Manifest Tech Destiny (And The Case Against Angie's List)

| About: Angie's List, (ANGI)

"We think the cloud is going to be huge, we are focusing on early stage disruptive startups who are shifting the paradigm." Tyler Winkelvoss, CNBC last week

"Wall Street isn't as lucrative as it once was- and for many years, the most ambitious, savvy, money-oriented people from top universities just went straight into investment banking. Now that those jobs have dwindled and seem unlikely to make a resurgence anytime soon, those same people are now heading west and hitching their wagons to the tech industry's star."- Techcrunch Article, April 29 2012

So the Winkelvosses think the Cloud is going to be huge. That's like saying tablets are going to be popular 3 years after the launch of the Ipad or that Hollywood is going to go nuts for 3D films 2 years after Avatar. To call these guys late to the party would be an insult to party crashers. Anyways, it is good to see that thanks to Web 2.0 Manifest Destiny is making a comeback except instead of Horace Greely telling us to 'Go West, Young Man'; we now have TechCrunch leading the way.

Yep, the Wall Street party is over and all the type A's are moving to San Francisco. But before you listen to TechCrunch and go looking for the Western Trail, you might just want to check in on exactly what Mr. Market thinks of all of this. Because contrary to popular geek belief, there is no tech party without cheap capital. And there is no cheap capital without the expectation of windfall exits. And the gatekeepers of windfall exits don't reside in San Francisco. So, before you turn up your nose at Mr. Market, you might want to make sure he still believes in Manifest Tech Destiny, because if he doesn't your wagon won't make it very far. And if recent developments are any indicator, Mr. Market's interest in his new toy is starting to wane.

The Deflating Web 2.0 Bubble

Groupon (NASDAQ:GRPN)- Down 50% over the past three months and still showing no signs of improvement. I'd write more about this, but I have beaten the topic to death over the last year. Google may still regret not buying Facebook, but I assure you they are happy that Groupon passed on them.

Zynga (NASDAQ:ZNGA)- Like Groupon, this Web 2.0 poster child has been getting pummeled of late. Shares are down almost 50% from their March high, and their recent earnings report didn't do much to alleviate concerns. Despite mostly positive metrics due to the increased shift to mobile, daily active users were only up 6% yr/yr and average bookings per user declined 16% sequentially. Not exactly the type of metrics you want to see a few months after going public. And the bad news doesn't stop there. Zynga's games seem to be eroding at an accelerating pace with games older than six months experiencing an over 30% decline in users in the quarter vs a 23% decline for the same group in q3. This is precisely why Zynga spent $200 million to buy one hit wonder Draw Something. Of course if you've followed the video game business over the years you know how important it is to have a hit franchise or two, but in the online world with super low barriers to entry and much shorter life cycles the need for hit replenishment is even greater. Now ask yourself how Zynga management feels about Draw Something's relatively quick decline to the #8 spot on Apples top ten list a few weeks after their purchase. Seems Viddy and DragonVale are a lot more interesting right now. Which bring me to my next point......

Is there an App Bubble?

Fiksu recently released some data that caught my attention. According to their research, iPhone App downloads declined by 30% in March. That's a pretty staggering decline even when you factor in for the novelty of the iPhone 4s launch wearing off, but is it a sign of a deflating bubble?

Well, that depends on what you consider a bubble. If you look at the app economy is not a pretty place. The average app costs between $30,000- $40,000 to develop and sells for about a $1.50, if it is not free. Seems unimposing at first glance, especially when you consider the potential scale, but the reality is very different. Apple's 25 billion app downloads have led to developer revenue of $4billion. That works out to an average of 16c per download or roughly a minimum of a 200k downloads to break even on development costs. And there are now over 550,000 apps in the app store. At a few seconds per app you'd need over 308 hours to go through every app. So, if you are not cracking the top ten list your odds of success are slim to none. And this is just the economics side of it.

