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Is YELP's Mobile Growth at Risk?

Last week, Yelp, Inc. (NYSE:YELP) posted an impressive second quarter 2013 earnings report showing year over year revenue growth of 69% to $55 million with adjusted EBITDA of $7.8 million. Average monthly unique visitors grew 38% year over year to 108 million and active local business accounts grew 62% to approximately 51,400.

Yelp is a website founded in 2004 that connects people with local businesses. Yelp considers itself "the leading local guide for real word-of-mouth on everything from boutiques and mechanics to restaurants and dentists." This word-of-mouth content is provided by users (affectionately referred to as Yelpers by Yelp management) who have written more than 42.5 million local reviews on various businesses providing valuable marketing services to thousands of businesses.

Since Yelp's earnings report on July 31, the stock has soared 36% ($41.80 to last Friday's close of $57.02). This two-day gain increases Yelp's year to date stock performance to +302% ($18.85 to $57.02) making it one of the hottest stock performers in the market for 2013.

These gains are impressive and the company is guiding for their growth to sustain itself for the full year of 2013. Yelp also raised full year revenue guidance to $224 million, representing 62% year over year growth on adjusted EBITDA of $28 million.

Based on this performance, Yelp is beginning to catch the attention of financial market news heavyweights like Jim Cramer of CNBC. In a show last week highlighting Yelp, he speculated that Apple (NASDAQ:AAPL) should consider buying Yelp for $75/share to enhance its social and mobile strategy.

For investors holding positions in Yelp this year and over the most recent trading days, congratulations on your stellar gains. With the recent news of Yelp's growth, many opportunistic investors will likely join you as new Yelp shareholders in hopes that Jim Cramer's $75/share buyout valuation prediction does come true.

But there is another facet of the Yelp story that investors may not be aware of yet. If you were doing responsible due diligence of reading the company's most recent 10-Q quarterly financial filing (August 2, 2013), you would not know this fact. If you were reading Yelp's official press releases, you would not know of this fact. And, if you listened to the company's most recent earnings conference call (July 31, 2013), you would not know of this fact.

Therefore, this article seeks to share a relatively unknown and hugely important fact, which could potentially impact the future earnings power of Yelp in one of its fastest growing segments, mobile advertising.

Patent Infringement Lawsuit Filed Against YELP by Blue Calypso

On October 17, 2012, Yelp was named in a complaint filed by Blue Calypso Inc. (OTCQB:BCYP) in the U.S. District Court for the Eastern District of Texas for allegedly infringing on two of its patents (7,664,516 and 8,155,679). The patents cover Blue Calypso's proprietary system for peer-to-peer advertising on mobile devices.

Not only is Blue Calypso confident that Yelp's mobile growth is fueled by their patented technology, they have also filed nearly identical patent infringement suits against social marketing heavyweights Groupon, Inc. (NASDAQ:GRPN), Living Social, IZEA (OTCQB:IZEA), MyLikes, and Foursquare.

If Blue Calypso's complaint has merit, its intellectual property may very well be driving the highest growth segment of Yelp's operations - the increasing use of mobile devices for searches and ad revenue. Yelp mobile now represents 40% of their ad sales and approximately 59% of all Yelp searches were on mobile devices.

Recent Development Negatively Impacting YELP

Since October 2012, the cases have slowly worked their way through the U.S. District Court. But the last two weeks have seen major developments adversely impacting defendants like Yelp.

In an unexpected order (available at pacer.gov) by U.S. District Court Judge Michael Schneider on July 19, 2013, the court consolidated all five defendants (Groupon, IZEA, Yelp, Foursquare, MyLikes) into the one lead case, "Blue Calypso, Inc. v. Groupon, Inc." for all pretrial purposes, including discovery and claim construction. Therefore, instead of having five separate cases, he ordered one lead case with Blue Calypso as the plaintiff against the five defendants. This is good news for Blue Calypso and bad news for the defendants including Yelp. With this order, the judge ruled that all motions filed prior to consolidation (July 19) must be refiled in the lead case to be considered by the court. In short, the judge closed Yelp's existing, nine-month-old case and all the work filed to date and added Yelp to the existing lead case titled "Blue Calypso, Inc. v. Groupon, Inc."

Therefore, Yelp (and the other defendants) must now basically start from scratch in their effort to defend against the patent infringement suit brought by Blue Calypso. While this may just seem like an unwelcome delay and costly inconvenience for Yelp as they refile what had been previously filed, what they are now facing regarding the plaintiff is quite different. In this case reset, Yelp must now deal with the reality that they are now battling against a much stronger plaintiff (Blue Calypso) than they argued against in their initial filings for two reasons.

