You will need Help if you hold on to Yelp after its IPO

Crowd-sourced business reviews site Yelp.com will be going public this week with shares starting to trade on the NY Stock Exchange on Friday (NYSE:YELP). The company is expected to price 7.15 million shares (8.2 million with underwriter’s over allotment) at a price range of $12 to $14 as of this writing. The company will have around 60 million shares outstanding post IPO. If priced at the midpoint of the range, $13, Yelp will have a market cap of $780 million.

Given the small amount of shares being offered and given the popularity and name recognition that the site enjoys, I expect the shares to do very well on their first day of trading and a nice IPO-day pop is expected. However, the main question is will the shares maintain their altitude post IPO and what will drive them higher in the future?

After looking at the latest Yelp S-1 filing, I can only say that the financial future of the company is not that promising in terms of future profitability in the next couple of years. If you believe that a company’s stock price is a function of its future profitability then you won’t find many profits in Yelp for the next couple of years. The company has never been profitable and lost nearly $17 million in 2011. However, Yelp has built an impressive website that saw 66 million monthly visitors last year – but how much is that worth?

Yelp generates revenue from local advertising (70% of total in 2011) by local merchants as well as branded display advertising (21%) and deals (9%). It operates in 46 markets (cities) in the US and 25 internationally for a total of 71 as of the end of 2011. What is noteworthy is that 44 markets (62% of total) are two years old or less (22 each in 2010 and 2011) which means that there was a huge investment in rolling out coverage of these markets with revenues still trickling in slowly. What is also noteworthy is that, at least in the US, each new market being opened is smaller, on average, than pre-existing markets. Logic says that you start operating in the biggest markets first then expand to smaller ones. So a market like San Francisco or New York City opened in 2005 and 2006 respectively are bigger than Providence (2010) and Buffalo (2011). It is “probable” that smaller markets are likely less expensive to set up and maintain but it is certain that they will likely generate less total revenue. This is significant in that future revenue growth will slow down as the company expands to new (smaller) markets – everything else being equal. So what else are you getting at a $780 million market cap:

- 24,000 paying local customers who shelled out $58.5 million in 2011 or $2440 per client per year. At $780 million market cap, you are paying $32,500 per client or 13.3x annual revenue for each local customer.
- 606,000 claimed businesses or in other words potential clients or leads. If you back out those 24,000 who are existing clients then you are paying $1340 per lead.
- 71 local markets that have been set up, local businesses catalogued, and sales and support staff hired to sell into and maintain. Per market, you are paying nearly $11 million.
- 66 million monthly visitors. This translates to $11.8 per monthly unique visitor

Now the purpose of this exercise is to show you what exactly you are paying for the set of digital assets that Yelp has. They are certainly valuable; they generate revenue and cost time and money to reproduce. However, are they worth the price you are paying or will pay post IPO? At $13 or higher my answer is a definite no. Having said that, I do expect a nice exuberant pop at the open and in the days immediately after the IPO. Yelp is a takeover play and not an earnings growth play. It is a speculative stock that will go up and down based on market sentiment for tech and social media stocks as well as the market overall. It is an ideal takeover for a big consolidator in the tech/social media space. Perhaps Google (NASDAQ:GOOG), Yahoo (NASDAQ:YHOO), AOL (NYSE:AOL), IAC (NASDAQ:IACI) may be interested at some point but most of these players already have a local/city product among their offerings. Still, if a consolidator picks it up, it won’t be at those multiple levels. My back of the envelope calculations puts the takeover value of Yelp today at $375 to $500 million ($6.25-$8.33 per share) based on a generous 50% revenue growth in 2012 to $125 million and based on the assumption that a consolidator can squeeze half of that in EBITDA ($62.25) and then slapping a 6 to 8 multiple on that. Incidentally, that comes out to the 4-5x sales multiple that I have always considered advertising based internet stocks are valued in a takeover by a strategic acquirer.

Perhaps with a new currency, its stock, Yelp can be the consolidator by rolling up other small local players such as Angies’ List (NASDAQ:ANGI) or Open Table (NASDAQ:OPEN). Either way, this stock is only for those with an extremely high tolerance for risk. Keep in mind that the longer Yelp remains public under its existing business plan the more likely it is to run out of cash and come back to the market to sell more shares diluting existing shareholders. So if you are lucky enough to get shares in the IPO from one of the Underwriters then you will be well served if you sell soon after the IPO. If you do not get any shares before it starts trading then you should look away and fight the temptation to jump in if you see the stock making huge advances.

Tagged NASDAQ:ANGI, NASDAQ:GOOG, NASDAQ:IACI, NASDAQ:OPEN, NASDAQ:YHOO, NYSE:AOL, NYSE:YELP