Rover: Growth Challenges And Leaves Room To Play (NASDAQ:ROVR)

Company profile

Rover (NASDAQ:ROVR) was founded in 2011 and went public through SPAC on August 2021. The company took 10 years to grow its revenue to 109.8 million in revenue and 372 workers in 2021. The company offers dog walking, dog boarding, and pet sitting on its online marketplace platform Rover.

The payout structure for Rover is as follows:

Rover receives 20% from the pet sitter and 7% from the pet owner.

The company identified a market niche

According to Rover, its main competitors are (1) family, friends, and neighbors; (2) independent local providers; (3) large commercial providers; and (4) online aggregators (Craigslist, Yelp).

We think Rover has done things right to break into the family, friends, and neighbor markets by offering the following service:

(1) Cashless payment: The company receives payment in advance from the pet owner and pays the pet care provider at the end of the service. Thus, it serves as a platform to protect both the buyer and service provider in the event of a dispute. In addition, cashless payments improve the conversion rate compared to cash transactions in family, friends, and neighbors scenarios. (2) The Rover guarantee: Rovers offer 24/7 support and $25,000 in payment for veterinary care. The care could be used to cover injuries to either the pet owners or the sitters’ pets or property damage to the pet owner’s house brought on by the pet care provider. The service establishes more trust between the pet owner and the care provider. In addition, the company differentiates themselves apart from large commercial providers and small independent suppliers through the following:

(3) Location and reviews based online platform: The online platform offers details such as the size, breed, and age of the pets they provide service to, date of availability, locations, and condition of the dwelling. This gives pet owners a variety of selections than those large or local providers.

Lack a moat to secure long-term growth

We believe the company lacks a moat since if the pet owner has their insurance and has developed a relationship with the care provider, they are more likely to skip the platform to do the offline transaction. Also, people who used to go to family, friends, and neighbors for care services, typically pay little or no compensation. One reason could be that people usually do not want to get involved in a financial dispute with an acquaintance. However, once an owner forms a habit of using Rover, the owner who has financial capability might in the end be comfortable to ask their acquaintance for care service with comparable compensation he spent on Rover. In this way, Rover may face long-term growth challenges.

Management seems not capable to take the company to the next stage

CEO and founder, Aaron Easterly, worked as a strategy manager at Atlas and Microsoft. Many of the members of the leadership team only have work experience in large conglomerates. Due to their similar backgrounds, they appear inexperienced in helping a startup to create the moat for further expansion. We don’t believe their current expansion strategy is executable in short term given the high rate and the low cash on hand. In the long term, there are existing larger competitors (Chewy, PetSmart, etc.) in the field they plan to expand. They will need a more solid proposition to convince the market.

The stock’s potential for growth has already been priced in

Understanding the fundamentals of the business model of the company, as well as its strengths and weaknesses, let’s dig into the stock valuation.

The company claims that its TAM is (1) the existing commercial market, (2) the pet services market

The existing commercial market is as follows by company: The total U.S. market for pet spending was $95 billion in 2019, including pet food, veterinary services, pet supplies, and non-medical services, according to Packaged Facts

1. The pet services market includes Overnight service and Daytime service.

The company says:

The table below details our calculation of the overnight services opportunity in the United States. According to the APPA, 67% of U.S. households, or 85 million households, had pets in 2020. To estimate trip nights per household, we take the Euromonitor estimate of 1.4 billion overnight trips in 2019 and assume 2.5 nights per domestic trip and 5.0 nights per international trip, for 3.9 billion total trip nights. Assuming 2.5 people per household, we calculate 11.4 total trip nights per household. This results in 964 million total addressable nights.

There were 97 million dogs and 76 million cats in U.S. households as of 2020, according to APPA, for a total of 173 million pets, an average of 2.0 per pet household. Based on our average nightly rate of approximately $35 per pet, this results in a total overnight market opportunity of $68.8 billion. This is more than 20x the size of the current commercial market for overnight pet services. Over the next ten years, with the growth of travel nights based on Euromonitor estimates, and our estimate of the increase in pet households, we calculate that the market could grow to $100.2 billion.

Regarding the market opportunity, we have the following comments.

TAM is likely exaggerated

• It is unlikely that Rover will enter the pet food, veterinarian services, or pet supply sector in 2023. The company should have difficulty finding lenders or equity investors to fund its expansion because it still operated at a loss and because of the current high-rate environment. Furthermore, the corporation has only 234 million in cash and cash equivalents on hand at this time. According to its past financial results, it already spent a lot to maintain its current platform and service (software and talent). It is unlikely that the company can use the funds on hand to enter pet food and pet supplies, which requires a substantial upfront logistical investment.

• For the pet service market, we believe that including cats in overnight services and giving them equal weight is likely overstating the significance of the cat market. Cats have fewer human service needs than dogs, given their naturals.

DCF model suggests downside even if they can grow

If we made the following assumptions using the market condition at the time of the IPO and management’s aggressive assumptions:

1. TAM 80 billion,
2. 10 % WACC,
3. 3 % terminal growth rate,
4. 20% free cash flow margin(L9M Q32021),
5. Net debt 290 million,
6. Outstanding shares 117 million.

The equity value was $1,479 ($12.7). This may be the cause of the stock pricing rationale over the 10-14 range after the IPO in August 2021. We think since then, the TAM, WACC, and free cash flow margin assumptions have changed due to the high rate environment. As a result, the shares fell from $14.62 following the IPO to the current 3.85.

Further, if we only take into account the dog pet service market and the following assumptions:

1. TAM: Using 97 million dogs instead of 173 million cats and dogs, $142 per booking and 4x per year (Q32022 data). $56 billion TAM instead of 80 billion,
2. 18% WACC,
3. 3% terminal growth rate,
4. 10% free cash flow margin (using around 10% EBITDA margin guidance from the company for FY 2022),
5. Net debt $234 million,
6. Outstanding shares 182 million.

Applying the DCF method, we can arrive at an equity value of 402 million ($2.2 per share), which implies a 43% decline.

We still have a significant margin of safety with the WACC and free cash flow margin sensitivity test below.

Action plan

Sell call

We don’t think the company has any chance to enter into a new market short term given the high rate environment is likely to continue through the rest of 2023. We think selling a call at a strike price of $5 and pocketing the premium is likely a profitable strategy. Given the uncertainty of the event of earning call, we prefer to buy May expired call, which offers a 28% return in around 90 days, over the August one. The more risk-averse investor could consider selling a call after the earnings call, which is anticipated to be in March.

Short stock

As of February 14, 2023, the borrowing fees are 2.1%, and there are 650,000 shares available for borrowing (1.7x of average trading volume). The costs of borrowing are relatively low compared to the potential loss of 43%. Although the upside loss range to the sell call is greater than that of shorting the stock, we still favor the selling call because we are more confident that the stock is unlikely to make a significant move in the short term as opposed to the long term.

Risk

Penetration exceeds 5%

The penetration rate should also be closely considered by the investors. The corporation claims that its current penetration rate in the United States, Canada, and Western Europe is 2.5%. The valuation rationale will change if they successfully surpass the 5% penetration or provide proof that they can exceed the rate.

In conclusion, we believe Rover is a young company with a good start, but they are struggling to create the moat necessary to ensure future growth. The company needs some time to figure out its value proposition before it can move to the next level. Given the company’s current fundamentals, we would rather sell call experiments in 2023 than short the stock.