Yelp: Will Smoke Lead to a Stock Fire?

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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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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 04, 2014, at 2:20 PM, thewiseking wrote:

    I would not touch this one with a ten foot pole. YELP is a known extortion scheme whereby businesses who decline to advertise wind up with their positive reviews filtered and their negative reviews made prominent. A cadre of so called elite Yelpers (chronically unemployed losers paid off in swag and free booze) are Yelps hired guns who do the dirty work of defaming small businesses for them and shilling for advertisers. IF you read this Class Action Complaint you will read the testimony of one such "Elite Yelper" Lily Jeung, who outlines how the extortion scheme works, how she was fired for writing a negative review on a big money advertiser and how it all comes down from Jeremy Stoppelman.

    Pay close attention to Class Action Complaints #47-58

    Regardint the Yelp business model.

    Thousands upon thousands of Yelp reviews are actually reviews of big chains like Starbuck and Chipotle rather than being genuine reviews of small businesses who lack advertising and p.r. budgets. If you look at the numbers for this IPO they simply do not add up. After all, how can YELP expect small businesses to advertise with a bulletin board which has already defamed them or threatens to do so? Keep in mind that this MONEY LOSING BUSINESS relies on advertising for over 60% of its revenue! Yelps advertising rates area a complete ripoff. While other online advertisers are charging 60 cents per 1000 impressions, Yelp is charging $600!!! To make matters even worse there are numerous class action lawsuits which have already been filed and many, many others in the works. The nail in the YELP coffin? GOOGLE is a powerful competitor which recently acquired Zagat. The removal of links to Google searches will considerably reduce Yelp traffic.

    No wonder Jeremy Stoppelman and other top brass absconded with 36Million in Series E funding by dumping shares in advance of this sham IPO and continue to dump shares at every given opportunity. The only analysts touting this dog are the shills working for the insiders trying to get out at a high price.

    The thousands of FTC complaints, subpoenas and class action lawsuits are only the tip of the iceberg. Look out below!

  • Report this Comment On April 04, 2014, at 5:31 PM, JaiYen wrote:

    I'd suggest that the whole Yelp is the Mafia thing is a big red herring. The true Achilles heel of Yelp is that they have refined their algorithm to act as a de facto editor of reviews published. It does not care about accuracy or truth but only interesting content for the sake of compelling reviews. Interesting reviews are what draws people to Yelp and without an editor, all the reviews become the "Joe did a great job" type of prose and Yelp loses its appeal and audience. Were this truth to be made public, the legal ramifications for Yelp would be catastrophic. If Yelp indeed edits the reviews, then Yelp is in fact liable for all the libel that populates its website. This is the dirty secret Yelp doesn't want known. In fact, they are overjoyed that advertisers fear they will be extorted if they don't buy. This false aura of threat keeps the small business buying ad space at $600 an impression. If and when the truth is known that Yelp edits reviews for entertainment value rather then authenticity, the door is open for lawsuits that could end Yelp as a viable enterprise. Accordingly, Yelp is a company that is destined to fail. It may be soon or it may be later but as shrewd attorney's eventually figure out the real actionable crime of Yelp's business, lawsuits will destroy it.

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Brian Nichols

Brian Nichols is the author of "5 Simple Steps to Find the Next Top-Performing Stock: How to Identify Investments that Can Double Quickly for Personal Success (2014)" and "Taking Charge With Value Investing (McGraw-Hill, 2013)". Brian is a value investor, but emphasizes psychology in his analysis. Brian studied psychology in undergrad, and uses his experience to find illogical value in the market. Brian covers technology and consumer goods for Motley Fool. Brian also updates all of his new and current positions in his Motley Fool CAPs page. Follow Brian on Twitter and like his page on Facebook for investment conversations and recent stories.

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