Tuesday, February 23, 2016

Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!

As I watch GoPro and LinkedIn, two high flying stocks of not that long ago, come back to earth my mind is drawn to two much told stories. The first is the Greek myth about Icarus, a man who had wings of feathers and wax, but then soared so high that the sun melted his wings and he fell to earth. The other is that of Lazarus, who in the biblical story, is raised from the dead, four days after his burial. As investors, the decision that we face with GoPro and LinkedIn is whether like Icarus, they soared too high and have been scorched (perhaps permanently) or like Lazarus, they will come back to life.

GoPro: Camera, Smart Phone Accessory or Social Media Company?
GoPro went public in June 2014 at $24/share and quickly climbed in the months following to hit $93.85 in October of that year. When I first valued the company in this post, the stock was still trading at more than $70/share. Led by Nick Woodman, a CEO who had a knack for keeping himself in the public eye (not necessarily a bad thing for publicity seeking start up), and selling an action camera that was taking the world by storm, the company’s spanning of the camera, smartphone accessory and social media businesses seemed to position it to conquer the world. Even at its peak, though, it was clear the competitive storm clouds were gathering as other players in the market, noting GoPro’s success, readied their own products.

In the last year, GoPro lost much of its luster as its product offerings have aged and sales growth has lagged expectations. It is a testimonial to these lowered expectations that investors were expecting revenues to drop, relative to the same quarter in the prior year, in the most recent quarterly earnings report from the company.

The company reported that it not only grew slower and shipped fewer units than expected in the most recent quarter, but also suggested that future revenues would be lower than expected. While the company’s defense was that consumers were waiting for the new GoPro 5, expected in 2016, investors were not assuaged. The stock dropped almost 20% on the news, hitting an all-time low of $9.78, right after the announcement.

To evaluate how the disappointments of the last year have impacted value, I went back to October 2014, when I valued the stock at $30.57. Viewing it as part camera, part smart phone and part social media company (whose primary market is composed of hyper active, over sharers), I estimated that it would be able to grow its revenues 36% a year, to reach about $10 billion in steady state, while earning a pre-tax operating margin of 12.5%. Revisiting that story, with the results in the earnings reports since, it looks like competition has arrived sooner and stronger than anticipated, and that the company’s revenue growth and operating margins will both be more muted.

In my updated valuation, I reduced my targeted revenues to $4.7 billion in steady state, my target operating margin to 9.84% (the average for electronics companies) and increased the likelihood that the company will fail to 20%. The value per share that I get with my updated estimates is $17.66, 35% higher than the price per share of $12.81, at the start of trading on February 22, 2016.  Looking at the simulation of values, here is what I get:
Spreadsheet with valuation
At its price of $12.81, there is a 68% chance that the stock is under valued, at least based on my assumptions.

I am fully aware of the risks embedded in this valuation. The first is that as an electronics hardware company that derives the bulk of its sales from one item, GoPro is exposed to a new product that is viewed as better by consumers, and especially so if that new product comes from a company with deep pockets and a big marketing budget; a Sony, Apple or Google would all fit the bill. The second is that the management of GoPro has been pushing a narrative that is unfocused and inconsistent, a potentially fatal error for a young company. I think that the company not only has to decide whether its future lies in action cameras or in social media and act accordingly, but it also has to stop sending mixed messages on growth; the stock buyback last year was clearly not what you would expect from a company with growth options.

Linkedin: The Online Networking Alternative?
LinkedIn went public in May 2011, about a year ahead of Facebook and can thus be viewed as one of the more seasoned social media companies in the market. Like GoPro, its stock price soared after the initial public offering:

LinkedIn Stock Price: IPO to Current
While it often lumped up with other social media companies, Linkedin is different at two levels. The first is that it is less dependent on advertising revenues than other social media companies, deriving almost 80% of its revenues from premium subscriptions that it sells its customers and from matching people up to jobs. The second is that its pathway to profitability has been both less steep and speedier than the other social media companies, with the company reporting profits (GAAP) in both 2013 and 2014, though they did lose money in 2015.

