The following interview was also featured in part on Business Insider
Today LinkedIn announced a merger deal with Microsoft in which the professional network will be acquired for $196/share cash. The transaction is expected to close at the end of this year. SumZero did a quick follow up with Selective Wealth Management PM Chris Devlin who originally pitched LNKD on SumZero several months ago and is now sitting at a 66% return. Mr. Devlin's comments on the merger as well as his original SumZero interview are below.
SumZero: How likely do you think it is that the merger will go through successfully? What roadblocks do you foresee, if any?
Christopher Devlin, Selective Wealth Management: We believe there is a high probability that the merger will go through successfully given the strength of MSFT's balance sheet. The company had a net cash position of $65 billion at the end of last quarter making this a relatively simply acquisition for the company. The regulatory risk is low because the competitive landscape would not change significantly from an anti-trust/regulatory perspective. We believe the most likely roadblock is a rival bid, specifically from Salesforce. MSFT is acquiring LNKD to improve the Dynamics CRM software and Office 365 enterprise offerings. A few weeks ago MSFT was the first bidder for Marketo--another firm we owned at Selective-- which is part of the automated marketing space and would integrate well with Dynamics. The activities of MSFT lately strongly suggest the company is interested in building out a CRM that will be able to take considerable market share from Salesforce. If I owned Salesforce stock I'd be concerned about this announcement and would strongly consider an all-stock offer to purchase LNKD at a higher price. It would help ensure the competitive position of Salesforce even if Salesforce has to overpay.
SumZero: Do you have a view on Microsoft at the moment?
Christopher Devlin, Selective Wealth Management: We are updating our appraisal of Microsoft and considering purchasing shares. MSFT is an excellent company and we believe this acquisition was very intelligent. We are glad to see MSFT decline post-announcement; it may give us a chance to make a purchase.
SumZero: Is this the best outcome for LNKD shareholders in your view?
Christopher Devlin, Selective Wealth Management: It is extremely difficult to find companies that are of similar quality to LNKD in terms of competitive positioning and opportunity for growth. In 10 years LNKD would have been worth many multiples of the acquisition price paid today so we are not sure if the acquisition was the best outcome for shareholders. Performing a DCF on LNKD as a standalone company does suggest that the price paid was fair, but now we are left with the task of replacing such an outstanding company in our portfolio. It will be challenging for us.
SumZero: Is the terminal value of LNKD greater under the umbrella of MSFT or as an independent company?
Christopher Devlin, Selective Wealth Management: LNKD is considerably more valuable as a Microsoft subsidiary than as a standalone business. Once LNKD's professional network is integrated into Microsoft Office 365 and Dynamics it will add tremendous value for subscribers. Our company uses Agile as our CRM and utilizes LNKD as part of our sales process. Until now we were not willing to pay a premium for Salesforce or Dynamics and went with the cheaper solution, but once LNKD's network is integrated into Dynamics we'd be willing to pay a premium for the subscription. We believe some companies will be willing to pay the high switching costs in terms of training and building marketing campaigns in a new CRM. Additionally, if MSFT can intelligently integrate LNKD's network into Office products it will continue to widen the moat the company has in the enterprise software space - which is MSFT's largest profit center.
Mr. Devlin's original interview with SumZero from May 2, 2016 is reproduced below:
In early February investors took one in the stomach when LinkedIn guided 2016 revenue to be about $300mm below analyst expectations. LNKD plummented almost 50% that day, which for Christopher Devlin of Selective Wealth Management in Richmond, VA was a huge opportunity. SumZero sat down with Mr. Devlin to discuss current valuations of the world's largest professional network and where the stock can go in the future.
SumZero: What about LNKD initially caught your attention as a value investor?
Christopher Devlin, Selective Wealth Management: LNKD has been on our investment watch list since the IPO in 2011. What first attracted us to the business was the quality of the company and its dominant market position. LNKD has a strong network effect that social networking sites benefit from. These types of internet properties tend to be a ‘winner-takes-all’ market and we believe that Linked has emerged as the sole victor for social networking in the professional realm. We’ve utilized Linked at our firm as a tool to generate leads and been premium members for quite some time. The service is irreplaceable for generating additional business and we see a tremendous opportunity for the company to leverage the platform in the future. This value proposition for members that we experience firsthand everyday initially drew us to the company, but it was the profitability of the business that made us want to become owners. LNKD is a cash cow and will be much more profitable in 10 years than it is today.
SumZero: What is the market missing about LNKD?
Christopher Devlin, Selective Wealth Management: The biggest misconception about fast growing tech firms, and LNKD in particular, is that many individuals believe these firms “aren’t profitable”. This misconception is rooted in how investors view sales and marketing expense for rapid growth tech companies. Most tech companies, particularly those that sell subscription services like LNKD, have huge sales teams. As the company scales potential profits are deferred to hire additional sales staff to accelerate the top line. The salaries paid to these sales reps is expensed immediately which allows fast growing firms to hire for years without showing GAAP reported earnings. However, these additional sales reps shouldn’t be viewed as an operating expense, but as a growth expense. It’s analogous to adding additional production as a manufacturing company. If you want to grow as a tech firm you need sales reps and GAAP reported profits are near zero. When the company elects to no longer pursue growth they can freeze hiring or even downsize their sales team and generated massive cash flows from the subscription base. If you calculate LNKD’s potential profits after backing out sales and marketing that is exclusively for growth – the firm is wildly profitable. If they elected too they could turn on the profit engine to the tune of more than $1 billion per year and maintain their competitive position in the marketplace.
