Meatless Future or Vegan Delusions? The Beyond Meat Valuation

In a big year for initial public offerings (IPOs), with Uber, Lyft, Pinterest and Zoom, to name just a few, already having gone public and more companies waiting in the wings, it is ironic that it is not a tech company, but a food company, Beyond Meat, that has managed to deliver the most dazzling post-IPO performance of any of the listings. As the stock increased seven-fold, investors who were able to get into the stock at the offering price have been enriched, but those who jumped on the bandwagon later have also reaped extraordinary returns. The speed and magnitude of the stock price rise has left many wondering whether investors have over reached and whether a correction is around the corner. 

The Meatless Meat Company!

The Company: Let's take a look at what Beyond Meat's products are and the market opening it is exploiting, before diving into a story and valuation for the company. The company, headquartered in Southern California, and founded in 2009, makes makes plant-based (pea protein) products that mimic burgers and ground meat  in taste, texture and aroma. In the prospectus that it filed leading up to its IPO, the company argues that its production process is revolutionary and new, and is responsible for its capacity to replicate animal-based meats. 

The Competitors: While Beyond Meat is a leader right now in the specialized sub-category of meatless meats, it faces a formidable competitor in Impossible Foods, another young start-up producing its own plant-based versions of meat-like products. Since it is very likely, especially after Beyond Meat's explosive market debut, that Impossible Foods will be going public soon, it is inevitable that there will be comparisons between the two companies. While I have done my own taste test, taste is in the mouth of the beholder, and this article perhaps has the most even-handed comparison of the two companies' products. Both companies have also adopted similar strategies of enlisting fast-food companies as product adopters, with Impossible Foods showing up on Burger King (Impossible Whopper) and White Castle menus, and Beyond Meat countering with TGI Friday's, Carl's Jr. and Red Robin. Other companies are taking note, including companies like Amy's Kitchen, a long standing producer of organic and vegan offerings, and companies like Tyson Foods and Perdue that derive the bulk of their revenues from meat, but see opportunity in this new market.

The Drivers: Both Beyond Meat and Impossible Foods have been helped by a shift away from meat to meatless alternatives, and that trend has been driven by three factors:

1. Health: While the research on the health consequences of eating meat continues, it has become part of conventional wisdom that meat-based diets (and red meat in particular) are associated with a greater risk of cardiovascular disease and cancer. This link provides a fairly balanced account of whether this belief is true, but for better or worse, it has led some meat eaters to cut back and sometimes stop consuming meat. 
2. Environment: As climate change and environmental concerns rise to the top of concerns for some, they are feeling the pressure to shift away from meat, in general, and beef, in particular, because of its environmental footprint. I am not  an environmental scold, but I don't think that there is any debate that meat-based diets puts a greater pressure on the environment 
3. Taste: Until recently, shifting away from a meat-based diet also meant giving up the taste and texture of meat, since most meat substitutes did not come close. As companies like Beyond Meat and Impossible Foods are showing, plant-based alternatives are getting better at mimicking real meat, and for those who are attached to the texture and taste of meat, that is making a difference in their diet decisions.

None of these three factors are likely to fade away. In fact, I think that we can safely assume that they will only get stronger over time, accelerating the shift from meat to meatless alternatives. 

Market Sizing

All of the talk about the shift to vegan and vegetarian diets can sometimes obscure two basic facts about this market and its underlying trends:

1. The meatless meat market is still small, relative to the overall meat market: In 2018, the meatless meat market had sales of $1-$5 billion, depending on how broadly you define meatless markets and the geographies that you look at. Defined as meatless meats, i.e., the products that Beyond Meat and Impossible Foods offer, it is closer to the lower end of the range, but inclusive of other meat alternatives (tofu, tempeh etc.) is at the upper end. No matter which end of the range you go with, it is small relative to the overall meat market that is in excess of $250 billion, just in the US, and closer to a trillion, if you expand it globally, in 2018. In fact, while the meat market has seen slow growth in the US and Europe, with a shift from beef to chicken, the global meat market has been growing, as increasing affluence in Asia, in general, and China, in particular, has increased meat consumption,  Depending on your perspective on Beyond Meats, that can be bad news or good news, since it can be taken by detractors as a sign that the overall market for meatless meats is not very big and by optimists that there is plenty of room to grow.
2. It is still a niche market: Meatless meat products have made their deepest inroads in urban and affluent populations and its allure is greatest with former meat-eaters rather than lifelong vegetarians, who don't crave either the taste or texture of meat. The plus is that this market has significant buying power, but the minus is that urban, well-to-do millennials can eat only so much. 

