Questions Abound with Social Media Stocks

by Tony D'Altorio

Questions Abound with Social Media Stocks

by Tony D’Altorio, Investment U Research

Monday, May 30, 2011

Wall Street went gaga last week over the IPO of the business-focused social network, LinkedIn (NYSE: LNKD).

The company garnered enormous attention as the first of the U.S. social networking and Web 2.0 companies to go public… including Facebook, couponing company Groupon and social games service Zynga.

LinkedIn’s big market debut was a smash hit, with its shares doubling in their first day of trading. Valued over $8 billion, it now trades at 30 times its 12-month revenue of $243 million and over 170 times its cash flow.

That’s stunning, especially considering that LinkedIn dates back to just 2003.

If Facebook received that same treatment, it would be valued at more than $60 billion. And Groupon would be worth $25 billion.

More than likely, investors bought it up at those insane prices because of the very limited number of shares available. LinkedIn offered just 7.8 million at first count.

But for long-term investors, the so-called deal doesn’t look nearly as worthwhile…

LinkedIn’s share structure resembles that of Google (Nasdaq: GOOG) and Chinese social media company Renren (NYSE: RENN) in many ways. For one, they all have dual voting structures, where new investors have a mere fraction of the votes held by company insiders and initial investors.

This protects the companies against hostile takeovers, but it also means the “little guy” doesn’t matter. The average investor only serves to drive the stock higher to benefit the fortunate few who got in early.

And many other companies in the sector prefer it just that way.

Social Media Sector

Warren Buffett, who shuns the tech sector, recently spoke up about social media companies. “Most of them will be over-priced,” he said, but “some will be huge winners, which will make up for the rest.”

History seems to favor his opinion. After all, for all of the companies like Pets.com that crashed and burned during the dot-com boom, a few big winners like Priceline.com (Nasdaq: PCLN) did emerge.

And as long as social network companies keep growing like they are, they have great revenue potential. But when that growth stalls or even slows, things tend to go bad quickly.

For proof of that harsh fact, look no further than Friendster or MySpace. In 2002 and 2003 respectively, they were pioneers and trendsetters; today, they’re all but forgotten.

So right now, yes, Facebook and Twitter clearly make for great businesses. The former is the world’s leading social network, with more than 500 million active users and about $2 billion in estimated advertising revenue last year.

Meanwhile, consultancy eMarketer says Twitter had revenue of $45 million in 2010. And that was with zero overseas revenue, which clearly gives it room to grow.

Even the social media bears see more advertising dollars flowing into social media companies, as marketers adjust to the shift in online consumption. But even so, many people go to social networks to socialize, not to buy…

So investors should be careful not to count their cash before any actual results come in.

Investing in Social Media

Investors interested in social networking companies have to keep the bigger picture in mind. In order to stay profitable, these companies have to not only expand rapidly but also prove themselves sustainable.

During the tech bubble, many such businesses couldn’t cut it. But many people believe things have changed enough to facilitate these companies this time.

After all, far more people around the world use the internet now. There are an estimated two billion online users today compared to just 248 million in 1999.

And this time, the frenzy was ignited somewhat more rationally by profit generation within the growing connections between social networking, gaming and the like.

That narrower focus should limit the number of companies coming to market. It should also hopefully limit most of the IPOs to higher quality companies.

But investors should remain cautious all the same.

Sure, go ahead and invest in social media stocks. Just do so with both eyes open.

Good investing,

Tony D’Altorio

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