Why Yelp is Only Worth $10

Yelp (NYSE:YELP) is one of the largest online business search, review and recommendation service, which enables consumers to access ratings and read reviews and opinions about local businesses like hotels, restaurants, salons, dentists and mechanics on their website. Local businesses are reviewed and rated by contributors. Yelp generates revenue mainly from local business advertising, display advertising and from additional services like Yelp deals, and deals with reservation services like OpenTable (NASDAQ:OPEN). It competes primarily with other online business review services like Google (NASDAQ:GOOG) Places, Yahoo (NASDAQ:YHOO) Local, Angie’s List, CityLocal and Gumtree; display advertising players like Google, Yahoo, Facebook and AOL (NYSE:AOL); and daily-deal sites like Groupon (NASDAQ:GRPN) and LivingSocial.

Check out our complete analysis of Yelp

We currently have a $10 Trefis price estimate for Yelp, which stands nearly 50% below its market price. Local advertising is its most valuable business, and accounts for around 54% of its overall value.

Yelp’s stock price reached a high of around $25 on IPO day, but crashed to $20 on the very next trading day. At $20, its implied valuation is around $1.25 billion, which means a price-to-sales ratio of more than 15. We don’t expect it to turn cash flow positive before 2013, which leads us to believe that Yelp’s business is worth much less — our Trefis price estimate for Yelp is around $10, implying a 50% downside from Yelp’s current market price.

Here’s why:

Local Advertising

Since Yelp’s biggest revenue source is local advertising, it has the greatest impact on its Trefis price estimate. Though local advertising revenue has almost tripled in the past 2 years to almost $60 million, we expect the revenue growth to slow down in the coming days, with a projected CAGR of around 24% throughout the forecast period.

Though Yelp will continue its expansion spree into new markets globally, its rate of expansion will be much slower than when it was just starting up, because of a much larger base. Yelp’s active local business accounts are expected to grow in lockstep with its expansion in additional markets, as it signs up more local businesses in them for its local advertising offerings. However, if it fails to gain traction in new markets outside the U.S., that could mean a direct hit to its local advertising revenue.

Additionally, as Yelp ventures out of the U.S., we expect its average revenue per business to show a decline, as businesses in developing economies generally spend much less on advertising than American businesses. The increasing competition in the online advertising space is also expected to weigh down on Yelp’s average ad revenue per business. We also expect the grim economic outlook in Europe and the U.S. to contribute to the decline in ad spending by businesses.

Display Advertising

Brand advertising is currently Yelp’s second largest source of revenue, accounting for around 18% of its revenue in 2011. Yelp’s online platform saw an average of around 58 million users every month, and we expect the count to shoot up to around 226 million by the end of the forecast period as Yelp starts offering more local business reviews. The growth in online visitors will be driven primarily by an increase in the number of consumers searching for local businesses online, in Yelp’s existing markets as well as the markets it plans to expand into. Our forecast is based on the assumption that Yelp will see reasonable success and be able to attract users in the new markets it enters, and there’s always the risk that it may not be able to.

We also expect its average advertising revenue per unique visitor to decline as it continues its expansion in markets outside the U.S., as well as the increasing competition in the display advertising market, where Yelp is relatively a very small player compared to giants like Facebook, Google, Yahoo etc.

Yelp Deals and Reservations

Despite tremendous competition in the daily deals space with juggernauts like Groupon and LivingSocial, we expect Yelp to significantly grow its revenue from deals and other services through the forecast period, reaching almost $70 million, almost 10 times its revenue in 2011. However, it will still be only a minor part of Yelp’s overall business, and wouldn’t justify such a high valuation by itself.

Operating Expenses

Most importantly, the single most important factor which drives Yelp’s value after its revenue growth is the growth in its operating expenses. Yelp’s operating expenses accounted for almost 95% of its overall revenues in 2011, with SG&A expenses accounting for 82% and R&D expenses accounting for 13%. We currently expect its SG&A costs to decline to around 50% of its revenue by the end of the forecast period, despite that fact that Yelp’s planned expansion spree will lead to increasing SG&A expenses, as Yelp will have to ramp up its marketing and operational costs to sustain its growth in new markets.

Our current forecast is a pretty optimistic one, and if Yelp is unable to control its clamp down on its expenses, it would mean a significant downside even from our current Trefis price estimate of $10.

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