2023-09-13 05:44:42 ET
Summary
- Instacart's IPO range of $26-$28 seems to apply an attractive multiple to the business, which trades at a low- to mid-20s multiple to free cash flow.
- Instacart's take rate has increased significantly, but there may be limited room for further expansion due to efficiency, competition and potential pushback from customers.
- Uber and DoorDash both are moving aggressively into grocery and Instacart needs to hold them off.
- On its face, CART looks like an excellent combination of value and growth. But if post-IPO investors agree, there may be a short opportunity barring outstanding execution.
Believe it or not, ahead of its initial public offering Instacart ( CART ) stock looks rather cheap. At $27 per share — the midpoint of the $26-$28 range — Instacart would have a fully-diluted market capitalization of $9.77 billion (including options, restricted stock, and other factors), and an enterprise value of $7.7 billion.
Trailing twelve-month Adjusted EBITDA is $486 million, suggesting an EV/EBITDA multiple under 16x. Investors familiar with tech companies might assume that the EBITDA is 'fake', and largely driven by stock-based compensation that is excluded from the reported metric, but that's not the case. SBC over the past four quarters is just $29 million; even adding that back, CART stock trades at less than 17x EBITDA.
Free cash flow figures tell a similar story. Normalized free cash flow, at a 25% tax rate, would be $340 million (capital expenditures here are exceptionally low); actual TTM free cash flow is $387 million. Those figures represent EV/FCF multiples of 23x and 20x, respectively.
In other words, the initial range doesn't seem to price in much growth for Instacart. That seems a surprise given the market's renewed optimism for growth and/or tech plays, as well as the broader opportunity in online grocery. But there are reasons why Instacart's multiple perhaps should look so low — and why $27 might not be quite the opportunity it appears, even assuming investors can access the IPO at that price.
The Take Rate Question
The relatively benign valuation assigned CART looks all the more attractive given how impressive recent growth has been. From 2019 to 2022, revenue increased at a 128% compound annualized rate, climbing from just $214 million to more than $2.5 billion. Obviously, the novel coronavirus pandemic played a major role — revenue increased 590% in 2020 — but Instacart posted top-line growth of 24% in 2021 before accelerating to 39% last year.
More recently, Instacart has shown an impressive ability to drive profitability. Adjusted EBITDA was just $34 million in 2021 before rising $187 million last year. So far in 2023, the figure has exploded, jumping to a profit of $279 million against a $20 million loss in the year-prior period.
From a headline perspective, this seems to a business firing on all cylinders, even considering the external tailwinds created by the pandemic. But if you look closer, there are questions about how much better the business can actually do.
One clear source of worry is on profit margins, and one of the biggest questions on that front centers on take rate. In 2019, Instacart's revenue was 4.16% of its GTV (gross transaction value, the actual amount spent by Instacart customers). Over the past four quarters, take rate has soared to 9.86%.
A little less than one-quarter of the expansion comes from advertising and other revenue, which has doubled as a proportion of GTV from its 1.3% level in 2019. The rest of the increase, however, comes from Instacart charging higher fees and operating more efficiently (since costs such as shopper incentives are not booked as expenses, but reductions to revenue). And it's difficult to see much more room for expansion in the metric. Competition from Uber ( UBER ) and DoorDash ( DASH ) should keep a lid on fees. Even inflation represents a modest risk: if a basket of groceries costs 20% more, the fees (based on cost rather than volume) increase by the same amount, even though the number of items in the basket remains unchanged. At a certain point, there's likely to be some pushback, particularly if macroeconomic worries rise in the near term.
The expansion in take rate no doubt has been a huge driver of the expansion in Adjusted EBITDA margins, which were 9% of revenue even in 2020 and 19% so far in 2023. Those higher fees are, for the most part, pure profit.
Instacart plans to drive more ad revenue, and is having success on that front: ad and other revenue rose 24% year-over-year in the first half. But, again, with real competition in the market, there's probably little, if any, room left for increases in terms of direct fees.
Cost Concerns
For a platform business in theory, a flattish take rate shouldn't be a huge problem for EBITDA margins. It might suggest limited margin expansion , but not necessarily margin contraction . But Instacart's operating leverage, for now, is somewhat muted by the fact that its operating expenses in two key areas are growing at a rapid clip. Customer acquisition spend increased 60% year-over-year in 2022, vastly outpacing the increase in revenue. Research and development expense jumped 40%, before its growth slowed to 7% in the first half of this year.
