- The justification for analysts' target prices seems almost recklessly aggressive, yet there doesn't appear to be a single dissenting voice on the street.
- The revenue & earnings beats seem intentionally manufactured by Wall Street, who despite having a reputation for optimism, seem to be very content low-balling their near-term estimates consistently for this company.
I'm not one for conspiracy theories, but indulge me for a moment. As I see it, there are two potential drivers that could be causing analysts to feel particularly cheerful when analyzing LinkedIn:
- The upcoming Facebook (FB) IPO. While the IB and research divisions are indeed separate and IB is legally not allowed to place pressure on analysts, no one ever got fired for NOT hurting business.
- Management and VC firms have been active sellers of the stock since the latest lock-up period expired. Building a good relationship with management certainly makes your job easier as an analyst and allowing prominent VC firms to exit at top dollar certainly doesn't hurt future business either. I've written about insider selling at LinkedIn previously here.
I certainly can't prove that anyone is up to anything nefarious, but in these types of situations, retail investors are the investors most likely to still be dancing once the music stops. In my analysis below, I summarize each major broker dealer's valuation approach and note some potential issues. Next, I walk through a comps table showing that under almost any valuation metric the firm looks pricey relative to its peers and to my own intrinsic valuation calculation. Finally, I show analyst estimates and management guidance over time. Despite consistent large beats, analysts seem very reluctant to stray far outside of management's conservative guidance.
How Wall Street Justifies Its Target Prices
Wall Street analysts generally approach valuation in one of two ways, either they build out a full discounted cash flow (DCF) model or they use a multiples approach (i.e. select an appropriate P/E, P/S, EV/EBITDA multiple and apply it to their estimate for LinkedIn) . As the tables below show, analysts who have gone the DCF route have tended to not account for share growth and thus overstated the value of the stock by 30-40%. Analysts that used a multiples approach have generally chosen extremely high multiples and provide very limited justification for these multiples. My full analysis is shown in the series of tables below:
As I mentioned in the tables above, both Morgan Stanley and Piper Jaffray provided sufficient disclosure for me to recreate their models. I've included links to my Excel models for each firm below:
- MS Model (corrected TP should be $94 vs $140 currently)
- Piper Jaffray Model (corrected TP should be $82 vs $145 currently)
Additionally, I've done a more detailed write-up on analysts ignoring share count growth in their DCF models here. While I have yet to receive a response from ANY of the analysts above, I'll make sure to update this posting if I do get any responses. Particularly if I've made a mistake.
LNKD Is One Of The Most Expensive Stocks By Any Metric
To place LinkedIn's valuation in context, I've created a comps table to compare some of the key valuation metrics across a set of peer companies. Only Salesforce.com (CRM) and Netsuite (N) approach LinkedIn's valuation, all other peer firms trade at substantially lower multiples. For peer companies, I've used Bloomberg's estimate data and the firm's closing price, market cap, and enterprise value (EV) as calculated by Yahoo!.
For LinkedIn's estimates, I've used my own model which forecasts three-separate scenarios (bull, base, bear). Additional detail on my estimates can be seen in the next section. In general, my estimates are actually higher than the street's estimates which makes the valuation multiples I arrive at appear less aggressive than they would appear if I used the Wall Street consensus numbers. Below I've provided a summary of the comps table, which shows how much higher LinkedIn's Valuation is even using 2014 estimates:
For those of you interested in reviewing the detailed version, my full comps table is shown below (apologies for the small font):
While some analysts will say that LinkedIn's superior growth justifies a higher multiple, I found very little numerical support for how those higher multiples were actually arrived at. Here's how I would approach determining what the right multiple is. I would look at expected peer growth from 2012 - 2014 for say EPS. In this case peers are expected to grow EPS at a median CAGR of 23%. Next, I would identify the multiple in 2012 at which these firms traded, in this case the median estimate is 26x 2012 EPS. Next, I would find the two-year period where I expected LinkedIn's CAGR to approach 23%.
Based on my model, that's 2014-2016, where I expect LinkedIn to grow EPS at a 24% CAGR (see table below). I would then apply a 26x multiple to my 2014 weighted average EPS estimate of $1.69 (for context, consensus in 2014 is $1.97). Finally, I would discount this valuation back two years to bring it to a 2012 estimate (I'll use a 12% discount rate consistent with my DCF analysis). Using this multiples approach I arrive at a target price of $35 using my estimates & $41 using the consensus numbers. These estimates are a 60-70% discount from current prices.
LNKD Trading At A 130% Premium to My Intrinsic Valuation
Many analysts take issue with a DCF model approach to valuation because it is so sensitive to a few key inputs. Furthermore, particularly with a high growth company like LinkedIn, much of the valuation depends on the out-year estimates which are notoriously difficult to estimate with any degree of accuracy.
