DoorDash's Valuation Is Excessively Optimistic

Summary

• The food delivery provider operates in a fast growing, huge addressable market.
• Revenues have soared as a function of the shift in the way people eat.
• The competitive landscape is vicious and nobody is earning economic profits.
• The network effects DASH enjoys do not necessarily lead to economic profits.
• The business model leaves DASH at the risk of being overthrown by a new entrant or current rival, meaning valuations are excessively optimistic.

Local food delivery logistics firm, DoorDash (NYSE:DASH), filed an S-1 statement in preparation for its IPO. In this article, we discuss DASH's business model, competitive landscape, and the network effects it enjoys. Ultimately, the business lacks, as we shall see, the conditions to earn economic profits within a reasonable period of time.

DASH Does Not Have a Moat

The business operates a two-sided market in which customers on the one hand and brick-and-mortar food businesses, mostly restaurants at this stage, use DASH's economic platform. As is typical with two-sided markets, merchants and customers experience network effects which the company hopes will result in economies of scale and significant barriers to entry.

Three core attributes drive value of network effects in digital platforms. Firstly, the threshold that has to be achieved in market share to break-even. Secondly, the quality of customer experience (CX) and the stickiness of the relationships created through the network. Lastly, how far the data generated by the networks helps service providers optimize products and pricing.

DASH customers enjoy faster delivery times as logistics nodes become denser with the addition of marginal merchants; merchants gain more data-centric insights and grow their market opportunity as marginal customers are added to the network. Merchants join the company's Marketplace, paying a fee, and take advantage of its services in order to reach more customers within their locale. Customers pay a delivery fee for orders, plus a separate fee, and any tip they leave. DASH also operates a membership program, DashPass whose goal is to increase customer loyalty and increase switching costs.

The success of Facebook's (FB) social network and Microsoft's (MSFT) operating system has led investors to take on faith the notion that the momentum driven flywheel of network-effects businesses leads to economies of scale and formidable barriers to entry, which in turn make the network more valuable. Yet, research shows that not all platform businesses exhibit network effects and those that do do not all enjoy winner-take-all benefits. There are many arenas that are highly competitive and where it is hard to see if any business will ever enjoy economic earnings.

The financial viability of DASH is partly a reflection of local node density -merchants on the one hand and prospective customers on the other-. Other than price, the ability to deliver food fast is the predominant consideration in the business. Product/service complexity is not great. There is a limit to how useful fast delivery times can be, as opposed to local listing on a platform like Airbnb. There is no point, to take an extreme example, of delivering food the moment the customer hangs up, because the customer simply cannot get to the door that fast.

The business is mostly a variable cost business, and the fixed costs tend to be localized. In other words, it does not matter to a user in Brooklyn how fast delivery times are in Chicago because the user is ordering from a local distribution network not a national one. Consequently, the fixed costs necessary to establish a rival within any given city are manageable and the total fixed costs of the network of local distribution networks are not a significant barrier to entry. There may be cities where only one food delivery platform can be sustained, but in the big cities, that is not the case and a competitor may be viable at a lower threshold in terms of market share. This is reflected in the many competitors that exist within the market, though DASH has, over the last 2 years, taken up half the market.

DASH's rapid ascent is taken as an indication of the robustness of the business. It should, however, demonstrate the absence of competitive advantages in the market. Switching costs are too insignificant to create durable relationships with customers. Customer captivity is very low and so market share can change very quickly. In an industry where share movements are small because of customer loyalty, a new entrant has to factor in a long period of deep losses while trying to win the market. DASH's competitors are a click away and so, customer loyalty is extremely difficult to achieve in the long term. Difficult, but not impossible, and yet the difficulty imposes a burden to spend heavily to subsidize customer purchases through DashPass, which gives unlimited deliveries for a month for a $9.99 subscription, and other loyalty and customer experience programs. And there is nothing preventing merchants from using two or more platforms.

