Nederlands: Linked In icon (Photo credit: Wikipedia)
The emotional range for "Social Networking" stocks mirrors the diversity of their business models. From the hype of FaceBook to the disillusion with GroupOn, investors need to focus on the underlying business models, and try to look past how these companies get there. True social networking companies benefit from lower marketing costs, and that is borne out in the financial analysis. LinkedIn, one such stock swept up in the excitement of social, has a solid business model and strong earnings potential.
LinkedIn achieved the objective of technology companies: to disrupt a traditional "bricks and mortar" or old-school business model. Then, LinkedIn then took disruption one step further up the value chain by bringing a community element to the online marketplace such that users actually want to be there for more than a one-off transaction. This is the New Higher Order of Technology, where new technology companies are actually disrupting old technology business models…in this case, LinkedIn has just trumped Monster Worldwide. While Facebook has created the paradigm for social networking, LinkedIn has actually applied it to a business model. Let's called it Applied Social Networking.
LinkedIn's business model works like this: everything they do is geared toward providing members, people like you and me, with tools to enhance their business networks. Since members see an immediate benefit, members are willing to share professional backgrounds and experiences with others, and to be open to new (employment) opportunities. By attracting the "honey" LinkedIn gets the "bees"; that is, now recruiters have an online database of 150M potential candidates without having to hire its own people to smile, dial and find prospects, while potentially annoying or jeopardizing a candidate and his/her current position. LinkedIn generates most of its revenue now from Hiring Solutions (mostly recruiters), which has grown from $30Min FY2009 to $260M in FY2011, up over 8x.
LinkedIn generates revenues from three sources: Hiring Solutions (basically revenue earned from recruiters), Marketing Solutions (basically revenue earned from advertisers) and Premium Subscriptions (recurring revenue earned mostly from members). Revenue growth in all areas has been accelerating since 2009, and revenues have been growing even faster the member growth, which implies a strong conversion from free services to paid services.
To put LinkedIn's revenue growth in perspective, compare its growth from 2009 to 2011 to Facebook. Facebook's total revenue has grown 377% while LinkedIn's has grown 333%. Note, FaceBook's revenue is a magnitude of 7x greater than LinkedIn, but LinkedIn is not as dependent on advertising as Facebook. LinkedIn's Applied Social Networking revenue stream (that to recruiters) has grown 621% from 2009 to 2011 while Facebook's overall revenue for the same period was up 377%.
That said, the value proposition to advertisers of LinkedIn is very similar to Facebook because of the detail of voluntary information members provide. Like Facebook, LinkedIn should be able to do very targeted advertising campaigns and, in this case, LinkedIn can target a wholly professional database. And like Facebook, LinkedIn's advertising revenue has grown almost 4x from 2009 to 2011.
There are two concerns with LinkedIn. First, growth in sales and marketing is outpacing revenue growth. If it weren't for stock based compensation, sales and marketing growth would be more aligned with revenue growth. Some analysts prefer to remove stock-based compensation expense from these calculations because it is not a cash out-of-pocket expense to the company and it can fluctuate with the stock price. However, other analysts believe stock-based compensation is a cost of doing business – that if you aren't giving your employees stock, you'd have to pay them cash so it is a legitimate expense to include as part of the operating income calculation. I tend to side with the latter and, in any event, it is worth keeping a close eye on how much LinkedIn has to spend in sales and marketing to attract revenue.
The second concern is valuation. Investors buying LinkedIn today at $97.65 or 89x estimated 2013 earnings of $1.10. Those estimates exceed estimated FY2012 earnings of $0.64 by 72%, rendering LinkedIn with an expensive PEG ratio of 1.8x. The good news is that the PEG declines over time and LinkedIn has established, in its three reported quarters, a propensity to exceed the estimated earnings by 5-13c, altering the dynamic toward attractiveness. LinkedIn's chart suggests momentum, which implies to current investors to hold the stock with upside expected. The current valuation suggests that LinkedIn is overvalued on traditional metrics; however with its strong "Applied Social Networking" business model, accelerating revenue growth, paid membership conversion and limited competition, LinkedIn is a very attractive growth stock to watch and, at the very least, build positions on dips.
Lastly, as the FaceBook IPO approaches, investors are going to become more aware and more interested in social networking stocks. LinkedIn will serve as an attractive comparison given its comparable growth and solid business model. Should LinkedIn continue to execute (read, exceed earnings expectations at a similar magnitude as it has the last three quarters), benefit from a stronger employment economy, and track its sales and marketing costs, LinkedIn could reach $120 by summer.
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