I, however, am a big fan of the DCF approach and work around some of these pitfalls by forecasting multiple highly-distinct scenarios. This helps me range bound the valuation in a very good scenario and in a very bad scenario. For LinkedIn, I forecast three scenarios and then probability weight the likelihood of each scenario coming to pass. A description of each scenario is shown below:
- Facebook-like Global Dominance - Assumes total global market dominance (85% penetration of total global professionals by 2020), pricing power across all divisions, EBITDA margin expansion to 36%, revenue CAGR of 29% from 2012 to 2020, and a terminal multiple of 20x. I have assumed a 35% probability of this scenario playing out.
- Market Leader With Pricing Pressure - Assumes market dominance (60% penetration of total global professionals by 2020), some competitors retain footholds in other countries, some pricing pressure in hiring solutions & premium subscriptions segments, EBITDA margins expand to 34%, revenue CAGR of 15% from 2012-2020, and a terminal multiple of 14x. I have assumed a 50% probability of this scenario playing out.
- MySpace Scenario - Assumes growth continues over the next few years, but begins to slow dramatically in the out-years as competitors begin to take share. Prices begin to fall and membership declines, feeding a vicious shrinking cycle. I have assumed a 15% probability of this scenario playing out.
Using the assumptions described above and a 12% cost of capital, I arrive at the following valuations for each scenario and a weighted average target price of $48. Based on my estimates, the market is currently factoring in more than a 100% probability of the Facebook-like Global Dominance scenario playing out. In terms of sensitivity, if I use a 10% discount rate instead of 12%, the valuation would jump to $54 (or up about 13% from my current valuation). My valuation summary table is shown below:
Also just for transparency sake, below I show a summary table of my estimates for the next few years for the firm's key metrics (again, apologies for the small font):
Analysts Unwilling To Paint Very Far Outside The Lines
While LinkedIn's public history is admittedly short, the firm has manufactured 3 huge consecutive beat and raise quarters. The process for manufacturing a beat seems to work as follows:
- The firm provides overly conservative guidance for the next quarter.
- Analysts forecast near-term results just a touch above management's conservative guidance, despite it being reasonably clear that estimates are exceptionally conservative.
- Analysts then justify their valuations by using either very, very aggressive out-year assumptions, exceptionally high multiples, and/or DCFs that don't account for share count growth.
- The firm reports earnings, which unsurprisingly beat the analysts' fairly pessimistic near-term estimates.
- Analysts then ratchet up their out-year estimates even further, but keep near-term estimates conservative and only a hair above management's guidance. Setting the stage for a beat next quarter.
- News articles and research reports come pouring out trumpeting another solid quarter involving a "beat and raise".
- The stock trades up on the news.
In the table below, I show how this has played out historically and how it's likely to happen again in 2Q12. One quick note on 3Q11, why the firm successfully manufactured a strong beat, the stock did trade down because the firm also simultaneously announced a reasonably large secondary offering.
Also just for a point of reference, my 2Q12 estimate for sales is $222mm (4.5% above guidance vs the street 1.7% above) and my estimate for adjusted EBITDA is $48mm (17% above guidance vs the street 3% above). I'm a bear and I'd be surprised if they didn't beat.
The stock appears grossly overvalued regardless of which valuation methodology you use. Additionally, Wall Street analysts seem complicit in keeping the stock elevated and in manufacturing quarterly earnings beats. It was interesting that I received zero responses from the analysts I reached out to about my valuation questions. I can't say that I know for sure what their motivations are, but I do find it interesting that management and large VC firms are consistent sellers during this period and that many Wall Street firms are currently engaged in the IPO of the largest social network in the world.
In the interest of full disclosure, I am short the stock (and yes, it's been painful). I'm actually now considering reducing my short. I still believe the company is tremendously overvalued, but I've become more nervous the more I've considered how analysts are incented to keep the valuation dream alive, at least for another few quarters (while large sellers exit). Additionally, a quick review of the annual proxy shows that management is incented to purchase revenue streams, without regard for purchase price, allowing them to continue to deliver top-line growth via acquisitions without fear of their comp being impacted for being bad stewards of shareholder capital.
In my view, it may now take an external event (e.g. a recession) to break the cycle of beat and raise. I'm not a macro economist, so I'm not entirely comfortable with an external economic event being a core piece of my investment thesis and hence why I'm considering shrinking my short. Having said that, I do believe there are other potential catalysts which could force analysts to reevaluate their valuation including:
- Facebook purchasing one of LinkedIn's competitors (e.g. BranchOut with 25mm members)
- Two of LinkedIn's competitors merging (e.g. Xing w/ 11mm members & Viadeo w/ 45mm members) creating a viable competitor.
- Slower customer acquisition continues in the corporate services divisions (growth QoQ slowed to 13% last quarter vs an avg of 24% over the previous 4 quarters)
- Premium subscriptions decline as the bump may be at least partially driven by members not canceling the free one-month trial that the firm had been offering.
One point I just want to be absolutely clear on. I like the company and the service it provides and I very much respect the growth the firm and the management team have been able to deliver. However, the business and the stock are two different things and I find the stock to be overvalued.
As always, your comments and questions below are appreciated. Thanks for reading.