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Pinning a Narrow Moat on the Pinterest Board

Profitability is in sight as we foresee Pinterest taking a pinch out of the global digital ad market.

In our view, Pinterest PINS, an online product and idea discovery company that generates revenue by selling digital ads, has an intrinsic value of $15 billion, or $22 per share on a fully diluted basis. The company is progressing toward an initial public offering by mid-April. After its last round of funding in June 2017, the company’s implied valuation was $12.3 billion, according to PitchBook. However, in its latest S-1 filing on April 8, Pinterest indicated an IPO price range of $15-$17; the $16 per share midpoint represents nearly an $11 billion market capitalization, below its last post-funding valuation. Assuming the IPO pricing remains in that range, we view Pinterest as an attractive investment opportunity.

We rate Pinterest as having a narrow economic moat and stable moat trend based on the network effect and intangible asset (data) moat sources, which we think can drive the company to profitability and excess returns on invested capital in the future. With more than 250 million average monthly users who access Pinterest with the intention of not only discovering ideas or products but also purchasing them immediately or in the future, we think the company can attract more online ad dollars. In our view, Pinterest can attract various types of ad campaigns through the marketing funnel--from broad exposure or awareness to targeting and actual conversion. We think opportunities exist for the company to gradually increase its share of the U.S. digital advertising market, after which, as its international users (mainly in Europe) increase, it will attract more ad dollars for that audience.

Pinterest is focused on carving out a piece of the global digital advertising space, which we value at a total addressable market of nearly $500 billion. While we don’t expect Pinterest to displace online advertising behemoths Google GOOG/GOOGL and Facebook FB or up-and-coming Amazon AMZN, we do expect it to attract a small pinch of digital ad spending.

We expect revenue to increase at a 35% compound annual growth rate for Pinterest through 2023, likely to be driven by overall growth in digital advertising (which we estimate at a 12% CAGR) plus the company adding more advertisers and the sale of more ad inventory as it is in its early growth stage. With strong top-line growth and Pinterest’s network effect and data economic moat sources, we expect gross margin and operating margin expansion and foresee the company becoming profitable in 2021, with the operating margin increasing to over 15% by 2023.

Pinning the Business on the Interest Founded in 2010, Pinterest now boasts over 250 million monthly active users who conduct over 2 billion monthly searches. Pinterest's audience is around two-thirds female and roughly 70% international (across all genders). Behind this popularity is the platform's appeal to users' interests. The platform is considered a place where users discover and curate various ideas or products based on specific interests or hobbies. The number of Pinterest users has increased at a 31% average rate since 2016. Such growth has been accompanied by average annual revenue growth of 59% and significantly lower operating losses. The company's 2018 revenue of $756 million was up 60% from 2017, with operating losses of only $75 million compared with the prior year's $138 million.

When thinking about Pinterest, it’s helpful to imagine a cork vision board digitalized. Ideas for which users join the platform come in the form of pins, which are photos, videos, or graphics that show up in a user’s home feed. Pins are created by users via a Pinterest browser button. The Pinterest browser button allows users to convert images or videos on external sites to pins on Pinterest, including links back to the site. Users, also known as pinners, can then see other user-generated pins in their feed based on their Pinterest taste graph--Pinterest’s engine for visual recommendations. If a user is particularly inspired by a pin, he or she can repin, or save, pins to user-created boards, which are collections of pins based on various themes the user assigns, like wedding planning, recipes to make, or travel destinations. Users can follow other users’ public boards, which will direct new pins from followed boards to a user’s following feed.

If pinners are browsing their home feed, it’s likely for the purpose of pure idea discovery. This feed is customized based on in-platform activity as well as cookies, which track overall browser activity to gauge other interests. Despite the customization, users may be on a specific mission when on the Pinterest platform. This mission could take the form of a text- or visual-based search based on specific subjects in need of inspiration, like elderflower cocktail recipes or beach bridesmaid dress styles. In order to use visual search, users can either take a photo of an item through the Pinterest app to discover ideas on how to style that item--like what to pair a jacket with--or to discover similar-looking products and where to buy them (for example, a chair that a user thinks may be overpriced at one store and wonders if there are cheaper alternatives). Visual search can also be conducted without taking photos on the spot. Pinners can use the Lens tool on already posted pins to highlight specific objects in the pin to find similar pins. Such visual searches make up roughly 600 million of Pinterest’s 2 billion-plus monthly searches and have at least doubled since February 2017’s 250 million monthly visual searches.

