Wednesday, February 9, 2011

Case study on shareholder dilution: OpenTable

OpenTable is an online restaurant reservation service.  From latest financial report, in North America it has  13795 restaurants signed up to its service out of a primary addressable market (universe of target clients), according to company, of 30k-35k restaurants (39.4%-46% penetration), and a secondary addressable market of up to 20k restaurants.  From its average restaurant client, excluding installation fees, it is earning between 6k-8k in revenue per year (closer to 8k if latest quarter is extrapolated).  Its spends over $7000 in sales and marketing costs per new restaurant acquisition.

OpenTable is a very exuberant stock story.  Shareholders have reason to be satisfied with management on the simple basis that shares have risen substantially, at the time of this writing (morning after earnings release), opening over $87/share.  Over $2B in total value.  This is 150x diluted earnings per share of 0.58.  If the company doubled its restaurants and doubled its revenue per restaurant tommorow, quadrupling its earnings, and then grew at 5% per year afterwards, it would justify a 15x earnings multiple, and a stock price that should be (2.32x15) $34.80.  Doubling that to account for international opportunities, which are significantly less developed than north america, $69.

According to OpenTable management, their reservation platform does not increase the total number of restaurant diners.  It just increases the number of diners who use opentable to make a reservation.  This means that if Opentable is as successful as the market hopes it becomes, that the service could simply be more of a tax on restaurants than a restaurant profit generator.  OpenTable claims that some of its restaurants in San Francisco have up to 50% or their reservations made through the software platform, and possibly explains why a SF restauranteur made this rant against the service in October 2010.  Considering that the cost of developing a competing platform would be 1-5M, and the sales and marketing costs of "stealing" 10000 of OpenTable's customers probably less than $70M, then there is a present and future competitive threat to the hoped success of its business model.  Competition on price becoming more of a threat the higher OpenTable's revenue per restaurant grows.

The above illustrates that although shareholders have reason to be happy with past and current performance, there is a wide range of possible future stock prices, and it would seem that the market is already at the very high end of that range.  External shareholders simply have no control over the outcome, and face unproductive risk and anxiety as a result.

2 core natural finance principles are that management and insiders should own the equity/shares of the company because they are the only ones able to foresee, and be responsible for outcomes; and that outside investors should never be diluted (new shares offered/given away) because involuntary dilution is figurative theft.  OpenTable has an aggressive employee/executive options program that illustrates several points in favour of natural finance and severe failings of traditional stock market investing model.

OpenTable's shares outstanding grew by at least 32.4% from the average 2009 level to the end of 2010 to just shy of 23M shares.  It has at least 1.3M optioned shares outstanding at the end of 2010 (company reports average diluted shares, so if options are awarded on last day of quarter, they only count as 1/90th of a diluted share).  Compared to previous quarter, options are growing at 184k shares (change in diluted shares) per quarter.  The compensation value it records for these options is $2.69M or $15.59/share.  From recent filings, Between January and Feb 7, 2011, several insiders exercised options that expire in 2017 at a strike price of $4.87 (this is the amount the company receives) and sold the stock for over $80 immediately thereafter.

The above indicates that the company has a generous options compensation package, offering employees very long term options.  If options  were being exercised at $87 proceeds to the company, then they would be dilution neutral to other shareholders.  At $4, they are management candy that take away shareholder value.  Whatever superb growth the market expects from the company in coming years, I'd be surprised if shareholders are factoring in 9% increase per year in shares outstanding.

As said before, shareholders have reason to be happy with performance of stock.  Therefore, there is coziness between shareholders, board of directors and management.  That shareholders are happy when a bubble is growing, creates a confluence of interests by all parties to help grow that bubble.  The potential for exaggerated financial reporting is quite real.  Financial analysts can also be provided with benefits aligned with stock price increase.  Regulators tend to only get involved if the company turns into an Enron disaster, which is quite unlikely for OpenTable.  All of these factors, allow management to reward itself within barely reasonable limits, and if they were to fudge on the proper valuation of employee option compensation (there is considerable leeway to do so), they would be unlikely caught if no one is likely to complain.  The 15.59/share per average option seems surprisingly low considering that the market values an 11 month $87-strike option (when stock is at $87) on OPEN at $23, and especially if the company continues to offer 10 year options.  OpenTable options are considerably more expensive (on public market) than average companies because it has such a wide range of opinions on possible outcomes.

Our financial systems should discourage outside investors from speculating without control and inside information through minority stock ownership.  The tax code should encourage loans instead.  Natural finance soft loans are less risky than traditional loans for investors, and allow them to make investment decisions based on simpler to forecast revenue and operating cashflows, and guarantees them never to be diluted by other investors or management compensation decisions.  From management's perspective, natural finance queued soft loans provide flexible financing repaid only when cashflow allows, at the lowest interest rate the market can bear, and a continuous source of financing.  Management and insiders can keep the entire ownership of the company.  Even in OpenTable's case, a spectacular stock promotion success story, if the company were worth only $1B (half), under natural finance, the 1B would belong entirely to insiders, and it would be better able to finance its expansion plans.

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