{"id":13283,"date":"2023-09-18T19:23:44","date_gmt":"2023-09-18T19:23:44","guid":{"rendered":"https:\/\/prosfunds.com\/markets\/likely-unsustainable-profits-and-an-expensive-valuation\/"},"modified":"2023-09-18T19:23:45","modified_gmt":"2023-09-18T19:23:45","slug":"likely-unsustainable-profits-and-an-expensive-valuation","status":"publish","type":"post","link":"https:\/\/prosfunds.com\/?p=13283","title":{"rendered":"Likely Unsustainable Profits And An Expensive Valuation"},"content":{"rendered":"<div>\n<p>Maplebear Inc., which operates as the better-known Instacart (CART), is expected to start trading September 19, 2023 at a ~$8.1 billion valuation. At $29\/share, the midpoint of its IPO price range, Instacart earns an unattractive Stock Rating and is this week\u2019s Danger Zone pick.<\/p>\n<p>While the latest valuation is certainly lower than the COVID-19 mania-induced ~$39 billion valuation it garnered in 2021, the expectations baked into the midpoint IPO price range remain overly optimistic.<\/p>\n<p>It\u2019s true, Instacart has built a profitable business. However, growth is slowing, competition is rising, and future profits look less likely. However, the stock\u2019s valuation implies the company will 9x profits and achieve revenue growth well above industry expectations. CART looks more than fully valued, and I think investors should pass on this IPO. Below, I\u2019ll use my reverse discounted cash flow (DCF) model to show how expensive the IPO is.<\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Looking to Kickstart \u201cDown-Round\u201d IPO Appetite<\/strong><\/h3>\n<p>Instacart soared in popularity during the COVID-19 pandemic as consumers increasingly turned to pickup and delivery of goods. During this time, Instacart was able to raise capital at a $39 billion valuation \u2013 a far cry from the expected midpoint IPO valuation of $7.5 billion.<\/p>\n<p><fbs-ad position=\"inread\" progressive=\"\" ad-id=\"article-0-inread\" aria-hidden=\"true\" role=\"presentation\"><\/fbs-ad><\/p>\n<p>The success (or lack thereof) of Instacart\u2019s IPO could be a telling sign for other venture capital-backed companies that are considering an IPO. If demand for Instacart stock is high, we could see a flood of VC-backed IPOs, albeit at considerably lower valuations than prior funding rounds. However, if Instacart flops, it could freeze an already slow IPO market. While Instacart is profitable, the expectations for future profit growth baked into its midpoint IPO valuation could scare off prudent investors.<\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Turning Profitable Just Before IPO<\/strong><\/h3>\n<p>Instacart\u2019s topline benefited greatly from the COVID-19 pandemic, with year-over-year (YoY) growth rates reaching 935% in 2Q20. While such stratospheric growth rates have subsided, the company successfully leveraged the leading market share it obtained to achieve profitability in 2022.<\/p>\n<p>Instacart\u2019s revenue grew 39% YoY in 2022 while its net operating profit after tax (NOPAT) improved from -$15 million in 2021 to positive $123 million in 2022. See Figure 1.<\/p>\n<p><strong>Figure 1: Instacart\u2019s Revenue &amp; NOPAT: 2021 \u2013 2022<\/strong><\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Instacart Took and Maintained Market Share<\/strong><\/h3>\n<p>After Instacart exploded in popularity during the COVID-19 pandemic, it has since successfully defended the market share it gained during that period. At the end of June 2023, of third-party platforms, Instacart holds:<\/p>\n<ul>\n<li>74% share of sales of orders greater than $75<\/li>\n<li>56% share of sales of orders less than $75<\/li>\n<\/ul>\n<p>Per Figure 2, Instacart\u2019s share of larger orders, those greater than $75, has been remarkably consistent since 2020, while its share of smaller orders has slowly increased.<\/p>\n<p><strong>Figure 2: Instacart Market Share by Order Size: January 2020 \u2013 June 2023<\/strong><\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>And the Company Scaled Efficiently<\/strong><\/h3>\n<p>Perhaps most impressive \u2013 and something that the majority of the overvalued IPOs of 2021 lacked \u2013 Instacart efficiently scaled its business during and after the rapid growth of 2020.<\/p>\n<p>In 2020, total expenses, which include cost of revenue, operations and support, R&amp;D, sales and marketing, and general and administrative, were 105% of revenue. In 2022, total expenses fell to 98% of revenue and just 82% of revenue in the first half of 2023. The biggest improvements come from:<\/p>\n<ul>\n<li>Cost of revenue: 40% to 25% of revenue from 2020 to 1H23<\/li>\n<li>Operations and support: 22% to 9% of revenue from 2020 to 1H23<\/li>\n<li>General and administrative: 19% to 9% of revenue from 2020 to 1H23<\/li>\n<\/ul>\n<p>The ability to grow the business while keeping costs under control drives Instacart\u2019s NOPAT margin from -1% in 2021 to 5% in 2022.