Tech Stocks After The Fall

In October, it was easy for me to write “The Next Stock Market Bubble” about social media stocks like LinkedIn and the heavily overvalued names in the Social Media X (SOCL) Fund that were trading at over 100x earnings, had trouble developing anything resembling consistently growing profits, and stood to dilute shareholders along the journey.

It is a far more difficult question for me to figure out whether a social media stock has fallen enough in price to be worth absorbing the risk of meandering profit growth, substantial stock ownership dilution, and the business model uncertainty that comes with the tech territory.

For instance, online reviewer Yelp (YELP) has fallen 4% today following a UBS downgrade in which the bank pointed out the difficulties Yelp has in growing its market and even greater difficulty in attracting significant employee talent because those with programming and social media savvy would much rather work at Apple, Google, Facebook, etc.

Still, the stock has fallen from $101 per share in 2014 to $19.89 here on March 9, 2016. When a business that is expected to grow earnings experiences an 80% drop like that, it is worth asking: Does this stock offer investors a deal?

The balance sheet at Yelp is in excellent condition. There is no debt. There is $365 million in cash, which has been used judiciously (Yelp had $389 million in cash back in 2014, and the $24 million decline has been used to cover the minor operating losses). The core business model, which relies on user-generated review content, is superior to a company like Pandora because Yelp doesn’t have to pay for content creation–it pays to create the review platform, and doesn’t face input costs when people log in to post their user reviews.

We laud Coca-Cola because it only costs pennies to create its syrup that it can turn around and sell for a dollar, and Yelp also takes a stab at this business model–a user creates the product for free, and then Yelp hosts advertising on the site that creates revenue.

Despite these advantages, there are downsides that weigh more heavily on the business model:

First, I doubt anyone will be using Yelp fifty years from now. The creative destruction in social media is enormous, and it happens quickly and results in almost total decimation of market share. If a cereal maker becomes unfashionable, the corporate death is usually a decades-long spiral where there is plenty of notice and time for management to diversify into other operations (e.g. think of Kellogg responding to the decline of American cereal consumption by purchasing Pringles chips).

If, say, Facebook creates a user review service that provides competition for Yelp, the business model could be gone instantly. Think about how popular Garmin and mapquest.com were in the early 2000s–it seemed intuitively appealing that people would also want directions somewhere. Well, the entrance of Google and Apple into the mapping business completely wrecked their business models overnight and without notice. That means, if you are to consider a stock like Yelp, it would have to be in the speculative/medium-term investing portion of an investment portfolio.

What especially bothers me about Yelp’s current business model is that it has only one profitable year since 2010 (Yelp had its IPO in 2012, but provided an accounting history dating back to 2010). It made $36 million in 2014, and other than that, has lost between $9 million and $20 million every year. This is bothersome because the post-recession 2010-2016 has been an excellent period of growth for advertiser payments. If you can’t make money in this advertising environment, what happens if something only half as bad as 2009 emerges? A moderate recession could see Yelp lose $50 million or so per year, and Yelp’s extreme economic sensitivity to the business cycle means that you should demand one heck of a discount before even contemplating the purchase of this stock.

What’s worse is that insiders (the officers and directors) own 21.9% of the Class A stock and 95.2% of the Class B stock. The Class B stock carries super-voting power–each Class B vote counts for ten votes, and each Class A vote counts for one vote. This company is the plaything of Yelp management, and as a result, the stock gets diluted by a few million shares per year. The outstanding stock grew by 22% from 2012 through 2015, meaning the company needed to achieve 22% intrinsic value growth of the firm over three years just to maintain the per share status quo of intrinsic value. You already know my opinion that the reporting of corporate earnings without respect to share dilution is an especially dishonest practice; a clear-eyed view of expected per share results is a necessary condition for properly appraising the value of any business.

When I run the numbers, I get this: Over the medium-term, the best Yelp can expect is $100 million in profits. That assumes high single digit user growth, advertising rates remaining high, and employee costs reasonable. But the share count will also increase from almost 80 million to around 95 million. Using these rosy assumption, the best Yelp can hope for is profits of $1.05 per share.

If the stock is valued at 20x earnings, the stock would be worth $21. And if the stock is valued at 25x earnings, it would be worth $26. That would mean, even if the business performs according to the high end of rosy expectations, you would get anywhere from 0.98% annual returns to 5.39% annual returns. Given the risk to advertiser rates and the possibility of user growth that could decline substantially, that is a terrible risk-adjusted deal.

You should absolutely insist on something like 15% annual returns for five years to fairly compensate you for assuming the business model risk of Yelp. That would mean waiting for it to fall to $13 per share if you thought it was capable of making $100 million and trading at 25x earnings, or around $10.50 per share if you thought that it would make $100 million and trade at 20x earnings five years from now.

The numbers just don’t work at $19. Even though the stock has fallen 80% over the past three years, it still hasn’t reached a point that would in any way compensate you for the guaranteed share dilution and the very real business model risk of another entrant consuming the business review traffic. Even for speculative or shorter term investment accounts, the price of Yelp stock needs to fall into the single digits before you stand a good chance of double-digit returns that fairly compensates you for risk. I’ll take the fairly certain 8-12% annual returns of Diageo any day of the week over Yelp at current prices. I’m also especially bothered by the fact that Yelp is struggling to be profitable in this favorable advertising rate environment. The disastrous two years for the price of Yelp’s stock still has not taken the firm to a point that fairly compensates you for the inherent risks. I’d stay away.