Pinterest, which is a mix between a social network and a search engine, is coming public. What does this company actually do, and how does it make money? In this episode of The Motley Fool's Industry Focus: Technology, host Dylan Lewis and contributor Brian Feroldi explain what Pinterest is, discuss what it does, and give their opinion on whether the stock should interest investors.

A full transcript follows the video.

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This video was recorded on March 29, 2019.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, March 29, and we're pinning another company to our 2019 IPO board. I'm your host, Dylan Lewis. I've got's Brian Feroldi on Skype. Brian, what'd you think about that little intro pun there?

Brian Feroldi: That was wonderful! That's 100% a reason to listen to this show, for those wonderful puns.

Lewis: [laughs] I do what I can. Listeners, we're going to be talking about Pinterest today, one of many tech companies that are going public in 2019. Kind of an interesting one, because this one has been around for quite some time. The business model is a little bit more mature. I think a lot of people are probably pretty familiar with this name. 

Feroldi: This is a company that I have personally had on my radar for several years now, because my wife has been an avid Pinterest user. I have personally used Pinterest to find gift ideas for her. I know that there's a lot of power in the engine, and I've been very interested in digging into the numbers behind this company. 

Lewis: For the uninitiated, I think Pinterest could maybe best be described as a combination of a Facebook, Instagram, and Etsy. If you look at the Venn diagram between all those social-media platforms, that's kind of where you find Pinterest. It's a lot of makers, DIY-ers, people that are looking for some inspiration through a visual medium. 

Feroldi: Yeah. They actually say that they're a visual search engine. People come there looking for ideas that they can't necessarily put into words, but they know it when they see it. When you see a picture of something, it could spark inspiration. A lot of their pinners go there to generate ideas.

Lewis: A lot of the stuff that you see on this platform is people doing DIY projects, whether it's home decor, possibly wedding planning, maybe planning for some renovations to the house, all that kind of stuff. 

Feroldi: Yeah, and this is a huge platform. Pinterest has 250 million active pinners, which is what they call users. To give you some context behind that, about 82 million of those are in the U.S. and about 184 of them are international. So this is actually a far more international company than I assumed from the get-go. 

Lewis: We see a slightly different number with their user metrics, too. We're very used to the monthly active and daily active when it comes to social media companies. We get a weekly active number from Pinterest. 

Feroldi: Yeah. Which sort of makes sense, because if you're going there for inspiration, perhaps you don't need to go there every day to message friends or keep in contact. I do think that makes some sense. But it's interesting to note. 

Lewis: Some other big metrics, just to give you a sense of how activity looks on this platform, about 2 billion monthly searches on the site. Over four billion boards, which is where people aggregate ideas and clips from all these different things that they are seeing on the platform. This is a platform that heavily slants female.

Feroldi: Yes, about two-thirds of users are female. I would have actually assumed it would be even higher slant female. But I did see that the number of males using Pinterest has been growing like crazy over the last couple of years. It's actually their fastest-growing segment. Some more metrics to put around that. About 80% of moms are on Pinterest, and about half of millennials use the site. 

Lewis: Those are U.S. metrics, right? Eighty percent of mothers in the United States, 50% of millennials in the United States. 

Feroldi: That's correct. One other thing that when I was reading through really jumped out to me is that 91% of Pinterest users say that the site is filled with positivity. When I compare that to, say, Facebook or Twitter or Snapchat, that's something that I think separates this company. 

Lewis: It is a little different. [laughs] Yeah, you don't run into quite the same toxic elements that you might find on some other social media platforms when you're on Pinterest. 

Feroldi: Yeah, that's definitely something that I think is very powerful about this platform. Another number that also jumped out to me was that 85% of users say that they go to Pinterest to start a new project. That's a huge number of people that go to the site, and then take some sort of action in their life. That could be a very valuable aspect to this platform.

Lewis: Especially because they are looking to monetize via ads. That's where most of their money's coming right now, and that seems to be the path for them long term. The pitch to advertisers is, "You have people coming onto this platform looking for ideas." Whether it's because they're planning an event, they're looking to do a major overhaul to what their garage looks like, maybe they just want to have a fun project for the weekend; very often, those types of things come with having to buy supplies or having to buy products to fill something out. I think the leap for advertisers isn't a very far one. 

Feroldi: Yeah. There's a quote in the S-1 that I think is worth highlighting here. They say: "The majority of pins saved on our service are from businesses. Ads do not compete with the content pinners want to see; they are the native content." That's something that, for me as the investor, makes me really excited. People are going to the site because they want to see ads from businesses!

