Since reporting earnings this quarter, Yelp (YELP 1.03%) stock is down almost 20%, and shares of Twilio (TWLO 0.70%) have fallen a whopping 30% -- even though both companies reported growth that was more or less in line with market expectations.
In this episode of Industry Focus: Tech, Motley Fool analysts Dylan Lewis and David Kretzmann explain why the market sold out of these companies so drastically, and then discuss whether or not these sell-offs could be buying opportunities for long-term investors. Find out how both companies make their money, what the biggest problems facing them are in the near term and long term, how they're handling their risks, and more.
A full transcript follows the video.
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This video was recorded on May 19, 2017.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, May 19, and we're taking a look at two beat-up tech stocks. I'm your host, Dylan Lewis, and I'm joined in the studio by Fool premium analyst David Kretzmann. David, how's it going?
David Kretzmann: I'm doing well, Dylan. It's good to see you!
Lewis: It's a little steamy in the studio.
Kretzmann: It's doubles as a sauna today.
Lewis: Yeah, Chris Hill came by and said, "You're going to want to be quick today." [laughs] We're going to try.
Kretzmann: We'll wrap it up as quickly as possible.
Lewis: We are doing a show in front of a live studio audience, in a sense.
Kretzmann: We have some guests.
Lewis: Yeah, we have some listeners, fans of the Fool, Layton and Sarah coming in from Arizona.
Kretzmann: Welcome to Fool HQ.
Lewis: Yeah. Listeners, if you're ever in the area and want to stop by, just give us a heads up, [email protected]. We always love meeting people who listen to the show. David, we are looking at two companies that sold off big after reporting earnings earlier this month, and maybe the market reaction was a little bit too strong.
Kretzmann: Yeah, I think that's always the question here. It's never fun to see stocks that you own get hit. If you have them on your watch list, maybe you're a little bit more excited; it could be a buying opportunity. Any time you see a stock get clobbered, like these two have been, in what was otherwise a pretty good earnings season across the board for a lot of stocks that we follow at the Fool, it's good to take a step back and re-evaluate the business and what to watch going forward.
Lewis: Today, we're going to look at Twilio and Yelp, see if maybe they belong on your watch list. Or, if you already own them, if maybe it's a chance to buy some more shares at a slightly cheaper cost basis. Twilio was down nearly 30% since reporting earnings earlier this month. As a reminder for people who might not be as familiar with the company, they are what they say is a cloud communications company. Basically, you can think of them as the company that provides building blocks for developers to include communication features. Basically, things like protected calling, two-factor authentication, stuff like that, in their apps and services. So, they make life a lot easier for developers, I think that's the best way to describe it in layman's terms.
Kretzmann: Yeah, and they have a lot of high-profile clients. Airbnb, Uber, to an extent, we'll talk about that.
Lewis: A sore subject.
Kretzmann: Right. So, they have a lot of high-profile customers. This is the type of company where you probably interact with their products or services without knowing it. It's a back-end company.
Lewis: Yeah, they are behind the scenes making everything happen. Really, the story with Twilio looking at their most recent report wasn't the trailing results. The company posted revenue of $87.4 million for the quarter, which is good for over 40% growth year over year. Top-line growth is decelerating a little bit, but they're still comfortably within the company's guidance. It was really the look at future guidance that sent the stock down. People were not super thrilled with some of the news about one of the company's biggest customers and what that might do to the company's financials.
Kretzmann: Yeah. In this case, it's Uber. With Twilio, they've had a lot of customer concentration, especially with Uber and WhatsApp, which is owned by Facebook (NASDAQ: FB). In this case, Uber essentially let Twilio know, "We're going to be looking to develop some of the technology in-house, and in some of the geographies around the world, we might be looking to switch over to other vendors." Essentially, that's 12% of Twilio's revenue that they can't count on over the next year or so.
Lewis: I hope that was at least a phone call. [laughs]
Kretzmann: Hopefully, a little bit of a heads-up.
Lewis: And not just a text, right? So, they are a very large part of the top line for Twilio, like we said. Customer concentration has been an issue for them in the past. But you look at the sell off, they lost $1 billion in market cap on this news, more or less. When you think about the revenue contribution that a customer like Uber has for them, it seems a little asymmetrical. I look at the trends of their top 10 customers and how much of their business they make up, and it seems like they're moving further and further away from that heavy reliance. So, there's a part of me that thinks maybe this is an overreaction by the market a little bit.
Kretzmann: Yeah, I think you can certainly argue that. Right now, their top 10 customers account for 25% of total revenue. And I think you said before the show that that number has actually been trending down over the past several quarters.
