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LinkedIn IPO Inflates the Tech Bubble

If you thought that Demand Media (DMD) IPO was overvalued in its IPO, then brace yourself: LinkedIn (LNKD) scored a $4.5 billion valuation, with share price topping out at $45. And then the stock price doubled this morning.

That undoubtedly put a big smile on the faces of those who got in early, like the people who those who purchased $30.79 shares on a secondary market sale in January. However, for those not giddy on the elixir of paper wealth, it's time to take a harder look at what is going on: a new tech bubble fueled by a desire to believe in Easy Street and aided by the new PR hype machine, secondary stock markets. Prices already look overheated, raising the question of whether corporate performance can improve enough to warrant frothy valuations. With the way things are starting, the answer is probably not.

At least the revenues are real
Unlike the bubble a decade ago, LinkedIn, Facebook, and other companies are making significant revenue rather than promising to make money sometime in the future. LinkedIn's amended S-1 form shows the company's steady growth (click to enlarge):

The company roughly doubled revenue annually over the last few years and the pace increased for the first quarter of 2011. Last year, LinkedIn had an honest-to-goodness profit of $15.4 million on sales of $243 million in revenue (clearly better than management's apparently fabricated claims of previous profitability).

But challenges have just begun. In 2011 Q1, revenue was more than double that of the same period in 2010, and yet income before taxes was 39.5 percent less. (Income after taxes introduces a misleading benefit for 2011.) Sales and marketing expenses jumped by 280 percent, handily outpacing the 210 percent revenue increase.

There was a big jump in stock-based compensation for sales and marketing. According to the S-1, LinkedIn authorized $1.1 million in stock-based compensation in the first quarter of 2011, versus $250,000 for the same period in 2010. Even so, factor out those numbers and you have sales and marketing costs of $10.2 million in 2010 and $28.6 million in 2011 -- still a 280 percent increase.

It's so popular, people don't show up any more
That shouldn't be a surprise. As Jim Edwards pointed out on BNET, LinkedIn has a major Achilles' heel: most of its members don't actually spend much time on the site. Out of the 100 million members the site boasts, a "substantial majority" doesn't visit LinkedIn even on a monthly basis.

All of the revenue sources -- tools to let corporations identify job candidates, marketing to site members, and premium member subscriptions -- depend on the number of members and, ultimately, how engaged those people are. Here's the split (click to enlarge):

The heavy growth is in hiring tools, with strong growth in marketing solutions. Premium memberships? Growing, but nowhere near as fast. Here's what LinkedIn says about each category:

  • Hiring Solutions -- "Growth in our hiring solutions will largely depend on our ability to grow our customer pipeline while maintaining strong renewal and upsell rates with current customers, which will depend on increased productivity from our expanded field sales organization." In other words, reduce the number of candidates that companies can effectively reach, and the revenue line is in danger.
  • Marketing Solutions -- "Growth in our marketing solutions will largely depend on our ability to provide marketers with targeted access to professionals, which will depend on our ability to increase our number of registered members, level of member engagement and advertising inventory." If people don't go to the site, then marketers won't be interested.
  • Premium Subscriptions -- "Growth in our premium subscriptions will largely depend on our ability to increase our number of registered members and level of member engagement as well as our ability to continue to offer features and content that our members, enterprises and professional organizations find compelling as sources of professional knowledge, insights and opportunities, while minimizing the number of cancellations and downgrades." If people don't find the free version worth using on a regular basis, why would they pay?
The number of registered members increased by 64 percent from 2009 to 2010, and by 58 percent from the first quarter of 2010 to Q1 of 2011. Membership growth is slowing, even as spending increases. And LinkedIn explicitly says that it expects the revenue growth rate to decline.

Double secret valuation
And yet, LinkedIn had a valuation of $4.5 billion, or about 18.5 times last year's revenue and 292 times earnings. Pro forma net income per share (assuming conversion of all shares into class B common stock) last year was $0.17. With a share price of $45, that's a P/E ratio of 265. Here are P/E ratios for some other Internet properties (numbers via Google Finance):

  • Yahoo (YHOO) -- P/E = 19.19
  • Google (GOOG) -- P/E = 20.81
  • eBay (EBAY) -- P/E = 23.31
Even if you compared the opening share price to projected 2011 earnings, you're still left with a multiple of 46. And then the stock price (and the ratios) almost doubled.

Why would LinkedIn get that big a bump? The expectation of growth. Investors bet that LinkedIn will Grow Like Crazy. Early participants can then happily invoke the greater fool theory and cash out. But LinkedIn says that growth will slow.

What we're seeing is the inflated irrational expectations of bubble investors. And helping to fuel that is the new stock PR industry of secondary markets. These companies regularly sell large blocks of stock in still-private companies, which provides a useful liquidity tool for vested employees and early investors. However, the results drive expectations of what a company is bound to do at the IPO. It's throwing chum into the financial waters.

This will last a few years until either people get disappointed and run from tech stocks in an over-reaction, Congress and/or the SEC decides to get involved, or the economy tanks when the next financial services bomb hits.


Image: morgueFile user hotblack, site standard license.
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