Putting the (Insta)cart before the (Grocery) horse: A COVID Favorite's Reality Check!

After years of rumors of an imminent IPO, Instacart has finally filed for a public offering of it’s shares, aspiring to raise about $600 million from markets, at a pricing of about $9-$10 billion for its equity. Coming in the week after ARM, an AI chip designer, also filed to go public, but with an estimated pricing of $55-$60 billion, it is an indication of how much the ground has shifted under Instacart since the heady days of 2020, when Instacart was viewed by some Americans as the only thing that stood between them and starvation. At that time, there were some who were suggesting that the company could go public at $50 billion or more, and pricing it on that basis, but reality has caught up with both the company and investors, and this IPO represents vastly downgraded expectations for the company’s future.

The Back Story

    To value Instacart, you have to start with an understanding of the business model that animates the company, as well the underlying business that it is intermediating. I start with this section with the Instacart business model, which is not complicated, but I will spend the rest of the section exploring the operating characteristics of the grocery business, and its online segment.

The Instacart Business Model

    The Instacart business model extends online shopping, already common in other areas of retailing, into the grocery store space. That is not to say that there aren't logistical challenges, especially because grocery store carry thousands of items, and grocery shopping lists can run to dozens of these, with varying unit measures (by item, by weight) and substitution questions (when items are out of stock). Instacart operates as the intermediary between customers and grocery stores, where customers pick the grocery store that they would like to shop at and the items that they would like to buy at that store, and Instacart does the rest:

Instacart hires store shoppers who gather the items for the order, checking with the customer on substitutions, if needed, and for those customers who choose the pick-up option, have them ready for pick-up. If home delivery is chosen as the option, a driver (who, in many cases, is also the shopper) delivers the groceries to the customer's home. Customers get the time-savings and convenience from having grocery shopping (and delivery, if chosen) done for them, but they pay in the form on both delivery fees and a service charge of 5-10% of the bill, depending on the store picked and the number of items in the basket. Instacart also offers a subscription model, Instacart Express, where subscribers in return for paying a subscription fee (annual or monthly) get free deliveries from the service.

    For grocery stores, Instacart is a mixed blessing. It does expand the customer base by bringing in those who could not or would not have shopped physically at the store, but stores often have to pay Instacart fulfillment fees, which they sometime pass through as higher prices on products. In addition, grocery stores lose direct relationships with customers as well as data on their shopping habits, which may be useful in making strategic and tactical decision on product mix and pricing.

    I will approach the analysis of the Instacart model's capacity for growth and value creation in four steps. In the first, I will look at the grocery business, both in terms of growth and profitability of grocery stores, since Instacart, as an intermediary in the business, will be affected by grocery business fundamentals. In the second, I will examine the forces that are pushing consumers to online grocery shopping, and the ceiling for that growth is much lower than it is than in other areas of retailing. In the third, I will focus on how the competition to Instacart, within the online grocery retail space, is shaping up, and the consequences for its market share. In the final, I will examine the operating costs faced by Instacart, especially in the content of how the fee pie will be shared by the company with its shoppers and drivers.

1. The Grocery Business

    When you are looking for an easy company to value, where you can safely extrapolate the past and not over indulge your imagination, you should try a grocery store. For decades, at least in the US and Europe, the grocery business has had a combination of low growth and low margins that, on the one hand, keep pricing in check and on the other, make the business an unlikely target for disruption. Let's start by looking at growth in aggregate revenues, across all grocery stores in the United States over the last three decades:

You will notice that revenue growth rate has been anemic for most of the thirty years covered in this analysis, and that even the spurts in growth you have seen in 2020 and 2022 have specific reasons, unlikely to be sustainable, with the COVID shutdown explaining the 2020 jump, and inflation in food prices explaining the 2022 increase.

    On the profitability front, the grocery business operates on slim margins, at every level. The gross margin, measuring how much grocery stores clear after covering the costs of the goods sold, has risen slightly over time, perhaps because of growth in processed and packaged food sales, but is still less than 25%. The operating margin, which is after all operating expenses, and a more complete measure of operating profitability has been about 5% or less for almost the entire period.

If you are an intermediary in a business with slim operating margins, as Instacart is, the low operating profitability of the grocery business will limit how much you can claim as a price for intermediation, in service fees.

