Web 2.0 = Tech Bubble 2.0?

KEY POINTS

• LinkedIn's first day of trading witnessed its stock surge by 109% to an intraday high of USD 122.69
• IPOs of Web 2.0 companies are in the pipelines, with Zynga and Facebook reportedly listing this year and next year respectively
• Exorbitant P/E ratio of LinkedIn tied to a dearth of supply of Web 2.0 companies
• The fall in the share price of Renren to below IPO levels provide a grim reminder of what are essentially still start-up companies
• Tech giants yet to see a rerating in their valuations
• The tech giants seen to view social media and social networks as part of a larger global strategy rather than a core business
• Increasing e-commerce, demand for cloud computing and growing capital expenditures to be the earnings drivers of the tech bellwethers

The recent initial public offering (IPO) of LinkedIn (a social-networking site for professionals) and its subsequent stock price movement, has led to warnings of a new tech bubble circa the Dot.Com period of the late 1990s. The stock of LinkedIn surged 109% by the end of its first day of trading, almost tripling in price from its launch price of USD 45 to an intraday high of USD 122.69 as investors clamoured for exposure to Web 2.0 companies.

THE IPO NETWORK EFFECT

The recent spate of IPOs by tech companies have comprised mainly of social media & networking companies from the world over. The Chinese companies led by Renren (a social-networking similar to Facebook) and Sina (similar to Twitter) , Russian companies led by Yandex (a Russian search engine dubbed the "Google of Russia") and the recent IPO of LinkedIn have all drawn investors attention back to the technology sector with a focus on social media companies. Taking a closer look at Renren, the company had surged 28.64% on its first day of trading, only for it to have given up its gains and trade below its IPO price as investors got over the initial euphoria and earnings growth concerns resurfaced.

With such high demand by investors wanting to buy into the growth of social-networking and social media, supply although tight for now, has a few offerings in the pipeline. Companies believed to be on-track for listing soon in 2011 include the likes of Zynga (a gaming company specialising in mobile games reportedly planning a listing which would make it the second largest gaming company by market capitalisation) and Pandora (a music streaming site) while the darling of social networks, Facebook, is expected to list only in 2012 or later.

With huge amounts expected to be raised by many of these start-ups, worries have resurfaced that markets have gone into a frenetic frenzy, throwing away the notion of valuations and are focusing purely on the growth story as told by these start-ups.

Peeling back the curtain, it is clear that the current tech/social media and networking companies are different from the internet start-ups of 1999. Presently, markets have attached some valuation measures to the current companies and not just on metrics such as "page time, screen time", paying attention to the actual business model and revenues behind the idea and not gazing only with longing eyes at the growth story painted. For example, Zynga reportedly earned USD 850million worth of revenue in 2010.

IRRATIONAL EXUBERANCE & VIRTUAL VALUATIONS

The newly minted companies have seen their stock prices sky rocket past the stars. With LinkedIn surging by 96.27% to USD 88.32 (as of 27 May 2011), it seems like IPOs of social media and networking sites are the modern day gold rush. Like everything else, all good things must come to an end. The fall in share price of Renren to levels below its IPO price presents a stark reminder to investors of what are essentially still start-up companies, with growth potential but with many potential pitfalls as well.

Linking it back to LinkedIn, the skyrocketing of its stock price saw its P/E follow suit. With a trailing 12 month Earnings Per share of only USD 0.070, the trailing 12 month P/E of the company as of 27 May 2011 was 1261.71x. The exorbitant P/E ratio of LinkedIn is based on a dearth of supply of web 2.0 IPOs as investors chase the story that is all the rage today.

If one were to bring down LinkedIn’s P/E to that of the MSCI AC World Information Technology Index’s estimated P/E of 13.0 (as of 27 May 2011), it would require LinkedIn’s earnings to grow approximately 97 times its current value, a mind boggling figure by all accounts. Assuming one gives LinkedIn a 5 year period to grow its earnings such that its P/E ratio is that of the MSCI AC World Information Technology Index, the company would need to grow at a compounded annual growth rate of 149.69%! Given the unlikelihood and unsustainable nature of such phenomenal growth, it might seem fair to say that the implied earnings growth given the P/E is too aggressive. (source:fundsupermart.com.my)