► This is a story of 'profitless prosperity'...
The term refers to when a company achieves incredible growth and high absolute sales levels, but without making a dime. Profitless prosperity companies rack up leading market shares in businesses in which they – and their primary competitors – register no profits and generally have no history of making any profits. Investors nevertheless assign big valuations to these companies in the hope that profits are just a few quarters – or maybe a few years – away.
In fairness, few businesses are profitable when they are initially founded, and plenty of successful companies have generated years of red ink before they finally flipped meaningfully and sustainably into the black.
But the tolerance for – and the valuations assigned to – such speculative, currently unprofitable companies has definitely expanded in recent years. As I explained in the April 5 Empire Financial Daily, the extraordinary financial performance of Internet giant Amazon (AMZN) and electric-vehicle leader Tesla (TSLA) has certainly gone a long way toward achieving the semi-impossible... making investors more patient.
There are a lot of reasons for a company to make losses before it flips into a profit-making position. Sometimes there are big upfront costs to getting production online. Other times, investments are necessary to build a brand, acquire customers, and educate prospective buyers about the features and benefits of an unfamiliar product or service.
In other words, businesses often have huge, fixed costs to get started – like building a plant. Or perhaps the investment is softer – for instance, the business requires a ton of advertising. But either way, the dream is that investments pay off and a company grows and eventually hits an inflection point, in which these costs are leveraged over a big enough revenue base that profits begin to flow.
Food-delivery services like DoorDash (DASH) and Grubhub acquirer/parent Just Eat Takeaway (GRUB) are the perfect examples of profitless prosperity...
These companies – along with rival Uber Eats, whose ride-hailing app parent Uber (UBER) I have said before is the ultimate example of profitless prosperity with its nearly $100 billion market cap and negative earnings – offer both stellar topline growth and negative net income.
It's not hard to understand why hope springs eternal for these companies eventually being profit winners... Their topline growth is breathtaking. In the first quarter, total orders grew 219% at DoorDash, leading to revenue growth of 198%. Uber Eats put up similarly eye-popping 230% sales growth in the first quarter.
But profits have remained elusive, even as demand for food-delivery services exploded during the pandemic. While DoorDash reports a healthy gross margin of around 50%, that's because the company only reports net revenues that equal about 12% of the gross revenues that customers pay for their meals. The money that DoorDash collects on behalf of a restaurant and turns over to it never hits its income statement.
A 50% gross margin is healthy, but because so much of the revenue that passes through DoorDash never hits its financial statements, the economic reality of the business is much tougher. But looking at the business from the perspective of a typical order illustrates how difficult the food-delivery business really is, and how razor-thin the margins actually are.
The delivery apps make money two ways – by charging restaurants a fee equal to a percentage of the order's value and by charging a service fee to customers ordering food. Despite these two revenue streams, a recent analysis by Deutsche Bank (DB) calculates that after all expenses, DoorDash only registers profits equal to 2.5% of the customer's total bill. Put another way, the average $36 order only generates about $0.90 in pre-tax profits for DoorDash.
The Wall Street Journal broke down where the money goes on your DoorDash order into a graphic that highlights just how tough this business is. Take a look...
Source: Wall Street Journal
As the Journal sums it up...
The math isn't pretty, but it's the best in the industry. While DoorDash hasn't posted an annual profit in its eight years of operation, it slipped out of the red for one quarter last year, becoming the only food-delivery company in the U.S. to do so during the health crisis.
Analysts don't expect the companies to turn profitable for at least a few more years. For now, they say, they're looking for the industry to prove that it can continue to grow and improve profit margins, even as diners return to restaurants.
Even the people running these companies admit how tough the business is... The Journal cites DoorDash COO Christopher Payne as saying, "This is a cost-intensive business that is low-margin and scale driven – that is absolutely correct."
And he's not the only one admitting the challenges ahead. Back in 2019, Grubhub co-founder and CEO Matt Maloney watched his stock tank almost 50% in a day when he issued a third-quarter investor letter that laid out with painstaking and rarely seen honesty how difficult the road to profitability would be...
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 growth.
Grubhub had actually started out as more of a pure marketplace model – like an eBay (EBAY) or Etsy (ETSY) – when it first came to the market. Its business focused on matching up consumers looking to order a delivered meal with restaurants who maintained their own delivery workforce. When an order was made on the site, the company got a finder's fee for making the match and handling payment... but it never actually laid hands on a bag of food.
The old pre-Takeaway Grubhub was actually profitable, with positive earnings per share ("EPS") of $0.31 in 2014, the year it went public. Its EPS would peak at $1.66 in 2018, before dropping more than 50% in 2019 – the year of the bombshell investor letter – and then going negative in 2020, before getting acquired earlier this year.
What turned Grubhub into a loss-maker was the growth of its delivery services. Being a marketplace that brought together restaurants and hungry at-home diners was profitable... but delivering the bags to a customer's door with a fleet of gig workers was not. Then, on top of that, competition in delivery services exploded in recent years, from giants like DoorDash, Uber Eats, and Postmates, as well as smaller, local startups.
Will these delivery app companies ever make money?
