LinkedIn Is Tier 1

"And, by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses. ... And most of the other people who've made a lot of money have done so in high-quality businesses."
-- Charlie Munger

At Tier 1 Investments, a Motley Fool Real-Money Portfolio, I seek out and invest in elite businesses. These include companies with the strongest competitive advantages, largest growth opportunities, and best management. I call these businesses Tier 1 enterprises, and LinkedIn (NYSE: LNKD  ) fits that description perfectly.

A deep and widening moat
With a network of more than 259 million members in more than 200 countries, and growing at the rate of two new members per second, LinkedIn is currently the world's largest professional network. LinkedIn is a platform that connects professionals around the world with career opportunities while also uniting thousands of businesses with the talent they need to run their organizations. As a multi-sided platform, LinkedIn stands to profit handsomely by connecting and delivering value to these two groups of users. And thanks to the powerful network effects that such a model enjoys -- meaning each person or company joining adds incremental value to the entire network -- that profit stands to grow exponentially in the years ahead.

LinkedIn has a diversified suite of product offerings, with three main business lines. Talent Solutions, which helps businesses recruit high-quality passively and actively job-seeking professionals, drive 57% of LinkedIn's revenue. The Marketing Solutions division, which comprises 23% of revenue, helps advertisers connect with LinkedIn's growing user base of professionals. The remaining 20% of revenue is earned in LinkedIn's Premium Subscriptions segment, which provides tools that help individuals and companies manage their professional identity, grow their business, and connect with talent.

Source: LinkedIn 

As members create and update their profiles, LinkedIn collects valuable data. As my colleague Tim Beyers explains:

LinkedIn eliminates a fair amount of the guesswork that comes with hiring new workers. Managers can see not only what you say about yourself but also what others say about you, who's connected to you, which companies you follow, which skills you claim, which skills you've proven, and best of all, what you think. Your posts become a window into your mind as a potential employee.

As a way to make its services even stickier to users and to promote more frequent usage, LinkedIn is building out its media content with its Pulse acquisition and Influencers program. I believe these moves will further increase user engagement and the value of LinkedIn's network, while also making it more likely that users will update their resumes and consider a job suggestion on the site. And by delivering more value to its clients, LinkedIn is increasing their switching costs and further strengthening its competitive position.

All told, I believe LinkedIn has a wide competitive moat around its platform because of strong network effects, diversified subscription-based revenue streams, and a valuable data collection cycle that competitors can't match. And with a rock-solid balance sheet with more than $2.2 billion in cash and no debt, LinkedIn has the resources to create new products and acquire others that boost engagement and increase the switching costs for its members. Together, these competitive advantages are allowing LinkedIn to fundamentally change the way professionals connect with each other and find opportunities, as well as how businesses recruit talent.

Tremendous growth opportunities
LinkedIn estimates that there are more than 3.3 billion people in the global workforce, more than 640 million of whom are professionals, and management pegs the number of companies with greater than 100 employees at about 200,000 globally. In total, LinkedIn estimates its current addressable market at $27 billion, with a long-term goal of growing its share of the worldwide market in talent acquisition valued at more than $85 billion. With 259 million members, 22,000 business customers, and revenue of less than $1.4 billion in the last year, LinkedIn has a tremendous runway for growth ahead.

In addition, the company is in the early stages of building products that take advantage of LinkedIn's growing database of member information. One such effort is a program that gives software developers access to the company's programming interface for creating plug-ins or apps that use LinkedIn data. This data is an asset that adds a tremendous amount of optionality to LinkedIn's business model, and I expect that many investors will be surprised by the new products LinkedIn offers in the years ahead.

Exceptional management
LinkedIn's leadership team is headed by Executive Chairman and co-founder Reid Hoffman and CEO Jeff Weiner. Hoffman focuses on broad strategy, innovation, and key initiatives. Before joining LinkedIn, Hoffman was the executive vice president of PayPal, and he also held management roles at Fujitsu and Apple.

Weiner superbly executes LinkedIn's business strategy. He joined the company in 2008 as an interim president and became CEO in 2009. Under his leadership, LinkedIn has grown its membership base from 33 million to more than 259 million members and increased its revenue more than tenfold. Like Hoffman, Weiner brings strong technology management experience, having previously served as the Executive Vice President of Yahoo!'s Network Division, where he managed Yahoo!'s consumer Web product portfolio, including Yahoo!'s Front Page, Mail, Search, and Media products.