Unlike many other platforms for shared content, Pinterest’s content doesn’t typically entail photos or videos of the users themselves and their friends, like Instagram often does. Rather, the content is geared toward inspiring users on things to do--how to decorate, date night ideas, or exercise regimens--or things to wear, such as travel attire or casual wedding dresses. Many posts include links to external sites for more on the subject, blog posts and articles, or for purchase of the items pinned. Pinterest has reported an intent to expand its content based on other interests like technology, financial services, and automotive to appeal to a broader user base. Still, male users are representing more and more space on the platform. As of February 2018, Pinterest reported that 38% of U.S. dads are on Pinterest, though this is still far from the 80% of U.S. moms on the platform.

Whatever the audience may be, Pinterest’s algorithm is improved by how users use the platform--or to be more exact, to which boards users decide to pin content. For example, users may pin a photo of a Parisian hotel lobby to a travel board they’ve curated because they want to visit that hotel. But another user may save that pin to an interior decorating board. These two different takes on the pin would signal to the algorithm that the pin could be an applicable fit to appear in the feeds of those interested in travel or interior decorating. Pinterest’s feed algorithm helps the company monetize the platform via promoted posts that are sprinkled among organic content.

How Pinterest Feeds Its Monetization Pinterest monetizes its platform via in-feed advertising, integrated with organic pins but denoted by a Promoted qualifier. While all advertising is bought via an auction model, advertisers can choose three means of advertisement: cost per click, cost per mille (thousand impressions), or cost per action. Advertisers can place additional bids to link their advertisements to keyword searches in order to reach a higher-quality audience.

Advertisers on Pinterest include large, midmarket, and small- and midsize-business advertisers, with the last often using a self-service ad manager. Within business profiles, businesses can post organic pins without paying, using various search engine optimization techniques. eMarketer estimates that roughly 40% of U.S. marketers used Pinterest in 2018. Currently, Pinterest directs most of its advertising sales effort in the United States, although it has now begun to slowly increase its international efforts, starting with Western Europe. Additionally, Pinterest is in the process of making the platform more shoppable, with live pricing and stock information accompanying pins and in-platform purchase available for select pins. We believe this will help the company further monetize the platform.

While Pinterest does not take a commission on sales associated with Pinterest advertising, it does offer tools for advertisers to track sales generated by Pinterest ads via Pinterest Tag. In turn, advertisers have an improved ability to analyze their return on advertisement spending. Pinterest Tag entails adding a specific base code to each page on an advertiser’s website and an additional event code on specific pages to track conversions across devices. The tool includes tracking actions like page visits, newsletter signups, videos watched, adding products to cart, and purchasing these items. Pinterest claims that advertisers should typically see clicks and engagements starting in 30 days, given that many pins are saved and then returned to.

Instagram vs. Pinterest Could Boil Down to Passive vs. Active We believe that Pinterest's most direct competitors include Facebook, Instagram, Google, Amazon, Snap SNAP, Twitter TWTR, and niche inspiring platforms like home decor site Houzz and recipe idea sites Tastemade and Allrecipes. Pinterest's appeal lies in the option to collect ideas and products covering a wide range of interests, each designated via a board. This is more convenient than opening accounts on multiple sites to collect ideas on various interests, like saving recipes on Tastemade and then decor ideas on Houzz. However, some Pinterest users may use the platform to view pins typically under one interest. In that case, more specialized niche sites like Allrecipes could bring more value add.

While Instagram can be used for inspiration under a variety of interests, users don’t necessarily save posts to return to later. Tagging oneself in a post comment is a workaround for this, but Pinterest’s repinning action and board organization make the platform ideal for saving content that users want to easily access again--like a dress one is considering buying or a recipe one plans to make. This suggests that this need to save a pin is tied to the plan to take action based on a pin. Still, this capability doesn’t make Pinterest more popular than Instagram. Pinterest’s very close ties with taking action on ideas could be a reason it may be used less frequently than Instagram, which is more passive.

