May 27, 2011
Should You Buy into the Social Networking Bubble?
By Andrew Mickey, Q1 Publishing
There’s nothing that attracts more investors – and eventually costs them more money – than a hot new growth sector.
Right now the hot new thing is social networking.
The stunning growth of Facebook over the years has whetted Wall Street’s appetite for any and all things social networking-related.
Last week’s screaming IPO of LinkedIn (NASDAQ:LNKD) and the lengthy run-up of Renren (NYSE:RENN) – touted as the “Facebook of China” – are perfect examples.
The smashing success of these two has many investors believing the social networking boom has reignited the dot-com bubble. And they’re thinking unbelievable valuations and expectations are just over the horizon.
Once you stepping away from the frenzy, however, you’ll see a much different picture emerging. One that reveals more realistic expectations and a sizeable trading opportunity, just not the one most investors are plowing their money into right now.
Great Stories and Great Investments
The newly listed companies are still in their early stages of development, have very short track records of revenues and earnings (if any), and have exceptional growth potential – at least on paper.
Many of them are nothing more than stories. And the key driver of successful IPOs is great stories. The herd loves stories. And the most-touted IPOs over the last couple of years have all had great ones.
For example, the best IPO “story” we’ve heard in the last few years was electric car battery-maker A123 Systems (NASDAQ:AONE).
A123 IPO’d in September 2009. The IPO market was dead at the time. Wall Street needed a great story to revive it.
A123 fit the bill perfectly.
A123’s battery technology was developed at MIT. The company was originally financed by Sequoia Capital - the same venture capital firm behind YouTube, Cisco, eBay, Yahoo, and dozens of others. It had a close relationship with General Electric. The U.S. government cut a $249 million check to help it ramp up production. And Morgan Stanley and Goldman Sachs were underwriting the whole deal and providing an added layer of credibility to the story.
At the time we wrote:
A123 Systems has no proven product, no major sales contract (GM actually passed on A123’s batteries for the Chevy Volt), very little production capacity, and no near-term prospects for profitability, and yet sports a market cap of more than $1.9 billion.
But Wall Street desperately wants – maybe even needs – a scorching hot IPO.
Wall Street got their hot IPO regardless of reality.
A123 shares hit the market at $17 per share. They ran to a high of $28 per share just over a week later.
A123 went through the same cycle that has befallen most great IPO stories. Its shares soared, the greedy herd piled in, and then reality slowly set in. A123 shares have steadily declined since hitting a high a week after the IPO. They now trade for less than $6 and a much more sensible valuation of $700 million.
LinkedIn and the whole social networking mini-boom are likely to play out very similarly.
Numbers Don’t Lie
Don’t get me wrong, LinkedIn is facing a very unique opportunity. It could really become a “business Facebook” or something similar. It’s still in its early phases of growth and with the right ideas, marketing, execution, and a good amount of luck, it could be eventually be worth the $9 billion or so the market current values it at.
But the odds that investors - a historically impatient group - willing to wait for LinkedIn to grow into its market value aren’t very good. Here’s what I mean.
LinkedIn has grown steadily over the years. The site was founded in 2003. It ended its first month with 4,500 members. Since then it has expanded exponentially. Its member rolls increased to 7.8 million in 2006, 30 million in 2008, and 101 million in March, 2011.
That’s impressive growth and rivals the current king of social networking. Facebook had one million unique users in 2004, 100 million in 2008, and surpassed 500 million last July.
Looking at total users alone, we can estimate that LinkedIn is about 1/5 the size of Facebook. In simple total market value terms, that would make LinkedIn about as 1/5th as valuable as Facebook. Given Facebook’s recent $65 billion valuation, LinkedIn would be justifiably priced at $13 billion. That’s not far from its current value of about $9 billion.
Here’s the thing though, LinkedIn is not Facebook. It’s not anything close to Facebook. And the more measurements we use, we can get a very close approximation of LinkedIn’s relative value.
The Return of “Stickiness”
The real value of any web site more than just how many users, it also needs the users to spend time return to the site and spend a lot of time there. The more time users spend on the site, the more ads they see, and the more they’re likely to follow those ads. It really is that simple.
It’s a web site’s “stickiness” that became a major focus during dot-com bubble days.
Once stickiness is added to the mix, a comparison of LinkedIn and Facebook provide a much better comparative valuation.
The Nielson Company, the gold standard in ratings firms, found the average Facebook user would spend 421 minutes (just over seven hours) per month on Facebook. That’s more than they would spend on Google, Yahoo, YouTube, Microsoft/Bing, Amazon, and Wikipedia combined.
Seven hours of ads per month, per each of the 500 million-plus users is why Facebook was recently valued at $65 billion.
The average LinkedIn user, meanwhile, doesn’t spend nearly as much time on LinkedIn as Facebook. A 2008 report from Nielson found users spent about 1/9th the amount of time on LinkedIn as they do on Facebook each month.
That puts the total time spent by all users on Facebook 45 times higher than LinkedIn (five times as many users spending nine times as much time).
Yet, given LinkedIn shares’ stellar run-up, Facebook is only about seven times higher than LinkedIn.
Clearly, something has got to give. And if the run in the most recent hot IPOs is any indication, the give will mostly likely come from LinkedIn’s share price.
Reality Always Trumps Stories
Despite the unrealistic valuations, a mini-bubble has formed in the social networking scene and anything connected is trading at a fairly high premium.
The high valuations are indicative of all the potential growth being priced in at current levels. In other words, they’re another case of great expectations. And we all know what great expectations lead to in stocks - greater disappointments.
The perfect example is MySpace. Remember MySpace? Just three years ago, MySpace had twice as many users than Facebook and MySpace users spent twice as much time on the MySpace site as they did on Facebook. Now MySpace isn’t even a factor in social networking anymore.
All currently hot social networking sites face similar risks of becoming “uncool” and disappearing just as fast as they arrived.
That’s why it’s time to disregard the excitement surrounding the hot IPOs. The combination of fast run-ups, great stories, and ample media coverage attract a lot of investors into them.
But, as with most hot investments where most investors are just looking to make a quick buck, they’ll end up losing far more than they ever even had a chance at making.
There will likely be opportunities in social networking - eventually. But so far they’ve been reserved for early-stage institutional investors and Wall Street insiders.
Good investing,
Andrew Mickey
Chief Investment Strategist, Q1 Publishing
