HelloFresh: Like Hims 2 Years Ago?
Deep Dive
Edited by Brian Birnbaum.
1.0 In the Pursuit of Critical Pains
HelloFresh is an extraordinary organization tasked with a difficult challenge: discovering customer pain points with the express purpose of evolving beyond convenience. If HelloFresh succeeds on this front, the sky's the limit.
At present HelloFresh trades at just over 0.14 times sales, as if it were nearing bankruptcy. On the contrary, HelloFresh has demonstrated exceptional process power to date. It operates one of the most complex supply chains on Earth, implying world class organizational capabilities in logistics, marketing, data analytics, and user interface design.
It is exceptionally rare to see a company operating at such a high level and constantly improving all four domains. The complicated nature of the business masks these organizational properties. The striking discrepancy between said properties and the current valuation makes for a potentially lucrative investment opportunity.
The compressed multiple derives from the market’s perception of microeconomic viability. A world in which the market is incorrect allots for 20 or even 30 times current prices based on multiple expansion alone. Further, the pandemic pulled demand forward, allowing HelloFresh to invest in updated logistics facilities and its RTE (ready-to-eat) business segment. While hurting the financials in the short term, such improvements stand to lend HF further upside.
Per the demonstrated process power, my view is that HelloFresh has more than reasonable odds of prospering financially.
HelloFresh’s main problem is the lack of utility beyond convenience. For a business to truly prosper, it has to effectively solve a growing volume of acute customer pains in a way that is increasingly harder to imitate and emulate profitably. Eventually, the idea is to make emulation effectively impossible. At present customers seem to perceive its utility along a spectrum–for some it solves a more acute pain, for others, less so.
Which is to say that, generally, HelloFresh leans towards the nice-to-have side of things.
To add further complexity to the quality of the demand driver, a given customer’s experience of product utility is typically not fixed along the spectrum. When they have more stress at work and thus less time to cook, HelloFresh provides a significant solution. Once their professional burden reverts to the mean, they regain time to cook, and HelloFresh too reverts to a product of convenience. This pendulum of utility also plays a major role in HF’s operational complexity, which I analyze further on.
HelloFresh solves the above by making its meal kits and RTE meals available for cheaper than marketplace alternatives across the board, such as buying food at the supermarket and cooking yourself. At this point pressing a button to receive high-quality, healthy food at a discount becomes a no-brainer in the same way an Uber does versus a taxi.
By analyzing customer reviews on various platforms you will see many mention price incentives issued by the company as essential. Without the discounts (subsidies, effectively), many customers don’t see the point of signing up to HelloFresh. Unfortunately, at this stage the company does not disclose key performance indicators regarding their prices in the various markets they operate in. I’d wager that these numbers would support greater demand for a cheaper product.
But the way forward isn’t to decrease costs and therefore margins. It’s to capitalize on market segments in which customers persistently value the exchange of money for time. By locating and saturating these pockets, HelloFresh keeps the flywheel spinning with improved unit economics over time.
In Q1 2024 the company announced a shift towards focusing on “higher quality customers” versus simply acquiring scale at all costs, which I believe is the correct strategic move at present. Previously, the company focused on acquiring scale at all costs in order to more quickly iterate the backbone of its business. Perhaps this new strategy will yield more appealing demand-side dynamics.
HelloFresh’s supply chain is one of the most complex on Earth. It essentially funnels and transforms perishables for millions of individuals worldwide, including vegetables, meat, fish, and chicken. Perishable items are quickly wasted in the wrong environmental conditions and especially so once cooked. Worldwide, 70% of perishables are wasted, whereas according to HelloFresh management the company only wastes 1% of perishables.
This is an extraordinary feat on its own, but even more so considering HelloFresh is the only meal delivery company on the planet that operates at this scale. The rest of its direct competitors have either ceased to exist or operate at much smaller scale. Further, the company has been producing positive cash from operations since the start of the pandemic, despite the ensuing slowdown, increased investments in logistics, and rapidly growing RTE business, which has grown 50% YoY.
