Deliveroo's IPO - What went wrong?

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When Deliveroo floated on the London Stock Exchange on 31st March 2021, it was one of the most highly anticipated IPOs that the London market had seen in years. But when the share price quickly collapsed, it was a reminder of just how risky these heavily promoted new listings can be - and why investors should be extremely wary of them.

Deliveroo’s IPO offer price of £3.90 per share valued it at around £7.6 billion, but less than a month later the price had fallen to £2.28, taking the valuation to £4.4 billion. The performance led to some undesirable headlines as the worst IPO in London’s history. In terms of absolute paper money losses, only time will tell.

However, at a time when tech company valuations are often eye-watering, and IPOs are seemingly a foolproof way for directors and existing shareholders to make money, what went wrong with Deliveroo? What were the warning signs that should have been heeded in all of this - particularly for those buying shares in what was one of the biggest IPOs in recent years?

The City’s hype machine lured investors in

The continuous flow of compelling promotional activity by news outlets, financial institutions, and the company itself, seems to have lured private investors into what many now see as an expensive and enthusiastically hyped IPO. Many of these investors are now nursing substantial paper losses.

On the 27th of March, the Sunday Times wrote that ‘Deliveroo is poised to swerve around doubters in the City and roar towards a blowout float this week, despite mounting concerns about its use of gig-economy workers.’

The Sunday Times added ‘the online takeaway giant…is set to price its listing towards the top end of the £8.8 billion range after filling demand for its offering on the first morning of the so-called roadshow on Monday, with strong interest from investors outside the UK.’

The Amazon of food delivery?

It’s not hard to see the appeal of an established, high growth, tech company floating on the market. Tech companies are already in scarce supply on the London Stock Exchange. The stellar performances of tech-related IPOs in the US, combined with the general ongoing market euphoria earmarked Deliveroo as a tantalising new stock market prospect.

Billed as the next big tech unicorn, “The Amazon of food delivery” would be an easy pitch for Deliveroo, if it were able to scale its operations in the same way.

The company argues that it’s on the right track in terms of growth, and it’s right in this respect. It now operates in 12 markets, providing its 7.1 million monthly active users with access to over 115,000 restaurants and grocers. Revenues have risen sharply in recent years and the Covid-19 pandemic has accelerated this growth.

The company’s aggressive expansion has seen its market share rise steadily in its core UK market. In February 2021, Deliveroo’s market share reached 26% (22% in March 2020) whilst its larger rival, Just Eat saw its market share fall to 45% (52% in March 2020), according to Edison Trends. But whilst revenues and operations continue to grow, profitability remains out of reach.

Deliveroo has weak fundamentals and a business model that might be hard to scale

The harsh truth is that Deliveroo's introduction to the London Stock Exchange was much like receiving a burger that has been in a bag on a bike for twenty minutes. Rushed, soggy, and undercooked.

Despite reported attempts by advisors to support the shares, they fell on issue and have continued to drift lower - proving to be an early disappointment for those that bought in early.

There are many reasons that might explain the performance: a capital-intensive business model, stiff competition, ongoing promotional activity, the reopening of restaurants post-Covid, an expensive valuation, and a ‘dual share’ structure that dilutes the power of regular shareholders.

Deliveroo’s Value Rank of just 13 gives an indication of the premium valuation of the shares (Data taken on 27th May 2021 and is subject to change - see Deliveroo’s StockReport for current ranks)

But perhaps the biggest reason could be that the idea of investing in Deliveroo is simply more attractive than the reality. Dig a little deeper into Deliveroo's finances (which is hard for investors to do with companies that are new to the market) and you find that the business model faces challenges in delivering the 'scalable tech' idea that private investors were attracted to. The inescapable fact is that the group's business model and potential economics pale in comparison to real 'Tech Unicorns'.

Rising revenue but rising costs, too?

Finding companies that have been profitable since their inception is a fairly rare phenomenon. But it seems that the market is ‘pricing in’ an awful lot of future profitable growth for Deliveroo. Even at the lower end of the IPO range, and after the subsequent immediate drubbing in the market, the current market capitalisation stands at just under £5 billion, nearly 2 months after flotation, for what has so far been a perennial loss-making entity.