Lewis: Yeah, six months ago, that was 31%.
Kretzmann: Yeah, so it's moving in the right direction. That's definitely what you like to see. They added 4,000 new customers, essentially new developers. So, by and large, they have a very diversified customer base. For me, the concerning part about this announcement with Uber isn't so much that Uber is developing some of the technology in-house, and they will be doing it under their own roof, because not many customers are going to take the time or resources to develop that kind of expertise and do it in-house. To me, the most concerning aspect of this Uber announcement is that Uber will be switching to other vendors in certain geographies that might provide better service, or charge a lower price, or whatever that may be. To me, that brings up some questions about, how much of a moat does Twilio have, if Uber is saying, "We can get a better deal, one way or another, in other geographies where we don't need to rely on Twilio." Then, tens of thousands of other developers could potentially make that same choice. To me, that's not as much of a leap as developing the tech in-house, which I think very few customers are likely to do. So, I think there's some bigger question marks around Twilio's moat, and I think that might be causing a lot of the skepticism or concern over Twilio right now.
Lewis: Yeah, I think that's a good point to make. They talked about this quite a bit in the conference call. Management was like, there are not a lot of our customers who can pull this off. The amount of resources that you need to put into developing all of this in-house and hosting it yourself and making it your own property, no one is going to want to do that. Maybe WhatsApp decides to do that at some point. But you look at their customer base, and aside from those two, there's really no one else in their profile. And just for background, I think WhatsApp makes up 5% of their top line right now.
Kretzmann: And that's also been trending down the past few quarters. Again, moving in the right direction, they're not overly dependent on one customer. And with Twilio, that is one of the risks. This isn't necessarily the easiest business to understand, unless you're a developer and working hands on with a product like Twilio. And another risk here, too, is that they are still unprofitable, they are still burning cash. That alone always will make a company more risky than a company that is producing cash and is profitable. But they do have $289 million in net cash. That's over 10% of their current market cap, which is $2.2 billion. So, they're not in danger of going anywhere overnight. And even without Uber, they're still guiding for about 30% sales growth this year. So, I am definitely more interested in Twilio than I was a few months ago when people were going gaga for this stock after the IPO, it was trading at pretty unsustainable levels. Like, OK, the expectations are pretty high, I'm not sure they can meet that. But, now, it seems more reasonable. And even with Uber leaving, as long as they can demonstrate that they have a moat and they are able to retain these customers that they bring on board, and hopefully they can expand the relationship with the customers they bring on board, if they can do that, I think this can be a sustainably profitable business over the long term. But, again, there are still some questions there, so I'm not surprised to see those questions continuing over the moat.
Lewis: Yeah. You talked about valuation a little bit. The company is currently trading for around six times sales. Less than nine months ago, they were double that. So, that's the fall from grace we've seen. I've certainly been keeping an eye on them for a while. I was really interested to see what happened in this report. When you think about investing in a recently public company, I know my tendency, at least, is to wait until we see three or four quarters of results. You see them growing the base of their non-big customers. In the instance of Snap, you see them figuring out their monetization strategy. There's so much that an early public company needs to work out. And in Twilio's case, there are some metrics that people might not be super familiar with that you want to see trending in certain directions. So, I think this is a reminder, in some ways, of why it can be better to wait and watch from the sidelines for these hot new public IPOs.
Kretzmann: Definitely. And, in general, I think a safe rule of thumb for investors is to wait at least six months after a company goes public. Just wait on the sidelines, let a company get a couple quarters under its belt, just get a sense for the direction management is taking the company in, and see if their strategy is playing out in a successful way. In the case of Twilio, the founder and CEO Jeff Lawson, who gets a lot of high praise from the industry and tech in general, he has a background with Amazon Web Services, and Twilio's business model is kind of similar to AWS, in some ways.
Lewis: And I believe they have a stake in Twilio, as well.
Kretzmann: I believe so. They at least have a partnership. But, he still owns over 7% of the company. That's after the six month lock-up expiration, which is, essentially, six months after the IPO, the insiders can sell their stock if they want. But he still owns a sizable stake. He seems to be pretty well-regarded in the space. So, it's nice to see a key insider like that still retaining a large stake, even after he could have, maybe, sold out.
