Yelp (NYSE:YELP) is one of the internet stocks that show me that people never learn. In 1999, investors were buying up companies with no profits hand over fist. When the bubble ended up bursting, many investors got burned badly, and it took many investors many years to recover their losses. Yelp resembles those stocks people used to love so much during the tech bubble of the late 1990s. Every time there is a development regarding the company, the share price shoots up by another 10-15%. Currently, the company is valued at $3.7 billion even though it is actually worth far less than that. Here are the 5 reasons Yelp's valuation doesn't make sense.
Reason 1: the fundamentals don't look attractive at all. I understand that companies like Yelp should trade like a start-up company and investors shouldn't worry too much about fundamentals. Yet, I can't help but notice that the company has never been profitable and that its chances of being highly profitable in the future are slim. Every time Yelp is able to grow its revenues, it ends up growing its expenses at an even faster rate. Yelp has a large sales department and the company's revenue growth barely keeps up with expenses. For example, in 2009, Yelp generated $25.81 million in revenues, but it spent $22.58 on administration and sales, and another $3.24 million on research and development. Next year, Yelp's revenues jumped to $47.73 million whereas its operating expenses jumped to $57.24. In 2011, as the revenues grew to $83 million, operating expenses grew to $99 million. Last year, Yelp generated $137 million in revenues and spent $156 million to generate that revenue. Year to date, Yelp generated $101 million in revenues, but spent $106 million on operations. At some point, the company's revenues will have to grow a lot faster than its expenses do, but this has never happened in the company's history. Yelp currently trades for 14 times its expected revenues and infinity times its earnings (since it doesn't have positive earnings or positive operating income).
In order to justify today's valuation, Yelp would have to increase its net income to $350-360 million at some point in the future. Looking at the trends in the company's margins, it would have to generate at least $2 billion in revenues to achieve that, which would mean that the company would have to grow its revenues by more than 10 times while its expenses grow much slower than that. The analysts expect Yelp to report a loss this year, followed by earning $0.18 in 2014, $0.54 in 2015 and $1.16 in 2016. If the company earns 18 cents next year and grows its earnings by 100% every year until the end of the decade and we apply 15% discount rate, the discounted cash flow analysis values the company at $44.50 per share. Keep in mind that doubling its income every year for the next 6 years would be pretty tough for the company and 15% is a conservative discount rate for a stock as volatile as this one. Usually companies in start-up status get higher discount rates due to their volatility. After all, riskier stocks should be more rewarding, right?
Reason 2: There is constant dilution at Yelp. Since the company is not very profitable, it is generous about paying its employees with stock options. Ever since the company became a public company, its share count has been going up, and this trend isn't likely to stop anytime soon. Because Yelp isn't very profitable and its shares are very expensive, the company is not in a position to conduct any buybacks. Last year, when Yelp announced its IPO, there were 59.87 million outstanding shares. Next quarter, this number climbed to 61.19 million. In the third quarter of 2012, Yelp had 62.22 million outstanding shares, which rose further to 63.51 million in the fourth quarter. In the first quarter of this year, the number of outstanding Yelp shares increased to 64.29 million. In the last year, the number of outstanding Yelp shares increased by 4.42 million (7.4%). I expect the dilution to accelerate in the next few weeks because employees are more likely to exercise their options right after a strong rally. Does Yelp have a back-up plan in case dilution gets out of control? The company would have to be profitable in order to buy back shares or pay its employees more so that they don't have to rely on stock sales for a living. Then, Yelp's operating expenses would get even higher.
Reason 3: Competition is emerging pretty strongly. Up until now, Yelp grew with very little competition because the yellow book market has been shrinking for a while. Lately, two companies, namely Google (NASDAQ:GOOG) and Facebook (NASDAQ:FB) took a notice of the potential in the local businesses for advertisement purposes. Google bought Zagat and incorporated it into its Google Maps product. Now users can search for local businesses and rate them (or read the reviews on them) using Google Maps. This is a game changer for Yelp. Additionally, in the latest conference call, Facebook reported having pages for more than 18 million local businesses and the list is expected to grow rapidly as we move forward. There might be even more entrants to the market as Nokia's HERE, Groupon, Bing and Yahoo Maps will be looking to eat some slices from the local business pie. Once the competition intensifies, Yelp's growth prospects will be much more limited than they are right now.
