Yelp for Profits

The reason I have spent my career focusing on investing in technology stocks is that profitability can grow like a tornado.  Technology companies, if they manage their business properly, have mostly fixed costs.  If they are able to lock on a trend that is growing dramatically, revenue will rise much faster than their cost structure and profitability can be explosive.  This can create huge rewards for investors!

The corner of technology to see this explosive growth, most recently, is Social Media companies.  Once a website like LinkedIn or Groupon is built and running successfully, the bulk of the costs have been paid for and adding new paying customers falls mostly to the bottom line.  If an investor catches a company as its business model is being proven, it can be like riding a rocket.  Why?  You don’t pay performance bonuses to web servers.

Its better to be late and pay up than be early and risk failure.  Some professional investors can afford to tie up capital for years without seeing results but for individuals, I don’t recommend being early.  As a young trader, it was drilled into my skull that “being early is being wrong” and I would rather hold a position like Intel that pays a 4% dividend than risk sitting in a stock for two years that might go nowhere or worse see its business model deteriorate.
The timing is right for social media companies.  After the Facebook and Groupon IPO debacles, there was concern that these businesses wouldn’t shift to mobile devices and they could not grow into profitability.  Over the last two quarters, however, these companies have proved that they can monetize mobile users; by incorporating advertisements into the content that people log on for.  Instead of sitting on the side of a screen or on top in a banner, the content is mixed directly into your news feed.  This may seem sneaky but its no different from product placement in movies, and it works.

Valuations seem very high but you’re buying real estate that doesn’t depreciate.  Once a brand has built a loyal following, it’s difficult to dislodge the vendor.  Amazon was the first very successful mover in online retail and each setback has proved to be a buying opportunity.  Since Amazon created its niche, Walmart and Target have aggressively attacked, but Amazon’s ease of use and customer loyalty have allowed the company to retain its brand recognition.  The same can be said for social media.  What would you pay for a company that generates steady cash over a generation?

Just being in the social media industry doesn’t guarantee success though.  Business models vary substantially from LinkedIn to Groupon and understanding the revenue and costs is crucial to success.  Our favorite name is YELP, a company that has its customers create its content, is building a transaction business through reservations, has a Google-like paid search listing, and derives the bulk of its revenue from mobile (59%), historically the stumbling block for Internet companies.

The valuation with YELP is difficult, it is just beginning to turn a profit but it is cash flow positive for the second quarter.  In the June quarter, it even bought back a small amount of stock ($193,000).

The best part of YELP may be the recent acquisition of SeatMe, a small competitor to OpenTable.  Like OpenTable, SeatMe acts as a restaurant management system but at a fraction of the price OpenTable charges.  The sticking point is variable costs. OpenTable charges $1 per reservation in addition to a monthly subscription fee and a setup fee.  SeatMe charges a low flat fee and can be run from an iPad.  For YELP, it will be accretive to earnings and it can be sold into the existing client base.  YELP is reaching profitability with its initial business model but this acquisition will provide a bump in earnings at just the right time as its earnings turn positive.

Tracking the Jackpot,

Tom Anderson.

 

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