Investment Themes: Core Value
Since the world has been in the grip of the coronavirus, a lot of new investment ideas popped up. Most of these have been focused on e-commerce and software platforms. One of these investment ideas is HelloFresh ($HFG.DE), a meal delivery company based in Germany with operations in Europe, North America and Oceania.
HelloFresh is the pioneer in this space and started in 2011. HelloFresh estimated the US market for home delivery meal kits to be worth more than USD 2.0 billion in 2019. Based on this metric, it would have around 50% market share in the US in 2019, making it one of the market leaders in the space. Through acquisitions and strong organic growth, it is positioned to also become the global market leader in the space for food delivery services.
- HelloFresh has seen incredible growth due to the coronavirus pandemic
- The business model is unique and can, in my opinion, be seen as a Blue Ocean
- It has built a strong brand that is currently the largest and strongest in the industry
- Assuming market growth and only slight improvements in operating margins the stock offers an implied return of 11.4% at the current share price of €45.06
- However, it is important to continuously assess the growth track of the company as pricing pressure and customer churn can have a large impact on the future value
POST UPDATE/RECTIFICATION LOG:
– HelloFresh expanded to Denmark in June 2020
– HelloFresh expanced capacity in the United States in August 2020 to meet demand
Many people came up with the idea to invest in HelloFresh earlier this year and these investors have been rewarded. On October 30th 2017 the stock closed at €10.25. A year later in 2018, the stock was still moving around that price. During the early months of 2019 the stock even went below that level, to eventually recover and grow to around €16 by the end of October 2019. HelloFresh showed it could achieve a positive (adjusted) EBITDA over 2019, and driven by the pandemic the stock soared to over €50 in July 2020. Right now the stock is at €45.06 (€7.5 Billion market capitalization based on 166 Million shares outstanding). The investors from 2019 are already rewarded with a more than 400% return. The question now is whether it is too late to step in, or whether it is still a great investment opportunity.
While the stock price has soared over the past years, it does seem that it has resistance around the €35 level (black line). Aside from that, the stock has been very volatile over the past months, meaning it can be wise to slowly build a position in this stock if you desire to do so.
HelloFresh delivers meal boxes with ready to cook meals for an affordable price. The meal boxes aim to offer healthy meals and to reduce food waste by tailoring the meals to the individual customer. As of 2019, HelloFresh operates in the following countries:
- The Netherlands
- The United Kingdom
- North America:
- The United States
- New Zealand
The reporting is split into the USA and International, where the USA only includes the USA and International includes all other geographies. The total population of this market is around 673 million people.
Given the requirements of the company to expand to geographies with high internet penetration, a developed infrastructure and high disposable income, the geographies to still expand to seem to be limited. The geographies I personally still see as opportunities on the short- to medium-term (around 5 years) are:
- Czech Republic
Most of the future growth needs to be achieved in the geographies where HelloFresh is currently active. The countries listed above offer a market expansion of 184 million new people (27.3% of the current geographies).
An additional opportunity is the expansion to other Eastern European and Asian countries in the future, but that would be a whole new culture and market to adhere to. Because of that, I don’t take this into account in my future view of the company (even though China, South Korea, Japan and some other South-East Asian economies may be very interesting for the product offering given HelloFresh its own market requirements).
The Cutting Edge
What makes HelloFresh such a strong player in the market is that it is focused on technology and rethinking the food supply chain. Whereas a regular supermarket or grocery delivery company would have an inventory that requires customers to make a choice, meaning that there will always be shortages and surpluses (including waste), HelloFresh has an optimal just-in-time supply chain model, where customers receive a customized meal, for which the ingredients are bought by HelloFresh based on the customers’ pre-determined choices. This optimized supply chain model allows for better margins and closer relationships with both suppliers and customers.
The product proposition enables upselling through boxes for starters, side dishes, fruit, wine and other special boxes, but it also allows for economies of scale, which will eventually result in better operating margins. Examples of possible product differentiation are to sell budget meals for people looking for this delivery service with a tighter budget, or ready to eat meals for people who don’t fancy having to cook for dinner.
