Six months ago, I was tasked with writing an article on the top food stocks to buy. Halfway through my research, I was certain I had my top three. 

Grubhub (GRUB) was one of them. And why not? The company was growing like crazy, is a leader in a niche that's growing in importance, and appeared to be surrounded by one of the strongest moats there is: the network effect

Alas, after digging deeper, I decided to toss it from consideration. Six months later (with the stock dramatically underperforming the market), I'm still taking a hard pass on Grubhub. I think you should, too. Here's why:

Businessman making a stop gesture

Image source: Getty Images.

What's a moat?

Before we go any further, it's important to define what a moat is. Popularized by Warren Buffett, it refers to a sustainable competitive advantage. Nothing is more important to investigate than a company's moat.

It's an oversimplification, but moats often come in four forms:

  1. Intangible assets This includes brand value, patents, and government protection (think utility companies for the last one).
  2. Low-cost production If your company can somehow offer the same thing as others at a lower price, you win!
  3. High switching costs Once people start using your product, it's a pain (financially or otherwise) to stop using it.
  4. Network effects Each additional user of a product or service makes that product or service more valuable for everyone else.

Grubhub's key moat comes from the network effect: The more restaurants that sign up to use Grubhub, the more customers are incentivized to use the platform to order food. And the more customers who order food on Grubhub, the more incentivized restaurants are to list on the site.

Those dynamics have played out perfectly for the company.

Metric 2015 2016 2017 2018 2019 Growth Rate
Active diners 6.75 million 8.17 million 14.46 million 17.7 million 22.6 million 35%
Restaurants 40,000 50,000 80,000 105,000 300,000 65%

Data source: SEC filings.

Diving into the weeds

With results like that, it's fair to ask what the problem is. As it turns out, it's threefold:

  1. The network effect is limited by geography.
  2. Diners can pick from other delivery services -- there's no real leverage.
  3. The economics are not favorable.

Let's look at these three in order.

While it might be true that Grubhub is the most popular delivery service in one city (say, New York), that doesn't mean it's the most popular in another (like Austin, Texas). In fact, according to research by SecondMeasure, while Grubhub has the lead in the Northeast, DoorDash and Uber's (UBER 1.21%) Uber Eats dominate much of the rest of the country.

And it doesn't stop there. Each additional active user in New York does nothing for restaurants in other sections of the country. That makes for a weak network effect.

Furthermore, there's nothing stopping an active user with Grubhub from also being an active user with the two aforementioned rivals. In fact, 27% of Grubhub diners also use DoorDash, while 15% use Uber Eats, and another 10% use Postmates.

When customers can shop around like that, the cheapest service wins. It encourages a race to the bottom: great for us customers, but terrible for shareholders. 

Finally, in his most recent letter to shareholders, Grubhub CEO Matt Maloney does an admirable job of highlighting the company's challenges. He explains how there are three types of restaurants people order from on Grubhub:

  1. Partnered QSR restaurants This is where Grubhub delivers goods from big fast-food chains like Yum! Brands' KFC.
  2. Nonpartnered restaurants These restaurants never even agreed to list on Grubhub. The company acts as more of a pickup service representing the customer.
  3. Partnered independent restaurants These are smaller, local chains that have agreed to partner (exclusively or not) with Grubhub.

When all is said and done, the first group adds zero profit for Grubhub. It just drives traffic. The second group has extremely limited profit potential as well. It is only the third group that actually moves the needle.

That's important to recognize, because much of the growth of restaurants on Grubhub's site has come via the second group: eateries that never agreed to list on Grubhub in the first place. Some of these locations don't even allow takeout or delivery and are forced to explain this to potential customers who are waiting for Grubhub to deliver their orders.

This is not a recipe for success. In fact, in my book, it's a recipe for disaster.

Investor takeaway

In the end, things will eventually normalize. The race to the bottom in pricing can't last forever; there will be a winner. But the winner will likely be a company that has other sources of income to supplement the food delivery business. That doesn't describe Grubhub, and that's why I think investors should take a hard pass on the stock.