Deliveroo’s business model means that scaling profitably might be tricky.

Let’s compare Deliveroo to a company like Netflix. Netflix is inherently scalable. New content will cost the same whether one subscriber or 100 million subscribers watch it. It can set a fixed budget for content production, and every new subscriber that it serves reduces the marginal cost per subscriber.

A business model that involves an ever-expanding army of cyclists that delivers food to doorsteps does not share those attractive marginal cost dynamics. As you scale, you need more cyclists. Yes, there will be a contribution to fixed costs – but there will still be a significant marginal cost of production (or delivery) and that won’t go away.

Unlike for some true, scalable tech stocks, there isn't a pot of gold at the end of the rainbow when it comes to scaling up for Deliveroo. It's a weaker business model overall and this can be clearly seen in the company’s financial statements along with those of its competitors.

Analysing Deliveroo’s cost model shows that it relies heavily on affluent, densely-populated areas to make profits.

An example of Deliveroo’s unattractive unit economics: a reliance on high value orders in affluent & densely populated regions.

The cost base will likely grow more or less in line with revenues. This is an inherently expensive one-to-one delivery model, where one single supplier delivers to one single customer at a time. Economies of scale are significantly reduced when compared to the one-to-many models of Amazon, and even traditional retailers like Tesco.

Deliveroo has accumulated over £1.1 billion in losses since 2013

After years of expansion, there is still no sign yet that the business model is about to turn a profit. Deliveroo has accumulated over £1.1 billion in losses since its creation in 2013 and despite the home delivery pandemic-induced tailwinds, it still recorded a £221 million operating loss last year.

On the upside, reduced losses and expanded revenue in 2020 could be a sign that profitability is on the way. The gross margin to Deliveroo, which includes delivery costs in cost of sales, has improved from 19% to 30% between 2018 and 2020. But it’s also the case that this would have actually fallen to 12% if we included other admin costs, such as delivery costs.

Losses have also been reduced by the big reductions in overheads and marketing costs. The company reduced its global headcount by 15% at the beginning of last year, reducing its marketing headcount from 747 to 202 and slashing its overall marketing budget in the process. But with sites reopening and looking to win back customers, Deliveroo might have to increase these costs again in the future.

Deliveroo is employing an uncertain vertical growth strategy

Then there is the 'horizontal vs. vertical' argument. Growing horizontally, by taking market share in your existing market, is historically a ‘safe’ strategy with a clear, well-developed playbook for execution.

Growing vertically, by taking share in adjacent markets, brings more execution risk. Deliveroo is doing everything it can to grow. Initiatives include:

• Deliveroo Editions - essentially operating delivery-only restaurants. This is capital intensive, as it relies on Deliveroo purchasing and setting up its own ‘dark kitchens’.
• Deliveroo Plus - the group's delivery subscription service currently being heavily promoted. The service aims to improve customer retention and increase order frequency, but this could impact upon margins per order placed.
• Deliveroo Signature - the white label operation, which enables restaurants to maintain their own delivery business and customer relationships via Deliveroo’s online platform. A relatively straightforward operation to run (similar to peers such as Just Eat), but perhaps fewer profits to be enjoyed.

Seizing more of the value chain makes sense, but it is not the original business model and Deliveroo will be competing against established operators.

What's more, the company that you buy today may not turn out to be the one that you own tomorrow. Or, as Mark Brumby at Langton Capital puts it:

If Deliveroo buys capacity (via purchasing restaurant companies or by building dark kitchens – which could be a more competitive market going forward) we may have a £5bn restaurant company on our hands that owns a lot of bicycles.

Who needs profits when you can just raise capital?

After eight years, it’s possible that Deliveroo has come to the conclusion that it will need to vertically integrate. This entails execution risk, adaptation and money. Probably lots of money. Prior to the IPO, Deliveroo had raised $1.7 billion of funding. How much more will be needed to become profitable?

