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Yelp Is Dirt Cheap At 400 Times Earnings

Feb. 06, 2015 2:48 PM ETYelp Inc. (YELP)3 Comments
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Summary

  • YELP reported strong fourth quarter earnings of 42 cents a share, boosted by a tax benefit.
  • Even after adjusting for this one time gain, YELP posted its third straight profitable quarter and adjusted full year net income of 14 cents.
  • While this currently equates to a scary sounding P/E ratio near 400, the stock actually looks cheap going forward.
  • As revenue growth continues to outpace expenses, YELP has the operating leverage to begin turning their 94% gross margins into earnings growth.

Restaurant review site Yelp (YELP) posted fourth quarter earnings that beat expectations, yet the stock has sold off on user growth concerns. I think this gives long term investors a good chance to buy the company cheaply before earnings growth really starts to kick in.

Fourth quarter earnings were a big headline number of 42 cents a share, but this included an income tax benefit that contributed 34 cents of this. Still, excluding this the 8 cents in EPS still beat expectations for the quarter, and while the recognition of the deferred tax asset valuation allowance is really only a bookkeeping detail, it does suggest that the company is becoming consistently profitable if they were able to release it.

Indeed, the company posted their first full year profit of 48 cents a share, or 14 cents of EPS after again adjusting for the tax benefit. This may not sound like much, especially with the stock trading at close to 400 times this, but the company only just became profitable and should enjoy rapid earnings growth going forward now that revenue growth is outpacing increases in expenses.

Revenue growth was again outstanding at 56% for the quarter and 62% for the year, resulting in $377.5M in sales for the year. Yelp also has ridiculously high 93% gross margins, as it's nice to have such a low cost of revenue when your users create your product for free. This means $351M in gross profit against only $341M in expenses to give over $10M in net income. Against 76M shares outstanding, this equates to the 14 cents in EPS.

Using this simplistic formula, we can come up with a spreadsheet to approximate Yelp's financial numbers for the next few years. Since gross margin has stayed relatively constant over the past few years, we just need to know the revenue growth and rate at which expenses will increase.

Yelp also issued guidance for 2015, including expected revenue growth of 43% for the full year, which seems fairly conservative since first quarter growth is supposed to come in at 51%. However, we will use this 43% for 2015 to remain conservative. Total operating expense increases have slowed steadily and usually come in at about 10% less than the revenue growth rate, but to again give ourselves a margin of safety we will cut this in half and use 5% less. When also factoring in a 5% increase in the number of shares outstanding, we get the following results:

Year Revenue Gross Margin Gross Profit Expenses Net Income Shares Outstanding EPS
2011 83,285.00 92.88% 77,354.00 93,525.00 -16,171.00 60,000.00 -0.27
2012 137,567.00 92.78% 127,639.00 146,404.00 -18,765.00 63,500.00 -0.30
2013 232,988.00 92.89% 216,427.00 225,250.00 -8,823.00 70,900.00 -0.12
2014 377,500.00 0.93 351,075.00 340,775.00 10,300.00 76,000.00 0.14
2015 539,825.00 0.93 502,037.25 470,269.50 31,767.75 79,800.00 0.40

Note that using these rates ends up with an EPS estimate for next year that is right in line with analyst estimates of 40 cents. This again does not seem like much against a stock price over 50, resulting in a triple digit P/E, but when we carry out the exercise over a longer time period Yelp's operating leverage becomes apparent.

Again being conservative and ratcheting the revenue growth rate down to 35% in subsequent years, against a 30% annual increase in expenses, we get the following:

Year Revenue Gross Margin Gross Profit Expenses Net Income Shares Outstanding EPS
2015 539,825.00 0.93 502,037.25 470,269.50 31,767.75 79,800.00 0.40
2016 728,763.75 0.93 677,750.29 611,350.35 66,399.94 83,790.00 0.79
2017 983,831.06 0.93 914,962.89 794,755.46 120,207.43 87,979.50 1.37
2018 1,328,171.93 0.93 1,235,199.90 1,033,182.09 202,017.81 92,378.48 2.19
2019 1,793,032.11 0.93 1,667,519.86 1,343,136.72 324,383.14 96,997.40 3.34
2020 2,420,593.35 0.93 2,251,151.82 1,746,077.73 505,074.08 101,847.27 4.96

Now we really start to see the earnings growth accelerate, with EPS nearly doubling the first year and increasing more than 10 fold in 5 years. Even if the stock price doubles between now and the end of 2020 for a 12% annual return, this would drive the P/E down to near 20, very reasonable for a company that is still growing earnings by nearly 50%.

