LinkedIn's (NYSE:LNKD) IPO pricing and subsequent ascent of its share price to $120-levels have created a lot of buzz over the past couple of weeks. However, industry observers and analysts have raised several questions. Most observers opined that LinkedIn's business model did not justify its IPO valuation, forget its post-IPO highs. The fundamental question was whether a company with a 2010 net profit of less than $10 mn commanded an $8-10 billion valuation, and whether estimated growth percentages in net profit would justify that kind of a valuation. Many equated LinkedIn to other online or social media stories like Yandex (NASDAQ:YNDX), Facebook, Zynga, Livingsocial, Groupon, etc., mentioning "bubble" valuation levels in this sector. Is this a justified view?
On the face of it, most people who watched private equity and secondary sales activity in private company shares of some of these names would not have been hugely surprised by what happened with LinkedIn's listing and Day 1 performance. Less than three months after Goldman Sachs' (NYSE:GS) investment in Facebook, valuing it at $50bn, shares were being lapped up in the private market sites like secondmarket.com, valuing it at $70 bn and above. This is compared to a reported 2007 valuation of $15 bn. Similarly, Groupon's paper valuation jumped several fold during news of the proposed Google (NASDAQ:GOOG) acquisition, and later. Living Social also received private funding valuing it at several billion dollars.
Thus, we can infer that there is some level of irrational exuberance among early investors in this sector. But it's probably wrong to equate a LinkedIn to a Yandex or a Facebook. Let's look at the key drivers - revenues, profit margins, potential revenue streams/hence growth potential, possible risk factors, etc.
Let's first look at the master story in this space - Facebook. Facebook's primary asset is its vast user base and associated data on demographics, user preferences, etc. This is very attractive for pure brand advertising and click-driven advertising, aka Google. FB's clients for advertising not only include normal products and services companies, but also Facebook-world entities like game and app players like Zynga. Despite low click through rates for ads, Facebook's enormous user base itself guarantees high potential "coverted" users and hence is a big attraction to advertisers. If we add potential user base micro-targeting, leveraging demographic info that Facebook has access to, this becomes even more attractive. The online ad revenue market is sized at $25 bn-plus now, and expected to grow multi-fold for next several years, with Facebook already having a 30% plus market share in this market in FY 2010. Thus, Facebook's revenue potential is huge from this area alone, as long as it retains and grows its user base, and smartly monetizes its "core asset" through various ways to milk ad revenues. Add to that revenues from other stuff like virtual gifts and whatever you can imagine in the online world, and you can clearly see that the revenue growth potential is huge. On top of this, if Facebook can move traditional mail users to Facebook messaging or mails, that further adds to i's attractivess to advertisers.
Lets look at some real numbers:
1) Facebook made an approximate $2bn in annual revenue in 2010. Assuming an extremely conservative revenue growth rate of 50% Y-O-Y (given its user base itself is increasing at over 3.6% monthly at this point), Facebook should touch $5 bn by FY 2012.
2) Now, assuming a steady state net profit margin of say 25-30%, assuming Google as the closest proxy, Facebook should make a net of $1.5 bn by 2012.
3) If Facebook can maintain a decent user growth rate m-o-m on top of its current 600 mn, and expand the "leveraging" of its "core assets" through expanding its portfolio of offerings, it is not unreasonable to expect a 30-50% growth rate for five years from 2012, followed by a steady state growth of at least 10-15%. Looking at how Google shaped up, easily an over 50% Y-O-Y growth from 1.6 bn in 2003 to over 16.6 bn in 2007, we can see that the above is not unreasonable to expect for Facebook.
The above alone would warrant a valuation in the $30-50 bn range. If we instead look at an above 50% growth for five years from 2012, you are talking about a valuation upwards of $50-60bn, depending on the discounting factor you assume for valuation. Of course, if another disruptive technology/trend shapes up which takes eyeballs away from Facebook and/or online media, all of the above can go for a toss. But then, which new-era business is not fraught with extreme risks associated with new entrants and substitutes?
Coming back to the original discussion, what we have to remember when we talk about Facebook is the breadth of the very concept - we are talking of an all-inclusive social media platform, without pretty much any limits or boundaries, geographic or otherwise. The core pillars of Facebook's value are a) stickiness of online social networking as a concept and b) stickiness of online advertising as a marketing/sales tool. The strength of the core pillars are one level below that of Google's, since online search as the primary driver is simply more powerful than online social networking as the primary driver.
Now, let's look at LinkedIn. LinkedIn made an estimated $2 mn on a revenue of $161 mn for the nine months ended Sept. 30, as compared to a loss of $4 mn on a topline of $80 mn for the same period in FY 2009. Also, 41% of its topline was related to hiring solutions and 27% related to premium subscriptions, as compared to 32% from pure-play marketing solutions. Thus, continued interest in paid user subscriptions and recruiter interest is critical to topline growth. From this, we can see that the primary drivers are even weaker: a) online professional networking and paid subscriptions for the same; and b) recruiter fees. Even if we add potentially new online advertising/marketing revenues targeted at the professional segment as a driver, it is clear that the fundamental drivers are nowhere as broad and powerful as compared to Google or Facebook. With this context, even the IPO valuation of $4 bn is seemingly high. As an example, it assumes an $100 mn-plus in 2012 net, along with a Google-like growth trajectory for the next 5-10 years.
Now let's look at Yandex. With an estimated $148 mn net profit on a topline of 500 mn in FY 2010 and an almost 40 million-plus unique user base with a 64% share in Russian search traffic, it is a "micro-Google" with an established business model. A valuation of $10 bn-plus is hence not completely out of reason, given Google's comparative unique user base. However, the relative narrowness of the target market and potential threat from Google might make the valuation a bit pricey at present.
Thus, online ad or social media business models need to be analyzed for their key drivers. We cannot jump in to equate LinkedIn to Facebook, Google or Yandex. Valuations will eventually reach stability, and at that point, winners will be the ones with strong core drivers. This is along the lines of how an Amazon.com (NASDAQ:AMZN) or an eBay (NASDAQ:EBAY) survived in the e-commerce world, as compared to several smaller players. The same story will be repeated in the online social media and online search world - clear winners will emerge long-term, one obviously being Google. And I for one am sure Facebook will be one of the winners. Unless Zuckerberg does something wildly unimaginative, and assuming Sheryl Sandberg stays.
Additional disclosure: No plans to go long or short on LNKD in the near future - I cannot bear the volatility!