$130 Billion Reasons to Not Short this Stock

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Whenever I see investors piling into a short position in a stock, I actually become more interested. I'm a contrarian at heart and I know that short sellers get it wrong sometimes; and when they’re wrong it can set up a short squeeze. This is when many investors who have sold the shares short are forced to buy them back to cover their position. When you can find a company with a good business model that is also being shorted, it can sometimes lead to big gains. This is why I've come back to Yelp (NYSE: YELP).

Yelping From Short Interest

For the second time this year, Sean Williams of The Motley Fool noticed a significant increase in the short interest of Yelp. His most recent article from Sept. 10 indicated that short interest in the stock had jumped 41.5% to a total of 40.5% of the float. This is an extremely high percentage, and if the shorts are wrong this would create massive potential to move the stock price up. Sean covered several reasons short-sellers might be willing to bet against Yelp.

First, “there's practically no barrier to entry preventing another company from setting up a review site similar to Yelp's.” Second, he mentioned the company is “solely reliant on advertising to drive its growth, and that's a model that put many dot-coms out of business in the early 2000s due to the ebb-and-flow nature of corporate spending.” Last, he noted that “Yelp also charges the highest cost per click to advertiser per 1,000 impressions of any advertiser according to VentureBeat.” While these are all valid concerns, some don't quite stand up with what is actually happening at the company. Understanding what Yelp does and why it's different is the key to knowing if the stock should be shorted.

What Does Yelp Do?

In essence, Yelp is a place for local businesses to connect with their customers. I've written about this before when Sean's article came out in April of this year, but I'll give you the quick summary here. Yelp is not just a review site. In his earlier article Sean compared Yelp to Angie's List (NASDAQ: ANGI), which, with no disrespect to Angie's List, just isn't fair. Angie's List charges a fee to access its information, Yelp does not. Angie's List has been losing money for years and analysts expect this to continue. Yelp is expected to become profitable next year. Angie's List is centered on customer reviews of businesses; Yelp is centered on businesses reaching customers. The main difference between Yelp and other sites is the depth of the company's research and efforts when they add a new locality.

Why Do Small Businesses Like Yelp?

This is probably the most important factor to why another company can't just “set up a review site similar to Yelp's.” Yelp provides a location for local business owners to set up their virtual shop. Unlike many other lesser known review sites, Yelp does a lot of groundwork before launching a new city. The company creates business pages for local businesses, and unlike some competitors it actually checks to make sure the information is correct. I can't tell you how many times I've seen information online about a company that was outdated, wrong, or the company didn't even exist anymore.

For small businesses, it's just as important that customers know where to find you so that they can review your business for others. Yelp checks addresses, phone numbers, and other pertinent data before launching a new city. The company hires a community manager who is usually from the area to support reviewers and organize meet-ups. Critically important is the fact that 91% of Yelp's revenue is from “local revenue.” Yelp's growth is based on local businesses, not based on “the ebb-and-flow nature of corporate spending.” With a 70% reviewer repeat rate, this is a sticky site for businesses to utilize in order to reach out to their customers.

What about Growth?

In the company's last earnings report, it showed revenue grew 67% and active local business accounts increased 113%. The company has grown from 80 to 90 markets in just the last few months. Yelp saw excellent organic growth in both reviews and unique visitors: reviews increased 54% to 30 million, and unique visitors increased 52% to 78 million. The main reason competition can't just step in and recreate Yelp's experience is that the information is 30 million times more relevant than last quarter. With 32,000 active local business accounts, small business owners can obviously see value in Yelp's offerings.

In addition, while Apple's new maps app has been widely talked about, there is no doubt this feature will improve. I personally have used it several times and had no problems. Yelp is integrated into iOS 6, which means millions of iPhones, iPads, and iPod Touch users have the ability to access Yelp reviews.

Many people would say that Yelp's growth isn't real because the company is still reporting losses. I would counter by saying that 62% of revenue last quarter was eaten up by sales and marketing costs. As Yelp reaches scale this cost should fall dramatically. I'm fine with a growing company spending freely on sales and marketing, if it means that down the line this will pay off.

Competition:

I know what most people would say: why do we need Yelp when we can find business information using Google (NASDAQ: GOOG)? Have you ever tried using Google to find a local business? If the company has a dedicated web site, the proliferation of businesses using the same or similar names in different parts of the country makes a web search much less reliable. Yelp's focus on local businesses makes it much easier for reviewer and users to find what they want. I could see Google finding Yelp as an attractive acquisition target, but when it comes to local businesses Yelp is better positioned.

Some might make the argument that Facebook (NASDAQ: FB) is a potential threat. It's true that a local business can set up a profile on Facebook and then promote itself to friends. However, that business isn't likely to get exposure to 78 million unique visitors in a three month timeframe. There is also no organized way to learn a lot about the business, with no place on the social network site for reviews and experiences with the company. I could also envision Facebook being interested in Yelp as an acquisition, but for local businesses, Yelp appears to be a better resource.

Conclusion:

Local advertising is still being done largely offline; in fact, only 15% of spending is done online. This isn't hard to understand if you think about it—if you own a local plumbing company, what's the likelihood that advertising on Google is going to do you a lot of good? Which do you think Google is going to spend more time targeting, a local plumbing company or E*Trade? However, local advertising is a $130 billion a year business, and 85% of this money hasn't found its way online yet. If Yelp continues to expand into new local markets, that's about 130 billion reasons not to short this stock.

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MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook and Google and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Facebook and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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