Description

HelloFresh is a German-based meal kit company. With more than 7.3 million active customers, half of which are in the US, it is the clear global leader in the meal kit industry. From 2014 to 2020 HelloFresh has increased its revenue from 70mn EUR to 3,750mn while the number of orders fulfilled has increased from 1.7mn to 74.30mn during the same period. Today, HelloFresh is the market leader in the meal kit business in all 14 countries in which it operates.

Meal kits are increasingly becoming a popular solution to discover recipes and cook fresh and healthy meals. Consumers receive a weekly box at their doorstep with at least 3 meals for two people. Ingredients are already pre-portioned and in the exact quantity to match the recipes that customers have selected. The price per serving is lower than the price of fresh individual products at a high-end grocery store. The service works as a weekly subscription that can be cancelled and reactivated at any time. The customer experience is designed to provide convenience, to discover fresh and healthy meals, to save preparation time and to reduce unnecessary waste.

Meal kits are rapidly making inroads in the way we consume food. From an investment perspective, what is even more encouraging is the unit economics of the meal kit business model, especially when compared to the fiercely competitive grocery business. The key financial traits that make the business model attractive are the following:

1. Very attractive gross margins -  Despite competitive pricing, meal kits have gross margins of around 65% vs 25% for traditional grocery models. Several factors explain such a high difference in gross margins, the most important one being waste reduction. Retail stores need to fill their shelves with the right product assortment and the right quantity to optimize sales. If they overload the shelves, they will have to throw away expired products. It is estimated that 15%-20% of perishable grocery items are wasted. However, meal kit companies know several days in advance how many recipes they have to prepare so they can order the exact quantity from their suppliers – this is in essence the most efficient manner of inventory management. Effectively, meal kits have almost no waste, generating 15%-20% efficiencies vs traditional grocery retailers. To this, we need to add that there is also no waste at the consumer level.

On top of that, meal kit companies are vertically integrated, sourcing goods directly from producers. By removing intermediaries and brands within the value chain, meal kit businesses can keep more of the profit pool. This direct-to-customer relationship also allows them to better understand customer needs, easily iterating the product without relying on market research. 

Moreover, meal kits enjoy some degree of pricing power as customers are willing to pay a premium for the convenience of getting fresh meals delivered at home and having exciting new recipes which make cooking a more joyful experience. 

2. Negative working capital -  Meal kit companies receive cash from customers several days before the order has to be effectively prepared and shipped. Once they receive the customer order, they source the products from their suppliers, paying them on average after 60 days. This dynamic creates a very attractive cash flow cycle, which allows them to fund very high organic growth rates. 

3. Relationship with suppliers - Meal kits are a very good channel for suppliers to market their products. Firstly, because meal kits tend to have national scale compared to the local scale of traditional grocery chains. Secondly, because the way you present the product in a meal kit is more attractive than in a grocery store. Instead of putting your product in an aisle together with other competing products, you are showing your product as part of a recipe. Finally, meal kits, unlike grocery stores, are far more flexible with the products they need to source because they can manage and change meals every week. That implies that meal kit companies have a very low dependency on a particular supplier or product, which gives them bargaining power without reaching a high scale. 

Contrary to our own thinking, meal kits are widely perceived by investors as a flawed business model. The most common concerns raised by investors when looking at the meal kit sector are 1) aggressive discounting, 2) high customer churn rate and 3) no barriers to entry. These concerns are validated with meal kit companies historically reporting consistent losses and industry pioneer Blue Apron’s implosion, making it easy to quickly dismiss the business model and assume that these companies are throwing venture capital money at unprofitable customers. But if one can invest marketing dollars prudently the business does lend itself to healthy profitability. Our analysis of HelloFresh numbers makes us confident that investor concerns are misplaced and can't be applied to the sector at large. 

1. Discounting -  In order to create a market for their service and let consumers try meal kits, HelloFresh offers discounts. Most of those incentives come in the form of vouchers. For instance, a typical voucher will offer the first meal kit for free or the first 3 meal kits at a 40% discount. In our view, discounting is not a problem by itself. Given the high gross margins, the payback for the industry is very attractive even with retention rates in the twenties. Actually, a meal kit consumer is profitable after just the fourth box is delivered and those customers that remain loyal subscribers for years are extremely profitable. 

2. Churn rate -  In a world that is being eaten by software, investors very quickly assume that all good subscription business models should have a very low churn and high revenue retention rates of 95%+. However, not all subscription-based services are created to have constant usage. The usage patterns of HelloFresh subscribers have nothing to do with any software-related subscription. There are different usage patterns depending on the type of consumer. You have the frequent user, who is deeply engaged with the service and relies on HelloFresh to solve weeknight dinners throughout the year. There is also the seasonal user, who tries for two months, stops the service, comes back, and so on. There is also the occasional user who thinks of HelloFresh as a meal solution when there are visits or when there is any type of event. And finally, there are the trialists, who just try and drop the service. The key message is that each customer segment finds the right frequency in the first year and afterwards they are very stable and predictable. Failing to recognize how customers interact with the service makes a retention rate of around 20% low enough to disregard a potential investment in the business. With this backdrop, the percentage of active subscribers that have reactivated their subscription is a key operating metric to understand the business. Currently, roughly a third of total active subscribers have reactivated their subscription. 

