Volatility might make for worrying times in the stock market, but it also has the potential to unveil hidden gems. When great companies get knocked down with the rest of them -- or worse than the rest of them -- it can be the perfect opportunity to invest in a strong company at a discount.

In this episode of Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma look at GrubHub (GRUB), the restaurant ordering platform that tumbled last month despite its exciting long-term plans. Tune in and find out what's behind the recent sell-off, how GrubHub has rapidly expanded across the U.S. in the face of growing competitionm and why the company's long-term opportunity is still so compelling.

A full transcript follows the video.

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This video was recorded on Oct. 30, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen. It's Tuesday, October 30th. It's my pleasure to welcome to the show senior Motley Fool contributor Asit Sharma, who's calling into The Fool HQ studio via Skype. Hey, Asit! Thanks for hopping on!

Asit Sharma: Thanks a lot, Vince! It's great to be back! Listeners, hello! It's been a while.

Shen: Last time we chatted, you were getting ready for a pretty big trip abroad. How was it? 

Sharma: It was awesome! I went to Germany to settle my oldest son into a university there. He's going to engineering school. I was in Hessen state, which is a really prosperous state. It was a beautiful place to see. I was intrigued by the vibrancy of the German manufacturing that I saw in that area. If we had time today, I would tell you all about it in detail. But alas, we have to move on. But thanks for asking. It was a lot of fun!

Shen: Did you end up having a chance to go to Spain like we talked about?

Sharma: I never made it. The thing I did was take an overnight train to Berlin on my last day because I'd never seen Berlin. I got to bop around there in the morning of my last day, which was really awesome. But I have to keep Spain, unfortunately, at the top of my bucket list. Have to knock it off soon!

Shen: Sounds like a really fun trip. As it turns out, since the last time that you were on Industry Focus with me, it was the beginning of October, that was actually right before the broad markets began their recent slide. The S&P 500 is down almost 10%, NASDAQ even more than that. Out of the 21 trading days in October so far, S&P has closed down for 16 of them. We're officially in negative territory for 2018 year to date. These can be pretty scary times for investors. Even I've made the mistake recently of making my portfolio very easily accessible on my phone through a new app. I'm checking it several times per day and wincing at all of the red that I'm seeing. We're going to a couple of minutes here to talk about the recent volatility, just to better understand what's going on, what to do next. Asit, fill us in. What's been driving the activity in the markets recently?

Sharma: There are a host of factors, one that I'm sure listeners have heard about on the news -- interest rates. Over time, interest rates can be one of the single biggest factors affecting markets. Both short and long-term rates are on the rise. The Federal Reserve is tightening the Fed Funds rate. That's preferred short-term rate that banks and other entities charge each other for overnight lending. It's tied to what's called the overnight rate. Also, the U.S. is paying slightly more on its debt than it has in recent years. The 30-year bond has ticked up to over 3% in under a year's time, from trading as low as under 2% last year. Both of these have implications for corporations. Of course, the Federal Reserve wants to tighten rates to cool a very strong economy. Those long-term rates have implications for companies which use a lot of debt in the marketplace for their investment activities, and also to return capital to shareholders. 

I have just a few others that I wanted to briefly touch on, as well. There's something that maybe is under the radar for many investors, and that's what I call the lapping of the U.S. tax reform. If you remember, we had tax legislation which lowered corporate rates a year ago. Many companies got a boost in earnings because they had more cash, less of a tax expense. Now, a year has gone by. By the next quarter, most companies will have shown a year's worth of that benefit. Wall Street analysts, institutional investors, and savvy retail investors are starting to discount that effect. Sort of, what have you shown me lately? This is interpreted by some as a type of effect that would last many years. I think it's more short-term in nature. You have to invest those earnings to get the benefit. We've had a few lackluster corporate profits. It's earning season. I know 3M disappointed from the manufacturing side. Amazon was a notable miss, which has a been a huge market leader for many years. 

