LinkedIn Corp (LNKD) Stock In The Danger Zone

Declining Margins

While LNKD’s revenue growth was slower in 2013, 57% is still nothing to sneeze at. Unfortunately, that growth in revenue has not translated into profit growth. In 2013, LNKD only grew after-tax profit (NOPAT) by 6%, from $41 million to $44 million. Its margins contracted from 4% to 3%, and its return on invested capital (ROIC) was cut in half, from 8% to 4%.

The typical justification when revenue growth fails to translate into profits is that the company is spending extra on sales and marketing to fuel further growth. However, LNKD’s sales and marketing expense only increased by 60% in 2013, just slightly faster than revenue.

The true culprits for LNKD were its administrative expenses, which increased by 76%, and depreciation and amortization, which increased by 68%. Gross margin also declined by half a percentage point. These are expenses that cannot easily be cut, and the fact that they’re growing faster than revenues is a major problem for LNKD.

Hidden Liabilities

LNKD doesn’t have any debt on its balance sheet, but that doesn’t mean there are no liabilities for investors to worry about. The company finances its office space and data centers through the use of off-balance sheet debt in the form of operating leases. LNKD has a total of $965 million in future operating lease obligations, which we discount to a present value of $750 million (28% of net assets).

LNKD also has roughly $400 million in employee stock option liabilities. The company has actually managed to reduce its outstanding options from 8 million at the end of 2012 to 5 million (5% of shares outstanding), but that still leaves a significant liability remaining.

Due to its secondary stock offering last year, LNKD has plenty of cash right now, but since it’s had a free cash flow of around -$400 million the past two years, that cash might not last very long.

Highly Overvalued

In order to justify its current valuation of ~$175/share, LNKD would need to grow NOPAT by 30% compounded annually for 23 years. Remember, this company only grew NOPAT by 6% last year. I simply don’t see a way for LNKD to achieve the growth implied by its valuation.

If we give LNKD credit for 15% compounded annual NOPAT growth for 15 years, the stock is worth around $25/share. Given the rising costs and competitive pressures LNKD faces, 15% for 15 years, is probably still being quite generous. It is hard to argue that LNKD will come close to justifying its $165/share valuation.

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