Beware the Facebook/Twitter/ Zynga/Pandora/HuffPo bubble!February 15, 2011: 11:05 AM ET
The revelation that JPMorgan Chase is planning a dedicated fund to invest in social media companies on behalf of its wealthy clients is the loudest announcement yet that the third (fourth?) Internet bubble is in full swing.
Every day, it seems, another Web company files papers for an initial public offering, and every day the chatter about possible valuations reaches new levels of absurdity. Because it's going to get pretty noisy around here soon, what with all the people trying to trample those in front of them in line to get their hands on some stock in tomorrow, I've put together a quick cheat-sheet for just how you might go about thinking about which companies you want a piece of. If, that is, you can even get your hands on them at all.
Companies that make a product that's fun to use, but have never earned a dime from me and probably never will.
Members: Facebook, Twitter, and Pandora.
Following its latest round of funding from Kleiner Perkins Caufield & Byers, Facebook's valuation is somewhere in the neighborhood of $52 billion, or north of 25 times revenues. Twitter comes in at $8 billion to $10 billion, or about 100 times revenues. And Pandora somewhere in the area of $1 billion or so, at a relatively modest 10 times revenues.
Let's do some simple math here, folks. Assume you bought an entire company that had $100 in revenues and 50% profit margins. And that you paid just two times revenues, or $200. It would still take you four years to break even with revenues holding steady. Pay 25 times revenues for that same company, and you're talking 50 years. Of course, the whole point of paying big multiples for early-stage growth companies is that you think they will grow into their valuation—that revenue and profit growth will be so stupendous that the payoff will come much, much quicker. Fine, assume that revenues in our fictional company double every year. At 25 times revenues, you're still talking about a six-year payback. And that's if margins hold steady and revenues actually do double every year. But that won't happen. (Amazon.com (AMZN) anyone?)
So…the only reason that you would ever pay anything approaching the multiples that Facebook and Twitter are currently valued at is if you assume there's a greater fool waiting down the road to take those shares off your hands. Ah, yes, the greater fool method of investing. It's a sure thing unless you're the fool left holding the bag when the road comes to an end. And the road will end.
Don't get me wrong. I post to Facebook pretty regularly. And if I lack my own tweeting skills, I still marvel at other peoples' several times a day. And I love, love, love Pandora. I listen to it nearly every single day over my 3G connection on my iPad. But it's easier than breathing to start poking holes in their growth possibilities. Pandora recently filed an S-1 with the Securities and Exchange Commission revealing that it intends to raise $100 million in its own IPO. The company reported that it had over 80 million users in the U.S. I don't believe it. There are only 175 million people in this country between the ages of 15 and 60. Would they have us believe that half of all people who would even conceivably use Pandora actually do so? I sincerely doubt it. The numbers certainly don't seem like it's all that: Through the first nine months of 2010, advertising revenue was just $78 million and subscription revenue was $12.3 million. (Who is subscribing to ad-free Pandora? You don't even look at the site when you're listening to music. Who cares if there are ads on it?)
How many basic advertising plays are people going to get suckered into buying just because they're on the Internet? Google, fine. But that company is like a pure distillation of advertising in the 21st century. The rest are just derivative. Facebook might really be selling data about me six ways from Sunday, but that doesn't make it the greatest investment opportunity on earth. Certainly not one worth 25 times revenues. And Twitter may help foment revolution, but that doesn't mean its ever going to make a meaningful amount of money. I'm not a buyer.
Members: Groupon, LinkedIn
These business models make a lot more sense to me. People who want to use LinkedIn in any real sense pay a subscription to belong to the professional social network. And what could be a more dedicated customer group than people looking for a job? For its part, Groupon takes a cut of each and every deal its users buy. There's nothing wrong with that math.
But again, recent private market trading of LinkedIn puts its valuation at $3 billion or so. Do you really want to buy shares of a company that did just $18 million in sales in a recent quarter at more than 30 times those sales? Why? Because you think LinkedIn is going to be the next Facebook? Don't try to sell your shares to me.
Groupon is a more intriguing story, in large part because CEO Andrew Mason in December spurned a $6 billion takeover offer from Google (GOOG). Is he crazy? I used to think so. But maybe he's crazy like a fox. The coupon site has about 60 million registered users worldwide and says it has saved them $1.6 billion through the power of collective buying. Give the site its cut of those deals, and you're talking about revenues of $500 million to $750 million, just for being this middleman. This is like eBay (EBAY) all over again. While a $6 billion valuation still makes no sense if a sane person were valuing the company, perhaps Mason saw better than his critics that we were entering another insane moment. In that regard, $6 billion may be low. I might be buying.
Companies that sell the lamest of products to customers I cannot even fathom.
I've said it once, and I'm sure I'll say it again: I do not understand how a world that includes the likes of Halo and Call of Duty also has people who choose instead to play games like Farmville. Sim City was cool—my brother Steve was addicted to it for a while there—but CityVille is a poor man's version of such. Apparently, though, enough people wile away the hours (and spend their own money on virtual goods—yet not even totally cool ones like in World of Warcraft) to result in a recent valuation of $7 billion to $9 billion. I don't even know where to go with this save to celebrate the fact that Zynga must make people happy. More power to them. But I'm not buying.
Companies that use slave labor and then sell the results.
Members: Huffington Post, AOL
Issues of morality aside, who wouldn't want to own an antebellum cotton plantation? I'm sure they minted money. With all the talk of billions of dollars above, does it really seem so ridiculous that the Huffington Post might be worth the $315 million that AOL (AOL) paid for it? Maybe not. Then again, can you really scale the thing beyond its current level? How many more unpaid writers can they find? And how much more content will they be able to steal from sites like The New York Times once they've driven the latter out of business? Again, don't get me wrong. I read HuffPo pretty much every day. (Although rarely the long-winded opinion pieces on the left of the page, and almost never Arianna, who is the epitome of the talking head. Is there anything about which the woman doesn't have an opinion?) And though it's not for sale anymore, having just been bought, I wouldn't buy it if I could. I will pass.
At least AOL has the decency to pay its people. Have you ever used Patch? I guess it's not really relevant to city dwellers, but it's weirdly fascinating up here in suburban Westchester. Some woman is making about $50,000 or so from AOL for publishing a daily paper just for me. (Thanks Marisa Iallonardo!) What a genius business. I hate to say it, but at a market capitalization of $2.3 billion, could AOL actually be a BUY? In 1997 or so, I wrote a piece in Money magazine that suggested that AOL was past its prime. But that was almost 15 years ago. Maybe it's worth another look.
I'll finish with a quick side point: With all the finger-pointing and outrage over just who screwed whom in the real estate bubble, it's worth noting just how quickly we all seem to be lining up for another kick at that can. Wall Street and the venture community are doing what they always do—giving the people what they want, regardless of the safety or soundness of the investment decision—and we're all wide-eyed with excitement. Don't say you weren't warned.
Also on Fortune.com: