I’ve made it clear that I’m bullish on technology stocks. Why the optimism? Because two powerful forces are working in technology companies’ favor at the same time…
- The technology sector is the most financially fit in the market.
- It boasts the best demand fundamentals, as new products are constantly being developed to do everyday business faster, cheaper and easier.
But just because I’m bullish on the sector doesn’t mean we can throw caution and selectivity out the window.
While a rising tech tide promises to lift technology stocks – high-quality and low-quality alike – eventually, the tide will shift. And when it does, a handful of tech stocks are destined to implode.
Or as Warren Buffett once said, “It’s only when the tide goes out that you learn who’s been swimming naked.”
I’m convinced that OpenTable (Nasdaq: OPEN) is one such company. Here’s why…
Overbooked at OpenTable
In case you’re unfamiliar with OpenTable, the company’s ERB (Electronic Reservation Book) software enables restaurant-goers to conveniently reserve tables either online or over the phone.
Founded in 1998, OpenTable operates in the United States, Canada, Mexico, Europe and Asia, and sports a unique business model, too. It makes money by charging restaurants one-time installation fees ($600 to $700), monthly service fees (roughly $199) and $1 for each seated customer.
But ever since its IPO in May 2009, I’ve been suspicious about its investment merit. Such suspicion proved to be the right call for about a year, as shares traded flat. But when the euphoria of a bull market kicked in, it was off to the races. The stock has rocketed 226% higher over the past year.
And that’s troubling.
Investors have flat-out bid up the share price into the stratosphere. At current prices, OpenTable now trades at an uber-frothy valuation of 155 times earnings and 54 times forward earnings. By comparison, the average technology stock trades for just 14 times earnings!
So while sales and earnings might be growing fast at OpenTable – up 60% and 65%, respectively, in the last quarter – no company deserves that kind of staggering premium. Especially not this one.
The Numbers Just Don’t Add Up
Approximately 30,000 restaurants in the United States take reservations – and OpenTable already services about half of those. Given that, U.S.-based growth is already pretty limited.
As for international markets, the company has yet to turn a profit. And it won’t be easy to do so, either, as they’re much more competitive. Gaining critical market share, even after the recent acquisition of the United Kingdom’s TopTable, will require significant upfront investments.
In the end, international expansion efforts promise to be a drag on earnings, not a boon. And for the foreseeable future, too.
But let’s play Devil’s Advocate and say that OpenTable achieves 100% penetration of the 30,000 reservation-taking restaurants in the United States and 100% penetration of the overseas market (an additional 60,000).
Based on its current subscription, reservation and one-time installation revenues, that market would be worth about $600 million.
The only problem? OpenTable’s current market cap is $2 billion. In other words, it’s trading at about three times its own market size. And that’s still not all…
Four More Fundamentals to Fear
In addition to a ridiculous premium, most investors don’t see the writing on the wall here. OpenTable also suffers from several other less than encouraging fundamentals:
~ High Unemployment: Restaurant reservation rates might be on the mend, but they remain well below historical norms. High unemployment and weak consumer confidence only compound the problem. Many people can’t afford to dine out on a regular basis, given the current state of the economy.
~ Bankruptcies Abound: The economic slowdown continues to force many restaurants to close their doors. Attrition rates are a very real and significant concern for OpenTable.
~ Questionable New Growth Strategies: OpenTable just launched a coupon-based service called Spotlight. Trouble is, it competes head-to-head with the already wildly popular Groupon service. Another formidable competitor, Yelp, is about to enter the fray, too. Such intense competition always leads to shrinking margins.
~ Changeable – and Unpredictable – Customer Trends: The thing about the restaurant business is that diners can switch allegiance with the click of the mouse. And that means OpenTable’s market share could erode quickly… and before it can concoct any efforts to combat it.
Add it all up and OpenTable’s lofty valuation leaves little room for error.
Any hint that growth is slowing should send shares tumbling to a more reasonable valuation. And that valuation is…
How to Overcome Indigestion As OpenTable Shares Drop to $40
By my estimates, OpenTable shares are only worth $40 a piece – about 55% below the current price.
Even insiders are nervous. How else do you explain the fact they haven’t bought a single share in the last six months, but have instead sold 1,154,140 shares? Not exactly a vote of confidence.
Of course, the stock could very well head higher still. But just like we learned during the dotcom days, reason and sanity ultimately prevails. The bottom line is that valuations matter – and I’m convinced that this tech stock won’t hold up to its sky-high current value.
If you currently own OpenTable shares, it would be easy to dismiss this analysis and call me a salty dog, since I missed the 200%-plus run-up. Fair enough. But at least do yourself a favor, just in case I’m right.
Protect your gains by either…
- Using a trailing stop.
- Purchasing enough put option contracts, so you can unload shares at a pre-determined price if the stock heads back to a more reasonable level.
- And if you’re a bit more adventurous, considering selling shares short or purchasing some long-dated put options.
Ahead of the tape,