Value Investors Club / GOODFOOD MARKET CORP (FOOD.)

Description

Goodfood is the leading meal-kit company in Canada. Since going public in the spring of 2107 the company

has grown subs by 290%, achieved a November run rate of $130mm and become the clear market leader.

Yet the stock has only increased by 45% to a EV of 135mm, or 1x sales. I believe the failed IPO of BlueApron

has poisoned the well for meal kit companies to be considered by value investors, and that upon closer

look the underlying business of Goodfood can be highly profitable and has a large moat.

The Meal Kit Industry:

Most investors are probably aware of the business model of these companies. A customer signs up

(usually for a free trial) and pays $60-$90 weekly for a box of food to be delivered to their home. The

customer can choose a few recipes that appeal to them from a list of 10-15 options and then follows the

step by step instructions on the recipe card to create a different dining experience than they otherwise

could have on their own. Customers are allowed to skip whichever weeks they want but must notify the

meal kit company a week in advance or else the box is auto shipped and the customer charged.

The industry claims the cost to the consumer is roughly the same as they would spend at the grocery

store. The reason meal kit co.’s can make a decent margin despite the added shipping costs is reduced

spoilage. While grocery stores experience food spoilage of 20-30%, for meal kits it is much lower.

Customers lock in their orders a week in advance; allowing these companies to order the right quantities

thus the spoilage rate for meal kits is 5%. Related, the food tends to be fresher and last longer when it

comes from a meal kit co. Why? There is one less step in the distribution process as meal kit food goes

from purveyor to DC to your fridge vs purveyor to DC to shelf to your fridge. That extra step can add 3-4

days for fresh food.

Benefits to customer: No need to plan whats for dinner, always have food in the fridge, exploring new

recipes.

Drawbacks to the consumer: Some view it as expensive, can be a grind to finish all the meals if you are

going out often, you actually need to put in about 30-45 minutes of cooking.

As mentioned in the intro, the industry is viewed negatively by many value investors. The common

criticisms are that there are no barriers to entry, customer churn is too high, there are over 100

competitors in the US, and the largest players have yet to be profitable. Some of these criticisms are true

but I believe the Canadian market is different than the US and provides for much greater potential to

become a good business environment for the 2 or 3 meal kit companies who emerge victorious from the

Darwinian process now playing out.

Why the industry is not crap:

If Amazon proved anything, it`s that scale can become a barrier to entry itself. There is no defining quality

that Amazon has that makes it a monopolistic force online, anyone can start an online merchant in a day,

but good luck if they hope to achieve profitability. Due to the scale Amazon has accrued over time, they

are happy to use loss leaders to expand out from their core existing businesses into adjacent verticals and

quickly become dominate in those new verticals. They fund this growth with the profit from the older,

more established businesses. They also realized long ago that the logistical scale they could get would be

a large cost advantage and have made large investments into these capabilities. This size and logistics

advantage creates a strong barrier to entry for anyone looking to compete without a large base business

(like Walmart for example) as one would be required to endure large losses for years before ever gaining

the scale necessary to compete effectively. (For a better understanding of how Amazon utilizes their

monopoly position please see this excellent Yale Law Review article by Khan

https://www.yalelawjournal.org/note/amazons-antitrust-paradox )

I believe Meal kit companies could eventually become similar dominate forces in the grocery industry. As

meal kit companies gain scale, they gain an ability to ship their goods more cheaply, purchase their good

more cheaply and increase their gross margin. When I attended the Goodfood IPO roadshow, the slide

that stuck out to me was the one below.

We can see the immense scale a meal kit company achieves when hitting critical mass in specific areas

from shipping alone. The average box of food shipped retails for $75. It is clear at low density levels meal

kits would never hit breakeven. Meal kit companies require this local scale to achieve profitability. This

also means that not all subs are equal. We want our customers to be concentrated in specific areas, not

spread out. We also want our customers to order frequently (not skip weeks) so we can drive our shipping

scale.

