With IPO valuations puffing up like a perfect souffle, you have to love Yelp's timing.
The fast-growing review website is set to go public this week. If everything goes according to plan, Yelp's underwriters will price the deal Thursday night. Trading will begin shortly after Friday's opening bell.
Going public is certainly a notable achievement, though investors will want to be careful with this one. Let's go over a few of the reasons why this blazing hot deal may leave investors as cold as gazpacho.
1. Yelp Still Isn't Profitable
The dot-com darling's growth is undeniable.
A whopping 66 million unique monthly visitors are loading Yelp's website in search of restaurant reviews, dining suggestions, and commentary about a host of other types of business, and nearly 6 million smartphone owners are firing up Yelp's mobile app on the go.
Yelp is generating reasonable revenue by placing ads on its growing page views. It also offers paying businesses an upgraded suite of marketing services.
Its revenue is certainly moving in the right direction. Yelp's top line soared 74% to $83.3 million last year. Unfortunately, the company also posted a net loss of $16.7 million. That's in line with its previous performance: Yelp has yet to turn a profit, and its annual deficits have widened every year since 2009.
2. Cliques Create Conflicts
It's probably a shock to see a popular website that relies on its visitors to create the lion's share of its content for free losing money. However, even that model has it setbacks.
Yelp inspires its users to become active and articulate, rewarding its most vocal contributors with Elite status. "We created the Yelp Elite Squad as a way of recognizing the most passionate Yelpers that makes our community so funny, useful and cool," the website explains.
Yelp also repays its vibrant tastemakers by inviting them to exclusive outings. Cliques form, and you can probably imagine how the non-Elite contributors feel.
It gets worse. Elite status earns members free food and drinks at new establishments or existing Yelp merchant marketing customers. Do you trust reviewers to provide fair and balanced commentary after being treated to a night of freebies?
3. The Review System Can Be Gamed
Potentially biased Elite reviews are just the tip of the iceberg.
There are 25 million reviews on the site. There are 5 million additional reviews that Yelp has filtered out, and another 1.8 million reviews that have been removed entirely.
Three years ago, some merchants accused Yelp of calling them up with an offer to remove negative reviews or push up the positive critiques if they became premium members. Yelp denied the allegations.
Even if it was in the wrong, the backlash leaves Yelp as a more reliable site today. Yelp claims that the millions of reviews that are not immediately visible are filtered for concerns about the reviewer. After all, folks gaming the system by talking up their venues and bashing the competitors should be rightfully filtered out.
However, there is still some degree of credibility concern. Users with too few reviews may be gaming the system. Users with too many reviews -- qualifying for Elite -- now have conflicts of interest.
The clouds of doubt exist. There are 606,000 claimed businesses on Yelp, and 24,000 of them are paying for premium marketing services. Are casual users aware of the reasons 4% of the merchants are paying Yelp, or will they simply come to their own conclusions?
4. This Isn't a Lucrative Niche
Yelp is often compared to TripAdvisor (TRIP), but that's not a fair match.
Hotel and travel service reviews account for just 2% of Yelp's content. That's a juicy market for TripAdvisor, since hotel operators and travel companies pay big bucks to reach folks ready to spring on big-ticket vacations. Obviously those advertisers aren't going to be wasting their time on a foodie-centric site like Yelp.
Restaurants and to a lesser extent shopping account for 62% of the reviews posted on Yelp. The emphasis limits the amount of money that an advertiser is willing to pay. Surely a Caribbean hotel is willing to pay more for a lead that will generate a weeklong suite booking than a local Jamaican restaurant hoping to fill a table.
5. Yelp Isn't Cheap
At the high end of its IPO pricing range of $14, Yelp would command a market cap of roughly $840 million. Since hot IPOs have been known to burn Friday morning investors with unsustainable pops, it's easy to see Yelp opening considerably higher than that.
It probably won't be pretty after that. Yelp is already hitting the market at a loftier revenue-based multiple than TripAdvisor and online dining reservations specialist OpenTable (OPEN). TripAdvisor and OpenTable aren't growing as quickly as Yelp, but at least they're profitable.
There are also the fears that Facebook, Google (GOOG), and even check-in leader Foursquare could invade Yelp's space -- and they will if Yelp's model is worthy of a $1 billion market valuation. Facebook's already arming venue operators with profile pages. Google bought Zagat last year.
Yes, Yelp is popular now, but there are too many uncertainties. Expect a sharp pop Friday, but don't be surprised if it's all downhill after that.
Longtime Motley Fool contributor Rick Munarriz does not own shares in any of the stocks in this article. The Motley Fool owns shares of OpenTable, TripAdvisor, and Google. Motley Fool newsletter services have recommended buying shares of OpenTable and Google.