I also wanted to touch on, really briefly, two more factors. One is a declining risk appetite. What that essentially means is, when markets get volatile and scary, and both Vince and I are checking our portfolios many times in a day, investors have traditionally moved money out of the stock market and into so-called safer assets like bonds. We've seen less of that since the Great Recession. We've seen investors stick with the stock market in the periodic sell-offs that we've had. We really haven't had deep corrections. But I think this year, at least what I've seen, is something different, notably this summer when we had one of the temporary sell-offs. I saw a lot of money rotating from broad-based instruments like mutual funds and ETFs into bonds. I think we'll see more of that ahead.

And, finally, everyone is familiar with the tariffs and the havoc that's wreaking across industries, both in the form of real so-called taxes that companies have to pay due to imposition of tariffs, but also rising commodity costs because there's so much uncertainty over how we'll resolve our trade disputes with China and other countries, even allies like Canada, as we've seen recently. I think that's causing investors to rethink their very optimistic long-term valuation thesis on the stock market. We've been able to whistle past the graveyard and pay for higher-valued stocks for the last several years. But the trade wars are putting a kink into that logic. 

For all these factors, the market certainly feels more vulnerable than it has in many years. I think we may be poised for some more downturn movement. What are your thoughts on what's going to come up over the next few months, Vince?

Shen: Thank you for that awesome overview of these different variables that are at play here. This time of year, especially for the consumer and retail sector, a major theme is always the outlook for the holiday quarter. You brought up Amazon. I think a big reason why they've been pummeled is for their modest guidance for that season. But overall, in terms of takeaways from what's going on right now, you have all these macro-level forces like what you mentioned -- the trade disputes, rising interest rates, even things like the upcoming midterm elections. These are all coming into play. But investors should not panic. It might feel like you need to do something, anything, right now, during these more uncertain periods in the market. But you have to keep your eye on the ball. As Foolish investors, that ball should hopefully be far enough out on the horizon that you're cautious right now, but not too, too fearful. If anything, these are the moments to be really curious.

One of my favorite pieces of advice often heard around Fool HQ is to have a watchlist of stocks ready for exactly these moments, when a lot of times, good companies go on sale. If you're not in a position to go on offense, looking for companies to pick up while they're potentially at a discount, defensive plays are not the same thing as hitting the sell button. Defense might mean reevaluating your portfolio to make sure you're properly diversified, or getting that stock watchlist ready for the next bout of volatility, or checking in on other parts of your personal finances that you've been neglecting. For example, how's your budget looking these days? Overall, definitely, again, not the time to panic and revert to too much of a short-term focus. 

I'm curious on your end, Asit -- maybe we've been watching our portfolios a little more carefully the past couple of weeks. Have you taken any action as a result of all the activity and the volatility this past month?

Sharma: Not really. I really believe in holding for the long-term, identifying a lot of great companies. Some of them aren't going to work out over time, some will do very well. For me, the market really has to take a big dive before I commit what little cash I have on the sidelines into the market. But look at it this way: that's an action in and of itself. If you have focused all along on quality, or maybe you haven't so much but are looking at quality names now, just holding tight for what your gut and your intellect tells you, "Hey, this seems like the right time to buy a great stock," that in itself is an action. If you can convince yourself that you're being active by holding back from maybe capitulating and selling just because of a little fear, I think that serves you well.

Vince, you gave such a great rundown. I rarely listen to our podcast the day after we air, but I'm going to go back and listen so I can take notes on what you just said about how to look at your portfolio. That was great advice. 

Shen: [laughs] There you go. Let's move on to the main part of our discussion today. Late last week, I was running screens looking at some of the biggest movers in the past month because of all the activity recently. Grubhub actually caught my eye. Its shares are down 40% in October, but even after those losses, the stock is still up about 15% in 2018. We haven't covered Grubhub on Industry Focus in a very long time. I was looking back at my notes, I think it's been two years, maybe a little bit more than that, since we've talked about the company. We're going to check in on them and some of the latest news from this niche e-commerce company. 

Grubhub, ticker GRUB, is an online platform for restaurant, takeout, and delivery orders. They're the largest player in the space. They have 95,000 restaurants in their network, 180 markets covered. That includes restaurants in over 1,600 cities. As a consumer, the attraction of Grubhub and a platform like this is to have hundreds or maybe even thousands of restaurants that you can search through and order from in a single website or mobile app. For restaurants, there's no upfront fees or costs to join Grubhub. Instead, the company will collect a percentage commission of each order that's placed through the platform. Grubhub also offers some additional services. For example, in some instances, they will handle the deliveries for a restaurant at an additional cost.

