Measuring Moats in Social Media

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?

<TRANSCRIPT>

Summer: LinkedIn has an extremely wide moat. Owning that professional identity is really a core attribute of what they have, and there is a cost to not having that. People actually care about their professional identity for customers, for partners, and then, the most obvious, for that new job that someone wants. There is a cost [to users] to not actually maintaining [their profile], to having that persona be out there in a public sphere. I think that, clearly, enterprises are looking to that as a recruiting source, and that's a great network effect, on the professional side, for that to be able to exist. I think that's very tough to penetrate. I think [other] people [would] have a hard time replicating that service. Certainly Facebook has not been able to do anything of that nature yet to-date.

I think the other aspects of that business are really just low-hanging fruit. As long as you have users there, let's figure out different ways to monetize them. Let's show ads in front of them. Let's see if they can pay for additional functionality, as well, so you get some price discrimination in there--what's called "freemium" services, mostly free, but some premium. I think that becomes really interesting. But if [LinkedIn] were an ad network only, if this were only an advertising platform, we would be remiss to call this a wide-moat business. So I think that's where we start to look at the differences in these three [companies].

Facebook is clearly a social network--tied to friends, tied to family. It's almost, in some ways, difficult to leave. If you belong to, say, a running club, and [Facebook is] where they're coordinating to be able to meet, you can't not go there; it becomes very important. It is replacing e-mail for some people. I think the sheer reach they have is hugely valuable for advertisers, and that's very, very tough [to replicate]. Very unique customer insight, unique customer data. Very, very broad reach. Those are two things we look for in moaty companies in the consumer Internet sector.

I think third, Twitter, certainly fits that unique customer insight [criteria]. Real-time information, immediately actionable--whether people are retweeting or favoriting or forwarding or somehow interacting with new accounts, that is interesting. The bigger challenge for them is reach. When you are at [approximately] 230 million monthly users, how do you end up becoming that mass-market 1 billion-user platform. And I think that still, big, big advertisers look for reach, and reach is extremely important. That is an area where, if [Twitter] were to convince us in some fashion that they're moving to this mass market, it's more likely that that is a wide-moat company. But right now, it's a narrow-moat-rated company.

Stipp: You mentioned some of the professional services that are attributable to LinkedIn, but you've also talked a lot about advertising. For these companies, is advertising really going to be the big business driver?

Summer: Absolutely for Twitter and for Facebook. As we talked about, broad reach is really important. So, for example, if they decided to start charging users, and your user base cuts by a third or cuts by two-thirds, that advertising business goes away and doesn't just go away by cutting by a third or two-thirds. Advertisers literally will lose interest, and you will have some of these small-business advertisers [coming in] as well. So we can get ads for teeth whiteners, and that's all we'll get.

When you think about LinkedIn, clearly that's low-hanging fruit for them. So it's just obvious that they can advertise--hopefully in a non-intrusive way, so it doesn't impair their business. But it's OK for that to be the dominant form of business for Facebook, OK for that to be the dominant form of business for Twitter. I think we've got to look at Exhibit A, which is Google. Clearly, it has created this massive enterprise, primarily on the back of advertising, so it's not a bad thing.

Stipp: You mentioned Google. They tried to get into the social space with the Google Circles. Are they really going to be a big player here, or have they given that up and let the other social network stocks have this?

Summer: It's interesting. Going back to what we talked about earlier, which is broad reach and unique customer insights and unique customer data--Google has a lot. They understand what we're searching for. I think they would make an argument, and we would mostly agree, that Google Plus is about capturing additional data of how [users] are interacting with content on the web, and I think that's a great thing. That little Google Plus, that +1 button, means that they're capturing new datasets, new things about users. Is it as massive and as important as Facebook and Twitter? I don't believe so, but when you can actually do a cross-section of that data with the search data, it still becomes very compelling, becomes very reinforcing.

We have to remember, the business of Facebook is still about driving traffic to Facebook. The business of Google, they already have traffic. So if there is a way to continue to get additional customer insight, that's a great thing for advertisers. It doesn't take away from Facebook per se, but it does fight for that advertising pie a little bit more aggressively.

Stipp: When you think of LinkedIn, Facebook, and Twitter, do you see them competing a lot with each other, or do you see that there is really room for the different kinds of services that they're offering, so that they can all be profitable and healthy going forward?

Summer: So I'll throw [Google] in there as well. So we think about Facebook, LinkedIn, and Google, I think that LinkedIn is the most obvious sort of self-contained entity, where we think they can survive. I think perhaps investors today, when they look at that valuation, maybe they're thinking they're going to encroach on the turf of Facebook and Google. Our valuation says no. We're a little bit more conservative in that view.

When we look at Google and Facebook, I think they are enemy No. 1 with each other. I think that's a long-term view. Right now, we don't think that either is really affecting the other in a negative way competitively. I think they are creating some stasis in the market--some stability of competition. I think that this is going to be an interesting discussion five years from now and 10 years from now, the lens we try and look through, which is, when do they start encroaching on each other's turf? Can Facebook start to change people's behavior with Graph Search and have people do things they weren't doing before and really pull traffic or activity away from Google? That's a broader question.

The fourth company in that mix [is] Twitter. In our bull case, for example, we think that Twitter possibly could get to the same levels of penetration as Facebook. I think the two services co-exist in that environment. But I think that the type of advertising, the use case for advertising, is very similar for Twitter and Facebook. I think they more directly compete for ad dollars. I think that, in my mind, those two companies compete quite heavily with each other over the long run.

Stipp: We talked about valuations of a couple of stocks earlier. Is the valuation in the social media space looking pretty hot right now, given they've been on such a good run?

Summer: If you look on a multiples basis, clearly. These companies are trading 15 to 22 times sales. It's just some ridiculous multiples in many ways. But if you look at our valuation, we think Facebook and LinkedIn are overvalued. Even on a multiples basis, our valuation would look pretty rich as well. I think the valuations have gotten a little ahead of themselves, with the exception of Twitter. Right now we think there is some upside. Now, it's a smaller company. I think that there is a lot more room for upside, a lot more room for growth--so that's part of it--as well as we're pretty bullish on that platform overall. But Facebook and LinkedIn, we think that they're pretty heavily valued and worth lightening up on here at these levels.

Stipp: Rick, great insights on a very fast-evolving space, a very interesting space. Thanks for joining me.

Summer: Sure thing.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

To learn more about Morningstar's institutional equity research services, please call +1 312 696-6869 or email us at BuysideSales@morningstar.com.