In their favor, the industry has seen a lot of consolidation – reducing the number of players and therefore the number of promotions that cut into profits. As a result, DoorDash and Uber Eats now control over 85% of U.S. food-delivery sales, according to data firm Edison Trends. As market power is concentrated, the need to promote and discount is going away... and consumers are paying more for delivery services (something that a reader recently wrote in about, and I experienced myself).
But ultimately, it will be a matter of scale. Can they get more people ordering, or can they get the people ordering to increase the amount they spend on each order? Looking at this part of the Journal graphic, you can see the two biggest pieces of the cost structure are "Advertising" and "Other costs," which are presumably general overhead ranging from IT to HR to finance...
Source: Wall Street Journal
Only 6% of the U.S. population uses DoorDash, the largest of the delivery services... which implies that it is still early days for exploiting the market and the opportunity to grow remains large.
Presumably, DoorDash could process twice as many orders, and the total amount spent on advertising and other costs wouldn't change that much. If theoretically the amount spent on advertising and other costs only went up 25% if orders doubled, then these costs per order would drop from the current $2.91 to just $1.82 per order... and profit per order would jump over 100% from the current $0.90 to $1.99, assuming everything else (refunds, promotions, order size, and fee percentages) stayed equal. This is how operating leverage works, and it's what DoorDash and Uber Eats bulls are waiting for.
According to the Journal, these companies are looking for ways to increase revenue by increasing average order size, and not just the number of orders...
Executives at DoorDash and Uber have spent the past year testing what they hope will be the secret sauce. They want to raise customers' average order size by expanding into more lucrative offerings like groceries and alcohol; bundle nonperishable goods with food to drive down delivery costs; and use technology to reduce errors by restaurants and drivers, translating into fewer refunds.
Bears on the food-delivery space would counter that if you couldn't get the number of orders or average order size necessary for profits during a global pandemic, then when will you get these things?
The end of the pandemic poses headwinds to maintaining order growth, both obvious – people are back to dining out – and less obvious... On June 24, New York state ended an emergency order that allowed restaurants and bars to sell pre-mixed cocktails through delivery services, something that was a boon to order size in the lucrative New York City delivery market since it went into effect last March.
Another risk looming large: regulation. According to the Journal...
More than 70 U.S. municipalities or states, seeking to help local businesses, temporarily capped what apps could charge restaurants last year during the pandemic, according to the Protect Our Restaurants advocacy group. Major cities are considering making those changes permanent, a move that would squeeze apps' already slim margins.
But the food-delivery apps may yet find scale through providing delivery services for third-party businesses. Retailers like Walmart (WMT) and Macy's (M) have turned to DoorDash for last mile delivery services from their stores. This is a potentially massive business... and source of scale to leverage those advertising and overhead costs.
Since the December initial public offering ('IPO'), DASH shares have been a volatile ride...
If you were lucky enough to get IPO shares at $102, you've been in the money the whole time. But for everyone else, timing has been everything given the roller coaster path...
I'm a believer that DoorDash will eventually find its way to scale... and at least some profits, now that the number of players in the U.S. has been rationalized sufficiently. That said, the stock is too pricey for me here, with an enterprise value ("EV") that's 13 times 2021 estimated sales and 275 times 2021 estimated earnings before interest, taxes, depreciation, and amortization ("EBITDA").
Even as a believer in the long-term potential, DoorDash will likely run into some tough comparisons soon with the pandemic quarters. While this is to be expected, these are big multiples to pay for decelerating growth... so I'm on the sidelines waiting for a better entry into DASH shares.
In the mailbag, thoughts Uber, Amazon's Prime Day, and Netflix's (NFLX) move into consumer products...
Do you think these delivery apps will ever make money? With only 6% of people having used DoorDash, do you think there's a long runway of potential customers they have yet to recruit... or is this just a service primarily for wealthy people who live in cities or dense suburbs? If you use these apps, will rising fees and reduced promotions make you more likely to go pick up your own takeout food? Share your thoughts in an e-mail to [email protected].
"Here's a slightly different perspective. I occasionally drive for Uber as a hobby. Last week I was offered a promotion: Drive three riders and get a $120 bonus. I was on the app for almost exactly 100 minutes, I earned $51.99 for the rides and, with the bonus, pocketed $172. The only other time I've driven since the beginning of the pandemic was in April, when I received a $100 bonus for one ride. Perhaps you can figure out the economics of this from the company's point of view." – Bill C.
Berna comment: No wonder prices are going up for Uber rides! But even surge pricing won't cover that $100 driver bonus for one ride. Thanks for writing in and sharing your experience, Bill.
"My adult daughter shopped for a new Samsung tablet for her 8-year-old daughter. She found Target (TGT) was significantly cheaper than Amazon and picked it up at the store nearby." – Bill D.
Berna comment: Interesting anecdote, Bill... and I'm relieved that I am not the only one with an eight-year-old who is asking for updated technology!
"I want to go on the Orange is the New Black ride! Woohoo!!" – Mike S.
Berna comment: Me too, Mike... I'm glad someone found my absurd suggestion amusing!
Regards,
Berna Barshay
July 6, 2021
