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Grubhub: Unrealistic Forward Guidance

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About: Grubhub Inc. (GRUB)
by: Sunny Research
Summary

GrubHub’s FY 2020 “guidance” does not factor in the required costs to compete effectively with peers.

GrubHub has no choice but to shell out these costs, given its 3-sided platform model.

Expect FY 2020 EPS to be deep in the red, versus consensus EPS estimates of $0.29.

Background

Recently, GrubHub’s stock tanked on Q3’s revenue miss, and earnings guidance which was a widely categorized as “disastrous”. In a nutshell, management admitted to underestimating competitive pressures, and succumbed to increased “investment spending” to fend of rival’s encroachment into its market share. Specifically, we point out that management’s confidence of FY 2020’s adjusted EBITDA being “well in excess of $100m” as highly unrealistic, or wildly optimistic. In previous quarters’ earnings, management has repeatedly shown the tendency to underestimate competition and downplay headwinds to growth and profitability. We are calling them out for this once more. To use CEO Matt Maloney’s own words against him: “..we’re just trying to pop those fallacies when we see them”.

Higher price incentives to print more red ink than guided

To stop losing market share, GrubHub needs to at least “match” the magnitude of price incentives shelled out by its rivals. According to data from Second Measure, GrubHub’s market share in September 2019 further declined to 30%, despite management ramping up marketing spend by $20+m per quarter since the 4th quarter of 2018. In GrubHub’s Q3 Q&A segment, its CEO mentioned: “..with all the major players expanded across the whole U.S., delivery coverage has now been commoditized. we all have roughly the same algorithm, same driver interactions, the same ETAs.. and now with non-partnered restaurant inventory becoming more prevalent, supply side is soon to be commoditized as well.”. This is an indirect admission to the validity of the bearish argument presented by those bearish on food delivery, where price competition has become the primary (if not only) value differential to platform participants, given that the current state of product differentiation between the players is next to nothing.

An analysis of price incentives provided by GrubHub and Uber Eats shows a yawning gap in magnitude of spending between the two. We used Uber Eats as an industry proxy as it is a major competitor with publicly disclosed data. Using Q3 data, GrubHub’s reported all-in take rate is 23%, vs. a “no-discount” steady-state take-rate of 27% as illustrated in the company’s delivery economics. As GrubHub presents revenues post discounts, it gave up 4% of take-rate to price incentives, translating into about $56m for the quarter.

(Source: Sunny Research, with inputs from company’s public disclosures)

On Uber Eats’s side, we computed an estimate of $123m in price incentives for the quarter. Uber Eats reports price discounts within COGS and S&M, so we backed out the amount after deducting core expense buckets as follows:

(Source: Sunny Research, with inputs from company’s public disclosures. Core COGS and Core S&M are excluding price discounting, deduced from company’s 10-Q)

Note that GrubHub’s $56m is apportioned to a market share of 30%, while Uber Eats’s $123m was apportioned to 20% of market share. As a result of the spending, Uber Eats managed to maintain market share throughout the quarter, while GrubHub lost 300bps of market share. If we view Uber Eats’s spending proportion as the minimum required to maintain market share in this increasingly competitive industry, then GrubHub’s spend is grossly insufficient. At a high level, grossing up Uber’s spend to a market share of 30% would yield $185m, suggesting that GrubHub’s spending shortfall is about $129m. Since price discounts have become the only value differential for participants to engage in a particular food delivery platform, it is no wonder that GrubHub is losing market share at a rapid clip. This is not surprising, given its CEO’s condemnation and unwillingness to engage in price discounting.

Given the above calculations, we see no path towards management’s expectations of “at least $100m in adjusted EBITDA in 2020”. Also outlined in the Q3 shareholder letter is GrubHub CEO’s industry assessment that “..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.” To keep up with the industry’s 10+% to 20+% in revenue growth (i.e. maintain market share) will require a c.$0.5bn run-rate ($129m per quarter calculated above) of additional spend, a calculation that will yield nothing remotely close to the guided $100m in adjusted EBITDA. In fact, we think that GrubHub is likely to be deep in the red for 2020.

Between a rock and a hard place

The table stakes are high, and GrubHub has little choice but to spend. As famous short-seller Jim Chanos mentioned in a recent CNBC interview, competing with Uber (and deep-pocketed rivals) is like “being locked in a cage with a psychopath with an ax”. As GrubHub’s platform model and accompanying premium growth valuation relies entirely on the premise of achieving exponential growth via network effects, it has to choose network growth every time, even if it means deep losses. This is why we see many platform businesses spend aggressively, especially in their early years. Growth precedes profitability for the platform business, and is even more so for nascent industries like food delivery where user penetration in the U.S. is only at 29% of total addressable market. This is the classic case of prisoner’s dilemma, in what is increasingly looking like winner-takes-all market, as poor industry economics disallow for smaller players to exist. As such, GrubHub is constrained by its business model to spend for growth or approach a scenario where shareholder value is wiped out from the inability to scale its network effects.

What will Softbank do?

A rationalization of the competitive environment may present a risk to this thesis. Softbank’s recent WeWork fiasco has attracted much investor scrutiny, which was exacerbated by its large losses at Uber as well. As a result, Softbank has pledged to push portfolio companies to shore up profitability, which marks a shift from its previous “growth-at-all-costs” strategy. Its garguantan Vision Fund is a backer of both Uber Eats and DoorDash, which combine for a whopping 58% market share in the U.S. food delivery market (post DoorDash’s acquisition of Caviar). As both Uber Eats and DoorDash both won market share by luring platform participants with substantial price incentives, we think a strategic reversal at the top might send ripples across the competitive landscape. While we have not heard any industry updates that competitive pressures are toning down, we do not exclude the possibility of a slightly more rationalized environment in the coming quarters. However, as discussed above, we still stand by the fact that the food delivery platform model requires significant capital to scale, and scaling is an absolute necessity to drive network effects and shareholder value in the early stages.

We also see another scenario this could be a positive catalyst to our thesis, which is if a potential merger of rivals happen. We have known for Softbank to push for consolidation between its portfolio companies to eliminate price competition between them, with examples of the cases being Uber and Grab in South East Asia, and Uber and Didi in China. In this scenario, scale and stronger network effects could be achieved by a potential operational consolidation of DoorDash and Uber Eats’s U.S. business, which will result in resource consolidation and more competitive pressures against a smaller GrubHub.

Impact on share price

We think that going deeper into the red will further push back the timeline to profitability, and increase the uncertainty of its eventual profitability. According to earnings consensus, it seems that the market is yet to be prepared for this. FY 2020 EPS estimates are still sitting at $0.29, a week after we saw a surge of downgrades and EPS revisions from the sell-side. As per our calculations above, we are expecting an already negative adjusted EBITDA, which translates into an even more negative EPS. Share prices should react negatively to more downside earnings surprises.

Takeaway

GrubHub has grossly underestimated costs required to effectively compete with rivals. Management continues to downplay the headwinds to growth and profitability. Investors should be mindful of the potential for more heavy losses to come.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.