Hoffman owns 13% of LinkedIn's shares, valued at more than $3.3 billion. Weiner also owns a sizable stake, valued at more than $21 million. These large ownership stakes should help to align Hoffman's and Weiner's interests with those of shareholders.

In addition to first-class leadership, LinkedIn has a strong work culture. As per Glassdoor.com, 92% of employees recommend LinkedIn to a friend, and 97% approve of Weiner. LinkedIn challenges employees to imagine their dream job, and then helps them work toward achieving it by offering both formal and informal training. Another program, called InDay, gives employees one day a month to pursue the ideas that most inspire them. As the company's outstanding performance has shown, these investments in employee engagement have more than paid for themselves.

Valuation
Today, we have the opportunity to initiate an ownership position in LinkedIn at a bit of a discount; shares are down about 16% from their highs of the year after LinkedIn reported third-quarter results and forward guidance that apparently disappointed Wall Street. I saw a quarter in which membership rose 38% to 259 million, revenue surged 56% to $393 million, and operating cash flow jumped 44% to $126 million -- all of which suggests to me that growth is very much alive and well at LinkedIn. And although LinkedIn surpassed Wall Street's expectations for both revenue and earnings per share, analysts were wary of LinkedIn's revenue guidance for the current quarter, which at a range of $415 million to $420 million came in below consensus estimates of $438 million. I'm far more focused on LinkedIn's revenue growth over the next decade than the next quarter, so -- as will often be the case -- I will strive to use Wall Street's short-term focus to my advantage by buying shares of LinkedIn at its currently depressed price.

Still, with LinkedIn's forward P/E ratio above 100 compared with analyst expectations of 54% earnings growth over the next five years, I understand why some investors consider LinkedIn's shares too expensive today. I, too, typically like to buy when those two metrics are more closely aligned. And although LinkedIn's true earnings power is somewhat understated because of the company's current high rate of investment to fuel its torrid growth, I acknowledge that LinkedIn is not an inexpensive stock. But, great growth companies rarely are, and I'm willing to pay a premium for quality.

Risks and why I'd sell
LinkedIn's shares, like those of many high-multiple, high-growth stocks, are likely to remain volatile. Revenue or earnings figures that come in below Wall Street's estimates could crush the shares. However, unless I see signs of a long-term erosion of LinkedIn's competitive advantages, I will probably view these periods of volatility as opportunities to add to my position in LinkedIn rather as a reason to sell.

A second risk relates to user engagement. The strength of LinkedIn's network is closely tied to the propensity of its users to update their resumes and personal information; recruiters won't continue to pay up for outdated information. Management is keenly aware of this and, as I previously stated, continues to develop new products and services that promote more regular usage of LinkedIn's network.

The risk I'm most focused on is the threat of competition. LinkedIn is far more than simply a professional version of Facebook (NASDAQ: FB  ) , as critics might call it, but nonetheless, Facebook and its massive user base do pose a threat. Facebook has already taken steps to build out more job and professionally focused services. So far, these have not taken hold to a point where I'm concerned that they will take significant share from LinkedIn. And I do believe that LinkedIn's exclusively professional focus will be a major competitive advantage versus Facebook and other traditional social media companies. In fact, Weiner has said that 80% of LinkedIn's members say they strongly value the network's separation of professional and personal identities. But as a fellow Tier 1 enterprise, Facebook is not to be taken lightly, and this is a battle I will be watching closely.

The Foolish bottom line
Like Fool co-founder David Gardner, I like to invest in companies that lead the world forward. LinkedIn, with its mission to "create economic opportunity for every member of the global workforce," fits that description. And as it creates opportunities for professionals around the world, I believe it will also create substantial profit opportunities for long-term investors. I have a high degree of confidence in LinkedIn's management team, leadership within its market segments, and future growth opportunities. And so, at least 24 hours after this article is published -- standard operating procedure for The Motley Fool's Real-Money Stock Picks program that's designed to give Fools the opportunity to buy ahead of us should they so choose -- I will be buying shares of LinkedIn in the Tier 1 Portfolio in hopes of profiting from the success of this elite business.

Next steps
I believe LinkedIn is poised for strong gains in 2014 -- and beyond. If you're interested in hearing about another stock our expert analysts think can surge in the year ahead, The Motley Fool's chief investment officer has just selected his No. 1 stock for 2014. You can find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2014." Just click here to access your free report and find out the name of this under-the-radar company.


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