<\/p>\n<p><strong>Figure 3: Instacart\u2019s Falling Expenses: 2022 \u2013 1H23<\/strong><\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Currently More Profitable than Peers and Customers<\/strong><\/h3>\n<p>Per Figure 4, Instacart has the highest NOPAT margin and return on invested capital (ROIC) amongst its competitors and partners. Not having the costly overhead of a traditional retailer and taking more of a middleman approach between the consumer and retailer has proven profitable, at least for now.<\/p>\n<p>Nevertheless, I\u2019m not confident in Instacart\u2019s ability to maintain leading margins and ROIC moving forward for reasons detailed below.<\/p>\n<p><strong>Figure 4: Instacart\u2019s Profitability Vs. Competition: TTM<\/strong><\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Future Looks Less Certain<\/strong><\/h3>\n<p>Despite the positives above, Instacart\u2019s future is not all roses:<\/p>\n<ul>\n<li>the COVID-19 induced growth is in the past<\/li>\n<li>competition is consolidating and better-resourced,<\/li>\n<li>Instacart\u2019s revenues remain highly concentrated, and<\/li>\n<li>its valuation already embeds very optimistic assumptions for future profit growth.<\/li>\n<\/ul>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Growth Is Slowing<\/strong><\/h3>\n<p>In the first half of 2023, GTV grew just 4% YoY while total orders grew less than 1% over the same time. Instacart expects much of the same moving forward, as it notes in its S-1:<\/p>\n<p><em>\u201cWe also expect GTV growth to be tempered across our existing and new customer cohorts over the near term.\u201d<\/em><\/p>\n<p>Instacart laid out specific reasons why growth would be \u201ctempered\u201d moving forward, such as:<\/p>\n<ul>\n<li>The subsiding effects of the COVID-19 pandemic on demand for online grocery<\/li>\n<li>including a return to pre-COVID grocery shopping behaviors,<\/li>\n<li>continuing macroeconomic uncertainty,<\/li>\n<li>the cessation of government stimulus,<\/li>\n<li>the declining effectiveness of historical growth initiatives as Instacart continues to scale, and<\/li>\n<li>the effects of initiatives to drive profitable growth.<\/li>\n<\/ul>\n<p>More specifically, these factors are expected to result in lower GTV and orders. They also lower average order value, which will further lower Instacart\u2019s revenue and margins.<\/p>\n<p>Instacart\u2019s revenue, gross transaction value (GTV), and total orders were once growing at triple digit YoY rates, but those days are now, clearly, behind us.<\/p>\n<p>Lastly, Instacart notes in its S-1 that the online grocery market is expected to grow at a compound annual growth rate of 10-18% from 2022 through 2025. Even the high end of that estimate would not be fast enough to justify Instacart\u2019s IPO valuation, as I\u2019ll show below.<\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Competition Is Plentiful<\/strong><\/h3>\n<p>I think it is hard for Instacart bulls to buy into the company\u2019s growth story continuing as it has in the past. As online grocery delivery rises in popularity, Instacart will find it tougher to maintain and take market share, as new competition floods into the industry. For instance, Instacart now faces competition from:<\/p>\n<p>Existing brick\/mortar and online grocery\/retailers<\/p>\n<ul>\n<li>Target (TGT)<\/li>\n<li>Walmart (WMT)<\/li>\n<li>Kroger (KR)<\/li>\n<li>Whole Foods\/Amazon (AMZN)<\/li>\n<\/ul>\n<p>Third party delivery platforms<\/p>\n<ul>\n<li>DoorDash (DASH)<\/li>\n<li>Shipt (owned by Target)<\/li>\n<li>Ubers Eats (UBER)<\/li>\n<li>Fresh Direct<\/li>\n<li>GoPuff<\/li>\n<li>DashMart (owned by DoorDash)<\/li>\n<li>Drizly \u2013 specialized in alcohol delivery (owned by Uber)<\/li>\n<\/ul>\n<p>Direct to consumer food delivery<\/p>\n<ul>\n<li>Blue Apron (APRN)<\/li>\n<li>HelloFresh<\/li>\n<li>HomeChef (owned by Kroger)<\/li>\n<\/ul>\n<p>Not only does the increased competition diminish pricing power, as competing services can choose to cut prices to take market share, but it creates low switching costs. Instacart warns in its S-1:<\/p>\n<p><em>\u201c\u2026 the cost to switch between providers of online grocery shopping is low for consumers, and consumers within various demographics have a propensity to shift to the lowest-cost or highest-quality provider and may use more than one delivery platform.\u201d<\/em><\/p>\n<p>In other words, its highly likely consumers will simply move to the lowest-cost provider, rather than stay loyal to any one service. Low switching costs also increases the cost to acquire and keep new customers, which would further lower Instacart\u2019s margins moving forward.<\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Partners Are Becoming Competitors<\/strong><\/h3>\n<p>As a third-party service, it\u2019s no secret that Instacart is heavily reliant upon its partners. Without grocery stores, there is no Instacart. Unfortunately for Instacart, its partners are quickly becoming competitors as they build out their own delivery services.