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By Jason Stipp and Rick Summer, CFA, CPA | 11-01-2013 01:00 PM

Measuring Moats in Social Media

Twitter, Facebook, LinkedIn, and Google each have moats, but there are some interesting distinctions among their competitive advantages.

Jason Stipp: I'm Jason Stipp for Morningstar.

Social-media stocks, including LinkedIn and Facebook, have been on a tear recently, especially notable ahead of the Twitter IPO.

What's caused this sector to be on fire? Here to offer his take is Rick Summer, who covers these stocks for Morningstar.

Thanks for joining me, Rick.

Rick Summer: Sure thing.

Stipp: This sector has been on fire recently, strong performance. We have seen rocky performance, as well, in the past. What's led to some of the recent robust results that we've seen there?

Summer: I think all social networking commentary begins and ends with Facebook in some ways. Clearly, they've been extremely successful in mobile--something that was an overhang, at least from the investment community's perspective, 12 months ago. Looking at how they've been able to turn on that spigot, if you will, by looking to Mobile News Feeds and other mobile products like Mobile App Install. They have been hugely important for the company.

Additionally, they launched something called FBX, which is an advertising exchange. So we see actually advertisers that are quite willing to invest in the platform, quite willing to go ahead and put advertising in front of end users, and quite frankly, Facebook is making it very easy to actually create additional ad product and ad inventory that's priced quite richly for them.

LinkedIn is bit of a different story. LinkedIn has three revenue streams: one from Talent Solutions, which is essentially recruiting; one from Member Services or subscriptions, which is a combination of salespeople trying to access other users as well as individuals just paying for more functionality on LinkedIn's site; and third, marketing, so that's advertising. Marketing has grown tremendously, but we think there's been some low-hanging fruit. LinkedIn has been able to essentially copy some of the things that Facebook is doing from an ad-format perspective; they let Facebook do the evangelism, then create the same ad format that seems to perform quite well. You have newsfeed ads as an example there.

On an ad-revenue-per-user basis, this is where some of the companies start to shift. We have Twitter, which is obviously going public here shortly, you have Facebook, and you have LinkedIn, and looking at ad revenue per user, we're actually seeing very strong performance from Twitter and Facebook, and much more calmly increasing performance from companies like LinkedIn. So thinking of that as a social networking stock, there is bit of a difference when we're thinking about that monetization engine.

I would say LinkedIn has a big halo around it: three revenue streams, it continues to outperform quarter-over-quarter. We think that there's not a lot of reality right now in the stock price as a result of that. [We have] very robust results in our model that we think they're going to achieve. We're at [a] $150 [fair value estimate] on that stock, and it's a 2-star stock.

Facebook… we've talked about this before. Ad products come out and really cause this great acceleration of revenue; that gets digested by advertisers, consumed by users. What's next? Always the "what next?" We think that Facebook inevitably will have those periods of "what's next for advertising." Probably not yet: We have ads that are launching on Instagram here this quarter that should perform quite well. But I think that there should be some malaise that ends up setting in, and we'll see what that does to the stock price. Today, it's trading a little bit ahead of where we think it belongs. We are at a $36 fair value; it's in 2-star/1-star territory right now for us. So, it's a great time to really be sellers, in our mind, for those two names.

Stipp: LinkedIn, Facebook, and Twitter all have moats, but they don't have the same size moat. The network effect is one of the sources of moat; these are all social networks. What are some of the differences, though, in the competitive advantages as you look across these companies?

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