I love Yelp. There’s a good chance you do, too. I use it at least once a day– I’ve written dozens of reviews (good and bad), and it’s always one of the very first mobile apps I download to a new phone or tablet. Millions of people agree with me.
All that said, these behaviors do not mean YELP is worth nearly $2B, as its stock price recently indicated (IPO first week of March, 2012, recent 52 week high of ~$32). As someone who lives, eats, and breathes social media, I’m (oddly?) the first person to call out when valuations don’t match reality– the issue being there is a fundamental, large gap between a property built on social media, featuring user-generated content, and that property simultaneously being a successful business. It is my absolute belief that a handful of companies will emerge from the noise to figure out how to navigate this gap, building strong, successful businesses– and this is the key part– while maintaining their user’s trust, respect, and expectations. Below, I will attempt to show my reasoning on why I don’t believe Yelp will find that sweet spot with its current business.
Note, the following thoughts presume Yelp’s current business model– local business buying advertising to highlight or extend their listings– prevails, and Yelp doesn’t have something amazing, novel and exciting up their sleeve (as you’ll see, I hope they do).
So here’s the basic premise– Yelp’s FUNDAMENTAL ISSUE is that to enable its community to thrive, it can’t make money at scale. I say ‘at scale’ to make it clear that I think Yelp is and could continue to be a great business in the way that so many unsung heroes of the American economy are profitable, treat their employees well, and provide a wonderful value to their customers and users. But I think enormous innovation will be required to put Yelp in the ranks of the world’s largest and most successful companies, which is where it is currently being valued by the stock market (and their investors).
The problem is that Yelp, to make money (again, at scale), would have to push the very features that make its community so successful, down, if not outright OUT. It’s a devil’s bargain. Today the bargain is definitely in favor of the user– Yelp ads, deals, etc., are unobtrusive and incredibly easy to ignore. But that attitude can’t last if expectations for the business remain where they are.
Unfortunately, I believe that advertisers simply cannot line up to pay Yelp and make its current approach work at scale. Note that I didn’t say advertisers will choose not to– I say they simply can’t. Why? There are a few critical things necessary for Yelp’s current business model to begin to thrive (at scale):
a) Yelp’s customers must FIRST have the ability to pay for marketing. This is easy to overlook, but the reality is that LOCAL restaurant reviews are Yelp’s largest area of content/success, and what Yelp is famous for. And it just so turns out that LOCAL restaurants run on RAZOR-THIN margins and cannot afford to advertise in GENERAL. The numbers in reality are incredibly sobering:
Profit margins [for full service restaurants]…varied according to the cost of the average check per person. Those with checks under $15 showed a profit of 3%. Those with checks from $15 to $24.99 boasted the highest profit margin at 3.5%. Finally, those with checks of $25 and over had the lowest profits, at 1.8%. Source: chron.com
[Note that the costs of doing business in the calculations above did NOT list marketing expense, so any advertising expense would have to come out of those heady 1-3% margins, lowering them further into oblivion]
b) Local restaurants generally rely on word of mouth and locality (you go to the pizza place on the corner, not across town) to gain customers, not advertising. There is a simple limit on what advertising can do for an eatery– a restaurant is stuck in place. Since people value location and will not typically drive for hours to eat, there are only a fixed amount of nearby customers that they can realistically hope to convince to come visit. For those who make eating decisions based on convenience and cuisine, making sure a restaurant shows up on a Google search– and even Yelp’s own free listings– are sufficient.
Looking at it from the business scope, beyond simple availability of capital and its anticipated effectiveness, advertising (online) is not *what these restaurants are used to doing,* and as such, there’s no budget– money or psychological– for it. Forget the specifics of any single space– teaching people to do something they’re not used to is HARD, especially when it costs serious money and has dubious benefit.
c) Next issue–a good restaurant, outside of special occasions like grand openings, does not NEED to advertise, and that is a poor use of its limited capital. Take an extreme example– French Laundry is $500/plate and will never need to spend a cent telling anyone about itself, even without a celebrity chef. The legend tells the story and recruits customers. The same thing goes for a hole-in-the-wall eatery in San Francisco that’s 4.5 stars. People tell each other about it, newspapers review them, you see a line outside every time you drive by. Put another way, a highly rated restaurant (on Yelp, or elsewhere) doesn’t need to spend serious money to attract customers— once off the ground, the location, rating and reputation is itself the advertisement.
Well then, if we take the really good restaurants out of the mix, what does that leave us to work with? The mediocre to bad restaurants, on the Yelp scale, we can say those are the 3 star and under restaurants (Yelp’s ratings are 1 to 5 stars, 1 being the worst).
d) So now that we’ve narrowed our pool of potential lucrative customers to mediocre to bad restaurants (remember, we’re analyzing the ‘at scale’ revenue scenario, so I’m leaving out the non-repeatable grand openings, new managements, limited promos etc.), let’s see why or why not they’d be regularly paying Yelp big money, and therefore, allowing Yelp to be a BIG business.
