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Allow me to preface this short thesis by saying that I actually like YELP quite a bit. I believe it is a useful service in many ways. My wife and I use Yelp to find a new restaurant almost weekly and it usually steers us somewhere enjoyable. In spite of my admiration for some of Yelp's services, it is impossible to justify its 1.95B market cap and 12x sales multiple. Yelp is operating on a flawed business model that will never achieve the growth anticipated by Wall Street.

(Note: I will be referring to the most recent 10-k, Yelp's Q1-13 informational slides, and the Q1-13 8-k earnings report extensively.) The macro view of the short thesis is contained in the following points, listed in order of importance:

1. Yelp's mom-and-pop customer base doesn't lend itself to scalability. Large chain restaurants and chain shopping locations generally don't advertise on Yelp (everyone knows what to expect from their neighborhood McDonald's), meaning mom and pop shops, or local businesses, as Yelp likes to call them, contribute the lion's share of revenue. The most recent earnings release shows that local businesses account for 86% of Yelp's revenue. This is a major flaw in Yelp's business model because price sensitive mom and pops don't have near the advertising budgets of larger chains and are more prone to going out of business, or terminating an advertising contract for budget reasons. Yelp can't rely on large, stable customers giving them lucrative long term contracts. Instead, it must acquire each individual customer, typically a one off. A Yelp salesman must go to each store and pick them off one-by-one, implying a high acquisition cost. Indeed, we see in 2011 that 1 dollar of sales/marketing resulted in 1.60 dollars of additional revenue. In 2012 and Q1-13 the ratio stayed exactly the same.

(click to enlarge)

This high acquisition cost would be understandable for a company in its incubation period, but Yelp has been operating for ten years and has yet to see positive economies of scale. There is no reason to believe that Yelp will ever experience economies of scale given the high acquisition cost and highly volatile nature of Yelp's customer base.

Compounding the issue is the fact that Yelp doesn't provide a substantial value proposition to build a solid revenue base. For businesses, Yelp's value is in its reviews. Positive reviews generate interest in the business while negative reviews hurt the business. Certainly having your company appear near the top of a search list helps, but in the end it is the reviews that drive customers to a business. The point here is that Yelp's value proposition is in its reviews, not paid advertising, the problem of course being that a business gets reviews on Yelp for free. Businesses getting the majority of Yelp's value for free illustrates the weakness in Yelp's future revenue potential. Reviews bring up another issue that should be noted. As stated previously, the reviews are the value driver of Yelp. Unfortunately, user generated review growth began decelerating at the end of Q4-11 and has continued through Q4-12. The following chart shows the deceleration over the last five quarters:

(click to enlarge)

The main value driver of Yelp has already started its deceleration process, further diminishing the future value of Yelp.

2. Yelp has already established itself in the premium markets, and its service clearly has substantially more value in a city like New York than in an Indianapolis. Indianapolis, as opposed to NY, has far less need for Yelp for a number of reasons. First, there is less population turnover. Someone who has lived in a city for several years has less of a need for Yelp's services than someone who moves into a new city. Likewise, someone who has lived in one place for a while has established eating and shopping habits and is less likely to seek a new restaurant on Yelp. Second, the area is more spread out, meaning less dining options around an individual, meaning less need for a Yelp type service. If I only have three Mexican restaurants in my city (think Salt Lake City) I have likely tried most of them or at least heard of them, so why do I need to research Mexican restaurants on Yelp? Third, the income per person is lower than a NY or SF, implying Yelp users in an Indianapolis are less attractive to advertisers. This is evidenced by the revenue/unique visitor metric, which in 2011 was around one dollar and remained the same in 2012, and then decreased in Q1-13 in spite of the more established cohorts increasing efficiency as they reach maturity.

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This chart represents cohort data from the 2012 10K:

Year-Over-Year

Year-Over-Year

Average

Growth in

Average Local

Growth in

Number

Cumulative

Average

Advertising

Average Local

of Yelp

Reviews

Cumulative

Revenue

Advertising

U.S. Market Cohort

Markets(1)

in 2012(2)

Reviews(3)

in 2012(4)

Revenue(5)

2005 - 2006

6

2,683

37%

9,316

59%

2007 - 2008

14

561

42%

2,082

86%

2009 - 2010

18

164

65%

397

177%

Here we see just how much more valuable those premium markets are to Yelp. The NY, SF, cohort cities (2005-2006) generate 4x as much revenue as the San Diego, San Jose, cohort cities (2007-2008). Additionally, the San Jose, San Diego cohort cities generate 6x the newest cohort cities (2009-2010). Certainly some of this discrepancy is due to the maturation of the oldest cohort, but maturation can't explain this large of a discrepancy. The most recent earnings release reiterated this point, with the first cohort accounting for half of their local ad revenue and the newest cohort accounting for 1/10 of the first. The lack of valuable undeveloped markets further shows that Yelp's future growth opportunities are limited.

