Despite Yelp's (YELP) inability to turn a profit since going public in the Spring of 2012, as shown here, some Wall Street analysts and pundits still remain bullish on the stock. Wall Street analysts who see significant upside for Yelp often base their opinion on the questionable logic that the company's future is bright because of the large amount of potential for local advertising revenue that still remains untapped by the company. Investors may want to question this logic since it is unclear whether these analysts and pundits understand fundamental issues that seem to exist within Yelp's business model and how the Federal Trade Commission's (FTC) recent decision on Google's (GOOG) search algorithm might negatively impact Yelp.
Yelp's Questionable Business Model:
Wall Street analysts who see potential for Yelp often point to the fact that only approximately four percent of the company's listings are actually paying customers (as described here). The questionable logic that follows is that 96 percent of the listings then could become paying customers and therefore Yelp's potential for future revenue growth is significant. Unfortunately, these analysts may have failed to consider that Yelp's business model seemingly prevents it from monetizing a significant amount of its listings. This is even after recognizing that some of Yelp's listings are geographic locations, and not businesses (for example, Yelp has reviews for places like "Lincoln Road" which is a street in Miami).
When analyzing future potential advertising revenue, investors may want to first consider that Yelp has been around for more than just a few years. More specifically, the company has been in existence since October of 2004. Despite having over eight years of experience trying to monetize local advertising revenue (during a period when competition was scarce or non-existent), Yelp has only been able monetize a very small fraction of its listings today. As competition increases from larger companies such as Google, Facebook (FB), and smaller rivals such as FourSquare, investors and analysts may want to ask themselves why they believe Yelp can increase its advertising revenue moving forward, especially in light of its eight year track record of generally being unprofitable and ability to only monetize a small fraction of listings during a period when competition was significantly limited. More discussion of the competitive landscape for Yelp can be found here.
Next, Yelp generates income by selling ad space to businesses. Yelp's "customers" are not the individuals who read and write reviews, but rather are the businesses that are being reviewed. As an aside, some analysts base their high opinion of Yelp on what they believe to be a strong "brand." These analysts seem to be confusing the brand image that Yelp has with its users (i.e. customers of local businesses), with the image that potential customers (i.e. local businesses) have of Yelp. Yelp's brand is, in fact, viewed very negatively by at least some of its potential customers, as evidenced by the "We Hate Yelp" and "Boycott Yelp" Facebook pages, which can be found here and here. This is of course notwithstanding the fact that Yelp's users have given the company a less than stellar three star rating, as found here.
More importantly, after taking into consideration the distinction between Yelp's customers and users, Professor Michael Luca's 2011 Harvard Business School case study on Yelp actually helps to establish that many of Yelp's potential customers (i.e. local businesses) have significant incentives to avoid advertising on Yelp all-together. If in fact local business revenue is directly tied to Yelp ratings (as the Harvard study, which can be found here, indicates), then local companies with less than top ratings should have no reason to want to draw more attention to, and highlight their negative reviews, along with their average, marginal, or poor Yelp ratings. Additionally, assuming that the Harvard Business case study is accurate, local businesses should now have a very strong incentive to reach potential customers before they ever get to Yelp, and should be spending their advertising dollars accordingly (more on this point later).
Moreover, the Harvard Business School study showed that Yelp ratings did "not affect restaurants with chain affiliation" leaving an entire, and very large, category of listings with little or no incentive to advertise on Yelp. Additionally, there was nothing in the Harvard Business School study that correlated advertising dollars spent on Yelp with increases in local businesses' revenue.
A close examination and analysis of the Harvard Business School case study may help to explain Yelp's persistent unprofitability. Also, when viewing Yelp's business model in the context of the Harvard Business School's case study, Yelp's potential for future revenue seems dramatically smaller than some may want you to believe. The universe of Yelp listings that might potentially be monetized should probably exclude all chain businesses (the Harvard Study indicated that chain businesses are generally unaffected by Yelp ratings), and should probably also exclude all local businesses rated less than four stars on Yelp (logically these companies should be focusing their advertising and marketing budgets to reach consumers before they get to Yelp, or directly on customers who are most likely to write online reviews). After taking all of this into account, and after excluding those Yelp listings that are for geographic locations and not businesses (e.g. roads, landmarks, destinations), the universe of potential untapped revenue starts to dramatically shrink. Essentially, the only companies that should have any incentive to advertise on Yelp would be small local businesses that are already very highly rated in markets with stiff competition from other highly rated small local businesses. All of a sudden, the fact that Yelp has only been able to monetize about four percent of its listings today, despite the fact that it had relatively little competition during the past eight years starts to make a lot more sense. Moreover, with competition for local ad dollars increasing from companies like Google and Facebook (which released its "Nearby" feature recently, as described here), how much of Yelp's existing fractional advertising business will it likely retain moving forward? While advocates of the company point to Yelp's near 72 percent contract renewal rate from one year to the next (as described here), remember that the 72 percent is a subset of its four percent of total listings. Unfortunately for Yelp, a large fraction of a small fraction still ends up being a small number when viewed in context of overall listings. Furthermore, what will that percentage look like in a year as Facebook expands its "Nearby" feature? How much of that four percent can Yelp retain if Apple (AAPL) replaces Yelp with FourSquare, as speculated in the article here? How many local businesses will extend expiring contracts now that Google has been given carte blanche to list Yelp wherever it might want in its user searches (more on this later)?
