LinkedIn (LNKD) became the first U.S. social media company to make its market debut. The firm priced its IPO at $45 per share on Wednesday and had traded up to almost $90 by Thursday morning. We have no doubts that investor demand for the shares is high, but our own fair value estimate of $27 per share breaks significantly with the current valuation. Morningstar senior analyst Rick Summer takes us through his investment thesis on the company, and what he sees over the longer-term that ultimately drives our lower valuation:
"LinkedIn has captured the social networking trend more successfully than any company in the U.S. aside from Facebook.
LinkedIn has carved out a rather large niche community focusing on the professional worker. The company provides a social network for users to create an identity and make connections with other professionals including colleagues, clients, bosses and business partners. More than 70 million users have developed profiles that detail personal information such as employment history, job responsibilities and education. Without question, this database of user information is proving valuable to users, advertisers and recruiters.
The company provides the services to individuals via a "freemium" (a hybrid free and premium) offering. We estimate that less than 0.5% of users pay a premium subscription fee to perform activities such as directly connecting to people they do not know. These premium subscription fees represented about 25% of revenues in 2010. In the long term, we view the more important sources of revenue to be hiring solutions and online advertising. First of all, the numerous page views offer an attractive place for advertisers. Because LinkedIn has significant user data, many business to business advertisers can run very targeted campaigns. This is a large market, and we estimate that businesses spend more than $30 billion on business to business advertising alone. This revenue stream represents approximately one third of revenues. The third source of revenue is perhaps the most obvious -- hiring solutions. Employers have begun to embrace LinkedIn for recruiting by searching user profiles posting jobs. This was the fastest growing segment in 2010, and it now represents more than 40% of revenues. Although LinkedIn is complementary to job sites Monster Worldwide (MWW) and CareerBuilder, we believe the ownership of the professional identity is the most defensible way to construct a moat in this industry.
We are encouraged by the size of LinkedIn's network and do not believe that the competition can launch a competing offering. First of all, LinkedIn profiles are now part of 70 million people's personal brand. When performing Internet searches on individuals, both LinkedIn and Facebook profiles regularly show up on the first page of results. LinkedIn's user base gets value in putting forth a cohesive professional image, in our opinion. Additionally, due to the infrequent nature of the loose connections in people's professional networks, LinkedIn provides a seamless way for users to always re-connect with their network. It's a contact database that users choose to keep updated.
Our biggest concern with LinkedIn is that its user base feels exploited and stops using the network. Online advertising is an important component of the company's revenue stream, and management has instituted some initiatives to increase traffic and page views at the website. It is not clear to us that individuals want to spend more time at LinkedIn, and the value may only be in the contact database and resume maintenance capabilities. If the website changes dramatically to become more of a content destination site, users may stop using LinkedIn.
The industry is young, but we are very positive on the prospects for the company. Still, even good companies should be bought for less than they are worth."
Valuation
"Our fair value estimate of $27 assumes LinkedIn extends its dominance as the preferred social networking site for professionals. We are forecasting annual revenues to grow 43% over the next five years, as combined revenues from hiring solutions and advertising reach more than $1.3 billion. We are also assuming GAAP operating margins reach the mid-20s by 2015.
"Online advertising is a key component of our valuation. LinkedIn doesn't currently do an efficient job translating traffic into revenue versus other Internet companies. In our model, we expect that page views and revenues grow at a much faster rate than users. Admittedly, a wholesale change in website traffic could have a dramatic difference in our valuation."
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