We can potentially justify raising this much capital if it’s allocated well. However, looking at the company’s quality metrics, such as its Return on Capital Employed (ROCE), Return on Equity (ROE) and Operating Margins, we can see that the cash that Deliveroo has raised and spent to date has not yet led it to profitability.

Deliveroo’s quality metrics reveal the extent of its poor all-round profitability to date. Data taken from Deliveroo’s StockReport, correct at the time of publishing.

A number of external factors stand in the way of profitability, too

Easing lockdown tailwinds

The increased revenues and loss reductions have only really been made possible because bars and restaurants had to close due to Covid-19 restrictions.

The company itself admits in its recent first quarter update to the market:

It is difficult to say how much of this [gross transaction value] growth has been driven by the special circumstances of the current lockdown restrictions in some of our markets.

The rate of growth is expected ‘to decelerate as lockdowns ease, but the extent of the deceleration remains uncertain.’

One would think that the marketing costs must be increased again in order to tempt people away from eating out in the future. Restaurants will do everything they can to pull customers back in, where they can upsell and encourage high-margin drink sales.

In some countries, restaurant chains are even going as far as asking their customers to avoid using aggregated online delivery services as this impacts upon their own margins. Cutting out the middleman makes sense for the sustainability of restaurants’ earnings in a post-pandemic world.

Ethical concerns about the ‘gig economy’

Another concern relates to Deliveroo’s compliance with the environmental, social and governance’ (ESG) issues that many investors are taking increasingly seriously. In particular, its use of ‘gig economy’ workers was reportedly a sticking point for some institutions during the IPO roadshow. Prominent UK investment fund providers, such as Aviva, Aberdeen Standard, and Legal & General, opted against taking part in the IPO over these concerns.

Recent legal rulings in the US over worker protections could ultimately put more pressure on Deliveroo's already weighty cost base. Uber Eats and Just Eat are already in the process of converting drivers to full employee status.

Deliveroo has also found itself in the spotlight in the past, with regard to ESG issues. An investigation carried out by The Bureau of Investigative Journalism, The Mirror newspaper, and ITV found that Deliveroo riders are paid less than the national minimum wage. The investigation even uncovered a case where a rider, who had worked 180 hours, had received the equivalent of £2 per hour.

Deliveroo is playing in an intensely competitive market

This is also an intensely competitive market and promotional activity is rampant across all three UK delivery platforms (Just Eat, Uber Eats & Deliveroo). Just Eat maintains a considerable market-leading position and these platforms are ‘sticky’. Analysis carried out by McKinsey showed that once customers are signed up, 80% will either never or rarely, leave for another competitor. So you can see why the focus on potentially costly customer acquisition is so important here.

What can investors learn from this?

How the City is incentivised to achieve high IPO prices

All things considered, it looks like Deliveroo has floated at the peak of a temporary lockdown tailwind, and benefitted from a strong current of interest surrounding IPOs at this time. While the price may go on to recover, it’s hard to dispel the sense that mega flotations like this are structured in a way that ensures that the banking and legal advisers involved are the first to benefit.

Indeed, reports suggest that Deliveroo’s board is facing a backlash from its shareholders over a supposed £18 million payout to be made to investment banks involved in the IPO. As part of the company’s prospectus filings, it was disclosed that the six banks involved would receive a fixed fee of 1.66% of the capital raised from the floatation, worth around £27.5 million in total. The additional £18 million payout relates to an incentive fee of 1.09%, which can be approved at the board’s discretion.

With such a large incentive to achieve the highest possible IPO offer price, it’s understandable that advisers will be ambitious. With proceeds of just under £1 billion for the company, the investment banks got their usual cuts and existing investors achieved their giant payday. But the risk is that new flotations become excessively-priced and heavily promoted, which makes them susceptible to disappointment for those buying in. A glance at the share price performance of Deliveroo and its main competitors illustrates this well.

Our latest research into IPOs has uncovered how the City reliably and consistently makes profits on IPOs, at the expense of private investors. You can get the full story - as well as learn how to avoid these situations - in our free IPO Survival Guide.