Blue Calypso's Strengthened Position As Plaintiff

First, over the last 90 days, Blue Calypso has received three new patents (Patent numbers 8,438,055; 8,452,646; 8,457,670) to further solidify their case of patent infringement. With this new firepower in their arsenal, Blue Calypso amended and strengthened their 2012-filed initial complaints against Yelp and the other four defendants on June 13, 2013. Now that the judge has consolidated the cases, defendants must now determine whether they will continue in court against a much stronger plaintiff or settle with Blue Calypso.

Secondly, the major news of last week was that the first of the five defendants, MyLikes, decided to settle with Blue Calypso instead of proceeding with this case post-consolidation order and post the issuance of Blue Calypso's three new patents. In the settlement announced on July 25, 2013, MyLikes has agreed to pay Blue Calypso the equivalent of a 3.5% royalty for the use of Blue Calypso patents.

Blue Calypso CEO Bill Ogle said in the settlement announcement,

"We are pleased to have reached an agreement that provides MyLikes access to our patent portfolio. This settlement demonstrates the strength of Blue Calypso's intellectual property and enables us to focus on future product innovations."

For background, MyLikes is a private company and considers its business "the largest content and social advertising platform in the world." Founded and run by two former Google stars (Bindu Reddy and Arvind Sundararajan), the company has attracted the funding and involvement of a team of highly respected angel and venture capital investors including Vinod Khosla (Khosla Ventures), Paul Buchheit (Gmail Creator), Joe Kraus, Georges Harik, Sanjeev Singh, David Hirsch, Metamorphic Ventures, XG Ventures, Deepchand Nishar and Aydin Senkut.

As a private company, public financial information on MyLikes is not available. But with their broad platform reach, top technical talent, and heavily funded advisors, MyLikes's royalty payments to Blue Calypso could become very valuable as the company continues to expand in this high growth market of word-of-mouth marketing.

With this strong, credible validation of the Blue Calypso patents, Yelp and the other defendants must assess anew whether to push ahead into a lengthy and costly litigation season with Blue Calypso or to settle out of court with a payment or a licensing deal.

Estimated Yelp Settlement Based on MyLikes Licensing Deal Metrics

Without annual revenue information for MyLikes, it is impossible to calculate the estimated value of their settled 3.5% royalty deal over the 13-year lifespan (valid until December 14, 2026) of Blue Calypso's patents.

But we can estimate a calculation of what a 3.5% royalty would cost Yelp over the course of 13 years based on their 2013 revenue guidance of $224 million (of which approximately 40% or $89 million will be from mobile ads). If we were to conservatively assume that Yelp would grow revenue at only a 10% annual rate over the next 13 years, mobile ad share of revenue would stay at 40%, and that Blue Calypso's patents are needed to generate Yelp's mobile ad revenue, a 3.5% royalty rate would cost Yelp approximately $84 million over 13 years in royalty payments.

Conclusion

While Yelp's recent earnings report has caused investors to bid up shares to reach +300% year to date gains, many have no idea of the risk involved in a relatively unknown, high stakes litigation battle, which could directly impact Yelp's robust, mobile growth.

The risk to Yelp shareholders if a settlement or royalty deal happens is that current and future revenue will be diminished based on the settlement terms with Blue Calypso until the patents expire in 2026. Conversely, Yelp may ultimately be successful in a jury trial verdict in fending off this patent infringement complaint. But, the cost and distraction of litigation over the next 18 months will come at a price to Yelp's bottom line and performance. The key Markman Hearing is scheduled for February 5, 2014, and the pretrial conference is scheduled for October 6, 2014, setting the stage for a jury trial in Q4 2014.

We will have to wait and see what Yelp decides to do - mitigate the risk of a jury trial by negotiating a settlement with Blue Calypso following fellow defendant MyLikes calculated decision last week or let the jury decide their fate. We do know that Yelp has a history of settling out of court for cash awards in previous suits against them as recently evidenced by a March 2011 suit by former employees, which resulted in a cash award of approximately $800,000 paid by Yelp to the plaintiffs in the first quarter of 2013.

Going forward, I would caution investors to not expect a play by play via press releases from Yelp's Investor Relations department. The best place to watch the legal action as it happens is by following the flow of court business via pacer.gov by referencing "cause number 6:12-cv-486, Blue Calypso, Inc. v. Groupon, Inc."

I am of strong conviction that MyLikes is likely not the first and only defendant to settle out of court with Blue Calypso instead of pressing their luck with individual jury awards for damages that could reach $84 million (in the case of Yelp) and likely much more with the largest defendant, Groupon, based on their annual revenue of over $2 billion, or 10X that of Yelp.

Disclosure: I am long OTCQB:BCYP. 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: Is Yelp's Mobile Growth At Risk?