Beat-Up Tech Stocks: Are Twilio and Yelp Buys?

In this episode ofIndustry 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'sFriday, May 19, and we'retaking 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'sa little steamy in the studio.

Kretzmann: It'sdoubles as a sauna today.

Lewis: Yeah,Chris Hill came by and said, "You'regoing to want to be quick today."[laughs] We'regoing to try.

Kretzmann: We'llwrap it up as quickly as possible.

Lewis: We aredoing a show in front of a live studio audience, in a sense.

Kretzmann: Wehave 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, justgive us a heads up, industryfocus@fool.com. We always lovemeeting people who listen to the show.David, we are looking at two companies that sold off bigafter reporting earnings earlier this month, andmaybe the market reaction was a little bit too strong.

Kretzmann: Yeah,I think that's always the question here. It'snever fun to see stocks that you own get hit. Ifyou 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 getclobbered, like these two have been, inwhat was otherwise a pretty good earnings seasonacross the board for a lot of stocks that we follow at the Fool,it's good to take a step back andre-evaluate the business andwhat to watch going forward.

Lewis: Today, we'regoing to look atTwilioandYelp, see ifmaybe they belong on your watch list. Or, if you already own them, ifmaybe it's a chance to buysome more shares at a slightly cheaper cost basis. Twilio was down nearly 30% sincereporting earningsearlier this month. As areminder for people who might not be as familiarwith the company, they arewhat they say is a cloud communications company. Basically,you can think of them asthe company that provides building blocks fordevelopers to include communication features. Basically, things likeprotected 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'lltalk about that.

Lewis: A sore subject.

Kretzmann: Right. So,they have a lot of high-profile customers. This is the type of company whereyou 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 Twiliolooking at their most recent reportwasn't the trailingresults. The company posted revenue of $87.4 million for the quarter, which is good for over 40% growth year over year. Top-line growth isdecelerating a little bit, but they're stillcomfortably within the company's guidance. It was really the look at future guidance that sentthe stock down. People were not super thrilled with some of the news about one of the company'sbiggest customers and whatthat might do to the company's financials.

Kretzmann: Yeah. In this case, it's Uber. With Twilio,they've had a lot ofcustomer concentration,especially with Uber and WhatsApp, which is owned byFacebook(NASDAQ: FB). In this case, Uberessentially let Twilio know, "We'regoing to be looking to develop some of the technology in-house, and in some of thegeographies around the world, we might be looking to switchover 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: Andnot just a text, right? So, they are a very largepart 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 revenuecontribution that a customer likeUber has for them, itseems a little asymmetrical. I look at the trends of their top 10customers 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 thinksmaybe this is an overreactionby 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. AndI think you said before the show that thatnumber has actually been trending downover the past several quarters.

Lewis: Yeah,six months ago, that was 31%.

Kretzmann: Yeah,so it's moving in the right direction. That'sdefinitely 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 thisannouncement with Uberisn't so much thatUber is developing some of the technology in-house, andthey will be doing it under their own roof, becausenot many customers are going to take the time or resources todevelop that kind of expertise and do it in-house. To me,the most concerning aspect of this Uber announcement is that Uber will beswitching to other vendors in certain geographies thatmight provide better service, orcharge a lower price, orwhatever 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, inother geographies wherewe 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, whichI think very few customers are likely to do. So, I think there'ssome 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 thisquite a bit in the conference call. Management was like, there arenot a lot of our customers who can pull this off. Theamount of resources that you need to put intodeveloping all of this in-house andhosting it yourself and making it your ownproperty, no one is going to want to do that. MaybeWhatsApp decides to do that at some point. Butyou look at their customer base, and aside from those two, there'sreally no one else in their profile. Andjust for background,I think WhatsApp makes up 5% of their top line right now.

Kretzmann: And that'salso 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 isone of the risks. This isn't necessarilythe easiest business to understand, unless you're a developer and working hands onwith a product like Twilio. And another risk here, too, is thatthey are still unprofitable, they are still burning cash. That alone always will make a company more risky than acompany that is producing cash and is profitable. But they do have$289 million in net cash. That'sover 10% of their current market cap, whichis $2.2 billion. So, they'renot in danger of going anywhere overnight. Andeven without Uber, they'restill guiding for about 30% sales growththis year. So,I am definitely more interested in Twilio thanI was a few months ago whenpeople 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 andthey are able to retain these customers that they bring on board, andhopefully they can expand therelationship with the customers they bring on board, ifthey can do that, I think this can be asustainably profitable business over the long term. But,again, there are still some questions there, so I'mnot surprised to see those questions continuing over the moat.

