Yelp: Why $76 May Not Be Crazy

Yelp (NYSE: YELP  ) may be the most polarizing stock since Amazon.com. The share price is up 250% since the beginning of 2013, but everybody seems to hate it. The top five articles on Seeking Alpha are all about shorting it, yet the price continues to go up. For good or bad, this is one of my favorite stocks -- not for 2014, but for the next five years. Somebody once asked me if Facebook would buy Yelp, and I responded "one day Yelp may buy Facebook." How's that for going out on a limb? Before you call the men with the white coats, hear me out.

The short thesis on Yelp is two pronged: competition and valuation. Clearly, a $76 stock that doesn't produce a GAAP profit has a high bar to live up to. The potential competition is not easy to dismiss, either. Google, Facebook (NASDAQ: FB  ) , and TripAdvisor are viable competitors. Despite this competition, however, revenue is growing dramatically fast, and there are no indications that competition is changing that trajectory. The following chart is from the investor presentation for the last earnings call:

Source: Yelp

The annual growth is impressive, but the more granular, quarterly data is more impressive. In fact, it appears to be accelerating. That's right, it's not slowing, it's accelerating from 65% to 68%. How could this be? Facebook, shortly after it launched, saw a reduction in advertising click-through because visitors were increasingly using mobile devices. Yelp, on the other hand, benefits when people access its information from mobile devices. Yelp is paid for access to the reviews that people are searching for, not clicking through to a product that is unrelated to your reason for opening the app. This is a completely different dynamic.

Source: Yelp

Unhappy clients don't spend more
One of the most interesting displays from the presentation is for active local business accounts. The year-over-year growth is 61%, slower than overall revenue, which means that existing customers are spending more with Yelp. Unhappy advertising clients don't increase their spending.

Competition seems to be the biggest issue for the company in terms of growing its business. Google and Facebook are considerably better capitalized than Yelp and the switching costs are zero for site visitors. However, since the end user doesn't have to pay for the service, why not go through a specialized niche vendor? Especially when you've created reviews for the site already.

How can the stock warrant such a high share price? 
Professional investors are looking through current estimates to what the company can produce in the future. The business can be tremendously profitable. Gross margins are 93% because the company doesn't have input costs the way a computer manufacturer would. The people who go to the website looking for reviews contribute their opinion for free. Wouldn't you like to start a business that didn't have to pay for raw materials?

Yelp could be profitable tomorrow if it wanted to be
Since operating costs are holding the company back from profitability, the company has the ability to manufacture an earnings number whenever it wants to. Today, sales and marketing expenses account for 73% of revenue. To use a technical accounting term, that's just nuts. A software company may have sales and marketing expenses as high as 40% of revenue, but not more. If Yelp's CFO decided to streamline the company and let the difference between these percentages -- $20 million -- fall through to the bottom line, at a 40% fully taxed rate, the company could have produced $0.17 per share.

While we can't say that shares of Yelp are worth $76 per, if its run rate was $0.70 and it grew profits by 60%, next year's estimate might be in the range of $1.12. If you assigned a 68 multiple to that -- since that is its revenue growth rate -- you would get a $76 share price. Maybe there's a method to the madness.

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