    To complete the grocery business story, it is also worth looking at the players in the business, and it should come as little surprise that it is dominated by a few big names. The biggest is Walmart, which derives close to 56% of its $400 billion in total revenues in the US, from groceries, but Target and Amazon (through Whole Foods and Amazon Fresh) are also big players. Krogers and Albertsons have emerged as the grocery store giants, by consolidating smaller grocery companies across the country: 

The fact that the grocery business is dominated by a few big names will also play a role in the Instacart valuation story, by affecting the bargaining power that Instacart has, in negotiating for its share of the grocery pie. In sum, the overall grocery pie is growing slowly, and the slice of the pie that is profit for those in the grocery game is slim, effectively limiting the valuation stories (and values) for every player in that game.

2. The Online Option

    Grocery shopping is different from other shopping, for many reasons. First, customers tend to favor a specific grocery store (or at most, a couple of stores) for most of their grocery needs. One reason for that is familiarity with store layout, since knowing where to find the items that you are looking for can make the difference between a 20-minute trip to the store and a hour-long slog. Another is location, with customers tending to shop at neighborhood stores, for much of their needs, since groceries do not do well with long transportation times. Second, for non-processed food, especially meats and produce, being able to see and sometimes touch items before you buy them is part of the shopping experience, with online pictures of the same products operating as poor substitute. For these reasons, grocery retail remained almost immune from the disruption wrought on the rest of brick-and-mortar retail, at least in the United States. Even so, there has always been always a segment of the population that has been open to online grocery shopping, sometimes because of physical constraints (homebound or unable to drive) and sometimes because of time and convenience (busy work and family schedules). That segment was viewed as a niche market, and until 2020, conventional players in the grocery business did not pay much attention to it, with the exception of Amazon. It was the COVID shutdown in 2020 that changed the dynamics, as online grocery shopping became not just an option, but sometimes the only option, for some. 

As a company that was built exclusively for this purpose, Instacart had a first-move advantage and saw customers, order and revenues all soar during the year. Caught up in the mood of the moment, it is easy to see why so many extrapolated Instacart’s success in 2020 into the future, forecasting that the shift to online grocery shopping would be permanent, and that Instacart would dominate that business.

      As COVID has eased, though, many of those who shopped for groceries online have returned to physical shopping, but it is undeniable that there are some who have decided that the convenience of online shopping exceeds any disadvantages, and have continued with that practice. In fact, while there is uncertainty on this front, the projection is that the percent of grocery shopping that will be done online will increase over time:

There are two points worth making about the trend towards online shopping. The first is that the ceiling on online grocery retail will remain much lower than the ceiling on online shopping in other areas in retail, with even optimists capping the share at 20%.  In short, the growth in online grocery sales will be higher than total grocery sales growth, but not overwhelmingly so. The second is that while some have persisted with online grocery shopping after 2020, it is less in deliveries and more in pick-ups, which will have implications for the market shares of competitors in the space.

3. The Competition

    In the first few months of the COVID shutdown, Instacart was dominant, partly because its platform was designed for online shopping, and partly because in a grocery market, where many stores were out of stock, it offered shopping choices to shoppers. That dominance, though, was short lived, since the grocers woke up quickly, and started offering online shopping services to their customer, with the tilt towards pick-up over delivery. The cost savings to customers was significant, since most grocery stores dispensed with service fees and used employees as shoppers, for their online customers. In the aftermath of COVID, the grocery stores have cemented their dominance of online grocery market, as can be seen in the market shares of the biggest online grocery retailers:

Walmart and Amazon are the two largest players in the online grocery market, and Instacart, while it has lost market share since 2020, is firmly in third place. Kroger's and Albertsons, the two largest grocery story chains, have also improved their standing. Instacart, as the only pure intermediary in this group, allows customers access to multiple grocery store options, and more choices when it comes to delivery, but even one that front, it is starting to face competition from Uber Eats, DoorDash and GrubHub. In short, Instacart will be lucky to hold on to its existing market share, even if it plays its cards right, leaving its growth at or below the growth in the overall online grocery shopping market.