When I got my first iPad a few years ago I downloaded some 60 apps in the first month or two, but after a few weeks I found I was only using 3-4 apps and the browser. (I eventually got bored of the whole thing and just gave my iPad to my brother, but then again I'm clearly not the norm) Anyway, it turns out I am not alone. The average iPhone user downloads about 80 apps in the first few months after purchase, but most those apps are barely used and subsequently deleted. According to one survey (the survey is dated but I am guessing based on the amount of Apps out there now that the data is even more supportive of these findings), less than 5% of iPhone users actually use a free app 30 days after they downloaded it, and it turns out that after a couple of months most people are only using 4-5 apps. Basically, downloading Apps is all about satisfying some element of curiosity, once that is out of the way people move on. And when they move on they tend to go back to the browser, messaging, their social network update apps, or heaven forbid the actual phone.

Now onto shorting Angie's List....

Company Angie's List Yelp Opentable
Market Cap $833 MLN $1.38 BILLION $932 MLN
Enterprise Value $755 MLN $1.28 $882 MLN
Trailing P/E NA NA 47x
Forward P/E NA NA 27x
P/B 24X 13X 8.5x
EBITDA 2011 ($45) MLN ($16) MLN 42 MLN
REVENUE 2011 $90 MLN $83 MLN $139 MLN
Operating Income Growth (100)% (70)% 77%

If you followed my Opentable (NASDAQ:OPEN) and Netflix (NASDAQ:NFLX) pieces in late 2010/early 2011 you will probably find this worthwhile. Angie's List (NASDAQ:ANGI) and Yelp (NYSE:YELP), two stocks that have gone public over the past six months, are in my view late cycle Web 2.0 bubble IPOs with challenging business models that are not supportive of current valuations. Both names provide business reviews at the local level with the US market being the main focus for now.(Yelp has started to push international while Angie's list continues to focus on the US) Yelp's recognition as a review product has been more about restaurants and hotel reviews though service reviews play a significant part. Angie's list on the other hand is really focused on 'high cost of failure' professional services for the home, health care and automotive space. Angie's list is a two tiered revenue model driven by charging subscribers an annual fee of between $30-$50 for access and local businesses for advertising. Yelp on the other hand predominately derives revenue from advertising and does not charge members for access. Both are still trying to achieve enough scale to be cash flow positive, and thus likely to be the most punished by the end of the markets infatuation with the Web 2.0 space. Both are spending very aggressively on marketing and sales to grow the revenue base and achieve economies of scale. Both models remain unproven, and in the case of Angie's list arguably utterly unsustainable without generous capital markets. (Doubling marketing spend to increase revenue by 50% is a risky proposition when you only have $80mln in cash on hand) In the last two quarters of 2011, Angie's List consumed $30 mln in cash from operations. Angie's list needed an ipo to continue to finance operations, and when the lockup expires in May I expect a significant portion of insiders who have been financing the accumulated $150 million plus equity deficit to be looking to exit. Both companies need an acquirer looking to fill a product hole to ever be able justify these valuations. I cannot envision such an acquirer emerging without a crash in the sector leading to distressed prices as the natural buyers of local (goog and amzn for example) are limited to a few companies that would love to see this space thin out.

Consequently, I favor shorting Angie's List because it loses out at Yelp's free user model expense (even though it seems to be increasingly moving in that direction if you look at how they have managed to rapidly expand the member base ), is spending very aggressively to acquire users, has a weaker balance sheet, is owned by shareholders who are more likely to exit quicker, and has lock up that is expiring shortly.

I added Opentable in the table because it is a stock I have written a lot about over the past year (mostly via my private distribution list) which offers a localized product that is related to these two companies. The only real difference of course is that Opentable has a more defensible business model, and sells a profitable product. Yet, Opentable's current valuation is at a discount to Yelp's and on par with Angie's List even though Opentable makes a lot more sense as an attractive target thanks to its established consumer brand and thoroughly penetrated restaurant network. The only difference I can see here is these two IPOs are new blood, and Opentable is old blood. And when that is all that stands out the cash burning later cycle new blood should make for ideal shorts.

