Written by Adrian Saville
The initial public offering market has rebounded sharply in 2011, with May 2011 the busiest month for tech IPOs since 2000. In the 2011 first half, $22 billion in capital was raised in the U.S. equity market, with an average value in excess of $2 billion per deal, putting the market on track to match 2007’s towering value of $54 billion.
Without question, LinkedIn has captured the most attention, with its share price rocketing from $45 to $122 on the first day of listing, giving the seven-year-old social networking company a market capitalization of $7.7 billion on the first day of trade.
A few days later, the Moscow-based web search company Yandex listed on the Nasdaq at $25 a share, with the price soaring 55% to close the first day at over $38. The stock price subsequently settled at $30, giving a market capitalization of $9.5 billion. Interest in the company is fueled by the fact that Yandex has almost triple Google’s market share in Russia where online advertising climbed 51% from 2008 to end-2010; and it is anticipated that Russia’s internet industry may account for 3.7% of the country’s GDP by 2015, more than double the level of 2009.
The flurry of IPO market activity in the first half also included the listing of the Chinese social networking business Renren on the New York Stock Exchange at $14 a share, translating into a $5 billion market cap. Strong arguments also have been made for investing in Renren, which has similarities to Facebook. The company has 31 million active monthly users, compared to Facebook’s eye-popping 500 million active monthly users, underlining its massive growth potential. Moreover, only 38% of Chinese Internet users visit social networking sites, compared to 81% of U.S. internet users.
Fueled by hype
The compelling arguments for these businesses have resulted in strong demand for “quality social-networking plays”, which are in short supply. Nick Train, manager of the Finsbury Growth and Income Trust, asserts that we are "years away … from the mania phase of any bubble” and that there are still “great money-making opportunities in technology, particularly, the Internet”. Train emphasizes that “we are at only an early stage of another boom, as digital and online technology is applied in previously unimaginable ways to both corporate and personal affairs”.
This type of enthusiasm is likely to fuel robust demand and support high valuations for other social-networking businesses, including Zynga, Twitter, Facebook and Groupon.
Some investors argue that traditional valuation measures may not apply to social networking and other high-profile internet companies. PriceWaterhouseCoopers opines that conventional valuation methods, such as price-earnings multiples, are flawed when used for social media firms. Instead, the firm points to a “value per user” approach, which is based on the assumption that a customer base can be monetized. Because many social media companies prioritize growth over earnings, analysts argue that a lack of earnings means an earnings ratio may be a misleading gauge of value.
But investors should not forget that newfangled valuation techniques, such as the “eye-balls-per-screen” multiple that was widely applied during the late-1990s’ dot-com bubble, are quickly shown to be baseless when it comes to the crunch. Time and again we see that while prices can run a long way ahead of value during exuberant periods, ultimately it is the asset base and profitability of a company that matter. Intangible assets are extremely vulnerable to debasement and “special case” valuation methods are prone to embarrassment.
Just as problematic as alternative valuation measures are alternative accounting metrics. Groupon is a prime candidate for the line-up, by devising a measure of profitability called “adjusted consolidated segment operating income." Adjusted CSOI ignores the cost of stock-based compensation and online marketing.
By manipulating (yes, manipulating) its financial reports in this way, the business was able to report adjusted CSOI of $60 million in 2010 and $81 million in the first quarter of 2011. But ignoring marketing expenses is laughable. As John Gapper observes in the Financial Times, “it is like counting the revenues from subscriber growth while ignoring the costs”.
The best way to turn a great business into a bad investment is to overpay for it
Cynicism aside, and despite the bright prospects for social networking businesses, the currently-popular investment arguments seem to overlook a key principle of investing: the best way to turn a great business into a bad investment is to overpay. On this count, the valuations that have been applied to the recent technology IPOs are almost impossible to explain or support.
For example, China’s Renren, with a $3.0 billion market cap, is valued at the equivalent of 35 times revenue (having been as high as 65 times revenue in May 2011), versus the industry average of 3.5 times. While revenue is growing extremely quickly, the company is losing money, pays no dividend and has no book value to speak of. In the case of Yandex, the market cap is a less demanding 18 times sales. However, the company’s earnings base is wafer thin, translating into a price-earnings multiple of 60 times last years’ earnings. LinkedIn is just as intriguing. At a market cap of $7.7 billion, the company is trading at more than 20 times its past twelve months’ sales and almost 500 times last year’s profits (having been as high as 1,200 times not that long ago.)
By contrast, Google trades at five times sales, 18 times earnings and 3.5 times book value per share. Although not necessarily a screaming bargain, relative to LinkedIn, Yandex and Renren, Google looks drop-dead gorgeous.
Could this time be different?
It would be naïve to suggest that the spectacular growth implied by current valuation multiples cannot happen. It can, and there are many examples of staggering company growth where valuation multiples that, at some point appeared outrageous, were later justified by history-making business successes. It is possible the valuations are justified is not the right question - investors should be asking if it likely that the stocks can grow into their valuations.
The answer has to be a resounding no, which means that the valuation multiples being applied do not belong to the world of intelligent or common-sense investing, but rather to a world of outrageous speculation and absurd optimism.
These may well be the world-class businesses of tomorrow, but they are not world-class investments. For that, we need to look elsewhere, for example, Intel.
It’s not on top … it’s inside
Established in 1968 as Integrated Electronics Corp., Intel’s is the world’s largest semiconductor chip maker. Despite its size and unexciting, middle-aged stature, Intel is an exceptionally well-run business that boasts a strong balance sheet, is highly profitable, has good prospects and is valued on compelling multiples. Through the cycle, Intel’s return on equity is about 25% and return on assets is about 15%. This is a good business, but what of its valuation?
Intel trades at 2.2 times its revenue of $48 billion and nine times its bottom line profit of $12.3 billion. These are undemanding multiples for a high-quality business. Moreover, the company has $12 billion in cash on its balance sheet, after spending some $2 billion buying back its own shares. So, on top of being a great business, the company is compellingly priced, making it a great investment.
The bubble is in emerging markets, too
Internet companies from emerging markets are stimulating just as much attention from investors. If anything, this means that the extreme pricing of these companies should be of greater concern to global investors because of the elevated threats of contagion and spill-over risk.
Inefficient pricing is even evident in the South African technology cluster. Consider, for instance, the media and technology business Naspers.
Naspers is a superb business with an enviable track record, strong management and a desirable portfolio of underlying businesses including Tencent Holdings’ QQ platform; Mail.ru in Russia; 2.4% of Facebook; 1.5% of Zynga; and just over 5% of Groupon. But Naspers and its underlying investments are richly priced. Tencent Holdings has a P/E of 40x and a price-book multiple of 15x while Mail.ru is priced at a similar 40x earnings. Naspers itself is valued at 30x last year’s earnings and, while the price/book ratio appears reasonably sober at a little more than 4x, the book value of the business is essentially represented by intangible assets. Naspers may be a great business with exceptional prospects, but it is already priced that way.
The bottom line … in a little over 140 characters
There is no mistake that the potential in social networking businesses is huge, especially if the companies get traction. But the recently-listed technology IPOs appear priced for infinity and beyond, just as during the 1990s dotcom bubble when the now-dull Intel achieved a peak price-earnings multiple of 100 times. The valuation multiples that have been applied to the social networking IPOs are outlandish.
The question is not whether or not there is a social networking IPO bubble, but rather will the bubble burst sooner rather than later.
Adrian Saville is chief investment manager of Cannon Asset Management, a money management firm based in Johannesburg, South Africa.