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Deliveroo's IPO valuation is too high

Deliveroo's IPO valuation takes it for granted that it will make big profits. Reality suggests this may be hard to do
Deliveroo's IPO valuation is too high

Deliveroo’s flotation on the London market has come with a mix of excitement and controversy. Despite cutting its IPO price range, the shares still look very expensive given that the business faces many risks and challenges in the years ahead and has a lot to prove.

The arrival of Deliveroo on the London Stock Exchange is seen as a boost for a market that is lacking in big tech stocks. Last year, the mere labelling of something as a 'tech stock' with a positive growth story attached to it had been more than enough to see its share price go through the roof.

In more recent times, there has been some sobering up in this mindset as the prospect of rising interest rates and a return to focusing on business fundamentals has seen some of the froth come off share prices. 

Deliveroo definitely falls into this category and it is no surprise to see the owners trying to cash in some of their investment and raise money to fund growth while the going is good. 

However, this IPO comes with the usual health warnings attached. These days little thought is given to leaving some value on the table to help create a decent aftermarket for the shares. It’s all about maximising value of the selling shareholders and existing investors and there’s nothing to suggest that there’s anything different with this IPO.

I’ll deal with some of the controversial issues attached to Deliveroo shortly, but for me the bottom line with this company and whether it will be a good investment or not comes down to whether it can make a lot of money from delivering food. Its initial flotation valuation certainly assumes that it will.

The delivery of food, whether it be from branded global fast-food outlets, high-street and local restaurants, takeaways and supermarkets has boomed over the past year fuelled by Covid-19 lockdowns. The trouble is, for the companies that are doing most of the delivering, very few, if any, of them appear to be making decent amounts of money from it. 

This is probably the reason why most supermarkets don’t tell investors how much money they are making from selling groceries over the internet. Even companies such as Ocado (OCDO) which has seen big revenue increases over the past year talks about profits in terms of Ebitda, which ignores the cost of replacing computer software and especially delivery vans. Once the costs of these are taken into account, there isn’t much money left over and certainly not enough to give a decent return on the amounts of money invested in the business.

So why will a food delivery company such as Deliveroo buck this trend? The company has been in business since 2013 and has made cumulative losses of £1.1bn since then, which included an operating loss of £221m in 2020. Maybe it stands a better chance because it does not own or rent lots of warehouse properties and fleets of delivery vans.

Deliveroo is a slightly different business to Just Eat Takeaway (JET), but is essentially trying to achieve the same thing. Its business is split into two parts. 

The first bit comes from restaurant delivery. Deliveroo connects consumers to restaurants via its website or mobile app and then gets its riders (many of them on bicycles with big boxes strapped to their backs) to deliver the food they have ordered to them. Only around 10 per cent of its deliveries are from takeaways, with the remainder coming from quick-service restaurants, national restaurant chains and independents.

Consumers pay for their food online, with Deliveroo taking a delivery fee and a commission from the restaurant from the amount paid. The fee paid by the restaurant depends on the type of service they choose. Fees for orders using Deliveroo riders are higher than for those where the restaurant does the deliveries itself.

The other part of Delveroo’s business concerns the delivery of on-demand groceries from convenience retailers in 30 minutes or less. The company has entered into partnerships with the likes of Morrisons, Co-op, Waitrose and Aldi in the UK as well as Carrefour in France and other International food retailers. Here, Deliveroo uses its riders to deliver small amounts of groceries in return for a fee.

By the end of 2020, Deliveroo had more than 6m monthly active customers in 12 countries buying from more than 115,000 restaurants with deliveries from more than 100,000 riders. Just over half the company’s revenues come from the UK and Ireland. The rest of the business is based in Europe, the Middle East and places such as Singapore and Australia. The company has had mixed fortunes overseas and exited the German market in 2019 and Taiwan in 2020.

