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Barrons Article on the Social Media Bubble


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Bubble Trouble


JUL,23,2011 12:00 AM EDT


Most seasoned investors are familiar with the great company/bad stock phenomenon, in which a fast-growing, innovative business becomes so well appreciated by the market that its shares become quickly and chronically overvalued. The rapidly emerging social-networking industry is approaching the status of great sector/bad stocks, much as dot-com companies did about a decade ago—even if, so far, there are only a few social-media stocks that are publicly traded, issued by secondary players in the industry, at that.


There is no set definition for a social-media company, but all involve large networks of individuals directly sharing and customizing information, or accessing tailored consumer offerings, via the Internet or email. The recitation of 10- and 11-figure implied values for several companies founded just a handful of years ago has become familiar to anyone paying even a little attention.


Depending on how you carve up the industry, eight leading companies that have either gone public, filed plans for an initial stock offering or are widely expected to do so by the end of next year are now estimated to be worth a combined $200 billion. Together, these eight companies—Facebook, Groupon, Zynga, LivingSocial, Twitter, LinkedIn (ticker: LNKD), Pandora Media (P) and Zillow (Z)—collected $3.5 billion in 2010 revenue. That's $1 billion less than, say, Washington Post (WPO), whose market value is $3.4 billion. Leaving aside Facebook, which seems to have the best shot at supporting its hypothetical $100 billion value through its market position, growth and profit margins, the rest have negligible profits at this point.


Facebook Envy: In the absence of a Facebook IPO, investors are eagerly "friending" the lesser lights in the social-media set. Those relationships might not end well.

ADMITTEDLY, IT'S AN OLD TRICK to compare fast-growing embryonic (or, in some cases adolescent) businesses to venerable but mature ones, to make the former appear wildly, recklessly valued. How about comparing the social-media kids to Google (GOOG), then, as the search-engine giant is hardly an Old Economy graybeard? Google's market capitalization is approaching $200 billion, but the company had $29 billion in revenue last year, on which it earned more than $8 billion.


For sure, Google was an expensive stock when it went public in late 2004 at 85 per share, although that price, in retrospect, is rightly viewed as a bargain. Yet Google has never traded at more than 29 times sales, and it approached 100 times earnings only for an instant. Its median price-to-sales ratio as a public company is 11; the current ratio is 7.0.


Based on Google's median price-to-sales ratio, the eight social-networking companies are between 20% and 100% overvalued—even assuming that some can grow into dominant franchises like Google.


This represents, if not a bubble, a bubble-in-waiting, but only because just a sliver of the sector is publicly traded. Once a broad set of investors gets its hands on these stocks, the companies are likely to attain vastly higher values than those currently anticipated and discussed.


Some might argue fairly that social-networking companies haven't reached bubble proportions, in part because social media represents an entirely new wave of innovation and commerce enabled by the existence of more than five billion Internet-enabled mobile devices. Also, unlike the tech craze of 1999, the companies raising capital now aren't mere gimmicky concepts but, for the most part, real businesses with revenue and, in most cases, a path to profitability. Finally, we aren't seeing—yet—the sort of broad-based, greed-propelled speculative frenzy among small investors that helped things get way out of hand a dozen years ago.


So, this isn't a straight replay of the '90s tech bubble, and therefore not a once-in-a-century misallocation of capital that will collapse a broad swath of the U.S. stock market by 80% before it's all done. But in a market where, as Sector & Sovereign Research's Paul Sagawa points out, 20% of large tech stocks trade at single-digit price/earnings ratios, the social-media group looks to be an overheated microclimate in a generally temperate investing zone.


CONSIDER LINKEDIN, the professional-networking service that went public in May. Priced at 45 each, its shares immediately doubled, then retreated to the low-60s in late June. At that point analysts for the deal's underwriting firms issued Buy ratings, igniting a surge in the stock that has carried it to 101 in the past three weeks. Its current price affords the company, which is expected to have revenue of $470 million this year, a market value of $9.7 billion.