Lewis: Yeah. You talked about valuation a little bit. Thecompany 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 youthink about investing in a recently public company,I know my tendency, at least, is to wait until we see three or fourquarters of results. You see them growing the base of their non-big customers. In the instance ofSnap, you see themfiguring out their monetization strategy. There'sso much that an early public company needs to work out. And in Twilio's case, there are some metrics thatpeople might not be super familiar with that you want to seetrending in certain directions. So, I think this is a reminder, in some ways, of whyit 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 waitat least six monthsafter a company goes public. Justwait on the sidelines, let a company get a couple quarters under its belt, justget a sense for the directionmanagement is taking the company in, and seeif their strategy is playing out in a successful way. In the case of Twilio, the founder and CEOJeff Lawson, whogets a lot of high praisefrom the industry and tech in general, hehas a background with AmazonWeb Services, and Twilio'sbusiness model is kind of similar to AWS, in some ways.

Lewis: AndI 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 asizable 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 thedeclining business -- Uber won'tdisappear overnight, it will be a slow,gradual slope off -- itlooks 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 millionover the course of 2017. For a company to lose $1 billion in market cap over that, I thinka 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 companycontinue 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 determinewhether or not this is a business that can besustainably 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 largeposition in a portfolio, especially now. It'sstill an unproven concept, theyhaven't proven that they can beprofitable 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 thatwould be the time I would look to, maybe, add a bit more.

Lewis: Yeah. AndI can see why people would like this business. There are a lot of reasons it's beenon my watch list for a little while. Any time you have a business that's doing the heavy lifting and the dirty workso that people can just plug something in andmake it happen, particularly on the tech side when it scales really well, that's going to be really appealing to investors. With their core businessand what they do, I think there's a lot to like, as long as the corebusiness metrics are moving in the right direction, I think it'ssomething for investors to certainly watch.

Kretzmann: Yeah. And by and large, I think those core metrics are moving in the right direction. Uber leavingraises some questions about it. But by and large, the core business isstill in pretty good shape at this point.

Lewis: David,switching over to another beat-up tech company, Yelp is down around 20% sincereporting earlier this month. It's the theme of the day. I think thestory was pretty similar with them. We hadearnings that were more or less in line with what the market was expecting. The problem was guidance.

Kretzmann: Yeah. Their revenue was up24% this quarter, which isn't bad. That's not slow growth. Butit's been an ongoing issue for Yelp,revenue deceleration. Theirrevenue had actually deceleratedevery 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. Andhere 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'sbounced around quarter to quarter, butit hasn't really grown significantly. The main waythe company generates revenue now is throughwhat it callslocal advertising accounts. Essentially, it has 139,000smallor local businesses that will pay foradvertising in some shape or form onYelp'splatform. To give some context, that'sout of 3.4 million claimedbusiness locations, whichessentially means there are about 3.5 million business owner accounts on Yelp.

Lewis: Peoplewho have verified, "This is my business," basically.

Kretzmann: Yeah,they verify with Yelp, so they'vetaking that step. Only about4% of those verified businesses on Yelp are paying customers right now. Andone of the issues that contributed to the slightly weak quarter, and perhaps the weakguidance as well is,essentially, their revenue retention rate waslower than they anticipated. In other words, thecustomers they have weren'tnecessarily paying the same amount, or evenpaying at all compared to previous quarters. So,certainly some concerns there. Yelp,like I said, the revenue has been deceleratingover the past three years. And over that time period,expenses continue to tick up, so the company's path tosustainable profitability is still a little murky.

Lewis: If you'relooking for the numbers here, Yelp revised itsguidance on their call for revenue from$850 million to$865 million for full-year 2017.Original guidance had been$880 million to $900 million. Thatdoesn't seem like a big drop. But when you'retalking about a company that should be growingpretty quickly, andshould 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, andthat's how you're making most of your money, and you're hearing that retentionisn't great, you want advertisers to be seeing the [return on investment] on their ad dollars, andfor it to be making sensefor them to continue plowing money back into the platform, because they're getting new customers, or doing something to do their business. If you'renot helping people do that withadvertising, you're not going to be avery successful advertising platform.