    On a personal note, and it qualifies purely as anecdotal evidence, we (in my household) have not used Instacart since the peak COVID days of 2020, as we have returned to physical grocery shopping for products where it matters, while preserving online shopping for products which are staples, but only for pick up, rather than delivery. Since we shop at Ralph's, a Kroger subsidiary, we use their online shopping app, since it costless, matches in-store discounts and comes with a Ralph employee as a shopper, that is familiar with what we usually buy. I know that there are others who have stayed with Instacart, perhaps because of the grocery store choices it offers or because of its delivery options, but we have little interest in either, and perhaps are closer to the norm than the exception.

4. Operating Economics

    The revenues that Instacart collects from customers, either in service fees or in subscription revenues have multiple costs to cover. By far, the biggest is the cost that the company faces in hiring and paying thousands of shoppers and drivers to operate its system. Like ride-sharing companies, the question of how Instacart categorizes these workers, and the resulting costs, will determine what it will be able to generate as operating profits:

1. Pay versus Commission: Instacart has traditionally paid its shoppers based upon the batches of work done (with a batch including shopping, packing and loading a customer order) and payments for deliveries made, with tips from customers accruing as additional income. In effect, that makes almost all of these expenses into variable costs, rising and falling with revenues, reducing risk to the company but also limiting benefits from economies of scale, as it gets bigger.
2. Independent contractor versus Employee: Instacart has argued that the shoppers and drivers who work for it are independent contractors, rather than employees. That distinction matters because an employee categorization will open up Instacart not only to additional costs (social security, health care etc.) but also to legal liabilities, for employee actions. Many states are pushing Instacart (and others users of independent contractors, like Uber and Lyft) to reclassify their workers as employees, and in 2023, Instacart paid $46.5 million, to settle a California lawsuit on this count. 

As a company built around a technology platform, Instacart also has significant spending on R&D, as well as on customer support services.  In many ways, the operating expense issues that Instacart faces parallel the issues that Uber and Lyft have faced in the last few years, and I do believe that, over time, Instacart will have no choice but to deal with their shoppers as employees, with the accompanying costs. 

The Instacart IPO

    To value Instacart ahead of its IPO, I will start with a look at the prospectus filed by the company, which will give me a chance to unload on my pet peeves about how these disclosures have evolved over time, then look at the operating history and unit economics at the company, before settling in on a valuation story (and valuation) of the company.

Prospectus Pet Peeves

    About two years ago, I wrote a post on what I called the disclosure dilemma, where the more companies disclose, the less informative these disclosures become. As part of the post, I talked about trends in IPO prospectuses over time, and the Instacart prospectus gives me a chance to revisit some of those trends that I highlighted. 

1. Disclosure Diarrhea: Apple and Microsoft, when they filed for their initial public offerings in the 1980s, had prospectuses that were less than 100 pages apiece; Apple weighed in at 73 pages and Microsoft had only 52. In 1997, when Amazon filed for a public offering, its prospectus was 47 pages long. I noted that prospectuses have become more and more bulky over time, with Airbnb's 2020 listing including a prospectus that was 350 pages long. With appendices, Instacart's prospectus stretches on to 416 pages.
2. “Tech” and AI: In common with many other companies that have gone public in the last decade, Instacart is quick to label itself a technology company, when the truth is that it is a grocery delivery company that uses technology to smooth the ride. In keeping with the times, the prospectus mentions AI multiple times, I counted 32 mentions of AI in the prospectus, and I remain skeptical that AI will (or should) alter grocery shopping in fundamental ways.
3. Adjusted EBITDA: I have written about the absolute foolishness of adding back stock-based compensation to get to adjusted earnings, noting that stock-based compensation is not a neutral non-cash expense (like depreciation) but one that an expense-in-kind, where you give away equity in your company to employees, either as options or as restricted stock. Needless to say, Instacart plows right ahead and not only adds back stock-based compensation but makes a host of other adjustments (see page 126 of prospectus). Since Instacart makes money without these adjustments, they only draw attention away from that good news.
4. Share count shenanigans: On page 19 of the prospectus, Instacart headlines that its share count will be 279.33 million shares, if the underwriters exercise their options, but two pages later (on page 21) the company discloses that it does not count restricted stock units, which are shares in existence that still have restrictions on trading or waiting to be vested, options and shares issuable on conversion of preferred shares. Adding these exception together, you get an ignored share count of 43.62 million, which brings the total share count to 322.94 million shares.

