2023-09-28 12:20:13 ET
Summary
- Instacart is an online grocery shopping company operating largely in the U.S. market.
- The U.S. online grocery market is expected to reach $284 billion by 2027, or 21% of the total market, representing a 5Y CAGR of 15.8%.
- Penetration of online, take rates, and switching costs are growth opportunities for the company, but could also be detractors.
- Instacart's take rate and margins may face downward pressure due to intensifying competition in the industry.
- At its current price of $29, there is an 11% potential downward move, based on base-case value per share, and a 55% chance of overvaluation.
Introduction
Following the Maplebear Inc. aka Instacart ( CART ) fresh IPO, I decided to have a look at the company’s performance, prospects, and ultimately valuation, in order to understand whether the current price level is justified (or fair, if one may use this word).
CART is an online grocery shopping company that seeks to make the grocery shopping experience for its clients effortless and convenient. To better understand the company’s prospects, the following section will focus on CART’s business model, recent performance, and, more importantly, growth opportunities – all of which will translate into the growth drivers that will be used in the company’s valuation.
Growth Opportunities
As of today, Instacart operates largely across the United States, with only 3% of its revenues in 2022 coming from Canada, even though this international market was launched as far back as December 2017. As a result, the analysis below and the investment thesis will center around the view that CART is a company with U.S. operations.
Online Penetration
Let us start with the total U.S. grocery market. According to Incisive/Mercatus report, total grocery sales in the U.S. in 2022 stood at around $1.1 trillion and are expected to grow to more than $1.3 trillion by 2027, representing a 3.5% CAGR. This is a huge market, but much of the growth potential for players like Instacart will depend on the penetration of the online component. With reference to the same study, the share of online was estimated to be 12.1% in 2022, or $136bln. Based on this figure and CART’s gross transaction value ((GTV)), the company’s implied market share stood at an impressive 21% in 2022.
Looking forward, online is expected to reach 21.2% of total U.S. grocery sales in 2027, or $284bln, which represents a CAGR of 15.8%. Though far from the total U.S. grocery market, this is still going to be an intense battleground for online grocery players. It also means that to grow its market share, CART's GTV must grow above 15% per year over the next 5 years. This may prove to be rather difficult, given that during the last two trailing twelve month ((TTM)) periods ending June, CART's GTV growth was 12% and 10% respectively (see the discussion around Table 2 below for more details).
Take Rate
Instacart currently generates its revenues from two sources: transactions and advertising. Over the last four reported years, based on TTM June-end periods, transaction revenues contributed more than 70% to total revenue of the company (Table 1).
Table 1
Company S-1/A and author's calculations
If we now focus more on this core side of CART’s business, it can be broken down into two major sources – GTV and the take rate, where the GTV depends on the number of orders per customer/orderer, (monthly) active count, and the average order value (AOV). Unfortunately, the company does not report the active customer/orderer count historically for each year (it did mention, though, in the filing there were 7.7mln monthly active orderers for the month ended June 2023). As a result, Table 2 below will provide platform-wide order count, instead.
Table 2
Incisive/Mercatus, company S-1/A, and author's calculations
We can notice several dynamics here:
- U.S. online grocery sales have shown a strong 32% CAGR over the last four years ended June.
- CART’s GTV has been able to outpace U.S. online grocery sales growth by 2 percentage points over the same period. However, period-to-period GTV growth has dropped precipitously from 95% in TTM Q2'2021 to 12% and 10%, respectively, during the following two periods. This may present a challenge for the company to, at least, maintain its current market share of 20% (see point 3 below), given that the online portion is going to grow at a 5Y CAGR of 15%, as mentioned above.
- Historically, GTV growth has allowed the company to expand its implied market share from 19.4% in TTM Q2’2020 to more than 20% for the latest period; though, after an abrupt rise in TTM Q2’2021, the following two periods saw a considerable decline.
- CART’s AOV has trended downward overall, largely driven by a reduction in bulk-buying seen during the peak of the COVID crisis. The good news, however, is that the current level is still substantially above that of the overall industry of $72 AOV in 2022, down from $107 in 2020 (Incisive/Mercatus, 2022).
- Assuming there were 7.7mln monthly active orderers at the end of 2022 (i.e., no change from the reported June 2023 figure), we can calculate that users made, on average, 2.8 purchases per month in 2022. Even though this puts the company marginally below the 2022 market average of 3.1 (Incisive/Mercatus, 2022), CART is more likely to have been, at worst, at the market level, given a lower active user base.