Doug Anmuth at JPMorgan, one of the deal's underwriters, downgraded LinkedIn to Neutral last week on a valuation basis. His current $85 share-price target is the product of a discounted-cash-flow analysis that foresees 20% annual revenue growth and 30% cash-flow increases from 2012 through 2020, at which point the stock will trade for 23.5 times cash flow.


So, if you are confident enough to look out nine years and see that LinkedIn will be among the most successful growth companies of our or any era, and assume it will trade at about double Google's current multiple of cash flow, even then the stock is worth 15% less than what the market is paying. Anmuth notes that LinkedIn's market value isn't much lower than the $15 billion afforded Netflix (NFLX). But Netflix is expected to have seven times LinkedIn's revenue and cash flow next year.


LinkedIn's rather gargantuan valuation suggests that investors eager to play the stunning growth, popularity and near-ubiquity of Facebook are grabbing at anything that faintly resembles it, even if that means paying up for a far more limited opportunity in a site whose users aren't remotely as engaged as Facebook's.


Even companies only tangentially attached to social media are being lifted by this tide. Last week Zillow, a Website that allows people to get home-price estimates and check recent real-estate transactions, soared 80% in its first day of trading following its IPO. The stock ended the week at around 34, having attained a $890 million market value. That compares with Zillow's 2010 revenue of $30 million.


Pandora Media affords a similar example. The company, an online competitor to radio that promises to customize playlists based on individual tastes, went public at 16, ran to 26 and now sits at 18.50. Pandora's $3 billion market value amounts to more than 16 times expected 2011 revenue.


FIRST COMES exclusivity, buzz and thus, status. Facebook used to be restricted to university e-mail addresses, and the new Google+ is offered only by invitation. Investment in private companies initially comes only from the plugged-in, such as venture capitalists. And when such companies go public, only a narrow slice of the business is floated. In LinkedIn's case, only 7.8 million shares of a total 94 million outstanding were sold. The public stock was passed around madly, with daily volume routinely exceeding two million shares.


For sure, each social-networking stock needs to be evaluated on its own merits. Lou Kerner, a longtime Internet analyst at Wedbush Securities, covers Facebook even in its pre-IPO state, and makes a plausible case that it can support its rumored worth of $100 billion.


Based on forecasts of a steadily increasing share of global ad revenue. and rapid increases in other revenue sources such as its share of online gaming and other transactions, Facebook should approach $4 billion in revenue this year, growing to $6.6 billion in 2012. Its cash-flow margin is near 50%, Kerner estimates, which would give the company $3.3 billion in cash flow next year. A multiple of 30 times cash flow, well below what Google traded at following its IPO, gets you to $100 billion.


Facebook is increasingly the way people find their way to other corners of the Internet. Its News Feed directs about 70% as much traffic to the rest of the Web as Google's search feature does, says John Aiken, head of equity research at ITG Investment Research. In May, 12.7% of all the minutes spent online globally were spent on Facebook. There's been some chatter that Facebook's domestic-user growth has plateaued, and Google+ has received fond reviews and grown quickly to 10 million users.


But the broad and deep economy of applications for Facebook, and the massive "installed base" of users, make it hard to bet too strenuously against huge growth projections for the company. Barclays Capital's Anthony DiClemente related last week that John Wren, CEO of the giant ad agency Omnicom, said social media is now part of almost every advertising, marketing-services and store-promotion campaign the company does. Facebook will get a disproportionate share of this incremental spending.


ASSUMING FACEBOOK SATISFIES hopes and expectations by going public next year, the stock immediately will rocket to an eye-watering valuation. Tech partisans like to compare this crop of IPOs to Netscape's debut exactly 16 years ago, which kicked off the multiyear boom that preceded the dot-com bust. Yet in July 1995, there were only 40 million Internet users in the world. Facebook alone has 700 million users, and its pervasiveness means the world already appreciates its power and is readying to pay top dollar to own a piece of it. After all, before Netscape went public, an Oscar-winning movie based on its founding hadn't netted $220 million in worldwide ticket sales.


