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(This is the fifth in our series about a certain kind of Internet Information provider that we call, “Desired Monopolies.” Please see the previous reports in the series, about Ariba (NASDAQ:ARBA), Zillow (NASDAQ:Z), Ancestry.com (NASDAQ:ACOM) and OpenTable (NASDAQ:OPEN)).

LinkedIn: Take this Job and Love It

How many things in life are really, really good, yet still over-rated? Madonna? The McRib sandwich? The Manchester United football club? The TV series Mad Men? Well, you can add LinkedIn (NYSE:LNKD) to that group. A company redefining how employers and employees find and relate to each other. A company growing revenue faster than 100 percent. A company with 84 percent gross profit margins. A company (oops) trading at a price:earnings ratio of 244.

There is a big dichotomy built in to LinkedIn and its stock price. Does the current price make sense, and the world at large does not appreciate LinkedIn’s future world-conquering business model? Or has the stock price already peaked? After all, having a P:E of 244 is insane in a world where Facebook (800 million members and counting) is only a press release away from turning LinkedIn into…MySpace.

For now, LinkedIn deserves to be considered a Desired Monopoly. It is the world’s largest dedicated employment networking site. And most people agree that there should be just one of those. Cementing LinkedIn’s status is its role as the center of a large and growing HR ecosystem: Over 40,000 registered developers are creating applications to leverage its database and technology, with third-party applications making 2 billion API calls to LinkedIn’s network each month.

LinkedIn views itself and its services as replacements for a variety of established institutions; the resume (the LinkedIn Profile), the business card (CardMunch), the Rolodex (LinkedIn Connections)... you get the picture. And with its very profitable business model and unquestioned role as the leader in on-line employment networking, LinkedIn is perhaps entitled to some hubris.

This self-possession is certainly evident in its capital structure. The company went public this past May 19, floating a mere 8.2 percent of its shares outstanding, far less than the traditional 15-20%. But the investment world has already figured out the cynicism behind low-float IPOs, and is punishing LinkedIn, Groupon (NASDAQ:GRPN), Zillow (Z), Pandora (NYSE:P) and others that also tried that trick. Zynga (ZYNG), which just filed to go public this week, seems to have wised up, it expects to sell 14.3 percent of its available stock.

But for LinkedIn, it’s too late and as you’ll read later on, the world is about to be flooded with LinkedIn stock. So with the stock price set to decline for the foreseeable future, you’ve got plenty of time to read up on the company. Just don’t plan on eating a McRib while you do so, McDonald's (NYSE:MCD) stopped selling them on November 14.

Data Sheet:

Name: LinkedIn Corporation

Market Cap: $6.43B

Trailing 12-months Revenue: $436.1 million

Forward Price:Earnings Ratio (estimated): 244x

HQ: Mountain View, CA

Founded: 1998

Description:

LinkedIn is the world’s largest on-line professional network. The company has 135 million members in over 200 countries and territories. LinkedIn members create, manage and share their professional identity online, build and engage with their professional network, access shared knowledge and insights, and find business opportunities. LinkedIn’s unofficial party line is that it wants "to connect talent with opportunity at massive scale.”

LinkedIn was founded in 1998, and re-incorporated in Delaware in March 2003. The company launched the first version of the LinkedIn.com website in May 2003. By the end of that year it had 14 employees and over 78,000 members. As of September 30, 2011, it had 1,797 employees and over 135 million members.

As of the end of September, 2011, LindedIn’s international business represented 32% of total revenue; international is growing faster than U.S. business, so it is expected to be a larger percentage of total revenue going forward. LinkedIn’s international HQ is in Dublin, Ireland, with sales and marketing offices in 10 other non-U.S. countries. Notably, the company does not have sales & marketing offices in Brazil, Russia or China, three of the four “BRIC” countries.

LinkedIn generates revenue in three segments:

1. Hiring Solutions (50% of YTD 2011 revs)

2. Marketing Solutions (30%) - both offline through a field sales organization or online

3. Premium Subscriptions (20%)

Market Opportunity/Addressable Market:

There are two ways to understand the market opportunity for LinkedIn (or any of its competitors).

