It's wise to be very suspicious of richly-valued IPOs. History has shown us time and again that many will end up stumbling badly once they must prove themselves on a quarterly basis. Yet in the early days of trading, these stocks are often accorded valuations that lead you to think they may be the next Google (Nasdaq: GOOG)
or Amazon.com (Nasdaq: AMZN)
That's why I suggested you steer clear of Zynga (Nasdaq: ZNGA) and Groupon (Nasdaq: GRPN) when I analyzed them six months ago.
"These companies should grow at a fast pace in 2012, but their stocks are quite vulnerable to the eventual, inevitable cool-down in growth that all businesses see as they reach maturity," I said back then. Sure enough, each stock now trades for roughly 80% less than their peak from just a few quarters ago. To be sure, I eventually suggested shares of Zynga had likely found a floor around $5 but they've since fallen to just $3.
I took a more benign view toward the third stock in the group, LinkedIn (Nasdaq: LNKD). Whereas I thought Groupon and Zynga were mere flashes in the pan, I noted that "At least LinkedIn has the feel of a real business tool and not just a social fad," adding that because of the automated nature of its business model, LinkedIn was positioned to generate solid profit margins as sales rise.
Still, I had never become fully convinced that LinkedIn has all that much upside. Yes the company is growing quickly, but the valuations remain quite stretched.
Now, I'm singing a different tune.
I think LinkedIn's stock is in fact overvalued and ready to tumble. Though the company has delivered several solid quarters since going public, early signs of maturity have kicked in, so it's only a matter of time before investors realize that expectations of stunningly robust perpetual growth will be hard to attain. The stock's value in relation to earnings is another major hurdle to overcome. One or both of these hurdles will likely cause this stock to stumble.
To get a sense of LinkedIn's growth trajectory, you can track quarter-to-growth rates. In coming quarters, this metric is looking a lot more sobering.
As you can see, LinkedIn has averaged roughly 17% sequential sales growth in the past three quarters, yet that figure is expected to slow to just 6% in the current quarter, and average 9% in the final two quarters. You can see by the year-over-year revenue growth rates that a clear deceleration has been underway since the third quarter of 2011.
To be fair, LinkedIn managed to exceed second-quarter revenue forecasts by roughly $11 million, so let's be generous and assume the company beats top-line forecasts by the same amount in the third and fourth quarters. You can still spot a trend of decelerating growth.
Right now, analysts anticipate that LinkedIn will likely boost sales about 50% in 2013, in large part because that's what the company is publicly predicting. In other words, most analysts have no clue. As we've seen with so many young high-growth companies, there really is no way of knowing how far a long a company is in terms of market saturation -- until it happens. And this is a lesson Groupon brought home this week with its earnings bombshell).
Even if LinkedIn boosts sales 50% in 2013, which equates to a $460 million sequential revenue increase, it will become significantly harder for LinkedIn to boost sales in 2014 at an even 40% clip. This equates to a $556 million increase in sales from 2013 levels. A target of 25% sales growth (or about $350 million) seems more feasible for a company that will already have had five years of awareness-building among potential clients under its belt.
So using an assumption of 25% sales growth in 2014 and beyond, and giving credit for marginleverage which should yield 35% earnings growth per share, let's revisit what LinkedIn's income statement might look like by mid-decade.
When I looked at LinkedIn back in February, I saw a path to $2 in earnings per share (EPS) by 2016. A few strong quarters and some generous assumptions later, and I'm now looking at $3 in EPS by then. Still, you need to know that this stock, which is currently being snapped up because of its high-growth characteristics, will eventually judged by its earnings power.
And it's simply impossible to square a $100 stock with $3 in EPS that is still four years away. Investors must always apply a discount rate on future earnings to compensate for the risk that earnings targets won't be achieved. So the true present value of those 2016 projected profits is actually well lower. What's a good multiple on 2016 profits? How about 20 or 25? That places fair value for this stock in the $65 to $80 range, which is well below the recent $103.
Risks to Consider: As an upside risk, a quick improvement in the job market could lead many more people to upgrade their visibility toward other employers, and LinkedIn would likely play a key role in that effort.
Action to Take --> When I looked at LinkedIn early this year, I suggested it would be harder for this stock to gain a richer multiple, limiting upside. Now, in an economy that has markedly slowed since then, investors have become much less forgiving of high earnings-multiple stocks that have stumbled. That's why Chipotle Mexican Grill (NYSE: CMG) has seen its stock fall by $150 since mid-April. Or why shares of Netflix (Nasdaq: NFLX) are nearly $200 off of their 52-week high. So it's the potential downside, and not just capped upside investors need to be thinking about.
There's no reason to anticipate a major blow-up for LinkedIn, as we've seen with Zynga or Groupon -- it's a company providing a worthwhile service to millions of users. Yet this good company is now tied to an extremely richly-valued stock, and it's unclear how much longer it can defy the laws of gravity.
-- David Sterman
David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of GOOG in one or more if its "real money" portfolios.
This article originally appeared on StreetAuthority
Author: David Sterman