Unlike GoPro, where expectations and stock prices had been on their way down in the year before the most recent earnings report, the most recent earnings report was a surprise, though, at least at first sight, it did not include information that would have led to this abrupt a reassessment:
Linkedin delivered earnings and revenue numbers that were higher then expectations and much of the negative reaction seems to have been to the guidance in the report.

While I have not valued Linkedin explicitly on this blog for the last few years, it has been a company that has impressed me for a simple reason. Unlike many other social media companies that seemed to be focused on just collecting users, Linkedin has always seemed more aware of the need to work on two channels, delivering more users to keep markets happy and working, at the same time, on monetizing these users in the other, for the eventuality that markets will start wanting more at some point in time. Its presence in the manpower market also means that it does not have to become one more player in the crowded online advertising market, where the two biggest players (Facebook and Google) are threatening to run up their scores. Nothing in the latest earnings report would lead me to reassess this story, with the only caveat being that the drop in earnings in the most recent year suggests that profit margins in the manpower business are likely to be smaller and more volatile than in the advertising business.

Allowing for Linkedin’s presence in two markets, I revalued the company with revenue growth of 25% a year for the next five years, leading to $15.3 billion in revenues in steady state (ten years from now), and a target pre-tax operating margin of 18%, lower than my target margins for Twitter or Facebook, reflecting the lower margins in the manpower business. The value per share that I get for the company is $103.49, about 10% below where the market is pricing the stock right now. The results of the simulation are presented below:

Spreadsheet with valuation
At its current stock price, there is about a 40% chance that the company is under valued.  If you have wanted to hold LinkedIn stock, and have been put off by the pricing, the price is tantalizingly close to making it happen. As with other social media companies, LinkedIn’s user base of 410 million and their activity on the platform are the drivers of its revenues and value.

The Acquisition Option
If you are already invested in GoPro or LinkedIn, one reason that you may have is that there will be someone out there, with deep pockets, who will acquire the firm, if the price stays where it is or drops further, thus putting a floor on the value. That is not an unreasonable assumption but to me, this has always been fool's gold, where the hope of an acquisition sustains value and the price goes up and down with each rumor. I have seen it play out on my Twitter investment and I do think it gets in the way of thinking seriously about whether your investment is backed by value.

That said, I do think that having an asset or assets that could be more valuable to another company or entity does increase the value of a company. It is akin to a floor, but it is a shifting floor, and here is why. Consider LinkedIn, a company with 410 million users. Even with the drop in market prices of social media companies in the last few months, the market is paying roughly $80/user (down from about $100/user a couple of years ago). You could argue that an acquirer would be a bargain, if they could acquire LinkedIn at $8 billion, roughly $20 a user. However, the price that an acquirer will be willing to pay for LinkedIn users will increase if revenues are growing at a healthy rate and the company is monetizing its users. 

To evaluate the impact that introducing the possibility of an acquisition does to LinkedIn's value, I started by assuming that the acquisition price for LinkedIn would be $8 billion, but that the value would range from $4 billion (if revenue growth is flat and margins are low) to $12 billion (if revenue growth is robust). I then reran the simulation of LinkedIn's valuation, with the assumption that the company would be bought out, if the market capitalization dropped below the acquisition price. In the picture below, I compare the values across the two simulations, one without an acquisition floor and one with:

You may be surprised by how small the effect of introducing an acquisition floor has on value but it reflects two realities. One is my assumption that the expected acquisition price is $8 billion; raising that number towards the current market capitalization of $15.4 billion will increase the effect. The other is my assumption that the acquisition price will slide lower, if LinkedIn's revenue growth and operating profitability lag. 