Lewis: Right now, we're starting to get a sense of what that ad business might look like. I know that they are not super mature in the ad business, but they are certainly further along than some of the other companies that we've seen come public recently -- thinking specifically of Snap there. You go to the most recent quarter and their financials, 60% growth in 2018, hitting $750 million in revenue. Almost all that's coming from the United States. Almost all that is ads. 

Feroldi: Yeah, that's their primary method of monetization right now. They are an ad-based platform. Even though their platform does entice many people to take action and buy things, they have chosen thus far to only fund their site with ads. Like you said, $750 million in total revenue, 60% growth last year, those are pretty exciting numbers. 95% of that total is coming from the U.S. So, although the majority of users are based outside of the U.S., right now this is a U.S.-centric revenue story.

Lewis: Yeah. That 60% figure is something we've seen going back about six or seven quarters now. It's not like we are seeing a deceleration. We've actually seen them go from anywhere between 57% and 61% over the last six or seven quarters. They've been able to maintain that growth rate pretty steadily as they've started to monetize their users a little bit more. 

Something super encouraging for me with this company as a fresh IPO is the fact that they have quite a bit of cash on hand.

Feroldi: Yeah, this is a company that, before their IPO, before they get this huge bolus of cash, they have $627 million in their bank account as of the end of the year. Compare that to their liabilities, which were just $281 million, and that's a mix of liabilities. The other thing that I think is worth pointing out here from a balance sheet perspective is, they do have $1.46 billion in redeemable convertible preferred stock. We don't know what's going to happen to that after the IPO. It's very likely that this company is going to raise a couple of billion dollars and their balance sheet could change completely. It wouldn't surprise me to have them wipe out all of their liabilities and be a cash-rich company. But those are the numbers as they stand today.

Lewis: Yeah. As is, they're starting from a pretty strong point. To be expected of a tech IPO, this company is losing money.

Feroldi: They did lose $63 million in 2018. That was down by about half from the year before. The thing that really excited me was, this company was actually profitable in the fourth quarter. Now, it is worth pointing out that this is a seasonal business from a revenue and use perspective, which makes sense. People who are going to be buying stuff from this platform are getting ideas mostly around the holidays, so the fourth quarter is one of their bigger quarters. But still, the fact that they were able to post a profit for the first time, that's got to be encouraging.

Lewis: A big reason for that is the fact that they're enjoying expanding gross margins. You look over the last couple of years, 62% gross margins in 2017, 68% in all of 2018. You go to Q4, where they started to post that profit, 75%. That's super encouraging.

Feroldi: Yeah. Expanding gross margin is something that gets me really excited. When a company is scaling its revenue and you see that its margins are growing at the same time, that can lead to outsize growth on the bottom line eventually.

Lewis: One thing that I think is worth digging into on the cost side is their cost of revenue. This is essentially the cost associated with delivering the core content on the platform. For a company like this, this is going to be their IT infrastructure. Pinterest takes a pretty similar approach to Snap. They use a third-party cloud provider to handle things for them rather than own and operate all their own IT infrastructure. On this show, we have criticized Snap for doing that because rather than have the fixed cost that leads to leverage, you have a variable cost that moves with usage. I think because Pinterest's ad business is a little bit more mature than Snap's was when it went public, it isn't as much of a problem; but, you're going to have a variable cost. I think cost of revenue is about 30% of sales. Almost all that is related to hosting costs. So, I think that's something that investors just need to keep in mind with this company. 

Feroldi: Yeah, definitely. The fact that they have decided to outsource the hosting of their site to, in this case, Amazon Web Services is the company that's powering Pinterest, that's a decision that they made. Perhaps after they get a big thing of money, they could think about, in the future, going with their own model where they build their own data centers to benefit from that leverage. But you're absolutely right, that's something that's worth pointing out. 

Lewis: With financials out of the way, why don't we talk about some of the more soft elements of the business? I'm thinking specifically here about the moat, Brian. What do you see when you look at it? 

Feroldi: Moat is super important when you're thinking about any investments. To my eyes, this company does have a somewhat of a moat. Right now, just their sheer amount of users that they have, they have a huge collection of data, a huge collection of pins and information about what their users like, what their users want to see. There is a social component to this. You can go on and you can check out your friends' boards, you can see what kind of things that they like, you can have people follow you. Those things do create somewhat of a network effect. The more users you have, the more pins you have, the more boards you have, and that does create somewhat of a flywheel that you could argue insulates them from competition. 

