Let's play a game: I'll paint a landscape of the market for you, and you'll tell me what year it is.
The bull market's been running strong for years. A constant stream of new money pushes it higher year after year. The strength of the rally is broad, but a select few stocks - the stocks of hot, new, internet based companies - have racked up astronomical gains with anorexic earnings, sporting valuations that get thinner by the hour.
So what year are we in? If you guessed 1999, you'd be right. And if you guessed 2013, you'd also be right.
The good news is that this time around, the bubble stocks are fewer and farther between, leaving the bull in better health than it was at the turn of the millennium. And although the new tech bubble is unlikely to wake the bear when it pops, it can certainly ruin your portfolio if you're unfortunate enough to own the bubble stocks when they deflate.
Here are two red hot tech stocks doomed to repeat their family history. And one that's walking the fine line between success and failure.
Salesforce.com (CRM) hasn't had the kind of monster run this year that many would characterize of a "bubble" stock, but it's overvalued and dangerous to your portfolio regardless.
Despite bringing in $3.05 billion in revenue for FY 2013 - an impressive 35% increase year over year - the company also increased its net loss by 2,500%, losing $270 million.
So how, you ask, does the dominant player in cloud-based sales, service, and marketing manage to grow revenue by 35% and still not turn a profit? How does a company that helped pioneer the very concept of using cloud-based enterprise software, that is on the forefront of bringing enterprise applications to the mobile world, and whose products are used by such titans of industry as GE, Wells Fargo, and Time Warner lose money for its shareholders?
The answer can be expressed with just three words: stock based compensation.
In fact, if you read or listened to the company's latest earnings conference call, you'd probably be surprised to learn that the company wasn't profitable last year. That's because the call only referenced the company's non-GAAP (Generally Accepted Accounting Practices) numbers, numbers that conveniently exclude such things as the costs of stock awarded to employees and executives, and according to which the company actually made a profit of $238 million for the year.
To be fair, there are other costs that the non-GAAP numbers exclude, but by far the largest was the $379 million in stock based compensation.
And to make matters worse, the company's FY 2014 guidance promises more of the same, with a 25 - 27% increase in revenue creating non-GAAP earnings of $288 million, but with stock based compensation of $503 million creating a net loss for the year.
There's nothing wrong with stock based compensation as a practice, but if the cost of awarding stock options to employees drags the company into three consecutive years of operating at a loss, then it seems like the only shareholders that management values are themselves.
Coupled with the fact that even if the company were to spontaneously eliminate the compensation, amortization, and interest expenses responsible for the discrepancies between the GAAP and non-GAAP figures it would still trade at 107 times this year's earnings and 88 times next year's guided earnings, Salesforce.com is not the kind of company I want to own.
At the end of the day, profit what matters most. And the management at Salesforce.com seems determined to avoid it at all costs.
As a stock, LinkedIn (LNKD) has come a long way in a short amount of time, with most of its gains occurring in just the past month. This is good news if you owned LinkedIn before its breakout, but bad news if you bought it afterwards.
More so than any other stock in this article, LinkedIn embodies the spirit of dot-com mania that possessed the market in the late 90's. It's a website with over 200 million users, and as a result of its business and professional networking focused platform, more than a few of those 200 million users also own stocks. It seems to have limitless potential, and since its product is something that so many market participants interact with on a daily basis, it seems like a no-brainer to own the stock.
But unfortunately, the problem is that only a tiny fraction of those 200 million users actually provide any revenue for the company, as evidenced by the fact that the stock currently trades at over 900 times earnings.
The cheapest paid subscription to the site costs $25 per month, or $75 per fiscal quarter for the purposes of my example. The company attributed roughly $60 million in revenue last quarter to the sales of its paid subscriptions. With these figures and a little back of the envelope math, we can deduce that only 800,000 users paid for premium subscriptions, or less than half of a percent of its user base.
And therein lies the problem. LinkedIn has other sources of revenue and paid subscriptions account for only 20% of its business, but at its core it provides a service that everyone wants to use and no one wants to pay for. And that's not the recipe for the kind of hyper-growth necessary to justify its grotesque valuation.
Consider the following: assuming that its share price stays static at $175, if the company doubled its profits five years in a row, it would still trade at over 50 times earnings by 2017. Even that's rich for a growth stock, and that's assuming a Herculean effort of business acumen on the part of the company's management.
Of course, none of this is the fault of LinkedIn itself. The company doesn't determine the price of its shares, we do. And right now, buyers of LinkedIn are euphoric about its future prospects, dooming the stock to the fate of so many tech darlings before it: the euphoria will last until the company fails to deliver on a quarter, only to be replaced with despair as investors watch their gains melt away or swing into losses.
To clarify, there's nothing wrong with LinkedIn as a company. It's the only player in its space and it makes a fine product, but right now the margins are slim (roughly 2% net profit) and the expectations are too high. If you're determined to own a piece of it, wait for it to come down significantly.
If you can't do that, then don't buy it at all.
Otherwise, you're chasing gains and almost certainly guaranteeing yourself a loss in the process.
Netflix (NFLX) is an interesting case because it's already had at least one meltdown. But that was back in 2011, and the stock has been on a tear lately.
The odd thing about Netflix though is that despite its valuation of 640 times earnings, it has - in my opinion - the best shot of all the overvalued shooting stars of today's market at living up to its valuation.
The company grew its paid streaming subscriber base almost 40% year over year, and makes a gross profit of about $888 million from its domestic streaming and DVD delivery service. Less the total operating expenses, taxes, and miscellaneous expenditures, that would leave Reed Hastings's company with a net profit of $406 million, earnings of $7.25 per share, and a stock that trades at a reasonable 25 times earnings.
So why did Netflix only put up earnings of $0.29 per share last year?
Because the company expanded too aggressively into international markets; it lost $389 million through its international streaming service last year, offsetting 95% of the company's handsome profits from its domestic counterpart in the process.
So Netflix is at a pivot point. It's stopped expanding its overseas operations, and hopes that the international subscriber base will grow, bringing in new revenue to offset the alarming costs and competition it's facing in its international markets.
I don't know if the international segment of the company will turn around or not, but I do know that if it doesn't start to pick up it will bleed the earnings quarter after quarter until Netflix either ceases international service (a decision which would return it to greater profitability quite quickly) or collapses under its own weight as it struggles to support a failed expansion bid.
All three of these stocks represent companies that make products many market participants use and rely on everyday. That's why, despite their thin (or even nonexistent) earnings, they sport fat valuations: the buyers are "investing in companies they know" without regard for the fundamentals behind those companies' stocks.
And in the midst of a strong bull run, these insanely expensive stocks may well continue to get more expensive. That's what makes them so dangerous: very few people get out at the top of a bubble.
So rather than rolling the dice and hoping that this time is different and these companies really can't be valued with standard metrics, the best way to win with these stocks is just not to play with them at all.
You could try to short them. But you'd better have a high tolerance for pain and a lot of wiggle room between you and a margin call if you think you can out-crazy the euphoric masses.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.