On Yelp's (NYSE:YELP) fourth quarter conference call, CFO Rob Krolik cited a BIA/Kelsey study that said local advertising spend in the U.S. will grow to $149 billion in 2017. The amount spent on digital advertising is expected to grow to $41 billion that year. The biggest purveyor of local ads in the U.S. is YP, and last week Yelp agreed to share resources with the directory publisher.
What's the deal?
The strategic agreement between Yelp and YP will allow YP to expand its advertising reach to include Yelp in its local ad network. YP CEO David Krantz says this move will allow its customers to reach 95% of the Internet audience through its own network and Yelp. Additionally, YP will be able to "enhance its customers' business listings on Yelp" (whatever that means). It sounds like YP will help make Yelp's product better.
In return, Yelp gains access to YP's local sales force and advertiser base. As of last quarter, YP's customer base was well ahead of Yelp with 575,000 customers compared to 67,000 advertisers at Yelp. More importantly, Yelp spends heavily to gain new customers, reinvesting 55% of revenue in sales and marketing last quarter.
The deal with YP should allow Yelp to gain new customers while spending less revenue allowing it to potentially turn a profit in the near future.
Limited by its size
The biggest limiting factor for Yelp is its size. As mentioned, it needs to heavily reinvest its revenue to add new customers. Compared to Internet advertising giants like Google and Facebook, Yelp just can't spend enough money.
Facebook spent $292 million on sales and marketing last quarter. That represents just 11.3% of Facebook's revenue, but it's over four times Yelp's revenue for the quarter. Similarly, Google spent 13.5% of its revenue on sales and marketing -- $2.13 billion.
Indeed, some of these expenses go toward consumer facing products instead of toward gaining new advertising partners, but the point is these companies are able to far outspend Yelp to attract new customers.
Facebook claims that over 1 million businesses advertise on its platforms. Not all of these are local, but the fact that YP has over half a million accounts indicates the amount of work left for Yelp. The partnership with YP will give Yelp a lot of help in gaining new business.
Yelp is still very much in growth mode, meaning that its spending now for profits later. Its forward P/E of 209 would indicate the market agrees that its potential for future profits is strong. With more than half of revenue going into sales and marketing, however, the profit margins will remain thin until there's more revenue to lever.
The company is beginning to show signs that there is leverage in the business model. The 55% reinvested in sales and marketing last quarter is an improvement from the year-ago period when it invested 62% of revenue in its sales force.
A better metric may be its price-to-sales ratio, which comes in at just over 24 for the last twelve months. Comparatively, Facebook trades for 21 times sales. Given that Yelp is expected to grow revenue faster than Facebook, the valuation seems more than fair.
Not without risks
Yelp certainly has its risks, but YP may be able to help alleviate one of them. That is, this partnership will help it compete with the big guns in Google and Facebook. Neither of the larger companies appear particularly threatened by Yelp, which is good because the company relies on both companies platforms to gain exposure.
Yelp is particularly reliant on Google to keep its site high in the search results. Should the search giant decide to pursue the local ad market more aggressively, it could do some damage to Yelp just as it did to Amazon.com with its product-listing ads. Yelp has already taken a defensive maneuver by partnering with Yahoo!
Yelp can only do so much to hedge its risks as it doesn't have the cash to compete with the big spenders. Strategic partnerships that lever its strengths, like the one with YP, are the order of the day.
Adam Levy has no position in any stocks mentioned. The Motley Fool recommends Facebook, Google, and Yelp. The Motley Fool owns shares of Facebook and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.