To give the company credit on useful disclosures, the company has followed the lead of other user-based companies in providing a cohort table (see page 111) on platform users (tracing how usage changes as users stay on the platform) and on unit economics (the size of an order, with the costs of filling it), but that good disclosure is hidden behind layers of flab.

An Operating History

    For young companies, you learn less by browsing through financial history than with much more mature companies, but it in instructive to look at the pathway that Instacart has taken to arrive at its current position.  For close to seven years after its founding in 2012, Instacart struggled to find its footing with customers, as relatively few were willing to jump on the online grocery shopping bandwagon. Coming into 2020, the  company had about 50 million subscribers and $215 million in revenues, and the $5.1 billion that customers spent on groceries on its platform was a tiny fraction of the $800 billion US grocery market. In a turn of fortune that I am sure that even Instacart did not see coming, the COVID shutdown changed the shopping dynamics. As homebound customers desperately looked for options to shop for and get groceries delivered at home, Instacart stepped into the fray, allowing user numbers, the value of gross transactions (GTV) and revenues to quadruple in 2020. 

It is undeniable that Instacart, like Zoom and Peloton, was a COVID winner, but like those companies, it has struggled to build on those winnings and deliver on the resulting unrealistic expectations. The good news for Instacart is that many of the customers who joined its platform at the height of COVID have stayed on, but the bad news is that growth has leveled off in the years since, and especially so leading into the initial public offering.

    As subscribers and grocery sales on the Instacart platform grew between 2019 and 2023, its business model has also been taking form, turning from losses to a measure of profitability in the twelve months leading into the offering:

Instacart Prospectus

Note again, though, that the bulk of the improvement in operating metrics occurred in 2020, and while the numbers have continued to improve since 2020, the change has been marginal. To understand the drivers of Instacart’s profitability over time, let us break down its components:

1. Take Rate: When an grocery order is placed on the Instacart platform, the service fees that Instacart collects represent its revenues from transactions, and the take rate measures these revenues as a percentage of the transaction value. Instacart's take rate has improved over time, doubling from 2.86% in 2019 to 5.70% in 2020, before leveling off in 2021 and 2022, and then increasing again to 7.49% in the last twelve months of 2023.
   
   
   Just to provide a contrast, Airbnb and Doordash, two other companies in the intermediary business have much higher take rates at 14% and 11.79% respectively. Much of that difference, though, is unbridgeable for a simple reason: the grocery business has significantly lower operating margins (at 5%) than the hospitality  (15% in 2022)  or restaurant businesses (16% in 2022). Put simply, Instacart's take rate will be lower, even with full economies of scale at play, than its counterparts in businesses with more profit buffer.
2. Operating expenses: The revenues that Instacart collects, from transactions and advertising, are used to cover its operating expenses, which are broken down into three categories: cost of goods sold, operations and support and G&A:
   
   
   There are economies of scale that kicked in, in 2020, and the good news is that those economies of scales continued to benefit the company in 2021 and 2022, as all three categories of expense decreased, as a percent of sales. 
3. Customer Acquisition and Reinvestment:  Growth comes with reinvestment, and in the case of Instacart, as with many other tech companies, that reinvestment is embedded in its operating expenses (instead of capital expenses), since their two biggest capital expenditures are the costs of acquiring new subscribers (shown as part of sales and marketing) and investments in technology/platform (shown as R&D). 
   
   
   Looking at the customer acquisition (selling) costs alone, there is evidence that these costs, in dollar terms and as a percent of revenues, after the steep drop off in 2020, are rising over time, indicating that there are more competitors for new online grocery shoppers.  If you add to that the same trend in R&D spending, it does look like the company is working harder and spending more to deliver growth after the COVID boost in 2020.
4. Unit Economics: With transaction-based businesses, like Instacart, understanding how the unit economies (on individual orders and platform users) are evolving over time can be useful in forecasting the future. Looking across Instacart's entire history, the typical order size has remained remarkably stable, at around $100, with the spurt in 2020 being the exception.

