Why Yelp’s Stock Is Overvalued After The Recent Rise

Since May, Yelp’s (NYSE:YELP) stock price has risen from $52 to over $81 in August, primarily driven by price revisions from Wall Street analysts and positive market sentiments. However, we believe the company’s stock is overvalued at the current market price as the company is currently expanding into geographies that will negatively impact the monetization rate of its core local ads business. In this article, we will explain the factors supporting our valuation of $60 and the risks that can hamper the company’s growth.

Check out our complete analysis of Yelp

Local Ads Business to Grow At Slower Pace

According to our estimates, the local ads business makes up over 80% of Yelp’s estimated value. The key drivers for this division are the average revenue per active local business account and the number of active local business accounts listed with Yelp. According to BIA/Kelsey, online local ad spending is expected to increase to $31.7 billion in 2014 and $52.7 billion in 2018. ^[1] The company has a total addressable market (TAM) of 76 million local businesses in the world, of which 53 million are present in the Americas and Europe. However, the number of active business, which pay for Yelp’s services, listed with the company is just a fraction of this market at 79,900 in Q2 2014. Furthermore, the number of claimed businesses, which have a listing with Yelp but do not pay for any of the premium services, stands at over 1.8 million. Considering that mature markets (regions where Yelp has been operational for more than five years) witness higher conversion rates from claimed businesses to active businesses, we expect strong growth in active business accounts. We expect that the base effect will limit the active business listing CAGR to 30%, and believe that the company can add at least 420,000 active business accounts by 2021.

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, the monetization rate of a city or region increases with time as more businesses sign up for premium services such as dedicated webpages and call to action to promote their products or services. The company’s ARPALB improved to $5,493 for regions where Yelp started offering services in 2005, and to $377 for regions where Yelp services started in 2010. ^[2] However, as Yelp introduces its services in new regions, we expect ARPALB to grow at a slower pace, as new regions such as Latin Americas have less spending power compared to the U.S., and fewer businesses in these regions are willing to pay for premium Yelp services. As a result, we expect that the blended ARPALB will grow at a slower rate.

Deals Revenue Might Fail To Materialize

Yelp’s Deal, Partnership and Other services (DPO) division has been slow to take off. Currently, Yelp generates revenue from this division through any transaction that might occur on its website. Yelp’s deals platform allows merchants to promote themselves, and offer discounted goods and services on a real-time basis to consumers directly on Yelp’s website and mobile app. Yelp charges a fee on Yelp Deals for acting as an agent in these transactions.

Yelp’s DPO division revenues grew by 32% from $7 million in 2011 to $12.3 million in 2013, primarily due to an increase in revenues from Yelp Deals and partnerships, as it forged partnerships with OpenTable and Orbitz. However, the pace of revenue growth has slowed down as the competition from daily deal service providers such as Groupon and LivingSocial increased.

Recently, Yelp launched new initiatives, such as the call to action and the delivery platform, to close the loop between discovering a business on Yelp and making a purchase from that business. We believe that the newly launched services will drive revenues at the DPO division going ahead. As users browse businesses, they can now place delivery orders with the businesses directly. This platform not only streamlines user experience with easy shopping on Yelp’s properties, but also supplements Yelp’s DPO revenues through the transaction fee that Yelp charges for any orders placed on its website. We estimate that the revenues for the DPO division will grow to $100 million by the end of our forecast period as Yelp’s delivery platform, product portfolio and transaction services gain traction. However, if revenues from these services were to increase at a slower rate to only $50 million by the end of our forecast period,  this will negatively impact market’s estimated stock price by at least 10%.

Competition to Impact Revenue Growth

Market 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 a 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 and there is always the risk of these companies expanding and leveraging their existing base to compete with Yelp. If this were to materialize, Yelp’s revenue growth could slow down. 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 Yelp’s stock on high expected revenue growth. The P/E ratio is less meaningful as the company is only now generating positive EPS.

Expansion To Impact Margins

The current market price implies a much higher growth rate 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 were almost $242 million, 103% its overall revenues, in 2013. While SG&A expenses account for 72%, R&D expense accounts for 16% of the revenues. We expect SG&A costs to decline to around 43% of revenue by the end of the forecast period. However, the company has expended its services to Latin America, with Chile being Yelp’s newest market. We believe that Yelp’s planned expansion spree may 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. This will reduce Yelp’s cash profits in the future.

Our price estimate for Yelp stands at $60, which is 25% below its current market price.

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1. U.S. Local Media Forecast, www.biakelsey.com [↩]
2. Yelp Q2 2014 Investor Presentation [↩]