BeursWolf Future Vision
The vision I personally have for HelloFresh is that it can disrupt the grocery store model. Whereas people are afraid that for example Amazon may take a meaningful role in this space (also through WholeFoods), I think the current model of Amazon will not make it both in terms of the business model, as well as for the consumer.
The reason why I think grocery shopping is the last retail branch to be disrupted by the e-commerce model is because there is a grocery store near every home, and hunger and thirst are needs of people that come and go on a very short-term. When you currently order food online, you have to individually select all individual products. However, when HelloFresh delivers your food they select the ingredients for you. The former carries the risk that, when you forget something, you still have to visit a local supermarket. The latter (HelloFresh) makes sure you have everything you need. This, combined with the strong brand HelloFresh has already built and the learning curve it has gone through over the past few years, mean that HelloFresh has a very strong market position in a market that can become the future of grocery shopping.
In terms of the business model, the online grocery store model generates a lot of waste, requires high inventories, and will have inefficient delivery routes (HelloFresh can plan routes because they can plan a one-time complete delivery as described above). Of course there will still be a need for the ad hoc grocery shopping. That is why I believe in a combination of the offline grocery store model with the current HelloFresh offering. An integrated product offering between a meal kit delivery company and an established grocery store is in my opinion inevitable. This combined product offering can be the ultimate brick-and-mortar food and beverage business model:
- Just-in-time efficient home delivery of perishable goods and specific non-perishable goods for all meals you want throughout the week (breakfast, snacks, lunch and dinner)
- Cheaper than the competition offline grocery stores only carrying limited perishable goods and mostly non-perishable goods that can stay in inventory for longer
- Optimum balance in the control where (a) the consumer is still in control of meal choice, and (b) the nutritional balance in meals and waste can be controlled by the company
Personally, I think that this attracts current market players to this industry. Interestingly, the CEO of Ahold Delhaize ($AD.AS), Frans Muller, mentioned something similar in a recent interview with the Dutch Financial Times. Loosely translated he said the following in this interview:
“We would rather acquire an innovative, online player, instead of a traditional retail company such as Hema”
“What we want is to further grow with our supermarkets and the online sale of food products”
“Since the outbreak of the virus people do not only cook more often, but they also look more closely at what they eat. We expect these trends to stay, and we want to act on these trends through acquisitions”
Even though Ahold Delhaize has the Allerhandebox as a similar product, I believe they may be looking at the possibilities to acquire a company in this exact space. Whether that will be HelloFresh is a big question, but I think it is the only one that directly fits in Ahold Delhaize’s vision in terms of brand value, geographical scope and financial strength. Still, at the current market capitalization, it would be a hard pill to swallow.
I do not see the competition become as strong as HelloFresh at this moment. HelloFresh has become the largest brand in this space. Other well-known brands are Blue Apron and Marley Spoon. Blue Apron ($APRN) has continuously diluted shareholders and has yet to gain real traction. With a market capitalization of $94 Million, Blue Apron is already dwarfed by HelloFresh its operating result over the first half year of 2020 of €181 Million. With a single convertible note offering of €175 Million, HelloFresh has enough capital at its disposal to blast this competitor out of the water, or acquire them to further strengthen their market position.
Marley Spoon ($MMM.AX) is the larger competitor with a market capitalization of $517 Million (AUD). Given the traction of Marley Spoon, this seems to be the main company to beat at the moment. However, Marley Spoon still has to find a real path to profitability. HelloFresh can use its head start to further strengthen its market position relative to Marley Spoon. Even if it becomes a serious competitor, the current $11.7 Trillion food and grocery retail market size should be sufficient for more than one player to offer great shareholder returns.
I want to assess the strategic positioning of HelloFresh through the Blue Ocean Strategy model. The cutting edge described above best reflects what business model revolution HelloFresh pursues. The visualization below shows how it differs from the regular supermarket business model and the common online grocery business model.
