Yelp Wanted?

The allure of the local advertising market has captured the attention of a host of Internet companies, and Yelp's (YELP) active community of 66 million monthly visitors who have written nearly 25 million reviews of local businesses has put the company at the head of the pack.

However, we are concerned that local businesses may not see enough value in the advertising platform to increase spending and justify the price of this IPO. Perhaps most importantly, the dual threat of  Google (GOOG) and Facebook may grab more of the local advertising pie, constraining Yelp's growth and profitability.

Key Investment Considerations
Morningstar's Take: Yelp's active community of users writing reviews of local businesses is difficult to replicate. Unfortunately, the company faces challenges translating the small advertising budgets of local businesses into profitability, as about 70% of ad revenue is eaten up by sales and marketing expenses. Although we ultimately expect operating leverage and resulting profitability, success is far from certain.

Thoughts on Economic Moat: We do not believe that Yelp has an economic moat. The ROI for its customers that buy advertising is meaningfully opaque, and the local ad sales effort is extremely expensive relative to the revenue opportunity at each local business. To transform competitive advantages into excess returns on capital, the company must generate additional revenue streams from its existing customer base.

Risks: Competition and the ad hoc nature of ad spending by local businesses provide serious downside risk for the company. On the upside, Yelp's opportunities in mobile and international markets may provide accelerating growth and profitability and prove our valuation to be overly conservative.

Valuation: Our preliminary valuation points to an enterprise value of approximately $500 million (3.9 times our 2012 sales projection) and a fair value estimate of $9 per share.

Initial Thoughts from Yelp's S-1 (Dec. 1, 2011)
We see Yelp as an Internet community site focused on consumer reviews of local businesses. Although we have yet to issue our formal moat rating for Yelp, the business has many characteristics that place it a step ahead of the competition. Unlike Angie's List, there is no cost to access reviews and no restriction to "high cost of failure" services such as plumbing, home remodeling, and health care. Therefore, Yelp has about 32 times more monthly reviews (2.5 million in 2011) than Angie's List and 62 times more unique visitors (61 million in 2011) than Angie's List can count as members. We believe the density of the community reviews is extremely difficult to replicate and creates a virtuous cycle whereby users continue to visit the website for recommendations and contribute their own ratings and reviews.

Without membership fees, Yelp relies on local and brand advertising for the vast majority of its revenue stream, especially following its August decision to scale back its daily deals business. The firm is on pace to record more than $75 million in revenue in 2011, an 80% growth rate that is consistent with its mid-80s average growth over the past three years.

Ultimately, the biggest challenge for businesses managing local communities and selling advertising is generating appropriate economic returns. While we are optimistic about the potential that local advertising offers, we remain concerned about the high cost of selling small advertising contracts to local businesses. Sales and marketing expenses represent more than 70% of revenue, a relatively consistent ratio over the past four years. Additionally, the company has yet to post an operating profit. While we believe the company can ultimately generate profits, we expect the business may need to create new sources of revenue as well translate its competitive advantages into favorable profitability. Finally, we can't ignore the competitive threats from Google and Facebook. Both companies offer other services to local businesses, and their deep pockets and patience could whittle away Yelp's leading positions in the marketplace over time.