The big question that we face is in estimating how much the shift towards vegan and vegetarian diets will continue, driven by health reasons or environmental concern (or guilt). There is also a question of whether some governments may accelerate the shift away from meat-based diets, with policies and subsidies. Given this uncertainty, it is not surprising that the forecasts for the size of the meatless meat market vary widely across forecasters. While they all agree that the market will grow, they disagree about the end number, with forecasts for 2023 ranging from $5 billion at the low end to $8 billion at the other extreme. Beyond Meat, in its prospectus, uses the expansion of non-dairy milk(soy, flax, almond mild) in the milk market as its basis, to estimate the market for meatless meat to be $35 billion in the long term. 

Beyond Meat: Story and Valuation

History: At the time of its public offering, Beyond Meat had all of the characteristics of a young company, not much separated from its start up days, with revenues of $87.9 million, operating losses of $26.5 million and a common equity of -$121.8 million. Its first earnings report, delivered to a rapturous market response, reported a tripling of revenues and a narrowing of operating losses, but even with it incorporated, the company remains a small, money losing company.

The Story: To value young companies, I first have to put my optimist hat on, and with it firmly in place, my story for Beyond Meat is that it is catching the front end of a significant shift towards vegan and vegetarian-based diets. The key parts of my story are below:

1. Total market for meatless meats will grow significantly: I see the total market for meatless meats growing from just over $1 billion in 2018 to $12 billion by 2028. While that is less than the $35 billion that Beyond Meat's back-of-the-envelope estimate delivers, it is closer to the upper end of the range of forecasts that you have for this market.
2. With Beyond Meat capturing a significant market share: As the market grows, the number of players will increase, but I see Beyond Meats capturing a 25% market share of this market, building on its early entry into the market and brand name recognition, partly from its fast food connections.
3. While delivering operating profits similar to the large US food processing companies: Over the next five years, I see pre-tax operating margins improving towards the 13.22% that US food processing business delivered in 2018, built largely on economies of scale and pricing power. 
4. And reinvesting a lot less, in delivering that growth: While Beyond Meat generates about a dollar in revenue per dollar in invested capital right now, I will assume that it will be able to use technology as its ally to invest more efficiently in the future. Specifically, I will assume that the company will generate $3 in revenue for every dollar in invested capital, about double what the typical US food processing company is able to generate.

Is there risk in this investment? Absolutely, and you may be surprised that my cost of capital is only 7.46%, but that reflects my assessment of risk in this investment, as a going concern and as part of a diversified portfolio. As a money-losing company that will require about $500 million in capital over the next four years to deliver on its potential, there remains a significant chance of failure, and I estimate the probability of failure to be 15%.

The Valuation: With the story in place, the valuation follows and the picture below captures the ingredients of value:

Download spreadsheet

With my story, which I believe reflects an upbeat story for the company, the value that I obtain for its equity is $3.3 billion, yielding a value per share of about $47. At the end of June 10, when I completed my valuation, the stock price was close to $170, well above my estimated  value. What the stock dropped almost $41 on June 11 to $127/share, it still remained over valued.

What if? As with any young company, the value of Beyond Meat is driven almost entirely by the story you tell about the company, and in this case, that story revolves around two key inputs. The first is the revenue that you believe the company can generate, once mature, and that reflects how big you think the market for meatless meats will get and Beyond Meat's market share of the market. The second   is its profitability at that point, which is a function of how much pricing power you believe the company will have. While I have assumed that Beyond Meat will deliver about $3 billion in revenues in 2028, with an operating  margin of 13.22%, your story for the company can lead you to very different estimates for one or both numbers:

The shaded cells represent break even points, where you could justify buying Beyond Meat at the price ($127) it was trading at on June 11, 2019. Put differently, if your story for the meatless meat market and Beyond Meat's place in it leads you to revenues of $5 billion or higher with an operating margin of 20%, you should be a value investor in the company. 

