Some space for bubble theory

Last week's sale of Myspace for just $US35 million offered a telling reminder of how fickle online friends can be. And as the new tech players line up for their own IPOs on the back of LinkedIn's big debut last month the public should not ignore the lessons of history – even if institutional investors try to talk up the “new paradigm” of internet stocks once again. Looking at the numbers provides some strong warnings to those who might be looking to cash in on the latest round of tech IPOs.

To take Myspace as an example, based on the current expected enterprise value per subscriber of Facebook, Rupert Murdoch's big social networking play would have been a $US45 billion company back in 2007 at its peak of popularity. But last week it sold for a value of less than $1 per subscriber – a shadow of its former $US40 per subscriber value implied in 2007 when it was believed to be a $US12 billion company.

But MySpace's valuation metrics from back in its heyday still puts it at the bottom of the pile compared to the current tech upstarts, including Facebook, Zynga, LinkedIn and Twitter (see chart).

Clearly, Facebook needs to extract some serious cash from its users to justify its predicted $US100 billion IPO valuation. Of course, to do this it can't lose popularity in the way Myspace did in recent years. But in a bad sign for Facebook, its user numbers have now declined for two months in a row in the US, UK and Canada, according to Inside Facebook, which tracks the site's user numbers worldwide. And with the key growth of its subscriber base in Indonesia, Brazil, India, Mexico and the Philippines it seems extracting that cash might become increasingly difficult. Add to this Google's next attempt at social media, Google , and Facebook might be pushing to IPO sooner than later.

But it's not just Facebook riding the new tech stock valuation wave, with other companies also evoking a sense of déjà vu. One of the biggest flops of the last dotcom era was Webvan, the original online grocery delivery service. During its IPO year (1999) the company delivered annual revenue of just over $US13 million, although its lead underwriter, Goldman Sachs, talked up its future prospects, projecting revenues of $US128 million for 2000 and $US518 million for 2001.

Even though the company reached a valuation of over $US6bn after its first day of trading it had filed for Chapter 11 bankruptcy protection within two years. But that initial valuation looks relatively modest compared to today's valuations, with LinkedIn hitting almost $US12 billion during its first day of trading and Groupon and Zynga expected to reach around $US25 billion and $US20 billion respectively at IPO (Zynga filed for its IPO last week).

Again, Webvan's financial ratios back then wouldn't put it too far out of line with today's crop of hopefuls – but it is still in stark contrast to Google's IPO in 2004 and Netscape's IPO of 1995. Comparing the expected IPO values to the projected following year revenue also shows how far out of line Webvan and today's new tech companies are with existing tech players such as Google, Apple, Amazon and even Yahoo! (see chart).

Of course, earnings ratios would be even worse, with many companies like Groupon and Pandora yet to turn a profit. As a point of reference, the year after Google's IPO it had delivered net earnings of just under $US1.5 billion. Of course, the high valuations of the new players are based on the expectation of huge future growth beyond just next year's revenue.

But looking at Facebook's required cashflows over the next decade shows that the equation to justify its current enterprise value – expected to be almost quadruple that of Google's IPO of 2004 – is quite simple: it roughly needs to grow to the current cashflow levels of Google and then maintain that level of cash for the next decade. And it probably needs to do it at least as fast as Google did. Clearly, this is not an easy task. But it is a common theme with all of the new tech companies that are fuelling what is looking more and more like a new technology stock market bubble.

Financial metrics aside, The Economist magazine just finished a ten day online debate, putting forward the motion: “This house believes that we are in a new tech bubble”. The debate closed with 69 per cent of voters agreeing with the motion. The opening remark put forward that we have entered the “Mania” phase of a bubble cycle, which happens to coincide with when public investors can jump into the action. Following the phases through the lifecycle looks strikingly familiar to anybody who remembers the events of over a decade ago (see chart).

If we have indeed entered the “Mania” phase, what happens next? Well, according to the creator of the chart, Dr. Jean-Paul Rodrigue:

“The public jumps in for this 'investment opportunity of a lifetime'. The expectation of future appreciation becomes a 'no brainer'. Floods of money come in creating even greater expectations and pushing prices to stratospheric levels. The higher the price, the more investments pour in. Unnoticed from the general public, the smart money as well as many institutional investors are quietly pulling out and selling their assets. Unbiased opinion about the fundamentals becomes increasingly difficult to find as many players are heavily invested and have every interest to keep asset inflation going.”

The other side of the argument in the debate was put forward by Ben Horowitz, co-founder of Venture Capital firm Andreessen Horowitz. Notably, his Silicon Valley firm have investments in just about any current tech firm you can imagine, including Facebook, Twitter, Groupon, FourSquare and Zynga (see chart below – note it is from March, when Facebook was considered to be half of its current expected IPO value; all red boxes are probably green now as well).

source: TechCrunch, March 2011

I've written previously about the inflation of Facebook's valuation on the back of transactions by institutional investors (see The Facebook Bubble, March 8, 2011), and in just four months the new accepted IPO value for Facebook has grown to $US100 billion. Even though Horowitz puts forward solid arguments from his own perspective, it's hard to remove the fact that institutional investors like his own firm are set to hugely benefit from the looming tech IPOs.

But it's not just the VCs, with Morgan Stanley and Goldman Sachs in the midst of things once again. Based on current valuations, for example, Morgan Stanley's investment in Twitter has grown by a factor of eight in less than two years while Goldman Sachs look set to more than double their Facebook investment in around one year. Last week's rumour that Citibank are looking at taking a $US1.2 billion stake in Facebook, believed in part to be on behalf of China's Sovereign Wealth Fund, certainly won't harm its already sky-high valuation. Clearly, individual investors should be wary of the hype from institutional investors.

Indeed, as Apple co-founder Steve Wozniak said of Google's IPO back in 2004: “I'm not buying. Past experience leaves the taste that a few people — never ourselves — will make out the first day, but that it's not likely to appreciate a lot in the near future or maybe even the long future”.

Although not correct in Google's case, his words look spot on in relation to today's tech upstarts – unless they too can consistently deliver strong growth and cash like Google has for the last seven years. But if you believe they can consistently do that for the next decade then there's no bubble to be worried about. Just try not to think about Myspace. And keep an eye on any quiet sales by institutional investors to avoid “Capitulation”. Buyer beware.

Andrew Harris is an independent telecommunications consultant who has advised on fibre, wireless and satellite business planning, financing, M&A and bankruptcies for operators, banks and governments worldwide since the late 1990s.