Lewis: Yeah. I think it's a little bit weaker than we'll see network effects from some of the other platforms. Facebook and Instagram probably have the strongest network effects in the social media space. Twitter's is pretty strong as well. I don't think Pinterest is quite on par with theirs. But there are a lot of elements there that, yes, the more people that are on there, the stronger the platform is going to be. 

Feroldi: Yeah, I completely agree with that. The other thing that I think this company benefits from is, it does have a really strong brand. The fact that 90% of their users say they associate the brand with positivity, I think that gives them a very strong brand that should separate them in the long term from, say their rivals. They do have a statement in their S-1 that says, "We're the third most relevant brand in the U.S." I can see that. I know that in my life, my wife just loves Pinterest, probably more than almost any other company that I can think of. So I do think there is value in that Pinterest name.

Lewis: Yeah, Nick Sciple and I were talking about Pinterest before we hopped into the studio to tape the show. He made the joke most people will waste half an hour on Instagram or Facebook and not really feel so great about it. They'll feel like they just fell down a black hole for a while. If you're on Pinterest for half an hour, chances are you're doing stuff, you're finding inspiration, you're working through a project, something like that. People don't seem to have that same social media dread that they do with some of the other platforms out there with Pinterest. 

Feroldi: Right, which is a very soft thing to talk about, but I do think that there is value there. So, does this company have a moat? I believe that it does. But there is an argument that it is not quite as strong as some other social media companies that we've talked about. 

Lewis: All right, Brian, let's talk potential. We looked at that growth rate, that 60%-ish growth rate. The big question for me is, is this something that they can sustain, possibly even accelerate, especially the way that user growth is going for them? 

Feroldi: This is an advertising play. The good news there for investors is that the advertising market is absolutely enormous. The total addressable market for digital advertising in 2018 was $272 billion. That number is expected to continue growing quickly and should reach $423 billion by 2022. If you could pretend that Pinterest could grab 1% of 2018's total pie, that would be $2.72 billion in revenue. To give you some perspective, that would be roughly 4X the revenue that they pulled in in 2018. The pie that they're going after is so massive that even if they could just get 1% of it, there is plenty of room for them to grow. 

Lewis: The necessary caveat there is, to do that, they are going to be competing with the likes of Google and Facebook and Facebook's property, Instagram. Those platforms are notoriously strong performers for people in the digital ad space. The reason that there's effectively a duopoly in digital advertising is, all the money spent on Google and Facebook's properties tends to give a pretty good ROI for the people that are spending that money.

Feroldi: Yeah. So, what kind of stats do we have to back up that making an investment in Pinterest is worthwhile for advertisers? Well, Pinterest, on their S-1, said that a household that looks at a retail product on Pinterest is 39% more likely to buy it than they would otherwise. Those that see products on the site on average spend 29% more on items that they see on Pinterest than they don't see. So, there is, I believe, value to be had for advertisers to say, "Getting this information in front of our audience on Pinterest does have an ROI for us."

Lewis: Yeah. The thing that I think is interesting is, a lot of the advertisers that they focused on early on have been in the retail and consumer packaged goods space. Those often are brands with pretty big ad budgets. [laughs] It might be that they're able to help reach people that are tending to do more brand advertising and might be able to do a little bit more performance advertising on their platform, rather than some of the other social media ones out there. 

Feroldi: Yeah. Pinterest has said that they do want to eventually expand into other verticals, other sectors of the market, to get advertising dollars. It's important to realize that they're still very early in the monetization stage. To put some numbers around that, a key metric for any of these companies that we talk about is average revenue per user. That's when you take your total revenue and divide it by the number of users that you have. In the fourth quarter, they made about $3.16 in the U.S. from their average user. The number in international was about $0.09. $0.09 for international users. To put some context around those numbers, last quarter, Facebook did $34 in revenue per user in the U.S. and $7.37 worldwide. When you compare those two, there is tremendous room for expansion on Pinterest's side.

​Lewis: Yeah, and I think a lot of that is going to be coming from the international markets. My pause here with this company is, the U.S. is a very mature market for them. You look, and user growth is up single digits year over year. They've been hovering around that 80 million number for quite some time. So really, the serious growth is going to be coming from increasing ad impressions and increasing ad prices in the United States. Outside of the United States, they have about two-thirds of their users. Right now, they're not monetizing them too much. They've been focusing most of those efforts in the U.S. But that user base is growing 30% year over year, so there's definitely something there. They're just going to have to harness it.