It is also worth understanding the cost structure of meal kit companies to see how they can eventually

reach profitability by expanding their product offering. While Goodfood reports an all-in gross margin of

approximately 35% this includes the cost of packaging, floor employees to portion and fill the boxes, as

shipping costs. HelloFresh actually breaks out gross margin purely for food alone, which runs at

approximately 65%. We can then see that if food margin is 65%, the margin of shipping incremental

product to a customer’s home is likely to approximate 50%. There would be some marginal cost to place

the extra products in the box and the slightly higher shipping weight, but overall it would provide a very

healthy contribution margin. Since there is virtually no SG&A attached to these incremental items, the

contribution ebitda margin should also be very close to 50%.

I believe taking all this into account meal kit co.’s should attempt to scale as quickly as possible, reaching

deep local density levels allowing their shipping costs to go down per unit and eventually reaching break

even ebitda levels. From there, they begin to add more items with incremental ebitda margins of 40%-

45%, we see how overall profit margins can reach acceptable profit levels.

Good food management understanding this concept very well, referring to themselves on the latest

conference call as a platform that has solved the logistics of successfully shipping perishable foods,

starting with dinner. From that base they intend to roll out more food options, starting with breakfast.

The market size opportunity is immense.

The other knock on the industry is very high churn rates. The industry tends to see over 50% of new

customers churn out in the first 3-6 months and by the end of the 6 month period you are left with a base

of 40% of customers remaining. Once a customer has been ordering for 6 months, the churn tends to drop

rapidly and the tail can be long. I approximate for Goodfood that long term churn is 5% per quarter once

a customer hits the 6 month mark.

The 60% churn rate for the first 6 months is concerning and a main reason investors have avoided the

space. Is the industry just the next Groupon, where you try it once and don’t return after the novelty has

worn off? I don’t believe so. A big reason for the elevated churn is the way in which meal kit co.’s gain

new customers. They often depend on word of mouth and therefore give existing customers free trial

coupons so their friend’s can get their first box for free. This encourages exponential growth, or as the

Goodfood CEO called it, viral growth. A natural repercussion of this is that many customers were never

serious about the product and instead wanted $75 worth of free groceries. However, given that the gross

margin is about 35%, if a customer takes 1 box for free you need to sell 2 more boxes to recoup the

expense. Many customers do order 1 or 2 more times before canceling, lowering the loss. It still results in

elevated churn but lowers the financial hit.

Worsening the effect of this, in the US there are over 100 meal kit providers and some savvy customers

can churn from free box to free box with many different providers, draining the profitability of each and

further increasing churn. This problem is not as acute for reasons discussed in the next section.

Canada vs the US:

The US has over 100 meal kit companies, offering US consumers a bevy of choices, but more importantly

killing the economics of the space. I discussed the advantages of local scale above, and explained how the

customer acquisition model can be ineffective if there are too many companies to choose from. This

should not be viewed as a condemnation of the space as a whole but instead be viewed as signs of an

emerging industry that has been well funded (maybe even overfunded) in a flush US VC market, where

consolidation must occur. I believe this will eventually happen in the US with the industry likely to move

to 4-5 national players with the scale to reach profitability. The US is one of the most highly competitive

meal kit geographies in the world, and this can be seen in HelloFresh’s results, where adjusted ebitda is

slightly positive in their International division and still negative in their US division. With more scale effects

and uniform regulation in the US we would expect the inverse, but the International market has better

industry dynamics currently.

In Canada the industry is much more consolidated and much less funded. There are a couple dozen meal

kit companies operating in Canada, and only 2 with national scale. A few weeks ago Hellofesh (#2)

announced they were buying Chefsplate (#3), to equal in size market leader Goodfood. Together

Goodfood and Hellofresh should have approximately 80% market share, creating an oligopoly. This should

lower the effects of customers jumping from sign up offer to sign up offer, and allow the scale effects for

the winners to start taking hold.

We should not be surprised to see this in Canada, as due to the large geographic footprint and low

population, has a number of oligopolistic industries where we don’t see this in the US. There is one Theatre

chain with 75% market share, 3 main wireless providers, 5 big banks, and 3 major grocers. All have profit

margins at similar, or greater levels than their US peers. I believe the meal kit industry will be the same in

Canada for some time yet.