1. The industry spending estimate for the HR/talent recruiting sector is $52B worldwide according to Morgan Stanley. This includes the online advertising associated with this sector. Two of LinkedIn’s three segments (Hiring Solutions and Marketing Solutions) comprehensively address this broad market. With just under $500 million in annual revenue, LinkedIn has captured only 1% of the total addressable market.

2. There are 30 million businesses in the United States, 99% of which are small businesses. But the remaining 300,000 large businesses employ 38% of the total domestic work force, or 58.7 million people. (This means large businesses, on average, have about 200 employees.) As of September 30, LinkedIn had 7,400 LinkedIn Corporate Solutions customers worldwide, or roughly 5,000 in the United States. This represents less than 2% of the total market opportunity in the U.S. alone. It’s worth noting that LinkedIn claims that 80 of the Fortune 100 are already LCS customers.

Recent Financial Performance:

After the market close on Thursday, November 3, LinkedIn reported its third quarter, which ended September 30. The company reported a GAAP quarterly loss of $0.02/share, which was slightly better than the ($0.04) loss expected by the Street. Revenue in the third quarter was $139.5m (up 126% year-over-year), again better than the $128.7 million consensus. What the company refers to as “Adjusted EBITDA” (basically a version of operating income) was $24.7 million.

LinkedIn management issued guidance for its fourth quarter (ending December 31). Revenue was expected to be in a range of $154 - $158 million (Q4 consensus at that time was $148.6 million) and Adjusted EBITDA in a range of $19 - $21 million (a decline from Q3).

LinkedIn’s three main business segments performed as follows in Q3:

· Hiring Solutions revenues were $71.0 million (up 160.3% from the year-earlier quarter). The key driver in this segment is LinkedIn’s Corporate Solutions (LCS) offering, which includes the core LinkedIn Recruiter product. As previously noted, the company reported 7,400 LCS customers as of September 30.

· Marketing Solutions revenues were $40.1 million (+113% y/y). Ad rates (as measured by the common industry metric of CPMs) were reported by the company to be steady, meaning that the growth in revenue was driven by larger numbers of advertisers buying larger amounts of advertising.

· Premium Subscriptions revenue was $28.4m (+81% y/y).

Key metrics that illuminate LinkedIn’s Q3 performance include:

· Total LinkedIn members grew to 131.2 million, up 63% year-over-year;

· 1,294 net new Corporate Solutions customers were added, up 138% from 3Q 2010;

· Unique visitors of 87.6 million per month (+64%);

· Linkedin.com page views of 7.6 billion (+51%);

· Total headcount rose 108% from last year to 1,797.

Two takeaways from LinkedIn’s third quarter financial performance:

· It’s very positive that revenue is growing in excess of 100%, while most of the “important” metrics are growing in the 50-60% range. This suggests very strong monetization by LinkedIn’s commercial customers, who are clearly paying the company more per search than a year ago.

· The unexpected decline in “Adjusted EBITDA” reflects an acceleration in operating expenses, particularly in sales and marketing. Sales and marketing was 31% of revenue, up sharply from 24% one year ago. Given the company’s explosive growth, and the need to remain pre-eminent in a winner-take-all market segment, management is probably wise to spend heavily. At a forward P:E of 244, no one is valuing LinkedIn on its near-term earnings, but on its long term opportunity.

Concerns/Risks/Issues:

Massive Unlocking of Shares, post IPO

Like Groupon, LinkedIn went public on May 19 of this year by issuing a very small proportion of its shares. This “low-float” IPO had the desired effect of goosing LinkedIn’s short-term performance: the stock priced at $45, opened at $83, peaked at $122.70 a few hours later, and closed at $94.25. Woo hoo!

But now the bill for that party is coming due. The primary lock-up expiration occurred on November 21. So when the company reported its Q3 earnings in early November, it simultaneously announced a forthcoming $500m follow-on offering with both primary and secondary shares. On November 14, it boosted the proposed offering amount to $800m. And on November 16, it priced the deal: 8.75m shares total at $71/share, equaling $621m.

