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Finance The Internet

What’s Missing From Pinterest’s IPO?

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The venture capital industry has bet $1.5 billion so far on Pinterest. That investment has done well in many respects. The company has amassed 265 million monthly active users, is approaching $1 billion in annual revenue, and just filed for an IPO. And the latest funding round pegged its market value at around $12 billion. Nothing to scoff at.

But the IPO valuation is projected to remain around $12 billion, not more than the private round as would usually be the case. Why? Also, why does the company aim to become the ‘un-social’ network, and to distinguish itself from Facebook in terms of its features around privacy? Why does the overall opportunity seem more muted, with the market value reflecting a relatively modest multiple compared to other “unicorns”?

The answers can be found by looking at Pinterest’s “product/market fit.” This concept was coined by venture capital guru Andy Rachleff, who defines it as follows: “When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens.” Venture rockstar Marc Andreessen echoes the sentiment when he says that “the market matters most.”

On paper, Pinterest looked like an ideal product/market fit, and in many respects, was ahead of its time. Started in 2010 – pre smartphone boom and 4G mind you – the platform crystallized the idea of a dream board, a place on the net where you could store the things you loved, wanted, or aspired to. It achieved one thing no other company had been able to– capturing and aggregating data around consumer aspirations. Likes are one thing, but aspirations are another. Creating a context centered on them is powerful and should be a mecca for brands and advertisers.

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Pinterest did many things right. But what it didn’t do – and still isn’t doing – is to offer sufficient improvements in cost dynamics or productivity beyond what’s already available in the market. What that means is Pinterest cannot monetize its platform at rates equal to or better than the established leader, namely Instagram. It cannot achieve lower customer acquisition costs, or better return on investment.

Pinterest and Instagram both began in 2010. In fact, Pinterest released its initial beta version a few months before Instagram. In that sense, both companies started on an equal footing with image-based consumer products. However, Instagram captured data about consumers much more quickly, which led it to grow faster. After the spring of 2012, when Facebook bought Instagram, obviously it had the advantage of leveraging that company’s huge user base. But there is a reason why Mark Zuckerberg aggressively went after Instagram instead of Pinterest. It was growing users and user time faster. And Sheryl Sandberg understood it was better positioned to eventually make money from advertising.

Let’s break down why, from the perspective of both the consumer and advertiser.

For the consumer, Pinterest is not an innovation, but instead a variation on what Instagram offers. Although the aspirational aspect of Pinterest’s dream board is exciting, it lacks network effects. Following a conceptual set of images does not typically become more valuable to a user the larger the audience grows, or become more exciting, as does following individual people and personalities on Instagram.

The challenge with product/market fit is that it cannot be evaluated in a vacuum. When there is an incumbent in place, adaptations of existing services make it exceedingly difficult to capture incremental consumer time or cannibalize time from competing platforms. As a result, this limits the ultimate scale potential of the company’s biggest asset, which is data.

From the advertiser standpoint, what matters are cost advantages that help achieve superior return on an investment in advertising. One of the most effective tools for measuring the effectiveness of a business is how it improves the productivity of assets. (Here’s an article we wrote that explains how that plays out in Hollywood.) In financial terms, what matters is asset turnover. Companies that can generate better returns for a given set of assets should be able to lower the cost of goods or services for customers and gain market share.

In the case of Pinterest – as for all the major ad platforms – the asset is data. The faster a company can capture data by gaining more users who spend more time on the service, the easier and cheaper it will be for advertisers to acquire customers. Pinterest cannot capture such data at the same rate as Instagram because the incremental benefits of the platform are not large enough to shift consumer time away from Facebook/Instagram where the consumer is already entrenched. Unfortunately for Pinterest, aspirational pins hold an inherent individualized value, whereas socially-driven likes carry a network appeal.

Think about it this way, Pinterest and Instagram are essentially both media platforms, and the business purpose of media is to hold consumer attention. If new and existing users do not spend more time on one platform, and less on the other, then that platform cannot leverage its data in a way that offers advertisers more attractive rates for more efficient advertising. Without a change in consumer behavior, the return on investment in advertising will not be superior. You may see headlines about Pinterest’s ad rates per thousand users being near parity with Facebook, while the trend is lower industry wide. But when it comes to the what it costs to acquire new customers, it’s a different story.

What’s important to keep in mind is that the consumer’s response to innovation is always inherently conservative. To understand Pinterest’s dilemma, think about this: If there was a newer and more useful way to type, what are the odds consumers would ditch the QWERTY keyboard? They are probably quite low. Pinterest is in the same boat. It’s just not better enough than Instagram to gain huge consumer loyalty and user growth.

Product/market fit is an important tool to use in evaluating companies. When we also consider the cost and productivity implications, though, it suggests that having the right product at the right time in the right market may not always be enough.

To that fundamental investment analysis tool we need to also add the idea that innovations are especially essential to change consumer behavior when incumbents already hold dominant share.

To be sure, Pinterest still only has a tiny slice of the $600 billion global ad pie and may reap some near-term benefits given Facebook’s current struggles. But without the ability to deliver superior returns on advertiser expenditures, the longer-term opportunities for Pinterest as an investment vehicle, given the likely valuation, are not good.

James Cakmak was a Wall Street security analyst for over 10 years covering the Internet sector. He is now co-founder of Snailz, a digital beauty booking marketplace in New York. Twitter: @JamesCakmak. Ryan Guttridge is Adjunct Professor at Smith School of Business, University of Maryland. They write regularly about tech and markets for Techonomy.

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