3. Yelp faces asymmetrical supply-demand. There is essentially unlimited competition for advertising revenue. Comparatively, the marginal cost of adding an advertiser is close to zero for most internet advertisers, meaning companies can and will lower prices to attract marginal advertising. In contrast, mom and pops are extremely price sensitive. More often than not, they choose the cheaper of two options unless there is a significant value proposition, which Yelp doesn't offer (generally speaking, many Yelp customers are actually dissatisfied with the website. Just look at Yelp's reviews on… Yelp). Yelp doesn't have the ability to command a premium for advertising space, implying, again, compressed margins and limited growth opportunity. Extremely successful growth companies have a significant value proposition that others can't replicate. Think Microsoft Windows, Intel's microchip, Apple's I-phone, Facebook, etc… These products were revolutionary and couldn't/can't be duplicated, which explains their incredible growth. Yelp doesn't offer a significantly differentiated product with significant value added. It is just another online advertiser among thousands of others. If anything, as it has already shown, Yelp will experience tight margins akin to a commodity or utility company.

4. Unique visitor growth is decelerating. Unique visitors, by definition, drive advertising revenue. No one would want to advertise on Yelp if people didn't visit the website. If unique visitor growth decelerates, then it stands to reason that advertising revenue decelerates with it, perhaps not immediately, but certainly over time. From Q4-11 to Q1-12, average monthly unique visitors grew by 8.5%. Q1-12 to Q2-12, it grew 9.6%. Q2-12 to Q3-12, growth was 6.6%. Lastly, in Q3-12 to Q4-12 it grew 3%. This is clearly not the high growth company we are pitched by Wall St. analysts.

(click to enlarge)

As a note, these numbers and the chart exclude the most recent quarter unique visitors for a very good reason. Unique visitors jumped to 102mm, according to Yelp. This represents an 18% jump from the previous quarter. An 18% jump is just too hard to believe when the trend is so clear from the above statistics. When asked about the drivers of this incredible jump during the recent earnings call, management simply said, "We don't know of anything in particular that caused the acceleration." I'll go ahead and speculate for the management on what event could cause this increase: Q4-12 was the release of Yelp's mobile app. Over 30% of Yelp's traffic came from this app in Q1-13 and my speculation is that Yelp is double-counting users due to the mobile app. For instance, a user who typically uses Yelp on their computer begins using the mobile app. Say in January they visit it on the PC. They visit Yelp again on the PC in February. This is only one unique visitor, but as soon as they visit Yelp on their phone they become two unique visitors. This is just speculation, but I believe that the unique visitor growth isn't reflecting 18% more people visiting the website, just some visiting on the PC and mobile app. The lack of cumulative reviews acceleration suggests the unique visitor growth isn't meaningful as well. I'm not accusing Yelp's management of being outright liars; they very well could believe they miraculously achieved 18% visitor growth without a reason. But I am saying this metric is misleading and should have been qualified by management.

The argument could be made that unique visitor growth is not necessary to drive revenue growth. Yelp could become more efficient, expand margins, maintain a loyal customer base, and generally become more profitable. Unfortunately, the preceding points in this thesis make it fairly clear that the opposite will happen - margins will compress further, there will continue to be customer churn, Yelp won't be able to command a premium for their service, etc… The numbers also disprove the notion. The stagnant revenue to sales expense and revenue to unique visitor metrics show a lack of scaling efficiencies in Yelp's business. Yelp has also operated at a significant EPS loss for its entire existence, so it's tough to see how it could transform into a cash cow. The following chart shows Yelp's GAAP EPS for each of the last five quarters.

(click to enlarge)

Q1-13 Earnings:

The most recent earnings release and subsequent short squeeze might have some worried that they are catching the proverbial "falling knife" by going short. This shouldn't be the case because, as I'll demonstrate, the most recent earnings release is nothing extraordinary and doesn't refute any of the arguments previously made in this thesis.

