Yelp can be shorted for a 50%+ return.

First, I believe understanding how a company became overvalued is important. It is much easier to short a stock that is overvalued because of institutional factors as opposed to shorting a stock with an investor base that genuinely believes in a valuation (CRM, etc.).

To illustrate why Yelp is overvalued, here is Citigroup analyst Mark Mahaney’s recent opinion on Yelp ($1.7 billion price target or 29x sales):

“However, with numerous players competing for local advertising dollars, and long lead times to profitability in new markets, growth prospects could be limited for the company.”

Valuing a company at 29x sales that could have limited growth prospects? Seriously?

By way of background on Mahaney, he is considered to be the Mary Meeker of the social media bubble. During the late 90s, Mahaney actually worked with Meeker as Morgan Stanley facilitated the issuance of billions in tech IPOs (many turning out to be worthless). Fast forward to today and Mahaney plays a similar role.

For some IPOs, Mahaney will actually spend up to 100 hours on the phone during the sales process of an IPO (see WSJ article link). Clearly, an investment bank with an optimistic sell-side analyst helps initial holders exit the stock. As a result, it makes sense that Mahaney would play some role in the sales process. And, in my opinion, his role in the sales process explains the generous price target.

http://online.wsj.com/article/SB10001424052970203899504577128822597068412.html

Here are a few more anecdotes that explain how the IPO process works. According to Zillow, Citi’s Mahaney was a big reason the company chose Citigroup to help run the IPO. The CEO of Active Network spent 18 months trying to determine according the WSJ, “which analysts gets it and likes the model.” In other words, companies getting ready for an IPO by building an optimistic financial model then wait to see which analysts are willing to take the valuation even higher in published sell-side “research.”

Clearly, this process is resulting in dramatically overvalued stocks that rational investors will not support over time. The collapse of Demand Media, Pandora and Groupon stocks show that the hype can go away quickly. I will explain why Yelp minus the hype is worth $3-5. And, once the hype goes away, the stock will fall quickly.

Why Yelp Will Never Achieve the Street’s Optimistic Profit Forecasts 
As with many privately held technology companies, Yelp was managed to maximize its public market valuation. From 2009 to 2011, Yelp grew revenue by 191% but at the cost of 203% growth in sales & marketing spending.

Clearly though, a large portion of the sales & marketing is investment for long-term growth. Yelp’s expectation for growth is derived from the expectation that a significant portion of the $114 billion spent on local advertising via traditional media will shift to the digital media (12% CAGR growth expectations through 2016). But, it is unlikely that Yelp will be able to capture a larger than proportional share of that growth for several reasons. As a result, the massive investment the company is making in growth will yield disappointing results.

Demographics Problem
On the positive side of Yelp’s current value proposition is the fact that its users have high average incomes. However, that dynamic will tend to change if the company successfully grows beyond high income cities like NYC, Boston and SF. Therefore, either Yelp will fail to grow or its revenue per user will decline. Already, revenue per thousand unique visitors has fallen from $27.9 in 2010 to only $25.5 in 2011. Clearly there is a growing demographic issue that will only get worse.

Supply and Demand Problem
If, for example, you run Olive Garden’s advertising department, your goal is to get the most value for your money. And, if you are a typical internet property you need to sell advertising space regardless of price (close to zero marginal cost). The combination of advertisers seeking to maximize value and online advertising property (growing) needing to sell ads will continue to push down advertising prices.

Limited Reach
Yelp is discovering that its platform’s sweet spot is heavily weighted towards consumers finding restaurants and shopping locations. After all, few people would see the need to write a review of a hardware store or movie theatre. And, building a critical mass of reviews is a huge driver of search engine relevance.

And, when branching out to higher spending categories (lawyers, contractors, etc.) Yelp faces stiff competition from already established properties such as Angie’s List.

If that dynamic does not change, traffic could trend lower over time as its current user base will gradually learn the existing area. The saturation dynamic implies that the utilization by current users will naturally trend down. As a result, Yelp needs user growth just to keep page views constant. If you combine the saturation problem with the declining ad rates, Yelp needs even more page view growth to hold revenue constant.