In the various quarterly conference calls that I have read, management alludes to having an internal marketing platform that enables them to acquire customers in a cost-effective manner. They claim to have a precise understanding of the impacts on user LTV (lifetime value), which I tend to believe is true, since achieving positive cash from operations without this level of control is nearly impossible.
The other company that I’ve seen master LTV is Spotify and as of Q2 2024 this is serving them well. HelloFresh’s business is essentially about getting their vertically integrated infrastructure to be as efficient as possible and pointing it to the right customers, so that unit economics work. The latter is all about understanding LTV and how to optimise it.
2.0 Operating Leverage
HelloFresh is positioned to launch additional verticals at marginal cost, which may increase operating leverage over the coming years. Furthermore, early signs of such leverage can be found within existing operations.
Two major data points speak boldly to HelloFresh’s ability to optimize processes:
It took HelloFresh seven years to scale the meal kit business to €1B in yearly revenue and eight years in total to achieve profitability. In turn, it’s taken them just three years to scale their RTE business to €1B in yearly revenue and profitability. As of Q1 2024, the RTE business is now at a €2B annual revenue run rate.
HelloFresh is constantly expanding their menus. From 2016 to 2017 their weekly menu expanded from six to somewhere between 30-40 recipes in “most of their advanced markets.” By the end of 2023 that number was up to 45.
Transforming and distributing perishables to millions of individuals worldwide is exponentially more complex as you add verticals and menu options. For example, the meal kit business requires that HelloFresh effectively send out perishables with an instruction set for customers to cook them at home. The RTE business, on the other hand, sends out cooked meals.
The fact that HelloFresh has been able to deploy its second vertical much quicker suggests that their operational backbone–logistics, marketing, user interface and data analytics–will remain a likely source of operating leverage going forward. Their backbone enables them to deploy subsequent verticals at a marginal cost, as is the case with RTE.
What remains to be seen is whether this actually improves unit economics. The post-pandemic lull in meal kit business and the increased investments in infrastructure shroud our vision. However, digging deeper into the company’s key performance indicators reveals some clues.
In the three graphs below you will see that, although the total number of customers remain flat since the pandemic (first graph), total orders are up considerably since 2020 (second graph), and revenue (third graph) continues to push records. These charts provide significant evidence of operating leverage.
Rising operating margin is also driven by a steadily rising AOV (average order value), per the graph below. The inflection point in AOV coincides with the launch of HelloFresh Market, which offers customers a range of additional grocery items and meal solutions that can be added to their regular meal kit deliveries, such as pantry staples, snacks and beverages and breakfast and specialty items.
Selling additional grocery items is the first successful instance of HelloFresh improving unit economics by deploying a new vertical, powered by its backbone.
Successful deployment of HelloFresh Market and RTE point to an organization capable of deploying new verticals. If revenue generated by these new verticals becomes accretive to the bottom line, HelloFresh will be on its way to meaningfully improved financial performance. Meanwhile, two key dynamics obfuscate HelloFresh’s financial advancement beyond the bottom line.
First, as you can see in the graph below, RTE revenue is up 54% YoY (mostly driven by the US, with the brand Factor_), but meal kit revenue is down 7.6% YoY. Meal kit revenue is much larger at present than RTE revenue, so the decline of the former is deleveraging HelloFresh’s existing logistical capacity.
Further, RTE requires cooking meals for customers and therefore additional investment as well, namely cooking facilities. As a result, procurement expenses as a % of revenue are rising, as you can see in the next graph.
For both segments HelloFresh has to procure the food it’s going to send out and then distribute it to customers. The more they lower these costs over time, the more HelloFresh makes every time it sends out a meal, and the more profitable it becomes. The graph below illustrates two key factors:
Procurement expenses started trending up in 2020, following the launch of RTE.