Despite those increases, as noted EBITDA margins have improved dramatically over the past four quarters. One core reason for that is that outside CAC and R&D, Instacart has held the line on spending. In fact, its total employee count peaked in the second quarter of last year, before declining in each of Q3 and Q4. The benefit of that headcount reduction should be lapped this quarter, which in turn removes one of the clear tailwinds behind margin expansion up to this point.
The 19% margins seen in the first half of this year, then, look potentially like something close to a ceiling. Increased ad revenue might drive some level of improvement, but any gains there might well be offset by a return to headcount growth starting in 2H 2023.
Bear in mind that ceiling exists in a scenario where nothing else goes wrong, and notably one in which competition simply means take rate expansion stalls out, rather than reverses. Indeed, looking closely at the business it doesn't seem a surprise that Instacart chose this quarter to go public; on the margin front, this might be about as good as it gets.
GTV Slows; Is Competition To Blame?
At a low- to mid-20s multiple to free cash flow, flattish margins should be good enough as long as revenue continues to increase. And, at least for now, it's doing so. In the first half, Instacart's revenue jumped 31% year-over-year.
But that figure is somewhat deceiving. The increase in revenue was due mostly to increased efficiency — including the end of shopper incentives paid during the first half of 2022. Advertising and other revenue increased 24%, providing another boost to take rate.
It wasn't higher customer spending that drove the growth, however. In fact, in the first half Instacart's GTV increased just 4% year-over-year. Orders were flat year-over-year. The cause of the relatively muted growth in both metrics appears to be that, at least in terms of customer spending, Instacart is losing market share.
On his company's Q2 conference call last month, DoorDash chief executive officer Tony Xu strongly suggested his company's GTV was growing much faster than 4% [emphasis mine] :
And that's one of the things that you saw, as we now have more non-restaurant stores on the platform in North America versus any other platform. We're growing faster than every other platform and gaining share dramatically in virtually all categories. And certainly -- and very specifically also in grocery .
For its part, Uber in May too launched ads for its grocery service . (Interestingly, the lead partner on the project was PepsiCo ( PEP ), which is making a $175 million investment in Instacart preferred stock alongside the IPO.) CEO Dara Khosrowshahi has made a concerted effort to expand beyond the company's core rideshare business, and emphasized on Uber's Q2 call that "we're now much more focused on grocery ."
The Bear Case For CART Stock
This is where the bull case for CART stock starts to get a bit wobbly. It's not at all guaranteed that the overall online grocery market is going to grow all that quickly. Right now, online penetration is about 12%, per figures from Instacart in the prospectus. In her letter in the prospectus, CEO Fidji Simo wrote that "online penetration could double or more over time".
Assume that doubling takes 10 years, and that inflation runs at 3-4%, and the market as a whole is growing at 11% annually. There's not a lot of room in that overall growth rate for market share erosion before Instacart's GTV completely flattens out.
And if GTV flattens out, profits likely do the same — at best. Take rate increases are probably close to maxed out. Opex growth should resume starting this quarter. Instacart even admitted to some near-term softness in ads, which it blamed on "macroeconomic uncertainty", but could also be a sign that manufacturers aren't getting the hoped-for return on investment, and/or are shifting some of their spending to Uber Eats and DoorDash.
These worries may not hit CART stock up front. The float after the IPO is going to be exceptionally thin: even with the underwriters' option, the company is only issuing 17.4 million shares (current stockholders are selling as well), less than 5% of the fully-diluted share count. It's possible Instacart manages to execute well, and year-prior comparisons in the second half of 2023 remain somewhat soft (though not as soft as those seen in the first half of the year). In the months after going public, CART is going to look like a cheap, growing stock with a thin float, and that might well be enough to drive upside in the shares.
But that upside, should it arrive, might present an interesting short opportunity come 2024. CART's valuation is reasonable in a world where Instacart, roughly speaking, holds its market share. But if that share erodes, it looks like the company has few, if any, levers to pull elsewhere, while the nature of the platform model means that a large portion of lost revenue comes off the bottom line as well. Simply put, CART might appear cheaper than an investor would expect, but it is not nearly as cheap as it appears.
For further details see:
Instacart: Cheap Valuation Supported By Competitive And Margin Risks