<\/p>\n<p>For instance, Kroger and Walmart offer their own delivery service, along with a monthly subscription that provides free delivery as just one of many perks. Kroger uses temperature-controlled trucks and can even pack items directly at local fulfilment centers, thereby providing the highest quality food available. Target also offers same day delivery through Shipt, which it acquired in 2017. Whole Foods, owned by Amazon, provides very robust pickup and delivery services.<\/p>\n<p>I previously highlighted the problem with grocery store partners as competitors when I first put Beyond Meat (BYND) in the Danger Zone, and the same problems apply to Instacart. Each grocery store that offers its own delivery service is going to be much more likely to direct shoppers to use it, rather than a third-party platform.<\/p>\n<p>Additionally, grocery stores, such as Kroger, have data on all shoppers that use their loyalty program. This data can be leveraged to target consumers most likely to use delivery service or promote the service as an add-on to consumers\u2019 existing shopping experience. Instacart has some data, but it is for a much smaller subset of shoppers as it only includes consumers that have used its service.<\/p>\n<p>The bottom line here is that, while grocery stores have been good partners thus far, Instacart faces a growing brigade of formidable competitors, each with their own incentives that don\u2019t align with Instacart\u2019s. Many of the competitors have more than enough capital and expertise to further expand their own delivery options and box Instacart out of the market.<\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Partners Are Also Heavily Concentrated<\/strong><\/h3>\n<p>Just three retailers accounted for 43% of Instacart\u2019s GTV in 2021, 2022, and the first half of 2023. Such a large concentration in such few partners further highlights how reliant Instacart is on said partners\/competitors. As these grocery stores build out their own delivery services, they could choose to suspend or cease relationships with Instacart, which would create a material reduction in Instacart\u2019s revenue and profits.<\/p>\n<p>As we all know from studying Michael Porter, large customers can also exert more influence over their suppliers, and in this case, partners. In other words, large customers have a lot of bargaining power when it comes to pricing. Should grocery stores decide that Instacart is taking too much in fees, they have significant leverage to negotiate better terms, reallocate funds to building their own service, or both. In any of those scenarios, Instacart\u2019s revenue and profit growth could take a big dive.<\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Valuation Implies Too Much Profit Growth<\/strong><\/h3>\n<p>When I use my reverse discounted cash flow (DCF) model to analyze the future cash flow expectations baked into CART, I find that shares, even at the midpoint, embed very optimistic assumptions about margins and growth. I think the stock holds downside risk at its IPO valuation.<\/p>\n<p>To justify the midpoint of its IPO valuation, my model shows Instacart would have to:<\/p>\n<ul>\n<li>maintain NOPAT margin at 4.8% (equal to 2022, despite expected margin pressures noted above) and<\/li>\n<li>grow revenue by 24% compounded annually (1.3x the high end of the projected online grocery market growth through 2025) for the next decade.<\/li>\n<\/ul>\n<p>In this scenario, Instacart would generate $22.5 billion in revenue in 2032, which is nearly 9x its 2022 revenue and 2.9x DoorDash\u2019s TTM revenue. I can use Instacart\u2019s take rate to estimate implied GTV in this scenario. \u201cTake rate\u201d is the percentage the company receives as transaction revenue out of every dollar worth of product sold on the platform. For this analysis, I assume:<\/p>\n<ul>\n<li>Instacart\u2019s transaction revenue is 72% of revenue in 2032 (equal to percent of revenue in 1H23)<\/li>\n<li>Instacart\u2019s take rate is 7% (equal to Instacart\u2019s transaction revenue as a % of GTV in 1H23)<\/li>\n<\/ul>\n<p>In this scenario, Instacart\u2019s implied GTV in 2032 would equal $227 billion, which is 7.9x higher than Instacart\u2019s 2022 GTV and 1.8x Uber\u2019s TTM gross bookings (similar metric to GTV).<\/p>\n<p>This scenario also implies Instacart grows NOPAT 24% compounded annually through 2032, earns $1.1 billion in NOPAT in 2032, and generates an ROIC of 118%. The implied NOPAT is 8.7x Instacart\u2019s 2022 NOPAT while the implied ROIC would be higher than all but 14 of the 2,977 companies my firm covers. For reference, Apple and Alphabet\u2019s TTM ROIC are 70% and 40%, respectively.<\/p>\n<p>It\u2019s also important to note that companies that grow revenue by 20%+ compounded annually for such a long period are \u201cunbelievably rare\u201d. The cash flows expectations in Instacart\u2019s midpoint IPO valuation are very high, which indicates there could be much more downside risk than upside potential.