Alex Cho
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Rethinking Yelp's Quarter and Why it Has More Upside Ahead

I guess the real takeaway from Yelp’s quarter was the phenomenal performance on reducing cost levers while sustaining high levels of productivity with its sales force. The growth in local advertising accounts (LAAs) and the sustained revenue growth was a bit surprising. In fact, the engagement growth was somewhat misleading and masks the improvements in operating efficiency in Q2’16. Furthermore, I don’t think any analyst was anticipating such a strong quarterly earning print out, as the company beat the consensus handily.

I’ve been hesitant to push the stock recently, as I anticipated that the stock might have priced in all of its gains already. Well, guess I was wrong, and I could easily see the stock trading at higher levels going forward assuming the marketing improvements drive sustained revenue growth at a 30% CAGR for the duration of the year.

Here was the key highlight on the earnings conference call:

Sales and marketing expense as a percentage of revenue was 54% in the current quarter, down from 60% in the first quarter of this year, and up from 51% in the second quarter of last year. Nearly all of that year-to-year increase is tied to our marketing investment.

The company reported a 1 percentage point improvement on gross margins, and was also able to drive sustained improvements operationally. This is more of a classic example where revenue ramps at a higher rate than costs, which is why profitability is expanding. I’ve witnessed cases like this (for example Facebook), but I wasn’t anticipating the execution over at Yelp would prove to be this strong given the more competitive environment for digital advertising spend. Furthermore, the company was able to sustain 5.7% growth in local advertising accounts, and also reported that they were able to reach economic break-even. The company’s aggressive spending on marketing seems to be paying off, and with net income expected to ramp over the next couple quarters, I believe the buy side finally got a strong enough of a rallying cry around the name.

Source: Freestockcharts

That being the case, investors should be cautious of anticipating sustained price gains following each quarterly earnings report. However, the improving narrative on operational performance keeps me optimistic in the stock.

The analysts over at Credit Suisse had this to say in response to the quarterly earnings report:

YELP reported 2Q16 revenue of $173.4m vs. guidance/cons/CS $167m-$171m/$169.8m/$169.1m. Local Advertising Accounts were 128.4k vs. CS 127k, ARPU $406 was also above CS $396, and Local Advertising revenue was $151.9m vs CS $147.2m. Our target price increases to $50 vs. prior $46 and our FY16 EPS estimate is now $0.58. Yelp delivered better than expected top and bottom line results for the second straight quarter primarily on the strength of its local advertising revenue – both local active advertisers and ARPU came in ahead of CS estimates. Management also offered better than- expected initial 3Q16 guidance for revenue/adj. EBITDA of $180m-$184m/$24m-$28m, which implies 35% incremental margins over 3Q15 which still benefited from ~$9m in high margin Brand Advertising revenue.

I’m starting to think the consensus is a little conservative on the revenue line. They’re anticipating y/y deceleration in Q3' and Q4'16, but I believe that the q/q trends will only exhibit momentum especially as we enter into the holiday quarters whereby the brick and mortar retail channel tends to market more aggressively driving advertising CPMs higher. Furthermore, the on-going ramp of LAAs could slow, but the likely deceleration in LAAs isn’t going to translate into a meaningful reduction to revenues, as pricing and the ongoing efforts of smaller advertising accounts to optimize advertising returns should translate into a better q/q ramp than what the consensus is anticipating.

Furthermore, with costs increasing at a slower rate than revenue ramp, I believe we’re finally witnessing that key inflection point where we can start to anticipate reasonable profitability metrics in the next couple years. That being the case the productivity of the organization could scale quite considerably despite the heavy commitment on SG&A spending.

I really like Yelp right here, I could see the stock price moving due to a couple more quarterly earnings beats. But the degree to which the company beats on earnings is going to be far less substantial with a repeat of Q1’16 and Q2’16 after hours less likely. However, the stock will likely outperform the broad market over the next couple months and even in the years ahead. So, if you’re looking for a small/mid cap play in the Internet space, Yelp seems like one of your better bets.

I continue to reiterate my buy recommendation and I plan to raise my price target from $31 to something even higher over the next couple months.