I originally invested in online consumer review platform Yelp (YELP) back in October 2015. It’s been a wild ride since then, with the stock currently trading roughly 50% below where it was three months ago. I had not bought or sold any shares since my initial purchase, which was essentially a tracking position. That changed a few weeks ago, when I more than doubled my position after the company reported fourth quarter results.
Yelp, founded in 2004, went public in March 2012 at $15 per share. On its first day of trading, the stock closed just shy of $25 per share, valuing the business at $1.5 billion.
The IPO almost never happened: Google – now Alphabet (GOOG) – and Yahoo! (YHOO) both made attempts to acquire the company around late 2009. Google was close to buying the company for about $600 million, according to Yelp COO Geoff Donaker (link). Yahoo! reportedly made an offer to buy Yelp for about $750 million around that same time, according to the New York Times (link). Both deals ultimately fell through, with the company going public two and a half years later.
Since the IPO, underlying growth at Yelp has been impressive. The important metrics are all multiples of what they were in 2012. Cumulative reviews on the platform will likely cross 100 million next quarter – an increase of more than 4x since the IPO. In addition to strong user growth and engagement, the company has also done a good job growing its customer base: the number of local advertising accounts has increased about 500% in less than four years, crossing 110,000.
Yelp primarily generates revenue by selling advertising to local businesses. As management has noted many times (and data from BIA/Kelsey show), these customers are still early in moving their ad spend online. This comment from the fourth quarter 2015 call is worth thinking about:
“Google and Facebook (FB) do come up, but in general, when [Yelp’s salespeople] hear Google and Facebook from a local advertiser, that’s a really good sign. That means that the local advertiser has already started to shift online, and it’s a great opportunity for us to talk with them about Yelp advertising. More often, frankly, we are dealing with prospects who don’t advertise online at all yet, and that’s a more difficult conversation because you are trying to get somebody effectively out of print to online, which is happening over time but is a more gradual process.”
Because a large percentage of customers require some assistance (and the company is reaching out to try and bring in new advertising customers), the business requires a large and growing team of salespeople. In 2010, Sales and Marketing expense was equal to 71% of revenues. This is the largest expense line at Yelp, followed (at that time) by General and Administrative expenses (24% of sales) and Product Development (14% of sales).
Management has set a long-term target that implies material operating leverage across the key expense lines (I adjust the guidance they provide by adding back stock-based compensation because it is a real expense). As an example, they believe G&A can be 8% to 11% of sales long term. Note that this expense line fell from about 24% of sales in 2010 to about 15% of sales in 2015.
Back to the largest expense line, Sales and Marketing, which accounted for 71% of sales in 2010. In the ensuing four years, Yelp reported material operating leverage: Sales and Marketing fell to 65% of sales in 2011, 62% in 2012, 57% in 2013 and 53% in 2014. Against long-term guidance, Yelp was moving swiftly toward management’s long-term goal on the largest expense line.
But businesses don’t move in a straight line. In 2015, Sales and Marketing expense increased by approximately 200 basis points to 55% of sales. This raises an important question: was 2015 a blip on the radar, or a sign of bigger issues at Yelp? Based on my research, I think it's likely to be a blip (although the pace of gains may slow materially from the 2011 to 2014 rate going forward).
As it relates to revenues, the days of 70% growth are gone. However, Yelp should be able to continue growing at a decent pace (well into the double digits) for some time. Depending on what you assume on margins, the valuation can get interesting. Using the low end of long-term guidance, the stock trades at a low-teens multiple of pretax normalized earnings. Obviously this statement is meaningless unless Yelp can actually hit this target long term.
Yelp isn’t alone in the space: It has competitors in Google and Facebook, among others, that bring a number of advantages to the table. Both companies have an interest in encroaching on Yelp’s space. But these interests are not new: Google has been trying to grab a foothold for at least five years (look at “Near Me Now,” launched back in January 2010 – here and here). In addition, Google has been soliciting ratings and reviews through Google Local for nearly a decade (the purchase of Zagat in 2011 was along this same goal). Facebook is still in the early stages of testing a service that many are calling the next Yelp killer.
Despite these attempts, Yelp has continued to grow its user base and reach. In the fight to be the go-to source for local consumer-generated reviews in the U.S., Yelp has held its own.
When Google attempted to buy Yelp in 2009, the company had annual revenues of less than $50 million, 10 million cumulative reviews on the platform and 10,000 active local business accounts. Since that time, each of those metrics has increased roughly tenfold.
Over that same period, the valuation for the business has roughly doubled. In the move from nearly $100 per share in early 2014 to less than $20 per share today, I think Mr. Maket has swung too far in the other direction. As always, I look forward to your thoughts.
