Why Online Dining Is Not So Hot

Adrian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

What do Yelp (NYSE: YELP), OpenTable (NASDAQ: OPEN) and Groupon (NASDAQ: GRPN) have in common? Well, in various degrees, all of these companies have exposure to the online dining segment. At first glance, this market looks highly attractive. At least in America, it seems that more users are using the Internet and apps to make their online reservations, read restaurant reviews and earn points for free meals. 

Attracted by the increasing number of users relying on online booking for their dinning, several startups are also in the game. But does this segment truly represent an investment opportunity? In this article I will explain why I'm bearish. We will analyze these three key players and provide an investment thesis. Keep reading!

Why online dining is not worth your time and money

To begin with, online dining isn't a new concept. It has taken OpenTable, the early mover in this segment, more than 12 years to achieve its current scale. The company practically made the market, so we can use its scale as a reference of how the overall market looks like in terms of current size and growth.

Looking at the number of installed restaurants of OpenTable since the first quarter of 2010, we can see that there is a clear decreasing trend in the growth rate of restaurants in the past three quarters. The "international" component also doesn't seem to have changed that much in size since the first quarter of 2010. This suggests that online dining isn't really getting very hot lately. The growth rate of other services will likely be different because some startups may be in the early stage of growth. The long-term picture, however, shows that it's hard to keep growing at the same pace once you reach 20,000 restaurants.

While 20,000 to 30,000 restaurants may sound like a big number, remember that this segment has low barriers to entry and increasingly fierce competition. It is also not desirable for any restaurant owner to use a booking system that highly dependent on a third-party application. This is because restaurants want to own their own data instead of paying for licenses to access their own bookings.

Luckily for restaurant owners, it's becoming increasingly easier to have a functional booking system on your website, do search engine optimization to promote your location and use free tools like Google Maps or Waze to reach nearby users. Each of these restaurants is also an indirect competitor, which doesn't look so sustainable. Most restaurants would prefer to go for a fixed payment and have their own online booking system than relying perpetually on a third-party app.

Now, let's analyze 3 representative stocks and see how they are dealing with these issues.

OpenTable: The dominant player, for the moment

With a price-to-earnings ratio of 56.79, OpenTable is the biggest player and an early mover. OpenTable's main upsides include relatively high customer retention and a long history of earnings and revenue growth. The downsides are that the growth rate of revenue is showing some recent decline and international operations still represent only a tiny contribution to total revenue. The international business isn't really growing and that keeps me worried, since the current price-to-earnings ratio suggests most investors look at OpenTable as a growth stock. Since 2006, for example, the company only managed to register 1,660 restaurants in Japan.

In one of its presentation slides, OpenTable mentions in the financial highlights section: "Predictable, profitable revenues." Allow me to disagree. Further competition can lead to a forced decrease in fees and this could have a direct negative impact on margins. Also, how do you explain the slight deceleration in number of restaurants registered?

Finally, the company's stock price is highly volatile. It rocketed to almost $120 in 2011, only to sink to $30 by the end of the year.

View: Bearish

Yelp's acquisition of SeatMe makes it a wonderful competitor at the right time

Global consumer review company Yelp announced in July that it will acquire SeatMe, an online restaurant reservation service founded by Alexander Kvamme and Jordan Mendelson in 2011, for $12.7 million. The acquisition looks quite strategic; Yelp has put a lot of focus on driving revenues from ads, and SeatMe (which is basically a software and not a search engine, as opposed to OpenTable which provides both services) sounds like an interesting complement. Yelp already has strong traffic and customers, so SeatMe is exactly what the company needed.

I went for a free trial and was amazed at the user interface, the speed and intuitive way of working that SeatMe has. Even better, it looks much cheaper than OpenTable and has no set-up fees. If Yelp can build a massive directory of restaurants using SeatMe, this could be a strong cash cow in the making. It seems like SeatMe is still pretty small and has a lot of room for growth.

View: Bullish

Groupon: more than just booking

Groupon is different than the others due to its group-buying feature. It also doesn't provide any booking system, so it's all about traffic and the ability of sending customers to a given restaurant. Since Groupon goes beyond dining, it is not totally exposed to this segment and its potential growth limits could go beyond OpenTable easily. Groupon has its own issues regarding profitability, however.

Its business model's main weakness is the fact that is much easier to get user registrations than restaurant registrations as high fees, massive discounts and sudden demand are not desirable for many owners. Despite having a somewhat flawed business model, however, Groupon is still growing its revenue significantly and generating a positive operating income.

View: Neutral

The bottom line

This segment doesn't really look attractive once you take into consideration the low barriers to entry, the disadvantages some restaurant owners may feel, increasing competition and the current growth rates of the biggest player. Sure, there is still room left for further growth, but there are also more interesting alternatives for those searching for growth stocks.

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Adrian Campos has no position in any stocks mentioned. The Motley Fool recommends OpenTable. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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