Is Yelps 20% Drop A Buying Opportunity For Investors?

By Motley Fool Staff Markets Fool.com

Yelp (NYSE: YELP)had revenue growth of 24% this quarter, but the stock is still down 20% this month on their earnings report.

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In this segment from Industry Focus: Tech, Motley Fool analysts Dylan Lewis and David Kretzmann look at Yelp's earnings reports and explain what trends had the stock sell off so drastically, and they talk about whether this 20% discount could be a buying opportunity for long-term investors. Find out what the biggest risks facing Yelp are today and how the company is facing them, how likely a buyout from behemoths such asFacebook (NASDAQ: FB)or Alphabet's(NASDAQ: GOOG) (NASDAQ: GOOGL)Google could be, why Yelp is having such a hard time with ad revenue, and more.

A full transcript follows the video.

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This video was recorded on May 19, 2017.

Dylan Lewis: Yelp is down around 20% since reporting earlier this month. It's the theme of the day. I think the story was pretty similar with them. We had earnings that were more or less in line with what the market was expecting. The problem was guidance.

David Kretzmann: Yeah. Their revenue was up 24% this quarter, which isn't bad. That's not slow growth. But it's been an ongoing issue for Yelp, revenue deceleration. Their revenue had actually decelerated every quarter since the third quarter of 2014. It's almost going on three years. At that point, their sales have grown about 68%. Essentially, that sales growth number ticked down steadily quarter by quarter. And here we are at 24%. Really, I think the company has run into some headwinds, because their total user base has essentially plateaued. They have 84 million desktop users; they have 73 million mobile users. That's bounced around quarter to quarter, but it hasn't really grown significantly. The main way the company generates revenue now is through what it calls local advertising accounts. Essentially, it has 139,000 small or local businesses that will pay for advertising in some shape or form on Yelp's platform. To give some context, that's out of 3.4 million claimed business locations, which essentially means there are about 3.5 million business owner accounts on Yelp.

Lewis: People who have verified, "This is my business," basically.

Kretzmann: Yeah, they verify with Yelp, so they've taking that step. Only about 4% of those verified businesses on Yelp are paying customers right now. And one of the issues that contributed to the slightly weak quarter, and perhaps the weak guidance as well is, essentially, their revenue retention rate was lower than they anticipated. In other words, the customers they have weren't necessarily paying the same amount, or even paying at all compared to previous quarters. So certainly some concerns there. Yelp, like I said, the revenue has been decelerating over the past three years. And over that time period, expenses continue to tick up, so the company's path to sustainable profitability is still a little murky.

Lewis: If you're looking for the numbers here, Yelp revised its guidance on their call for revenue from $850 million to $865 million for full-year 2017. Original guidance had been $880 million to $900 million. That doesn't seem like a big drop. But when you're talking about a company that should be growing pretty quickly, and should be moving the top line, I think that's where it starts to become a reason for pause, and where you have this reaction. Certainly, if you are an advertising platform, and that's how you're making most of your money, and you're hearing that retention isn't great, you want advertisers to be seeing the [return on investment] on their ad dollars, and for it to be making sense for them to continue plowing money back into the platform, because they're getting new customers, or doing something to do their business. If you're not helping people do that with advertising, you're not going to be a very successful advertising platform.

Kretzmann: Yeah, especially when you're talking about the digital advertising space, which has largely been dominated by Google and Facebook. Yelp has to really demonstrate a value proposition that's attractive the customers. If that revenue retention rate is dropping or not growing, that could demonstrate that they're struggling a little bit to compete with the behemoths like Facebook and Google where these digital ad dollars are naturally flowing. Yelp, over the past year and a half, has really gone through a lot of internal shake-ups. The chairman and then-CFO both departed the company within five or six months of each other. Usually, if you have high-profile executives or board members leaving within a few months of each other, that raises, for me, a yellow flag. Then they've also been slowly but surely dwindling down their international business, and they're refocusing on North America, where they are seeing better metrics, as far as bringing on paid accounts. But, there are some attractive attributes to the business itself. The new CFO a couple quarters ago mentioned that no single custom rate makes up more than 0.5% of total sales.

Lewis: So the opposite of Twilio'sproblem.

Kretzmann: Essentially, yeah. Very diversified. No single geographic market is more than 15% of revenue. And the company's largest category, which is actually home and local services, so plumbing or home repairs or things like that, that generates less than a third of total local advertising revenue. So as far as revenue goes, it's a fairly diversified business across all of these segments and customers. But the trouble is when you have a stagnant user base, trying to get more of those businesses to pay out to reach what is a stagnant user base, I think they're running into some headwinds there. If that user base isn't growing, and you're competing against Google Maps or Facebook Reviews, or all these other things from much larger competitors, I understand why the company is running into headwinds.

Lewis: Yeah. All the digital ad market research that I read is showing the power that Google and Facebook wield is consolidating, getting bigger and bigger, and very often it's coming at the expense of these smaller platforms. This is not all that different from the conversation I had following Twitter'searnings. You look at the declining price of ad engagements on their platform, and I think some of that is simply because advertisers are seeing better [returns on investment] elsewhere. Facebook, in its recent quarterly calls, paid a lot of attention to small businesses. You can look, they've highlighted the number of small businesses that are advertising on the platform, that have pages on the platform. So, local is clearly a focus for them, even though they are this massive, massive global phenomenon at this point.

Kretzmann: Yeah. Another company I follow, [Priceline Group], which is the online travel agency, you might have talked about it on this show, they own Booking.com, Kayak, online travel agencies like that. On their conference calls, pretty repeatedly, they say, "We want to spend more money on Facebook." So that gives you an idea, these advertisers want to spend more on Facebook and Google. That's where they're seeing the highest [returns on investment]. So if you're someone like Yelp or Twitter, they're facing many more struggles competing against those much more dominant platforms, in terms of digital ad spending. But with Yelp, similar to Twilio, I think there are some business dynamics that are attractive. The company actually has a net cash total of $486 million, which is 21% of its current market cap. To me, that suggests, there is at least a cushion here.

I think the most likely out for Yelp would be getting acquired by someone. Because I think they do have a relevant platform, but I think it needs to be part of something larger. I just don't see this being a thriving, sustainable business on its own. Having over a fifth of your market value in cash, that should provide a cushion. They are producing positive free cash flow, even though a lot of that, similar to Twitter, is due to stock-based compensation. But even when you back out that stock-based compensation, the business is producing positive free cash flow. So they're not in danger of going under anytime soon. But, yeah, to me, it's hard for me to see them surviving and doing well on their own, so I wouldn't be surprised if you see an acquisition. Their market value right now is similar to Twilio's, about $2.3 billion. So, they could be snapped up by one of those bigger players pretty easily.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. David Kretzmann owns shares of Alphabet (C shares), Facebook, Priceline Group, and Twitter. Dylan Lewis owns shares of Alphabet (A shares) and Facebook. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Facebook, Priceline Group, and Twitter. The Motley Fool recommends Twilio and Yelp. The Motley Fool has a disclosure policy.