Facebook Looks to Catch Up to LinkedIn

Social-media juggernauts Facebook (FB) and LinkedIn (LNKD) have a lot in common.

Facebook is the undeniable leader in helping friends connect with friends. LinkedIn is the leader in helping friends connect with jobs. Both are headquartered in California's Silicon Valley -- Facebook in Menlo Park and LinkedIn in Mountain View. Both also are relative market infants, first issuing stock in widely anticipated public offerings -- LinkedIn in May 2011; Facebook in May 2012.

However, when it comes to investment performance, the two couldn't be more different. LinkedIn has been an investor's dream. The shares launched with a bang, nearly doubling in price on the first day of trading and continuing to climb from there. With the stock at $109.05, those who got in at LinkedIn's initial offering price of $45 per share have earned a 142% return in less than two years (all prices are as of the December 6 close).

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Facebook, on the other hand, has been an investor's nightmare. Its share price popped from the $38 offering price to nearly $45 on the first day of trading but started sliding immediately afterward. The stock finally bottomed at just under $18 in early September and now trades at $26.97. But that still leaves initial investors with a 29% loss – assuming they were lucky enough to get in on the initial public offering.

But things are starting to look better for Facebook and remain bright for LinkedIn. Both companies have "a lot of opportunity," says Wedbush Securities Michael Pachter, who rates Facebook shares a buy (he doesn't formally cover LinkedIn).

To understand why analysts are high on both stocks, it helps to review the factors that have caused the stocks of these two social media giants to diverge so dramatically.

Facebook was wildly profitable before its initial public offering. But the mere act of going public caused its profits to evaporate, primarily because of stock-based compensation expenses that kicked in after the IPO. In the first nine months of 2011, net income totaled $463 million. In the same period of 2012, however, Facebook lost $11 million. The main reason for the decline: Employees and other insiders were so richly rewarded with stock options that Facebook's compensation expenses have soared. Total share-based compensation expenses rocketed to $1.4 billion during the first nine months of 2012, compared with $141 million in the same period of 2011.

Still, the market can be highly forgiving to young companies that post losses as long as revenues are growing quickly. Facebook's revenues grew at a brisk 36% pace over the first nine months of 2012 compared with the same period of 2011. But that's a far cry from the 87% growth in revenues in 2011. "That's a slowdown, but when you're talking about 36% revenue growth with a multibillion-dollar company, that's not at all bad," says Needham & Co. analyst Kerry Rice, who rates the stock a buy. LinkedIn, on the other hand, has been experiencing the blistering growth rates that Facebook enjoyed before it went public. In the first nine months of 2012, revenues jumped from $354 million to $669 million. Meanwhile profits doubled, to $10.1 million. (Fully diluted per-share earnings, which account for dilution from employee stock-option programs, were up just 80%, to 9 cents per share.)

Of course, growth rates tend to be higher when companies are smaller. After all, a $100 million gain would double the revenue of a $100-million-in-sales company, but it would give just a 10% boost to a company with a billion in sales. And LinkedIn is still a fraction of Facebook's size. However, what also may be affecting the stocks is how each company generates sales and profits.

LinkedIn's business model is fairly simple. The company is ultimately a job-search and networking site. Anyone can post his or her resume on the site for free. Users can also get co-workers and colleagues to post recommendations and "endorsements" of their professional skills without paying a cent. But those who want premium services – such as information on who among the site's 187 million users are actively looking for work, or which employers are hiring or reviewing resumes – need to subscribe. Subscription prices range from $20 to $100 a month, depending on the level of service required.

Given that companies and recruiters often spend thousands of dollars to find a single employee, it's not surprising that they've been willing to pay LinkedIn for access to its vast database of resumes and the ability to post their help-wanted ads. Individuals seeking new work are also buying premium memberships in droves, with some 13.5 million individuals subscribing at the end of the third quarter. That gives LinkedIn a rich and fairly predictable revenue stream.

Citi Research analyst Neil Doshi is also impressed with LinkedIn's management and thinks the company is in the relatively early stages of mining the vast growth potential of these varied streams of revenue. Indeed, analysts predict that LinkedIn's earnings will expand a blistering 60% to 70% over the next three to five years, a growth rate that easily justifies the stock's lofty valuation -- 85 times projected 2013 earnings of $1.28 per share. Doshi thinks the stock will hit $135 within a year.

Facebook, by contrast, gets about 86% of its sales from advertising, with the rest coming from revenue-sharing fees from partners, such as game-maker Zynga. Although Facebook's ad revenues increased by one-third in the first nine months of 2012, the fickle nature of Internet advertising has been on investors' minds since General Motors pulled a $10 million account from Facebook right before its initial public offering, says Rice.

Thus, investors have been anxious to see Facebook broaden its business and potential sources of income. Some of that is already happening, says Rice. When the company issued third-quarter earnings, for instance, it noted that it now has some 600 million customers who access Facebook via mobile applications for phones and tablets – an arena where Facebook had previously been lacking. That new platform gives the company more places to sell advertising and potentially more opportunities to develop new sources of income, which, Rice says, contributed to the recent rebound in Facebook's stock.

Sterne Agee analyst Arvind Bhatia also thinks Facebook is looking at ways to generate revenue from Instagram, a photo site it bought earlier this year for $1 billion.

To be sure, it's difficult to visualize how Facebook can replicate the blistering growth of its early years, but at its current share price, it may not need to. The stock, which is slated to join the Nasdaq-100 index on December 12, sells for 41 times projected 2013 earnings of $0.65 per share. That is high, but analysts expect the company to deliver annual earnings growth of 27% over the next three to five years. That sort of growth rate can justify premium prices, says Pachter. He predicts that Facebook will sell for $35 within a year. That's little comfort for investors who bought the shares at $38, but it's an opportunity for those able to buy now.

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