3. Barriers to entry -  Even once understood that the unit economics are attractive, at a first glance, meal kits seem to be a simple business with no entry barriers. And to be honest this is probably the case at a very small scale. However, it is extremely complicated to execute at scale. We note the following key challenges to operate at scale: 

a) Consistent customer experience -  Creating new and engaging recipes that appeal to a large section of the audience and delivering them flawlessly are critical to providing a good customer experience. Unlike other online products, when it comes to food, customers are less forgiving with the tolerance of slippage of the delivery time reducing to a few hours. As the business scales from regional to national level the execution complexity grows exponentially, putting immense stress on the system. Putting systems and processes in place and managing the sourcing, manufacturing and delivery are the biggest challenges that need to be addressed. 

b) Investing in growing the market - Meal kits is a nascent industry and customers need to be introduced to the product. As explained above, industry players usually invest heavily in marketing and provide discounts to entice new customers to try the product and experience the concept. As in any other low-ticket discretionary spend, customer churn is very high and many customers are just discount seekers that don’t repeat the purchase once the discount is withdrawn. A very high degree of marketing expertise is required, as acquiring too few customers can lead to a lack of scale but acquiring the wrong customers can lead to serious capital losses. Overall, it is a business that can look easy for new entrants but that at scale requires impeccable execution on many fronts to succeed, as can be seen in the hundreds of failed meal kit companies. HelloFresh has demonstrated its ability to operate profitably at scale.

If there is one trait about HelloFresh that keeps coming up in conversations with ex-employees, suppliers and industry experts is their first-class execution. This is also reflected in their reported numbers. HelloFresh has managed to grow the top line at 70% CAGR since 2018, improve operating margins from negative 7% to positive 11% and triple net cash position. This outstanding track record was achieved without any new external capital, which speaks to the underlying profitability and cash generation of the business. 

HelloFresh has demonstrated an ability to excel at both sides of the business and across fourteen different markets, even when it has entered markets with an already consolidated market leader. For instance, in the US, they launched three years after Blue Apron and now they sell five times more. They boast more than 50% share in all markets in which they operate and they are the most profitable listed meal kit company by a wide margin. In 2020, HelloFresh reported 11% operating margins compared to GoodFood’s 3% margin. Other large peers like Blue Apron and Marley Spoon are still reporting negative operating margins.

Sustainable Growth and Opportunities 

Covid did benefit meal kit companies and all the listed meal kit companies that we track have seen an acceleration in their growth rate in 2020 without increasing their marketing investments. Not surprisingly considering the market's perception of the business model explained above, markets had been worried that HelloFresh would see an increase in churn after the pandemic. We believe that this is overblown and that the impact of the pandemic on the business will be more permanent than isolated. We can all probably already get a sense of how deeply ingrained in our lives some of the habits formed during the hard stage of the pandemic are. 

There is also no sign that customers acquired during the pandemic are of lower value vs prior cohorts. The key customer metrics reported by HelloFresh for the first quarter of 2021 (average order value and number of orders per customer) are better than a year ago. Also, the fact that they keep building and adding facilities even in their more mature markets is indicative of the quality of their current demand and the growth that they see ahead. 

We believe there are several growth levers that will contribute to sustain the double-digit growth rate of HelloFresh for many years to come. 

1. Higher Penetration -  Only 3% of US households subscribe to a meal kit service. As HelloFresh improves the value proposition through more variety (expanding recipes to choose from 30 to 100 recipes) and higher convenience (including recipes with less cooking time and flexible delivery schedule) we believe there is room to at least double that penetration rate. Demographic tailwinds should help here as younger generations are more health conscious and more willing to pay for convenience. 

2. New Markets -  HelloFresh is already present in 14 countries. They plan to open one or two new markets per year and have just launched in Norway, with Italy coming soon. 

3. New Products -  In addition to meal kits, HelloFresh is offering a ready-to-eat meal solution for those with less time or not willing to cook. This is a complementary offering to meal kits and a good alternative for meal kit customers that unsubscribe because of the cooking time required. 

4. Higher Wallet Share - HelloFresh is part of the food chain and can leverage its D2C relationship to address the much larger opportunity by "filling the pipe" with complementary products to the meal kit. Each additional grocery item added to the box comes at a high incremental margin and, on top of that, increases convenience for the customer by completing a higher percentage of the grocery basket in one order. HelloFresh Marketplace is the name of this initiative and has already reached 150 grocery items in some key markets. We expect the company to add more SKUs and address the wider grocery needs of the customer's overtime. 

As HelloFresh builds its grocery and ready-to-eat meal solution business it is gradually evolving from a pure meal kit business to a fully integrated meal solution company. If management continues to execute well, they could unlock significant value for investors beyond their core meal kit business. Judging by their historical execution and demonstrated ambition, it is a bet we are willing to take.

Catalyst

Higher Penetration, entering new markets, adding new products and higher wallet share