Does Pinterest Have a Moat?

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Pinterest is on the verge of hitting the public markets. This means that investors finally have financial statements to review and can gain clarity into potential pitfalls that might lie ahead.

In this segment from Industry Focus: Technology, host Dylan Lewis and contributor Brian Feroldi discuss the company's competitive strengths, management team, corporate culture, and some of its potential risks.

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A full transcript follows the video.

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This video was recorded on March 29, 2019.

Dylan Lewis: With financials out of the way, why don't we talk about some of the more soft elements of the business? I'm thinking specifically here about the moat, Brian. What do you see when you look at it?

Brian Feroldi: Moat is super important when you're thinking about any investments. To my eyes, this company does have a somewhat of a moat. Right now, just their sheer amount of users that they have, they have a huge collection of data, a huge collection of pins and information about what their users like, what their users want to see. There is a social component to this. You can go on and you can check out your friends' boards, you can see what kind of things that they like, you can have people follow you. Those things do create somewhat of a network effect. The more users you have, the more pins you have, the more boards you have, and that does create somewhat of a flywheel that you could argue insulates them from competition.

Lewis: Yeah. I think it's a little bit weaker than we'll see network effects from some of the other platforms. Facebook and Instagram probably have the strongest network effects in the social media space. Twitter's is pretty strong as well. I don't think Pinterest is quite on par with theirs. But there are a lot of elements there that, yes, the more people that are on there, the stronger the platform is going to be.

Feroldi: Yeah, I completely agree with that. The other thing that I think this company benefits from is, it does have a really strong brand. The fact that 90% of their users say they associate the brand with positivity, I think that gives them a very strong brand that should separate them in the long term from, say their rivals. They do have a statement in their S-1 that says, "We're the third most relevant brand in the U.S." I can see that. I know that in my life, my wife just loves Pinterest, probably more than almost any other company that I can think of. So I do think there is value in that Pinterest name.

Lewis: Yeah, Nick Sciple and I were talking about Pinterest before we hopped into the studio to tape the show. He made the joke most people will waste half an hour on Instagram or Facebook and not really feel so great about it. They'll feel like they just fell down a black hole for a while. If you're on Pinterest for half an hour, chances are you're doing stuff, you're finding inspiration, you're working through a project, something like that. People don't seem to have that same social media dread that they do with some of the other platforms out there with Pinterest.

Feroldi: Right, which is a very soft thing to talk about, but I do think that there is value there. So, does this company have a moat? I believe that it does. But there is an argument that it is not quite as strong as some other social media companies that we've talked about.

Lewis: All right, Brian, let's talk potential. We looked at that growth rate, that 60%-ish growth rate. The big question for me is, is this something that they can sustain, possibly even accelerate, especially the way that user growth is going for them?

Feroldi: This is an advertising play. The good news there for investors is that the advertising market is absolutely enormous. The total addressable market for digital advertising in 2018 was $272 billion. That number is expected to continue growing quickly and should reach $423 billion by 2022. If you could pretend that Pinterest could grab 1% of 2018's total pie, that would be $2.72 billion in revenue. To give you some perspective, that would be roughly four times the revenue that they pulled in in 2018. The pie that they're going after is so massive that even if they could just get 1% of it, there is plenty of room for them to grow.

Lewis: The necessary caveat there is, to do that, they are going to be competing with the likes of Google and Facebook and Facebook's property, Instagram. Those platforms are notoriously strong performers for people in the digital ad space. The reason that there's effectively a duopoly in digital advertising is, all the money spent on Google and Facebook's properties tends to give a pretty good ROI for the people that are spending that money.

Feroldi: Yeah. So, what kind of stats do we have to back up that making an investment in Pinterest is worthwhile for advertisers? Well, Pinterest, on their S-1, said that a household that looks at a retail product on Pinterest is 39% more likely to buy it than they would otherwise. Those that see products on the site on average spend 29% more on items that they see on Pinterest than they don't see. So, there is, I believe, value to be had for advertisers to say, "Getting this information in front of our audience on Pinterest does have an ROI for us."

Lewis: Yeah. The thing that I think is interesting is, a lot of the advertisers that they focused on early on have been in the retail and consumer packaged goods space. Those often are brands with pretty big ad budgets. [laughs] It might be that they're able to help reach people that are tending to do more brand advertising and might be able to do a little bit more performance advertising on their platform, rather than some of the other social media ones out there.