How to Play This: Acquisition risk is always a risk with stocks like these (you can't account for the greater fool) which is why I favor Angie as a short over Yelp or Opentable at these levels. Management will be forced to continue to invest heavily to grow the revenue base which makes this a much less appealing acquisition at this point in time for a scale player (they'd rather buy a very well established local network at this point in the cycle). And without the risk of an acquisition the stock should be trading closer to $400 million (i'd say $150-200..but that would probably be viewed as blasphemy at this point) which is a 40-50% decline from the current share price.

I have attached a table of key Angie's List operating metrics below. Here are some observations....

  • Angie's List core value proposition is that if people pay for a membership the reviews are more likely to be worthwhile. Yet, over the last year Angie has experienced very impressive paid member growth with almost negligible membership revenue growth. Their explanation for this is that as they enter new markets they offer free memberships to build out the community, and that tiered pricing is being used more in their most mature markets. Considering that Angie's List has been around since 1995 I find it hard to believe that doubling their sub base in the past year didn't involve a bit of a model shift more in the direction of Yelp's free service. Spend a little time on Google and you will find all kinds of promo codes for free memberships and steep discounts to support this view despite managments insistence that this is business as usual when it comes to new market entry.
  • Angie's List growth is very correlated to marketing, and you can really pick this up by tracking deferred revenue trends. A slight dip in spending and the growth tends to fizzle.
  • Angie is however benefiting from rising service provider revenue which is a good sign, and evidence that this model seems to be morphing into another cut and dry local advertising product with advertiser revenue substituting for membership revenue. The metrics here are solid though I think they have been somewhat goosed by a shift to shorter term service provider contracts. Nothing wrong with this trend if you ask me except that I wouldn't pay $800 million right now for this strategy.
  • Marketing expenses are a significant portion of total revenue, and will be rising to roughly 80% of total revenue in Q2 based on current guidance.
  • As Angie spends to gain scale losses continue to rise, and at this pace could see the company in an equity deficit by the end of q3 as current shareholder equity is only $33mln. These are the type of financial data points that attract bloomberg screening shortsellers. Not exactly a cause for celebration as I'd prefer shorts who get the business model limitations, but I am not going to complain this either.

Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012
Paid Subscribers 674490 821769 988224 1074757 1221387
Membership Revenue($ millions) 7 7.9 9.1 9.8 9.9
Avg Revenue Per Paying Member $10.38 $9.62 $9.21 $9.12 $8.1
Deferred Membership Revenue ($ Mln) NA NA 17.5 17.1 18.2
Service Providers 17577 19750 21927 24095 27100
Service Provider Ad Revenue ($ Millions) 10.6 13 14.8 17.7 21.1
603 658 674 737 778
Marketing Expenses($ Millions) 11.1 18.1 18.7 8.1 17.6
Net Loss ($ Millions) 9.6 16.1 17.3 6 13.4

Now onto Facebook....

Privco recently put out a nice little piece comparing pre-IPO Google to pre-IPO Facebook. It doesn't paint a pretty picture for Facebook, and actually is a good example of the rarely mentioned downside to the Web 2.0 build and then monetize approach when it comes to going public. What's that downside? Disappointing organic growth prospects. If you don't start monetizing until your network is mature, your growth rate is going to slow down pretty fast.

Google didn't have that problem as its organic growth coincided with its monetization. Facebook doesn't have that luxury, and as the IPO approaches this is becoming more of a concern. Make no mistake this is probably not going to stop a $100 billion+ valuation once it starts trading, but the honeymoon for these shares will be short if Mark Zuckerburg Inc can't start showing 30-40% revenue growth. The Privco analysis highlights these concerns though I will point out the authors pay little attention (zero mention) to the fact that Facebook pre-IPO margins are nearly double what Google's were in 2004. (It may grow slower on the top line, but the bottom line is a lot fatter.)

Disclosure: I am short ANGI, ZNGA, GRPN.