When Yelp (YELP) was trading for $50, everybody was talking about how overvalued the company is, how the growth expectations don't really match-up with the high valuation and how a lot of future success was built in the company even though it as unjustified. Fast forward several months and Yelp is now trading at $78, even though there have been no changes to the fundamental story. Yelp continues to be one of these stocks getting pumped up by hype alone.
Currently Yelp has 70.3 million shares outstanding, which values the company at $5.5 billion. Each quarter, Yelp adds another 750,000 to 1 million shares to its total count due to stock based employee compensation and option awards getting exercised. As soon as the managers of the company are awarded new stock, they tend to drop their stock like a hot potato. For example, on December 30th, the CEO Jeremy Stoppelman exercised options to acquire 14,705 shares and he sold those shares on the very same day. If you look at all his trades in the last couple years, you'll realize that it is very rare that he holds Yelp stocks for more than one day. Whenever he's awarded new stock, he sells it pretty much immediately. They say that executives can sell shares for any reason and it shouldn't be a source of worry, which is something I agree with; however, it is fair to be concerned about the fact that the CEO of the company doesn't want to hold any shares of it and insider sales are increasing the dilution, making the company even more ridiculously overvalued.
Lately some analysts have been pumping the stock up with ridiculous price targets like $90 and above. JPMorgan's Kaizad Gotla seems to think that Yelp is worth $89 per share, while Dana Telsey of Telsey Advisory Group thinks that Yelp should trade for $95 per share. The ironic thing is that while analysts are continuing to increase their price targets, they are reducing their earnings estimates for the company. About 3 months ago, the average analyst saw Yelp earning 24 cents per share for the year of 2014, but now the average analyst sees it earning 19 cents per share. This is a reduction of 21%.
As per revenue, analysts see Yelp generating $347.62M in 2014. Even the most optimistic analysts see the company generate $368.32M while more pessimistic estimates go as low as $329.16M. Considering how Yelp is expected to generate $229.62 million in 2013, the average estimate represents a growth rate of 51.39% whereas the most optimistic estimate represents a growth rate of 60.40% and the most pessimistic estimate represents a growth rate of 43.34%. Considering how Yelp's growth rate in 2013 was 67% and how it was 75% for the previous 3 years; we can see a slowdown in Yelp's growth even in the most optimistic estimates.
Now there are two arguments Yelp bulls use to justify the company's ridiculously high valuation, which represents 415 times its forward earnings, 16 times its forward revenue and 28 times its book value. The first argument is that Yelp is expanding to more countries and that its growth will accelerate as a result of this expansion. Keep in mind that Yelp has failed to post a profit in its history even though it's been operating in the US, Canada and Western Europe where each visitor will bring far more revenue than in the rest of the world. For example, Facebook (FB) generates revenues of $4.85 per user in the US and Canada, compared to $1.96 in Europe, $0.81 in Asia and $0.67 in the rest of the world. Acquiring one member in the US is like acquiring 2.47 European members, 5.99 Asian members and 7.24 members from elsewhere in terms of revenues. If Yelp fails to make a profit on its American and Canadian users, how will it make a profit in the international markets where advertisement revenue is far less?
The second argument Yelp bulls use is that one of the big players such as Google (GOOG), Apple (AAPL) or Facebook will make an offer to acquire Yelp at a premium. This doesn't make sense in more than one ways. First, there is no reason for Google, Apple or Facebook to acquire Yelp. These companies can always integrate Yelp's reviews in their system without buying Yelp. In fact, Apple's iOS and Google's search engine already utilize Yelp reviews in many ways. These companies won't buy Yelp for financial reasons either because Yelp represents a very tiny revenue or income growth for these players, especially compared to its hefty price. Besides, if there was a possibility of Yelp getting acquired by one of the big players, the management of the company would have been well-aware of that. Would the management be selling every share they are awarded almost immediately if they saw Yelp getting acquired by a big name? They wouldn't. This tells me that even Yelp's management doesn't put much faith in such an acquisition.
Many analysts expect Yelp to grow into today's valuation in 10-15 years if everything goes perfectly. Here is the problem: when you are making projections that far ahead with very little certainty, you have to discount for the time value. For example, if a company is expected to grow to $20 billion of valuation in 10 years, we have to discount 10 years of appreciation from the company's current share value, because investors that put their money in a company today will be expecting to make money on their investment. Even if we expect Yelp's value to appreciate by 10% every year, it will reach a size of $14 billion in 10 years. If it's going to take Yelp 10-15 years to justify today's valuation of $5.5 billion; how long will it take it to grow into a size large enough to justify $14 billion in 10 years? If we discount for future appreciations and factor-in the ongoing dilution and slowing growth, it will take decades (if ever) before Yelp justifies today's valuation.
At this point, shorting Yelp is also dangerous because this stock gets pumped up by the market on any news or even in the absence of news. Many stocks were pumped up to ridiculous levels during the dot.com bubble of the late 1990s but sooner or later, valuations catch up with reality. People usually give Amazon (AMZN) as an example to justify high valuations of internet stocks; however, there are tens of examples that failed miserably for every Amazon. Companies like Amazon are not the rule, they are the exception.
Additional disclosure: I'm long both calls and puts of YELP for insurance purposes.