As well, we are less at risk of US players using their scale to enter Canada. Due to perishable food laws at

the border, there is little efficiency to be gained from having a large US operation, as companies must

have stand alone units and DCs in Canada.

Management and Company History:

Goodfood was founded by Jonathan Ferrari and Neil Cuggy in 2014. They continue to act as CEO and COO

respectively. They met while working as investment banking analysts at RBC. After receiving their bonus

cheques after the 3rdyear, they both quit to become entrepreneurs. Their initial plan was to launch a VC

fund, but after a fewmonths decided there was a void in Canada for the fast growing meal kit industry.

They decided to launch their own meal kit company in 2014, benchmarking off the experiences of Blue

Apron and HelloFresh while trying to avoid the mistakes made by both.

Jon and Neil launched Goodfood out of an apartment, initially handling all facets of the business

themselves, from designing the menus, to picking up the ingredients from the local farmers market, to

portioning and home delivery. As the number of subscribers grew they ultimately moved to a proper

production facility in Montreal that served them well until summer 2016, were they moved again to a

facility that could support up to $200mm (10x) of revenues.

The company IPOed in June 2016 with 23k subs at $2.00 per share. At the time they had expanded to

serving all of eastern Canada (Ontario to the maritimes) and were roughly even in size to their main

competitor, Chef’s Plate, despite having launched one year later. Since then the company has grown

tremendously, increasing their sub count to 89k 15 months later, and having opened up a western Canada

facility in Calgary, to offer their product coast to coast. They are now the largest meal kit company in

Canada, ahead of #2 Hello Fresh and #3 Chef’s plate.

I have discussions often with Jonathan and Neil and am always impressed with their operating ability and

visions for the company. They are in this for the long game, and understand that while they could show

profitability today if they slowed down, they must press their advantage to ultimately build a much larger

and more profitable company. Indeed the company has already said they are profitable in their biggest

market, Quebec, and will be in Ontario soon as well. Speaking with Jonathan, he has said many times he

believes this is a billion dollar company.

Both co-founders retained large equity stakes, currently at 11.4mm shares each or almost 44% of all

shares outstanding combined. This position represents all of their wealth and they have not sold any

shares to public markets other than a miniscule amount to pay taxes last spring.

Financials:

Goodfood has an August 31st year end. 2017 and 2018 are actuals:

	Years Ended Aug 31st
	2017	2018	2019	2020

Gross revs	23,081,362	84,092,897	189,174,126	323,710,693
Incentives	3,285,122	13,591,140	26,103,706	35,010,535
Net Revs	19,796,240	70,501,757	163,070,420	288,700,159
growth y-o-y		256%	131%	77%

COGS	16,206,503	55,841,951	119,194,579	201,388,578
GP	3,589,737	14,659,806	43,875,841	87,311,580
Gross margin	18.1%	20.8%	26.9%	30.2%
Adjusted gm	29.8%	33.6%	37.0%	37.8%

SG&A	7,013,250	23,617,947	44,500,000	65,900,000
EBITDA	-3,423,513	-8,958,141	-624,159	21,411,580



SG&A % of Revs	35.4%	33.5%	27.3%	22.8%
EBITDA %	-17.3%	-12.7%	-0.4%	7.4%

While these numbers may look aggressive, I think they are a reasonable baseline, and with a current EV

of $135mm you can see why there is large upside at the current share price.

Revenues: Driven by subs x ARPU. The company already reported being at a runrate of over $107 million

at year end 2018. My sub forecast (not shown here) calls for subs to increase 84% in 2019 from year end

levels. This would be a deceleration from the 187% growth experienced in 2018. Given the greenfield

expansion out west and relatively low levels of penetration of meal kits in Canada vs. more developed

markets such as the US, this is achievable.