The importance of reviewing the prospectus

Every company that floats on the stock market has a prospectus, which in many ways is a sales document - but one that can still alert investors to potential red flags. With Deliveroo, the financial statements were an obvious place to start, and the mounting losses over the years were an important factor in the investment case.

The prospectus also documented other potential risks. Research by the Responsible Investor highlighted that, on page 122 of the prospectus, a legal provision of £112.2 million had been set aside to cover for any potential rulings on its workforce. The document also contains information about the company’s legal proceedings in Europe, where the Amsterdam Appeals Court recently found that Deliveroo’s riders should be classed as employees, as opposed to freelancers. With the UK Supreme Court also ruling in favour of Uber drivers as workers, it paints a potentially uncertain outlook for the company’s future operating model.

These issues were laid out in the prospectus, which is why investors considering buying into an IPO should read these key documents.

Assessing the ownership structure

Finally, there is the company’s unusual ownership structure, which is seldom seen in companies quoted on the London Stock Exchange. Founder and CEO, Will Shu, received Class B shares as part of a dual-class share structure. These allow him to carry 20 votes for every share held, as opposed to just 1 vote for each Class A share. This entitlement will last for three years, at which point the Class B shares will be converted into Class A shares.

This kind of arrangement is not unheard of, but it can be unsettling for both institutional and individual investors - because it means they don’t have as much say in the running of the business as they might usually expect.

What might the future hold for Deliveroo?

Booming demand for online food delivery

There are plenty of reasons to be optimistic about Deliveroo’s future. Online food delivery is booming. Analysis by Frost & Sullivan shows that the online food delivery market could be worth $200 billion by 2025. Whilst the gradual easing of lockdowns may see demand subside in the medium-term, the pandemic might have changed online food delivery habits for good.

Whilst Deliveroo still lags behind its larger rival, Just Eat, it’s growing more rapidly than any of its main competitors and across all of its key markets. In 2017, Deloitte acknowledged Deliveroo as the fastest growing technology firm in the UK, having grown by over 100,000% over the four year period since its inception.

Amazon’s backing

Amazon purchased a 16% stake in the company in May 2019, and this kind of support should not be overlooked. Amazon clearly sees an opportunity in the online food delivery market. Its financial backing, combined with its logistical expertise, could make Deliveroo a winner in the long term.

An appetite for innovation and a drive to succeed

Deliveroo’s constant innovation is also one of its key strengths that could help it succeed in the future. The Deliveroo Editions sites are quickly expanding, enabling Deliveroo to generate higher margins as it owns the kitchen space. An expanded partnership agreement with Waitrose has also just been established following a successful trial.

According to Grand View Research, ‘The global online grocery market size was valued at $189.81 billion in 2019 and is projected to register a CAGR of 24.8% from 2020 to 2027’ reaching a market size of over $1.1 trillion. There is inevitably huge potential for Deliveroo to leverage its logistical expertise in this market.

Moving forward, the development of autonomous vehicles could transform the entire cost model of the company. Deliveroo’s willingness to explore ways to boost its profitability should provide some reassurance to shareholders that the historical losses won’t be a permanent fixture of the future.

Summary

IPOs are a difficult field to navigate. The absence of information in the public domain makes it a real challenge to adequately appraise IPO opportunities. However, it is the fear of missing out (FOMO) that often overwhelms investors and forces them into mistakes. It is tough to filter out the noise when you consider the constant bombardment of promotional activity from news outlets trying to encourage purchasing decisions.

Nevertheless, IPOs can be profitable endeavours in the right circumstances. Reading through a prospectus might not be the most captivating way to spend your time, but it could dramatically improve your chances of picking a winner. Industry research, competitor analysis, regulatory changes, and institutional ownership information are equally important to review and the time taken to assess these factors can reap its rewards.

It remains to be seen whether Deliveroo can turn its fortunes around, but its IPO disappointment has without a doubt provided the investment community with some invaluable lessons on why it’s so important to dig into the details of IPOs in the future.