From personalized advertising to improved data management, social media has shown promising secular trends. At the same time, software and media companies like Microsoft (MSFT) and Google (GOOG) have raced to build so-called "clouds" that enable content producers to smoothly access information on different channels.
These two exciting developments in technology have pushed multiples skyward in emerging tech companies. In this article, I will present a DCF model on LinkedIn (LNKD) and then review why the social networking industry looks promising. Overall, I believe that investors should diversify across the entire industry to benefit from the rise of personalized advertising.
First, let's begin with an assumption about the top-line. LinkedIn finished FY2011 with $522M in revenue, which more than doubled off of the preceding year. Over the next half decade, analysts model around 69.6% per annum growth.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold trending from 15.5% to 15% of revenue while SG&A holds steady at 42%, R&D trends from 25% to 22%, and capex trends from 13% to 6%. Taxes are estimated at 23% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around -5% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by 12% yields a fair value figure of $144.06, implying more than 30% upside. Since my model is highly uncertain - and I view 69.6% per annum growth over the next half decade as bullish - I apply this high discount rate. There really is no clear way to project free cash flow, but discount rates can help put different scenarios into context. The market seems to be discounting my assumptions at 14%, which is overly bearish and would only be practical for highly speculative emerging stocks.
With LinkedIn 30% undervalued, where does that lead the other players? Well, Facebook (FB) was expected to have 2011 revenue of $4B-$4.3B; but it instead revealed revenue of only $3.7B in its S-1 filing. This means that the largest social networking site will IPO at around 27x revenue. LinkedIn , which is really Facebook with a professional motif, trades at 21.2x revenue.
By contrast, Izea trades at only 2.8x 2011 revenue. Izea is a social media sponsorship company that helps individuals monetize content on Facebook, Google+, Twitter, and other high-growth platforms. They compensate bloggers, mobile promoters, and tweeters to distribute information about various products within social media channels. Izea's services provide broad and personalized exposure to relevant viewers.
Ultimately, investors do not need to directly invest in LinkedIn to capitalize off of the social media craze. Broad exposure across the industry is ideal given the practicality of personalized advertising. Here's why "next generation" advertising will come from social media:
While large media businesses attempt to vertically integrate throughout various mediums (ie. search, social networking, mobile, television), software-makers will produce the infrastructure necessary for subsequent growth. This positive feedback loop wherein data demand drives software creation, which, in turn, drives yet greater data demand and so forth, is precisely what makes advertising in social media so attractive.
In the process, advertisers are increasingly getting access to personal data. While many have criticized Facebook for supposed intrusion of privacy, the truth is that users of the social network are not giving away their information for free. They are giving it in return for the right to access the site in an optimal way. Advertisers are then able to more efficiently target prospective consumers. As I earlier illustrated here, Google's integration of this "next generation" advertising in its search results has showcased how fun and rewarding this can be.
If you are still skeptical about how access to personal information can actually be a good thing for both advertisers and content producers, allow me one more example. In this example, I intend to demonstrate social media's effectiveness through showcasing the contradictory case -- that is, by exposing the flaws of traditional advertising.
So, just yesterday, I was watching the season finale of Survivor on CBS.com. Everything was going well, and I was enjoying the show, but I couldn't happen to be anything but annoyed by the eight different advertisements that had nothing to do with my interests. In the particularly obnoxious advertisement below, I was actually redirected from the CBS.com site and to a company website marketing hair products. Now, I have nothing against Drugstore.com's Nexxus Frizz, but it simply is not something I would consider buying within at least the next century.
The advertisement was inefficient for three main reasons. First, it did not pique my personal interest. Second, if the company just did a cursory review of my personal information -- or even just my demographic -- it would be immediately obvious that I was not a target consumer. Third, the advertisement makes me less likely to go to CBS.com. You know that type of feeling you get when you are at a cinema and getting ready to watch a mature comedy when several advertisements for the latest Jim Carrey or Jack Black films start rolling? Companies are implicitly suggesting that you have a high likelihood of belonging to a certain background. And it makes you feel uncomfortable when they are wrong.
By contrast, the advertisements on Google and Facebook directly target what we personally express interest in. Searching for "movies"? You'll get ads for movies. Posting comments on your Facebook wall? You'll get ads based on your personal data. Sending out corporate emails on Gmail? You'll get ads based on the content of those emails. It works. And it is significantly more efficient than the Nexxus Frizz advertisement. That's not to say, however, that mass advertising does not have its purpose. Rather, it is simply to make a point about why social media advertising -- far from something to be feared -- should be something that is embraced.
With the barriers to personalized advertising disappearing, investors have a strong reason to be optimistic about Facebook's prospects. This positive secular trend is buttressed by cloud developers that are spreading out more of our personal information across different mediums. Accordingly, I strongly recommend broad diversification across both social media companies and software makers. This includes backing everything from Google and Microsoft to Facebook, LinkedIn, and maller companies.
Additional disclosure: The distributor of this research report is not a licensed investment adviser or broker-dealer. Investors are cautioned to perform their own due diligence. We seek business relationships with all of the firms in our coverage, but research covered in this note is independent and commissioned. Always discuss investments with a licensed professional before making any financial decision.