Social Bubble

I have never been a fan of tech stocks. They are naturally bubble-prone. Unlike any other industry, say manufacturing or commodities or even finance, their prospects can never really be quantified. Another problem with the industry is the extra hype it tends to create which eventually cools off as and when investors realize the actual worth. Precisely the reason for the dotcom bubble of 2000 which saw the share prices of various tech firms plunge.

But investors haven’t learned from the mistakes of 2000. Another tech bubble is now inflating. The Initial Public Offerings (IPO) by internet or rather social-media companies has come back to life. The recent IPO of LinkedIn, whose share price more than doubled on the first day of trading (from an offer price of $ 45 to the closing price of $ 94) at the New York Stock Exchange (NYSE), places the Company’s valuation at $ 9 Bn. Yandex, Russia’s largest search engine, floated its shares on the NYSE which saw its price rising by 50% on the first day of trading. In December 2010, Youku – China's version of Youtube – went public, with a first day valuation of $ 4.4 Bn against 2010 revenues of $ 59 Mn. And more recently, in May 2011, RenRen – Chinas version of Facebook – had a first day valuation of $ 7.4 Bn against 2010 revenues of $ 77 Mn. Groupon, an online group buying website that offers discount coupons, has recently filed its IPO application and is likely to have a valuation of $ 15 Bn against 2010 revenues of $ 713Mn. And don’t even get me started on the mother of all the madness – Facebook – which is targeting an IPO in October 2011 valuing the Company at a whopping $ 70 Bn.

Dr. Jean-Paul Rodrigue at the Dept. of Global Studies & Geography, Hofstra University, presents the lifecycle of a tech stock in this graph. We have entered the ‘Mania phase’ where we are now witnessing an irrational demand for the tech stocks. What follows the mania phase is disaster.

Unlike software & hardware technology firms, the problem with the social-media companies is that their business model is yet to be fully tested. David Reibstein, Wharton marketing professor, raises few very valid concerns about Groupon's model. He points out that the Groupon business model works better during recession than it does during a vibrant economy. The reason some retailers might be willing to provide supply to Groupon is because they have excess inventory. As the economy picks up and there is less excess inventory, the availability of supply will go down. The willingness of the merchant to offer deep discounts will go down. The business proposition to the customer will be less attractive if [the item or service being offered] doesn't have the same deep discount. Although Groupon may boast of a subscriber base of 83Mn+, the snag is that the Company is still in the red. It lost $390 Mn in 2010 and $103 Mn in the first quarter of this year. A statement by Groupon's chief in its IPO prospectus is laughable:

“The path to success will have twists and turns, moments of brilliance and other moments of sheer stupidity. Knowing that this will at times be a bumpy ride, we thank you for considering joining us”.

How very assuring!

Yes it is true that social networks and mobile applications are reinventing the way businesses function. But irrational exuberance has returned to the internet world & investors should beware. Take a break and rethink those valuations. Are they really justified? Or else what’s next? Soon you will find yourself putting your money in companies like Zynga, creator of the online game Farmville, in which players grow vegetables and breed pigs. That’s beyond disaster!

[With inputs from The Economist & knowledge @ Wharton]