Investors know that there are multiple ways to approach stock-picking. Momentum investors, for example, identify hot stocks that have the support of key technical patterns. It's a strategy that has been put to great use in StreetAuthority's Maximum Profit newsletter.
At the simplest level, such an approach targets out-of-favor stocks that may possess ample latent upside, or exceedingly popular stocks that appear ripe for a pullback. As an example, that approach recently led me to conclude that shares of Amazon.com, Inc. (Nasdaq: AMZN) were now fully valued or even overvalued.
Yet, I don't always consider popular stocks to be overvalued -- if they have the catalysts in place for more upside. Companies, such as Netflix, Inc. (Nasdaq: NFLX) or Salesforce.com, Inc. (NYSE: CRM), continue to revolutionize their respective industry niches, and you simply can't bet against them, even as they remain near all-time highs.
Contrarian investing works so well with dot-com stocks, simply because these stocks can trade all over the map. As an example, I was a big fan of LinkedIn Corp. (NYSE: LNKD) when its shares slid to around $150 last April from a peak of $240. Back then, I noted that the stock we being penalized by "a management decision to ramp up expenses in 2014 in support of growth. That's a wise long-term move, but it can spook investors focused on the short term," I wrote. Investors eventually grew comfortable with that strategy, and shares have rebounded an impressive 60% in the past 10 months.
Right now, I see the same kind of set up in place for another dot-com business model. Shares of consumer ratings provider Yelp, Inc. (NYSE: YELP) have plunged more than 50% from their 52-week high. As was the case with LinkedIn, short-term concerns are obscuring a still-bright long-term future.
In the fourth quarter of 2014, Yelp saw a sequential drop in the number of active users on its web site. That gave the impression that a business model, which has grown at least 60% per year for seven-straight years, was suddenly stuck in the mud. That pullback is actually the result of seasonality, which had been masked in prior fourth quarters due to previous scorching levels of growth.
Still, Yelp's management has decided to do what LinkedIn's management did in early 2014: Boost marketing spending to ensure that growth stays robust. The higher spending will mean that Yelp will likely generate around $100 million in earnings before interest, taxes, depreciation and amortization, or EBITDA, this year, below prior consensus forecasts of around $120 million.
Management also noted another financial metric that is seemingly being ignored by investors. The company's business model, as it approaches maturity, is poised to generate 35-to-40% EBITDA margins, which is roughly five percentage points higher than previous guidance.
Perhaps sensing that investors still remained dubious about the company's growth prospects, Yelp's management recently announced the acquisition of Eat24, a fast-growing rival to GrubHub, Inc. (Nasdaq: GRUB), the online reservations site. GrubHub may be the better known site, but Eat24 now has the financial backing of Yelp, which should help to rapidly accelerate its visibility and market share. (Yelp already had a relationship with Eat24 before, but will now keep all of the transaction fees and has greater incentive to promote the feature.)
When the deal was announced, Yelp's management noted that sales trends for the core site have picked up after the Q4 pullback. Yelp now expects to deliver around $120 million in sales this quarter and around $540 million in 2015, which representing more than 40% growth. Analysts at Merrill Lynch (who have a $65 price target) think sales will exceed $900 million by 2017.
Yet investors shouldn't focus solely on financial metrics. Instead, they should also be looking at the size of Yelp's customer base, which already approaches 140 million and should hit 200 million in a few years as the company expands into international markets. As with many dot-com business models, such growth can come without a commensurate investment in infrastructure expenses, which is why management sees such robust EBITDA margins within a few years.
I'm not fully convinced that we will be talking about Yelp as a standalone business model in a few years. Google, Inc. (Nasdaq: GOOG) has been repeatedly rumored to have pursued acquisition talks with Yelp in the past, and similar rumors have surfaced regarding interest from Microsoft Corp. (Nasdaq: MSFT). When this stock was approaching $100, leading to an $8 billion valuation, such a move seemed less likely. With shares of Yelp now trading much lower, buyout talks may again be pursued.
Assuming Yelp remains independent, how do you value such a stock? Analysts at Oppenheimer think shares will rebound to $73, which equates to 13 times their 2020 EBITDA forecasts of $760 million. That may seem to be a rich multiple, until you consider that Yelp's EBITDA is expected to grow even faster than other dot-coms such as LinkedIn or Zillow, Inc. (Nasdaq: Z).
Risks To Consider: Companies such as Google or Microsoft may decide to more aggressively invest in their own consumer rating sites, which would dampen Yelp's sales growth and margin potential.
Action To Take --> Look for shares of Yelp to mount a rally as the company delivers on its sales and EBITDA targets in the quarter ahead. The recent appearances of slowing growth should prove to be short-lived, and Yelp remains far healthier than its lagging share price indicates.
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