Lewis: Yeah. If you're looking for the actual impact here that we're seeing for revenue, with Uber moving away, they projected that the hit from the declining business -- Uber won't disappear overnight, it will be a slow, gradual slope off -- it looks like it will be a $10 [million]-$11 million hit to revenue in 2017. I think, all told, if you look at Uber's contribution, somewhere in the $40 [million]-$60 million over the course of 2017. For a company to lose $1 billion in market cap over that, I think a lot of the market reaction speaks more to those moat concerns than to them losing a specific customer. And that's really the thing to watch. Can this company continue to add new customers, build them up, and stay diversified in that customer base? Because that's what's going to fuel their growth going forward.
Kretzmann: Yeah. To me, that's the No. 1 thing for investors to watch. I think that's the main factor that will determine whether or not this is a business that can be sustainably profitable over the long term. If you do own shares of Twilio, or if you're looking to buy shares, this is a company that I wouldn't make a large position in a portfolio, especially now. It's still an unproven concept, they haven't proven that they can be profitable and produce positive free cash flow. There are still some questions about the moat. So, I would make this a smaller position in the portfolio, if you are looking at it. Then, if they are able to prove themselves out over time, the stock should do well. And that would, naturally, make the position a bigger part of your portfolio. And that would be the time I would look to, maybe, add a bit more.
Lewis: Yeah. And I can see why people would like this business. There are a lot of reasons it's been on my watch list for a little while. Any time you have a business that's doing the heavy lifting and the dirty work so that people can just plug something in and make it happen, particularly on the tech side when it scales really well, that's going to be really appealing to investors. With their core business and what they do, I think there's a lot to like, as long as the core business metrics are moving in the right direction, I think it's something for investors to certainly watch.
Kretzmann: Yeah. And by and large, I think those core metrics are moving in the right direction. Uber leaving raises some questions about it. But by and large, the core business is still in pretty good shape at this point.
Lewis: David, switching over to another beat-up tech company, Yelp is down around 20% since reporting earlier this month. It's the theme of the day. I think the story was pretty similar with them. We had earnings that were more or less in line with what the market was expecting. The problem was guidance.
Kretzmann: Yeah. Their revenue was up 24% this quarter, which isn't bad. That's not slow growth. But it's been an ongoing issue for Yelp, revenue deceleration. Their revenue had actually decelerated every quarter since the third quarter of 2014. It's almost going on three years. At that point, their sales have grown about 68%. Essentially, that sales growth number ticked down steadily quarter by quarter. And here we are at 24%. Really, I think the company has run into some headwinds, because their total user base has essentially plateaued. They have 84 million desktop users, they have 73 million mobile users. That's bounced around quarter to quarter, but it hasn't really grown significantly. The main way the company generates revenue now is through what it calls local advertising accounts. Essentially, it has 139,000 small or local businesses that will pay for advertising in some shape or form on Yelp's platform. To give some context, that's out of 3.4 million claimed business locations, which essentially means there are about 3.5 million business owner accounts on Yelp.
Lewis: People who have verified, "This is my business," basically.
Kretzmann: Yeah, they verify with Yelp, so they've taking that step. Only about 4% of those verified businesses on Yelp are paying customers right now. And one of the issues that contributed to the slightly weak quarter, and perhaps the weak guidance as well is, essentially, their revenue retention rate was lower than they anticipated. In other words, the customers they have weren't necessarily paying the same amount, or even paying at all compared to previous quarters. So, certainly some concerns there. Yelp, like I said, the revenue has been decelerating over the past three years. And over that time period, expenses continue to tick up, so the company's path to sustainable profitability is still a little murky.
Lewis: If you're looking for the numbers here, Yelp revised its guidance on their call for revenue from $850 million to $865 million for full-year 2017. Original guidance had been $880 million to $900 million. That doesn't seem like a big drop. But when you're talking about a company that should be growing pretty quickly, and should be moving the top line, I think that's where it starts to become a reason for pause, and where you have this reaction. Certainly, if you are an advertising platform, and that's how you're making most of your money, and you're hearing that retention isn't great, you want advertisers to be seeing the [return on investment] on their ad dollars, and for it to be making sense for them to continue plowing money back into the platform, because they're getting new customers, or doing something to do their business. If you're not helping people do that with advertising, you're not going to be a very successful advertising platform.
Kretzmann: Yeah, especially when you're talking about the digital advertising space, which has largely been dominated by Google and Facebook. Yelp has to really demonstrate a value proposition that's attractive the customers. If that revenue retention rate is dropping or not growing, that could demonstrate that they're struggling a little bit to compete with the behemoths like Facebook and Google where these digital ad dollars are naturally flowing. Yelp, over the past year and a half, has really gone through a lot of internal shake-ups. The chairman and then-CFO both departed the company within five or six months of each other. Usually, if you have high-profile executives or board members leaving within a few months of each other, that raises, for me, a yellow flag. Then, they've also been slowly but surely dwindling down their international business, and they're refocusing on North America, where they are seeing better metrics, as far as bringing on paid accounts. But, there are some attractive attributes to the business itself. The new CFO a couple quarters ago mentioned that no single custom rate makes up more than 0.5% of total sales.
