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Ticker: LinkedIn (NYSE:LNKD)

Rating: SELL

Price Target: Increase from $62 to $82

Introduction:

LinkedIn is the world's largest professional network on the Internet. The company recently announced that it has more than 200 million members in over 200 countries and territories. New members are joining LinkedIn at a rate of two per second. To put this figure into prospective, Facebook (NASDAQ:FB) has over one billion active monthly users as of late 2012. Google+ (NASDAQ:GOOG) has over 300 million members, and Monster Worldwide (NYSE:MWW) ranks among the top 100 websites visited in the U.S. The social network space has formidable competition with already established networks and followers. Further, the company continues to grow in multiples while lacking profits, which we believe creates risk and leads us to like other companies better.

Currently, we have a Sell-rating on LNKD with a price target of $82. When we are looking for investment opportunities, we want to balance growth, value, and fundamental metrics. We believe that while growth is good, value is much too high, and metrics appear to show weakness in the company. In our opinion, LNKD has not justified its valuation.

Company Profile:

LinkedIn is an online professional network that allows individuals to create professional identities on a social network. Members create profiles, manage them, and connect professional networks. In addition to a network of professional profiles, the network includes career opportunities, industry groups. LinkedIn Corporate Solutions allows enterprises and professionals to find and hire employees. LinkedIn Subscriptions allows recruiters to find potential hires, and LinkedIn ads allow businesses to distribute ads toward target members. The company was founded in 2002 and is headquartered in Mountain View, CA.

Thesis:

Valuation -

Currently, LNKD operates with an extremely high PE ratio near 850 and future PE over 90. Both rates show extreme belief by investors in the future of the company. Our issue with the company starts there. High valuations mean companies have high growth, and it means that investors believe that growth can continue for some time. Is this the case with LNKD?

During Q3, LNKD achieved about an 80% YoY (year over year) net revenue growth. While definitely impressive, the company has to continue to put up these types of gaudy numbers to continue to hold high valuations, which creates significant risk for investors. Growth will continue, but the company will have to grow by similar rates for several years just for LNKD to maintain its current price. In order to consistently put up these numbers, LNKD must continue to increase its member base and member engagement on both desktop and mobile. According to various Securities and Exchange (SEC) filings, LNKD disclosed that it plans to continue to spend a lot of money. This is vital in order to stay competitive in the ever-changing technological landscape, but also is a potential risk to the stock.

If we take a 20 PE as an average PE ratio of most companies, it would take EPS to grow by 4000%+ for LNKD to get to a 20 PE ratio. We do not foresee any type of growth to that level for the company. Other indications of just how overvalued this company is its 16+ P/S ratio. While the company may see less earnings due to lots of reinvestments, price/sales is a clean look at the company's price as it relates to money made. Typically, good value on P/S is anything below 2. 2-5 is moderate. Above 5 is fairly overvalued.

The LNKD situation is, interestingly enough, very similar to Amazon (NASDAQ:AMZN). AMZN spends a large portion of its cash on improving its distribution centers and preparing itself to have economies of scale for the future. The difference we see for AMZN is that its valuations are not as rich, and the company has created a better shopping experience that is easier. LNKD has created a social networking site with a business spin. It's much easier to create social networking engines than it is to build the distribution and clientele network that AMZN has built.

Catalyst -

What can lead LNKD down? Our obvious first notion is the valuations of the company do not suggest long-term investment but short-term overvaluation. Therefore, we believe that any signs of slowed growth in the coming quarters will see significant correcting for the stock. Further, we worry about the company's competition growing… especially from already known players like FB, GOOG, Microsoft (NASDAQ:MSFT), and MWW. Google+ has been built as an open-source platform that is much easier for developers to build software/searches around than LNKD. In the future, this could allow for much easier and cheaper searches of potential clients on Google+. Further, FB has introduced its Job Board, which has tons of jobs available to match with the Facebook population. With 1B people on FB, it's much easier to find someone than on LNKD. Once again, we worry about the combination of competition stealing any thunder from LNKD at all because at this time, shares are suggesting a bulletproof economic moat that seems to not exist.

Economic Moat -

The key to any great company is obviously its ability to create some sort of economic moat that cannot be replicated or penetrated. We worry that LNKD has very little economic moat. While the company obviously has strength in its sheer size, GOOG and FB are much larger, more established companies with more money to spend. It is not difficult to create job-focused websites, and current valuations suggest that the company has an extensive economic moat. At the same time, the company has created a very strong community system that will be tough to replicate or beat. We believe, though, that from the monetizing side of the business, which for LNKD comes from working with businesses to find candidates, that it has little economic moat.