Pinterest also faces the other behemoth--Google--and the up-and-coming Amazon as competitors. While we do not expect Pinterest to displace Google as the leading digital advertising company, nor do we foresee Pinterest’s presence having any impact on Google’s ad revenue, we do expect the company to differentiate itself in some ways and attract a small pinch of the ad dollars. When it comes to product search, especially nonbrand product search, pinners may use Pinterest a bit more, which gives advertisers the expectation of a higher conversion rate, driving an increase in ad dollars. For the same reason, Amazon is attracting advertisers due to its product search. We also do not expect Pinterest to threaten Amazon’s burgeoning position in online advertising. However, some brand-building advertisers may turn to Pinterest as Amazon continues to invest heavily in its private-label offerings, which could dilute the value of its ad real estate for some advertisers.

While we think Pinterest’s call to action via inspiring images could damp its daily usage, we also think it explains why Pinterest has such positive reviews from its pinners. The 2018 Prophet Brand Relevance Index ranked Pinterest as the third most relevant brand after Apple and Amazon. This study was based largely on boasting a positive experience with users and making users’ lives simpler. We think that in contrast with Instagram, the platform experience could also be attributed to be more positive because it doesn’t include “fear of missing out” or other types of psychological feelings (jealousy and so on) innate in social media posts of acquaintances. But that doesn’t mean Pinterest isn’t susceptible to other user content issues.

Pins Can Prick: Pinterest Not Immune to Content Platform Risks As a platform for content sharing, Pinterest is susceptible to blame for spreading misinformation via pins. Pinterest's post policy, formalized in 2013, advocates against self-harm and health misinformation. Pinterest uses a mix of user feedback as well as URL blocks to reduce the spread of misinformation. However, the company has reported there are still a number of misinformative pins to address, which could be solved by improving its detection technology.

Additionally, by having an international audience, Pinterest is subject to Europe’s General Data Protection Regulation. Instapaper, a tool to save articles from external sites to read for later and formerly owned by Pinterest, was disabled for two months in 2018 in order to avoid noncompliance with GDPR, even though it had several years to adapt to the changes. Still, there has been little public outcry based on how Pinterest uses pinners’ data and whom this may be shared with.

Yes, a Narrow Moat While Competing With Wide-Moat Facebook, Google, and Amazon We view Pinterest as a narrow-moat company. We believe Pinterest has displayed a network effect among its users and has begun to compile valuable intangible assets, or user data, both of which we think it can effectively monetize and generate return on invested capital for at least 10 years. We assign Pinterest a stable moat trend rating. While over time, with higher user monetization, Pinterest is expected to earn excess returns on invested capital, it also will be going up against the online ad space behemoths, including wide-moat Facebook and its Instagram, both of which can increase their investments in Pinterest's social commerce space. For this reason, in our view, while Pinterest's competitive advantage will remain intact, it will not necessarily strengthen or weaken.

Indications of the network effect and intangible asset economic moat sources include Pinterest’s user growth (albeit this is expected to decelerate) and increase in average revenue generated per user through advertising. We think these trends will continue, which will lead to operating leverage, future profitability, and excess return on invested capital over time. We think Pinterest’s strategy is on the right track and there is room in the digital advertising market for Pinterest to grow and become profitable. In our view, while Pinterest’s user count is not as impressive as that of Facebook or Instagram, the understanding that it is not just another online social platform, it is not a similar passive medium, and its users come on the platform with the purpose of finding ideas or products will help the company attract ad dollars.

Pinterest accommodates an average of around 250 million users, or pinners, per month who are in search of pictures or videos of various products or ideas (or discovery, as the company refers to it). Discovery items may include fashion, products to help remodel homes, recipes, and much more. Pinners may also be willing to post pictures and videos about those products and ideas. Pins posted by the pinners can be grouped and saved on what the company calls boards. Every user can view such user curated content--the boards or the individual pins. In addition, based on what users may view as helpful or influencing ideas, they can follow other users or their boards. As more users post pins or save pins on their boards, other users benefit as they come across more products and ideas that help answer their questions, creating a network effect. While historical data is limited, we think that growth in Pinterest’s monthly active users, from 128 million in the first quarter of 2016 to 265 million in the fourth quarter of 2018, displays the network effect. Growth in pinners has decelerated, which is likely to continue; however, the monetization of Pinterest’s users is expected to improve.

