Yelp: Room To Run

Summary

• Yelp is an intriguing investment based its strong revenue growth, solid balance sheet, large market opportunity and modest price-to-sales ratio.
• Fears of slowing growth resulted in a bumpy 2016 and an opportunity for investors to pick up an attractive company at an appealing price.
• The growing self-service channel and improving sales productivity could prove a catalyst to propel the stock higher.
• My scenario-weighted valuation with fair value in the range of $50-56 per share represents a sizable margin of safety to Yelp’s current $40 share price for a patient investor.

Yelp (NYSE:YELP) has had a rough couple of years, peaking at $97 per share in 2014 before bottoming near $15 per share in Feb 2016. Management missteps, changing strategies and the absence of any operating leverage led to the decline. However, company strategy has sharpened and the market opportunity remains large. Even after an impressive rally in the back half of 2016, the stock has room to run based on its very modest valuation.

In 2016, the company has brought the focus back to its core: connecting people to great local businesses in the US and Canada. It is doing this by increasing engagement of consumers and businesses on the platform and expanding its transactions functionality. Additionally, since bringing Lanny Baker onto the management team as CFO in April, the company has showed impressive margin improvement while continuing to scale its business.

Company Strategy:

Yelp's strategy is to grow its communities and users within those communities, while increasing consumer engagement and enhancing monetization by attracting more local businesses to promote themselves on its platform.

While Yelp has a presence in more than 30 countries, the company recently announced it is ceasing all international sales activity to focus its efforts at growing its business in the US and Canada. These international markets represented less than 1% of Yelp's revenue, but a much larger percentage of spend.

At the end of Q3 2016, Yelp had 115 million cumulative reviews on its platform, (up 30% from Q3 2015) and 25 million unique app devices (up 24% from Q3 2015). While Yelp content also can be accessed through the desktop and mobile web, traffic via its app is growing the fastest and offers the lowest traffic acquisition cost. Additionally, the company asserts that app users view more than 10 times as many pages as website users. In Q3 2016, 74% of searches and 65% of ad clicks came from mobile (the company does not break this out between mobile web and mobile app).

Market Opportunity:

Yelp estimates that US local ad spend will be $151 billion in 2016 (as a comparison, BIA Kelsey estimates 2017 local US ad spend at $148.8 billion). Of that $151 billion, it estimates online and mobile spend to be $24 billion and growing. Local businesses are still spending $72 billion on direct mail, newspapers, yellow pages and magazines. In the growing digital and mobile world, these legacy advertising channels for local businesses will shrink and shift to online and mobile advertising, which has a more targeted reach and often better ROI. With 2016 estimated sales of $709-713 million, Yelp has a tremendous opportunity to grow its revenues and market share.

Source: Yelp 3Q16 Investor Presentation

Yelp estimates that there are over 20 million local businesses in the US, most of which are already on its platform. At the end of Q3 2016, 3.2 million businesses were claimed by owners (up 28% from Q3 2015) and 135K had local advertising accounts with Yelp (up 30% from Q3 2015). Again, this represents an outsized opportunity for growth in the US.

Additionally, as the depth and scale of content grow on the platform, the platform will become more widely known, more relevant and attract new consumers. This will, in turn, increase the value to businesses of advertising on Yelp. Yelp still has an outsized opportunity to grow engagement and revenues in its existing communities. At the end of Q3 2016, reviews in its oldest communities (started in 2005-2006) grew by 25% YoY with revenue growing at 31% YoY.

Future Growth Opportunities:

New products and deeper penetration into categories outside the restaurant and shopping space will drive growth for years to come.

• Material penetration into categories outside of the restaurant and shopping space. The content on the Yelp platform is concentrated in the restaurant and shopping categories. While this can be viewed as a risk to growth, it is also a growth opportunity. The content base in these categories largely grew virally. It makes sense that these categories would grow the fastest, as consumers make many more spending decisions on shopping and restaurants than on home services, such as hiring a plumber or a tax accountant. While the home services review base may take longer to grow, it may represent an outsized revenue opportunity, with these businesses willing to spend more on advertising to drive leads. After all, the average job in the home services category has a much higher ticket value than a restaurant meal, making the leads more valuable. This is already illustrated in Yelp's revenue. In Q3 2016, the home services category comprised 13% of reviewed businesses, but 30% of Yelp's local advertising revenue.
• Get a Quote. This is a new feature that businesses can add to their profiles to allow consumers to request a quote. While this is a free feature for businesses to use on the platform, it has the potential to add a new advertising revenue stream. Once a consumer submits a quote request to a business, they are redirected to a page displaying similar businesses and asked if they would like to submit their quote request to another company. This is new advertising inventory available to sell to businesses that will want to be listed on this page. Ad clicks through this channel are likely to be very qualified or "hot" leads, making this advertising very valuable to both local businesses and Yelp alike.
• Food delivery. Food delivery is an area that can greatly expand Yelp's transaction revenue. In February 2015, Yelp purchased Eat24, a leading online food ordering service that was previously a partner on the Yelp platform. Eat24 has a standalone app but is also integrated into the Yelp platform, allowing consumers to place and pay for food delivery orders directly through Yelp. Yelp earns a commission on these sales and it increases user and business engagement on the platform.
• Yelp Deals. Also a relatively new product, but with potential for huge growth, Yelp Deals allows businesses to offer promotional and discounted deals directly on the Yelp platform. Yelp Deals is structured similar to the Groupon (GRPN) model. There is no upfront cost to businesses and Yelp earns revenue through a fee structure based on transaction volume. Yelp processes the consumer payments and remits to the businesses their share of the revenue.
• Nowait. Yelp has recently partnered with Nowait and has fully integrated its 3,200 restaurant locations into the Yelp platform. Restaurants that use Nowait allow users to see their current wait times and add their name to the wait list without being present. Users then receive a text message when their table is ready. Earlier this year, Yelp disclosed that it made an $8 million investment in Nowait. This partnership adds another valuable consumer feature to the Yelp platform and greatly increases the user reach for Nowait.
• Self-service sales channel. Yelp has been building out a self-service sales channel, which allows businesses a convenient way to purchase Yelp products without needing to speak with a sales representative. In Q3 2016, sales through the self-service channel more than doubled, materially impacting sales force productivity. Growth in this channel has the potential to greatly accelerate Yelp's margin expansion. As an example, SG&A, as a percent of sales, was 66.7% in Q3 2016, down from 72.4% in the same period the prior year.