Kretzmann: Yeah,especially when you're talking about the digital advertising space, which has largely been dominated byGoogleand Facebook. Yelp has to reallydemonstrate a value proposition that'sattractive the customers. If that revenue retention rate is dropping or not growing, that could demonstrate that they'restruggling a little bit to compete with the behemoths likeFacebook and Google where thesedigital ad dollars are naturally flowing. Yelp,over the past year and a half, has really gone through a lot ofinternal shake-ups. The chairman and then-CFO bothdeparted 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'vealso been slowly but surelydwindling down their international business, and they'rerefocusing on North America, wherethey are seeing better metrics, as far as bringing on paid accounts. But, there are someattractive attributes to the business itself. The new CFO a couple quarters ago mentioned that no singlecustom rate makes up more than 0.5% of total sales.

Lewis: So,the opposite of Twilio's problem.

Kretzmann: Essentially, yeah. Very diversified. No singlegeographic market is more than15% of revenue. Andthe company's largest category, which is actually home and local services, soplumbing or home repairs or things like that, thatgenerates less than a third of total local advertising revenue. So, as far as revenue goes, it's a fairly diversified business acrossall of these segments and customers. But the trouble iswhen 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'rerunning into some headwinds there. If that user base isn't growing,and you're competing against Google Maps or Facebook Reviews, orall these other things from much larger competitors, I understand why thecompany is running into headwinds.

Lewis: Yeah. All thedigital ad market research thatI read is showing the power thatGoogle and Facebook wield is consolidating, gettingbigger and bigger, and very often it'scoming at the expense of these smaller platforms. This isnot all that different from the conversation I had followingTwitter'searnings. You look at the declining price of adengagements on their platform, and I thinksome 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 smallbusinesses. You can look, they'vehighlighted the number of small businesses that areadvertising on the platform, that have Pageson the platform. So,local is clearly a focus for them,even though they are this massive, massiveglobal phenomenon at this point.

Kretzmann: Yeah. Anothercompany I follow,Priceline, which is theonline travel agency, you might have talked about it on this show, they ownBooking.com, Kayak,online travel agencies like that. On theirconference calls, prettyrepeatedly, they say, "We want to spend more money on Facebook." So,that gives you an idea, these advertisers want to spendmore 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 morestruggles competing against thosemuch more dominant platforms, in terms of digital ad spending. But, with Yelp, similar to Twilio,I think there are some business dynamics that areattractive. The company actually has a net cash total of$486 million, which is21% of its current market cap. To me, that suggests,there is at least a cushion here.I think the most likely out for Yelpwould be getting acquired by someone. BecauseI think they do have a relevant platform, butI think it needs to be part of something larger. Ijust 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 acushion. They areproducing positive free cash flow,even though a lot of that,similar to Twitter, is due to stock-basedcompensation. But even when you back out that stock-based compensation, the business isproducing positive free cash flow. So, they'renot in danger of going under anytime soon. But, yeah, to me,it's hard for me to see themsurviving and doing wellon their own, so I wouldn't be surprisedif 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 playerspretty easily.

Lewis: Yeah.I know my personal feeling with these two stocks is, Twilio remainsmuch more interesting because it'sso much earlier on in the story, and it seems like there'smuch 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 willexplosively grow in the next few years.

Kretzmann: Yeah. And despite the concerns with Uber leaving Twilio, I just see Twilio beinga little bit more differentiated.I agree with you, I think they have abigger greenfield opportunity. Yelp is just operating insuch a competitive space, with reviews alone,let alone digital advertising, thepeople 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, haveexpanded without raking up a lot of debt. That makes them a little bit saferas they work through these muddier waters. Yeah,it'll be interesting to see where they go from here.

Lewis: Yeah. We willcheck in when we have more results come next quarter, see how they're doing.

Kretzmann: Hopefullybrighter times ahead.

Lewis: Yeah. Thank you for joining me today, David!

Kretzmann: Thank you!

Lewis: Listeners,thatdoes 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 industryfocus@fool.com, 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!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. David Kretzmann owns shares of Alphabet (C shares), Facebook, Priceline Group, and Twitter. Dylan Lewis owns shares of Alphabet (A shares) and Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Facebook, Priceline Group, and Twitter. The Motley Fool recommends Twilio and Yelp. The Motley Fool has a disclosure policy.