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Yelp: An Intriguing Setup Into 2020

Yelp (NYSE:YELP) recently reported financial results for the second quarter of fiscal 2019.

Revenues for the period increased 9% to $262 million, with a significant increase in ad clicks offset by a decline in the average cost per click. Note that this is a material increase in the pace of growth from the first half of the year, when revenues increased by roughly 5%. In addition, management expects another acceleration in growth in the fourth quarter (and possibly into 2020), with revenues expected to climb by a low double-digit percentage year over year.


Yelp is seeing continued success among its largest clients, with a 21% increase in revenues from multi-location customers (and the likely reason behind an acceleration in paying advertiser locations growth). Importantly, the increase was driven by continued engagement among existing advertisers (mid-teens growth in that segment), as well as the addition of new clients. As I noted last quarter, I take comfort in the fact these customers are likely the most capable at understanding the efficacy of their ad spend. If they are allocating additional dollars to Yelp, it's likely because they are seeing returns on the investment that justifies incremental spend.

User engagement continues to grow as well, reaching 38 million app unique devices in the quarter (up 11% year over year), along with a 17% increase in cumulative reviews. That said, as shown below, the pace of app-unique device growth has slowed a bit in recent quarters. While that partly reflects the reality of trying to sustain growth off of a larger base, I would start to be a bit concerned if the number of net additions continued to decline (it added roughly 3.6 million net devices year-over-year in the third quarter, compared to an average of roughly 4.5 million devices added per quarter over the past two years).

Across the platform, Yelp continues to see user activity in its key categories move beyond the legacy directory and review product. In restaurants, this includes reservations through Yelp Waitlist and Yelp Reservations (the number of seated diners more than doubled year over year) and online ordering through its long-term partnership with Grubhub (GRUB). And in categories like Home and Local Services, Yelp's most important vertical in terms of revenues, this includes offerings like Request A Quote, Portfolios, and Verified License. In my opinion, these changes have resulted in a better product for app users, advertisers and the company (with revenues in the vertical increasing by nearly 40% over the past two years to $95 million in the third quarter).

A shift toward self-serve customers (with self-serve revenues up nearly 40% in the quarter) and larger accounts means Yelp can generate the same dollar of revenues with fewer salespeople. As a result, sales headcount in the quarter declined by 1% year over year, with local sales headcount falling 5% (offset by a one-third increase in salespeople serving multi-location customers).

The reduction in headcount, combined with mid-to-high single-digit growth in revenues, is leading to sales and marketing expense operating leverage: year to date, sales and marketing expense has been equal to 50.2% of revenues - an improvement of roughly 160 basis points.

The improvement in local salesforce productivity is the primary driver of the nearly 200 basis point gain in year-to-date Ebitda margins (to 20.5%), with operating income increasing 17% over the same period. Based on the long-term guidance that management has committed itself to, it's clear they expect this trend to continue over the next few years as well.

Yelp currently has $417 million in cash and equivalents and no long-term debt (roughly $6 per share of net cash). The company has accelerated the pact of capital returns to shareholders, with $475 million spent on share repurchases through the first nine months of the year (at an average cost of $34 per share). The result has been a mid-teens decline in the diluted share count. While the pace of repurchases will almost certainly slow going forward, the strength of the balance sheet still gives them some flexibility to pursue opportunities when given the chance to do so.

Conclusion

Anybody that builds a simple financial model based on the long-term guidance that management has put forth will clearly see Mr. Market remains quite skeptical that the company will come anywhere close to hitting these targets. Personally, I agree with that conclusion. Assuming revenue growth will accelerate another 500 basis points and that it will expand margins by roughly 250 basis points a year over the next four to five years is too aggressive for my blood.

But with lesser assumptions, I still can see a scenario where the equity looks attractively valued here. If management can get anywhere close to their expectations, that would be icing on the cake. If they even deliver 10% annual revenue growth and 30% Ebitda margins, the stock will almost certainly be a home run from current levels. I think the fact that they continue to improve the product offering (for consumers and advertisers alike), in addition to the shift toward larger customers and self-serve, should put it in a position to generate better economics. For that reason, I'm intrigued by the implied odds on this bet.

By my math, even if the company falls well short of its publicly stated financial targets, it will earn somewhere around $3 to $3.5 in 2023 (that assumes roughly 8% annualized revenue growth, 27% Ebitda margins in the terminal period and a small benefit from repurchases, which still leaves a lot of net cash sitting on the balance sheet). Said differently, the stock trades at roughly 10 times earnings if you look out a few years.

That's a long way of saying I like the risk-reward at these levels. For that reason, I continue to be a Yelp shareholder. This isn't my highest-conviction position, but it is one where I believe the upside in the event of favorable business results could be massive. I wish the stock had not run higher on the third-quarter results, but that's life. Hopefully this bout of optimism fades. If I'm given the chance to add to my position at a lower price, I will happily do so.

Disclosure: Long Yelp.

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This article first appeared on GuruFocus.