Feroldi: Yeah. Pinterest has said that they do want to eventually expand into other verticals, other sectors of the market, to get advertising dollars. It's important to realize that they're still very early in the monetization stage. To put some numbers around that, a key metric for any of these companies that we talk about is average revenue per user. That's when you take your total revenue and divide it by the number of users that you have. In the fourth quarter, they made about $3.16 in the U.S. from their average user. The number in international was about $0.09 -- $0.09 for international users. To put some context around those numbers, last quarter, Facebook did $34 in revenue per user in the U.S. and $7.37 worldwide. When you compare those two, there is tremendous room for expansion on Pinterest's side.

​Lewis: Yeah, and I think a lot of that is going to be coming from the international markets. My pause here with this company is, the U.S. is a very mature market for them. You look, and user growth is up single digits year over year. They've been hovering around that 80 million number for quite some time. So really, the serious growth is going to be coming from increasing ad impressions and increasing ad prices in the United States. Outside of the United States, they have about two-thirds of their users. Right now, they're not monetizing them too much. They've been focusing most of those efforts in the U.S. But that user base is growing 30% year over year, so there's definitely something there. They're just going to have to harness it.

Feroldi: Yeah, I think you hit the nail on the head there. We've seen this work very well for Facebook, though, in the past. Their numbers in the States were growing, but their revenue was growing far faster because they proved to advertisers that their platform was worth spending dollars on. The challenge ahead for Pinterest is going to be to do the same thing to follow in Facebook's footsteps. That is a risk that investors are taking on.

Lewis: Brian, I know you like to look at customers as well when you're breaking down businesses, what do you see when you look at Pinterest?

Feroldi: I like to think about the relationship between customers and the business when I'm thinking about investing in a stock. Here, it's important to note that the customers we're talking about are the people that give the company revenue. Not users. Customers are advertisers. Are they expensive to onboard? Well, in platforms like this, the answer is usually yes. There is a significant sales and marketing cost to get a big brand to advertise on your platform, to get them set up. But once they are on there, are they dependable? Will they keep giving you revenue on a consistent basis? The answer there is yes. Advertising is a continuous expense that they have. Revenue is recurring. And it appears to be dependable.

The other thing I like to think about is, does Pinterest have pricing power? Can they raise their profit margin over time? From what we've seen, yes. Their gross margin is expanding. There is an argument to be made that this is a company with recurring revenue and with pricing power. That is something that very much excites me.

Lewis: Yeah, this isn't recurring revenue in the way that a software-as-a-service company would have recurring revenue. The performance needs to be there on the ad side to have those advertisers continue spending money. By a lot of indications, though, the performance seems to be there.

Feroldi: Yeah, I totally agree with you.

Lewis: Brian, what do you think of management and the company culture? I know this is one of the big things you like to hone in on, too. I think we couldn't have a conversation about an S-1 or an upcoming IPO without talking about the CEO and the leadership at a business.

Feroldi: We like to see that the people that founded the company are still running the show. That is the case with Pinterest. The two co-founders are Ben Silbermann and Evan Sharp. Ben Silbermann is the company's CEO, and Evan Sharp is the company's chief creative officer. These guys are still very much on the board. They do hold a significant amount of Class B stock, which gives them supervoting power, as we've seen with many other companies. We don't know exactly what their ownership percentage is going to be until after they go public and those numbers get released. But I think it's fair to say that they're going to have a sizable amount of their net worth tied up in this business.

From an employee perspective, I checked them out on Glassdoor. They get 4.2 stars out of five. 90% of employees approve of Ben Silbermann. Those are pretty good numbers. I think investors should feel good about the management and corporate culture here.

Lewis: All right. Why don't we take a step back and look at the company and the stock? That's what people are going to be buying here. I look at this business, Brian, and I'm a little torn. There are a lot of things going in the right direction. I think the nice, steady, consistent top-line growth is there. I think that profitability is going to be pretty easy to project out for this business, especially the way margins are moving. I would not be shocked if we hit somewhat consistent profitability in 2019, unless anything crazy happens with stock-based comp after the IPO.

That said, I do have some concerns. What do you see concern-wise? What do you see risk-wise when you look at this business?

Feroldi: Yeah, there's always a couple of things to think about. I have a checklist, as you know, that I go through with big concerns. I always ask, is this a penny stock? In this case, no. Pinterest is huge. Is there any excess customer concentration? The good news there is, no, there were no customers that were more than 10% of revenue last year. That's good. I then ask, are there any industrywide headwinds that this company has faced? I'm going to say no. I think this company has tailwinds. They're taking advantage of the move to digital advertisement.