Macro Bets and Micro Value

As you can see from the what-if analysis on Beyond Meat's value, the value that you obtain for Beyond Meat is determined mostly by how large you believe that market for meatless meats will end up being. In fact, there are some investors whose primary reason for investing in Beyond Meat is as a bet on a macro trend towards vegan and vegetarian diets. That said, it is worth remembering that investors don't get pay offs from making the right macro bets, but from the micro vehicles (individual investments) that they use as proxies for those bets. To get the pay off from a correct macro call, there are two additional assessments that investors have to make:

1. Industry structure: A growing market may not translate into high value businesses, if it is crowded and intensely competitive. That market will deliver high revenue growth, but with low or no profitability, and no pathway to sustainable profits and value added. In contrast, a growing market where there are significant barriers to entry and a few big winners can result in high-value companies with large market share and unscalable moats. 
2. Winners and Losers: Assuming that there is potential for value creation in a market, investors have to pick the companies that are most likely to win in that market. That is difficult to do, when you are looking at young companies in a young market, but there is no way around making that judgment. In a post from 2015, I argued that in big (or potentially big) markets, you can expect companies to be collectively over valued early in the game. 

In my Beyond Meat valuation, I have implicitly made assumptions about both these components, by first allowing operating margins to converge on those of large food processing companies and then making Beyond Meat one of the winners in the meatless meat market, by giving it a 25% market share. My defense of these assumptions is simple. I believe that the meatless meat market will evolve like the broader food business, with a few big players dominating, with similar competitive advantages including brand name, economies of scale and access to distribution systems. I also believe that Beyond Meat and Impossible Foods, as front runners in this market, will use their access to capital to scale up quickly. Their use of fast food chains feeds into this strategy, with bulk sales increasing revenues quickly, allowing for economies of scale, and name-brand offerings (Impossible Whopper at Burger Kind, Beyond Famous Star burger at Carl's Jr.) helping improve brand name recognition. I will undoubtedly have to revisit these assumptions as the market evolves and some of you may disagree with me strongly on one or both assumptions. If so, please do download the spreadsheet and make your best judgments to derive your value for the company.

A Trading Play

Early in a company's life, it is the pricing game that dominates and it is futile to use fundamentals to try to explain a stock price or day-to-day changes. This table, from one of my presentations on corporate life cycles, illustrates how investors and trades view companies as they move through the life cycle.

For a young company like Beyond Meat, making the transition from start-up to young growth, it is all pricing all the time, with stories about market size driving the pricing,. This trading phenomenon is exacerbated by the fact that it is one of the few pure plays on a macro trend, i.e., a shift in diets away from meat to plant-based options. That leads me to two conclusions. The first is an unexceptional one and it is that you will see wide swings in the stock price on a day to day basis, for little or no reason. That is a feature of priced stocks, not a bug, as mood and momentum shift for no perceptible reasons. The second is that selling short on a stock like this one (small, with a small float) is a dangerous game, since you are unlikely to have time as your ally, and while you may be right in the long term, you may bankrupt yourself before you are vindicated. 

YouTube Video

Links

1. Beyond Meat: Prospectus for IPO
2. Valuation of Beyond Meat (June 2019)

Past Posts

1. Big Markets, Over Confidence and the Big Market Delusion (August 2015)

Big Markets, Over Confidence and the Macro Delusion!

In early October of 2013, I was sitting in CNBC, waiting to talk about Twitter, which had just filed its prospectus (for its initial public offering). I was sharing the room with an analyst who was very bullish on the company, and he asked me what I thought Twitter was worth. When I replied that I had not had a chance to value the company yet, he suggested that I should save myself the trouble, and that the stock was worth at least $60 a share. Curious, I asked him why, and he said that Twitter would use its large user base to make money in the "huge" online advertising market. When I questioned him on how huge the market was, his answer was that he did not have a number, but he just knew that it was "really big". I am thankful to him, since he framed how I started my valuation of Twitter, which is with an assessment of the size of the online advertising market globally. Since I talked to that analyst, I have also become more more aware of the big market argument, and I have seen it used over and over in other markets, often as the primary and sometimes the only reason for assigning high values to companies in these markets. These analysts may very well be right about these markets being very big, but I think that suggesting that a company will be assured growth and profits, just because it targets these markets, not only misses several intermediate steps, but also exposes investors and business-owners to the macro delusion.