We might get a preview of this manic dynamic born of pent-up excitement for Facebook when Zynga, the social-gaming player, comes public. It created FarmVille, Mafia Wars and related online games, and users collectively spend a reported two billion minutes a day playing them. Zynga is entirely entwined with the Facebook economy, using its platform and online currency to sell virtual goods. Revenue is running at a $1 billion annual rate, cash flow is on pace to exceed $400 million and the company turned a small bottom-line profit last year. Valuation talk is around $20 billion.


WHEN IT COMES TO TWITTER, fixing its potential value is almost entirely an exercise in conjecture. It has grown stupendously to 200 million users who "tweet" brief messages to "followers" who choose to track their musings in real time, all at no cost. But the company has only gingerly attempted to monetize its reams of message-traffic via advertising. Revenue last year was around $50 million. Trade publisher eMarketer figures it can get to $150 million this year.


"Looking at Twitter, it's harder to do the same kind of analysis because it's so early in the development of its business systems," says Kerner of Wedbush. Yet he points to the $8 billion Microsoft (MSFT) paid for Skype, noting Twitter "potentially could have more users who are more engaged than Skype."


And then there are the "group buying" networks such as Groupon, which has registered IPO plans and could perhaps attain a $30 billion valuation. Groupon offers e-mail subscribers "daily deals," discounts for local stores and restaurants, and takes some 40% of what the merchants charge as a bounty for introducing them to a new customer. Growth has been astounding, from zero revenue three years ago to $713 million last year and $644 million in just this year's first quarter. Losses are widening as well: They were $456 million in 2010 and $146 million in the first quarter of 2011.


Consumers seem to love the deals, and the idea of allowing local businesses to reach new customers in bulk is innovative. Yet, as Barron's reported this month (Preview, July 11), a study has shown little loyalty among merchants in an increasingly crowded sector. Google and Facebook, Amazon (AMZN) and eBay (EBAY) have now joined in. And close on Groupon's heels is LivingSocial, a daily-deal site, which counts Amazon among its investors. LivingSocial was valued above $3 billion last spring after its latest funding round, and Sector & Sovereign and others are citing potential valuations of $15 billion.


Aiken, the Internet analyst, notes that Groupon's take on transactions seems unsustainably high relative to the others. He even goes so far as to say one can view Groupon, in some cases, as providing short-term loans to struggling businesses that get cash up front when the groupons are sold, but don't deliver the product until they're redeemed. Groupon's business is also not particularly virtual: It has 9,000 employees, up from 7,000 several months ago, many of them hoofing around to recruit new retail locations. No doubt the IPO will make quite a splash given the buzz, but it probably won't represent a great deal for investors.


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WHENEVER A NEW and exciting sector catches investors' fancy and raises their animal spirits, yesterday's darlings suffer at least some level of neglect. As the nearby table shows, a number of established Web-related companies also exploiting social networks to one degree or another are afforded comparatively prosaic valuations.


Possibly no company is more starkly underloved in this context than Google, which even after the latest spurt in its stock fetches less than 17 times this year's expected earnings. It's true that Facebook's encroachment on Google's role in dispatching eyeballs across the Web is a modest concern. Yet Google is perhaps the best play on the whole mobile-computing megatrend, via its Android smartphone operating system. And, as noted, it has answered with the Google+ social network, which likely will be cleverly integrated with the company's Gmail and YouTube properties. And management has been an admirable acquirer. When it paid $1.65 billion in stock for YouTube five years ago, it was considered a fat sum for an outfit without a real business.


Imagine what YouTube would fetch now, when the similarly viral and profitless Twitter is "worth" $8 billion.

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