The optimizations are gained in procurement through efficient and just-in-time warehousing and fulfillment. Similar to the online model there are no stores between the warehouse and the customer, which also means that customers need to spend less time doing their groceries. Finally, HelloFresh its business model offers the advantage to customize portions and meals for health and customization purposes, and it can all be done in one delivery (whereas the traditional online model needs to come and go as often as the consumer wants).
Before diving into the financials I want to take a look at the risks facing this business model. While it can be easily explained that it offers unique value to customers, it is more expensive than regular grocery shopping. Customer churn and pricing are therefore the biggest risks facing HelloFresh in my opinion. There are currently no consistent numbers on what part of the customer base is recurring, and what part is churned.
The simple truth is that HelloFresh offers a very low entry barrier product for consumers with attractive entry pricing. When churn is high, large marketing investments can result in growth even with large churn numbers. Therefore, I will tread carefully with this stock over the first few years. The moment where growth stops is the moment where the stock can take a tough beating.
In terms of pricing I believe the current average price per meal of just over €6 is not sustainable in the long-term (shopping in a supermarket is still much cheaper), so it is something to take a look at in forecasting the future margins.
The most important thing to note in the financial statements is that HelloFresh achieved incredible revenue growth already before the coronavirus pandemic started. Revenue growth has been consistently higher than 40% starting in 2017, with revenue growth of 84.8% in the first half of 2020 (assuming the second half of 2020 is exactly equal to the first half of 2020).
Even though the improvements in the contribution margin (defined as the revenues minus procurement and fulfillment expenses) reversed in the first half of 2020, it can be noted that this is the result of relatively higher fulfillment expenses due to the coronavirus. The procurement expenses as a percentage of revenues still improved in 2020. Due to the large increase in revenues in 2020, HelloFresh achieved a positive operating result of €181 Million over the first half year of 2020.
The revenue growth is mainly driven by the increase in the number of meals delivered. The underlying figures measured by HelloFresh are the number of orders, number of meals, value per order and value per meal. The take away from the historical trend here is that as people buy more in one order, the price per meal decreases.
The average price per meal in the first half of 2020 was €6.42. I believe people wish to spend between €4 and €5 per meal on average, underlining the possible future pricing pressure that HelloFresh may face.
The balance sheet shows that HelloFresh operates with a negative working capital model, which is very interesting as this will pay the company money as it grows faster. The operating cash flow was therefore much higher than the operating income in the first half of 2020, because of the divestment in working capital. HelloFresh can use this capital together with the freshly raised convertible note of €175 Million to further grow and strengthen its position in its core markets. HelloFresh is in a unique position as a start-up growth company with a very strong balance sheet, positive net cash position, and a business model that provides additional growth capital through a negative working capital and superior operating margins.
Note that the financial statements do not necessarily match the financial statements reported by the company, since some classifications have been changed to reflect a BeursWolf vision on the financials
The Forecast and Valuation
I divide the forecast of the free cash flow of HelloFresh in three segments:
- Revenue Growth
- Operating Margin
- Other Assumptions
In this forecast, I will use a two-step time horizon. The first period will be a high growth phase from 2020 up until 2027. Then there will be a slower growth period from 2028 up until 2031, from where the terminal value will be calculated.
The revenue growth has been incredible over the past years, so it would only be logical to extrapolate this growth into the future. However, there is a possibility that a lot of growth has been taken forward due to the pandemic, meaning that growth will be relatively slower in 2021 and the years thereafter. To accommodate for this, I will just apply a flat market growth rate of 12.8% to the revenues based on market growth expectations. After 2027, I will flatten the growth curve to 5.0% per year. This growth path from 2020 onwards (where I will assume the second half of the year to be equal to the first one) results in revenues of €9.4 Billion by 2031.
Of course that is a great revenue number, but let’s run a sanity check on that. If revenues per meal stay constant at €6.42, this means HelloFresh would deliver about 1.5 Billion meals in 2031. Looking at the total identified market (current and new) of 857 Million people and one meal per day, this would mean a total ‘meal market share’ of 0.47% (in other words, about one in every 200 meals would be delivered by HelloFresh). When looking at the meals delivered in the first half of 2020 and the 673 Million people in the current markets, this market share is 0.21% (or one in every 500 meals).