Fighting my Preconceptions
I must start with a confession. After watching the price drop on these two stocks, and prior to my valuations, I really, really wanted LinkedIn to be my investment choice. I like the company for many reasons:
  1. As noted earlier, unlike many other social media companies, it is not just an online advertising company.
  2. The other business (networking and manpower) that the company operates in is appealing both because of its size, and the nature of the competition.
  3. The top management of LinkedIn has struck me as more competent and less publicity-conscious that those at some other high profile social media companies. I think it is good news that I had to think a few minutes about who LinkedIn's CEO was (Jeff Weiner) and check my answer.
I have a sneaking suspicion that my biases did affect my inputs for both companies, making me more pessimistic in my GoPro inputs and more optimistic on my LinkedIn values. That said, the values that I obtained were not in keeping with my preconceptions. In spite of my inputs, GoPro is significantly under valued and in spite of my implicit attempts to pump it up, LinkedIn does not make my value cut. Put differently, the market reaction to the most recent earnings report at LinkedIn was clearly an over reaction, but it just moved the stock from extremely over valued, on my scale, to close to fair value. 

YouTube Video

  1. GoPro - Bloomberg Summary (including 2015 numbers)
  2. LinkedIn - Bloomberg Summary (including 2015 numbers)
  1. GoPro - Valuation in February 2016
  2. Twitter - Valuation in February 2016
Blog posts in this series
  1. A Violent Earnings Season: The Pricing and Value Games
  2. Race to the top: The Duel between Alphabet and Apple!
  3. The Disruptive Duo: Amazon and Netflix 
  4. Management Matters: Facebook and Twitter
  5. Lazarus Rising or Icarus Falling? The GoPro and LinkedIn Question!
  6. Investor or Trader? Finding your place in the Value/Price Game! (Later this year)
  7. The Perfect Investor Base? Corporation and the Value/Price Game (Later this year)
  8. Taming the Market? Rules, Regulations and Restrictions (Later this year)


Anonymous said...

Thank You Mr. Damodaran for the multiple valuations of companies over past couple of weeks. Just curious on whether you added any of the mentioned companies (apple, Gopro,Linkedln Facebook) into your portfolio?


Anonymous said...

Hi Aswath. You can valuate and analyse a company, but you don't need invest in it. You have the option of wait. For both companies (GoPro and Linkedln) the best choice is wait until they prove be more riskless.

In tech's sector, efficiency is fatal. One mistep and you can be past.

Can you valuate bank sector, please? they are volatile recently. European banks are sufering more. But american's banks are paying the bill too. Any spotlight here is welcome.

Anonymous said...

I am loving the videos at the end of the articles. As I can see, you improve yourself time by time.

Valuation tools, valuation of the week, short online class are some examples. Congratulations. You are very good.

Claudio said...

Dear Professor,

Thank you very much for every Musings ob Markets' email. I enjoy them a lot. If you allow me to make you a suggestion I would recommend you a very simple change to them, which is to add the subject in the email so as to better identify it in our Prof Damodaran's folder. As an example, the current email would say: Musings on Markets-Lazarus Rising or Icarus Folding The GoPro and Linkedin Question! or maybe Musings on Market-The GoPro and Linkedin Question!

Best regards,

Ashutosh said...

It's great to follow you, on blog and on Twitter also. Thanks for reaching so many things to us

steve said...

LNKD is interesting, but i do find your Rev assumption to be on the aggressive side in light of operating results the last few quarters. LNKD may have a lot of registered users, but the number who actually regularly visit the site is substantially lower. Add to it that the majority of page views come from a minority of members and at least to me, Rev growth of 25% may be quite challenging. 3rd party research that has been done for the company estimates there are 640 million professionals worldwide and with 400 million users, LNDK may have a hard time adding to these ranks. Of course, they could try to target the non professional workers, but that is speculative.
LNKD therefore in my view remains quite overvalued and substantial revenue growth is questionable. I would need to see some results supportive of your assumptions before i would invest in it.
Just like TWTR, LNKD having a lot of registered members does not mean that they can be monetized in any meaningful way. LNKD has made great strides in doing so since its IPO, but has very large challenges in achieving substantial growth going forward. Key will be getting users to become more engaged with the platform.

Anonymous said...

