Risk To Yelp’s $44 Valuation

In our previous note, we looked at the factors that will drive revenue growth at Yelp (NYSE:YELP). To recap, we are encouraged by the growth in Yelp’s business and have substantially increased our forecast for the number of active business accounts that Yelp can target, the number of unique visitors, as well as the revenues from deal businesses. Additionally, we believe that launch of advertising on a mobile platform will fuel the growth of the brand advertising division for the company as well. Despite the upgrade, our stock price estimate stands 30% below the current market price, which has more than tripled over the past year. In this article, we will discuss the factors that can negatively impact Yelp’s stock price in the future.

Check out our complete analysis of Yelp

Factors That Can Drag The Stock Price

Operating Expenses A Concern- The current market price implies a much higher growth than we presently forecast. However, the single most important factor that drives Yelp’s value after its revenue growth is the growth in its operating expenses. Yelp has had to incur high operating expenses to fuel its rapid expansion. Yelp’s operating expenses accounted for almost $170 million,  104% its overall revenues, in the first nine months of 2013. While the SG&A expense accounts for 76%, R&D expense accounts for 16% of the revenues. We expect SG&A costs to decline to around 43% of its revenue by the end of the forecast period. However, Yelp’s planned expansion spree can lead to an increase in SG&A expense as it will have to increase its marketing and operational costs to sustain the growth in new markets. If Yelp’s expenses were to increase by a lot more than what we currently expect, this would negatively impact the stock’s value meaningfully.

Expansion Plans To Weigh on Average Revenue Per Active Business- Average revenue per active local business (ARPALB) is one of the most important drivers in our valuation for Yelp’s locals ads business. According to Yelp, monetization rate of a city or region increases with time. While ARPALB was at $3,800 for regions where Yelp started offering services in 2005, it was $950 for regions where Yelp services started in 2010. ^[1] As Yelp introduces its services in new regions, we expect that this trend will negatively impact average revenue. Additionally, as Yelp expands internationally, the average revenue will decline further as local businesses in these markets tend to spend less on ads compared to their counter parts in the U.S. We expect average revenue for Yelp to decline from $2,730 in 2012 to $2,550 by the end of our forecast period.

Competition Can Challenge Yelp’s Growth– Our forecast is based on the assumption that Yelp will see reasonable success across its business lines and will be able to attract users in the new markets it enters. Although Yelp has first mover advantage in social local review services, other Internet giants can leverage their data, experience and money to launch similar services in the future. Companies such as Google (NASDAQ:GOOG) and Yahoo (NASDAQ:YHOO) have competing services such as Google Places and Yahoo! Local. There’s always the risk that these companies can expand and leverage their existing base to compete with Yelp. If this were to materialize, Yelp’s revenue growth can slowdown. This could hurt the stock as the high price to sales-per-share ratio (a bit over 20x) suggests that the market is mainly pricing Yelps’s stock on high expected revenue growth. The P/E ratio is less meaningful as the company is only now generating positive EPS.

Our price estimate for Yelp stands at $44.44, which is 30% below its current the market price. We invite the reader to adjust the model and create his or her own alternative valuation.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. Yelp Q3 2013 Investor Presentation [↩]