Yelp: Will Smoke Lead to a Stock Fire?

Yelp's stock is falling fast following serious allegations, but could fall significantly further if those claims are proven to be true.

Apr 4, 2014 at 2:00PM

Yelp (NYSE:YELP) has a lot of questions to answer. The company is now at the epicenter of a scandal surrounding the legitimacy of its reviews. In the past, this well-documented issue was overlooked, but with the stock more than 30% off its high in March, and a Wall Street Journal probe under way, these issues have become much more damning. Furthermore, with its entire business model now being questioned, advertising revenue may become more difficult against the likes of Facebook (NASDAQ:FB) and Google, meaning Yelp could become the next Angie's List (NASDAQ:ANGI).

Since Yelp's IPO in 2012, it has grown into a social media favorite, generating gains of 190% since its public market debut. While the company is no stranger to controversy, a column from the Wall Street Journal might include the most serious allegations to-date.

The article adds to prior accusations that Yelp "hurts" the ratings of local businesses that decline to buy advertising from the company. For small companies that rely primarily on word-of-mouth, this can be difficult to manage.

These allegations compliment last weekend's report from the L.A. Times  that Yelp has removed competitors' ads, along with bad reviews, for certain businesses that purchased advertisements.

Over the last six years, 2,046 FTC complaints have been filed against Yelp, many for reasons related to these problems, and Yelp has stated that it now receives, on average, six subpoenas per months. Clearly there is smoke, but is there fire?

With all things considered, there are three key issues: Is Yelp punishing small and medium-sized businesses that do not purchase advertising? Is Yelp removing bad reviews? And, is Yelp providing bad reviews about the competition of paying advertisers?

These allegations are a concern because Yelp's entire business model revolves around reviews, and more importantly, reviews by consumers. Therefore, if reviews are being altered by the company directly, or by a company Yelp hired to "work" its reviews, there would be a major issue with how consumers view Yelp. There might even be restitution due to those who lost business thanks to negative reviews.

How could this happen?
Looking at Yelp's valuation, from its fourth-quarter and full-year earnings, it's clear how such aggression on behalf of the company could have been created.

For 2014, Yelp is expecting revenue of $355 million. If successful, that would represent growth of more than 52%. Yet, despite this growth, Yelp is still just a fraction of the size of peers Google and Facebook, against whom it competes in the advertising business.

Specifically, 23% of Google's $16.86 billion in fourth-quarter revenue came from its advertising network, but 67% came from Google sites, which are also heavily dependent on ads. Therefore, Yelp must find an edge to survive, and has done so by targeting small businesses.

At the end of 2013, Yelp had 67,000 local business accounts, a 69% increase over the year prior. In light of all that occurred in the last week, it's a wonder how many of these accounts were obtained using the methods described in the Wall Street Journal and L.A. Times articles.

With that said, a tarnished image and the belief that reviews aren't legit will undoubtedly affect the company's 120 million monthly unique visitors, which will hurt its valuation. Currently, Yelp is trading at 23 times sales, despite its losses, a market cap over $5 billion. In comparison, Facebook, with the same growth rate, and operating margins of 37% versus negative 3.4% for Yelp, trades at 20 times sales. Hence, using this comparison alone, investors must believe that Yelp could have further to fall.

Final thoughts
Perhaps the most important question for Yelp investors is, if the allegations prove to be accurate, how much further could the stock fall?

To answer this question, look at Angie's List, a company operating a very similar business model that has also often been accused of providing top ratings for paying customers. Citron Research, headed by famed short-seller Andrew Left, has covered the Angie's List story excessively, showing how 71.9% of the companys' revenue comes from service provider fees, those being reviewed, which consequently are given "Grade A" reviews and top placement on the site.

This is this relevant because Angie's List is down 55% from its 52-week high, a decline that began when the pay-for-reviews stories began to circulate. While this may be an indication of what could occur for Yelp, investors should note that Angie's List trades at just three times sales, implying that Yelp could in fact fall much further if the allegations are proven to be correct.

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Facebook, Google (C shares), and Yelp. The Motley Fool owns shares of Facebook and Google (C shares). 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.

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