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Did Blue Apron Build Itself a Catch-22?

Blue Apron (NYSE: APRN) reported mixed third-quarter earnings results. It beat on the top line, but its loss per share was bigger than anticipated. The market initially cheered the results, but management's fourth-quarter outlook quickly soured the mood. By the end of the day, Blue Apron shares plummeted to an all-time low.

While management expects its second-half revenue to remain stable, it lowered its earnings expectations. That's surprising, considering the company reported that the missteps with the transition to its Linden, N.J., warehouse have been resolved. The warehouse is now fulfilling 50% of all orders.

The only problem is, "Linden performed at a margin that was significantly lower than the average of our existing centers" during the third quarter, according to CEO Matt Salzberg.

Management wants to expand its profit margin before it ramps up marketing again. But to expand its margin, it needs to use the full capacity of its Linden center. And it won't get to full capacity unless it adds new customers with marketing. So there's something of a Catch-22 on Salzberg's hands.

Image source: Blue Apron.

Margin improvement is an immediate priority

Blue Apron started pulling back on marketing spend in the second quarter after its transition to the Linden facility went worse than anticipated. Problems in the transition led to a drop in the "on-time and in-full," or OTIF, delivery of Blue Apron's meal kits. Naturally, the lower the OTIF delivery rate, the more dissatisfied customers Blue Apron has, and fewer people order a second or third time from the company.

Now that the transition to the Linden facility is complete, however, OTIF rates should climb back up to 2016 levels. But it's not clear that profit margin will follow.

Salzberg noted the company will no longer have to run two east coast fulfillment centers in the fourth quarter and could eliminate duplicative costs. When pressed for details, though, he dodged the question and talked about seasonal cost savings with produce and packaging instead. For reference, cost of goods increased 13% year over year last quarter.

Another area where Blue Apron is seeing increased operating costs is its product, technology, general & administrative expense, which increased 31% year over year. Recent layoffs coupled with the eventual shuttering of its Jersey City warehouse should help reduce those expenses.

Blue Apron reported a larger-than-expected third quarter net loss due to the increased costs. It also lowered its net loss outlook for the second half of the year, which doesn't indicate confidence that management will turn around its margins in the near future.

Why Blue Apron needs to start marketing again

Blue Apron's Linden facility is designed to handle a lot more orders than its old Jersey City warehouse. It's 2.5-times the size to begin with and it's filled with automation technology. In order to take advantage of the higher overhead costs, Blue Apron needs to scale its total customer orders. The pullback on marketing has cost it 180,000 net customers and 668,000 total quarterly orders over the last six months.

What's more, Blue Apron is seeing more and more competition come into the market. HelloFresh, which recently made its IPO, says it expects to overtake Blue Apron's U.S. market share by the end of the year.

A survey found the German company took 28.4% of the market in September compared to Blue Apron's 40.3%. But Blue Apron's share is declining quickly while HelloFresh is rapidly gaining.

HelloFresh is also ramping up its marketing. The company increased its marketing spend more than 50% through the first six months of 2017.

There's also the potential for Amazon (NASDAQ: AMZN) to enter to the market at some point in the near future, following its acquisition of Whole Foods. The grocery chain Albertsons recently acquired Plated, another meal-kit service, providing it capital and distribution to expand its operations.

The longer Blue Apron waits to ramp up its marketing spend again, the more market share it's ceding. And if it waits until its operating margin is back on track, it might have already lost control of the market. It's going to be hard to expand its margin without scaling its fulfillment at Linden. And it's going to be hard to scale without spending more on marketing.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Adam Levy owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.