The reason the stock price has rapidly risen the past day or two is purely due to a short squeeze. The revenue growth was admittedly solid, but not outstanding. From Q4-12 to Q1-13, revenue growth was 12%, which is actually lower than the 13% from Q3-12 to Q4-12, and substantially lower than the 19% from Q1-12 to Q2-12.

(click to enlarge)

This 5mm in revenue growth was, of course, accompanied by a 3mm increase in sales and marketing. Indeed, all operating margins saw little improvement when common sized against revenue.

Op. Expense

Q4-12 Expense as % of Revenue

Q1-13 Expense as % of Revenue

COGS

7.30%

7.25%

Sales and Marketing

61.98%

61.16%

Product Dev.

15.17%

15.70%

General and Admin.

19.08%

19.01%

Depreciation

5.88%

5.38%

Restructuring

3.07%

1.46%

Again, where is the scalability of this business model if revenue growth has a near 1.5:1 relationship with sales and marketing growth, and no meaningful margin improvements anywhere else?

Mobile App and International Growth:

There is currently a lot of hype regarding the mobile app and international opportunities as big growth catalysts. I just have two quick comments on this. First, mobile app usage is necessarily bad for Yelp. Internet advertisers are struggling to figure out how to monetize mobile apps (Facebook, anyone?), so if anything, increased mobile app usage just further devalues Yelp. Second, international growth having a meaningful impact on earnings is a dream. Sure, they might be able to generate revenue growth through international expansion, but the fact is that Yelp's revenue growth is only due to increased expenses and not because of scalability. If anything, expenses will only be greater in international markets and Yelp will see less return on investment than in the US/Canada.

Valuation:

Trying to come up with a precise number on what a company like Yelp is worth is near impossible, so I won't try. If Yelp does ever become profitable, I believe the argument I've made refutes the idea that it is a high growth company worthy of its insane 12.3x price to sales multiple. To put this multiple in perspective, using the 2012 year end revenue, if Yelp increased revenue 15% every quarter for three years it would still trade at a 4x price to sales multiple. Considering the dearth of growth opportunity available to Yelp, I wouldn't take that bet. This is likely a mute point though considering Yelp will probably not achieve profitability due to the high acquisition costs and customer churn.

Here is what I consider the most bullish scenario for Yelp: They realize there is limited growth with their current business model and decide to focus on their established cohorts. They start to see a loyal customer base develop (not likely because of reasons mentioned previously), become more efficient operationally, and are able to cut back on sales and marketing (very unlikely due to the low quality of Yelp's cash stream and constant need for new customers). In this scenario, a decent comparison of value would be HomeAdvisor.com.

HomeAdvisor is certainly not a perfect comparison, for obvious reasons (HomeAdvisor is more of a niche and Yelp has much more scope being the biggest difference), but they have similar business models (both are free review sites that attract business advertising). In any case, it gives us some idea of what Yelp should be worth in a best case scenario. HomeAdvisors's valuation can actually be found in a Citron report on Angie's List (NASDAQ:ANGI). HomeAdvisors.com is valued at 280mm by Goldman Sachs (NYSE:GS) and 320mm by Deutsche Bank (NYSE:DB). I should also mention that HomeAdvisors.com is actually profitable, and it only commands a 7x EBITDA multiple. Since Yelp doesn't have positive EBITDA, a meaningful valuation still can't be created, but the fact that a comparable company that is generating profit is only valued at an average of 300mm just shows how ridiculous Yelp's 2b market cap is. If we postulate that Yelp can eventually achieve twice the EBITDA of HomeAdvisors, then it is still only worth 600mm, or around 10$/share. Again, this is an extremely rough back of the envelope calculation, but it shows how outlandish the 2b dollar valuation is.

Short term prospects/future catalysts:

Right now is about as perfect an opportunity to open a short position as you can get. The short squeeze has artificially increased the price to an unsustainable level in the very short term. Once things calm down and shorts stop covering, the stock is basically guaranteed at least a 5% drop.

Long term, the clear catalyst is a deceleration in top-line revenue growth. Internet companies like Yelp are purely valued by Wall Street based on revenue growth. If there is any deceleration in revenue growth, watch out below. I believe there will be a deceleration in Q2, or Q3 of this year because of the deceleration across Yelp's other meaningful metrics. At some point, the deterioration in the other metrics will be reflected in revenue growth. A more intangible catalyst is the Wall Street hype decreasing. As Yelp gets further away from its IPO date it becomes less and less of a growth story, the Wall Street hype will cool down in the coming months, putting further downward pressure on Yelp's price.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in YELP over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Can Yelp Live Up To Its 12X Sales Multiple?