Sector Spotlight—Yelp on the Menu

One name in the Internet/social media space that often gets mentioned as a possible takeover target is Yelp (YELP), the provider of local business reviews via online and mobile. Since so many investors see Yelp as a buyout candidate, the stock has historically traded with an embedded deal premium.

But with the shares recently at $51.40, down sharply from the all-time high of $101.75 reached last March, Yelp’s valuation has come in enough that potential acquirers might take a second look.

I have always thought Yelp would be better as part of a larger consumer-focused tech company. The service has hidden value as a  “shadow” search player; if people are searching within the Yelp ecosystem for all types of reviews, they are not using traditional search engines.

It’s very easy for Yelp users to pop open the app on their mobile phones to search for local businesses, bypassing Google entirely. In the latest quarter, even 45% of all Yelp reviews written were posted from a smartphone or tablet.

Yelp’s positioning in local, mobile and search is precisely why Google (GOOGL) considers the company such a fierce competitor. The two rivals in 2009 actually engaged in buyout talks, but Yelp backed away when Google would not meet its price.

Yelp has already done a lot of the hard lifting needed to build up its user base and expand engagement. After launching in China and Hong Kong in the third quarter of 2014 (and in Japan earlier last year), Yelp is now in 29 countries and available in 16 languages.

Average monthly unique visitors in Q3 rose 19% year over year to 139 million, with average monthly mobile unique visitors expanding 46% to 73 million. International traffic advanced 40% to 30 million unique visitors on a monthly average basis.

Cumulative reviews on the platform in the latest quarter grew 41% to 67 million, with Yelp users in Q3 contributing 5.3 million reviews, the largest quarterly increase in company history.

More than 1.9 million local businesses worldwide have claimed their Yelp pages, up 40% from the year-ago level. A business “takes ownership” of its page (it’s free to do so) by filling in key information (such as hours and menus), adding photos, responding to customer reviews and even creating a Yelp Deal or mobile check-in offer to convert visitors to paying customers. For businesses, the whole idea is to use Yelp to engage with customers (and potential customers) in order to drive more revenue growth.

In Q3, the number of active local business accounts (those actually advertising on the Yelp platform) rose 51% to 86,200. Advertisers from quarter to quarter often leave and come back to Yelp (based on marketing budgets), so the company is constantly doing a balancing act between upgrading claimed local businesses to paying accounts and at the same time dealing with churn across the installed base.

A big reason for the stock’s pullback from the all-time high: deceleration during the past two quarters in the number of active local business accounts added. In Q2, 5,900 new accounts were brought on, down from 6,800 adds in the March quarter. While account growth in Q3 stepped up a bit to 6,300 adds, this still represented a slower overall pace

For a company that depends on a regular inflow of new clients because of constant advertiser churn, this growth slowdown in active local business additions has caused some concern. However, Yelp in Q3 still managed to deliver local ad revenue of $85.1 million (83% of total revenue), representing growth of 66%.

Management has explained that all quarterly sales quotas are based on ad revenue—not the number of new accounts brought on—and that all quotas are being met. Basically, Yelp has been able to increase average revenue per user (ARPU) despite seeing fewer-than-expected net new local additions.

Analysts at SunTrust Robinson Humphrey have pointed out that a deviation between active local business account additions and local ad revenue growth has occurred in the past (notably as recently as the second half of 2012) and eventually reverted back to more normal levels. According to the firm, growth in active local business accounts and local ad revenue growth “have a very similar trajectory (as they should), with local ad revenue growth showing a slightly better trajectory on account of modestly rising ARPU.”

A big focus for Yelp these days is what it calls “closing the loop” on its platform. This involves expanding its social media role beyond reviews to include reservations and transactions. Yelp wants to be seen as a marketplace where consumers can find the information they are looking for and then easily perform a transaction associated with the information.

In Q3 2013, Yelp bought SeatMe and then relaunched the restaurant reservation service. At the time of the deal, there were about 200 businesses accepting reservations via SeatMe; at the end of the most recent Q3, more than 5,000 businesses had signed up for the offering.

In total, consumers are now able to use the Yelp Platform to transact with more than 28,000 businesses, ranging from restaurants and hotels to resorts and spas. The company recently added Yelp Platform reservations and transactions to its analytics dashboard, enabling local businesses to see how many consumers are interacting with them via Yelp.

In Q3, gross margin was 94%. There is plenty of leverage in the operating model, as Yelp’s sales and marketing expenses represent 53% of revenue. With the large local ad opportunity ahead of it, Yelp in the latest quarter expanded its sales headcount by 52%. The company plans to continue to invest in sales and marketing to help build out the installed base of paid business accounts.

With Yelp’s market cap down to $3.7 billion, the stock trades at 9.8 times the 2014 consensus revenue estimate of $376 million and 6.9 times the 2015 consensus of $538 million (expected growth of just over 43%).

Last June, Priceline (PCLN) paid $2.6 billion in cash to acquire online restaurant reservation service OpenTable, representing a forward revenue multiple of 11.5. While Yelp these days may not be able to command that type of valuation, the company does represent an important strategic asset in social media (including the critical local component), with a solid user base and strong top-line growth. Any further weakness in the share price from here could really put Yelp into play.

 

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