LinkedIn (NYSE:LNKD) has been an out-performer among the recent tech IPOs. While Facebook (NASDAQ:FB) and Zynga (NASDAQ:ZNGA) have plummeted from their IPO valuations, LinkedIn’s stock has rocketed higher. This can be attributed to a solid business model and high growth. However, we believe that despite these positive factors, LinkedIn is overpriced. We currently have a $54 Trefis price estimate for LinkedIn, which stands nearly 55% below its market price.
While this is partly because we use a diluted share count to arrive at our stock price estimate, most of the difference could be attributed to unbridled optimism regarding LinkedIn’s growth prospects by the overall market. We currently have very optimistic growth projections for LinkedIn, but even that does not justify such a high price for LinkedIn, which is currently trading at a P/E ratio of nearly 1,000. Furthermore, we believe that certain risks such as the potential competition from existing internet and technology giants are not being priced in by the market.
Current Valuation Implies Tremendous Growth
LinkedIn has grown rapidly over the past couple of years, but it cannot be expected to maintain the same pace going forward. The company had an average of more than 6,500 corporate customers in 2011. We expect this figure to grow past 12,000 in 2012 and further increase to more than 40,000 by the end of our forecast period. This will be driven by LinkedIn’s expansion internationally as it signs up more corporate customers for its hiring solutions, its most valuable business. This is already very optimistic expectation but still does not warrant the valuation that LinkedIn has.
We also assume that LinkedIn will be able to increase its average revenue per business customer in the coming years, by demonstrating greater value to corporate customers and introducing new features and services. However, in order to gain more customers, it may have to reduce pricing for new customers, which could negatively impact average revenue generated per customer.
We currently have an average annual growth rate forecast of close to 24% for LinkedIn’s recruitment services and job listing segment, which is sufficiently optimistic. As the revenue base grows, growth is likely to come down. The current valuation demands an annual average growth rate which is much higher than 24% for the next 7-8 years. This is highly unlikely to happen.
Furthermore, we expect LinkedIn’s advertising and marketing revenues to also grow at an average annual growth rate of nearly 24% based on its expected growth trajectory in global markets as well as an increase in mobile advertising revenue which is expected to drive growth. Even if we assume continued growth in the number of page views as well as average revenue per view as we currently do, it still wouldn’t justify such a high valuation.
Operating Expenses Remain A Concern
LinkedIn has had to incur high operating expenses to fuel its rapid expansion. We expect it to rein in the expenses going forward and we project its expenses (as a percentage of gross profit) to decline every year. However, even if you assume that LinkedIn’s expenses will be reduced by a lot more than what we currently project, this would not move the stock’s value meaningfully.
Two cost items that investors should consider are R&D (research and development) and SG&A (selling, general and administrative) costs. These two figures stood at 27% and 51% of LinkedIn’s total gross profits respectively in 2011. We forecast R&D figure to drop from 27% to 17% by the end of our forecast period and SG&A figure to decline from 51% to 37% during the same period. If LinkedIn has to claim any remote justification for its current market price, it will need to leverage its growing user base much more efficiently than we currently see.
Furthermore, LinkedIn has also stated that taxes are likely to remain high in the short term. 
Competitive Risks Are Not Priced In
We feel that the market is not pricing in future competitive risks adequately. Although LinkedIn currently has a unique advantage of mixing social networking with recruitment services, the barriers to entry are low. There is no reason why its competitors Monster (NYSE:MWW) can not do something similar to enhance the interactivity among professionals and help applicants and employers in better targeting. In addition to this, internet giants such as Google (NASDAQ:GOOG) and Facebook (NASDAQ:FB) have vast amount of information and influence over their internet user base to allow them to create viable recruitment portals that can pose a serious threat to LinkedIn.
The market’s optimism for LinkedIn could be compared to what Netflix (NASDAQ:NFLX) saw in early 2011 when its stock price soared to $300, riding on wave of high subscriber growth. But that wasn’t sustainable. Even though management’s missteps were a factor in stock’s slide, one can not deny the fact that the competitive picture became much clearer for Netflix over the past year and several giants with deep pockets have emerged as threats. These include Comcast (NASDAQ:CMCSA), Dish Network (NASDAQ:DISH) and Verizon (NYSE:VZ).
There is no doubt that there is a possibility that something similar could happen for LinkedIn in the future. Competitive threats can not be ignored even though they may not be very apparent right now.Notes:
- LinkedIn’s Q2 2012 Earnings Transcript [↩]