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As summer temperatures continue to rise, the stock market continues to push through earnings season. One of the hottest sectors this time around is the social media space. A number of better than expected reports from these names have pushed these stocks sharply higher in a short period of time. Many of these names have become overheated, and it seems like a giant bubble is forming. Today, I'll analyze the space, look at some company growth profiles, examine valuations, and determine what investors should do.

Today's group / an important distinction:

There are seven names I will discuss today in the social media space, and they include Facebook (FB), LinkedIn (LNKD), Zillow (Z), Trulia (TRLA), Yelp (YELP), Groupon (GRPN), and Pandora (P). I also want to look at how these names stack up against technology industry giants, mainly Apple (AAPL) and Google (GOOG), two companies who certainly are not strangers to growth.

Before I get into the bulk of this article, there is one item I must discuss. For the social media names, almost all of them (Yelp is the only exception I believe) will have earnings per share numbers that are non-GAAP. What does this mean? Well, GAAP numbers are the actual financial numbers you will see in a 10-Q or 10-K filing. Many of these companies provide non-GAAP numbers, which exclude share-based compensation and some other adjustments in certain cases. Analyst estimates are usually based on the non-GAAP numbers. Non-GAAP numbers are generally going to be higher, making these companies either look more profitable than they really are, or profitable when they really are losing money. Even Google, a name I'll discuss today, has a variety of GAAP and non-GAAP numbers, so I will state which numbers I am using when. But the key takeaway for investors is that when you see a given level of earnings per share for these names, please realize that they are non-GAAP numbers. A good example is Facebook, which had non-GAAP Q2 income of $488 million ($0.19 per share), but GAAP net income of $333 million ($0.13 per share).

Some recent earnings reports:

I mentioned in my intro that some of these names have reported earnings already. Facebook is obviously the biggest name in this space, and it recently reported second quarter results. Revenues of $1.81 billion beat by almost $200 million, and non-GAAP earnings per share of $0.19 beat by a nickel. This was a complete blowout, and Facebook shares rallied $7.85, or 29.6% on the news. Facebook shares have rallied even more since then, closing above their $38 IPO price on Friday. Facebook is up 43.5% since reporting earnings.

LinkedIn, the second biggest name in this group, just reported their second quarter a few days ago. Revenues of $363.7 million beat by almost $10 million, and non-GAAP earnings per share of $0.38 beat by seven cents. LinkedIn is a great example of the difference between GAAP and non-GAAP results, as GAAP earnings per share were just $0.03. The company also handed in a Q3 and full year revenue forecast that was weaker than expected. However, that did not stop shares from rising 10.6% to a new all-time high on Friday.

Shares of Trulia also raced to a new high after the company reported its second quarter results. Revenues of $29.7 million beat by about $2 million, the five cent non-GAAP profit beat by a penny, and the company's Q3 revenue forecast beat expectations. Trulia shares raced higher by 19.5% on the news, which also sent shares of fellow site Zillow rocketing to a new high as well.

Yelp also announced second quarter results this past week. Revenues of $55 million beat by almost $2 million, and the penny loss beat by three cents. The company also handed in a revenue forecast that was above its previous guidance and analyst expectations. In the two days of trading since their report, shares are up 36.4%, and that includes the more than $2 pullback we saw from Friday's high.

You may have noticed a pattern there. All of these names have beaten estimates, with many issuing guidance that was above expectations. Does that mean that these companies are figuring out how to deliver solid revenues while keeping costs in check, or does that mean analysts have been too negative on the space? That's something that each investor will have to decide for themselves.

Recent performance statistics:

Many of these names have rallied strongly in recent weeks, even the names that have not reported their quarters just yet. The following table shows some basic statistics for each name. You'll notice that most are near their 52-week highs, and they all have performed extremely well this year.

(click to enlarge)

Five of the seven names have more than doubled this year, while two of the names have more than tripled. Zillow was included in my list of growth stocks to watch this year. When I did the mid-year update on those names, Zillow was up 102.88% for the first six months. It's now up more than 212% on the year. It's only been a month plus a few days, so Zillow has continued to sparkle. Zillow will report earnings this Tuesday, so will the rally hold? We'll find out soon.

Current growth expectations:

Many of these names are very early in their growth stages. Some of these names didn't even exist a decade ago, and many have only begun trading in the public market in recent years. The following table shows the currently expected growth for each name in terms of revenues and earnings per share, for their current fiscal year and next fiscal year. Again, when it comes to earnings per share, investors should always do their own due diligence on a name to see how a name calculates both its GAAP and non-GAAP numbers.

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*Zillow expected to swing from $0.38 profit in 2012 to $0.05 loss in 2013, then back to $0.54 profit in 2014. Trulia expected to swing from $0.70 loss in 2012 to $0.18 profit in 2013. Yelp expected to improve 2013 loss to $0.12 after a loss of $0.33 in 2012, and then swing to $0.25 profit in 2014. Pandora expected to swing from $0.08 loss in prior fiscal year (ending January 2013) to $0.04 profit in current fiscal year (ending January 2014).

