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In this post, institutional money manager Robert Peck explains why he plans to buy LinkedIn’s (LNKD) stock when the company goes public and why he thinks other investors should buy it, too.The Bottom Line
Since most of you wont have the time or inclination to read the full post below, the main take away is that the upcoming IPO of LinkedIn is a unique opportunity for investors to own a truly special and rare Internet company.
LinkedIn is a market leader with reinforcing network effects in a huge, underpenetrated market. It is experiencing rarely seen levels of growth, and is steered by experienced management and a well-respected board. Most of you will agree with these points, but may get hung up on valuation – my recommendation is to look through the near term estimates that are likely too low anyway and invest in one of the next platform plays on the Internet.
Top 10 Reasons Why You Should Buy this IPO
1. The Company Has a Track Record of Success — One of the things that separates this company (and many Internet IPOs lately) is the proven track record – this is in stark contrast to many of the “dot com busts” in 2000, who had little proven merit. Starting with the LinkedIn’s vision of “creating economic opportunity for every professional in the world,” the company has set an ambitious goal. Amazingly though, the company has been executing against that goal, building a registered user base of over 100m, up from just 32m in 2008, for an ~80% compounded growth rate (CAGR):
Registered Members (m)
However, some could be sceptical about this growth, questioning how truly active these members are. Interestingly though, Unique Visitors are up over 60% over the last 5 quarters, and pageviews per member per month, have risen ~25% to 23. While some of this increase in PVs is from recruiters, the members are clearly becoming more active. Moreover, I think the new products that LinkedIn is working on are designed to increase the activity of members on the site in the future.
PageViews per Registered Member per Month
Moreover, this large growing community has attracted the attention of paying corporate customers, who have grown even faster (~130% since 2008) to over 4.8m.
Growth of Corporate Customers
The success LinkedIn is seeing in these metrics, manifests in its financials (which I do into more detail below), further differentiating from the 2000 dot com busts.
2. A True Network Effect Business is Rare — Many companies claim to have a network effect (the idea that the larger the business becomes, the more valuable it becomes to new customers / members). LinkedIn truly becomes more valuable to members the bigger it gets, as it provides more networking opportunities. Moreover, for recruiters, the larger the talent pool is, the more valuable LinkedIn becomes for finding potential job candidates.
Finally, the more recruiters that are on the site patrolling for job vacancy candidates, the more likely a member is to be discovered and find their next dream job. This cycle just continues to feed on itself, forming a very strong barrier to competitors. (i.e. think eBay’ s vast seller & buyer network effect).
3. Linked Becoming a True Platform – I think that much like Facebook and Twitter have built platforms on which others can develop, LinkedIn is also creating a platform where their data can be accessed by 3rd Parties via APIs. This harnesses the “wisdom of crowds” and the vast creativity that one company could never produce. It makes LinkedIn’s data the centrepiece of the Internet’s professional graph and makes LinkedIn ubiquitous. While the monetization and impact to the financials is hard to fully gauge at this point, like most platform stories, the platform manifests its value in the financials eventually – this clearly positions LinkedIn well for the long term. Platform companies are valuable – and rare.
4. The Market Opportunity is Tremendous and Underpenetrated – One of the great things about investing in Internet companies is that the target markets can be tremendous and relatively nascent online. LinkedIn’s market is no exception. IDC estimates the worldwide talent acquisition market as $85b vs. LinkedIn’s 2010 revenues of ~$240m. To hone the market opportunity further, the “hiring solutions market” was $27b in 2010, making LinkedIn’s ENTIRE 2010 revenue base <1%. What’s more enticing is that only ~$100m of LinkedIn’s revenues was from “Hiring Solutions”, so the penetration of the market is much less. Even if one looks at 100% of LinkedIn’s revenues in 2014 growing to ~ $1b, that would still be less than 4% of the market – the point here is that there is a lot of room for LinkedIn to grow. With over 640m people in the worldwide professional labour force and over 3b in the total worldwide labour force, there is also still a lot of room to grow LinkedIn’s membership base further too.
5. Large Barriers to Entry Create a Competitive Advantage – While this point relates to the first three points pretty closely, it is worth emphasising. The established success of the company, combined with the network effects of the business, and the platform nature of the it make it very difficult for a competitor to steal share. The size will remain attractive to recruiters and leave less of a budget to help support smaller upstart competition.
