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In the wake of Facebook's (FB) recent "Graph Search" announcement and the FTC's decision that allows Google (GOOG) to place Yelp's (YELP) free link anywhere it wants in its user searches, Yelp boldly responded by… announcing plans to provide health code rating information associated with its restaurant listings.

While Yelp's recent announcement may be useful for individuals who use the website for dining decisions, the move may have left more than a few investors puzzled since it further antagonizes the relationship between Yelp and a significant subsection of its customer base (i.e. local restaurants), adds yet another incentive for local restaurants to pre-empt their customers from visiting Yelp, and further reduces the universe of companies with any incentive to advertise with the popular online review site. Moreover, this decision has the potential to create liability for the company.

Consistently Finding New Ways to Antagonize Local Business:

As previously discussed here, investors should be wary not to confuse Yelp's customer base (i.e. local businesses) with Yelp's users (i.e. the customers of local businesses). A failure to recognize such a distinction might make Yelp's recent announcement seem positive for the company. While providing health code ratings to Yelp users gives them more information, the decision is clearly not favorable to local restaurants based on the reaction from the New York Restaurant Association, as described here. In summary, oftentimes online information on a health inspection is out of date or has nothing to do with food safety. Moreover, certain ratings have the potential to be incorrectly perceived in a negative light by the general public who may not understand nuances associated with a particular rating, as described here.

The practical effect of Yelp's most recent decision is that it has increased the number of local restaurants that should have incentives to pre-empt their potential customers from ever reaching Yelp's website. If a local restaurant has a concern about a finding issued by its local health inspector, that restaurant now has an incentive to spend more advertising dollars to prevent its potential customer base from ever finding that information on Yelp. In light of the FTC's recent decision on Google's search algorithm, those local restaurants should be making every effort to push Yelp's free link to the bottom of any user search.

Moreover, the move seems to further reduce the number of restaurants with an incentive to advertise with Yelp. It now appears, that the only restaurants that should have an incentive to advertise are those local restaurants that are highly rated, with favorable health code ratings, in regions where there is stiff competition among other equally highly-rated restaurants that also have favorable health code ratings. Logically, local restaurants that are highly rated, but received negative health code ratings, now have little incentive to advertise with Yelp since it would only serve to highlight that negative health code rating information. With this in mind, investors may want to further question Yelp's ability to retain the advertising revenue from its already small fractional base of four percent of the company's overall listings.

Potential Liability:

While various types and forms of litigation surrounding Yelp have already been widely publicized (as described here), Yelp's most recent decision has the potential to create more legal liability for the company. While there is probably nothing that prohibits Yelp from displaying health code ratings that are publicly available, it may want to proceed with caution if it decides to move ahead with its plan. Failure to carefully handle the ratings assigned to local restaurants could lead to potential problems. For example, what happens if Yelp's website accidentally lists an incorrect heath code rating for a local restaurant? What happens if Yelp accidentally links negative health code rating information that belongs to one local restaurant and transposes it on a different restaurant's listing? What happens if a local restaurant's health code rating is upgraded but that upgrade fails to properly update on Yelp in a timely manner?

Michael Luca's 2011 Harvard School of Business case study on Yelp helped to establish that information available on Yelp's website could potentially have a direct impact on a local restaurant's revenue. If negative health code rating information linked to a local restaurant listed on Yelp is not updated in a timely manner or is inaccurate, that negative information could potentially negatively impact business for that particular restaurant. If Yelp does not proceed with caution, its new feature has the potential to generate even more litigation for the company. For example, a local restaurant might decide to take legal action against Yelp because it believed that it lost, or is losing, revenue due to inaccurate or outdated information being publicly posted by Yelp. Alternatively, some savvy plaintiff's attorney might decide to explore whether there might be money to be made in a potential class action lawsuit targeting inaccuracies in Yelp's public postings of health code ratings.

Conclusion:

The company has already admitted that its new feature doesn't "necessarily provide a direct contribution to Yelp's bottom line," as described in the article here. In light of that admission, Yelp investors may want to pause to consider why an unprofitable company, facing significant increases in competition from the likes of Facebook and Google, made the decision to invest its time, energy, and resources in an unprofitable project.

While making a positive impact on society is certainly a noble goal, these types of efforts are generally best left to governments, municipalities, and non-profit advocacy organizations. It's unlikely that we'll see companies like Facebook and Google follow suit in this endeavor, since as a general matter, private companies tend to avoid these kinds of activities as they don't tend to result in favorable returns on investment.

Then again some of Yelp's management might already realize that the company might not be headed in the right direction. This could help to explain why Joseph Nachman (Yelp's Sr. VP of Revenue), Geoffrey Donaker (Yelp's COO), and Wilson Laurence (Yelp's General Counsel and Secretary) sold off a collective total of over 21,000 shares of Yelp stock in the first ten days of January, as shown here.

Source: How The Decision To List Health Code Ratings Could Hurt 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 but have no underlying stake in the company's stock, meaning I have a negative outlook on the company.