Additionally, restaurant /store advertising is not an ideal value proposition for an advertiser. 
Yelp’s advertising space is near the coveted ‘point of decision’ but the point of Yelp is to allow users to make decisions based on objective reviews rather than on advertising. A 2011 Harvard study by Michael Luca actually quantified this. According to Luca’s study, customer’s reviews are a huge driver of restaurant sales (no surprise). The magnitude of the impact was surprise though. Because reviews are so much more important than advertisements, the incremental sales gain from an advertisement tends to be limited.

Link to study - http://drfd.hbs.edu/fit/public/facultyInfo.do?facInfo=pub&facEmId=mluca

And, as Yelp has been around for several years, advertisers have established a fair value for the ad space using detailed analytics. So the idea that advertisers will reach some new level of excitement about advertising on Yelp is unrealistic.

Mobile Trend Unfavorable 
Furthermore, a growing number of users are accessing Yelp via mobile platforms. Advertisements on mobile platforms are worth only a fraction of an ad viewed on a non-mobile computer. Why? The size makes it easier for the viewer to ignore the ads and there is less of an incentive to click on mobile ads to how phones are structured.

Yelp’s Primary Asset 
It is important to analyze Yelp’s key assets and capabilities that allow it to succeed. First, Yelp aggregates a significant number of reviews (62% restaurant and shopping). Through the company’s technology and employees, unhelpful reviews are pruned. As a result, Yelp now has a reputation for credible online reviews of local merchants. And, the large number of reviews encourages others to write even more reviews. And the growing review base attracts even more readers. The company is quick to point out that the model involves no customer acquisition costs (more on why that is a negative later). What really matters is merchant acquisition costs. Given the ratio between incremental revenue and ad spending, it is safe to assume the costs are very high.

Yelp’s Google Problem and the Reverse Network Effect
Yelp clearly depends on the network effect to generate ongoing revenue. But, the network effect can work against you. As the venture capitalist Fred Wilson recently said in an FT interview:

“Network effects are powerful in both directions. They can help you grow exponentially. But when they are going against you, they work just as fast. MySpace’s decline was mind-blowingly quick. RIM’s has been as well. Who is next?”

It is hard to say whether or not Google via Zagat can grab the momentum for Yelp. Regardless, the ever present risk makes the cash flows less valuable.

It is likely that Google’s network will have a materially negative impact on Yelp even without a complete victory for Google. The key components of Yelp’s asset (credibility, visibility and number of reviews) can easily be matched by Google after its 2011 Zagat acquisition. As the Zagat acquisition is still only a few months old, Google has not yet removed the pay wall. But, Google has stated many times that they want a large portion of the local advertising market.

Zagat combined with Google places can clearly do that. 
Google also has meaningful advantages over Yelp. First, Google has a complete technology platform that provides more practical value to users (i.e. maps, connection to Gmail, etc. that yield a steady flow of traffic). Second, Google can view relations with advertisers in a wider context. Zagat, for example, could become a loss leader for Google’s customer acquisition strategy. Even if it is not a loss leader, Google can offer comprehensive packages (bundling) that give better value to advertisers. Also, the scale implies Google has a cost advantage over Yelp. For example, Google is investing in advertising relationships regardless of its Zagat success so the marginal cost relative to Yelp’s is very low (life time value of a customer dynamics). Google’s cost advantage will give the company an edge over Yelp.

Additionally, Yelp depends on Google’s search engine to drive traffic (the downside of no traffic acquisition costs). Google might claim that it would never bias search engines in favor of its own properties but there is no way to know for sure. There is no question that Google wants Zagat’s traffic to grow and search is a big driver of growth. And, search engine algorithms change all the time. It is not always easy to stay in the top 3-5 search results (note the many problems Demand Media is having on this front).

Yelp is currently accusing Google of using its reviews in Google Places search results in the Senate Subcommittee on Antitrust, Competition Policy and Consumer rights. According to Yelp’s CEO, Google agreed to remove the reviews but also said it would pull Yelp’s reviews from search results. Regardless of the outcome, it is clear Yelp depends on traffic generation via its biggest competitor. And I have a hard time see how the government can closely regulate complex ever-evolving search algorithms. Zagat and Google Places will have a home town referee at a minimum.

Link to testimony - http://www.scribd.com/doc/65727557/Yelp-Testimony

Other Meaningful Competition
Yelp also faces meaningful competition from old media (newspapers, radio, TV, etc.). Traditional media sources have relatively high fixed levels of spots they need to fill with relatively low or no marginal costs. So, the prices on local ads will only go down. It is important to note that the supply of ad space is growing every year while the demand for advertising is barely growing.