Facebook and Google have the size and can try to penetrate the “professional graph” but it is not at their core. While Facebook may have cornered the “social graph” on the Internet, I think LinkedIn is clearly a leader in the “professional graph” – further, I don’t think it would be easy for Facebook to spread its social graph dominance into the “professional graph,” as people general want to separate their close friends and family from work colleagues – each group of people should see different information. Smaller, focused sites (i.e. Dice.com for technology jobs) can co-exist due to their hyper specialisation, but longer term these sites have to keep an eye on what further products / abilities LinkedIn creates.
6. Top Notch Leadership & Well Respected Board – While many investors will look at the quality of a management team, I think the board quality can be just as important. LinkedIn happens to have high quality in both areas. On the management side, the team is led by CEO Jeff Weiner who earned a strong reputation at Yahoo!, where he worked for 7 years until 2008. Complementing Jeff is CFO Steven Sordello, who has earned a strong reputation as CFO of two public companies: Ask Jeeves and TiVo. The very strong board complements the management team, led by Chairman / Cofounder Reid Hoffman who was also the CEO from 2003-2007 and an EVP at PayPal. Also on the board is well-respected VC partner Mike Moritz (Sequoia), who has been on the boards of Google, Yahoo!, Zappos and is currently on the board of Green Dot.
The rest of the board is very strong as well with the former CEO of Ask Jeeves (Skip Battle), CMO of Netflix (Leslie Kilgore) and respected VCs Greylock and TCV. It’s this leadership that is deciding to build LinkedIn for the long term, investing in the near term against the tremendous long term opportunity – I like that they are focusing on maximizing the long term value, and not feeling pressured to juice near term financials for Wall Street.
7. The Product is Better – It’s more Economical for Recruiting Clients – Not only do I see value in the core of the product (creating a networking base for members), but I also think that LinkedIn provides a more economic means for corporate clients to find job candidates. For example, the average package for a company looking to find a candidate to fill a job opening is $8000 / yr. That compares to the typical 25% of the candidate’s base salary fee that’s usually paid to recruiters (or $25,000 on a $100,000 salary). So a large corporation can use the site to not only fill 1 job opening cheaper, but also it can fill multiple job openings, all for the $8000 fee. That’s a powerful cost savings and likely a large reason behind the explosive clients growth – it’s simply a good product.
8. Very Few “Warnings” in the S-1 —The document that the company files to do its IPO is called an S-1. This is where all the financial information and discussion of the business resides. Moreover, it’s where the company has to disclose as many warnings about its business as possible (i.e. this is where it points out every potential pitfall to protect itself later should something go wrong). For example, when Demand Media filed its S-1 for its IPO, one of the first warnings, was that it was susceptible to any changes by Google’s algorithm – we’ve recently seen how Google’s “panda” algorithm change has hurt Demand Media’s traffic. But what struck me in reading the LinkedIn warnings (officially dubbed “risk factors”), were the lack of any really significant issues. Don’t get me wrong, there were many boilerplate risk factors (short operating history, stock could be volatile, susceptible to cyber attacks, etc), but there wasn’t anything unusual to worry about. This is fantastic for investors, as this is where the company really tries to stress all that could go wrong to protect itself later.
9. Tremendous Financials – All of the points I’ve made above would be mute, without the support of strong financials. LinkedIn should grow revenue >70% this year, with a compounded annual growth rate (CAGR) of >50% through 2013. This should put the company ~ $1b in revenue by 2014. One of the great things about this revenue is that it’s highly visible, as customers commit to yearlong packages. Hiring solutions should represent > 50% of revenues this year, growing over 130%; but the other two segments (Marketing Solutions and Premium Subscriptions) are growing >70% and 50% respectively. International growth is fueling a lot of this but it still represents a large opportunity as International was only 27% of revenues in 2010. Coupled with this strong revenue growth is the long-term margin expansion – currently LinkedIn’s EBITDA (think of as cash operating profit) is only in the mid single digits, as the company is investing for the future (i.e. infrastructure, increased sales people).
Side Note: One point I want to make here is the “Fred Wilson marketing point.” If you’ve followed the Internet sector lately, prominent Union Square VC partner Fred Wilson implied that the best companies don’t need to spend as much on marketing as companies with inferior products (I’m paraphrasing). I agree with this to an extent, as great products tend to get “free” viral marketing. LinkedIn’s near term investments in Sales & Marketing, are not being spent on advertising, but more on ramping the sales force. I believe LinkedIn is a great example of Fred’s point, as it too benefits from the free viral marketing of its product.
