The Case Against Yelp

Yelp describes itself as a company that, “connects people with great local businesses.” Boasting over 205 million reviews of businesses globally, the digital marketing company sells ads on its platform, and elsewhere, primarily to restaurants, retail, and home services companies. The same industries that are likely to be negatively impacted by macro factors which we will further discuss.

Adding to our macro concerns, Yelp has been the subject of over 2,000 FTC complaints, and two certified class action lawsuits from investors where the company felt compelled to settle claims for tens of millions of dollars in total. Yelp has also been sued by countless businesses listed on their website, as well as clients, citing deceptive behavior, unfair business practices, and even extortion-like behavior.

Macro

Ad spend tends to be cyclical for companies. For Small & Medium Businesses (SMBs), this tends to be even more true although the cycles may be shorter since they don’t have much bureaucracy. SMB’s remain Yelps primary target market with a focus on RR&O (Restaurants, Retail & Others).

The cycle is simple:

1. Spending increases in the economy

2. Business picks up

3. SMB owners decide they should get their product out there and put some funds into an ad budget

The opposite happens when the macro picture is bleak and spending in the economy starts to retreat, as we are seeing now. So, the decline in the level of GDP is completely in line with our thesis of decreases in consumer spending leading to lower ad budgets.

However, as you can tell this happens with a time lag. Just as ad budgets are not put in place immediately, they are not cut immediately either. So, we believe that in the coming quarters we will see major pullbacks in ad spending.

More importantly, the recent retail spending data shows that consumer spending is decreasing across retail and restaurants, which is Yelp’s main target market.

Finally, the SMBs are having to contend with other cost pressures - raw material, freight and wages. It would make perfect sense for them to spend less on advertising and reallocate the funds to these other costs.

Fundamentals

On the face of it, the Company’s financial performance looks acceptable. They obviously suffered during Covid, as spending on services and restaurants retreated.

However, since then they’ve had several quarters of sequential growth and they are faring better.

They’re also generating Operating Cash Flow, which is a positive.

There are still a few red flags in their financial statements that make us uncomfortable.

Employee Stock Purchase Plan: The Company has a Stock Purchase Program for their employees wherein the employees can purchase stock of Yelp for a discount of 15% and the funds are taken from their payroll.

In and of itself, this is probably not such a problem in theory but the Company actually states this as one of their sources of cash which tells us that they are dependent on this and probably "encouraging” employees into the program, forgoing part of their wages for stock. Moreover, they issue common stock for this plan, making the plan dilutive for other shareholders.

Cash Flows: While they are cash flow positive at USD 177m (trailing twelve months), USD 125m of that amount is an add back from Stock Compensation.

Capitalized Assets: Finally, their capitalized expenses for website and in-house software development have been exorbitant over the years. Now, while the levels are comparable to other tech companies like Twilio, their business model remains much lighter than companies like Twilio. This means that they probably needn’t make investments at that level.

As can be seen above, for half-year 2022, they capitalized USD 14.3m under this banner. Looking at their S-1 from their IPO, the level was USD 5.6m at the time.

The only upside to this is that they are heavily depreciating these items using a 3-year time period.

The fair value of this company based on projected cash flows is $28.79.

Usage metrics

The majority of Yelp's traffic originates on mobile devices, largely through the Yelp app. Using iPhones as a proxy to measure popularity we can see that it seems to be on a decline recently.

While Yelp itself hosts reviews of businesses, apps are also given feedback by users, and Yelp's feedback trends have been increasingly net negative.

Yelp had previously published a metric called "app unique devices," but as of the latest 10-Q filing, that metric has been redacted. Before the redaction, however, even with Yelp's in-house metrics we could see that usage was declining. The company left the following note regarding their "app unique devices" metric:

".. our metrics may be affected by mobile applications that automatically contact our servers for regular updates with no discernible user action involved; this activity can cause our system to count the device associated with the app as an app unique device in a given period."

Meaning that the company may or may not have been providing reliable user metrics, a subject of contention in several lawsuits, including two class actions that Yelp settled. More on that later.

Because Yelp is essentially admitting that they cannot differentiate between users that actually utilize their app and do not, despite spending about a quarter billion on technology, it tells us that they are either intentionally obfuscating their metrics or their technology is so rudimentary that it doesn't have any way to know if you signed up for Yelp, searched for a restaurant, or otherwise actively engaged it.

Usage metrics that the vast majority of apps collect with off the shelf technology.

Technology

Yelp’s algorithm is the subject of contention as many business owners feel that the prioritization of reviews is unfair to them. Some have even accused the advertising company of rewarding business owners who advertise with more positive reviews being displayed. A subject that was litigated, with the 9th Circuit Court ruling in Yelp’s favor, saying in effect the company is free to do whatever it pleases, including changing review visibility, for advertisers.

Yelp does have a patent [1] that pertains to review visibility, but it does not detail how reviews are prioritized or de-prioritized outside if keyword and interest matching. I.e. if a vegetarian restaurant search is done, reviews mentioning the word vegetarian or related therewith may be more visible. This does not include, however, filtered reviews. Only those that are visible on the website.