There is one thing I do want to point out. The question that I always ask is, does this business rely on outside forces for success? Is there something that's outside of the company's control that controls their destiny? And there is an argument to be made that that could be an issue here. A lot of the people that log in to Pinterest actually go through the logins through Google and Facebook. They also get a lot of organic search results through Google. If Google or Facebook decided to change their ways, that could put a damper on Pinterest's growth numbers.

Lewis: Yeah. Not only is Facebook a competitor, they are also, in some ways, holding the keys for some people to have access to Pinterest. Not necessarily a dynamic that you'd love to see long-term. You'd like to see them control all their user logins and be divorced from that a little bit.

One thing, I mentioned this earlier, that I think people do need to keep in mind is, the cost structure is also something to worry about a little bit. Because they don't own and operate all of their data centers, and they rely on AWS, they are going to be at the whims of someone who has a lot of clout in the cloud market. They won't control that cost in the way that they would if they owned and operated it.

Feroldi: Yeah, that's absolutely something for investors to watch. For me, the encouraging thing to see is that even with that, this company is still expanding its gross margin rapidly. It does show that they are leveraging somewhat their costs. But I would prefer to see them own their own data centers. Hopefully that is a move that this company makes with the huge bolus of cash that it's going to get.

Another thing that's worth pointing out is, the valuation of this company has actually stalled a little bit. Back in 2015, the company raised money at an $11 billion valuation. Then, in 2017, they raised it at about $12 billion. The early reports that we've seen thus far indicate that this company is going to come public slightly over $12 billion. That's not a lot of market cap expansion for a four-year period, even though this business has been growing nicely.

Lewis: Yeah. I'm not really sure what to make of that, Brian. I have to be honest. You look at the revenue growth that they've enjoyed over the last couple of years, and I don't know if the 2015 valuation was too rich and it's stalled because the business results just had to catch up with the valuation, or if there's something that we're missing here looking at this analysis.

Feroldi: Right. So, that is something for investors to watch. I prefer to buy stocks that continually go up. A lot of other venture capitalists do, too. They want to see that number continue to grow steadily. The fact that it has capped out is something to watch. Investors need to be wary of any new IPO when it comes out. We don't know how the management team is going to handle being a public company. It changes the culture, it changes the way they operate, it changes the way that they can do things. Suddenly, they have a number every 90 days that they have to hit. I always like to observe IPOs from the sidelines for a quarter or two before I just dive in because that is a significant challenge that not every company masters.

Lewis: I'm 100% with you on that one, Brian, for all the reasons that you mentioned, and also because there are some metrics, especially related to an ad business, that I want to see with Pinterest that I haven't gotten a chance to see yet. The cost per engagement, the CPE, or the cost per thousand impressions, and the ad load for this, are going to be some of the main drivers of growth in the U.S. market, and we don't have a really firm sense of what those numbers look like for Pinterest. Yet most major ad-based businesses -- your Twitters, your Facebooks of the world -- will give you year over year growth rates or sequential growth rates to show you where those metrics are trending. We haven't gotten a sense of what that looks like yet. So, for me, I want to get a sense of, what does ad inventory look like? Is it pretty saturated on the platform? Or is there room for them to expand that out? What's going on with pricing? Can we expect growth there, too?

Feroldi: Yeah, I think that's completely reasonable to think about. However, one thing I do want to say is that I will probably be a buyer of this IPO on day one for one reason. That is, I am keenly interested in getting my wife interested in the stock market. [laughs] I haven't been able to do it at all yet. But I do think that she likes this business enough that if I told her that we owned a teeny, tiny little bit in our portfolio, and I showed her some metrics, it might prompt her to get interested. I'm not going to go hog wild, but I probably will buy a few shares on the day of the IPO.

Lewis: Sometimes you just need to find the thing that keeps you interested and gets you a little invested. I know for me, when I am just starting to really get excited about a business, sometimes I will take a small position just so that when I'm checking my brokerage every now and then, I see the shares, and I'm tracking them on a day-to-day basis or a weekly basis, getting a sense of the direction the business is going in. So, I hear you there, Brian, given all the other caveats that we threw out there about IPOs.

Feroldi: Yeah. So, this is one that I'm probably going to break some of my own rules on. But, again, it's just going to be a tiny percent of my portfolio. Before I would make a substantial commitment to this company, I would definitely want to see at least two quarters of results to see how they operate before I would do anything like that.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Brian Feroldi has no position in any of the stocks mentioned. Dylan Lewis has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends GOOGL, GOOG, FB, and TWTR. The Motley Fool has a disclosure policy.