Avoid This Overvalued Stock With Network Economies
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Premium valuations, coupled with network economies, set alarm bells ringing. The stories of MSN versus Facebook and Yahoo! versus Google, should be telling of the low customer switching costs for firms which have network effects as their moat. As such, LifeLock (NYSE: LOCK), which is trading at lofty valuations of 23 times EV/EBITDA and 27 times forward P/E, should be avoided.
Listed in October 2012, LifeLock is a leading provider of proactive identity theft protection services for consumers and identity risk assessment and fraud protection services for enterprises. It provides consumers with the tools necessary to protect themselves from identity theft and manage their credit.
Moats that matter
LifeLock benefits from the network effect, which is essentially a case of how the strong gets stronger. Like other companies such as social networking sites, credit card companies, and stock exchanges, the value of LifeLock’s network grows with additional users. Members of LifeLock’s network contribute to the value of the network by strengthening LifeLock’s data repositories and accuracy of its algorithms through their responses to alerted transactions.
According to its 2012 10-K, LifeLock had approximately 2.5 million paying members as at Dec. 31, 2012, including more than 250 enterprise customers such as top U.S. financial institutions, credit card issuers, and wireless service providers.
There are a few indicators to monitor the results of the network effect, including retention rates and growth in membership figures. LifeLock has done well on both counts, increasing its annual member retention rate from 82.7% to 87.1% in 2012 and growing its member base by 20%.
LifeLock’s premium LifeLock Ultimate services were named by Javelin Strategy & Research as a “Best in Class Overall” identity theft protection solution in October 2012. Companies like LifeLock with a significant market share are well-positioned to take advantage of network economies and further expand its user base.
That being said, a research by Morningstar, the authority on moats, showed that network effect firms had the highest variability of ROA, ROE, and operating margin over the past decade, raising concerns about the sustainability of such moats.
There is a limit on the extent that membership retention rates can be improved, so the real source of growth for LifeLock will come from the expansion of identity theft protection services industry itself. According to the 2013 Identity Fraud Report published by Javelin Strategy & Research, the number of identity fraud incidents increased by one million more consumers over in 2012, and almost one in four consumers who received a data breach letter became victims of identity fraud in the last year. In March 2012, LifeLock acquired ID Analytics, a leader in enterprise identity risk management that provides visibility into identity risk and credit worthiness, to further enhance its capabilities in combating identity fraud.
Intersections is a provider of subscription-based consumer protection services, helping consumers protect themselves against identity theft or fraud, and understand and monitor their credit profiles and other personal information.
Equifax is a credit bureau, which organizes and assimilates data on consumers and businesses worldwide, and uses advanced analytics and proprietary technology to create and deliver customized insights for its clients. It is one of the three largest U.S. credit bureaus along with Experian and TransUnion.
LifeLock is trading at a huge premium over its peers, with a trailing twelve month P/E of 58 and a trailing twelve month EV/EBITDA of 23. In contrast, Intersections and Equifax are valued by the market at eight times and 26 times trailing twelve month P/E respectively. Equifax pales in comparison to its peer in terms of ROA, having delivered a ROA of 7%, about half that of LifeLock and Intersections. LifeLock is not justified in trading at a premium over Intersections, given that they have achieved similar ROAs of between 12%-13%, and have strong balance sheets with negligible debt.
When a stock is valued at a huge premium to its peers with no significant difference in financial metrics and competitive advantages, investors need to exercise caution to avoid investing in an overvalued stock
Mark Lin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!