Big Markets! Really, Really Big Markets!

Would I rather that my company operate in a big market than a small one? Of course. Increasing market potential, holding all else constant, is good for value, but for that value to be generated, a whole host of other pieces have to fall into place. First, the company has to be able to capture a reasonable market share of that big market, a task that can be made difficult if the market is splintered, localized or intensely competitive. Second, the company has to be able to generate profits in that big market and create value from growth, also a function of the firm's competitive advantages and market pricing constraints. Third, once profitable, the company has to be able to keep new entrants out, easier in some sectors than in others.

It is therefore dangerous to base your argument for investing in a company and assigning it high value entirely on the size of the market that it serves, but that danger does not seem stop analysts and investors from doing so. Here are four examples:

China: A billion-plus people makes any market large, and if you add rapid economic growth and a
burgeoning middle class to the mix, you have the makings of a marketing wet dream. Visions of millions of cell phones, refrigerators and cars being sold were enough to justify attaching large premiums to companies that had even a peripheral connection to China. The events of the last few weeks have made the China story a little shakier, but it will undoubtedly return, once things settle down.

Online Advertising: It is undeniable that more and more of business advertising is moving online, and this shift has not only pushed Google, Facebook and Alibaba to the front lines of large market cap companies but has been the impetus behind Twitter, Yelp, Linkedin and a host of other social media companies capturing market capitalizations that seem outsized, relative to their operating metrics.

The Sharing Economy: Even as private businesses, Uber and Airbnb have not only captured the attention of investors, with multi-billion dollar valuations, but have also disrupted conventional approaches to doing business. In the process, they have opened up the sharing paradigm, where private property (car, house) owners can put excess capacity in what they own to profitable use. 

The Cloud: This is a recent entrant to the "big" market parade, as both technology titans such as Intel, Google and Amazon and new entrants such as Box vie to put our music, video, data and even our computing capabilities on large shared computers. Bessemer Venture Partners, which tracks companies that generate revenues from cloud computing, estimated a collective market capitalization of $170 billion for these companies in August 2015.

I am sure that you will find more examples add to the list. For example, just a couple of weeks ago, Morgan Stanley issued a strong buy recommendation on Tesla and based it entirely on its potential growth in the "mobility services" market. It took me two readings of the report for me to figure out that the mobility service market was a hybrid of the car sharing and driverless car markets, a potentially huge market, that would have become even enormous, if you were able to slap ads on the cars and put them in China.

The Macro Delusion: Individual Rationality, Collective Irrationality

When you label a market as a bubble, you take the easy way out, since a market bubble suggests that the investors who push prices to unsustainably high levels are being irrational, crazy and perhaps even stupid. It is for that reason that I have used the word guardedly (and when I have, regretted it), and taken issue with "market bubblers" in earlier posts. Even if you believe that assets (real estate, stocks, bonds) are being over priced, you will almost always be better served assuming that investors setting these prices have their own reasons for doing so, and understanding those reasons (even if you disagree with them).

To see how (almost) rational and (mostly) smart individuals can be fooled by big market potential into being collectively irrational, assume that you are an entrepreneur who has come up with a product that you see as having a large potential market and that, based on that assessment, you are able to convince venture capitalists to fund your business.

Note that everyone in this picture is behaving sensibly. The entrepreneur has created a product that he sees as fulfilling a large market need and the venture capitalists backing the entrepreneur see the potential for profit from the product.

Now assume that six other entrepreneurs see the same big market potential at about the same time you do, and create their own products to fulfill that market need, and that each finds venture capitalists to back his or her product and vision. 

To make the game interesting, let's make each of these entrepreneurs bright and knowledgeable about their products, and let's make the VCs also smart and business savvy. If this were a rational market place, each entrepreneur and his/her VC backers should be valuing his/her business, based on assessments of market potential and success, and the existence of current and future competitors.