The declining revenue per active local business accounts from $3,650 in 2009 to only $3,350 in 2011 is a direct result of this intense competition for local ad dollars (-9%).

Clearly, there is room for Yelp (unless people gradually migrate to Google/Zagat which is why I would not buy this company at more than 2x sales) but margins will compress as competition for limited advertising dollars heats up. Furthermore, Yelp’s traffic growth will be constrained by Google’s desire to break into the local advertising market. As a result, Yelp’s revenue growth will likely be meaningfully lower than its profit growth.

Customer Switching Costs and Operating Leverage 
It is important to note that not only is capturing incremental ad dollars is difficult. Additionally, keep customers is difficult as well. Small businesses are generally very discipline with respect to ad spending due to thin margins.

And, referring back to the Harvard study, independent restaurants benefit much more than chain restaurants as chain restaurants already have reputations established. As a result, Yelp’s sales force needs to work one location at a time to get a sale in most cases. But, the independent restaurants can still leave Yelp at any time (making retention efforts costly and time intensive). Yelp’s customer make-up implies the business is anything but a high quality stream of cash flows.

Valuation
Precisely valuing a company like Yelp is an exercise in futility. But I will try to arrive at a reasonable estimate that takes into consideration the company’s growth prospects (to insure a generous result). And, here is a preliminary perspective that demonstrates what a great short Yelp is: Yelp’s valuation - $1.3 billion.

Yelp’s Business in the Largest Markets
I believe it is important to separate Yelp’s business into larger markets relative to small markets because of how differently small market cities operate. First, and somewhat obviously, big cities have larger populations and as a result have more user potential. Second, the demand for Yelp’s services is positively correlated with city size / urbanization. In large urban cities such as NYC, there are hundreds of places to eat/shop within a reasonable distance. Third, average incomes are higher in cities such as NYC so the advertising revenue per monthly unique visitor will be higher. Fourth, a place like NYC or Boston has very high turnover rate relative to smaller cities. New residents are very likely to need Yelp-type services. But in a city like Denver with more stability, residents are much less likely to need a service like Yelp to discover local restaurants and shopping locations. Finally, larger cities have larger numbers of tourism / business travelers. As a result, user traffic is naturally higher.

Yelp’s largest and oldest markets (2006-2007) include NYC, SF, LA, Seattle, Chicago and Boston. Yelp makes, on average, $5.8 million from those cities. Yelp’s next cohort (14 cities; 2007-2008) includes mostly smaller but still large cities (San Diego, Austin, Portland, San Jose, Denver, Detroit, etc.). Yelp makes $1.1 million per city from that cohort. Clearly the lower number in the second cohort is partly due to the later start so I will grow it by 50% to adjust for the timing difference (unrealistic but adds margin of safety). 
Yelp’s revenue in the largest U.S. markets per year is $58 million (assuming 50% growth in the second cohort). To value this business, I will assume a 15% profit margin (massive margin expansion) and 20% CAGR over 3 years (implies $15m in profits). Assuming the business trades at 25x earnings which implies future CAGR of 15%+ (unlikely for reasons I explain) the future value is $376 million. Discounting the future value back to the present yields a value of $283 million (10% discount rate).

The pushback from the bullish side is that the oldest cohort grew revenue by 57% y/y in 2011. First, that growth was due in large part to a massive and unsustainable surge in marketing and sales. Second, the massive 2-3 year growth surge has lowered the number of potential new users in Yelp’s first cohort group. So not only does Yelp need a larger incremental revenue number to maintain growth, it needs to capture a larger fraction of the existing potential user base. From a probability standpoint, the odds of a person in a city like NY or Chicago not knowing about Yelp after the company’s massive push has dropped. Therefore it is safe to conclude that a large number of non-users will never need Yelp.

And, according to Yelp’s official blog, 85% of consumers already use the internet to find local businesses. If only 30% were using the internet, I would be more optimistic about future growth. The 85% figure just illustrates part of the reason Yelp was able to grow so rapidly.