This group of restaurants first must have the money to pay for marketing (as discussed above, I find this doubtful) and then the DESIRE to pay for promotion online– specifically at Yelp. What is Yelp? A site that specializes in community ratings, and where these very restaurants are being rated poorly in a genuine, authentic environment of millions of users. And there you have it in a nutshell– what makes Yelp good for users makes it very bad for the restaurants that need marketing help.
Think about that a bit more, pretending you are a restaurant owner of a 3 star reviewed place in Yelp. To advertise there would be like clamoring to put your ad on a review of your restaurant in the local newspaper, where they told you ahead of time you’re going to get a mediocre to bad (C+/B-) review. To be blunt, to advertise there would make you look either stupid (don’t they know they got a bad review), or desperate (the ad essentially tries to refute the review, “we’re not so bad” etc).
So, let’s recap:
- Yelp’s biggest (current) value is having tons and tons of authentic, excellent restaurant reviews
- The authenticity of the reviews is precisely what keeps their community thriving, and therefore generating more reviews
- That audience built by Yelp’s genuine reviews and thriving community would seem to make a juicy target for advertising
- Yet local restaurants have almost no money left in their budgets for advertising, nor do they typically need/want to advertise: great restaurants rely on word of mouth and reputation, bad restaurants do not want to pay money to promote themselves where they are being disparaged.
- Restaurants are also limited in their potential audience by their location– you can’t convince people to regularly drive an hour to go to a mediocre Chinese restaurant, no matter how good the price or advertising might be, because there’s a dozen other Chinese restaurants that are about as good much closer by.
Many of these very same issues apply across the board to Yelp’s other business models, such as its Groupon-esque deal-of-the-day (can’t do a deal of the day for a 2 star restaurant without upsetting the community that Yelp is allowing bad business to promote itself, etc.)
Now that we’ve nuked the business case for Yelp raking in capital let’s touch upon a few other really important points that would hopefully steer them away from this type of model in the long run:
a) Yelp is a nice-to-have product, with very low switching costs for consumers. When I’m looking for restaurant reviews, I’ll read almost anything that seems credible. Yelp may be my first stop, but it’s not my only or last. IMO there are almost 15 sources of reviews for a given restaurant, at least 3 of them highly credible (think Newspaper, Facebook, decrepit CitySearch, Google, Zagat, Chowhound, etc.). The barrier to entry is as low as getting together a budget to go out and start a blog reviewing restaurants in your local area.
In fact, if my next post here is an in-depth review of my favorite San Francisco restaurants (Koo and Lavash, for those interested), throw in a few detailed comments from readers agreeing or disagreeing with me, and I’ve basically achieved a nearly complete restaurant review, 80/20 ruling the value of the Yelp page of that same restaurant.
b) Selling advertising to brick-and-mortar local business generally requires a sales force. These are not the folks that are firing up AdWords every night and optimizing their local advertising spend. Certainly this will erode over time and the owners will be more comfortable and aggressive about managing their own spend (Google is betting big on this with Local ads for Maps, etc.), but the general case requires a person and a phone call. Those people are expensive.
c) Diminishing returns– there are only so many major metropolitan areas in the world, where something like restaurant choice is even an issue. Yes, each has millions upon millions of people– and tens of thousands of potential advertisers– in them, but even those are finite.
Yelp has done a great job of making its way through the US and now internationally, but their most recent office opening was in Sweden- a country of 10M people. For that, they have all the overhead of language localization, opening local offices, and hiring local sales people to bring in the customers, and local community managers to gain the trust and be responsive of the local population. That all costs serious $, and there is no real economy of scale– you can’t repurpose your NYC sales force to also resell Stockholm.
Also, the further they get away from their ‘home base’ of SF and the USA, the more of an issue the competition / low barrier to entry is from a) above. Look no further for a great example of this than how local deal-of-the-day company Piexe Urbano has absolutely crushed deal-of-the-day behemoth Groupon in Brazil (and soon, Argentina).
I love Yelp, and wish them the best in success. In their shoes, I’d try to discover what niches of advertisers don’t have the severe locality limitations that restaurants do– auto mechanics and doctors are some that come to mind– and focus hard on making sure that I win that business. More importantly, I’d try to find a way to align the value of my end users (Yelpers) and my customers (local business), perhaps with something like loyalty cards that for $X got you significant discounts at specific local businesses (remember those coupon books you’d make your parents buy as a kid to support your school?), extracting maximum returns from the investments I’ve made in each geography I’ve expanded into.
I won’t be so ridiculous as to pretend I know how to solve Yelp’s growth problems, and I certainly know (first hand!) that it’s much easier to try to point out flaws in someone’s business than to fix it. And I swore to myself I wouldn’t end my post this way, but I just…can’t…resist…. “and all that is FOOD FOR THOUGHT!” ;)
Stock Market Disclosure: For all the reasons above, I have puts at these levels, until the valuation is in line with their current business outlook, or they innovate away from the current approaches.