Technology Times June 2010
Vol. III, No. 1   March 2012

Departments

Investor Insight

Break out the bubble(ly)
… before it bursts

Social media: The rapidly growing testament
to an industry bubble

By Carter Caldwell, Principal, Cross Atlantic Capital Partners

Carter Caldwell

Carter Caldwell

Social media companies are fueling an industry bubble, and as shown by the recent IPOs and current valuations, it will burst. There’s no doubt that companies like Facebook, Zynga, Groupon and LinkedIn offer advertisers a vehicle to get in front of many potential customers. For instance, Facebook indicates that it has 845 million active users, Groupon has 115 million, LinkedIn has 135 million and Zynga has 227 million.

These numbers are astounding by any measurement.

However, these companies’ market caps, such as Groupon’s $13 billion, Zynga’s $8.6 billion, LinkedIn’s $7.45 billion and — drum roll please — Facebook’s $102.6 billion valuation as of February 9 — assume continued astounding expectations for its earnings growth rates. In the one week since filing its IPO, Facebook’s privately traded shares rose in value by 10% to reach that $102.6 billion. Let’s look at what that means: A P/E of 102.6 and valued at 27 times trailing 12-month sales.

Richard Waters of the Financial Times wrote of Facebook, “While up 69% from a year before, advertising growth slowed sharply from the growth of 145% the year before. For a company whose shares will trade on expectations of continued sky-high growth, any further signs of deceleration will be scrutinized closely in coming quarters.”

It is not possible for these earnings growth rates to continue as quickly as the market is anticipating and upon which it is basing its valuations. These company valuations are based on unattainably high earnings growth rate expectations, echoed by Ryan Jacob, a U.S. Internet fund manager when he said, “To get comfortable with the valuations people are talking about, you have to be assuming they will develop other revenue streams.”

When growth falls below these expectations, the companies’ respective valuations will drop — and drop quickly. The valuations associated with these companies give rise to some outrageous statistics such as those put forth in Seeking Alpha’s article by Shmulik Karpf, which indicate that for LinkedIn to become fairly priced (P/E of 30, at the most), the company must increase its annual revenues by 50% for the next 17 consecutive years, or by 20% for 38 years in a row. For Zynga to become fairy priced in terms of growth (EPG = 1 at the most), the company needs to triple its current annual earnings growth, which currently stands at 114%. Put differently, Zynga needs to show a sensational (and obviously unsustainable) earnings growth of 342% per annum. Finally, Groupon has yet to show a profit, so it has no P/E ascribed to it, which only makes matters worse. But based on its Price/Book, in order to become fairly priced (P/B = 2, at the most), Groupon’s stock price must decrease by more than 75%.

Groupon and Zynga are good examples of IPO hype with little substance. If a company’s stock price were an accurate measurement of a company’s value and earning’s growth, then one would note that Groupon’s stock price is down more than 25% since its IPO, and Zynga is up only 4%. This performance (or lack thereof) shows that the growth rates are not as large as were expected when the companies went public.

LinkedIn has shown that there is a market for social networking — it has had a 66% increase in its share price since its IPO. However, one study found that of the 19 social media IPOs of 2011, the vast majority were later trading below their IPO price.

After Facebook crossed the $100 billion valuation mark, Erik Gordon, a professor at the Ross School of Business at the University of Michigan, told Bloomberg BusinessWeek, “The upside for long-term investors is pretty shaky at these prices. It’s got to be a Google and a half for the stock to move higher.” Investors see the possibility that Facebook can overtake Google in terms of the amount that companies advertise online because Facebook collects more detailed information, allowing advertisers to target customers easier. This then comes down to how you see ad dollars being split between Google and Facebook. At a $100 billion valuation, are you willing to place your bet that Facebook can overtake Google?

Let’s look at some of the reasons why the earnings growth rates upon which the market is basing its valuations will slow and why this is a growing bubble.

User saturation

Ultimately, there are only so many eyeballs that a company can access. Tim Loughran, a finance professor at Notre Dame, told PCMagazine that the tremendous growth rate of Facebook’s user base in the past few years can’t go on forever. Damon Poeter of PCMagazine continued, “The company is going to run out of new users eventually.” To compensate for this, the key to Facebook improving its profitability and continuing to develop additional profit streams is to derive them from existing users. With 845 million users, there is the chance that it can do so and the market’s $100 billion bet — and that’s what it is — is expecting it.

The key to Facebook’s long-term profitability is developing additional revenue streams, but, more importantly, acquiring more value from existing users. Sterne Agee’s analyst Arvind Bhatia said that Zynga’s bookings growth will slow to 20% in 2012 and 17% in 2013, even though the company’s bookings growth in the two years leading up to its IPO was 156% in 2010 and 37% in 2011. Growth rate expectations like these have led the market to apply such enormous valuations to social media companies; however these growth rates are simply not sustainable.

Jason Zweig of The Fundamentalist wrote in his article, “A Matter of Expectations,” that “over the past half century, only 10% of companies in the S&P 500 have increased their earnings at an average rate of at least 20% a year for five years running. Only 3% have raised earnings at least 20% annually for a decade. And none — zero, zippo, the big schneid — have sustained 20% earnings growth for 15 years or more.”