<\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>59% Downside if Growth Matches Industry<\/strong><\/h3>\n<p>Below I present an additional reverse DCF scenario to illustrate the downside risk even if I give the company credit for more reasonable growth assumptions than those outlined above.<\/p>\n<p>If I assume Instacart\u2019s:<\/p>\n<ul>\n<li>NOPAT margin remains at 4.8% and<\/li>\n<li>revenue grows 14% compounded annually (midpoint of projected industry growth through 2205) for the next decade, then<\/li>\n<\/ul>\n<p>CART would be worth just $12\/share today \u2013 a 59% downside to the midpoint IPO price range.<\/p>\n<p>In this scenario, Instacart\u2019s revenue would still grow to $9.5 billion in fiscal 2032, or 3.7x Instacart\u2019s 2022 revenue. If I make the same assumptions as above regarding Instacart\u2019s revenue breakdown and take rate, this scenario implies the company\u2019s GTV grows to $95.8 billion which would be 3.3x Instacart\u2019s 2022 GTV and 80% of Uber\u2019s TTM gross bookings.<\/p>\n<p>This scenario also implies the company grows NOPAT 14% compounded annually through 2032, earns $454 million in NOPAT in 2032, and generates a 50% ROIC in 2032.<\/p>\n<p>Figure 5 compares Instacart\u2019s implied future NOPAT in these scenarios to its historical NOPAT.<\/p>\n<p><strong>Figure 5: Midpoint IPO Price Looks Fully Valued<\/strong><\/p>\n<p>Each of the above scenarios assume Instacart grows revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is highly unlikely but allows me to create best-case scenarios that demonstrate the high level of expectations embedded in the current valuation.<\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>Control Concentrated in Hands of Few<\/strong><\/h3>\n<p>While not as bad as some recent IPOs, Instacart\u2019s new investors will have limited control over corporate governance. Upon completion of the IPO, executives, directors, and other \u201ccornerstone\u201d investors who already own more than 5% of the company will own ~40% of Instacart\u2019s outstanding shares.<\/p>\n<p>The 40% is the floor for \u201ccornerstone\u201d ownership. Multiple \u201ccornerstone investors\u201d including some that already own more than 5% of the company, have expressed interest in buying additional shares upon IPO, which would further increase their ownership, and control over, the company.<\/p>\n<h3 class=\"subhead3-embed color-body bg-base font-accent font-size text-align\"><strong>No White Knight To Save Investors<\/strong><\/h3>\n<p>The expectations baked into Instacart\u2019s IPO valuation look highly optimistic. Often, the best hope investors might have in overvalued stocks is for an established company to acquire the firm. However, investors shouldn\u2019t get their hopes up. As noted above, competitors are already building out their own delivery services. Acquiring Instacart wouldn\u2019t necessarily create all that much value for a single retailer or grocer. Instacart\u2019s primary value creation opportunity is in the scale it can achieve by connecting buyers with multiple retailers and grocers. I think Instacart either succeeds or fails on its own.<\/p>\n<p>Additionally, Instacart\u2019s economic book value, or no growth value, is less than $2\/share \u2013 a 93% downside to the midpoint IPO price range. Potential acquirers will not likely have interest in paying anywhere close to the lofty IPO valuation for a business that looks likely to face significant challenges moving forward.<\/p>\n<p><em>Disclosure: David Trainer, Kyle Guske II, Italo Mendon\u00e7a, and Hakan Salt receive no compensation to write about any specific stock, style, or theme.<\/em><\/p>\n<\/div>\n<p>Read the full article <a href=\"https:\/\/www.forbes.com\/sites\/greatspeculations\/2023\/09\/18\/instacart-likely-unsustainable-profits-and-an-expensive-valuation\/\" target=\"_blank\" rel=\"noopener\">here<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Maplebear Inc., which operates as the better-known Instacart (CART), is expected to start trading September 19, 2023 at a ~$8.1 billion valuation. At $29\/share, the midpoint of its IPO price range, Instacart earns an unattractive Stock Rating and is this week\u2019s Danger Zone pick. While the latest valuation is certainly lower than the COVID-19 mania-induced [&hellip;]<\/p>\n","protected":false},"author":1,"featured_media":13284,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"content-type":"","footnotes":""},"categories":[33],"tags":[],"class_list":{"0":"post-13283","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-markets"},"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v21.0 - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>Likely Unsustainable Profits And An Expensive Valuation | Prosfunds<\/title>\n<meta name=\"description\" content=\"Maplebear Inc., which operates as the better-known Instacart (CART), is expected to start trading September 19, 2023 at a ~$8.1 billion valuation. 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