Pinterest (NYSE:PINS), which is a business that describes itself as a "visual discovery engine," recently became a publicly traded company. Demand for the shares was red-hot out of the gate, but that enthusiasm has waned in recent weeks after the company reported a much larger-than-expected loss in its first-quarter earnings report.

Are shares a buy now that the valuation is more reasonable? Let's see how Pinterest stacks up against my investing criteria to see if this business is worth betting on.

A woman browsing Pinterest on a tablet

Image source: Pinterest.

1. Financials

  • Revenue growth: Pinterest reported $202 million in revenue last quarter. That number beat the consensus estimate on Wall Street and represented 54% growth over the year-ago period.
  • Balance sheet: The company's cash balance was about $642 million as of March 31. This figure doesn't include the $1.4 billion that was raised during the IPO, either. Pinterest does have $1.47 billion worth of redeemable convertible preferred stock outstanding, which could lead to significant dilution down the road. Other than that, the company's liabilities appear to be minimal.
  • Profits: Pinterest lost $41 million in the first quarter of 2019. However, the company produced more than $29 million in free cash flow during the same time frame. It was also profitable during the fourth quarter of 2019.
  • Margins: Pinterest's gross margin expanded by 380 basis points to 63.5% in the most recent quarter. Adjusted EBITDA margin and net margin are both trending in the right direction, too. 

Overall, Pinterest is growing fast, expanding its margins, and has lots of cash on its balance sheet. The small net loss doesn't concern me much since the business is producing free cash flow. There's a lot to like about this company's financials. 

2. Moat

I love to invest in companies that boast a strong competitive advantage. To my eye, Pinterest has two main factors working in its favor:

  • Brand: Last year, a global brand and marketing consultancy called Prophet ranked Pinterest as "the third most relevant brand in the United States." It also ranked first in the "inspiration" category. What's more, a recent survey by Talk Shoppe showed that 91% of users stated that "Pinterest is filled with positivity." This makes me believe that the brand name is valuable and could help it to woo away some adverting dollars from social media platforms such as Twitter, Facebook (NASDAQ:FB), and Snap
  • Network effect: Pinterest's users visit its site primarily to find inspiration and get ideas from other users (which are called "pinners"). There's an argument to be made that this generates a modest network effect since new users naturally want to gravitate to the platform where they can find the most ideas. That leads to more sharing of ideas, which in turn attracts more pinners.

I think that these two factors should help Pinterest to stand apart from the crowd, even in a competitive marketplace.

3. Potential

Pinterest makes money through digital advertising, which is an enormous market that is growing quickly. Total spending on digital advertising topped $272 billion in 2018. This number expected to exceed $423 billion by 2022. For context, Pinterest is currently projecting that its revenue in 2019 will be just over $1 billion.  

Another metric that helps to showcase the potential of this business is the average revenue per user (ARPU). In the most recent quarter, Pinterest generated $0.73 in ARPU. For context, Facebook generated $6.42 in ARPU during the same time period.

No matter how you look at it, there appears to be an incredible growth runway ahead of this business.

Check out Pinterest's latest earnings transcript

4. Customers

  • Acquisition: Pinterest spent $260 million on sales and marketing costs in 2018, which amounted to 34% of total revenue. While this number will likely decline as a percentage of revenue over time, there's no doubt that Pinterest has to spend lavishly to attract new advertisers to the platform.  
  • Dependence: Pinterest was founded in 2010, so we don't have data that shows how well this company's top line would hold up in a recession. However, since advertising in an ongoing expense for most businesses, my hunch is that its customers will continue to spend money with Pinterest even during periods of economic stress.
  • Is revenue recurring? Yes. Advertising in a recurring expense for most businesses.
  • Pricing power: Pinterest's gross margin has consistently expanded over time. That's a clear indication that this business has some pricing power.

5. Management and company culture

Two of Pinterest's co-founders are still running the show today. Benjamin Silbermann is CEO and Evan Sharp is the company's chief creative officer.

Silbermann currently owns 11.4% of shares outstanding, which makes his position worth more than $1 billion at current prices. Sharp owns 2.1% of the company, which is worth $260 million.

I love to invest in companies where the founders are still calling the shots. I also like it when they have a significant portion of their net worth tied up in the business. That's clearly the case with Pinterest.

Employees also seem to like working for Pinterest and generally believe that Silbermann is doing a good job. The company gets 4.2 stars out of 5 on Glassdoor.com, and 87% of employees approve of the CEO.

Overall, I like Pinterest's management team and corporate culture.

6. The stock

I love to invest in stocks that have already gone on to beat the market, so I was pleased to see that Pinterest's shares were riding high after its IPO. However, the stock has cooled off in recent weeks.

Since the company has only been public for a month, I don't think investors have enough information to determine whether or not this stock is a winner just yet.

Red flags?

  • Is it a penny stock? No. Shares currently trade for about $25 each, and the market cap is over $13 billion.
  • Is there excess customer concentration? No customer accounted for more than 10% of revenue in 2018.
  • Does the industry face long-term headwinds? No. The market for digital advertising is growing.
  • Does the business rely on any outside forces for success? No. 
  • Is stock-based compensation excessive? The company only reported $1 million in share-based compensation expense in the first quarter of 2019. However, the company stated that if its IPO had occurred during the first quarter, then it would have recorded a cumulative share-based compensation expense of $975 million. What's more, another $925 million in share-based compensation is expected to be recognized over the next 3.7 years. These numbers are quite high given that its current market cap is $13.5 billion.

Another factor that is worth highlighting is that user growth in the U.S. is only in the single digits, which suggests that Pinterest is nearing a saturation point in its most mature market. Thankfully, the numbers still look good in international markets, but this remains an area to watch.

Pinterest is a buy

Pinterest didn't ace my test, but I still think that there is a lot to like about this business over the long term. The recent sell-off has also pulled the valuation down to "only" 16 times trailing sales. That's still a premium price, but it might not be unreasonable given the sky-high growth potential.

I recently decided to initiate a small starter position in Pinterest because I believe that the company is well-positioned to drive years of above-average growth. I look forward to following this business for many years to come.