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Don't 'Friend' These IPOs

Investors could be well-served by avoiding contact with the recent spate of social-networking offerings.

Bearemy Glaser, 06/26/2011

Excitement over technology is really nothing new. From the excitement over new tulips in 17th century Holland to Pets.com, investors have always had a knack for rushing to put money behind what they think is going to be the next big thing.

And the same thing might be happening again. Institutional and individual excitement about social-networking firms is building rapidly. The buzz around nearly every IPO, IPO filing, private deal, and rumor can occasionally be deafening. This week, I'm going to look at why people are so excited about these firms and why they are likely to be let down again.

Looking for Growth
Investors are desperate for growth. But there isn't much to be found in the developed world. The recovery in the United States appears to be slowing down, and there is no sign that the economy is going to be growing at a considerable pace anytime soon. Stocks look fully valued, and investors putting money to work today aren't expected to see huge returns from equities. Fixed-income doesn't look much better considering rates and inflation have nowhere to go but up. The picture in Europe isn't any rosier. The sovereign debt crises and accompanying austerity measures have put the brakes on growth in the eurozone. It could take years to sort out these issues and for the continent get back on track.

Enter the Internet. Social networking and other tech firms have been growing at a rate much faster than that of the rest of the economy. What started off as moody teenagers customizing their MySpace or Friendster profiles has become a real business with people of all ages joining up with Facebook or Twitter to connect with others. As these sites have grown and become even more ubiquitous, holdouts begin to feel pressure to also join the party out of fear of missing what their friends and family are saying. This network effect has fueled the growth of these sites and given them a considerable chunk of the Internet audience. What's been exciting about this growth for many is that it is greenfield. These sites have created a whole new category. The growth isn't just a shifting of consumer preferences from one brand to another.

And Emerging Markets Too!
These growing social networks also provide a way to tap emerging-markets consumers. Developing economies are one part of the world that is still growing. For the most part, much of the emerging world has their fiscal houses in order and most have young populations eager to join the middle class. Furthermore, investors are increasingly seeing social networks and the Internet as a good way to tap into these consumers. Internet penetration and access is rapidly rising, and as it continues to expand, users in emerging markets are happily signing up for services and connecting to the broader world. In fact, now much of the growth of sites like Facebook is coming from emerging markets.

Here Come the Bankers
It isn't that shocking then when you combine a tech story, an emerging-markets-growth story, and a lack-of-growth-everywhere-else story that you get a lot of investors very excited about an idea. But there are also groups that are actively trying to stoke this excitement. Banks have had a rough couple of years. Those that survived the financial crisis have had trouble returning to their previous earnings power. Investment banking is one area where bankers are trying to make up for some of the loss. This means you have a lot of bankers out there trying to push IPOs, private placements, and other services so that they can get a fee. They are happy to pounce upon (and further hype) a fast-growing sector in order to boost their bottom lines.

But alas much of this hype is just that.

Can They Make Money?
Growth is great, but it is only great for investors if the firm can grow profitably. Unlike other tech darlings such as Apple AAPL, which makes money hand over fist, social-networking sites have so far fallen short on profit. Now of course these are businesses that are very much in their infancy. Thus, there is a ton of investment that needs to be made, so it makes some sense that all revenue (and then some) will be plowed back into the business. But it isn't clear that there is a coherent business model other than "get really big and figure it out later." This is not a road to riches for investors.

Firms like LinkedIn LNKD have tried to lift revenues through premium subscription models and selling access to job-seekers, but so far those initiatives haven't created meaningful profitability. All of those eyeballs are worth something; display and other advertising will bring cash in. But it is very hard to justify the incredible valuations that are being discussed for some of the sites.

Furthermore, that growth in emerging markets that investors are so excited about can actually be a liability for profitability. The bandwidth costs of delivering rich-content websites is quite expensive, but advertising rates in developing markets are quite low. Advertisers are just less willing to part with huge sums of money to target users who don't have a large amount of disposable income. To combat this, many sites from Facebook to YouTube have created "light" versions of their products to attempt to keep bandwidth down, but this can only solve so much of the problem.

Even firms like Groupon that are bringing in prodigious amounts of cash from users ponying up for coupons are not as profitable as people had initially imagined. The amount of money these firms have to spend on infrastructure and sales has evaporated their margins.

Until social-networking firms unlock the secret to monetizing their user bases, investors should remain cautious.

Will They Be Also-Rans?
The Internet is littered with mighty giants that are now shadows of their former selves. AOL AOL and Yahoo YHOO are the two that come to mind at first, but there are plenty more examples of firms that hit a market first, expand quickly, and still manage to return very little to shareholders. It's hard to know what disruptive technology or consumer trend is going to derail the current growth trajectories of these firms coming to market now (or rumored to be coming to the market). It isn't reasonable to price in a wide moat for a company that is just starting to create its competitive advantages. Many of the firms have strong network effects now, but so did MySpace and even AOL at one point. A few missteps and the lure of something shiny and new could radically change these young companies.

Profitable Firms Start to Waste Money
The mania surrounding some of these new firms is also having an impact on the better-established, profitable tech giants. The management teams of big companies like Google GOOG or Microsoft MSFT don't want to feel left out of party. They seem willing to throw around a decent amount of cash to lock up the newest thing and keep potential competitors at bay. Unfortunately, these acquisitions rarely pan out. The huge price tag and integration problems tend to erase any strategic benefits. So the cash gets wasted instead of being invested wisely (or even just returned to shareholders). The artificially high value of these firms is throwing off the asset-allocation decisions of companies that should be focused on their core.

Despite the excitement around these companies, investors should likely steer clear of these IPOs. Again, with all the question marks and uncertainty, it's hard to justify these valuations. It can be frustrating looking for growth in this environment, but you shouldn't jump on this bandwagon.

What are your thoughts on these social-networking firms? Are you enticed by their potential growth, or do you have no desire to "like" them?

Bearish markets editor Bearemy Glaser is the worry-prone alter-ego of markets editor Jeremy Glaser. Each week, Bearemy will share what's topping his list of concerns and invites you to reply or add your own in the comments section below.

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