Making A Venture Investment Case For LinkedIn

| About: Microsoft Corporation (MSFT)
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LinkedIn (LNKD) is an extremely expensive stock within the social media sector. Many investors have lost tremendous sums of money over the past 12 months in the social media sector, (in Facebook (NASDAQ:FB), Zynga (NASDAQ:ZNGA), and Groupon (NASDAQ:GRPN) to name a few). Recently LinkedIn was trading at 9 times consensus 2013 revenue and over 80 times consensus 2013 earnings - ridiculous valuation based on any traditional valuation benchmarks. Who would be crazy enough to invest their hard earned money in that stock?

Well, I recently purchased what is for me a meaningful position in LNKD, and may add more over time. What was I thinking? Have I gone mad? Maybe.

First let's agree LNKD is a very speculative investment opportunity and no one should put money into the stock that they are not prepared to fully lose. In addition a pullback is likely so even if an investor wanted to buy the stock this is not likely the optimal time to step in.

However, let me explain why I bought LNKD and took on such significant risk.

I have a vision of LNKD in 10 years when LNKD might be the primary contact database for the working world. Every member obliges to keep their own profile up to date, and in return every member gets access to an updated global contact database in real time. No need to maintain your own contact database anymore. In effect, if no other company catches LNKD, they could become the only comprehensive global database of human capital.

What is that worth to the world? Let's take a cut at translating that strategic value into numbers 10 years from now:

Assumption 1: Number of Members in 10 years

Assume approximately 8 billion on the planet in 10 years, and that 10% of the global population would want to be part of a global contact database. That would mean 800MM LNKD members in ten years (still a smaller member base then Facebook user statistics has already attained).

Assumption 2: Total revenue in 10 years

There is a wide range of assumptions someone could make here. LNKD currently has three revenue sources: Hiring Solutions, Marketing Solutions and Premium Subscriptions. As an individual business member I currently pay LNKD $24.99 per month (a bit less then a dollar a day) which allows me to make notes on individual contacts, categorize contacts, among other capabilities.

Between LNKD's three revenue streams, if you annualized reported Q2 2012 revenue, you get:

  • Hiring solutions $412MM
  • Marketing Solutions $192MM
  • Premium Solutions $152MM
  • Total Revenues $756MM

In ten years for Hiring Solutions and Marketing Solutions I assume that revenues grow with user growth, which I project to be 4.5 times more than today (800MM users vs 175MM users now). In addition, I double that revenue number, as I assume prices for the products will double once over ten years as the intensity of usage increases and LinkedIn becomes a critical "go to" application versus a "nice to have" application in people's lives.

  • Hiring Solutions would be $412MM x 4.5 x 2 = $3.7 billion
  • Marketing Solutions would be $192MM x 4.5 x 2 = $1.7 billion

For Premium solutions I assume 1% of users will pay a fee similar to what I currently pay ($24/month for expanded capabilities) and 2% go for a base level of expanded capabilities at $5 per month (16 cents per day). Obviously the pricing and product offering will be much more complicated than this but I make these assumptions as a proxy for Premium Solutions in 10 years. As an example of future upside I talked to a headhunter who said if LinkedIn just added a few more basic elements of contact management functionality he would drop his SalesForce subscription and be willing to pay even more then he currently pays today for his LinkedIn subscription service.

  • Premium Solutions in 10 years would then be:
  • 800MM users x 1% x $24.99 x 12 months = $2.4 billion
  • 800MM users x 2% x $5 x 12 months = $1.0 billion
  • Total premium Solutions revenue $3.4 billion

Total revenue in ten years based on the above scenario:

  • Hiring Solutions $3.7 billion
  • Marketing Solutions $1.7 billion
  • Premium Solutions $3.4 billion
  • Total Revenue $8.8 billion

To put the $8.8 billion of revenue in perspective, IBIS World estimates the global recruitment and services market at $590 billion.

So this would represent approximately 1.5% of that market size number. Of course the value of LinkedIn as a networked contact database goes way beyond recruiting, to other sectors, like sales, advertising, and administration, and in turn there are other unforeseen revenue streams that are likely to develop that have not been modeled here.

Assumption 3: Profitability

In 2011 Google (NASDAQ:GOOG) brought approximately 25% of their revenue to the bottom line as net profit. For various reasons, given that users create LNKD's content for free, I think LNKD will be more profitable then Google but let's stay with the Google benchmark. So we take 25% of the $8.8 billion in revenue and get $2.2 billion of net profit in ten years. At 15 times earnings that represents a market cap of $33 billion. In addition if we assume average cash flow over the ten years of $1.0 billion we add another $10 billion in cash for a total enterprise value of $43 billion. Assuming no further share dilution a $43 billion enterprise valuation would equate to a share price of about $412 per share in ten years and an internal rate of return in excess of 13%. Not bad in a low return world.

Obviously the above may not happen - but it might.

That is why I took the risk and bought LNKD at a nosebleed valuation.

Disclosure: I am long LNKD, GOOG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Tried to click the button to have LNKD be the primary ticker but didn't seem to work.