- The take rate, fluctuating at rather stable level of slightly above 5% during the first three periods, has shot up above 7% during the last TTM. As will be discussed below, not only do I not expect this level to have significant upside potential, but also am concerned it may be faced with a downward pressure going forward.
Let us further narrow down our focus and look at the take rate.
- Starting with its components, the company generates its transaction revenues from retailer and customer fees, net of discounts and customer incentives; there are also shopper earnings, but these are passthroughs that flow fully to shoppers. Customer fees consist of delivery and service fees; however, there is a $99 yearly (or $9.99 monthly) Instacart+ subscription option, that eliminates delivery fees and reduces the service fee. Before shopper fee and incentives/discounts eliminations, retailer and customer fees generated almost 15% of GTV in 2022.
- Even though the take rate has been on the rise, especially during the latest TTM period, there is an element of concern over possible headwinds in the future stemming from the intensifying competition. As per the company’s own admission (S-1/A, p.238), it comes both from the original retailers that have their own digital offerings and digital-only players that include Amazon ( AMZN ), Shipt, Peapod, DoorDash ( DASH ), Uber Eats ( UBER ), Thrive Market, and so on. As a result, the take rate could be under pressure to revise lower in the future in the fact of tighter competition.
- Notwithstanding the competition, there could also be a natural cap on the level the take rate may rise to. Consider some of the players in the online “retail” business, such as DASH, eBay ( EBAY ), and Etsy ( ETSY ). All of these companies have take-rates within an 11%-14% bound (company 10Ks), yet the products/goods they sell, in most cases, sit higher up in the value chain, which is even more evident for DASH. Despite the fact that “grocery is the largest category in all of retail” (S-1/A, p.107), the risk is that this business delivers low operating margins (3.3% in the US and 4.5% globally) versus other online-ready industries, such as restaurants/dining (15.4% in the US and 10.4% globally); as a result, low-double-digit take rates commanded by other online platforms could be unachievable for CART.
Switching Costs
As of today, it appears that the cost to switch from Instacart to an alternative service is rather low, given how much choice there is already, from traditional retailers launching their own fulfilment services (such as Kroger) to food delivery services expanding into groceries (such as UberEats), to online retailers (think Amazon) to direct competition (Shipt or Peapod). In fact, as more consumers become wary of the various services they are subscribed to, the fact that around 70% of adult population have an Amazon Prime subscription could challenge the idea of having more than one grocery subscription – after all, if Prime is able to provide the delivery of any goods, in addition to groceries (Amazon Fresh/WholeFoods), why bother having an Instacart subscription? Yes, Instacart may have better availability and choice options at the moment, but the competition is likely to catch up in the future.
Valuation
To start with, the value drivers that we shall discuss below will center around my views on CART – Instacart is an online grocery delivery platform that operates in a large and growing U.S. online grocery market but is yet to experience the consequences of the intensifying competition on its take rate and margins.
- Growth – as discussed previously, us e-grocery sales are expected to reach around $284bln in 2027, representing 15.8% CAGR over the next 5 years. To arrive at the expected sales growth rate for CART, I will make the following assumptions:
- the company will, roughly, be able to retain its current market share of around 20%. This will imply the expected GTV of $57bln.
- Maintaining the market share will come at a cost, however. The take rate will be assumed to decline to 6% (roughly, the aggregate level of 2022) from the current 7.1%, as the company will have to adjust its pricing to acquire and maintain its customers in the face of greater competition. Target operating margin will also come under pressure for the same very reason, but more on this in the Profitability section below.
- Ads contribution will remain at the current 30% level.
As a result, expected transaction revenues are projected to reach $3.4bln in 2027 ($57bln * 6%) and total revenues to be $4.9bln ($3.4bln / (1-30%) ), which implies a 5Y CAGR of around 13.8%.
As such, the base-case revenue growth will be based on three stages:
- 13.8% growth in Year 1 to Year 5.
- 13.8% to 4.6% ( 10-Year US Treasury Note ) gradual decline from Year 6 to Year 10.
- 4.6% in the terminal period (Year 10 onwards).
- Profitability – CART is no different to many other companies that provide EBITDA adjustments, nor is it different by including stock-based compensation ((SBC)) expense. As I mentioned in my previous articles, SBC is a real and recurring expense, which must not be adjusted for, but which is often a significant part of the adjustments, which very often make an unprofitable company look profitable.
Figure 1
Company S-1/A and author's calculations
In the case of CART, EBITDA adjustment is a mixed bag – it does include some rightly categorized non-recurring items, but the SBC still explained around a third of the total adjustment in the previous three periods and a whopping 71% during the latest. Nevertheless, GAAP EBITDA was positive during the last TTM, so the SBC effect was muted.