The main aim of the business is to improve the choice and delivery experience of consumers while giving restaurants and grocers access to new customers and revenue sources. Its attempts to achieve this have differentiated it from some of its competitors.

Deliveroo has a business called Editions, which has set up kitchens that are only used for delivery orders (these are often referred to as dark kitchens). These give restaurants an opportunity to grow their delivery businesses in new areas without a lot of upfront costs. The restaurants put their own chefs in the kitchens with Deliveroo taking care of the technology behind the ordering and deliveries. Deliveroo has more than 250 kitchens in eight markets and is using some of the cash raised in the IPO to build more of them.

Signature is Delveroo’s white-label service to restaurants. The restaurants interact with their customers under their own trading name or brand with Deliveroo managing the digital side of the business in terms of collecting payments, websites and apps, customer service and delivery.

These initiatives have helped Deliveroo build up good relationships with its restaurant customers and explains why some of them only use it for deliveries and have exclusive menus with it.

The company has also been working on growing and retaining its customer base by investing in service quality. This comes in the form of restaurant choice, but also technological niceties such as the ability to track deliveries in real time and monthly subscription plans which give unlimited deliveries on minimum qualifying orders.

 

Is there enough operating leverage in this business? 

Deliveroo has been successful in growing its revenues, but is still making losses at the operating profit level. It needs to show that it can leverage its substantial fixed costs (largely staff, marketing and IT costs) and generate big and growing profits.

In 2020, Deliveroo had a gross transaction value (GTV) of £4.08bn, which represented the total value of all the orders made over its platform. This was 64 per cent higher than the year before and was helped by the surge in orders due to Covid-19 lockdowns.

The fees from restaurants, supermarkets and consumers equated to just over 29 per cent of the GTV, giving £1.19bn of revenues. By far the biggest cost of these revenues was the cost of paying its riders to deliver the food ordered. Other costs include items such as credit card fees. After these costs were paid, Deliveroo was left with gross profits of £357m, but this was not enough to cover the fixed costs in the business and the company made a £221m operating loss.

That said, there are encouraging signs of operating leverage within the business as the £419m increase in revenues led to a £98.8m reduction in operating losses.

The gross profit margin on revenues has improved significantly from 18.5 per cent in 2018 to 30 per cent last year. The key driver here has been a reduction in the cost of delivery. Deliveroo has invested in algorithms that learn delivery routes in local neighbourhoods which make deliveries more efficient. An increase in order volumes also improves the local delivery density and drives down delivery costs. These helped to allow Deliveroo to have positive Ebitda in the second and third quarters of 2020.

All this is well and good but it might also highlight a potential problem with the business model. Could it be that it can only be effective in densely populated big cities? Some prominent fund managers such as James Anderson of Scottish Mortgage Trust (SMT) (who has been a big investor in similar companies such as Delivery Hero and Grubhub) have expressed concerns that Deliveroo is too reliant on the UK and London in particular to get the business economics to stack up and that when it is applied in less populated areas it will not work or work as well.

 

Will changing employment law blow a hole in the business model?

Deliveroo is an exponent of the gig economy. Depending on your point of view, it offers the benefits of flexible working that’s great for work-life balance or is a huge exploitation of workers and a big tax and cost dodge. Either way, changes in employment law could cause Deliveroo and others with a similar business model a big headache.

Deliveroo argues that its riders are independent and self-employed contractors who are free to work when they want and for who they want, which includes Deliveroo’s competitors. As a result, they get paid for the work they do (a gig) and are not entitled to holiday pay, sick pay, severance pay, minimum wages or pensions.

As has been seen with the likes of Uber, governments across the world can have a different view of things. The European Commission is also looking at the status of workers in the gig economy.

Deliveroo has already fallen foul of the law in Italy. It has a liability for the back pay of wages and benefits between September 2015 and October 2020 when it changed its rider model. 