Lewis: So, the opposite of Twilio's problem.
Kretzmann: Essentially, yeah. Very diversified. No single geographic market is more than 15% of revenue. And the company's largest category, which is actually home and local services, so plumbing or home repairs or things like that, that generates less than a third of total local advertising revenue. So, as far as revenue goes, it's a fairly diversified business across all of these segments and customers. But the trouble is when you have a stagnant user base, trying to get more of those businesses to pay out to reach what is a stagnant user base, I think they're running into some headwinds there. If that user base isn't growing, and you're competing against Google Maps or Facebook Reviews, or all these other things from much larger competitors, I understand why the company is running into headwinds.
Lewis: Yeah. All the digital ad market research that I read is showing the power that Google and Facebook wield is consolidating, getting bigger and bigger, and very often it's coming at the expense of these smaller platforms. This is not all that different from the conversation I had following Twitter's earnings. You look at the declining price of ad engagements on their platform, and I think some of that is simply because advertisers are seeing better [returns on investment] elsewhere. Facebook, in its recent quarterly calls, paid a lot of attention to small businesses. You can look, they've highlighted the number of small businesses that are advertising on the platform, that have Pages on the platform. So, local is clearly a focus for them, even though they are this massive, massive global phenomenon at this point.
Kretzmann: Yeah. Another company I follow, Priceline, which is the online travel agency, you might have talked about it on this show, they own Booking.com, Kayak, online travel agencies like that. On their conference calls, pretty repeatedly, they say, "We want to spend more money on Facebook." So, that gives you an idea, these advertisers want to spend more on Facebook and Google. That's where they're seeing the highest [returns on investment]. So, if you're someone like Yelp or Twitter, they're facing many more struggles competing against those much more dominant platforms, in terms of digital ad spending. But, with Yelp, similar to Twilio, I think there are some business dynamics that are attractive. The company actually has a net cash total of $486 million, which is 21% of its current market cap. To me, that suggests, there is at least a cushion here. I think the most likely out for Yelp would be getting acquired by someone. Because I think they do have a relevant platform, but I think it needs to be part of something larger. I just don't see this being a thriving, sustainable business on its own. Having over a fifth of your market value in cash, that should provide a cushion. They are producing positive free cash flow, even though a lot of that, similar to Twitter, is due to stock-based compensation. But even when you back out that stock-based compensation, the business is producing positive free cash flow. So, they're not in danger of going under anytime soon. But, yeah, to me, it's hard for me to see them surviving and doing well on their own, so I wouldn't be surprised if you see an acquisition. Their market value right now is similar to Twilio's, about $2.3 billion. So, they could be snapped up by one of those bigger players pretty easily.
Lewis: Yeah. I know my personal feeling with these two stocks is, Twilio remains much more interesting because it's so much earlier on in the story, and it seems like there's much more growth ahead of it. I don't see that huge ramp for Yelp. There are some really nice things with its business, but it is something that seems to be more plodding along than it is something that will explosively grow in the next few years.
Kretzmann: Yeah. And despite the concerns with Uber leaving Twilio, I just see Twilio being a little bit more differentiated. I agree with you, I think they have a bigger greenfield opportunity. Yelp is just operating in such a competitive space, with reviews alone, let alone digital advertising, the people who are actually going to pay you to sustain your business. I think Twilio has a clear path to become a larger, sustainable, profitable company. But, yeah, both of these are beaten down. But I do like that both of these companies, by and large, have expanded without raking up a lot of debt. That makes them a little bit safer as they work through these muddier waters. Yeah, it'll be interesting to see where they go from here.
Lewis: Yeah. We will check in when we have more results come next quarter, see how they're doing.
Kretzmann: Hopefully brighter times ahead.
Lewis: Yeah. Thank you for joining me today, David!
Kretzmann: Thank you!
Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say, "Hey," you can shoot us an email at [email protected], or tweet us @MFIndustryFocus as well. If you're looking for more of our stuff, subscribe on iTunes, or check out the Fool's family of shows at Fool.com/podcasts.
As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thank you to Austin Morgan for all of his work behind the glass, tolerating my ad read mess-ups. For David Kretzmann, I'm Dylan Lewis, thanks for listening and Fool on!