Meanwhile, as an online platform company, CART has R&D expenses and, in line with my usual approach, as explained in the previous articles, I will deem these expenses as investments into future platform development and capitalize them. As a result of that, R&D-adjusted operating margin, as of June-end 2023, stood at 22.2%.
Looking forward, however, I will argue that there are several factors that may lead to a decline in the operating margin:
- SBC expense after going public may start to play a greater role in total expenses. As can be seen in the Table 3 below, CART’s SBC, as percentage of total revenue, has declined to just 1% over the four TTM periods ending June. Meanwhile, SBC expense for online platforms discussed earlier has much greater role in the expense structure. Even if we take EBAY, we are looking at 400-500bps decline in operating margins from the current level, but it may well be even higher. Table 3.
Company S-1/A and author's calculations
- Intensifying competition not only will put a downward pressure on the take rates, as discussed above, but also on margins. This will arise from the company having to spend more on marketing – something it admits in its S-1/A filing (p.110) is already occurring – and give up more profits for incentives and promotions in order to acquire customers.
As a consequence, I will assume that the current operating margins will decline to 15% in year 10.
- Reinvestment – for CART, over the last three years (in TTM periods), the reinvestment ratio (a composite term that includes capex, D&A, and working capital investments) averaged out at 1.25. Given high investment needs to further develop the platform, I will assume this ratio will remain at this level going forward.
To calculate the reinvestment rate in the terminal period, we shall use the re-arranged sustainable growth formula at the stakeholder level:
Reinvestment rate = Sustainable growth / ROIC,
whereby the sustainable growth will equal the 10-year Treasury Note rate of 4.6% and an ROIC of 9.1% (equal to terminal period WACC):
Reinvestment rate = 4.6% / 9.1% = 0.51% (to be multiplied by the after-tax adjusted EBIT to arrive at an absolute value).
- Risk – using market values of equity and debt (including leases), we have the following:
Equity | After-Tax Debt | Capital | |
Weight in Cost of Capital | 99.6% | 0.4% | 100% |
Component cost | 11.0% | 2.95% | 10.98% |
The equity component was calculated using the risk-free rate of 4.6%, ERP (geographically weighted by sales) of 5.28% and a levered bottom-up beta of 1.21. The pre-tax debt component was 3.83% (in line with the terms of the company’s lease rates provided in the S-1/A):
Cost of equity = 4.6% + 1.21*5.28% = 11.0
Cost of debt = 3.83% * (1-23%) = 2.95%
Consequently, the 5-year transitional WACC of 10.98% will be linearly adjusted downwards during the remaining five years to a terminal rate of 9.1%.
Apart from these major assumptions, the following has been applied in the model as well:
- Share count of 320.3mln, consisting of 279.45mln common stock (including 3.3mln additional optional shares available to underwriters for purchase), 6mln Series A preferred stock, and 31.5mln RSUs, all as of August 15, 2023 (S-1/A, p.25).
- Marginal tax rate of 23%.
- Value of debt of $43mln, comprising operating lease liabilities.
- Value of options of $463mln, based on 20.5mln options outstanding, average strike price of $7.42, average maturity of 3.65 years, and standard deviation of 51% (S-1/A, p. F-52,53).
- Loss carryforwards of $930mln, which will reduce the taxable base once the company becomes profitable.
- IPO proceeds of $640.9mln (S-1/A, p.19), assuming underwriters exercise their option to purchase additional shares of common stock).
The table below presents the model results:
At current price per share of around $29 and the computed value per share of almost $26, the stock is overvalued by about 11%. To account for the uncertainty factor in the main assumptions discussed above, the Monte Carlo simulation of 10K trials has been conducted by applying probability distributions to base-case assumptions of revenue growth, operating margin, reinvestment ratio, and the WACC. The results are provided below:
Figure 2
Figure 2 shows the median value per share of $27.5 (vertical green line) and the area (colored red) above the current price level of $29 (which was also the midpoint of the initial IPO price range). As a result of these simulations, given the distribution assumptions, it appears there is around 55% chance the stock is overvalued at its current price level. To note, there are certain scenarios (though with relatively lower chance of occurrence), under which the value per share could be higher.
Only a few days ago, this article would likely provide a sell rating, given Instacart stock was trading at $30+ price level (implying a 70%+ chance of overvaluation). For now, given the narrow price-value gap and a close call on the overvaluation likelihood, the valuation rating for CART is neutral.
For further details see:
Instacart: More Downside Is Possible