Evaluation of Risks:

Yelp has several areas of risk that a thoughtful investor should consider.

• Competition. Yelp competes with many competitors, both online and offline. Offline competitors include companies that specialize in direct mail, yellow page listings, and advertising services in local newspapers, magazines, radio, and television. Online competitors include search engines such as Google (GOOG) (GOOGL), social media platforms such as Facebook (FB) and other review websites, such as TripAdvisor (TRIP) and Angie's List (ANGI).
• Reliance on internet search engines. While Yelp continues to grow its organic traffic through its mobile app, the company still relies on search engines to drive a large amount of traffic to its platform at low acquisition costs. Search display and rankings are largely out of Yelp's control and are subject to change by the search engine. Additionally, if a search engine came out with a product that directly competes with Yelp, it could prioritize search results to its own product. While not something baked into my base scenario, this is a real risk that could result in lower traffic growth or higher traffic acquisition costs.
• Failure to increase engagement. Particularly in the United Sates, there are few major geographic markets that Yelp has not already entered. Expansion into smaller markets may not yield the same growth it has experienced in larger markets. As a result, Yelp will need to grow and increase the engagement of users in existing markets in order to continue its growth rate.
• Pigeon hole effect. Yelp may struggle to grow its advertising business outside of the restaurant and shopping space if businesses and consumers perceive Yelp as primarily a restaurant and shopping review platform. Currently, 42% of the businesses on the Yelp platform that have been reviewed and 57% of cumulative reviews are in the restaurant or shopping categories. More on this later.
• Business cycle risk. Yelp is susceptible to business cycle risk as adverse economic conditions can negatively affect business advertising spend. Additionally, since Yelp primarily does business with small and medium-sized businesses that may have smaller advertising budgets, to begin with, economic downturns may have an outsized effect on its customer base. On the flip side, when consumer demand drops, qualified leads may become more valuable to certain businesses, which could increase the importance of advertising on Yelp's platform.
• Management and human capital risk. Yelp is a young company with a short operating history that has only recently begun monetizing the business. There is a risk that an inexperienced management team may not effectively manage the company's growth or efficiently integrate acquired companies or technologies into its platform and infrastructure. Additionally, the company relies on its ability to attract, develop and retain top talent. Competitors such as Google and Facebook compete for many of the same skill sets and may be more effective at attracting these top candidates.

Valuation:

First, from a balance sheet standpoint, Yelp is in a strong position. At the end of Q3 2016, the company had $432 million in cash and short-term investments compared to current liabilities of $80 million and no long-term debt. Additionally, the company has been organically funding its growth, allowing its cash position to remain steady or grow over the past several years.

Due to Yelp's strategy of aggressively growing revenues and market share in the US, the company currently does not report a profit. Since this makes traditional valuation metrics based on earnings problematic, I've valued Yelp on both a discounted free cash flow (FCF) and a price-to-sales multiple basis.

For the discounted FCF valuation, I used a forecast period through 2025 before making a continuing value assumption. I like to use a three-scenario forecast model, forecasting a base case, an optimistic case and a pessimistic case, which allows me a framework to understand how wide the potential distribution of outcomes may be. For the discount rate, I used the Capital Asset Pricing model to estimate the cost of equity. Below is a summary of the valuation and assumptions made:

Since the discounted cash flow approach requires a multitude of assumptions, some of which can be highly sensitive and compound on each other, I also used a price-to-sales multiple approach to estimate Yelp's value.

Price-to-sales multiples have been a key metric for investors to value and compare high-growth tech companies that do not yet report earnings. Yelp has a business model very similar to Google, Facebook and LinkedIn, all of which trade at much higher price-to-sales multiples even though Yelp exhibits a similar revenue growth rate. NOTE: LinkedIn was acquired by Microsoft (MSFT) in December 2016. LinkedIn's price-to-sales multiple reflects Microsoft's acquisition price.

For this valuation, I again used a three-scenario model. I valued the company based on my 2018 sales forecast before discounting back to present.

Both models yielded similar scenario-weighted results with a valuation between $50-56 per share. The FCF valuation came in slightly lower due primarily to a lower valuation in the pessimistic scenario.

The biggest risk to Yelp's value is significantly decelerating revenue growth, which is represented in my pessimistic scenarios. However, I believe my 20% probability weighting of this scenario is reasonable, as the large market opportunity and Yelp's incumbent position make near-term deceleration in local ad revenue less likely.

In short, I believe a Yelp investment at today's $40 share price represents a sufficient margin of safety for a patient investor. New products, underpenetrated categories and a large domestic market opportunity should continue to propel revenue growth at a high rate for years to come, while sales force productivity and SG&A leverage should lead to rapidly increasing free cash flow over the next decade.

Supporting Documents

1. Yelp_Valuation_Model.xlsx

Analyst’s Disclosure: I am/we are long YELP. 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.