Yelp Inc. (NYSE:YELP) has plummeted over 20% in the last week or so, caught up in a very bad week for social media stocks as compatriots LinkedIn Corp. (NYSE:LNKD) and Twitter Inc. (NYSE:TWTR) both posted disappointing earnings.
It’s tempting to get caught up in the unique narrative of each of these social media stocks, and make some case about how Yelp stock is “disrupting” business listings and revenues — or maybe, how the company has great “mindshare” as the default place to get recommendations for restaurants when you visit a new town.
But as an investors, I don’t care about fancy verbs and nouns that Silicon Valley comes up with to justify the nosebleed valuation of YELP stock and other social media players.
The only things I care about are revenue and profits, and how both those metrics are growing.
And sadly, Yelp isn’t seeing the movement that it should on either front — and that’s a sign that the recent selloff could only be the beginning.
Yelp Stock Losing the Ad War
If you’re an investor, you need to get to the core of how a company makes money. That’s easy with a restaurant stock — it makes food and sells that food, hopefully at a good margin to loyal customers.
But social media stocks aren’t quite as intuitive. So it’s worth pointing out explicitly that Yelp is decidedly not a review company… it is a local advertising company.
Consider that in Q1, Yelp reported a total of $118.5 million in revenue. Of that, $98.5 million or 83% came from local advertising accounts.
That makes sense, since if you’re an Italian restaurant in Sheboygan,Wisc., you’d want your ads to appear on Yelp’s pages when someone logs in and looks for an Italian restaurant in Sheboygan.
But there are some fundamental problems with this business model. Namely, local restaurants and repair shops don’t have infinite ad budgets, so YELP stock is focused on a core customer with a low ceiling.
Similarly, those local businesses have a host of other outlets to advertise on — like online advertising heavyweights Google Inc. (NASDAQ:GOOG) and Facebook Inc. (NASDAQ:FB), both of which allow for very sophisticated targeting.
For instance, that same Italian restaurant could filter Facebook users by geography to target those local to Sheboygan. And then, if it wanted, it could even target folks in a certain demographic — for instance, adults 25-35 with children in order to promote a “kids eat free on Tuesdays” campaign.
Or take Google, which can serve ads based on specific searches — like when someone types “Sheboygan italian restaurants” into a search page — as well as other metrics.
YELP Stock Doesn’t Have the Numbers
Does Yelp offer a specific audience, and is the review site perhaps a better place to interact with customers since they are actively looking for a business instead of just browsing the web? Maybe.
But based on the numbers, Yelp’s value isn’t substantive enough to boost its margins. Yelp is barely a break-even company now, with a projected EPS of just 13 cents this year and 50 in FY2016. But somehow Wall Street hasn’t adjusted expectations — giving YELP stock a forward price-to-earnings of almost 80!
Furthermore, Yelp user growth is slowing. Total monthly visitors to Yelp.com via desktop or via the mobile app grew just 8% year-over-year, to approximately 142 million. That’s also up only about 5% from the user tally in the previous quarter.
Another sign to watch: While Yelp stock saw ad revenue up on the quarter, the costs of marketing Yelp advertising opportunities are up dramatically, too. Consider that sales and marketing expenses jumped 45% year-over-year, and that total expenses jump from $81 million to almost $123 million — a 52% increase.
Sure, Yelp revenue was up over $42 million for and 55% increase year-over-year … but that just barely covers the surge in expenses.
YELP stock investors need to pay close attention to these rising expenses and the very thin margins at which the company is currently operating. While it’s crucial that Yelp gets out there and competes with Google and Facebook, if there are no profits to be had as the company plows all its ad dollars into sales and doesn’t have anything left … that’s a dangerous place to be.
Facebook and Google are giants in the ad game, and it seems unlikely that Yelp is going to be able to fend them off for much longer — especially considering it doesn’t have that much wiggle room on margins, is already trading for a tremendous premium and is seeing sentiment shift on Wall Street after earnings.
I wouldn’t trust Yelp stock here, given these factors.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. As of this writing, he did not hold a position in any of the aforementioned securities. Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP.