Feroldi: Yeah, I think you hit the nail on the head there. We've seen this work very well for Facebook, though, in the past. Their numbers in the States were growing, but their revenue was growing far faster because they proved to advertisers that their platform was worth spending dollars on. The challenge ahead for Pinterest is going to be to do the same thing to follow in Facebook's footsteps. That is a risk that investors are taking on.

Lewis: Brian, I know you like to look at customers as well when you're breaking down businesses, what do you see when you look at Pinterest? 

Feroldi: I like to think about the relationship between customers and the business when I'm thinking about investing in a stock. Here, it's important to note that the customers we're talking about are the people that give the company revenue. Not users. Customers are advertisers. Are they expensive to onboard? Well, in platforms like this, the answer is usually yes. There is a significant sales and marketing cost to get a big brand to advertise on your platform, to get them set up. But once they are on there, are they dependable? Will they keep giving you revenue on a consistent basis? The answer there is yes. Advertising is a continuous expense that they have. Revenue is recurring. And it appears to be a dependable.

The other thing I like to think about is, does Pinterest have pricing power? Can they raise their profit margin over time? From what we've seen, yes. Their gross margin is expanding. There is an argument to be made that this is a company with recurring revenue and with pricing power. That is something that very much excites me. 

Lewis: Yeah, this isn't recurring revenue in the way that a software-as-a-service company would have recurring revenue. The performance needs to be there on the ad side to have those advertisers continue spending money. By a lot of indication, though, the performance seems to be there. 

Feroldi: Yeah, I totally agree with you.

Lewis: Brian, what you think of management and the company culture? I know this is one of the big things you like to hone in on, too. I think we couldn't have a conversation about an S-1 or an upcoming IPO without talking about the CEO and the leadership at a business. 

Feroldi: We like to see that the people that founded the company are still running the show. That is the case with Pinterest. The two co-founders are Ben Silbermann and Evan Sharp. Ben Silbermann is the company's CEO, and Evan Sharp is the company's chief creative officer. These guys are still very much on the board. They do hold a significant amount of class B stock, which gives them super voting power, as we've seen with many other companies. We don't know exactly what their ownership percentage is going to be until after they go public and those numbers get released. But I think it's fair to say that they're going to have a sizable amount of their net worth tied up in this business. 

From an employee perspective, I checked them out on Glassdoor. They get 4.2 stars out of five. 90% of employees approve of Ben Silbermann. Those are pretty good numbers. I think investors should feel good about the management and corporate culture here. 

Lewis: All right. Why don't we take a step back and look at the company and the stock? That's what people are going to be buying here. I look at this business, Brian, and I'm a little torn. There are a lot of things going in the right direction. I think the nice, steady, consistent top line growth is there. I think that profitability is going to be pretty easy to project out for this business, especially the way margins are moving. I would not be shocked if we hit somewhat consistent profitability in 2019, unless anything crazy happens with stock-based comp after the IPO.

That said, I do have some concerns. What do you see concern-wise? What do you see risk-wise when you look at this business? 

Feroldi: Yeah, there's always a couple of things to think about. I have a checklist, as you know, that I go through with big concerns. I always ask, is this a penny stock? In this case, no. Pinterest is huge. Is there any excess customer concentration? The good news there is, no, there were no customers that were more than 10% of revenue last year. That's good. I then ask, are there any industrywide headwinds that this company has faced? I'm going to say no. I think this company has tailwinds. They're taking advantage of the move to digital advertisement. 

There is one thing I do want to point out. The question that I always ask is, does this business rely on outside forces for success? Is there something that's outside of the company's control that controls their destiny? And there is an argument to be made that that could be an issue here. A lot of the people that log in to Pinterest actually go through the logins through Google and Facebook. They also get a lot of organic search results through Google. If Google or Facebook decided to change their ways, that could put a damper on Pinterest's growth numbers. 

Lewis: Yeah. Not only is Facebook a competitor, they are also, in some ways, holding the keys for some people to have access to Pinterest. Not necessarily a dynamic that you'd love to see long-term. You'd like to see them control all their user logins and be divorced from that a little bit. 

One thing, I mentioned this earlier, that I think people do need to keep in mind is, the cost structure is also something to worry about a little bit. Because they don't own and operate all of their data centers, and they rely on AWS, they are going to be at the whims of someone who has a lot of clout in the cloud market. They won't control that cost in the way that they would if they owned and operated it. 

