YouTube - Yelp's Greatest Threat

Aug.26.13 | About: Yelp (YELP)

Trading at more than 200 times FY 2014 consensus earnings estimates, you'd think there isn't a problem in sight for Yelp (NYSE:YELP). Yet, as detailed in a Fast Company article, angel investor Peter Shankman is betting Yelp will be out of business within 24 months. He cites two reasons: One, consumers are turning to more trusted sources for reviews, such as friends and family, online. Two, business are complaining Yelp is burying positive reviews of companies that don't advertise with them.

The latter allegations gained prominence recently when a town hall for business owners put on by Yelp went awry. At the event, the audience criticized Yelp for aggressive sales tactics and bogus reviews.

Many slammed the company for allowing reviewers to post inflammatory comments -- one restaurant manager said she cried for three days after a Yelper wrote that her restaurant was filled with Nazis. Others said they had been subjected to aggressive advertising calls from Yelp.

Vintage clothing shop owner Reiko Roberts said the advertising pressure amounted to extortion. She said that when she declined to buy ads, 'the lower reviews go to the top and the higher reviews go to the bottom.'

As this article highlights, a certain number of bogus reviews will always exist. Researchers at MIT and Northwestern found, for instance, that 5% of online reviews at a major retailer were written by people with no record of actually purchasing the items reviewed. And, of course, Yelp reviews don't always do an establishment justice, as shown in this article about three-Michelin-star restaurants getting one-star Yelp ratings.

The issue is important to small business owners because there is evidence that Yelp really does matter. As this Harvard study shows, Yelp ratings do have a material impact on independent restaurants. Yelp's ability to drive revenue to small business might at first seem very bullish for the company. But it's advertising that Yelp needs to drive revenue, not just reviews. And therein lies the problem. As the Harvard study shows, chain restaurants are not materially affected by Yelp reviews. So Yelp needs to depend on independents. But the very power of the rating system means that advertising in this case should be ineffective. If you are a small business with great reviews on Yelp, do you also need to advertise on Yelp? And if you have poor reviews on Yelp, do you want to help fund a site bashing your business?

In part, I believe it is this quandary that is fueling conspiracy theories of Yelp manipulating reviews based on whether or not businesses are advertising with Yelp. The thinking probably goes like this: The only real value Yelp has is its reviews, so review manipulation must be what Yelp is selling. But I believe the real long-term problem with Yelp's business model is Shankman's first point. There is evidence to suggest that Yelp reviews, once truly valuable, are losing some of their value. Yelp likes to compare itself to YouTube -- what YouTube is doing to television, Yelp is doing to the yellow pages. But new evidence suggests that what YouTube is doing to television, YouTube might also be doing to Yelp.

According to Zocalo Group's 2013 Recommendations Study, YouTube -- not Yelp -- is now the most credible source for online recommendations. A friend liking a brand page on Facebook (NASDAQ:FB) is second. Traditional online reviews like Yelp are third. Yelp claims to bring "word of mouth" online and is trying to position itself as a social media play. But clearly, reviews from YouTube and Facebook are more "word of mouth" and more "social media" than Yelp. Plainly, your friend's reviews on Facebook are more valuable than random, anonymous postings on Yelp. Yelp likes to trumpet "powerful network effects," but who has more powerful network effects: YouTube and Facebook? Or Yelp?

So, in Yelp we have an advertising business model that doesn't make sense that has been given a pass because of the truly useful reviews that Yelp used to generate, and the promise of increasing network effects. So what happens now that those reviews are quickly losing their relevance due to encroachment by two of the most disruptive companies of our generation -- Google (NASDAQ:GOOG) and Facebook?

Perhaps Shankman's pronouncement is just a publicity stunt, but we are seeing major insider selling at Yelp, and management's unwillingness to deal in the numbers is disconcerting. I'll give two examples. During the most recent earnings call, analyst Stephen Ju asked management about dropping ARPU (average revenue per user). The response from the CFO? "We don't really look at it that way." Likewise, when analyst Mark May asked management to comment on the fact that average reviews per unique visitor is not growing, the COO responded: "...a little bit like ARPU, that's certainly a ratio you can look at. It's not one we pay a lot of attention to internally."

Can Yelp keep going up? Sure. Trading at around 19 times revenue, Yelp stopped responding to fundamentals long ago. But don't call buying Yelp anything but speculation at this point. And now that YouTube and Facebook may be displacing Yelp reviews, it seems to be particularly dangerous speculation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.