Finally, the data that DASH can deliver to its merchants is an important element of their outreach. The data, however, is data whose insights are obtainable by any number of firms, including Uber (UBER), who enjoyed market leadership and one assumes gathered a lot of data about their customers. DASH is not necessarily gathering data which is not available to its rivals or tech firms in general and so is not the barrier to entry it seems and does not necessarily prevent UBER from retaking market leadership, or GRUB for that matter making a come-from-behind play for leadership.

A Huge, Fast-Growing Market

The food-delivery-as-a-service market has exploded over the last few years. The decline of cooking-from-home, and the rise of the convenience economy -a rise that the COVID-19 lockdowns has only furthered- has created a market with a potential for stratospheric economic profits. In 2019 alone, Americans spent $1.9 trillion on food and beverages, with $600.5 billion of that representing expenditure on restaurants. To put this into perspective, global GDP in 2019 was $87 trillion. Off-premise food consumption has grown from 44% of food and beverage spend to 50%, or $302.6 billion, in 2019, indicating a growth in the food-delivery market opportunity. In 2019, DASH's Marketplace GOV had only captured $8 billion of that $302.6 billion spend. 58% of all adults and 70% of millennials in 2019 reported that they are more likely to eat off-premise than on-premise.

The size of the market has attracted billions of dollars in VC money as investors bet on food delivery becoming a vital aspect of how we eat. Success has not been easy to come by and many of the early entrants have gone out of business or been sold. DASH has grown aggressively to take advantage of this huge market opportunity, growing market share from 17% in 2018 to 50% in October 2020.

Revenue has grown from $291 million in 2018 to $1.916 billion for the first 9 months of 2020 ended 30 September, giving a CAGR of 98.44%. To put this into perspective, if DASH's CAGR remains above 45% for the 2018-2020 period, its revenue growth will be comparable to only 2.5% of firms across the world who have attained 3-year CAGR rates above 45%. This is a company growing at the limit of what is possible.

Nobody is Earning Economic Profits

It's clear we are talking about a huge market and, in accordance with capital cycle theory, the stratospheric market opportunity on offer has attracted not only DASH but Uber (through its UberEats subsidiary), Postmates (acquired by Uber), Grubhub and other players. The trouble with competition is that it forces everyone to spend to defend and grow, and, this is often overlooked, it allows merchants to get better deals and shop around. There is nothing preventing a merchant from using DASH alongside other platforms and I am not convinced the switching costs are a significant barrier. Competition has resulted in an arena in which consumers may benefit from food-delivery services but economic profits simply are not accruing to the rival platforms.

DASH's losses are deep and largely the norm in the food-delivery business, as the chart below demonstrates.

DASH's NOPAT margin has remained steady at -31% from 2019 to the TTM period.

DASH's capital efficiency has remained the same with invested capital at 0.84 from 2019 to date. GRUB improved its capital efficiency while UBER's fell. Flat and negative NOPAT margins and invested capital turns have led to flat and negative returns on invested capital (ROIC) of -56.7% from 2019 to the TTM period.

Profitability has taken a huge hit. Economic earnings have fallen off a cliff, going from -$258.87 in 2018 to -$667.03 in the TTM period.

The company burns through its free cash flow (FCF), and that will not be changing any time soon. There is an idea that DASH is purely a digital platform, but this ignores the physical infrastructure and technologies that it has to invest in to develop its distribution. Not only is free cash flow used to fund customer acquisition, it has invested in its physical infrastructure, autonomous vehicles and drone delivery technologies. The costs of these investments are huge and have barely begun. The company is still in attack-mode so there should be no illusions about the investments that DASH will have to make, especially given that its vision is much broader than food delivery. These investments will create the future that DASH needs for its business model and company vision to be viable.

In the last two years, the company has burned through $2.8 billion in FCF, which is about 10% of its enterprise value (estimated at $28 billion) and this is only going to rise.

Conclusion

With a price-to-economic-book-value (PEBV) of -0.7, DASH is very unattractively priced. The pricing implies a competitive advantage period (CAP) of 100 years with revenue growing at 5.2%. Given the questions raised about its competitive landscape and business model, I think the business does not have the conditions to thrive and its position is not unbreachable. Nevertheless, given the mania for tech stocks, DASH's price is likely to take off in the near term.

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.