Feroldi: Yeah, that's absolutely something for investors to watch. For me, the encouraging thing to see is that even with that, this company is still expanding its gross margin rapidly. It does show that they are leveraging somewhat their costs. But I would prefer to see them own their own data centers. Hopefully that is a move that this company makes with the huge bolus of cash that it's going to get.

Another thing that's worth pointing out is, the valuation of this company has actually stalled a little bit. Back in 2015, the company raised money at an $11 billion valuation. Then, in 2017, they raised it at about $12 billion. The early reports that we've seen thus far indicate that this company is going to come public slightly over $12 billion. That's not a lot of market cap expansion for a four-year period, even though this business has been growing nicely.

Lewis: Yeah. I'm not really sure what to make of that, Brian. I have to be honest. You look at the revenue growth that they've enjoyed over the last couple of years, and I don't know if the 2015 valuation was too rich and it's stalled because the business results just had to catch up with the valuation, or if there's something that we're missing here looking at this analysis.

Feroldi: Right. So, that is something for investors to watch. I prefer to buy stocks that continually go up. A lot of other venture capitalists do, too. They want to see that number continue to grow steadily. The fact that it has capped out is something to watch. Investors need to be wary of any new IPO when it comes out. We don't know how the management team is going to handle being a public company. It changes the culture, it changes the way they operate, it changes the way that they can do things. Suddenly, they have a number every 90 days that they have to hit. I always like to observe IPOs from the sidelines for a quarter or two before I just dive in because that is a significant challenge that not every company masters. 

Lewis: I'm 100% with you on that one, Brian, for all the reasons that you mentioned, and also because there are some metrics, especially related to an ad business, that I want to see with Pinterest that I haven't gotten a chance to see yet. The cost per engagement, the CPE, or the cost per thousand impressions, and the ad load for this, are going to be some of the main drivers of growth in the U.S. market, and we don't have a really firm sense of what those numbers look like for Pinterest. Yet most major ad based businesses -- your Twitters, your Facebooks of the world -- will give you year over year growth rates or sequential growth rates to show you where those metrics are trending. We haven't gotten a sense of what that looks like yet. So, for me, I want to get a sense of, what does ad inventory look like? Is it pretty saturated on the platform? Or is there room for them to expand that out? What's going on with pricing? Can we expect growth there, too? 

Feroldi: Yeah, I think that's completely reasonable to think about. However, one thing I do want to say is that I will probably be a buyer of this IPO on day one for one reason. That is, I am keenly interested in getting my wife interested in the stock market. [laughs] I haven't been able to do it at all yet. But I do think that she likes this business enough that if I told her that we owned a teeny, tiny little bit in our portfolio, and I showed her some metrics, it might prompt her to get interested. I'm not going to go hog wild, but I probably will buy a few shares on the day of the IPO. 

Lewis: Sometimes you just need to find the thing that keeps you interested and gets you a little invested. I know for me, when I am just starting to really get excited about a business, sometimes I will take a small position just so that when I'm checking my brokerage every now and then, I see the shares, and I'm tracking them on a day-to-day basis or a weekly basis, getting a sense of the direction the business is going in. So, I hear you there, Brian, given all the other caveats that we threw out there about IPOs. 

Feroldi: Yeah. So, this is one that I'm probably going to break some of my own rules one. But, again, it's just going to be a tiny percent of my portfolio. Before I would make a substantial commitment to this company, I would definitely want to see at least two quarters of results to see how they operate before I would do anything like that.

Lewis: Well, if that happens, you'll have the whole family in on investing at this point, right? 

Feroldi: Absolutely! I've got my kids, they are shareholders. It'd be great to have my wife join them. [laughs] 

Lewis: [laughs] That'd be awesome! From what I understand, we'll be having you and your kids on the show fairly soon?

Feroldi: Yeah! We're going to be taking a trip down to D.C., come visit headquarters for a little bit. My whole family will be in the studio at some point in two or three weeks. We're really looking forward to that!

Lewis: Listeners who enjoyed having Matthew Cochrane's kids sneak into the end of an episode a couple of weeks back, get ready. We have more children in the studio coming soon. 

Brian, thanks for hopping on today's show!

Feroldi: Hey, thanks for having me! Glad to have you back from vacation!

Lewis: Yeah, happy to be back! Listeners, that does it for this episode of Industry Focus. If you have any questions or you want to reach out and say hey, you can shoot us an email over at [email protected], or you can tweet us @MFIndustryFocus. If you want more of our stuff, subscribe on iTunes or check out videos from the podcast over on YouTube. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass! For Brian Feroldi, I'm Dylan Lewis. Thanks for listening and Fool on!