There’s a knee-jerk case for arguing that Yelp Inc (NYSE:YELP) stock is overvalued. After all, the YELP stock price sits at 118 times next year’s consensus earnings per share, and ~90x even backing out its cash on the balance sheet.
That seems like a huge figure for a company showing decelerating revenue growth and relatively thin profitability. But, by the numbers, YELP’s valuation isn’t that bad. The stock trades for about 3x 2018 revenue on an enterprise basis, which is actually a low multiple for an online advertising business. Similarly, EV/EBITDA is in the high teens.
As for the company’s price-earnings ratio, Yelp’s net margins are so thin that a modest change suggests huge growth. Net profit even next year is likely to come in at little over 3% of sales. Once the business matures and leverages its operating expenses, that figure should rise and narrow the net income gap.
But even skipping past the high P/E ratio, Yelp still has key problems that make it a sell, if not an outright short. That operating leverage isn’t necessarily coming any time soon, because the company has a huge sales force, not the same “network effect” seen with online players like Facebook Inc (NASDAQ:FB) and Alphabet Inc (NASDAQ:GOOGL) unit Google. User growth is flattening out, leaving Yelp reliant on that salesforce — and new customers — to drive growth.
That seems too much to ask — and the valuation seems to price in too much success. YELP isn’t a sell just because of a 100+ forward P/E, but it is a sell.
Part of the reason for recent strength in the YELP stock price is that traffic has improved. But from a long-term standpoint, Yelp traffic growth still looks rather muted.
For instance, in its 10-K, Yelp details the “cumulative” number of reviews available on its site. But yearly additions have stalled out:
Reviews are growing mid-single-digits. So is growth in unique mobile users. Desktop growth looks strong in Q3 — but the company found a “robot” that elevated traffic a year ago, and removed that traffic from its 2016 numbers. Desktop traffic in Q3 was up just 6% over a two-year period.
Traffic is growing — but not particularly quickly. Most of the revenue growth is coming from an increasing number of advertisers, with that figure rising 17% year-over-year in Q3.
But that’s an expensive proposition. Per the company’s Q3 conference call, just 10% of ad revenue comes from “self-serve.” The rest comes from the sales team, which drives nearly 60% of Yelp’s headcount.
That’s not a successful online model. It’s a model that looks a lot like that of Groupon Inc (NASDAQ:GRPN). And while GRPN stock has rallied this year, and the company posted a nice Q3 report, GRPN still is down huge from all-time highs and is valued much more cheaply than is Yelp.
More broadly, it’s simply not a sustainable growth model. If users are growing mid-single-digits, advertising isn’t going to rise much more than that over the long haul. And even if the YELP stock price isn’t as bad as the 118 forward P/E suggests, it’s not priced for decelerating growth either.
The other problem for YELP’s valuation is its massive use of stock-based compensation. Adjusted EBITDA is guided to $154-$157 million this year. Stock-based compensation, however, is excluded from that figure — and is guided to total $100-$102 million.
In other words, two-thirds of what pre-tax (and pre-capital-expenditure) profits Yelp reportedly is driving are coming from the issuance of YELP stock. That aside, free cash flow this year should be in the $30 million range (assuming ~$25 million in capital expenditures).
Suddenly, the YELP stock price again looks expensive, at about 100x P/FCF. And if revenue growth is decelerating, margins thus have to expand.
But how? What revenue growth Yelp is driving is coming from the salesforce efforts. Costs can’t be cut there — and sales and marketing already account for 56% of revenue. Competition is coming: both Facebook and Amazon.com, Inc. (NASDAQ:AMZN) are targeting the space, as Luke Lango pointed out this month. That will limit pricing power and perhaps force Yelp to ramp up marketing.
There’s been some speculation that Google’s antitrust fine from the EU could help Yelp internationally. But the company, at the moment, derives just 2% of its revenue from outside the U.S. It seems highly unlikely that even a chastened Google will allow Yelp to succeed where it hasn’t for over a decade.
Even if Yelp doesn’t need a lot in the way of margin expansion to help support the valuation, it’s still unclear how it finds even that. Yelp needs revenue to grow — but traffic isn’t helping enough on that front. It needs to leverage operating expenses — but it likely has to ramp up sales and marketing.
It looks like the market is pricing in quite a bit of success for Yelp. But the path to that type of success already looks blocked.
As of this writing, Vince Martin has no positions in any securities mentioned.