At the end of 2020, there was a £112m provision for these costs on Deliveroo’s balance sheet, which was driven by a £79m increase last year. These costs have been expensed (to the company’s credit not as an exceptional item) in the income statement, but no cash has yet flowed out of the company.

The big worry is that these liabilities might represent the tip of an iceberg. If governments increasingly say that Deliveroo’s riders are employees then the company could face a huge and currently unquantifiable bill for back payments as well as suffering a big blow to the economics of its business model. This is a real risk which needs to be reflected in the valuation of the company and it doesn’t look as though it is.

A separate rider issue is whether Deliveroo can keep hold of them long enough. The average rider only works for the company for 10 months before leaving. Competition for workers is hotting up with rivals such as Just Eat now offering employed status. 

Then there is the controversial subject as to how much Deliveroo’s riders actually earn. The Independent Workers’ Union has said that some Deliveroo riders earn as little as £2 per hour in the UK with as many as one-third earning less than the minimum wage. Deliveroo has countered this by saying riders can earn £13 an hour at busier times. 

These concerns, along with the fact that the founder will have 57 per cent of the voting rights while owning just over  6 per cent of the shares have put many fund managers off investing in the IPO and partly explain why the offer range was cut back to 390p-410p from 390p-460p on Monday this week.

 

Current trading is good but IPO valuation looks too rich given the risks

Unsurprisingly, given lockdowns and other Covid-19 restrictions, Deliveroo has started 2021 strongly with GTV up by 121 per cent in the first two months of the year. It is guiding to 30-40 per cent GTV growth for the whole of 2021 with a gross margin on that GTV of between 7.5 per cent and 8 per cent.

This would imply flattish GTV growth for the rest of 2021 compared with 2020 and gross profit growth of around 28 per cent and a slight reduction in gross margin percentage on revenues to produce gross profits of between £424m and £457m.

Given the run rate in fixed costs this suggests that Deliveroo will make another operating loss in 2021, but probably one that is much smaller than in 2020.

Looking further out, the company is bullish and reckons it can keep on growing its GTV at a rate of 20 to 25 per cent for the next few years at a GTV gross margin of 8.5 per cent as efficiencies improve. With fixed costs growing at a slower rate, this should comfortably push the company to an operating profit.

However, this assumes that the status quo on its business model – especially rider wages – and competitive environment remains.

While its markets are likely to grow it remains to be seen how the cake is divided up. Consumers are likely to return to restaurants when lockdown ends while restaurants will welcome the higher margins that fuller in-house occupancies will bring. 

The grocery delivery business is a nice source of growth for both parties, but it’s an industry with razor-thin margins and not much scope for fee growth. A return to office working will also see more convenience shopping in lunch hours and on the way home.

Predicting future revenues and the likely pattern of them is therefore difficult. Whether the current industry structure is helpful enough to make them profitable is another matter. Is there enough profitable business to go around?

There’s grounds for thinking that there isn’t as evidenced by consolidation in the marketplace. Just Eat and Takeaway.com merged and have also bought Grubhub in the US. It is also competing aggressively on fees to build scale and operating leverage.  

Delivery Hero has quit its home German market because it can’t make enough money from it, while Uber decided to give up on the idea of dark kitchens. Amazon decided to invest in Deliveroo rather than go it alone in this area.

So what price tag do you put on a business with a highly uncertain growth profile and big risks like Deliveroo?

With no profits, it is likely to be valued on its revenues. At the lower end of its IPO pricing range of 390p, the business was valued at 6.2 times last year’s revenues. This is a premium to Just Eat on 5.8 times but a discount to the likes of DoorDash (US:DASH) on 14.9 times, which looks frothy to say the least.

If Deliveroo can tackle its challenges and leverage its revenues then it could be a business that might make very good profits. The problem for investors is that its valuation arguably takes this for granted while a reality check suggests it could be hard. These shares are therefore a very high-risk investment. 

 

See also - Fund managers express doubts ahead of Deliveroo IPO