ARPU is roughly $78 per box shipped today, having increased from $75 at the time of the IPO. The increase

can be explained by the introduction of premium priced products such as easy prep (pre cut foods) and

artisan (higher priced ingredients). I have ARPU being roughly stable over my forecast horizon but this

could prove to be conservative, as the company is currently beta testing new products such as breakfast

which will soon be rolled out (more on that later).

I take confidence in my 2019 and 2020 revenue forecast from a couple actions of management. Firstly,

they announced they are expanding their eastern facility next summer. The eastern facility currently can

handle $200m of revenue, increasing to $400m. They would not be planning the expansion this early if

they didn’t believe eastern Canada would be bumping up against that limit by year end 2019. Secondly,

when competitor Hello Fresh stated they are targeting a combined $200mm in revenues in 2019 (with

newly acquired Chef’s Plate included), Goodfood management stated that number doesn’t scare them.

Adjusting my quarters to match up with the 2019 calendar year, I would be at $222 million.

Adjusted gross margin: Here I am calling for improvement but less so than last year. The 37% should be

achievable when one considers that the company just posted a 35% gross margin in their August quarter.

Summers are the worst quarter seasonally for meal kit companies as customers are on vacation or eating

out more, and ordering less. This increases shipping costs on a per unit basis and there is worse overhead

absorption. As well more refrigeration is needed to keep ingredients fresh.

I confirmed with management that each of the other 3 quarters per year should come in higher than the

summer quarter. As well, there is some inefficiency from the just launched Calgary facility (launched

spring 2018) that should start to fade over time, increasing GM.

True gross margin is simply a function of gross add incentives and credits given for errors to existing

clients. I model roughly $80 incentive per gross add as well as a 5% credit overall to come out of revenue.

Thus while the 5% is constant, as growth slows in the out year true gross margin closes the gap with

adjusted gross margin.

SG&A: The company is beginning to show the scale effects of its prior investments. In it’s most recent

quarter, revenue grew 196% while SG&A 123%. I believe this will continue over the next 2 years, especially

as many of the larger investments, such as opening a second facility in the west, have been made.

Combined these numbers indicate a company that is close to breakeven today, and has the ability to scale

into decent ebitda margins in the near term. I will outline the product and company roadmap over the

next year that can get them beyond these numbers below.

CAC and LTV: A big question investors have about the business model is long term profitability given

elevated churn levels. My assumptions are that 50% of customers quit after 3 months, at 6 months we

are left with 40%, and then we see long term churn of 5% per quarter thereafter. Even under these churn

assumptions, with ARPU of 1500 per year, the LTV going out 5 years is just over $2,000 per gross add. At

35% gross margin, that leads to contribution profit of $700 per sub. I compare this to CAC of just north

of $200 and we can see the attractive economics (CAC derived by assuming $80 in signup bonuses/sub

plus all marketing costs over estimated gross adds). It is worth noting Goodfood talks about a CAC under

$100 but calculates it differently.

Roadmap:

Goodfood management have been active since the IPO in June 2017. In the past 18 months the company

has seamlessly moved to a larger eastern canada facility (something Blue Apron botched), launched more

meal options (more choice, easy prep, artisan) and opened up a western canada facility in Calgary to

service the entire country. The next 12 months will be equally busy with the following roadmap:

Launch Breakfast. The company has hired the former head of Uber eats Montreal to lead their breakfast

rollout. They are currently beta testing the product, expanding geographies each week. Goodfood should

be able to roll out the product nationally by spring. This will have the benefit of driving higher ARPU and

ultimately higher gross margins for the reasons already discussed. Attach rates for the beta test have been

10-15% of existing customer with very little marketing dollars spent.

Launch an App. It is a bit surprising this hasn’t already been rolled out, but the company hired an app

developer last month and the product should be out this spring. Meal kits, which required customers to

toggle their delivery weeks on/off, is a natural app product. While not a revenue driver, it should lead to

a better customer experience.

Loyalty program. The company has begun testing different rewards for driving higher engagement, such

as a recent prize of 4 consecutive weekly orders triggering a free Artisan meal. Below is an email I sent

the CEO in the spring, which I feel outlines the positive benefits of starting a loyalty program.