Revenue and EPS Outlook -

As we can see below, we are pricing in a lot of growth in earnings and cash flow for the company of over 800% in the past five years. Despite strong outlook for the company, we still worry about valuation. Even with nearly $400M in operating income in 2016, we should see an EPS at current operating income: EPS ratio of 2.0. That EPS would put the PE ratio at 63, still too strong. LNKD has put up impressive numbers year-over-year in its various revenue sections. However, there are some red flags in its latest quarter. LNKD increased net revenues 80%, which is impressive -- not many companies can say that -- but the red flag comes a few line items lower. Product development and sales/marketing costs increased 107% and 80.5%, respectively. These two expense items together make up over 61% of LNKD's revenues and 63% of its total cost. Should this trend continue, LNKD investors will become skeptical about its cost discipline and maybe discount its lofty multiple.

Price Target Analysis -

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

43

104

182

270

391

Taxes

17

42

73

108

156

Depreciation

69

100

125

155

179

Capital Expendit.

-121

-115

-130

-142

-138

Working Capital

50

50

50

50

50

Available Cash Flow

-76

-3

54

125

203

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for LNKD: 8.04%

2012

2013

2014

2015

2016

PV Factor of WACC

0.925583117

0.856704107

0.792950858

0.733941927

*

PV of Available Cash Flow

-71

-2

43

92

*

* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.

Cap Rate for LNKD: 4.56%

2016

Available Cash Flow

$225.60

Divided by Cap Rate

2.04%

Residual Value

11,058.82

Multiply by 2016 PV Factor

0.733941927

PV of Residual Value

$8,117

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

$61.96

PV of Residual Value

$8,117

Cash/Cash Equivalents

271

Interest Bearing Debt

0.00

Equity Value

8450

We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.

Step 5.

Divide equity value by shares outstanding:

Equity Value

8450

Shares Outstanding

103.3

Price Target

$82

Profit/Value Industry Comparisons:

Profitability:

Q1-Q3 2012

Q1 - Q3 2011

Operating Margin

4.5%

4.5%

Gross Margin

71.0%

84.2%

Return on Equity

1.2%

1.0%

Profitability is currently low for LNKD. This should drastically improve for the company in the next couple years, but we see most profits already priced into the stock. Let's compare the company's profits to other similar companies -- Facebook, Google, and Monster Worldwide. FB is currently operating with a 74% gross margin, 12% operating margin, and 1.4% ROE. GOOG is currently operating with a 60% gross margin, 27% operating margin, and 17% ROE. Finally, MWW operates with a 5% operating margin, and -16% ROE. LNKD lags FB and GOOG, and even if we see LNKD operating at those levels, EPS and operating income will still be limited.

Value:

Current

Industry Average

P/E

715.3

27.9

Future P/E

86.6

N/A

How does LNKD compare to competition to here?

FB operates with a 295 PE and 49 future PE. GOOG operates with a 23 PE and 14 future PE, and MWW operates with a 9 PE and 13 future PE. Once again, LNKD operates with much higher valuations and lower profitability. Not a winning combination for investing.

Variant -

For the time being, we anticipate to see shares at least stay fairly flat, if not move higher. The reason is that the market is currently mesmerized by LNKD's exceptional growth and the bubble that has been created around new social network sites and new technology. Therefore, the variant of our opinion is that we could easily be wrong about LNKD seeing a valuation correction. As long as the idea of more future growth continues to exist, LNKD will likely continue to be strong. Recently, LNKD made an interesting acquisition of Slideshare, a San Francisco-based provider of an online platform that allows users to upload and share documents. The company is considered to be the YouTube of slideshows. Content here is both professional and educational. The purpose of the company is to share ideas, conduct research, connect with others, and generate leads for businesses. If the company can move in the direction of creating more space for meeting other professionals and grow its appeal to businesses to use them for job searches, it will see some success.

Bottom Line -

The Oxen Group is adamantly committed to investing for long-term growth. Growth cannot, however, come in exchange for asymmetric risk -- this seems to be the case with LNKD. There is no question LNKD is a great American new technology company that even rivals FB, but when it comes to investing, all value in LNKD seems already priced in and then some. LNKD has built an impressive network of users. This creates a barrier to entry for new firms, but there are risks. Should another social networking giant like GOOG or FB gain traction in the networking space, LNKD could be at risk. Moreover, many high multiple names have cracked at the slightest downbeat forecast. We anticipate similar action for LNKD.

Source: Reality Will Set In For LinkedIn, Reiterated As Sell