Let's now add the twist that causes the deviation from rationality and make both the entrepreneurs and VCs over confident, the former in the superiority of their products over the competition, and the latter in their capacity to pick winners. This is neither an original assumption, nor a particularly radical one, since there is substantial evidence already that both groups (entrepreneurs and venture capitalists) attract over confident individuals.  The game now changes, since each business cluster (the entrepreneur  and the venture capitalists that back his or her business) will now over estimate its capacity to succeed and its probability of success, resulting in the following. First, the businesses that are targeting the big market will be collectively over valued. Second, the market place will become more crowded and competitive over time, especially with new entrants being drawn in because of the over valuation. Thus, while revenue growth in the aggregate may very well match expectations of the market being big, the revenue growth at firms will fall below collective expectations and operating margins will be lower than expected. Third, the aggregate valuation of the sector will eventually decline and some of the entrants will fold, but there will be a few winners, where the entrepreneurs and VCs will be well rewarded for their investments.

The collective over valuation of the companies in the big market will bear resemblance to a bubble, and the correction will lead to the usual hand wringing about bubbles and market excesses, but the culprit is over confidence, a characteristic that is almost a prerequisite for successful entrepreneurship and venture capital investing. That is one reason that I feel no need to inveigh against bubbles in the social media space, since this is a feature of investing in young, start-up businesses in big markets, not a bug. That said, the extent of the over pricing will vary, depending upon the following:

1. The Degree of Over Confidence: The greater the over confidence exhibited by entrepreneurs and investors in their own products and investment abilities, the greater will be the over pricing. While both groups are predisposed to over confidence, that over confidence tends to increase with success in the market. Not surprisingly, therefore, the longer a market boom lasts in a business space, the larger the over pricing will tend to get in that space. If fact, you can make a reasonable argument that the over pricing will be greater in markets where you have more experienced venture capitalists and serial entrepreneurs.
2. The Size of the Market: As the target market gets bigger, it is far more likely that it will attract more entrants, and if you add in the over confidence they bring to the game, the collective over pricing will increase.
3. Uncertainty: The more uncertainty there is about business models and the capacity to convert them into end revenues, the more over confidence will skew the numbers, leading to greater over pricing in the market. 
4. Winner-take-all markets: The over pricing will be much greater in markets, where there are global networking benefits (i.e., growth feeds on itself) and winners can walk away with dominant market shares. Since the payoffs to success is greater in these markets, misestimating the probability of success will have a much bigger effect on value.

The Online Ad Market and Social Media Company Valuations

The market that best lends itself to run this experiment today is the online advertising market, with the influx of social media companies into the marketplace in the last few years. To run my experiment, I took the market capitalization of each company in the online advertising space and backed out of the expected revenues ten years from now. To do this, I had to make assumptions about the rest of the variables in my valuation (the cost of capital, target operating margin and sales to capital ratio) and hold them fixed, while I varied my revenue growth rate until I arrived at the current market capitalization. 

The figure below illustrates this process using Facebook with the enterprise value of $245,662 million from August 25, 2015, base revenues of $14,640 million  (trailing 12 months) and a cost of capital of 9%. Leaving the existing margins unchanged at 32.42%, we can solve for the imputed revenue in year 10:

Spreadsheet

I assume that Facebook's current proportion of revenues from advertising (91%) will remain unchanged over the next decade, yielding imputed revenues from advertising for Facebook of $117,731 million in 2025. The assumption that the advertising proportion will remain unchanged may be questionable, at least with some of the other companies on the list below, where investors may be pricing in growth in new markets into the value. You undoubtedly will disagree with this and some of my other assumptions, which is why I will let you make your own in the attached spreadsheet and solve for your estimate of future revenues.

I repeat this process with other publicly traded companies with significant online advertising revenues, using a fixed cost of capital and a target pre-tax operating margin of  either the current margin or 20%, whichever is higher, for every firm. Note that both assumptions are aggressive (the cost of capital may have been set too low and the operating margin is probably too high, given competition) and both will push imputed revenues in year 10 down.