Pinterest monetizes its users and generates revenue by selling ad space to advertisers. In our view, the simple interaction and exchange of ideas based on products and ideas among Pinners creates the word-of-mouth marketing, which is considered effective by advertisers. This gives Pinterest and its advertising clients a better idea about user interests or tastes, which creates what Pinterest refers to as the Taste Graph. Analysis of Taste Graph data helps Pinterest and advertisers post more relevant and effective ads, or Promoted Pins, which may generate attractive conversion rates. Whether a pinner immediately takes action or not, in our view advertisers still benefit as they can retarget the same users in the future, further increasing conversion rates. Advertisers could be drawn to the Pinterest platform as the number of users and, more important, content posted by the users increases.

While the company will be competing with digital advertising giants like Google, Facebook, and more recently Amazon, we believe it can attract enough advertisers or ad dollars to become profitable and generate excess return on invested capital.

Pinterest can attract various types of ad campaigns through the marketing funnel--from broad exposure or awareness to targeting and actual conversion. This is mainly due to two things. First, pinners access the app or website with the purpose of finding different types of products or ideas. Second, the likelihood that pinners’ intentions as they save, post, and exchange pictures and videos of various products are to make purchases, quickly or at some point in the future, is high. Such a social commerce platform could help advertisers to not only introduce brands or new products to the nearly quarter of a billion pinners, but to also target various groups with specific products for immediate purchase on the app. Based on growth in user monetization, or average revenue generated per user, it appears that Pinterest’s platform is attracting ad dollars.

We also think Pinterest’s more innovative features have attracted retailers and direct-to-consumer brands to purchase ads on the platform. Some of those features include Product Pins, Shop the Look, and visual search tool Lens. Product Pins are basically native ads that contain pictures or videos of products and services with real-time availability and pricing updates, along with purchasing capabilities. Many retailers post those pins in order to make the purchase much easier for the pinners by avoiding the hassle of going to the retailer’s website.

Shop the Look is more of a social feature as it identifies different products within pins that are for sale and users can purchase. When a user clicks on a product in a pin, Pinterest returns pictures of similar products with information about price and availability.

Lens, which can be combined with text search, is Pinterest’s most innovative and interactive tool, in our opinion, as it helps users focus on any product in a pin and asks Pinterest to conduct a visual search and bring back pictures or videos of similar products. Some of those visual search results could be purchased right away, while others could be images of similar products that Pinterest’s machine learning-based visual search technology (which includes image recognition) identified as relevant for the user to see or explore. Pinterest’s Lens and the technology behind it also allow users to activate the camera on their mobile device, focus on any product around them, and conduct a visual search for similar products automatically on the app. Facebook acquired a company providing similar visual search technology, GrokStyle, in early February. Google, Amazon, and eBay are also making investments in visual search.

Pinterest is also using QR codes along with its own version, referred to as Pincodes, to help consumers not only receive more information about products while in stores but also find similar products possibly provided by other retailers or brands.

Currently, Pinterest’s visual search capabilities and content created by its pinners are attracting more users or pinners. In addition, as more users generate more content, make more recommendations, and create more useful pin boards, more data is generated regarding their various interests and tastes, which we believe helps advertisers utilize one of the most effective advertising methods: word of mouth. All of this could strengthen Pinterest’s network effect, thereby garnering a positive moat trend. However, while we expect Pinterest to generate excess returns on invested capital for at least 10 years, strengthening of the company’s moat sources could be offset by increasing investments in similar spaces by wide-moat competitors such as Facebook, Google, and Amazon.

While Pinterest is one of the leading players in the evolving social commerce market, we believe the larger ecosystems of its competitors may limit growth acceleration of its users. In addition, growth in new users, user engagement, and time spent on Pinterest may be constrained in the long run, given the 24-hour limit on time spent on various mobile device apps per day. For this reason, as apps such as Instagram and Facebook enhance their e-commerce features, users could stay on those platforms even when they have the intention of searching for products and ideas and possibly making a purchase.

