Description

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Business Model

In the summer of 2013 GrubHub (based in Chicago and present in most major metropolitan areas throughout the U.S.) merged with Seamless (based in New York) to form GrubHub Inc., which is now the dominant online food ordering platform in the U.S.  by market share (~65% market share of online food ordering from independent restaurants).  GrubHub and Seamless enable customers to search, order, and pay for takeout or delivery from local restaurants via GrubHub’s websites and mobile apps.  GrubHub then sends the orders to the specified restaurant (most frequently via GrubHub’s OrderHub network but sometimes still via fax or e-mail), confirms the restaurant’s receipt of the order, and provides updates to diners as the order is prepared.  GrubHub periodically remits payment back to the restaurant less the ~14% commission they charge on the order.  Unlike fixed fee models like Opentable, where fees in the past have exacerbated captive restaurants, GrubHub’s commissions have a 10% floor but ultimately are determined by a bidding system in which restaurants paying higher commissions get priority in list rankings on GrubHub’s site.

Thesis

·        Low Market Penetration Enables Long Duration of Strong Growth:  Based on GrubHub’s disclosures, only ~3% of the independent restaurant takeout market was ordered online in 2013.  Using online reservation site Opentable.com as a precedent, in 2007 only ~4% of reservations in their core market were being done online.  Six years later in 2013, I estimate that Opentable.com’s penetration had risen to 20%, a 5x increase in penetration.  Assuming that the online ordering market penetration curve roughly follows the online reservation market over the 2013-2019 period, online ordering should grow at a ~35% CAGR.

·        Significant Barriers to Entry Leads to Stable Market Share:  GrubHub’s strong competitive positioning (and 14% take rate) stem from the fact that it connects fragmented pools of buyers (diners) and sellers (independent restaurants) in a market that has high incremental margins.  As a result, it makes economic sense for restaurants to use GrubHub to the extent that it brings incremental diners.  Restaurants may also use GrubHub’s competitors (e.g. Eat24, Delivery.com), but importantly unless a restaurant is running at full capacity (when it might make sense to turn off GrubHub) independent restaurants lack the ability to direct diners to a cheaper platform.  Further, GrubHub’s order technology is increasingly being integrated into the food delivery work flow, which will limit the number of order platforms a restaurant would want to connect to.  The question then becomes how to attract diners.  From the diner’s perspective, GrubHub has the best technology (popular website highly rated apps, order progress updates in part enabled by the in-restaurant OrderHub technology), the broadest offering of restaurants, a strong branding (GrubHub’s scale and high commissions enable a large marketing budget, and it would be very hard for a subscale me too product featuring lower commissions to be able to replicate GrubHub’s customer acquisition engine), and corporate relationships.   GrubHub’s first mover advantage has given it a sizable base of diners and restaurants, and the network effect that makes GrubHub’s business so defensible is the same reason it’s hard for GrubHub to break into new markets (Just Eat, a European online food ordering company focused on international expansion, admits that they don’t even try to break into new markets organically and instead pay up for the #1 or #2 player).

·        Industry Dynamics and OTA Precedent Validate Pricing:  While GrubHub’s 14% commission rate is high relative to the average restaurant’s operating margin, restaurant gross margins are commonly >30%, gross margins on takeout are higher than normal, a presence on GrubHub typically increases a restaurant’s takeout business, and GrubHub orders are typically >20% larger than average.  I view GrubHub’s value add as comparable to the online travel agencies (OTAs) in Europe (fragmented buyers and sellers, high incremental margins, and generally operating below capacity), and I think the mid-teens commission Booking.com earns in Europe sets a precedent for GrubHub’s pricing.

Valuation

·        Given how early we are in market penetration, the most logical thing for GrubHub to do is to focus on market share and greenfield development, not profits.  GrubHub’s national TV campaigns and early push into Tier 2 and 3 cities suggest to me that they get that message, but despite their best efforts the company is already generating cash and has robust adjusted EBITDA margins of ~30%.  Valuing GrubHub is difficult because it is expensive on near term metrics (on consensus 2015 estimates its 8x EV/sales, 26x EV/EBITDA, and 63x P/E.)  My main method of valuation is to look at Opentable, and before being acquired by Priceline Opentable.com was trading at 42x forward earnings at a point in its growth curve that I estimate is 7 years ahead of where GrubHub is today.  GrubHub currently trades at 60x my 2015E adjusted EPS estimate of $0.58.  If pricing and market share hold and the penetration ramp plays out as I expect and in 7 years GrubHub trades at 40x when it is at a comparable point in its penetration curve to Opentable last year, the stock would be worth $120, or a 23% IRR from where we currently stand.  While this time horizon introduces a lot of execution risk and uncertainty, given GrubHub’s strong model and competitive advantages I think a 23% discount rate is unwarranted (at a 15% discount rate the stock would be worth $52 today), and as the market realizes the duration of GrubHub’s topline and earnings growth I expect the stock price to increase.  Alternatively, I think that a comparison of EV/EBITDA to the 3 year sales CAGR is helpful for looking at the internet stock peer set, and at 23x my 2015 EBITDA estimate GRUB compares favorably to other comparably fast growers like YELP (29x) and LNKD (31x).

Key Risks

Competition:  Frequently mentioned competitive threats for GrubHub are Amazon (which is moving into the local services business), Eat24 (a smaller version of GrubHub), and Yelp (which partners with delivery.com and Eat24 to offer food ordering through its main site).  In general, I think that GrubHub’s first mover advantage, scale, network effect, branding, and the shift to mobile will enable GrubHub to maintain its market share.  Of the group, Amazon notably doesn’t have any capital constraints and could temporarily be disruptive if it tries to make a push in certain cities, which is a risk.

Valuation:  GrubHub has a high valuation relative to its near term earnings potential and is particularly susceptible to mis-steps.

DISCLAIMER: The author is long GRUB.  This is not a recommendation to buy or sell any investment.  Additionally, this document should not be relied upon to make an investment decision as the numbers and figures presented are solely the author’s estimates.  Investors should contact the company directly and read GRUB public filings to form their own opinions and make their own investment decisions.  The author may transact in the securities of GRUB without notice.  

Catalyst

I think consensus’ modeling of GrubHub’s revenue deceleration is overly conservative, and I think faster than expected revenue growth will be a catalyst for the stock.