“Clearly the most important part for the business to succeed is to have high customer ARPU which drive

higher margins due to the density of the weekly shipping network. It seems like the gross margin for a

box of an existing customer in a dense market should be something close to 40% or $30 a box. And the

other important aspect is reducing churn, to really drive a high LTV once the CAC has been

spent. Further, there are behavioral benefits of customers learning to order frequently, which is to

have goodfood become a standard part of their life.

Given that, I would think a VIP program would be focused on rewarding customers for ordering often

and that triggers rewards. Ex when a customer orders 3 weeks out of 4 in a month they are entered into

the VIP program and they stay active in it until their order rate drops below 3 a month. They can then

regain entry the next month. This would really incentivize people on the fence about that extra week.

Sitting at 2 orders for the month, it will encourage them to order that extra box ($30 GM) to hit the

target. And it starts training them on the behavioral aspects of incorporating goodfood every week

leading to higher LTV. Finally, if anyone is like my friends in the states who are customers of 3 meal kit

companies and order 1 per week based off the most attractive menu, it encourages loyalty. “

Management agrees and had already been thinking of rolling out a loyalty program before this

discussion.

Finally, Goodfood recently announced they would like to roll out products for all times of day, and all

levels of preparation. I expect them to roll out a real made meal option for lunch some time next summer.

Competition:

The Canadian market has recently been consolidated down to 2 national players. On October 18th Hello

Fresh announced they are acquiring Chef’s Plate for an undisclosed amount. Chef’s Plate was the first large player in

Canada, but in the past year has been passed by both Goodfood and Hellofresh.

While data is hard to come by given HelloFresh does not break out Canada and Chef’s Plate is private, I

have seen documents that indicate Goodfood did about 80% higher revenue than Chef’s Plate in Q2 2018.

The two companies were the same size last fall, indicating Chef’s Plate’s revenue growth had slowed

drastically.

Hellofresh is a newer entrant, having launched their Canadian operations in summer 2016. They have

marketed aggressively and built up a sizable business, however my best guess based on website traffic

and facebook likes is they are still smaller than Goodfood.

The combined Hellofresh/Chef’s Plate has stated a revenue projection of 200mm in 2019. Goodfood

should do slightly more, marginally maintaining their leadership position. Ultimately it should now be a 2

horse race, with each company having an estimated 40% national market share.

The 3rd largest remaining player will be MissFresh, which was acquired by Metro (3rd largest Canadian

grocer) in summer 2017. Metro has not made a big push since acquiring the company.

Competitively, Goodfood is the lowest priced option in Canada despite having equal meal quality (or

better) to Hello Fresh. Hello Fresh charges roughly 20% more for the same options.

See the table below for pricing options. All numbers are Cdn $.

Pricing	3 meals 2 ppl	4 meals 2 ppl	2 meals 4 ppl

Goodfood	65	78	78
ChefsPlate	65.7	87.6	78
MissFresh	65.94	78.32	78.32
Hellofresh	80	100	x

HelloFresh has indicated they may use Chef’s Plate as a flanker brand, with lower pricing and more basic

protein options, while leaving HelloFresh as the premium offering. So far there have been no change to

the Chef’s Plate pricing model. The Hello Fresh flanker brand in the US, Everyplate, is priced about 20%

under Goodfood when adjusting for fx. This is possibly the route HelloFresh will take with Chef’s Plate

going forward.

The market is currently semi-rational, with both players trying to add subs aggressively but neither having

cut pricing from initial levels. In the medium term this may change. Price cuts, while detrimental to

margins in the short term, can boost competitive position and build a strong moat in the long run (see

earlier discussion for why this isn’t a crap business). See the below slide from Hello Fresh’s Q2 report on

the long term impact of price cuts

I agree with the slide wholeheartedly and know Goodfood management agrees as well. A price cut would

also have the secondary effect of discouraging any more VC funding of private competitors, as the path

to profitability is that much harder when the market leader is under cutting you.