Reason 4: Yelp's relationship with small businesses is deteriorating. Yelp has a lot of angry customers and they are pretty loud and clear about their anger. More than 700 small business owners have filed FTC complaints with Yelp over a variety of issues. Even in Yelp's on page, the company is rated as 3 stars, down from 4.2 stars last year. There are tens of news stories where local business owners claim that Yelp's sales people approach them with promises of
removing their negative reviews in exchange of buying advertisement from the company." The problem stems from Yelp's filter.
The company uses a special algorithm to filter out reviews that it considers to be unreal. The reviews that are seen to be "bad" by Yelp's algorithm are being sent to a separate section where they are not included in a local company's average score. There are problems with this though. Yelp doesn't explain what its algorithm is based on. In some cases, more than half of the reviews are filtered out. Many business owners claim that there is a pattern in what is being filtered, where positive reviews get filtered out if they refuse to buy advertisement from Yelp. This is a very serious accusation, and I am not capable of judging whether it is true or not; however, there are thousands of such stories on the internet, and regardless of whether the stories are true or not, they hurt Yelp's relationship with its biggest source of income, the small businesses. If a company collects its revenues from small businesses, it has to be in a good relationship with small businesses. Companies who have bad relationships with their customers don't stay in business for long. I am not saying Yelp's business model is scam; however, there seems to be a lot of bad apples in the company's sales force.
Reason 5: Yelp is likely to have legal troubles in the future. When thousands of small business owners are angry, not only will they take their advertisement money elsewhere, but also they will be tempted to take legal action against Yelp. Imagine a local restaurant with 10 reviews, 5 good and 5 bad reviews. What happens if Yelp filters out the 5 good reviews and leaves the restaurant with 5 bad reviews and a terrible rating to deal with? The restaurant will lose a lot of potential clients who look it up on Yelp. Many business owners claim and this is exactly what is happening at the moment, and this resulted in a lawsuit a while back. While the court decided that there wasn't enough evidence to prove that Yelp was:
extorting money from small businesses in exchange for filtering out negative reviews
however, there will be more lawsuits coming up in the near future as more small business owners feel like they are being hurt by Yelp's practices. In fact a law company is already collecting data from small business owners for its next lawsuit.
Some of the user comments on Yelp's own website are pretty strong and a large number of people claim that they were approached by Yale's sales people who saw changes in their business page after the encounter.
For example a small business owner from Vista, California posted:
For instance I had 25 reviews and 3 were shown [in my business' page] and the other ones (22 reviews) were filtered and I had 3 stars. Then after their sales guy called me and I blew him off, I have 1 star and [my page] only shows 1 bad review from 2011 (everything else is filtered out).
Here is a similar post from another small business owner in Santa Clemente:
I advertised on YELP, and after almost a year, I decided I could not afford to advertise with them anymore. All the reviews I had built up on my website mysteriously went into the FILTERED area. The one review which was sketchy is still up. The YELP people use YELP to manipulate business owners into paying them money in order to keep the good reviews up and this is just purely criminal. I have no problem answering back true Yelp reviews and keeping my business running well. However, since that time we have not received any good or bad reviews. In fact, people say they write them but they do not show up.
There are literally hundreds of similar comments which you can read by checking the link I provided. In Better Business Bureau's website, more than 1,000 similar complaints are listed against Yelp. Reportedly, the company responds all the complaints with a generic, "Our filter is an automated system and there is nothing we can do about it," response. Legally, Yelp can't be held responsible from the reviews that appear on its website, because each person is responsible for his or her postings. On the other hand, Yelp might be punishable if its sales representatives are found to approach people with promises of
removing negative reviews on their page in exchange of buying advertisement from them.
The case is difficult to prove, but if enough small business owners testify against Yelp, this might change things.
In conclusion, Yelp doesn't seem like a good bet right now, even though the stock is being pumped up to the moon. I don't suggest shorting the company either because of it's too dangerous to short hype.