After this year, margins should start to grow, hitting mid teens next year and ~20% by 2013 – longer term EBITDA margins should grow north of 30%. This margin expansion means that profits are growing faster than revenues – a great thing for the company and investors. Free Cash Flow (cash flow from operations – capital expenditures) should be near flat this year, as the company invests aggressively. However, as the company spends more at normalized levels, free cash flow should approach $100 in 2013. This metric should grow even faster than EBITDA, as capex reduces to normalized levels of 8% of revenues over time.
Lastly, the company will have a very clean balance sheet as it starts its public life – the company will have no debt and ~ $300m of cash. It can use this cash for further investments, acquisitions, or for a rainy day should the economy turn sour for a while. Once again, this is a great place for the company to be as it gives it cushion, as well as options.
10. Valuation is More Reasonable Then First Glance – Taking the high end of the offering range ($32-35 per share), LNKD appears to have an Enterprise Value of ~$3.5b and can be viewed as richly valued at 45x next year’s EBITDA and 240x next year’s earnings. However, we’ve seen these platform / network effect / hyper growth companies before (this reminds me of OpenTable’s IPO). These types of companies are ones that investors are willing to pay a premium for, and the better way to look at them is to look out a few years and compare the multiples to the growth.
To account for the rapid growth, we need to look out a few years and see where earnings can be to derive a target for the stock in a few years. It seems that the industry expects the company to generate over $950m in revenues, EBITDA margins near 25%, and EPS of > $1 of EPS in 2014. However, I think these estimates may prove conservative, as a company typically gives guidance to its bankers that it feels is readily achievable (so it is more likely to beat Street estimates).
Hence, I think that the company can probably do over $1b in revenues in 2014, likely still growing >20% for $1.2b in revenues for 2015. At a 27% margin (the company said long term margins should be > 30%), that would equate to ~$325m of EBITDA, EPS > $1.60 and FCF >$210m. Quality Software as a Service (SaaS) companies like Salesforce or Concur can trade anywhere from 5-7x forward sales. So with $1.2b in revenues in 2015, a 6x multiple would imply an Enterprise value of $7.2b in 2014 – adding in the cash and cash flow over that time and that would be a over an $8b equity value for >$80 a share 3 years from now. That would imply over 125% return from the IPO if done at $35. Similarly, applying a 50x forward PE multiple (reasonable as EPS should still be growing 50%+ at that point) to the EPS of $1.60 in 2015 would imply a target >$80 a share. Applying a similar free cash flow multiple would also support this level. Lastly, the top SaaS names can warrant a forward EBITDA multiple of 20-30x. Applying a 25x forward multiple would also derive a stock greater than $80 in 2014.
How Big can LinkedIn Be? I think the most difficult part for investors will trying to sketch “how big LinkedIn can be?” As I mentioned above, the market for Hiring Solutions is almost $30b Is it reasonable that 20% is online over time (ecommerce expected to get up to 20% over time). That’s a $6b online hiring solutions market online. If LinkedIn establishes itself as the pre-imminent player in the space, it’s reasonable to think it could be a third of the online market or $2b of revenue from Hiring Solutions alone.
Next, layer on top of that the Talent Based Advertising market, which LinkedIn cites as $25b currently. Should 20% migrate online as well for another $5b target opportunity? Maybe LinkedIn takes 20% of that market for another $1b revenue opportunity? Together, that implies LinkedIn could reach $3b in revenues – at a 35% EBITDA margin that would be over $1b in EBITDA and $600m in earnings (40% tax rate) or $6 share. SaaS companies trade anywhere from 30-60x forward earnings. Since LinkedIn would be more likely more mature at this point, if we applied the low end of the range (30x multiple), that would imply a $180 stock. To be clear, I’m not saying this is where the stock should be immediately after the IPO, but I’m merely sketching the potential for the company should it continue to execute.
Summarizing. It’s hard to argue that LinkedIn is a unique company with strong leadership that is executing against a large opportunity. I think many investors will agree with that but will struggle with trying to figure out the right valuation. While the IPO may look expensive on short term numbers, I think by looking a little more long term, investors will appreciate what valuation LinkedIn could grow into. Lastly, investors should take note that not one of the 3 largest VCs are selling any shares (and management is barely selling any either) – it would appear as if they may agree with me.
May the markets always move your way,
– Buyside Insider
(I can be reached via Henry Blodget, if needed)