Hi prof.I am sorry but I found this post boring and repeatitive . I understand you write on valuation however it astounds me that you do not deleve a little deeper into the whys rather than repeating yourself. I would rather enjoy the why of for example why is there a sudden decline in social media usage it is because people are now bored of the oh-so-fantastic new toy, are there more mediums of entertainment has social media reached its tipping point as far as the user base is concerned its social media pointless and ineffectual. Considering the type of scandals that seem to have briken out the seeming authenticity of the medium iself the utter lies and propaganda the utter chaos that seems to have decended on earth from the very advent of it leaves little for one to wonder why on earth social media still exists.Why it is important for valuation. I think it gives me a prospective short medium and long term about the very future of social media. I heard about something called brain to brain communication god forbid if that becomes useable on a consumer levelI do not know the links on brain to brain communication were genuine or not considering I found it on net where I also found myself lying on a slice of pizza I have serious doubts the social media future. Anyways I look forward your next post.

Aswath Damodaran said...

It is tough not to repeat the same points when you are talking about companies that are in the same business, online advertising. As for social media usage, scandals notwithstanding, do you really think that people are partaking less of it than ever before? In fact, I think that the growth of social media has been inexorable, with tweets becoming the way we get breaking news, Facebook becoming our mechanism for sharing with friends and relatives and Google becoming our gateway to finding stuff. I think that the point you raise is a legitimate one, which is whether you can use this growth in social media as a platform for growing revenues (from advertising, manpower or whatever else). That remains debatable, with Facebook being the shining exception. That is a point I made in my post on big market delusions and will be return to. This series, though, was never meant to confront macro issues, but micro ones. And just a note of caution. If you spend the bulk of your valuation time thinking about macro questions, you will miss the micro ones right in front of you.

Michal said...

Professor, I have a question about the valuation method.
FCFF is defined as EBIT*(1-t) + depreciation/amortization - investments
You take EBIT as a basis for your calculation, but I never saw you add the depreciation/amortization when calculating Free Cash Flow to Firm.
Why is that?

Aswath Damodaran said...

I net out reinvestment from EBIT (1-t) and reinvestment = cap ex - depreciation + change in non-cash WC. It is just a short cut.

Anonymous said...

Can you please give more insight into your targeted pre-tax margin of 18% for LNKD? This is far higher than they have ever achieved, and with revenue/employee only 1/3 of facebook, you would need to believe that they can grow without any additional hiring.

Unknown said...

Professor - would you happen to have any blog posts on normalized vs. diluted EPS? When a company is reporting normalized earnings i.e. removing acquisition related expenses, forex, etc. Can you justify not using diluted EPS in a conservative valuation model? If you happen to have a previous blog post on this I'd like to read it if you can send a link. Thank you.

F said...

Professor Damodaran, what is your comment to David Trainer´s recent 20$ valuation of LinkedIn? He writes about "hidden liabilities ... because LinkedIn finances its office space and data centers through the use of off-balance sheet debt in the form of operating leases" and a "pre-tax margin of 4%, which was achieved in 2014, but has since fallen to -2.7% over the trailing-twelve-months".

Tom Nguyen said...

Professor. Do you think that the company's valuation is very sensitive to Capital Expenditure? The free cash flow for Linkedin turned negative in 2015 due to large Capex. If they keep investing at these rate and revenue cannot keep up, it would reduce their share price significantly.

Hemanth Manda said...

I see that you using simulation in your valuations lately. Its been a while since I have used simulations. Wondering which probability distribution curves you are using for your assumptions and what do you determine determine the variables of those input distribution curves ( other than mean). IF there is a detailed article on this, appreciate if you can point me to it.

Anonymous said...

Hi professor,

With the benefit of hindsight, i am curious to know how the valuation would look like given the acquisition value of 26 billion dollars that MSFT eventually paid. Any thoughts/insights?

Anonymous said...

@hemanth you should see professors most recent article which covers how to account for uncertainty by attaching probability distributions to your valuation.