FTC's Decision May Allow Small Businesses to Preempt Customers' Use of Yelp
The questionable logic that analysts have used to justify Yelp's lofty valuations also faces another challenge, namely the FTC's determination that Google's search algorithm was not unfair to competition. The FTC's decision is significant because Yelp specifically identified two main concerns about Google. First Yelp didn't like the fact that Google was using information in its search listings from reviews that were pulled from Yelp (a practice known as "scraping"). More importantly, Yelp did not like its placements in Google search results. Although Yelp won a very minor victory by preventing Google from "scraping" its content, the FTC unanimously voted "not to pursue a case accusing Google of using unfair competition to enhance its search business." This is important because Google retains the ability to push "links to competing sites lower." Websites like Yelp will likely draw "fewer customers as a result of Google's free links" and will be forced to "advertise more to draw traffic," as described in the New York Times article found here.
The FTC's decision is especially brutal to Yelp because, as Jeremy Stoppelman (the company's CEO) indicated during Yelp's Q3 earnings call, a majority of Yelp's web traffic is "driven by search engines, particularly Google." Like many small businesses that complain about how Yelp lists their business information, Yelp is getting a dose of its own medicine as it is now at the mercy of Google's search algorithm for placement in user searches. Moreover, inputting the search term "Italian Restaurants" in Google gives individuals a list of names of local Italian restaurants, ratings provided by Google (through Zagat or Google local), and links to take users directly to individual businesses. A direct link to a search for Italian restaurants in Google can be found here, with Yelp's free link in the middle to the bottom of the page. As Google begins to populate more and more local businesses directly on search pages, the FTC's decision could potentially allow Google search users to seamlessly find local businesses, and ratings associated with those local businesses, without ever seeing a free link to a third party website like Yelp.
Additionally, the FTC's decision does nothing to help Yelp's stagnating web traffic. Figures from comScore's Metrix Multi Platform show that Yelp barely broke the top 30 US websites (coming in at 29, which was below companies like Craigslist and Pandora) for overall US web traffic (as identified here in Fred Wilson's November 29, 2012 blog). Additionally, the Quantcast chart below shows that web traffic to Yelp is still significantly off its August 2012 highs.
As discussed above, many local businesses already had incentives to focus their advertising dollars and marketing efforts on media other than Yelp. After the FTC's recent decision, they may have even more incentives to go elsewhere. Now that the FTC has determined that Google's search algorithm is not unfair to competition, local advertisers may have more incentives to spend their marketing dollars targeting websites where individuals begin their searches (such as Google). These issues are only compounded by Yelp's seeming inability to significantly grow web traffic organically. This should be of special concern for Yelp, since Jeremy Stoppelman indicated that search engines like Google generally drive web traffic for Yelp. The FTC's decision could also spur local businesses that dislike Yelp's practices, to focus even more of their efforts and advertising dollars on preempting potential customers from ever reaching Yelp. The FTC's decision seems to essentially relegate Yelp to competing with its own potential customers (i.e. small local businesses) for advertising space on Google. This has the potential to create a vicious and negative downward cycle for Yelp. In order to generate the web traffic that might justify customers to advertise with Yelp, Yelp may have to spend significant dollars on advertising to promote its own website. Yet again, Yelp may be in a situation where the only way it can increase revenue is by paying more money out, to bring less money in, (just as it did with the Qype acquisition, as described here).
The FTC's recent decision on Google's search algorithm seems to place additional and significant pressure on Yelp. As Yelp reviews become more and more like the scrawlings on a bathroom wall (as described here by Anthony Bourdain, and as consumers grow more concerned about being sued for posting online reviews, as described here), Yelp's remaining useful feature would likely have been as an online listing of local companies. After the FTC decision, even more questions are raised about Yelp's future profitability, since individual users may never make it to Yelp's website for that list of local businesses, now that all the information they need can be found directly from Google's search results page. In a nutshell, if Yelp's prior web traffic was driven by search engines like Google, investors may want to consider what Yelp's future might be like now that the FTC has decided Google's search algorithm can place Yelp just about anywhere it wants on that search results page.
And of course if internet users can't find a link to Yelp's webpage when looking for a local business, how long will it be before Yelp becomes the MySpace of online review?
Jeremy Stoppelman, other Yelp insiders, and some of the company's beneficial owners might already be asking themselves the same question. As noted here, they disposed of, or sold, over 15 million shares of Yelp since the company's 2012 Q3 earnings call held less than three months ago (a list of transactions can be found here). Investors placing their faith in the opinions of those Wall Street analysts and pundits who seem to be bullish on the stock might want to ask themselves why Yelp's insiders and beneficial owners don't seem to be doing the same.
Disclosure: I am short YELP.
Additional disclosure: Nothing in this article should be construed as legal or financial advice. The opinions expressed in the article are the author's own. I have a negative outlook on Yelp and am long Yelp put contracts, meaning I have a negative outlook on the company.