Reservations About the Stock Price on OpenTable

Erik Kobayashi-Solomon: Hi. I am Erik Kobayashi-Solomon, co-editor of Morningstar's OptionInvestor. Today it's my great pleasure to welcome R.J. Hottovy, who is senior restaurant analyst here at Morningstar.

R.J., thanks for coming.

R.J. Hottovy: Thanks for having me.

Kobayashi-Solomon: So, just recently I wrote an options article with a bearish strategy on a company that you cover, OpenTable, and just wanted to ask you a little about that company.

Hottovy: Sure.

Kobayashi-Solomon: First off, I think a lot of people are not really familiar with OpenTable's business model, their product offering. Can you kind of run us through what they do?

Hottovy: Yeah, absolutely. I think a lot of consumers are becoming more aware of the OpenTable.com offering, which is where you can go online and make reservations in real time at your favorite restaurants.

Kobayashi-Solomon: Okay. So, rather than using the phone I go online, I can reserve a table at some place.

Hottovy: Absolutely. It makes it a lot easier to make reservations. But in reality, it's actually a three-pronged business model, where the restaurants pay to have the reservation platform installed at their restaurants. They also pay a monthly subscription fee to OpenTable. And lastly, they pay for every reservation that is booked through OpenTable.com or if it's booked on the company's website, that's still linked to the OpenTable system. So, it's a three-pronged approach here: installation, subscription and reservation revenue.

<TRANSCRIPT>

Kobayashi-Solomon: Now, just regarding electronic reservation services, I always picture reservations being done on a pen and paper. What's been the uptake of their service or like services?

Hottovy: Yeah, I mean, I think the draw initially to restaurants was just – in this environment they are struggling to cut costs in any way possible. And I think this helps them out on the front-of-the-house situation, where you don't need that upfront staff to take reservations and man the phones.

But in reality what we like about the business, and in fact this is a narrow moat, company, we like that it actually is a customer acquisition tool. As more and more people become aware of OpenTable.com and the ability to make reservations there, the more important it becomes for restaurants to be on OpenTable.

Kobayashi-Solomon: So, it kind of gives these restaurants some visibility to their clients in addition to these kind of logistical services?

Hottovy: Yes, in fact, we see a network effect happening here, which again we like to see that in terms of building an economic mode. So, the business models quite compelling in our minds.

Kobayashi-Solomon: Okay, okay, wait. I have to ask you because you're saying, it's got a narrow economic moat, talking about a compelling business case, and yet this is a bearish call, and I'd like to resolve those two. This is a valuation call on your part?

Hottovy: Yeah, this is more of a valuation call on my part. Right now my fair value estimate on OpenTable is $18 per share.

Kobayashi-Solomon: It is trading way above that, right?

Hottovy: Exactly, it's trading at right now at 76 times my 2011 EPS estimate, and it's also trading at 26 my 2019 EPS estimate. So, I'd think…

Kobayashi-Solomon: ...Quite a growth premium there.

Hottovy: Exactly. I think it's gotten ahead of itself quite a bit here. Just some of the assumptions that I have in my model; I am generating pretty good growth numbers. I have 30% growth top line this year and over the 10-year period in my discounted cash remodel, I have that decelerating to about 10%. Also, pretty healthy margins. I have them at about a 20% operating margin this year and ramping out to 30% to 35% over time, which puts them in the upper echelon of Internet-based companies right now.

Kobayashi-Solomon: And it really doesn't seem like you're making huge bearish assumptions. I mean 30% growth right now, that seems to be pretty healthy.

Hottovy: The growth is contingent on how many restaurants they can get to install this service and right now, they are at about a third of the 30,000 restaurants in the U.S. that take reservations, and about 2,000 locations internationally. But under my assumptions, even if they were to capture all 30,000 restaurants in the U.S., which seems unlikely given the turnover that you see at the reservation-taking restaurants side of the business. Even at that point the numbers that we're seeing and where the stock is trading is so bloated…

Kobayashi-Solomon: And this is kind of with the economic backdrop is less people are wanting to go to restaurants, more people are wanting to eat at home, saving money, all of that, right?

Hottovy: Certainly we've seen a secular trend, more people eating at home. But we've seen traffic tick up a little bit at the high-end reservation-taking restaurant space; really that's tied to corporate spending, too. It's an entertainment expense for a lot of people, and so we've seen that tick up a little bit, but it's still mixed results, but generally speaking, we have seen reservation revenues up quite a bit, too, and lot of that has just to do with the number of restaurants that have become aware of this.

Kobayashi-Solomon: Right, right, got you. All right. So, this company IPOed just recently, charged ahead on the day of their IPO; they keep beating their quarters. So, of course, me in a bearish position, I am worried about these upside risks. I know you're saying that valuation looks stretched right now. But what may you be missing about this? Is there a possibility of some other kind of business line that would really warrant their stock price?

Hottovy: There are a few things that keep me up at night about this one.

Kobayashi-Solomon: Okay.

Hottovy: The first thing being other revenue channels, and I think you mentioned that as other revenue drivers potentially. There is one potential thing is if they expand the number of reservation-taking restaurants, they have a secondary product they are testing called OpenTable Connect, which is more designed for, you know, smaller café-type situations where they are not looking for a high level of volume, but just want something to automate and quickly take reservations. So, if that really took off, that may expand the overall market, and that is one thing that concerns me.

Kobayashi-Solomon: So we should be looking at those numbers as we're watching.

Hottovy: Exactly and I do keep track of that as well, and some of that is baked into my numbers as well--that they do pick up that [OpenTable Connect offering].

The other is potentially adding advertising as a revenue stream. Right now, advertising is not part of their model. But if advertising were to become a significant generator of revenue through OpenTable.com that may change the dynamics of the model a little bit more.

Kobayashi-Solomon: So restaurants advertising for space or preferred location …

Hottovy: Or just even, generally, a third party, somebody advertising on the OpenTable.com site, but again that would probably be restaurants there as well. So, those would be the potential risks.

And I guess the third risk that I would add to the situation is that it's a pretty thin float on the stock, there isn't a lot of movement there. Still a lot of holders and executives, and initial funding rounds, who have pretty significant stakes, so thinly-traded. So that is one of the things I keep an eye on.

Kobayashi-Solomon: So by float you mean the shares available for trading in public markets?

Hottovy: Absolutely, absolutely.

Kobayashi-Solomon: Okay. Well, thanks a lot. It really seems like an interesting idea. Thanks for coming in.

Hottovy: Thank you for having me.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website where you'll find many more great option ideas based on Morningstar's fundamental research.