:AMZN) and Uber (Private:UBER) into the space. Uber launched its UberEats service in 2014, and Amazon launched its own service, Amazon Fresh, in the same year. Currently, Amazon only operates in Seattle, and Uber in several cities - Chicago, Los Angeles, New York, Toronto, and Barcelona. While the increased competition for GrubHub is alarming, one must take into consideration the fact that delivery is a very local business and there are no obvious economies of scale. So, the entrance of very large competitors is not as negative as it might appear.

It is difficult at this stage to determine the competitive landscape of delivery in the future. However, it is clear that GrubHub's core service of facilitating orders (where it is the indisputable leader) will not be severely impacted, especially because it is detached from the actual last-mile delivery. A user on grubhub.com will most likely have his/her order facilitated by the restaurant's own service (restaurants that list on GrubHub already have an in-house delivery service to begin with). As such, the fact that the user will remain on GrubHub's platform is the key issue, not which firm will serve as the agent of delivery.

In this context, it would be better to think of UberEats and others as couriers. Moreover, for something like Uber, last-mile delivery is a non-core area. It is difficult to imagine Uber spending considerable resource building an order-facilitation website with as much depth as grubhub.com. The fact that its presence is limited to six cities alone is a testament to this. So, it is reasonably clear that the virtuous cycle GrubHub enjoys in its website business should not be heavily influenced by entrants to last-mile delivery. In fact, the proliferation of these companies might be a net-positive for GRUB.

With an increasing number of companies committed to last-mile, the overall TAM for GrubHub could certainly expand. Restaurants that did not previously deliver might begin to use third-party groups (such as Uber) for delivery, while companies such as GrubHub and Eat24 facilitate their orders. That said, however, a prospective GRUB investor should be worried about management destroying value by pursuing last-mile delivery even if competition intensifies. We will have to wait and see how this unfolds.

For additional reading on why Uber's dominance of food delivery is not so certain, refer to this article.

Market Opportunity

GRUB's size in relation to its TAM is very small. According to EuroMonitor International, the independent restaurant takeout/delivery market is roughly $70 billion, with only 5% of orders placed over the Internet in 2014. The other 95% of orders are still placed through traditional channels such as phone or in-person. GrubHub handled $2.4 billion in gross sales in 2015, giving the company a mere 3.4% penetration.

This is GrubHub's long-term opportunity. In fact, the combination of economic growth and the proliferation of the aforementioned delivery startups should allow this market to grow at GDP rates at the very minimum. Given the value provided to the diner with respect to reduced friction in ordering, the $70 billion takeout/delivery market should continue to transition online. To evaluate GrubHub's ability to drive further online penetration, one can look at a number of relevant examples.

OpenTable serves as a useful comparison. It is a company that allows diners to make reservations electronically and serves as a useful comparison. It is similar to GrubHub in that it is improving restaurant functionality and offering both customers and users a compelling value proposition. Restaurant reservation was once a purely offline activity, as with delivery.

However, OpenTable's strong market share growth has shown that the shift to online, as it concerns dining, is a secular one. OpenTable helps seat 39-40% of reservation-taking restaurants in the US (See graph below). Over a longer-term horizon, one might expect an average 40% penetration across the US (with dense urban areas having higher than average, and rural areas below) for GrubHub as well.

Source: Barclays

In San Francisco, OpenTable has even stronger market share, seating 52% of all reservation-taking restaurants (see below). This reflects GrubHub's potential opportunity in urban areas with high population density. The national pizza chains are a helpful precedent case for the online shift of takeout ordering, with roughly 45-50% online penetration for the largest chains like Domino's (NYSE:DPZ) and Papa John's (NASDAQ:PZZA) today.

It seems evident that when online functionality is available, customers will generally opt to use it. So, the main challenge for GrubHub is not to create demand for a service, as other companies relying on network effects (particularly the social media companies) have had to do. There is ample evidence that users will naturally shift to online if possible.

Source: Susquehanna

Take Rate

In 2015, GrubHub's realized take rate was approximately 15%. This trend has been steadily upwards, due to a number of initiatives undertaken by the company. In April 2014, GrubHub launched Auction Sort as the default sort algorithm on Seamless, giving restaurants the ability to bid competitively for higher prioritization in the sort order. While Auction Sort has been the default algorithm on the GrubHub site for some time, Seamless historically sorted search results alphabetically. In this alphabetical sort model, pricing was fixed according to transaction volume, where restaurants received a discount depending on the size of their gross sales on GrubHub.

The auction-based sort algorithm incentivized restaurants to pay a higher take rate to Seamless. Consequently, GrubHub's take rate increased by 90bps to 14.4% in 4Q14 from 13.5% in 1Q14. Today of course, it is even higher, at 15%. Longer term, it would be sensible to assume GrubHub's take rate will gradually increase as Auction Sort continues to promote competitive bidding in core markets.

In the near term, however, take rate could remain flat in the 14-15% range as the company pushes into new markets. As with other companies (such as Netflix (NASDAQ:NFLX) and Amazon), GRUB would be wise to keep rates low until its competitive advantage is well established. For purposes of valuation, I assume a flat 15%, although recognize that it will likely increase over time.

