The Bubble Network: Deflating the Social Media Frenzy

The Bubble Network: Deflating the Social Media Frenzy | West Coast ...

August 2011

In the Facebook movie, The Social Network, one of the original investors asks the question, ?A million dollars isn?t cool, you know what?s cool? ? A billion dollars.? Now, less than a decade after inception, Facebook is looking very cool indeed with a projected public offering in the neighborhood of $100 billion and perhaps the most anticipated IPO since Google.

The internet music company Pandora and the professional networking site LinkedIn each had IPOs this spring at nearly $3 billion and $9 billion valuations respectively. In addition to Facebook?s expected IPO in 2012, Groupon, Living Social, and Zynga have all filed paperwork declaring their intentions to make a public offering in the near future. Despite high national unemployment and a ubiquitous sense of economic gloom, the prospect of public investment in the internet social media movement has resulted in a frenzy of excitement not seen since, well, the last internet bubble.

While bubble speculators debate whether or not there is a bubble, entrepreneurial investors let the logic of fundamental analysis guide them to temper hysteria and identify sound investment opportunities. Each new internet company must be evaluated in the same way any potential investment is evaluated; on its own merits. In that way, the current frenzy looks less like a bubble, and more like a handful of potentially over valued companies. Rather than one giant industry-wide bubble, like we have experienced in the past with housing or the internet, this social media phenomenon appears to be closer to what one might witness when watching children play with bubbles on the playground; many individual bubbles will pop on their own with little or no economic reverberations, while a few float away.

?Like? This

As Yogi Berra once wisely observed, ?the future isn?t what it used to be,? and, right now, the future is internet technology; effortlessly connecting users to friends, colleagues, commerce, discounts, food, music, news and entertainment. Lending further credence to the movement, in July, President Obama held a Twitter town hall meeting. During a recent coworker meeting in our office, a round of hands showed that nearly everyone had a Facebook page. One of the holdouts, despite strong reservations, volunteered to start a page and share the experience for this newsletter. She explains,

Because my primary concern was privacy, I initially spent time adjusting the settings to be as restrictive as possible without defeating the whole concept of social networking. Another concern was how time consuming it might be: spending hours looking up old classmates and coworkers. I found others to be exceedingly helpful when asking for advice, tips or their own personal Facebook experience. Ask a coworker for help with spreadsheet data entry and he?s too busy; ask him to show you how to ?tag a photo? and he suddenly has time. With social networking, it is only fun if everyone is playing the same game. Friends and family were thrilled that I finally arrived at the party.

As the above account illustrates, the public?s relationship with social media is highly personal and familiar. Most have made connecting to social sites as routine as checking email or grabbing lunch. Therefore, the prospect of investing in a stock that is well understood and deeply associated with daily life is very enticing, and clearly more exciting than, say, the next discount clothing company public offering. If the world was run by 7 year old boys, and the company responsible for the current toy action figure craze was going public, we would likely be witnessing a similar level of mania.

This frenzy was perhaps most visible in the wild price fluctuations of LinkedIn, the first social networking site to go public. Trading opened at a price of $45 and from there the stock nearly tripled to $122 before closing its opening day at $94. Subsequent closing prices dropped to the low $60s in June and have climbed again to over $100. In the July 25th issue, Fortune magazine explains that real estate agents and luxury car dealers sense a ?boomlet? in Silicon Valley (where LinkedIn offices are located) and are anxiously waiting for a windfall when employee shares vest in the coming months.

Back to Basics: Signs of a Strong Company

When evaluating what to buy, entrepreneurial investors look for specific strengths that suggest a company of quality. These criteria include a simple business model, wide competitive advantage, recurring revenue, a healthy corporate culture, and low reinvention risk among others. If a company stacks up well against these first tests, we are then ready to perform a more comprehensive financial analysis. With these qualitative factors forming the basis of the inspection, we are able to deconstruct the current bubble hysteria surrounding the social media internet companies. For example, Living Social and Groupon provide a similar online service of offering discounts at local merchants (narrow competitive advantage), yet they have no inventory risk and low capital requirements.

Similarly, Facebook attractively sits with a strong revenue base, low inventory risk, and a near monopoly of the social networking environment. But holds on market share are exceedingly tenuous, as Friendster and MySpace have proven. The average Google user may (or may not) remember that Lycos and Yahoo were the seemingly unassailable leaders of internet search services in the very recent past. And now Google has launched a competitor to Facebook with the service, Google+. As Mark Zuckerberg?s character explains in the The Social Network, ?Even a few people leaving would reverberate through the entire userbase. The users are interconnected. That is the whole point. College kids are online because their friends are online and if one domino goes, the other dominos go.?

Using established quality checks, some new internet companies are extremely appealing while others are not. Yet the bubble debate stubbornly continues to group all the tech companies together while viewing the current events with the same lenses that were used during the last internet bubble. One overpriced stock does not sink all boats.

The housing bubble in the 2000s and the internet bubble of the 90s were largely a middle class phenomenon. Wide-spread public participation swelled until the ?pop? and the echo boomed across the whole nation. Today?s phenomenon, however, is distinctly different. Original Facebook investor Peter Thiel convincingly argues that the current so-called tech bubble lacks some fundamental elements of bubbles past. Namely, because most of the new companies are not yet public, at this point only venture capitalists have actual money at stake. He states in a New York Times article in June, ?much of the bubble talk surrounds five companies: Groupon, LinkedIn, Zynga, Facebook and Twitter?five companies do not make a bubble.? Today, while there is not yet mass participation, there is mass enthusiasm which makes fundamental evaluations and ?strong company? tests all the more vital.

FOMO: Fear of Missing Out

In a recent opinion article in TechCrunch, a leading industry publication, Mark Suster states, ?What I believe is happening is that private-market investors are getting ahead of themselves for FOMO: fear of missing out.? This results in a disconnect between price and value. Perhaps the most fundamental principle of value investing is to resist the temptation to allow emotion to guide buying decisions and to instead buy when price represents an adequate discount to value.

Instead, by our estimation, prices for social media companies in general are at a premium to value; complicated by the fact that so much of their value is influenced by the anticipation of growth in future earnings. For example, LinkedIn has a $9 billion valuation with just $243 million in 2010 revenue; Groupon?s IPO is projected between $20 to $30 billion with just $713 million in revenue last year; online gaming site Zynga has an estimated $20 billion value with $593 in revenue, and Facebook?s $100 billion valuation is supported by $2 billion in revenue.

In fact, for the price of Facebook at its projected?IPO value, one could own all of the following?companies: Starbuck?s, Fed Ex, Hershey,?Molson Coors, the New York Stock Exchange?and Clorox. Yet while a stock?s valuation may?resemble a floating bubble, it should not let one?conclude that the company is not worthwhile or that the profits are not?real. Similar to the recent?technology bubble, we have?no doubt that a number of recent and future internet?start-ups will be wildly successful and make investors money. The?problem we see is that the current valuations?already assume extraordinary future success for?years to come and this simply can not be true?for all start-ups. In this highly emotional time,?it is foolish to speculate which companies will weather the winds and which will ?pop? early.?However, it is always wise to apply time-tested?fundamental tools of analysis to determine??strong? companies, with robust cash flow,?resilient business models, and solid dividend?yields that are also reasonably priced.