   

   Instacart Prospectus

   
   On an inflation-adjusted basis, especially in 2021 and 2022, the average order size has decreased over time. That, by itself, may not be a problem, if Instacart customers are ordering more often, especially as they stay on the platform for longer, and to answer this, I look at Instacart's estimates of revenues, by cohort class:

   

   Instacart Prospectus

The good news is that customers who joined the platform in 2017, 2018, 2019 and 2021 spend more on the platform, the longer they are on it. The bad news is that customers in joined in 2020, Instacart's biggest year of growth in users, are spending less on the platform in 2021 and 2022, indicating that some of the COVID gains are slipping away. That should not be surprising, since many customers who used Instacart in 2020 did so only because they had no alternatives, and once the shutdown ended, returned to old habits.

    As the company has struggled, coming off its COVID high, there has been turnover in its management ranks. Apoorva Mehta, who founded the company and oversaw its COVID growth, stepped down as CEO of the company in 2022, and was replaced with Fido Simo, a Facebook executive, with the impetus for the change rumored to have come from Sequoia, the biggest single stockholder in the company. Before you instinctively jump to the defense of founders, like Mr. Mehta, it is worth noting that he owned only 10% of the outstanding shares in the company in 2022. In short, scaling up and high growth often require large capital infusions, and a side cost almost always will be a reduction in founder control of the company. 

The Valuation Story & Intrinsic Value

    With that long lead-in, I have the basis for my Instacart story, and it reflects both the good and bad news in the company's operating history. 

1. Growth: To estimate revenue growth at Instacart, I think it makes sense to break down revenues into transaction revenues and advertising revenues, with the former coming from service fees and subscriptions, and the latter from ads. To estimate transaction revenues, I will assume that gross transaction value on the platform will track growth in online grocery retailing, which seems to have settled into a compounded annual growth rate of about 12%, for the next five years. I will assume that Instacart will maintain its market share of the online grocery market, in the face of competition, but only by cutting its fees and accepting a take rate of 6%, by year 5, down from 7.5% in the trailing 12 months. Advertising revenues, though, are assumed to keep track with gross transactions on the platform.
2. Profitability: Drawing on the company's history of delivering economies of scale on cost of goods sold and operations support, I will assume that the company will be able to improve its operating margins over time to 25%. The tensions between Instacart and its shoppers, as well as push back from grocery stores, will keep a lid on these margins and prevent further improvement.
3. Reinvestment: As user growth levels off, I expect the company to revert to its capital-light origins, and spend far less on customer acquisitions, as well as on acquisitions. This allows me to assume that the company will be able to deliver $3.13 in revenues, for every dollar invested, roughly matching the global industry average.

With these assumptions in place, the value that I get for the company is shown below:

My Instacart Valuation

With my story and inputs, the value per share that I get for Instacart is about $29, close to the offer price being floated of $30 per share. 

    There is, of course, the very real possibility that I could be wrong on my estimates (in either direction) of key inputs: the growth in GTV, the take rate, the operating margin and the cost of capital, and to account for this uncertainty, I fall back on a simulation:

As you can see, at the offer price of $30/share, the company is priced close to its median value, and the distribution of values suggests that there is less upside in this company than in some of the other growth companies I have valued in recent years.

The Offering

    Instacart was expected to hit the market on September 19, and the reception that it gets may tell us as much about the market, as it does about the company. In my posts on the market, starting mid-year last year and extending into this one, I noted that risk capital had retreated o the sidelines, and one of the statistics that I used was the number of IPOs hitting the market. After hitting an all-time high in 2021, the IPO market has frozen, and the ARM, Instacart and Birkenstock IPOs hitting the market in September may be a sign of a thaw. That sign will become stronger, if the offerings are well received and there is a price pop on the offering. 