Of the 8.75 million shares offered, ~7.5m were from existing shareholders (i.e., venture backers including Bessemer Ventures, Greylock and Bain). This has boosted the total float from just 9 million (the IPO shares) to about 17 million, with an additional 23 million shares being “unlocked” and ready to be sold. And with 97.6 million shares outstanding (excluding options and stock grants), there are another 56 million shares that will “unlock” in late February 2012. Dare we mention the additional 17.6 million shares represented by outstanding employee stock options, restricted stock and the over-allotment shares (the “greenshoe”) issued in the November secondary offering? (Sorry, I couldn’t help piling on.)

The bottom line: There’s no earnings dilution from all the secondary shares unlocking. However, the price of everything is determined by supply and demand. And if the supply of shares for sale in the market is going to continuously increase for the foreseeable future, the price of LinkedIn’s stock isn’t going up anytime soon.

Facebook

At their core, Facebook and LinkedIn are social networks. With one big difference: Facebook has 800 million members and LinkedIn has “only” 135 million.

Facebook has not made a major effort to provide a LinkedIn-style professional network service. However, Facebook does offer several services that could be interpreted as competitive. First, of course, virtually every business in the world has a presence on Facebook, where it curates (to varying degrees) its image. The second aspect is the many applications that operate “on top” of Facebook’s vast network (we discuss these in the following section).

Competitive Landscape:

· BranchOut, the largest job board on Facebook, which already has 3 million job listings and 20,000 internships. BranchOut (like Zynga) is its own business but essentially relies upon Facebook’s network to deliver its service. Most reviews of BranchOut are favorable, but mostly in the context of a company that barely existed a year ago. The shortest way to convey how far BranchOut has come in such a short time, is to note that LinkedIn recently blocked access of its newly launched “Groups” API to BranchOut (and some other job/recruitment sites). The official reason for this had to do with technology compatibility, but no credible observer believes this was the only reason.

· BeKnown, is another Facebook application designed to turn it into a recruiting platform. BeKnown is controlled by Monster.com, the largest dedicated job search site, and largely seeks to extend the Monster search tools and site experience onto the Facebook network. BeKnown only went “live” in mid 2011, so despite its pedigree its strength and reach are negligible at this time.

· Talent.me – again, another Facebook application. One review summed it up thusly: “Talent.me gives you the ability to post status messages in a box and format identical to Facebook’s while also seeing your Facebook Wall and Messages tab, but the ability to recommend and post your resume like that of LinkedIn.” And like BranchOut and BeKnown, you have the ability to export much of your LinkedIn information to get started.

· Google+: Specifically, Google+’s Profiles for Business. Using Google+’s Circles feature, Google+ users can create some of the same experience as found on LinkedIn. Moreover, G+ Profiles users can integrate Google Analytics into the content, permitting, for example, a marketing campaign to a select Circle, which can then be tracked for efficacy.

· Generalist job search web sites, such as Monster.com, Careerbuilder, HotJobs.

· International competitors, such as Xing (Germany) and Viadeo (France). Tianji, described by some as the “LinkedIn of China” is wholly owned by Viadeo.

· Specialist job search sites like Dice Holdings.

· The Old Way – e.g., paper resumes, business cards, job fairs, professional networking events, etc.

Our takeaway from the Competitive Landscape? There’s plenty for LinkedIn to be worried about. Ultimately, success in employers and employees finding each other is a numbers game, driven by network effects. Since successful features (like Google+’s Circles) can quickly be copied, the primary differentiation will be the size of the network. Facebook wins that contest hands down.