Numbers & Valuations in US dollars for all companies (Folder with valuations)

The collective online advertising revenues imputed into the market prices of the publicly traded companies on this list, in August 2015, was $523 billion.  Note that this list is not comprehensive, since it excludes some smaller companies that also generate revenues from online advertising and the not-inconsiderable secondary revenues from online advertising, generated by firms in other businesses (such as Apple). It also does not include the online adverting revenues being imputed into the valuations of private businesses like Snapchat, that are waiting in the wings. Consequently, I am understating the imputed online advertising revenue that is being priced into the market right now.

To gauge whether these imputed revenues are viable, I looked at both the total advertising market globally and the online advertising portion of it. In 2014, the total advertising market globally was about $545 billion, with $138 billion from digital (online) advertising (Sources: Zenith Optimedia. eMarketer). The growth rate in overall advertising is likely to reflect the growth in revenues at corporations, but online advertising as a proportion of total advertising will continue to increase. In the table below, I allow for different growth rates in the overall advertising market over the 2015-2025 time period and varying proportions moving to digital advertising to arrive at these estimates of digital/online advertising revenues in 2025:

Even with optimistic assumptions about the growth in total advertising and the online advertising portion of it climbing to 50% of revenues, the total online advertising market in 2025 is expected to be $466 billion. The imputed revenues from the publicly traded companies on my list is already in excess of that number, and it seems reasonable to conclude that these companies are being over priced, relative to the market (online advertising) that they are expected to profit from.

As more companies line up to enter this space, this gap between the size of the market that is priced in and the actual market will continue to grow, but investors will continue to fund these companies, even if they are aware of the gap. After all, the nature of over confidence is that founders and investors are convinced that the over pricing is not at their firms, but in the rest of the market. There are two threats to this over confidence and they are inevitable. The first is that as companies in this space continue to report earnings and revenues, you will see more negative surprises (lower revenue growth, shrinking margins and more reinvestment) and some price adjustment. The second is that there is no better deflator of investors over confidence than a market panic, and if the China crisis does not do it, there will be others down the road.

What now?

Even if you accept my argument that big markets can create macro delusions and that these delusions can lead to a gap between collective expectations and reality, what you should do, in response, will depend on how you approach investing. If you are a trader, playing the pricing game, you may not care about the gap, since your returns will be based on timing, i.e., entering the market at the right time and exiting before the delusion is laid bare. It is possible that a lot of public investors and venture capitalists in this space are playing this pricing game and some of them will get very rich doing so. 

If you are a founder/owner or private investor interested in the long term value of your business, you may not be able to do much about your over confidence but there are a few simple steps that you can take to keep it in check. I do know that many in the start-up community view intrinsic valuations (or DCFs) with suspicion, but done right, a DCF is more than a valuation of a company. It provides a template for how you hope to convert products/users/downloads into revenues and profits, how much capital you will need to deliver the growth you so eagerly seek, and how competition will impinge on your best laid plans (by affecting growth and margins).  

If you are a public market investor, surveying a "big market" group of companies, this post is not a clarion call to abandon the group, but to approach it differently. You can still make money investing in this sector, but only if you are selective about the companies that you invest in (which requires that you grapple with estimating the size of the big market and make your best judgments on winners and losers)  and are cognizant of the price that you are paying, not only when you buy the stock but while your hold it. In fact, your very best investments may come from mis-pricing in this segment.

No matter which group you belong to, it is time that we stop labeling each other. If you are on the outside (of these big markets) looking in, don't be so quick to categorize players in the market as irrational, shallow and naive. If you are on the inside looking out, stop thinking of anyone who does not buy into your big market thesis as a Luddite, out of touch with technology and stuck in the past. You and I should be able to disagree about the values of Uber, Snapchat and Twitter, without our motives being impugned, our intelligence questioned and our sanity put to the test.

YouTube Version
I know that this is a long post and that your attention may have flagged half way through. To remedy that, I decided to make a YouTube video around this post. I hope you enjoy it!

Attachments

1. Imputed Online Ad Revenues by Company (with raw data on the companies)
2. Spreadsheet to compute Imputed Online Ad Revenues
3. Folder with imputed revenue spreadsheets for companies