Obviously, these names are going to show more growth than established names like Apple and Google. Apple is expected to grow revenues by 10.8% in this fiscal year, when adjusting for the extra week in the prior fiscal year. That growth is projected to fall into the single digits next year, although Apple is a victim of the law of large numbers. It's hard to grow revenues by 20% or 30% when your base is $170 billion. Google's revenue growth is projected to be in the high teens or maybe low 20s, percentage wise this year, with a bit less growth in its following year. Google also uses a complex GAAP/non-GAAP system for its revenues and earnings, which makes that name even harder to analyze.

Let's think about the potential growth another way. In its 2004 fiscal year, Apple had revenues of $8.28 billion, and Google's GAAP revenues were $3.19 billion in 2004. This fiscal year, Apple is expected to do just under $170 billion, and Google's GAAP estimate is $59.62 billion. As a comparison, Facebook is expected to do $7.28 billion, although that number might rise if Facebook continues to do well. What's my overall point? Well, it will be much clearer in the next section, but for now, think about this. What will Facebook's revenues be in 2022? Does anyone think they can get to $60 billion like Google, or $170 billion like Apple? Only time will tell.

Sky high valuations:

While growth is certainly important, what you are paying for that growth is even more important. For instance, all else being equal, which of these names would you rather hypothetically buy?

  • Company A is growing revenues and earnings at 10% this year, trades for 1.8 times expected sales at 15 times expected EPS.
  • Company B is growing revenues and earnings at 12% this year, trades for 2.8 times expected sales and 25 times expected EPS.

Company B provides 20% more growth on paper, but you are paying so much more for it. I would assume you would rather own company A. Again, this is a hypothetical example, but you get the overall point.

So the following table shows price to sales and price to earnings comparisons, when measurable, among the seven social media names. For the sales and earnings figures, I am using the current expectations by wall street analysts as of Sunday. Some of these estimates are likely to change in the coming days, as a number of these names reported earnings last week and more are about to report. Of course, the stock prices will certainly change too.

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How do these valuations stack up? Well, Apple currently trades for 2.48 times its current fiscal year revenue estimate, and 11.85 times earnings. Google currently trades for about 5.06 times its expected GAAP revenues this year, with a valuation even higher if you take out traffic acquisition costs and get a non-GAAP revenue figure. On an earnings per share front, Google trades for 20.82 times its expected non-GAAP earnings figure, and that would be even higher if you count GAAP earnings, which are lower like many of the social media names.

Just to highlight an example, Facebook is expected to do $7.28 billion in revenues this year and $9.43 billion next year. For Facebook to get down to Apple's price to sales valuation of 2.48, Facebook would need yearly revenues of $37 billion. How many years from now will that be? Yes, Facebook will be growing faster than Apple for a while, but you are paying a king's ransom for that growth. Don't forget, as executive option compensation adds to the share count, Facebook's market cap will continue to grow, even if the stock stays at the same price. Facebook's market cap of more than $92 billion is almost 1/3 that of Google's $302 billion. Google's revenues, even in 2014, are supposed to be more than 7 times that of Facebook.

Just look at the growth to valuation comparison between Groupon and the others. Groupon's revenues are expected to show the least growth, and the name's price to sales valuation is very low and actually below that of Apple. Sure, part of that has to do with the company's recent problems, but you get the point. Lower growth gets a lower valuation. Yelp is another interesting example. Despite Yelp shares rising from $19 to $57 so far this year, and a sky-high valuation, Jim Cramer thinks Apple should buy Yelp for $75.00. That would be one ridiculously high valuation multiple for a takeover.

What about short sellers?

A lot of times when these names have sharp rallies, many attribute the gains to short covering. Some of these names are heavily shorted, while others are not. The following table shows how many shares were short in these stocks (middle of July update from NASDAQ), along with data on the float and outstanding share count.

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*Taken from Yahoo! Finance.

You will notice that Facebook and LinkedIn actually have a very small percentage of shares short. In fact, the latest count on Facebook, at under 40 million, is less than the 50 million average daily volume over the past three months. So while there may have been some short covering after Facebook's earnings report, the short percentage was not that high to begin with.

It will be interesting to see how some of the recent earnings reports change short interest at the next few updates. The next short interest update will come towards the end of this week, so I'll report on what I am seeing the following Monday. You probably won't see too many changes due to earnings reports, as a lot of them came after the latest round was calculated. But I think you will see short interest come down for many of these names over the next few updates. A lot of these earnings reports have been strong.

Final Thoughts:

While some of these social media names have reported quarterly numbers that were better than analysts have expected, many of these stocks have run too far too fast. These names do provide a lot more growth opportunities than more established names like Google and Apple. However, you are paying a small fortune for that growth, so investors must choose wisely. A bubble certainly appears to be forming in many of these names, and you don't want to be the one that buys at the top. How soon this bubble will burst is a matter of opinion, but when it does, it won't be pretty. We've seen some of these names collapse before, and it wouldn't surprise me if we see it happen again in the near future.

Source: The Social Media Bubble Continues To Bloat

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.