- Yelp's revenue growth is a little difficult to predict due to conflicting data points.
- However, analyst estimates on sales still seem conservative, which reduces expectation risk.
- Furthermore, I believe there's a compelling deep value case, so investors should get aggressive prior to Q1'16 earnings.
Yelp (NYSE:YELP) certainly remains one of the more interesting internet plays due to its comparatively cheap valuation, limited penetration in developed markets, and ramping transaction growth (a true dark horse). That being the case, there are also limitations to the investment thesis given diminishing efficiency with sales reps, ramping costs, and near maxed out gross margins (90% gross margins in prior quarter). The stock tends to be extremely volatile following earnings announcements, as the stock fell by 9% following its Q4’15 report.
Despite the volatility, I believe concerns over margins/growth/valuation are already priced into the company creating an easier path to recovery. The company plans to increase investment into marketing from $30 million to $50 million, roughly a 66% increase, which draws similar parallels to Groupon (another company I cover). The increased marketing spend helps offset churn rates, as roughly 50% of its current ad-buyers don’t plan on buying ad units over the next 12-months, according to Morgan Stanley.
On the Q4’15 conference call Yelp stated, “Our customer repeat rate, defined as a percentage of existing customers from which we recognized revenue in the immediately preceding 12-month period, was 77% for the fourth quarter of 2015.” In 2014 (prior year), Morgan Stanley conducted the same survey and roughly 50% planned on not spending any additional money on Yelp’s ad products (same as 2015), but the churn turned out to be 22% as opposed to 50%. So, the survey responses by small business owners aren’t that reliable, which speaks of the uncertainty of SMBs (small medium businesses) in the current business environment given the high failure rates of first-year businesses in general. Roughly 20% to 30% of businesses close each year (estimates vary), but SBA statistics imply a 24.2% failure rate in the second year of a business. Therefore, a good chunk of Yelp’s churn is attributable to doors closing, which speaks of the dysfunction of start-ups as opposed to weak ad products.
Therefore, the company’s guidance figure of $154 million to $157 million sales for Q1’16 is inclusive of churn and new account additions. So, even with ramping marketing spend, it’s hard to determine whether Yelp will beat estimates. The consensus estimate for Q1’16 revenues is $155.56 million, and the company is expected to grow by 31.3% y/y. The consensus is at the middle of Yelp’s guidance range, which makes the figure a little more beatable. However, the company primarily trades on sales estimates, and not earnings. Hence, the headline revenue figure is the most important figure going into Q1’16 earnings.
Yelp believes its ad products generate some of the highest ROIs based on their own metrics. However, to the average business owner who’s unfamiliar with ad terminology, conversion metrics and measured marketing returns, its become difficult to further penetrate the total addressable market. Furthermore, Yelp’s product isn’t compatible with all businesses, as many of the businesses selling goods and services in the United States aren’t direct to consumer and many have a digital presence as well. Furthermore, Yelp mentioned on the prior call, that they had 100,000 advertising accounts and that there are 20 million businesses in the United States. So, Yelp is under-penetrated, and isn’t exactly subject to saturation risk. So, the recent deceleration to ad sales has more to do with sub-optimal execution as opposed to a lack of market opportunities.
As you can tell, the company is losing sales productivity per sales rep. The company’s accounts per sales rep declined by 20% per quarter in FY’15, according to Morgan Stanley. Since direct sales aren't scaling economically, the company needs to further develop and simplify the self-serve platform. The declining sales growth trajectory can be blamed on the management.
However, a compelling value-thesis can be argued despite management concerns.
I’m comparing Yelp to other social media names because its business model is based on user-generated content, utilizes a network effect and sells digital advertising.
As you can tell, Yelp’s P/S ratio is the cheapest out of the group including Facebook (NASDAQ:FB), LinkedIn (NYSE:LNKD), and Twitter (NYSE:TWTR). The company trades at a 2.1 P/S multiple, which is significantly cheaper than LinkedIn and Twitter which trade at 4.5x sales. To be fair, Twitter is expected to grow by 39.5% in Q1’16, so its premium to Yelp can be partially attributed to a faster growth rate. However, LinkedIn is expected to grow sales by 30.10% (compared to Yelp at 31.3%), but trades at twice the multiple. Hence, out of the group, I argue that Yelp provides the best value per unit of growth, i.e. GARP (growth at a reasonable price). I’m not negating my stance on Facebook here, but there’s no denying the deep value opportunity in Yelp.
Coming out of Q4’15 some analysts are still upbeat on the company. At least Mark Mahaney from RBC Capital Markets (ranked 7th out of sell-side analysts on Tip Ranks) believes the company is heavily undervalued. I haven’t modeled my own estimates for Yelp quite yet, but I do agree with some of Mark’s commentary.
Furthermore, I am yet to receive an earnings preview from Mark, so I’m quoting comments he made in a prior report from February 8th 2016:
YELP has been one of the biggest underperformers in the ‘Net sector, down 47% in 2015 and 44% YTD. This seems excessive to us. We believe current valuation (9X ’16E EV/EBITDA & 5X ’17E EV/EBITDA with 30%+ organic ’16E revenue growth AND margin expansion) provides a highly attractive risk-reward. Q4 results and the ’16 outlook clearly suggest Local Ad Revenue growth stabilization. We still see in Yelp a strong and improving local solution and an asset with significant strategic value (RBC maintained its outperform recommendation and lowered its price target from $42 to $33).
As it currently stands, I think investors can get a little aggressive going into earnings. The management team reset expectations on the prior earnings call and with the stock down significantly from its 52-week high of $52.51 – the risk-to-reward still favors the bulls.
As such, I’m initiating my Yelp coverage with a buy recommendation, and will offer a price target after Yelp reports earnings on May 4th, 2016.