Of course, revenue growth could slow more than expected, or expenses start to increase at a faster rate, so we can also conduct a sensitivity analysis at different rates of each. The following table presents the 2020 EPS estimates at various growth rate combinations:

Expense Growth Rate
20 25 30 35 40
25 3.55 0.95 -2.1 -5.66 -9.79
Revenue 30 6.81 4.21 1.16 -2.4 -6.53
Growth 35 10.61 8.01 4.96 1.4 -2.73
Rate 40 15.02 12.42 9.37 5.81 1.68
45 20.11 17.5 14.45 10.89 6.76

The risk-reward certainly seems to be skewed in favor of owning the stock, as long as the revenue growth rate stays ahead, or even just equals the rate at which expenses grow. Of course, if the rates did converge, investors probably wouldn't be too excited over the buck and change with a low earnings growth rate that would result, but taking these as downside cases at a 20-25 multiple would result in the stock being cut roughly in half.

However, it seems more likely that Yelp can maintain their revenue growth at a pace ahead of expenses as their platform matures and start up costs to move into new markets subside. These cases where revenue growth runs 10-15 percent ahead of cost increases could lead to double digit earnings per share by 2020.

The stock would likely command a premium multiple as well, and at 30 times earnings you'd be looking at a $300 stock, 6 times where it's currently trading. This may seem absurdly high, but this would still only give Yelp a market cap of $30B, about what Twitter is currently valued at, and I think Yelp's targeted advertising is much easier to monetize than that platform.

You can say that trying to extrapolate out so far into the future is at best an exercise in futility and at worst a fool's errand, but I just sought to run the numbers to demonstrate how Yelp might end up being cheap at today's price even though it might currently appear to be expensive at first glance.

If this thesis plays out then we should have plenty of time to buy the stock and enjoy the ride up as Yelp's earnings power becomes more apparent, but I think today's earnings related selloff offers an attractive entry point. The only reason the stock seems to be down after hours is that people are caught up on the fact that average monthly unique visitors only increased 13%.

I think short term investors are being a little myopic in just focusing on this single user growth number. While obviously the platform benefits from more users as it adds to the network effect, the more important thing financially is to begin monetizing these users. Mobile users, which were up more at 37%, are probably more relevant in this regard, since they are more likely to be out actively looking for a restaurant while using Yelp, making them the ideal audience to target.

Yelp has only just begun tapping into this by selling ads to restaurants, which I think will continue allocating a larger share of their advertising budgets to mobile platforms like Yelp, which offers the ultimate in targeting advertising: an ad for exactly what you're looking for at that very moment. Local business accounts rose 39% and advertising accounts rose even more, by 48%.

I love Yelp's business model where they benefit from the network effect of each additional user helping to create content while at the same time becoming a desirable captive audience to advertise to. Slowing user growth might be a temporary concern, but it's all about keeping users active and engaged, which I think the platform's functionality will continue to do, which will in turn attract a larger share of restaurants and businesses to begin advertising.

And now I think Yelp has demonstrated the profitability necessary to show that it will be a financial success as well. I will try to use any weakness in the stock tomorrow to try to accumulate shares in this great business, whose potential I think is dramatically underestimated at a market cap of $4B. I think the company may be a buyout candidate at this valuation since it would probably take more than this to replicate their network.

However, I would be against a buyout and more interested in owning it long term since I have demonstrated how much long term earnings power it could have, and would hate to see it stolen away from shareholders at only a slight premium before it can realize that potential.

Analyst's Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in YELP over the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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