Pricing versus Investing

    I have long argued that IPOs are priced, not valued, notwithstanding the lip service that everyone involved in the process, including VCs, founders and bankers, pays to valuation, The difference between valuing and pricing is that while the former requires that you grapple with business questions on growth, profitability and reinvestment, the latter is based on how much investors are paying for peer group companies, a subjective judgment, but one made nevertheless. In keeping with this theme, I compared the proposed pricing for Instacart against the pricing of its peer group. That peer group is not other grocery companies, since the Instacart model is very different, but other intermediary companies like Airbnb and Doordash, which like Instacart, take a slice of transaction revenues in the markets they serve, and try to keep costs under control:

While Instacart looks cheap, relative to Doordash and Airbnb, this pricing is an illustration of the limits of the approach.  Instacart trades at a much lower multiple of revenues, because its take rate (as a percent of gross transaction value) is much lower than the slices that Doordash and Airbnb keep. Airbnb keeps 14% of gross transaction value, Doordash keeps more than 11.79%, but Instacart keeps only 7.5%, if advertising revenues are excluded. Instacart and Doordash both trade at lower multiples of revenues than Airbnb, but that is because Airbnb has higher expected growth and higher operating margins in steady state.    

Previewing the Offering

  Since pricing is about mood and momentum, it is worth looking at the ARM IPO offering on September 14, which saw the company's stock price, which was offered at $51, open for trading at $56.10 and close the dat at $63.59. If that mood spills over into this week, I expect Instacart's IPO to pop on its opening day as well, especially given the fact that the offering price seems to reflect a relatively conservative outlook for the company, and the pricing looks favorable. Even if it does not, I don't see much benefit to buying the stock at the offering price, not only because it looks fairly valued, but also because I don't see enough of an upside, even if things work out in the company's favor. 

    The question of what the market will do became moot, even as I was finishing this post, the stock started trading(September 19), and popped to $42 per share, before giving back some of its gains to settle at about $38 per share. At those prices, you would need more upbeat assumptions about online grocery growth and take rates than I am willing to make, but with this market, who knows? The stock may be trading at a discount on value, a week from now. 

The VC Game

    In the last decade, we have raised venture capital to "great investor" status, driven by stories of investments that have paid off in huge returns. In fact, good venture capitalists are often viewed as shrewd assessors of business potential, capable of separating the wheat from the chaff, when it comes to start-ups. That is true for some of them, but I believe that venture capital is a pricing game, with little heed paid to value, and that  the most successful venture capitalists share more traits with great traders, than with great investors. Not only are the best venture capitalists good at pricing the businesses they invest in, honing in on to the traits that are being priced in (users, subscribers, downloads etc.), but are just as good at making sure that these business scale up these traits. Their success comes from timing skills, entering a business at the right time and just as critically, exiting before the momentum shifts.

    Instacart's multiple venture capital rounds illustrates this process well, and you can see the pricing of the company at each round below:

The earliest providers of capital to the company will walk away with substantial profits, even if the company's market cap ends up at $9 - $9.5 billion, as indicated by the offering price. The seed capital providers (Khosla, Canaan and Y Combinator) will have earned at 55% compounded annual return on their investment, at the IPO offering price, well in excess of the S&P 500 annual return of 13.04% over the same period. Every subsequent round earns a lower annual return, and all investments in Instacart made after 2015 have underperformed the S&P 500 significantly, and the NASDAQ by even more.  The biggest losers in this capital game have been those who provided capital in 2020 and 2021, when COVID pushed up both capital needs and company pricing to new highs. The Series I investment in 2021, when the company was priced at $39 billion,will see markdowns in excess of 60%. While there is no redeeming grace for Fidelity and T. Rowe Price, it is true that Sequoia also invested earlier in the company, and will walk away with substantial returns on its total investment. Thus, the write down that Sequoia takes for its $300 million investment in 2021 will be more than offset by the gains it made on the $21 million that it invested in the company in 2013 and 2014. 

   The notion that there is smart money, i.e., that there is an investor group that is somehow wiser, more informed and less likely to act emotionally than the rest of us, and that it earns higher returns than the rest of us, is deeply held. In my view, it is a mirage, since every group that is anointed as smart money ultimately ends up looking average (in terms of behavior and returns), when all is said and done. It happened to mutual fund managers decades ago, and it has happened to hedge funds and private equity over the last two decades. For those who are holding on to the belief that venture capitalists are the last bastion of smart money, it is time to let go. While there are a few exceptions, venture capitalists for the most part are traders on steroids, riding the momentum train, and being ridden over by it, when it turns. 

YouTube Video

Instacart files

1. Instacart Prospectus
2. My Instacart Valuation