SumZero: A few months ago LNKD dropped almost 50% in one day after seemingly minor guidance adjustments. Why was the drop so violent?
Christopher Devlin, Selective Wealth Management: The sharp decline in LNKD’s share price highlights the difficulty in valuing extremely rapid growth firms. When performing a discounted cash flow analysis the “fair value” of a company varies dramatically depending on if you use a growth rate of 40% or 20%. This change in growth causes wild swings in valuation. There really is no remedy to this difficulty other than to be cautious and not to overpay for a rapid growth company. When LNKD was growing in excess of 40% per year and analyst were modeling this growth out several years the valuation was way too high. Extrapolating 40% growth rates for any company for sustained periods of time is likely a bad idea – those types of growth rates are nearly impossible to maintain. We always used a much lower growth rate when calculating the fair value of LNKD and believe the 50% drop brought the price of LNKD back to reality. It wasn’t a matter of LNKD becoming cheap as it was LNKD becoming fair.
SumZero: Is this why even though it seems widely thought that LNKD may have dropped farther than it should have, the stock has still not recovered?
Christopher Devlin, Selective Wealth Management: It is not conclusive if LNKD dropped farther than it should. Again, using healthy growth rates of 15% to 20% the stock price is reasonable at the current level. When we purchased LNKD we were not anticipating a rapid repricing, but rather expected above average growth for many years. After the sharp decline you can be a long term holder of LNKD and do very well. If the price multiple never recovers we’ll do very well. We wouldn’t anticipate any type of repricing unless the growth accelerates in the upcoming quarters – which it may or may not. If the company posted growth in excess of 30% I suspect the stock would recover much of the price decline because investors would change their DFC’s to include a 30% growth rate instead of 15% to 20%. This likely would be a bad idea and prove a temporary recovery when growth returns to the 15 to 20% levels.
SumZero: Is LNKD still attractive to buy at today’s prices?
Christopher Devlin, Selective Wealth Management: We like LNKD at prices below $100 per share.
SumZero: What key metrics should investors be paying attention to as your thesis matures?
Christopher Devlin, Selective Wealth Management: Investors will want to pay close attention to the retention rate of recurring revenue, user engagement, and top line growth. LNKD generates substantial revenues from their Talent Solutions division which is subscription based. If corporations continue to renew their subscriptions it means they see real value in LNKD’s professional network. These renewal rates have been high historically – but you’ll want to stay on top of that metric as time passes. It is a very easy way to assess “Does the market like our product?”. High retention rates means clients are happy with LNKD’s services.
In addition to retention rates you’ll want to pay close attention to revenue growth. It is very likely that revenue growth at LNKD will be lumpy. When you have an internet property, like LNKD or FB, the key is to figure out ways to monetize the user base. This monetization does not occur in straight lines. The company constantly tests new ideas to see if users enjoy various features. Most ideas fail and don’t end up meaningful revenue drivers, but on occasion, an idea is a huge hit. When you have 400 million users logging onto your site an idea that generates an additional $10 per user on average is a very big deal, but again, it’s hard to know which ideas will be a big hit and which will fail. This makes revenue growth very sporadic and investors should be ok with wild swings in the growth rate for LNKD. We’d advise investors to be patient with LNKD and keep track of user engagement. If user engagement is high the company will continue to create new ways to monetize those users.
SumZero: What are the biggest risks associated with the trade in your view?
Christopher Devlin, Selective Wealth Management: LNKD has a large net cash position which greatly reduces risk as owners. We typically target debt free businesses and LNKD basically fits that mold. The biggest risks we identified prior to our purchase would be competition from FB. We didn’t view ERP software or other job placement companies as serious competitors, but thought if FB launched a professional version it might be intimidating as an owner of LNKD. In addition to this threat we believed the stock based compensation expense at the company could materially impact our investment. The company currently dilutes between 4% and 6% per year through grants and options for employees – which is almost double or triple Google or Microsoft. We’d like to see this level of stock based compensation decline so we are not diluted out of our profits as owners of the business.
SumZero: Where else do you see value in the market today?
Christopher Devlin, Selective Wealth Management: We don’t see tremendous value right now and are patiently waiting for good opportunities. The oil and gas sector has some interesting plays, particularly in debt free businesses that provide products or services to O&G exploration companies. Many of these debt free distribution companies are suffering as rigs come offline in the US. Exploration companies are pushing back purchases of necessary supplies to save cash in the short term. If the price of oil recovers we’d expect significant purchases to make up for the inventories that have dwindled down for O&G exploration companies. The key though would be to look at debt free names that will easily survive a sustained downturn. Other than that we aren’t seeing a tremendous amount of opportunity out there. We currently have almost 33% cash and are prepared to take action when prices turn south again.