Financial Analysis (DCF and Comparative):

As part of our analysis of LinkedIn, we built a Discounted Cash Flow (DCF) model for the company. We used the following parameters and values to arrive at our DCF value:

· Term: 5 years;

· Initial Cash Flow: $56.475 million (this represents the estimated annual free cash flow for the current fiscal year, 2011);

· Short Term Cash Flow Growth Rate: 10% (conservatively far lower than the ~100% CAGR that LinkedIn is currently achieving);

· Long Term Cash Flow Growth Rate: 4% (closer to long-term GDP trends);

· Discount Rate: 8.78% (derived using CAPM: Risk Free Rate = 3.06% from the 30–year Treasury Bond; 4.4% equity risk premium from Ibbotson; and an estimated Beta of 1.30);

· Current Share Count: 96.276 million.

Using these inputs, our calculated DCF value per LinkedIn share is $16.53, 75% lower than the current share price of around $65. On one hand, a DCF valuation isn’t really suited to a high growth company like LinkedIn that is re-investing virtually all its cash flow right back into the company.

But LinkedIn’s business model is simple, and their prodigious cash flow ought to flow to investors, but won’t be anytime soon, because it’s being re-invested (ironically) in hiring a lot of employees.

Now let’s look at LinkedIn compared with six other software-as-a-service peers:

LinkedIn

Ariba

CoStar

Open
Table

Ancestry
.com

Zillow

Google

Ticker

LNKD

ARBA

CSGP

OPEN

ACOM

Z

GOOG

Market Cap

$6.43B

$2.84B

$1.69B

$840.1M

$1.04B

$617.1M

$194.13B

LTM Revs

$436.1m

$443.8m

$243.8m

$133.1m

$378.2m

$55.7m

$35.76b

Op CF Margins

28.8%

17.1%

13.1%

36.7%

29.8%

28.0%

39.6%

MRQ Rev Growth

125.7%

44.6%

11.7%

40.1%

30.0%

131.6%

33.4%

Forward P:E

244.2

26.9

59.9

23.7

16.1

74.6

13.7

EV: Revs

12.32

5.63

4.34

5.19

2.55

9.28

4.29

Float: Shares Out

0.445

0.985

0.954

0.741

0.681

0.237

0.788

Source:

Yahoo Finance

LTM=Last 12 months, CF=Cash Flow, MRQ=Most Recent Quarter

We had several takeaways from this data:

· LNKD’s forward price:earnings ratio of 244 is simply crazy for a company, a) that is facing serious risks to its business model; b) that is not yet profitable; and c) whose forward earnings estimates were recently revised downward.

· With less than half of its shares outstanding freely tradable, the steady flow of LinkedIn shares coming to market is an essentially permanent headwind.

It’s worth remembering, though, that LNKD’s 84% gross margins offer a tantalizing glimpse at the potential profitability of the company. All it needs to do is begin growing its operating costs at a rate slower than revenue growth. But there’s no natural point at which that would automatically happen.

Conclusion (Buy, Sell or Neutral?):

LinkedIn is clearly the market leader in its space and a Desired Monopoly. LinkedIn network members don’t want to tend to multiple professional networks, and employers don’t want all their potential candidates in one place on-line. With 135 million members, LinkedIn is in the enviable position of being the largest player in a mostly untapped multi-billion dollar industry sector.

The company is growing prodigiously, but its expenses are too, and at a greater rate. This means the company is still posting losses. Moreover, after the company reported its September quarter, the Street earnings consensus for 2012 declined from $0.38/share to $0.27. This in turn elevated LinkedIn’s forward Price:Earnings ratio to 244.

So let’s sum up: good company, great opportunity, growing quickly, positive cash flow, not yet profitable, estimates declining, shares flooding the market and a valuation that requires an oxygen mask to read. Plus a company called Facebook, lurking on the margin of the employment space, serving as a host to a variety of small but well-funded competitors. If Facebook brought to bear the full force of its 800+ million members on the employment networking market, LNKD’s 84% gross margins would be a thing of the past, along with its stratospheric valuation.

If indeed you’re seeking alpha, you need to Sell/Short shares of LinkedIn.

Source: LinkedIn: Living In Facebook's Shadow

Additional disclosure: I am long ARBA in the Separately Managed Account product for which I am the portfolio manager and in which I am an investor.