Last week we discussed the opportunities that lie ahead of LinkedIn (NASDAQ:LNKD) as the company continues to gain share in $27 billion recruitment industry with its disruptive business model (see LinkedIn: Opportunities & Threats (Part 1)). In this note, we’ll focus on some of the key threats that LinkedIn faces or may face in the near future. The price that the company is paying for its rapid growth isn’t cheap, and its success could influence other industry incumbents and new players to adopt a similar model which could impact its business going forward. In addition, most of LinkedIn’s user base growth is likely to come from emerging markets of Asia and Latin America where the pricing power is relatively low. This could moderate the topline growth and mitigate the operating leverage gain that is necessary to justify the current market valuation.
Our price estimate for LinkedIn stands at $154, implying a discount of about 30% to the market price.
Threat: High Spending On Marketing And R&D Efforts
LinkedIn’s EBITDA margins are less than half of that for Facebook primarily due to high spending on R&D (research and development) and SG&A (selling, general and administrative) expenses. The primary component of SG&A cost is sales & marketing expense, which has grown substantially over the years and has offset most of the operating leverage that LinkedIn gained due to strong revenue growth. These figures stood at 25% and 49% of LinkedIn’s total gross profits, respectively, in 2012 and are not expected to change materially this year.
R&D costs mainly include salaries and benefits for engineers, product managers and developers. As LinkedIn expands internationally and continues to develop new features, it will continue to incur high R&D costs due to an increase in the headcount. Also, the company has been expanding its field sales organization to reach out to potential corporate clients. This has led to a substantial increase in its sales and marketing costs, which may continue to be the case in the near term.
We forecast the R&D figure to drop from to 15% by the end of our forecast period and the SG&A figure to decline from 39% during the same period. If LinkedIn has to claim any justification for its current market price, it will need to leverage its growing user base much more efficiently than we currently see.
Threat: Potential Competition In Future
Although LinkedIn currently has a unique advantage of mixing social networking with recruitment services, other Internet giants could leverage their data and experience to do something similar in the future. A slowdown in the growth would hurt the stock as the high P/E (price to earnings ratio) suggests that the market is mainly pricing LinkedIn’s stock on high expected earnings growth. Companies such as Google (NASDAQ:GOOG) and Facebook (NASDAQ:FB) have a vast amount of information and influence over their Internet user base, which could allow them to create viable recruitment portals. In Australia, online jobs marketplace SEEK is ramping up its technology efforts to launch new analytics portal that will better suggest potential jobs to jobseekers. Monster has also been trying to optimize its search functionality and algorithm.
Facebook started moving in this direction last year with its Social Jobs app and could potentially create an ecosystem for professionals. LinkedIn currently has a brand that is recognized in professional context but so has Netflix (NASDAQ:NFLX) (in context of Internet video). It didn’t take long for companies with deep pockets to come up with competing video services.
Threat: Slowdown In Revenue Growth Due To Expansion In Low Income Countries
At the end of Q3 2013, approximately 34% of LinkedIn’s members were in the U.S. This implies that the company had around 89 million members domestically, covering roughly 57% of the country’s labor force. Latin America, South America and Asia-Pacific regions account for the bulk of world’s population but only 35% of LinkedIn’s total membership base. There is still a lot of potential for the company to expand in these regions but that will come at a cost. The growth in average revenue per customer will be negatively impacted due to low purchasing power of developing countries. This will ultimately translate into a slowdown in LinkedIn’s revenue growth, which is the primary metric that the stock has traded on so far.