Luckily for Goodfood, Hello Fresh is attempting this strategy in the U.S. first before doing anything in

Canada. As well, since they are already priced 20% higher than Goodfood, a cut in Canada may simply

bring them in line with a similar Goodfood product.

Valuation:

I am targeting a Goodfood share price of $6, or roughly double the current trading price in the next 12

months. This works out to roughly 1x 2020 sales (12 months forward at that point) and 13.5x 2020 EBITDA.

Hellofresh currently trades for 0.6x 2020 revenues and 14x 2020 ebitda, after having fallen 20% after

disappointing Q3 earnings. Hellofresh is also experiencing much slower growth of 28% over the next 12

months.

Looking at prior transactions in the space provides a sanity check, with Home Chef recently having been

acquired in the U.S. by #1 grocer Kroger. The sales price was disclosed at $200mm upfront with anearnout

of up to $500mm. Using the midpoint of the earnout for a total consideration of $450 the takeout price

equates to trailing 1.8x 2017 sales. It was disclosed that Home Chef had been growing revenue at 150%

and had a couple of profitable quarters. Goodfood will be at a similar spot on both metrics in 12 months

time, when they report their 2019 actual. 1.8x my 2019 sales forecast also equates to $6 in 12 months

time.

Ultimately I believe Goodfood will be bought out by one of the 2 largest grocers in canada, Loblaw or

Sobey’s. In the US we have seen the 2 largest grocers buy out Home Chef and Plated in the past 14 months.

The fit is obvious, with procurement and possible DC savings, as well as easy cross promotion

opportunities by acquiring new customers through the brick and mortar network. The Canadian grocers

have to be taking a look given the moves by their US counterparts.

For either Loblaw or Sobey’s, Goodfood is the only meal kit company of size. Hellofresh, being an

international operator, is not for sale. Chef’s Plate was just taken out. Missfresh (small) was bought by

Metro over a year ago. Both Sobey’s and Loblaws have struggled with home delivery, with Loblaw’s only

recently rolling out insta cart but pushing customers toopt for click and collect much more strongly.

Sobey’s signed a deal with Ocado in early 2018 but will not be ready to roll out their home delivery until

2020. A meal kit company would fit in well with their grocery home delivery ambition, and in recent

meetings with management Sobey’s seemed more open to the idea of one day having a meal kit solution

that did Loblaw. Both Jonathan and Neil come from an investment banking background and would likely

be amenable to a sale at the right price.

Conclusion:

Goodfood is the market leader in a fast growing industry. While the industry as a whole has had difficulties

in the past year reaching profitability, I believe differences exist in Canada that lead to an easier roadmap

to profitability. The business model itself is not broken, but only works when in an oligopoly state,

something that will eventually happen in the U.S. market and has already happened in Canada.

Goodfood’s EV, at only $135mm Canadian, does not reflect its 256% growth last year nor it’s future

profitability levels in the medium term.

Risks:

- While not necessarily a risk I believe my EBITDA forecast for 2020 may not materialize, but for the right

reasons. The company may be on the precipice of 5%+ EBITDA margins and decide to make the investment

in price as discussed above. I believe this would be the right move to make, increasing customer order

rates, altering customer behaviour, taking away a pain point, and discouraging entry into the industry

from others. But this would have a direct impact of margins. Given the model is working capital negative

as these companies grow, Goodfood would still be free cash flow positive despite being EBITDA break

even. In that scenario we would see an increase in revenue and subs and a drop in EBITDA.

- The industry is still in early stages and most companies have yet to turn a profit.

- Barriers to entry are low although barriers to profit are high

- International players like Hellofresh may use international operating profits to fund losses in Canada as

they attempt to develop a large market share.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Subscriber growth coming in faster than the street expects (Dec 3rd week)

EBITDA breakeven (spring 2019)

Sale to a grocer

show sort by

			2018	2019
Price:	2.87	EPS	0	0.30
Shares Out. (in M):	52	P/E	x	10
Market Cap (in $M):	150	P/FCF	x	10
Net Debt (in $M):	-20	EBIT	0	17
TEV (in $M):	130	TEV/EBIT	0	10