Fulfilment expenses as a percentage of revenue trended up from 2019 to early 2022. They’re now declining, but were still higher in Q1 2024 than they were in Q1 2019. HelloFresh is allegedly investing continuously in its fulfillment facilities in order to drive increased personalization, which according to management is a key demand driver.
As a result of the nominal increase in procurement and fulfillment expenses, contribution margin has trended down since Q1 2019. HelloFresh defines contribution margin as the revenue remaining after deducting procurement and fulfillment expenses, while excluding share-based compensation expenses. The decline of this metric explains why, despite revenue trending higher, net income conversion has trended lower. In Q3 2021 net income as a % of revenue came in at 1.63%, while it came in at -4.04% in Q1 2024, as you can see in the next graph.
The decline in net income as a % of revenue coincides with the decline in total number of customers and is ultimately what makes the market believe the company is in a general state of decline. However, it can also be argued that the decline coincides with inflation (from 2021 to present, arguably) and the rapid ramping of RTE over the last year, both of which suggest the alleged decline of the business isn’t quite so.
Although gross margins are essentially flat since 2019, they are up from 55.27% in 2014 to 64.21% in the TTM. The company has the ability to increase earning power over time. Thus I’m inclined to believe that the company has an innate ability to decrease procurement and fulfillment expenses in relative terms. If they do end up finding and resolving customers’ pain points, HelloFresh might see considerable upside.
3.0 Financials
A declining cash balance may have forced management to cut the current investment cycle short, which would be a serious concern.
The cash balance is key to the thesis. It’s declined quarterly since late 2021. We also must watch how cash flow production relates to capital expenditures. As you can see in the graph below, as of Q1 2024 cash and equivalents exceeded long term debt by $224.34M. However, as you can see in the next graph, from early 2021 until Q1 2024 CapEx has been considerably exceeding cash from operations, which is why the net cash position has been declining.
Regarding the inversion of the CapEx to cash from operations scenario, there are two possibilities:
The spread has flipped because, at the natural “end” of the current investment cycle, sufficient capital has been deployed to hit the next growth gear.
The investment cycle has been cut short because the cash balance was declining too quickly.
If the latter is the case, HelloFresh will require external financing. For HelloFresh to solve acute customer pains and thus strengthen its financials, the level of personalization, quality, and convenience needs to improve significantly.
Deeply understanding the company’s investment cycles is fundamental. My impression of CEO Dominik Richter is that he is an exceptionally smart guy who perfectly understands what makes an organization great: a culture of continuous improvement.
In turn, CapEx cycles are inherent to building such a culture.
Towards the end of the interview below, Dominik talks explicitly about how he thinks about culture. He doesn’t mention CapEx cycles, however, and this is what raises my hackles.
4.0 Conclusion
HelloFresh currently operates under a series of brand names, which, as Dominik explains above, is by design. It enables HelloFresh to target specific segments of the market, with different price-to-quality expectations. This seems to be an ideal structure through which HelloFresh can become indispensable to customers. For now, I don’t believe the company has quite achieved that, but it may just be a matter of time.
Beyond the top line, my impression is that the company excels at optimizing processes and systems. If they strengthen their demand drivers, as discussed, I believe the company has a bright future ahead. The rise in procurement and fulfillment expenses seen over the last few years is a result of the pandemic pulling demand forward and the company stepping up its CapEx to improve its logistics facilities, driven mainly by the rapid growth of RTE.
In the recent past I’ve learned that one can rarely go wrong investing in companies with deeply ingrained cultures of constant optimization. Yet I’ve also learned that companies that do not solve a growing volume of acute customer pains tend to do poorly over time, no matter how much they may optimize. HelloFresh is currently in the latter bucket with an option of moving into the former.
In order for HelloFresh to evolve into a gastronomic panacea, it needs to become increasingly competitive on price when compared to the time, labor, and money spend on buying and cooking one’s own food.
I’ll be tracking this company closely going forward.
Until next time!
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