One of the easiest ways to evaluate a company's business model is to look at how much it spends acquiring a user or client and what it expects to earn on each. If the first number is bigger than the second, then the company should either stop acquiring clients/users or do something drastic to rectify the situation.
Where does LinkedIn stand?
In 2011, LinkedIn acquired around 14-15m new users per quarter, which is a strong growth rate, but the rate of growth is declining. Over the same period, marketing costs rose from $29m in Q1 to $53m in Q4, an increase of seventy seven percent.
This means that the costs of acquiring new users has risen from $2.70 per user to $3.80 over the course of the year. While a difference of $1.10 may seem trivial on this scale, if you are acquiring new users at a rate of 50-60m per year, and you want to profit from them, you have to have a clear idea of where things are headed.
At present, LinkedIn make less revenue per user than it cost to acquire them. While revenue per user rose from 93 cents in Q1 to $1.16 in Q4, the user acquisition costs have risen three times faster. Net income margin has declined from 6.4 percent last year to 2.2 percent in Q4 on a 12 month rolling basis. This is the equivalent of net income per user of 5 to 6 cents per quarter. At the current rate, this translates into a pay-back time of 48 to 66 years, which is not sustainable as the expected life of a user would be much less than 48 years.
If margins rose in the long run, to 20% for example, the payback time would be halved. If the marketing costs of $53m were halved then the net income margin in Q4 would be 20 percent.
One potential objection to this analysis would stem from the fact that some of the marketing expense is intended to attract corporate clients to LinkedIn's hiring solution. In this case the pay-back time is halved to 7-8 years.
Why is LinkedIn still making money?
While LinkedIn may have acquired 55m users at an unsustainable level in 2011, they also have 90 million existing users, which were acquired more cheaply in the past. For instance, in 2009, the average cost of acquiring users was $1.10, less than a third of today's level. In the same time period, net income per user has risen from 3c to 6c.
It is this cheaper backlog of users that allows LinkedIn to make money today. If the current pattern continues, however, then the balance will be tipped and LinkedIn will become a loss-making company. The new intake of users is much larger than when the firm were acquiring them more cheaply, and so the tipping point is now rapidly approaching.
However, marketing costs are easy to bring down. If they were to halve their marketing costs it would add $82m to LinkedIn's bottom line. This would, however, hurt the intake of new users.
In conclusion, LinkedIn does not have a sustainable level of marketing costs versus income at the moment. The margins are not high enough to capture the investments so LinkedIn is getting closer to the point where they have to revert to a more sustainable business model
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