Some have expressed concern that these take rates will be unsustainable. However, there is clear value accruing to restaurant owners as well. Orders generated on GrubHub are nearly 100% incremental for independent restaurants, as those takeout diners otherwise most likely would have ordered from other restaurants on GrubHub anyway. By accepting higher take rates, restaurants can drive incremental sales on the platform through higher placement in search results, despite a lower margin.

However, such a lower margin can be justified, as users that discover restaurants through the platform can potentially be converted into regular dine-in customers in the future (give the fact that these are most likely incremental customers). As this dynamic will change when GrubHub and its competitors become increasingly ubiquitous, there is certainly a ceiling for how high take rates can potentially go. Yet, I would like to say that the ceiling is most likely not 15% (although for the sake of conservatism, I use only 15%).

Margins

As stated previously, the company appears to be low-margin, but this is obscured due to its heavy spending on growth. To get a better sense of what its profitability can be, one must look to GRUB's international counterparts, Delivery Hero and JustEat, which have already achieved substantial scale. Seen below, JustEat already has 44% EBITDA margins in the UK. In Denmark, these margins are at 44%. Compare that to the consolidated margins of 24% and one realizes that the consolidated numbers do not reveal everything.

Looking at the margins in a geography where the company is already dominant will give a better insight into its terminal level of profitability. In the context of fast-growth internet companies, Netflix might represent a good model to consider. Netflix, too is already highly profitable in the US (and with considerable runway to increase prices, might become even more so), and is losing money to pursue growth internationally.

Similarly, GRUB is profitable in its core market of NYC, has scope to raise take rates later on, and is investing to grow in other areas. I believe this is a sound long-term strategy. As an aside, it is interesting to note that JustEat is profitable in a non-core market - it began in the UK but is already successful in Denmark.

Given that it was able to leverage its scale in the UK to succeed in a different market, I believe GRUB can do the same in the US. Critics of the company have claimed that the space is highly localized, but having a core-market as a cash cow to fund aggressive growth has been a clear recipe for success within tech.

Click to enlarge

A similar case can be made for Delivery Hero, which earns 57% EBITDA margins in its top two markets, the UK and Germany. Note that the fact that Delivery Hero has had success in other markets as well further reinforces the case that GRUB can succeed in the US. While Delivery Hero and JustEat must now compete with one another in Europe, GRUB is virtually unrivaled in the US (on the order facilitation front).

Also, I would add that the operating leverage that GrubHub will realize will likely be higher than can be seen here. The fact that Delivery Hero can earn 57% margins this early on in a smaller market means GrubHub should very comfortably drive 50% EBIT margins when it matures. Note that EBIT is very close to EBITDA, as CapEx is minimal (roughly $6 million in 2015).

Valuation

Putting in all together results in the following table. Looking at the company 10 years out, let's assume that the delivery market expands to $85B given an extremely conservative 2% CAGR. Further, let's assume that 39% of these orders are conducted online, and GRUB maintains its current 51% market share. It is highly likely that the company's scale advantages will result in greater share.

Moreover, it might be possible that more than 39% will order online, particularly in urban areas. Finally, with 15% take rates and 50% EBIT margins (again, highly conservative), the company will do roughly $1.27B in EBIT. You are buying the company today for 1.5X EBIT. If this unfolds over 10 years, and the company is valued at 12X EBIT, you make 8X your money for a roughly 23% IRR. To the extent that more of the company's success becomes discounted into the stock, the return potentials are even greater. Consider, for example, how much of the future growth in NFLX/FB/AMZN, etc. has already been discounted into the stock.

TAM ($M)

85,000

Online Penetration

39%

GRUB Market Share

51%

Take Rate

15%

EBIT Margin

50%

GRUB Pro-forma EBIT ($M)

1268.0

Click to enlarge

Of course, this is not to say that risks are not present in this investment. Given that this does rely on future growth assumptions that may not be met, one should be careful. However, I do want to stress that there is considerable margin of safety from the fact that GRUB is already profitable in its core markets. Even if it doesn't achieve these targets, it can easily pull back from its huge growth-related spending initiatives, raise take rates slightly, and become highly profitable.

Similar principles apply to a company like Netflix, which can easily stop spending on international growth, raise its prices by a few dollars, which would leave the stock at a reasonable valuation. I might write an article in the future about looking at GRUB on a steady state basis to further elaborate upon this discussion. Until then, I want to end how I started, which is by saying don't be overcome by sticker shock!

I am a student of value investing and Ben Graham, but in this case, it would be wise to follow a different approach. The TTM numbers are meaningless here. Consider how ridiculous Google appeared on TTM metrics when it IPO'ed initially. Investors could have bought GOOGL for 1X future P/E when the stock went public, and those who held on certainly made a fantastic investment. I believe a similar opportunity can be found in GRUB for a long-term investor who is willing to hold the stock through volatility over a multi-year time frame.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GRUB over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.