GrubHub Stock Deservedly Up 25% Today

If I made acquisitions for Microsoft, I would not spend my time adding LinkedIn to the stable but instead focus on the acquisition of a company like GrubHub which offers the best combination of sustainability and growth out of all the new tech companies that have arisen in the social media era.

There are four things I like about GrubHub that distinguish from many of its industry peers: (1) it actually earns a profit; (2) that profit is growing at a very high rate; (3) the expected share count dilution over the coming years is not obscene; and (4) the business model doesn’t exploit an illusory faddish concept.

GrubHub makes it money by setting up the online software and creating a platform app that permits people to make take-out and pick-up orders at restaurants that are traditionally sit-down. GrubHub has a tremendous first mover advantage in the drive-thru-ification of the $9 to $16 meal market, and also earns referral/affiliate income through its sites and the eponymous

Today, GrubHub announced that it earned a profit of $0.15 per share for the quarter, an increase of 37% compared to its reported profits for the second quarter of 2015. Usually, GrubHub’s growth comes in at a solid clip for the first three quarters, and then experiences a significant pop during the fourth-quarter Christmas season when people eat out more. I would estimate its current earnings power for the 2016 year to be somewhere around $58 million in net profits, or $0.70 per share.

The current rise to $38 per share gives it a real-time P/E ratio of 54, which is probably fair given that the business is still small enough that it seems to offer a fair possibility of continuing its high growth rate. The margins at GrubHub are absolutely crazy–it only has 1,000 employees churning out those $58 million in net-of-tax profits. The operating margins were 25% last year.

The share count of 84 million is only expected to rise to 90 million over the next three years, and the business has no debt. I also think the business model at GrubHub has a promising long-term future, as more and more local pizza chops and mom-and-pop restaurants will want to offer a functioning take-out option to boost traffic.

What separates GrubHub from many of the other companies that have arisen in the social media generation is that there is a connection between restaurants and customers that is the result of a clear business purpose–order online, and pick up quickly. Customers have a need for convenience, and businesses have a need to purchase services from GrubHub so that they can participate in the trend in favor of take-out-and-go.

In the past, I’ve poked at the Global X Social Media Index Fund (SOCL) for owning businesses that generate no profits and trade at astronomical valuations compared to projected cash flows. There’s another reason why I don’t like many of their holdings–most social media companies lack that privity between another business and a customer that would make the social media company’s interjection into the relationship essential over the long term.

One of Global X’s holdings is Angie’s List. It is perfectly understandable why customers want to check out site reviews. But what incentive is there for a business to become a participant? How would you get a business to become linked to Angie’s List in an integral, long-term fashion for the long haul? You can’t. If anything, it is a pest to small and local businesses who don’t want to be publicly accountable for every single error, can’t convey to readers that the dissatisfied customer may be crazy, and plus there is the overall human nature aspect that we are more likely to go out of our way to document a bad experience than a good one as a way of nursing grievances.

What makes me think that GrubHub has a fair shot of achieving staying power is that its services require a fair moment of technology sophistication mixed with security expertise. Considering that there is a fair amount of security needed because people use their credit cards to make their transactions, there is minimal risk of an app destroying GrubHub’s business. You don’t want to be analogous to a Garmin shareholder during the advent of Google and Apple maps.

The reason why GrubHub has less of a risk from Google and Apple is the result of ongoing security maintenance concerns. The hands-on requirement of providing ongoing security maintenance, plus operating on an industry where there is an incentive to steal data for a personal benefit, makes it unlikely that a Google side project would introduce a technology that would hijack the economics of the GrubHub business model.

The valuation of GrubHub has been wildly inconsistent since its IPO in 2014. If you are someone who is susceptible to thinking that the wisdom of an investment sharply correlates to the latest sentiment surrounding the stock, you should definitely stay away. GrubHub traded between $29 and $45 during its IPO year, traded between $22 and $47 last year, and has traded between $17 and $38 per share this year. Part of the volatility is at least understandable–whether you expect 15%, 20%, or 25% annual earnings growth for the next five years will lead to very different values of what ought to be considered a fair price for the stock today.

GrubHub is the rare social media era company that has caught my attention. There are real profits that are growing quickly, the demand for its services is likely to grow in the coming years, and the company seems like an ideal buyout candidate for firms like Google somewhere down the road. Usually, trendy tech stocks going up 24% in a day is a signal of a bubble, but GrubHub is one of the rare exceptions. I would classify the odds of GrubHub beating the S&P 500 over the next five years as “more likely than not”, and it also comes with a much higher total return ceiling under a “What if things go right?” scenario compared to most of the companies that I cover here.