Yelp (YELP), the local review website founded in 2004, has a market capitalization of approximately $1.35 billion. Following the well-publicized and successful IPO on March 2, 2012, the shares have maintained their valuation - unlike some other IPOs this year.
As is typical of primary offerings, the insiders and underwriters held the cards: they get to choose the price and time of the IPO. Further, and as is typical, they sold the shares at exorbitant prices to the lowly and uninformed capital holders. Warren Buffett made this point about IPOs in his 1992 letter to shareholders:
The new-issue market, on the other hand, is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of a public offering or in a negotiated transaction: It's rare you'll find x for 1/2x here. Indeed, in the case of common-stock offerings, selling shareholders are often motivated to unload only when they feel the market is overpaying.
As usual, it turns out those uninformed capital holders (and buyers of the IPO) were mutual funds and institutions:
(Source: Yahoo! Finance)
Anyway, in the case of Yelp, it is obvious that the IPO was overpriced. In fact, the IPO was purely a way to raise money for the company since it could not raise money for itself through operations. Notice that the cash from operations has only breached into the positive territory a few times:
And while the negative cash from operations figure is almost enough to make any investment in Yelp speculative by definition, the common stock has some additional limitations an investor ought to know about.
Class A verse Class B
The equity issued during the IPO was Yelp's "Class A" common stock - that is, the publicly traded common is "Class A."
A "Class A" share, as usual, has one vote per share. The "Class B" shares, on the other hand, have 10 votes per share. According to page 33 of Yelp's S-1, the "Class B" shares - owned by "founders, directors, executive officers and employee" - control approximately 98.7% of the voting power. That means that "Class A" is absolutely powerless:
[T]he dual class structure of our common stock has the effect of concentrating voting control with those stockholders who held our stock prior to this offering, including our founders, directors, executive officers and employees and their affiliates, and limiting your ability to influence corporate matters - Page 8, S-1/Amendment 4
If their poor operating performance - in a financial sense - cannot justify the share price, then this additional lack of power is a further insult to new Yelp shareholders.
Stock Based Compensation
Note also that they say that employees hold "Class B" shares. I mention this to point out that their share-based compensation practices are significant. Notice that the stock-based compensation figure (circled in red) is 4.8 times higher than the capital expenditure figure (in orange):
(Source: June 30 10-Q, page 4)
This suggests two things: (1) the share price at the grant date for the compensation was unduly high, relative to other expenses (check!) and (2) the company is relying heavily on stock based compensation - perhaps because they have some cash flow problems.
Unfortunately, recent transactions put the market price at about $22.00 a share - which means some person (or computer algorithm) is buying the shares at a price implying a market capitalization of about $1.346 billion:
$22.00 per share * 61,190,489 shares = $1,346,190,758
Because a financial figure in isolation has no meaning, we will shortly look at this compared with the company's other operating results. But first, let us look at some other operating statistics. To repeat, operating cash flow has been mostly negative:
Also, the net loss is getting worse and also the IPO was a massive share count injection.
When a company is making money, increases in shares outstanding drive down the net income per share. Conversely, when a company is losing money, additional shares outstanding will drive down the net loss per share. That is to say, that the losses, in absolute terms, are 3 times worse in the six-month period from January 2012 to June 2012 than it was in the period of January 2011 to June 2011. Of course, with the massive share dilution, the net loss per share has decreased year-over-year - not, however, due to improvements, but because of increases in the share count.
Perhaps it will be able to improve profit margins--and hence revenue growth justifies the current price?
Assuming that Yelp is on track to record about $120 million in revenue (which would be a significant improvement over last year) and considering they presently have approximately 61,190,489 shares outstanding:
$120,000,000 / 61,190,489 shares = $1.96 of revenue per share
Their hypothetical future price-to-sales ratio is, then, about 11. Put another way, if all of the revenue instantly became profit, the PE would be 11. But, of course, none of the revenue is profit (as it has been running losses). This is to say, having a positive profit margin will not, by itself, justify the current market valuation.
Perhaps, net losses as a percent of revenue have been falling?
Loss as a percent of revenue
Six months ended June 2011
Six months ended June 2012
An improvement, I suppose, but the difference is only 0.15 percent - hardly a meaningful indicator. I should also say that the main driver of the stock appears to be the revenue growth rate. Very well, let us put that in context.
Does the growth rate justify the share price?
Revenue is growing substantially:
(Source: June 30 10-Q, page 2)
But, unfortunately, the net loss is growing at a faster rate - at about 197% year-over-year:
(Source: June 30 10-Q, page 2)
This analysis might not be fair for various reasons. For instance, the share-based compensation (with a common stock that is overvalued relative to earnings) is a large non-cash charge against net income - hence the net income loss, in terms of cash flow, is less bad than the net income suggests.
Nevertheless, let us focus on the revenue growth of 66%. Let us assume (probably wrongly) that the company can achieve a free-cash-flow margin of 10%. Free-cash-flow margin is, of course, free-cash-flow divided by revenue.
|Year||Free-cash-flow1 Margin||Projected Revenue||Revenue Growth Rate|
Even with the assumption of a 10% free-cash-flow margin (unlikely) and with continued revenue growth of 66%, Yelp - if the share price does not change - wouldn't be "fair priced" till four or five years out. This is to say that it has to (1) maintain its growth for the current valuation to be sustained, but, more importantly, it (2) also has to improve its profit margins.
Some Miscellaneous Curiosities from the S-1:
- When Yelp counts its cumulative reviews, it still counts those reviews that were removed - sounds like a bad practice (S-1/Amendment 4, page 3).
- Yelp states that it has no plan in the foreseeable future to initiate a dividend: that is, purchasing Yelp is only about price appreciation (S-1/Amendment 4, page 71).
- About 10 months ago, the fair value of the common stock was estimated at about $11.40 per share. The techniques used to estimate fair value are extremely subjective (they have to be when you are not turning a profit), but are we to assume that Yelp shares have doubled in value within the last 10 months? See the fair value assumptions below:
(Source: S-1/Amendment 4, page 72)
There is no margin of safety with this stock - in effect, a buyer today is paying for a Herculean effort in the future. Even if it turns a profit, it will need to continue to grow revenue such that it enters into a normal valuation range. Historically, the company has negative net income, negative cash from operations, and deeply negative free cash flow. Yelp might be a good service, but it is a bad stock.
One other object of note, the lock-up period, which limited inside selling, ended last week. Now that the lock-up period is over, perhaps there will be additional pressure on the shares to the downside.
- For articles, Free-cash-flow = Operation Cash Flow - Capital Expenditures
- Capital expenditures, in this case, include both: (1) "Purchases of property, equipment, and software" and (2) "Capitalized website and software development costs."
- "Fair price," in this instance, is where the equities are priced near the average free-cash-flow yield of the DJIA: or approximately 7.35%. Free-cash-flow yield is equal to free-cash-flow dividend by market capitalization.