Up approximately 75% in the last 12 months, LinkedIn (LNKD.DL) has proven bears terribly wrong. Though the company's valuation has kept many investors cautious, there is no ignoring the stock's phenomenal performance since the company's IPO. LinkedIn's premium valuation might seem insane, but it's not enough reason to short the stock. Why? LinkedIn's powerful and expanding moat.
You're going to need a bigger moat
Identifying economic moats, or a company's durable competitive advantage, is imperative to a solid long-term investing strategy. In a nutshell, moats protect a company's profits from potential entrants. Bruce Greenwald, author of Competition Demystified, says the job of identifying and managing a company's moat is management's ultimate priority in competitive strategy.
Though moats come in many forms, a network effect is one of the most powerful. LinkedIn is a prime example: The company's entrenched network of employees and employers grows stronger with each additional user. For every new member, the platform becomes more useful to members, recruiters, and advertisers. As the platform outgrows its peers, the switching costs of leaving LinkedIn for a less-useful platform become greater.
Beyond LinkedIn's powerful network effect, it has an advantage over its social peers in terms of its superior ability to make more money from its network. First, LinkedIn has a much smaller reliance on fickle advertising revenue. Facebook, for example, derives 84% of revenue from advertising compared to LinkedIn's 26.6% in fiscal 2012. The rest of LinkedIn's revenue comes from recruitment services, job postings, and premium account subscriptions. Even more impressive, LinkedIn is much more effective at making money from its users than Facebook. For example, even though only a small percentage of LinkedIn visitors visit the site every day, it generates about $8 annually per monthly average user compared to Facebook's $5.
Analyzing moat trends
But it's important to not stop at simply identifying a moat. Next, investors should analyze a company's moat trend to identify whether or not its moat is expanding or eroding. The process is simple:
- Identify the key metrics driving the company's moat.
- Take a look at the key metric trends.
- Draw conclusions regarding the company's moat trend based on an analysis of its moat-driving metrics.
Three key metrics are central to LinkedIn's moat: members, unique visitors, and page views. Member growth represents increased demand due to a compelling offering or greater awareness. Increased unique visitors give the company a better chance of converting more visitors to members. Finally, page views reveal the "stickiness" of LinkedIn's website. Each of these metrics boost the usefulness of the website to LinkedIn's three target customers: members, recruiters, and advertisers.
LinkedIn's members are up 39%, year over year, to 202 million. Considering that's still just a fraction of Facebook's more than 1 billion monthly active users, there is still room to grow -- especially considering LinkedIn's impressive international growth. For instance, compared to the year-ago quarter, revenue more than doubled in all of LinkedIn's international regions. Furthermore, three years ago only 25% of LinkedIn members came from international markets. Today, however, over 64% of LinkedIn members originate abroad.
Unique visitors -- users who have visited the LinkedIn website at least once during the month whether they are a member or not -- are also up substantially. According to LinkedIn's internal measurements, they've risen 29% year over year. This means that more users across the world are finding more reasons to visit LinkedIn's website.
Page views give us a closer look at user engagement, as opposed to the absolute volume measured by the unique visitors metric. The metric measures the number of pages on LinkedIn's website a user views during a measured period. According to LinkedIn's internal measurements, page views grew 67% in Q4 from the year-ago quarter, marking a substantial increase in member engagement.
Entrenchment at its best
With membership, page views, and unique visitors up 67%, 39%, and 29%, respectively, moat momentum appears to be in LinkedIn's favor. To no one's surprise, advertisers have flocked to the social network, with LinkedIn's advertisers more than doubling from Q4 2011 to Q4 2012.
In contrast, Monster Worldwide (MWW) is a classic example of what happens to social networks when their network effect begins to erode. As LinkedIn's network grows stronger, Monster's value proposition becomes less attractive. In the company's fourth quarter, bookings, revenue, operating income, and EPS all saw year-over-year declines in the double digits. At just 8.3 times earnings, Wall Street's sentiment is a reflection of the poor expectations investors have for Monster's future.
Though Monster management is quick to say "year-over-year decline in total bookings ... is primarily attributable to continued weakness in Europe, which has been negatively affected by global economic challenges," LinkedIn's powerful network plays a role in the decline as well; with a fast-growing user base, LinkedIn offers advertisers and employers an increasingly compelling value proposition.
Never short castles
There is no doubt that LinkedIn is an outstanding business. Despite its positive moat trend, however, I'm still not willing to make an outperform CAPScall on the company -- there is simply too much perfection priced into the stock. But that doesn't mean I would short the stock, either. In fact, I would never short any company with a solid moat. But long-term investors should keep an eye on LinkedIn in 2013 for an opportunity to re-examine buying opportunities on any significant sell-offs.