Residual value

Residual value is critical, given that there is no residual value tied to social media companies that are heavily dependent upon advertising, if advertising spending recedes. Zynga’s $1.02 billion in revenue is based almost solely on online games and advertising, whereas Electronic Arts’ $4 billion in revenue is derived from going toe to toe with Zynga’s online gaming community (EA’s The Sims Social is currently the fastest-growing game on Facebook), as well from products with residual value. If online advertising spending recedes, then Zynga’s advertising-based model will be severely affected. EA, however has significant residual value given that a sizeable amount of its revenue is derived from packaged goods, such as its video games Madden NFL and FIFA Soccer; from its major gaming studios in Orlando, Vancouver, Montreal and Sweden; and from its partnerships with George Lucas’s LucasArts, Nokia and Hasbro. There is a clear difference between Zynga and EA.

EA has continued to pursue the leading position in the online social gaming community by acquiring the London-based social gaming startup Playfish. Edge Magazine’s Nathan Brown wrote, “EA is the first true challenger to Zynga’s dominance on Facebook, with The Sims Social rapidly closing in on CityVille, the most popular game of all time on the social network. The Playfish-developed Sims title currently boasts 65.1 million monthly active users compared to CityVille’s 71.3 million.”

Then EA launched Origin, an online service to sell downloadable games directly to consumers, and acquired PopCap Games, the company behind hits such as Plants vs. Zombies and Bejeweled. When the bubble bursts, the difference between Zynga and EA is that EA has residual value outside its online games business.

Revenue stream

Social media-related companies’ revenues are dependent upon advertising. Facebook’s S-1 filing reported $3.71 billion in 2011 revenue. When taking into consideration its 845 million active users, this equates to only $4.39 per active user, which Tim Loughran said, “is a surprisingly low number. Right now, they have 845 million active users. If they get 3 billion active users (a hard-to-imagine number), keeping the assumption of $4.39 revenue for each user, Facebook would have yearly revenue of only $13.17 billion.” Just to put that into perspective, Apple reported a profit of $13.06 billion last quarter alone.

Facebook made it clear that 85% of its revenue is derived from advertising. The company made a good move in lowering its dependence on advertising revenue from 95% in 2010 to 85% now. And Facebook’s S-1 filing says, “Our advertisers typically do not have long-term advertising commitments with us.” As a result, having such a dependence upon this form of revenue means that any substantive swing in market performance that causes ad spending to slow will have a dramatic effect. Facebook has taken this to heart and has incorporated a new revenue line in its Facebook Credits, which are used to purchase virtual goods in games as well as music and movies. Facebook takes a 30% fee for these transactions.

But what about the other social media companies whose revenue is intimately tied to advertising?

A startling example of how the social media ecosystem is linked and how changes in one company will affect the others to a dramatic degree is shown by the fact that 94% of Zynga’s revenue in December 2011 was dependent upon Facebook. So, if Facebook’s revenues drop, then Zynga’s will too. And, just to make matters worse in this incestuous and co-dependent relationship is the fact that Zynga accounted for more than 12% of Facebook’s overall revenue in 2011. To address this, Zynga will have to diversify its portfolio and reduce its dependence upon Facebook by moving onto other platforms, such as Google+, which has yet to secure much of a sizable foothold.

Some investors are expecting that Facebook will offer its global platform to other companies to use as a way to launch their own line of business. For this, Facebook could charge a form of “rent.” However, Facebook won’t be able to offer this anytime soon. Additionally, it could be eclipsed by Google or some other offering.

New entrants

New companies entering the market, which has very low barriers to entry, add evidence of a social media industry bubble. Private equity investors are throwing money at the industry. VentureDeal’s first quarter 2011 report showed that the sector received $3.5 billion in venture capital funding, which was a 169% increase in dollar percentage values. Of this $3.5 billion, Facebook and Groupon accounted for nearly 70%. In the second quarter, another $1.96 billion was invested, of which Groupon competitors LivingSocial and Coupons.com each secured $200 million. For the third quarter, another $2.3 billion was invested in the industry, of which Twitter received $400 million. Other social network companies raising money in the third quarter include Gojee, a social network that encourages foodies to share recipes with each other across the globe.

Ultimately, this is an industry in which companies have enormously large user bases, but even more enormous valuations. According to The Financial Times’ Lex Column, “The user base is so big that it makes the traditional metrics for valuing an Internet IPO (or any IPO) look a little silly.”

Consider: Facebook’s $100 billion+ valuation is 100 times earnings, compared to that of Apple’s — which is 13 times. Microsoft’s is 11 times, and the market’s is 12 times. Finally, Facebook’s valuation is also almost 27 times revenue — which is 5 times Google’s valuation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.



Carter Caldwell is a Principal at Cross Atlantic Capital Partners, an international venture capital firm that has delivered top-quartile results and is focused on investing in innovative technology and technology-enabled services companies. With four funds and $500 million under management, Cross Atlantic is closely engaged with an extensive network of resources to nurture and grow its portfolio companies and provide superior returns to its investors. For more information, visit www.xacp.com.


Bookmark and Share