All these factors push growth rates down. Keep in mind, I am projecting 73% growth in three years despite all these dynamics (and 15% long-term CAGR which is not going to happen). As a side note, look at the chart of Yelp’s worldwide traffic. The growth does not appear to be exponential. Yet, the revenue growth required for the valuation is exponential. http://www.google.com/trends/?q=yelp

Yelp’s Second Tier City Business
Yelp’s third, 29-city cohort has mostly smaller cities (Indianapolis, Kansas City, Providence, etc.) and launched in 2009-2010. The revenue per city in that cohort is only $143,000 per year. The small number indicates that it takes several years for Yelp to make a meaningful amount of revenue from a city. And it confirms that usage levels in smaller cities are low relative to large ones.
As the second tier cities are not currently profitable, it is difficult to assign value to them. However, I will assume 350% revenue growth and 15% profit margins which yield a $2.8 million in profits (leaving room for more new cities). Using a 25 multiple gives me a future value of $70 million. It will clearly take many years to reach this revenue and margin target so I will discount the value back 5 years. Using the 5 year time frame yields a value of $43 million.

Yelp’s International Business 
Yelp first launched internationally in 2009 with locations in London, Toronto and Vancouver. The move overseas illustrates the how little operating leverage Yelp has. For each market, Yelp needs a local sales team and office. The total investment for international growth alone will be $15 million or 18% of trailing twelve months sales. Furthermore, because of complex cultural issues, international legal issues, and tax laws, international growth will be at much lower margins.

To be generous, I will assume Yelp gets a position in 200 of the largest cities in the world and generates $1 million per year from each city. Note that San Diego is the world’s 198th largest city so $1 million is very generous. Additionally, the weighted average income of the top 200 cities is more than 50% lower than Yelp’s largest two cohorts. Given the additional costs, I will assume a 10% profit margin ($20 million in normalized profits). Applying a 20x multiple yields a future value of $400 million. Discounting that back to the present at 15% (higher risks and less certainty) over 7 years (international expansion takes even longer) yields a value of $150 million.

Other Sources of Growth
To help the IPO buzz, Yelp’s management team speculated out the prospects of new lines of business it thinks it can enter. For example, the company has a small daily deals operation. The company tested daily deals in the summer of 2010 and things did not go well. And, in the summer of 2011, the company reduced its daily deals team from 30 to 15. Given the daily deals business is barely profitable and very competitive, I can’t see any reason to give Yelp any value for the business.

But, just in case some other new business line works out, I will assume they are able to generate $500 million in future revenue on non-core activities with a 5% profit margin five years into the future. Using a 10 multiple and a 15% discount rate (due to the uncertainty) yields a present value of $124 million. Keep in mind that this is perhaps the most unrealistic portion of the bull case. This is pure margin of safety for short-sellers.

Sum of the Parts in the Irrational Bull Case 
Even with very optimistic assumptions about growth and margin expansions the total value of Yelp is only $600 million ($10 per share). And that assumes Yelp dominates every market they enter and captures meaningful share in new markets that are currently barely profitable.

Sum of the Parts in the Rational Bull Case
First, assuming a 25x exit multiple is unrealistic for markets that will likely be mature in three years. After all, how many people in NY or Boston haven’t heard of Yelp? I will still assume an above market multiple of 15x for its core business ($170 million). Second, 350% CAGR in smaller markets is unrealistic. I will apply a 20% discount which yields a value of $34 million. Third, because Yelp’s track record internationally is relatively weak (cultural factors make it hard for Yelp to do well) I will use a 20% discount rate as opposed to a 15% discount rate ($112 million). Fourth, there is no reason to assign any value to the other sources of potential revenue growth for the above mentioned reasons. Based on those adjustments, I think a fair value in the bull case for Yelp is $316 million or $5.30 per share.

As a long investor, I would not get interested until 2x sales or ~$2.80 per share. There is a reason Warren Buffet doesn’t like technology. Trends change on a dime and as a result, cash flows are very uncertain.

Catalysts
The group of analysts that value the company from a venture capital or investment banking perspective has a strong incentive to distort valuations to the upside. The farther away Yelp gets from the IPO, the more likely it becomes that Yelp’s stock will be valued rationally by the public markets. Look up the stock charts for Demand Media, Pandora, and Groupon.

The catalyst will be the more rational side of the stock market recognizing that Yelp is a small risky company that depends on beating Google and taking share in an intensely competitive local advertising market. Yelp minus the hype = $3-5 stock.

Disclosure: I am short Yelp.