Like the majority of media players, Yelp (NYSE:YELP) has been hit hard by the Covid-19 pandemic. A well-known name in the digital advertising space, the stock has lost over 40% of its market value YTD (year-to-date). At a P/S (price-to-sales) multiple of 1.54x and a P/B (price-to-book) multiple of 1.78x, the stock definitely appears cheap.
However, there is a good enough reason why this advertising business is going down, despite the company's solid reputation and relatively strong balance sheet. And, as the pandemic continues, Yelp's core business will most likely suffer even more. Considering the underlying uncertainties and high level of risk, I contend that it is best to avoid Yelp in 2020.
Company overview
Founded in 2004 by Russel Simmons and Jeremy Stoppelman, Yelp works by creating a directory of local and chain businesses and then connecting these businesses to consumers. The company offers free and premium services to the listed businesses. In the case of fully paid membership, businesses are charged a fixed amount per month based on the number of impressions. The ad-model is similar to that of Google, where paid members are listed at the top of the search functionality.
U.S. recovery seems to be stuttering and Yelp is bound to feel the pain
The success of any advertising business is mainly associated with the level of overall economic activity and Yelp is no different.
The company had highlighted signs of recovery in its second quarter earnings call and reiterated the various efforts it has put in to recover business in its recent local economic impact report.
However, things are far from rosy and are in fact not even trending in the right direction. Covid-19 cases are rising and the U.S. labor market is slowing noticeably. Subsequently, demand for the majority of services remains lackluster.
The story presented in Yelp's local economic report is also not very different.
Business closures in the restaurant and retail sector have taken a turn for the worse.
Although the company has highlighted the resilience of its home and local services, this category is not large enough to offset the business losses in other categories.
We were told that the restaurant business and especially dine-in would recover significantly not before 2021. However, the recent report highlights a more dire situation. Of the total restaurant closures, a whopping 61% are not expected to reopen at all. The number of permanent closures is also not far behind if we consider other major consumer discretionary businesses, considered to be major revenue drivers for Yelp. In the absence of any more fiscal funding, the small business environment in the U.S. is pretty dire.
Yelp's financial metrics will remain depressed until late 2021
Although Yelp's topline growth continued to grow quarter-over-quarter in 2019, the growth rate was nothing to get excited about.
And then, the Covid-19 pandemic has caused a dramatic 32% YoY revenue decline in the second quarter of fiscal 2020.
Analysts are expecting a steep revenue decline in fiscal 2020, and then a reversal in 2021. However, we can see that both revenues and EPS are expected to stay significantly below pre-Covid-19 levels even in fiscal 2021.
Other key metrics are also hinting at much deeper problems with the company's business model. Yelp's paying advertising locations, a substitute for paying advertising accounts, was down 31% YoY to 549K in the second quarter. While the company had expected this metric to recover in the third quarter, it seems quite difficult considering the overall macroeconomic conditions in the U.S.
High customer churn has been a key problem for the company since late 2017. At that time, the company made a dramatic change in the business model, from offering annual contracts to monthly contracts. Although this move led to a surge in total customers, the majority of these were not high-quality ones. Quite a number of customers prefer to opt for advertising only in strong seasons.
The company's focus on small businesses is a major challenge for customer retention, considering that only 66% of small businesses survive at least for two years even in normal times. But these are pandemic times. While Yelp has not provided churn numbers, it is clear that this metric must be pretty dire in today's difficult environment, considering that consumer retention was already a challenge in good times.
High churn implies that the company has to constantly add to its customer base to further grow. This requires a large sales force team. However, the company's focus on cost-cutting implies that it cannot expand its employee base rapidly. This will lead to a much slower recovery in the customer base in future quarters.
Ironically, Yelp is rated with just two stars on its own website, which reflects the kind of brand loyalty that the company is enjoying.
There have been some positives
Responding to the crisis, Yelp has been focusing on cost-cutting initiatives. The company managed to reduce its operating costs by $71 million in the second quarter of fiscal 2020. Hence, although revenues dropped by 32% YoY to $169 million, the company has reported positive adjusted EBITDA of $11 million.
Yelp has also increased its cash balance from $491 million at the end of the first quarter to $526 million at the end of the second quarter, mainly through positive operating cash flows and releasing restricted cash. The company has generated net operating cash flows worth $164 million and free cash flows of $129 million in the last 12 months. The total debt of $220.9 million is pretty manageable, considering ultra-low interest rates and more than sufficient cash balance.
I also see a slight possibility of some big competitors such as Alphabet (GOOG) (GOOGL) or Facebook (FB) acquiring this company in the near future. In that case, we may see share prices trending upward.
Verdict
Honestly, I do not see much upside in the stock at least until the end of 2021, considering the weak business environment and the very high possibility of prolonged U.S. economic recovery. Although the consensus target price is around $25.41, almost 29% higher than the last close, I find it pretty high.
For investors to start relying on this stock, it is absolutely essential for Yelp to demonstrate substantial signs of revenue and profitability improvements. Until then, it is best for retail investors to avoid this stock.