Asit, the company reported their third quarter results last week on October 25th. Definitely a catalyst for rocky trading, but the stock has actually been sliding pretty consistently all month. I'm curious what your take is on the recent trading and the latest news from the company.

Sharma: The company had a great third quarter. Revenues were $247 million. They were up 52% year over year. Net income increased 75% year over year. Really, on so many metrics -- for example, their active diners, they blew it out of the ballpark. Active diners were up 67% to 16.4 million. Their average daily "Grubs" or deliveries were up 37% year over year. We have all these great numbers, but nonetheless, the stock started to slide. 

Before we delve very deeply into the mechanics of why it fell, I want to put into context what we've just discussed. The market has been soft. I call this the Icarus syndrome. The companies which fly the highest, the closest to the sun, when that market activity heats up but not in a good way, they tend to be the first ones to fall. I'll note that this company, which has really dominated the delivery space, and now is facing some competition from the likes of Uber Eats and some other companies, they've enjoyed a lot of love from Wall Street and retail investors. It's been a high flyer. The one-year-forward P/E ratio that Grubhub enjoyed as recently as six weeks ago was 72X forward earnings. That's a really stretched valuation. And in a matter of six weeks, it's down to about 41X earnings, maybe more reasonably priced now. 

I just wanted to kick this off by saying, part of this is market context. Part of this is the market readjusting what it thinks of some great companies, not necessarily bad companies, great companies which have been high flyers. 

Shen: Yeah, I think it's good context to have. Some of those really strong growth figures that you mentioned, they've been getting a little bit extra juice from the many acquisitions that the company has closed since 2017. Grubhub has scooped up a lot of smaller ordering delivery platforms like LevelUp, Eat24, which was previously a part of Yelp. Still, this double-digit growth that we're seeing across the board -- you mentioned revenue up 52%, net income up over 70% as of the latest report. Some of those important metrics, like active diners, daily average Grubs, but also the gross food sales -- that's the total value of orders placed through the platform. This includes not only food and beverages, but also stuff like taxes and delivery fees. Gross food sales hit $1.2 billion last quarter.

Overall, this third quarter report is in a period of the year that's typically slower for the company. Its busiest months, they say, tend to be in September to April. Full-year revenue for 2018 is actually expected to clear $1 billion for the first time. 

In my eyes, there's a lot to like in the picture that's painted by the growth of those numbers in the report. In the next part of our discussion, we'll talk about some of the competitive pressure that has also been a big part of the Grubhub narrative in 2018.

Going back to Grubhub, growth and investments have been accelerating for the company. Something else that I've seen as a concern taking hold and affecting the Grubhub story this year is also based around competition, and a few other factors that we'll get to. Based on a few different sources, Grubhub's share of the delivery market is about 35-40%. That puts it in the No. 1 position. But Uber Eats and DoorDash are growing very quickly, nipping at the company's heels. They themselves now control pretty substantial portions of this delivery platform market. Uber Eats is expanding very quickly so that their delivery service will reach 70% of the U.S. this year. It's been a big push for the company. I'm curious, what are your thoughts here in terms of this upstart competition from these smaller entrants, and how that might impact Grubhub going forward? Management talked a lot about their marketing in the second half of the year, in the fourth quarter, as they're seeing a lot of momentum in that growth. Do you think that's also part of this competitive push that they're seeing from these rivals?

Sharma: I think it is. CEO Matthew Maloney gave a really interesting analogy in the company's most recent conference call. It indicated management's perspective that competition really isn't hurting them, there's enough for everyone here because the market is very new. He basically pointed to the effect that Starbucks had as it went into second-tier cities and opened up a coffee market so that other entrants could come in and sell coffee. Independent coffee houses could also flourish. Starbucks' expansion was, for a time, good for everybody, and the company itself really wasn't hurt by new competition. It just brought more people into this whole coffee loop. The same thing is, yes, it's evident in the delivery market, as ordering goes offline to online through your mobile device. It slowly spreads. For the time being, I think management's probably correct to say that they are not adversely threatened by competition.