If the average price per meal would decrease to €4 this would result in the delivery of 2.4 Billion meals in 2031 or a market share of 0.75%. Even though this may still sound feasible in terms of the market share, the problem lies in the margins that can be achieved with these revenues and the delivery of either 1.5 Billion or 2.4 Billion meals for the same revenue number.
The expenses of HelloFresh consist of procurement expenses, fulfillment expenses, marketing expenses and general and administrative expenses. For simplicity purposes, I assume marketing and general and administrative expenses stay constant as a percentage of revenues.
The contribution margin (revenues minus procurement and fulfillment expenses) increased from 17.0% in 2016 to 28.6% in 2019. Whereas fulfillment expenses decreased from 40% to 36% of revenues, procurement expenses decreased even further, from 43% to 35%. I assume fulfillment expenses to decrease to 36% of revenues by 2022 and thereafter (after an increase to 38% in the first half of 2020) and procurement expenses to decrease to 34% by 2021. This results in a long-term contribution margin of 30%.
As a sanity check for this 30%, I checked the gross margin of some other super market chains. For example, Ahold Delhaize has a gross profit margin of around 27% and an operating margin of around 4%. Because of the unique, scalable and more efficient business model, I expect HelloFresh to achieve superior margins.
The assumptions described above would result in a long-term operating margin of 13.7%. If pricing pressure would start to play a role in the meal kit delivery business, this can put pressure on the operating margins. In this worst case scenario I would – for simplicity purposes – assume the contribution margin of HelloFresh to remain constant at the level of the first half year of 2020 (10.8%).
Other assumptions that are necessary to calculate the free cash flow from the operating margins are the tax expenses, net working capital investments, and capital expenditure requirements (including depreciation and amortization).
From 2021 onwards, I expect the German tax rate to apply to the operating income (15%). In terms of working capital, I expect the current assets to stay at 4% of revenues (similar to the first half of 2020 at 3.8%) and the current liabilities to stay at 10.5% of operating expenses (similar to the first half of 2020 at 10.4%). I use this conservative approach to make sure the valuation is not influenced by large improvements in working capital.
In terms of capital expenditures and depreciation and amortization expenses, HelloFresh noted that it was operating at full capacity in the first half of 2020. I would estimate (based on the capital expenditures in the period 2016-2019) that the required capital expenditures to maintain the current capacity are €50 Million per year (with a similar D&A profile) and the capital expenditures made to achieve this additional capacity are around €100 Million. The growth path to 2031 means revenues will triple. Hence, I would expect growth capex of €200 million over the next ten years. To model this in the forecast, I assume the capital expenditures to grow from €75 Million in 2021 to €150 Million in 2031. As a conservative addition I take into account €10 Million of annual capital expenditures for software development. The IFRS lease expenses stay constant as a percentage of revenues.
Free Cash Flow Forecast and Implied Market Return
The free cash flows resulting from this forecast are about 80% of the forecasted operating income. To make sure the terminal value is not overvalued, I assume the free cash flow for this calculation to be equal to 80% of the operating income in 2031, or about €1 Billion euros. I assume a terminal growth rate of 1.5%.
When applying a goal search this results in a 11.44% discount rate to arrive at the current market capitalization and share price of €45.06. In the scenario where operating margins will not improve (and would stay constant at 10.8%), this would result in a discount rate of 9.59%.
When in-home delivery of ready to eat and ready to cook meals continues its growth path and HelloFresh can maintain its market position and can slightly improve its margin profile, my current expectations are that investors will be rewarded with a return of around 11.4% per year. This is above the market return and would therefore imply that HelloFresh currently offers above average market returns.
However, it is important to keep a close look at the following key metrics in the future reports of the company and to see how that impacts the value of the stock:
- Overall revenue growth (above 12.8%)
- Customer retention
- Revenue per meal (currently €6.42)
- Operating margin (growing to or above 13.7%)
- New growth investmens and acquisitions
Disclosure: I currently own shares in $HFG.DE