Description

Yelp stock is down 70%+ from its highs due to a series of disappointing quarters which has reduced the rate of the company’s organic revenue growth from 60%+ historically to about 36% this year.

The reduction in organic growth rates can be attributed to the following:

·         A reduction in sales force growth from around 50% historically to 30% in 2015, partly due to increasing competition for sales people.

·         A reduction in display revenue, which will be down about 25% this year, primarily due to management’s decision to de-emphasize this product to improve the customer experience on the site.

·         Lapping a large Yellow Pages distribution deal which benefited 2014 growth rates.

Management attributes the primary driver of the slower growth rate to the reduction in sales force growth. While there has been a high degree of wage inflation and competition across the internet landscape for programing talent, there has also been some increased competition for sales people. However, this issue should be quite manageable given the more commodity-like nature of Yelp’s sales force and the company’s ability to hire sales people across multiple geographies. The key question here is whether or not investors should believe managements claim that the slowdown in growth rates is the result some challenges hiring sales people (a manageable issue) or due to something more concerning, such as a slowdown in demand for Yelp’s advertising products. I am inclined to believe management for the following reasons:

·         Yelp’s ad product is one that must be sold by a sales person. Yelp’s product is sold to a highly fragmented base of relatively unsophisticated ad buyers – SMBs. These buyers are relatively unaware of their advertising options and the value proposition of online advertising. Furthermore, it is particularly difficult to calculate a clear ROI from Yelp ads because of the difficultly in linking clicks back to in-store sales transactions, which further necessitates a sales pitch. This dynamic makes Yelp’s local ad revenue growth highly correlated to its sales force growth. This is somewhat of a unique dynamic in the internet advertising landscape. Facebook, Pandora, or Zillow ad revenue growth would be more correlated to the underlying demand for its products, the efficacy of its ads (more measurable than Yelp), and the supply and pricing of competing ad options.

·         We see that Yelp’s local ad revenue growth is highly correlated to its sales headcount growth

·         Historically Yelp has increased the sales productivity of their sales force over time. Over the past three years, Yelp’s has grown its local ad revenue per sales person by around 12% a year, a pattern that has been fairly consistent and has continued in 2015. This is an important data point that suggests underlying demand for Yelp’s ad products are increasing, rather than deteriorating.

·         Steady to increasing repeat rates also suggests that there isn’t an underlying demand issue.

Q2 Earnings

Yelp stock sold off 25% after Q2 earnings. The market focused on a large revenue guide down, but ignored the fact that the quarter itself was good:

·         Revenues of 133.9mm came in at the high end of company guidance of 131 to 134.

·         Local ad revenue growth rates inflected upwards to 9.4% sequentially, versus the 5.9% rate in Q1 which was negatively impacted by operational issues.

·         Local advertising account additions of 6900 grew 13% y/y, the first positive inflection after four quarters of disappointment with respect to this metric.

I believe this creates an attractive setup where guidance and growth expectations has been reset to achievable levels.

A high quality company

Yelp currently trades at about 3.8x 2015 revenue. Traditional valuation metrics don’t apply given the marginal level of profitability the company currently operates at. However, this is a cheap valuation for a company that I believe can sustain topline growth rates of 30 to 35%. Similar high growth stocks operating at modest levels of profitability, such as Zillow or Linkedin, trade at much higher revenue multiples with lower organic growth rates. This valuation reflects the lack of confidence in Yelp’s ability to achieve my expected growth rates given the string of disappointing quarters.

Yelp’s market opportunity is quite large and attractive. Local internet advertising has been called the Holy Grail of online advertising given the extremely large TAM and low levels of internet advertising penetration. Yelp’s is one of the few publically traded internet stocks with very low levels of ad sell out rates. This gives them a highly visible path of growing revenues by steadily increasing monetization without necessarily having to grow consumer usage.

Yelp remains a highly strategic asset, which should continue to provide valuation support despite the recent developments in the name. Yelp has proven to be an extremely durable consumer facing brand for local reviews. The company’s is well known to have high quality review content, particularly in its core restaurant category, thanks to a carefully cultivated, unique reviewer community.  Yelp’s consumer engagement has grown steadily each year despite Google’s aggressive inroads in this space and heavy promotion of its own local review products over yelp in search results.

Catalyst

Meeting guidance, showing that 30 to 40% organic growth rates are sustainable.