However, one of the things that gave analysts a little bit of a jolt on this last earnings report and during the call was the fact that Grubhub said, "We're going to spend more on marketing. We're actually going to ratchet it up in the fourth quarter." Investors, if you're looking for one of the concrete, telltale signs of why the stock took a dive, when the company released its third quarter earnings, after giving such a rosy picture of the past three months, it revised its fourth quarter EBITDA -- earnings before interest, taxes, depreciation, and amortization -- down from a range of $40-50 million, which was about $25 million below what it had guided to previously in the year. They broke down that change into the following buckets. Basically, the company is going to spend $10-20 million in new marketing in the fourth quarter. It's going to spend $10 million on new delivery markets. And it's going to spend $2-3 million in investment in a recent acquisition called LevelUp, which provides a lot of great technology for ordering.

What was interesting during the call is that management didn't commit to how much of that $10-20 million in extra marketing it would spend. Basically, management's take was, "Business is so great and we are converting so many customers in new markets that we'll be opportunistic. It may be $10 million that we spend. If opportunities present themselves as we're expanding through our new partnership with Yum! Brands (NYSE: YUM)," which we'll get to in a moment, "we might spend $20 million." And that uncertainty unnerved investors because the alternate story that you could tack on is that maybe Grubhub is having to spend more promotionally because it is seeing competition from Uber Eats and DoorDash. 

Vince, I was curious on your perspective on that waffling on how much they would spend in this aggressive marketing push. Do you think it's competition-based? Or do you take management's word that they're doing so well and having such a great increase in average revenue per customer that this is the time to invest?

Shen: During the earnings call, I feel like management was really trying to hammer home the point that the increased sales spend that they've been pushing -- keep in mind here, sales and marketing are a pretty big part of the company's income statement. For the past two years, it was around 22% of revenue. They really hammered home the point that this sales and marketing spend, they're seeing such strong results in terms of the cost per acquisition and how that compares to the lifetime value of the customers that they're signing on, that as a result of that, they feel comfortable increasing this spending. They think it's a good investment for them. They had some numbers to support that idea. The third quarter is typically a slower period, but they added 800,000 active users in the quarter, making it the biggest quarter of sequential active diner additions in the company's history. So there's something there, I think, in terms of the momentum and the strength and the rationale for that spending.

The challenge on the competition end, delivery is definitely a point of growth and an area that the company really wants to expand. Grubhub is accelerating its expansion plans for delivery to more than 200 new markets in 2018. It'll hit about 300 total. A lot of that expansion is concentrated in the second half of the year. Grubhub has actually seen growth in its revenue margin as a percentage of gross food sales. If you take their top line number and divide it by their total gross food sales, a metric that I mentioned earlier, in 2015, revenue was 15.4% of gross food sales on the platform. That number topped 28% in the most recent quarter. It's becoming a bigger and bigger revenue stream for the company, with an annual run rate for deliveries of $1.6 billion, because of this push.

A big part of the momentum that they're seeing, the drive there, is also from this partnership with Yum! Brands that you mentioned. Let's get into that part of the story. The growing delivery business adding to the opportunities that the company has, a big part of that is the deliveries that they're doing for Taco Bell and KFC. What's the story there?

Sharma: The company signed an agreement with Yum! Brands in February to assist the thousands of KFC and Taco Bell locations across the U.S. enter their system. This came with a $200 million investment that Yum! Brands undertook into Grubhub to provide them some capital to do this push. 

I think of this as maybe the law of unintended consequences. As a result, Vince just mentioned, the company is going to be in nearly 300 different markets by the end of this year. The company began this year with the goal of hitting about 100 new markets. After they signed this deal, it became 200 markets. They had 80 previously. If you want to peel back this onion a little bit, these markets are defined as CBSAs, core-based statistical areas. I know this because an analyst asked on the recent conference call, "Give us some clarity on what these markets are." Management said, "They're CBSAs." That's a statistical metropolitan area that can be as small as 10,000 people and above. But when you reach this number of 280 areas within the U.S., you're covering most of the United States. If you just think about the enormous task of working through all of Yum! Brands' thousands and thousands of outlets in the U.S., you can understand how you'd get coverage very quickly.