We think that some of the features provided by Pinterest increase the likelihood of pinners taking action, such as purchasing a product on Pinterest. These features increase the probability that advertisers will purchase ads from Pinterest. However, Instagram is adding similar features (such as Instagram Checkout) which we think could make it more attractive to advertisers as the ads will have a greater reach, given Instagram’s more than 1 billion or Facebook’s overall more than 2 billion monthly active users. We do think that while Pinterest has fewer users, advertisers will still allocate ad dollars to the platform, as the chance of a higher percentage of Pinterest users making a purchase at some point and/or conducting word-of-mouth marketing will remain high. We expect Pinterest to increase its global digital ad spending market share to 1%-2% in 10 years from what we estimate was only 0.3% last year.

In our view, Facebook’s Instagram also has the advantage of attracting more celebrities or well-known characters to create Instagram accounts. However, Pinterest is not far behind. One of the biggest drivers in social commerce is influence marketing, where various products, trends, or ideas are pushed on by renowned people on social platforms. According to an eMarketer report in late 2018, some data supports this as it was concluded that 23% and 10% of Internet users are being influenced to buy products or services on Facebook and Instagram, respectively, while that was the case for 7% on Pinterest, which we think is comparable to Instagram. However, as it is plausible that there are more influencers or celebrities on Instagram than on Pinterest, more influence marketing and/or ad dollars for social commerce could go to Facebook and Instagram, offsetting the potential strengthening of Pinterest’s moat sources.

While Pinterest does not refer to itself as a social network platform, it does benefit from network effect like Facebook. Pinterest probably has a weaker social graph than Facebook or Instagram, which may create some difficulty for it to attract significantly more ad dollars consistently. Advertising on social platforms is more effective if the recommendations, likes, comments, and other input come from trusted people. According to a survey conducted by Deloitte and published by eMarketer in October 2018, U.S. Internet users trust product recommendations by friends and family members, who probably spend more time on social networks like Facebook and Instagram, the most. However, we think this negative could also be offset by the fact that pinners are on Pinterest for the same purpose: searching for products and ideas. For this reason, recommendations and/or pins by fellow pinners could also be trusted highly, as alternate or bad intentions by users are less likely.

Last, while various Pinterest features attract pinners, we think Instagram can copy those features, like what it has done to Snap over the last three-plus years. For example, while its user-curated content feature, referred to as Collections, is currently private, Instagram can also give its users the option to make Collections accessible by other users, like Pinterest’s pins and user-created boards. With over 1 billion users, Instagram would have access to more data about users’ interests in products, which in turn would help it attract more advertisers and/or ad dollars. Plus, other companies such as Facebook, Google, Amazon, and eBay are making investments in visual search. The adoption of similar new features on Instagram or other apps by users may take time, however, which may help Pinterest maintain its network effect and intangible asset moat sources for at least 10 years.

There Is Room in Digital Advertising for Smaller Players Like Pinterest We estimate nearly a $500 billion total addressable market for Pinterest, which represents the global digital advertising market. In our view, given that pinners access the Pinterest app with the intention of not only discovering ideas or products but also purchasing them immediately or in the future, advertisers are willing to purchase ads from the company. We think opportunities still exist for Pinterest to gradually grab a larger share of the U.S. digital advertising market, after which, as its international users (mainly in Europe) increase, it will attract more ad dollars for that audience.

Based on figures from eMarketer and IDC, we estimate global digital advertising to grow at nearly a 12% CAGR to $500 billion by 2023. Such growth will be mainly driven by continuing transition of ad dollars from traditional advertising (such as TV, radio, print, and out of home) to digital advertising.

Within digital advertising, search advertising represents 40%-50% of total digital ad spending, as demand has remained stable. We estimate that search ad spending will grow at a 13% CAGR through 2023, which we view as positive for Pinterest.

We note that search advertising growth may be higher, given the increasing visual search features. We think users may find image- or video-based searches easier as they do not necessarily have to describe what they are looking for in words. This widens the results that may grab users’ attention, giving advertisers an opportunity to help users discover brands or products. Plus, according to a survey conducted by ViSenze and published by eMarketer in 2018, more young users are comfortable having the visual search option when shopping online.

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