Yelp recently released location-driven ad targeting and keyword boosting as an effort to try to address criticisms about the advertising not being effective. They also added functionality for potential clients to request callbacks from businesses, and last year Yelp also began to offer off-platform advertising in an effort to gain a broader reach and compete with the likes of Google and Facebook. Interestingly enough even though the company has spent over a quarter billion dollars on technology in the form of software, hardware, and development since its founding in 2004, it has not made any effort to verify the credibility of reviews by introducing any sort of transactional verification (such that the reviewer would demonstrate they did business with the company in question) or identity verification (in order to mitigate the problem of fake accounts writing false reviews).

Ostensibly these policies would add friction and reduce the total amount of reviews and as a result engagement. But they would also ensure content submitted was verifiable, unique, and by actual people, thus increasing trust in the website.

Yelp has spoken about the 1/9/90 rule applying to them. In that 90% don’t write reviews, 9%, referred to as editors, participate by commenting, rating, or sharing content, and only 1% of the users actually create content, or reviews. This is one reason they are likely hesitant to add any friction to the review process.

Litigation

Yelp has been sued a fair number of times, and settled recently in two separate class action suits [2] brought by investors over misrepresenting their metrics, efficacy of advertising, and regarding the churn rate of their advertising program.

These lawsuits began as early as 2017. The first class action lawsuit, Ingrao vs Stoppelman, alleged that Yelp "engaged in an unlawful scheme designed to materially mislead Yelp shareholders about the purported success of the Company's business and advertising model and its prospects for future revenue and earnings growth." Yelp has also been repeatedly sued by business owners, as mentioned above, but also in several separate suits. In a few suits they have lost, including Hadeed Carpet v Yelp, where the company was forced to reveal the identity of anonymous reviewers.

Yelp attempted to claim first amendment privileges for the anonymous reviewers, but a Virginia judge ultimately rejected this claim, and Yelp failed at their appeal attempt as well. These lawsuits demonstrate that Yelp has had two separate class actions certified by judges and settled them as they were likely to lose if they were litigated. Yet corporate governance changes were only put into effect in 2022, thus there are at least 5 years where Yelp was apparently knowingly misleading investors and clients.

Reputation

While Yelp itself is an advertising website that aggregates reviews to create a consensus on the reputation of companies through the number of stars they receive (or do not), Yelp’s own reputation isn’t without significant problems.

Not only have many business owners sued the company, but we’ve also seen over two thousand FTC complaints [3], and a rather poor impression within the online community of advertising specialists.

The consensus, beyond concerns regarding how Yelp filters reviews, is that Yelp’s own advertising platform isn’t very effective. Return on investment is often seen as better on platforms like Google and Meta, as opposed to Yelp. This makes sense as Yelp not only has a relatively limited ecosystem, but in less populous areas it is hard given the lower saturation of Yelp as a platform for them to reliably show related and helpful content.

Technical Analysis

Large area of confluence on weekly chart, price seeing resistance, just over a large demand zone, but below several significant potential supply zones inside that high volume node. The chart seems to be forming a pennant pattern as we’ve seen consolidation of price through lower highs and higher lows since the breakdown during the COVID crash.

Options Positioning

There is a rather sizable amount of put exposure at the $29 and $31 strike, concentrated at the September 16th monthly expiration as of Friday’s close. The lower price, where there is a larger concentration of puts, aligns with our trade idea.

Our Trade Idea

Selling into weakness here and continuing to add to the position should it cross under $34 on a closing basis.

An initial price target of $29 is reasonable based on both our fundamental and technical analysis, but if $27.95 breaks on a weekly closing basis we would be tempted to continue holding runners (1/3rd to 1/4th of original position size) with that downside momentum building, a second more aggressive price target of $19.65 is not unreasonable.

To manage risk in this trade we would add an upside trailing stop of 3%. We would cover the position if it breaks back above $35.37 on a closing basis, assuming it crosses below that price. That does seem like a tight stop, because it is. That is a rather key area of potential supply and if we break above that high volume node it will probably unleash some upside price momentum. Initially.

Disclaimer:

Nothing in this article is meant to be construed as or taken to be investing or trading advice. All content is provided for informational and educational purposes only. Consult with your financial advisor before making any investment or trading decisions to be sure they are appropriate for your risk tolerance and financial goals.

Authors:

This article was written jointly by Ayesha Tariq, CFA and Markets & Mayhem.

References:

[1] Surfacing relevant reviews - https://patents.justia.com/patent/9621662

[2] Yelp Investor Class Action Lawsuit is Nicholas R. Ingrao v. Jeremy Stoppelman et al., Case No. 3:20-cv-02753, in the U.S. District Court for the Northern District of California & Yelp Investor Class Action Lawsuit is Jonathan Davis, et al., v, Yelp, Inc., et al, Case No. 3:18-cv-00400-EMC in the U.S. District Court Northern District of California.

[3] FTC Subpoena Revelations, Thousands Of Complaints Send Yelp’s Stock Price Tumbling