 I'd like to go back to Starbucks as a great analogy. What this has done is, it's basically put the company's footprint in hyperdrive. When Starbucks was developing, it took years to wind its way across the United States. Those investors who are listening who invest in or follow Dunkin' Donuts know that it's slowly been creeping westward. It takes very little capital for Uber Eats to go into an area. Their biggest expense is just signing up drivers and making sure that they have enough drivers to hit a saturation or equilibrium point where they can make money. I think this admission on management's part, that, "Look, this partnership has been great for us. It's really put us in this hyperdrive and extended our footprint," I think that's causing some institutional investors to rethink the valuation. This part of growth now is going to be a little bit harder. Once you've gone into almost every geographical area that you could potentially enter, well, then you've got to go ahead and convert customers. You have to fend off the competition that inevitably is going to come now that you've set up shop. 

So, to me, this is the unintended consequence of a pretty great deal for Grubhub. And I should say that over the long-term, this really only means good things for the company. Besides maybe a partnership with McDonald's, which Grubhub probably won't get because Uber Eats has teamed up with McDonald's, you couldn't ask for a bigger or better partner than Yum! Brands. And they actually have thousands of different restaurant partners. This is the most prominent one. To me, I think it's a blessing and also a little bit of a curse, this rapid expansion.

Shen: We have a couple of more minutes here. I want to touch on two more things before we wrap up. One thing, as an investor, to keep in mind, with all of these growth opportunities and the strong numbers that we've seen the company deliver, keep in mind that operational expenses are going up quickly, as well. Because of the increase in Grubhub-delivered orders and the expansion of that service that they're offering to their restaurant partners, that is going to require more input from the company, in terms of infrastructure build-out, hiring drivers into these markets they go into. Management tried to make the case during the recent call, because of this accelerated delivery expansion, saying that these initial phases when they first enter markets are the costliest, and eventually they're able to make those operations more efficient and improve their profitability there as the business scales.

Something else I also want to mention, in terms of other opportunities as Grubhub is flooding through its U.S. market, they're offering their restaurant partners additional services, things like website templates, integrated point of sale systems, they'll offer more prominent positioning on their platform for a higher commission, and also some loyalty and payment programs through a recent acquisition. The strategy here, of course, is to create a sticky enough ecosystem and enough scale as the biggest online ordering delivery platform that restaurants will naturally flock to Grubhub if they want to up their digital delivery game. The push here from management shows a long-term mindset and view that's good to see, because these are great opportunities for the company to become an essential part of local restaurant operations and takeout business apparatus.

Any final thoughts from you before we wrap up?

Sharma: I love what you just spoke about, Vince. In the near-term, they're going to acquire more operating expense to build out this infrastructure. But over the long-term, the lifetime value of the customer increases. What you've pointed out is a nuance that management is very aware of. A restaurant looks at an Uber Eats or DoorDash or Grubhub as a way to more revenue, but it also perceives it as a toll on its P&L statement because you have to pay that commission for the delivery. I think that Grubhub is maybe more focused vs. its competitors on becoming an enterprise client for a restaurant, to help it succeed in other parts of the profit and loss statement, which are technology-based, such as Vince mentioned, these platforms which do draw in customers and help repeat business thrive. Then, it will be seen over the long-term as less of a toll booth-type company and more of a partner, maybe a one-stop-shop, to help a smaller chain have the same type of outward-facing infrastructure that a larger company might not. That's one thing that I really like about Grubhub, and one reason I think that maybe if these multiples fall a little further -- say, if the market continues to be weak -- maybe even at these levels, there's a little bit of a buying opportunity emerging for those who want to buy Grubhub and hold it for several years. 

Shen: Yeah. I think this is a good example of an instance where, in the beginning of the show, we talked about the volatility and the downturn in the markets. But, you also have these opportunities in these moments to, like I did, run a screen, or do a little bit of extra due diligence on companies you've been watching, start building stock list for companies like this that we haven't talked about in some time, revisit the business and find a gem like this one. I think the long-term opportunity for Grubhub is pretty solid. It's great to find companies like this in these moments.

Thanks a lot, Asit, for joining us today!

Sharma: I appreciate it! Vince, this episode has made me hungry. I'm getting ready to order some food after we sign off.

Shen: Awesome! Fools, as always, thank you for listening. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!