Valuations On High-Flying Internet Related Stocks Continue To Race Upward

Oct.20.13 | About: Facebook (FB)

This post rides piggyback on a recent Seeking Alpha Market Current quoting concerns from Art Cashin (formerly featured on CNBC) regarding "a bubble in cloud/mobile tech names" and is a follow-up from an early September post I wrote titled "Valuation Update: Internet High-Fliers Experience Large Mark-Ups."

The reference to valuations caught my attention because I have done periodic posts showing the relative rankings of various internet-related names using the price-to-sales ratio. I do not use price-to-earnings because some of the companies do not have positive earnings. Price-to-book is slippery given most of these companies have their strength in intellectual and virtual capital that does not get accounted well in book valuations. A snippet from the SA Market Current:

"'I do worry a little bit that we're beginning to hear things that are reminiscent of the 1999-2000 period-the number of hits, the number of eyeballs,' says UBS' Art Cashin, suggesting a new tech bubble is afoot.

Cashin doesn't claim all tech names are taking part - many large-caps still go for less than 15x trailing EPS and 3x sales - just some of those with strong cloud and/or mobile exposure. 'We're beginning to see a case of old tech/new tech.'"

At some point I should create a tracker for mobile and/or cloud-based tech names, but for now, I just have this tracker for internet-based names. Most of these companies have mobile components and some have cloud-based businesses. I created the tracker to keep tabs on the multiples the market is willing to pay for some of the more speculative names in the high-tech space. I also wanted to get a sense of the potential over-valuation of the hotter and newer names related to the more "mature" internet companies. My assumption is that all valuations will eventually converge toward the middle of the range (or lower) - whether through maturing business models, reality bringing multiples down to earth, and/or growing into a lofty valuation over time.

I now have 17 months of data collected from Yahoo!Finance. On the x-axis are the various companies. The legend for the tickers is posted below the chart. On the y-axis is the price-to-sales ratio taken from Yahoo!Finance. The different color-coded bars represent various checkpoints where I updated the data. The checkpoints are a bit random (unfortunately), but they do show which companies continue to streak higher, which ones are losing favor, and which ones are so mature they simply stay put.

Price-to-Sales Ratios of Various Internet-Related Companies From March 6, 2012 to Oct 18, 2013Click to enlarge

Price-to-Sales Ratios of Various Internet-Related Companies From March 6, 2012 to Oct 18, 2013

Key to ticker symbols: AMZN (Amazon), ANGI (Angie's List), AOL (NYSE:AOL), EBAY (eBAY), FB (Facebook), GOOG (Google), GRPN (Groupon), LNKD (LinkedIn), LOV (Spark Networks), MEET (MeetMe), MM (Milennial Media), MSFT (Microsoft), MWW (Monster), OPEN (Open Table), P (Pandora), PCLN (priceline.com), SCOR (Comscore), SFLY (Shutterfly), TRIP (TripAdvisor), VELT (VELT), YELP (NYSE:YELP), YHOO (Yahoo), Z (Zillow), ZNGA (Zynga)

Google just reported earnings that the market loved, resulting in a spectacular 14% pop above the $1000 barrier. Note how this move simply keeps GOOG running in place versus its P/S ratio (I wish I had used this to bet on a positive upside for the stock!). Yelp has retaken the top spot from Zillow while LinkedIn holds onto its #2 spot. You can see how expectations continue to race ahead for many of the high-valued companies including Pandora, Facebook, and YELP. Overall, you can see that high valuations are not new for the high-fliers in the internet-space although 2013 has delivered ever higher valuations for these names.

A special note on FB since I laid out a trading strategy after its post-earnings pop in July. From that post on July 31, 2013:

"In my last T2108 Update, I discussed my FB trading strategy. Soon after that, I changed course. I realized that the best way to play an eventual reversal is not to wait patiently for a good entry and buy puts just in case FB falls before I set up my position. Instead, I need to build up a short position and buy call options as hedges.

I did just that on Tuesday buy shorting a few shares and buying a few September $40 call options. Much to my surprise, FB shot up shortly thereafter and by today's open, my FB calls were already closed out for a 150% gain (I wish I had bought more!). Today's fade on FB after perfectly hitting the IPO price of $38 is suggestive, but the rally may be far from over. FB is capturing imaginations again, and analysts are rapidly upgrading the stock and hiking up revenue and earnings expectations. I will have more to say about this in a separate post. Suffice to say that when dreams expand, the courage increases to try buying high and selling even higher."

Almost three months later after slowly building up a short position and many turns of buying and selling call options, I have to say that being an unabashed bull would have clearly been the better angle. Instead, all the money made on the call options is just keeping pace with the losses on the short position. Moreover, FB has not provided as many dips as I expected along the way up. This dynamic means that I have not been as aggressive with the call-buying as I expected at the beginning of this trading strategy; I have bought smaller positions in anticipation of or in case of further downside from the dip. I continue to think FB's call options are relatively cheap given the persistent and steady march upwards; a strong trend supported by firmly bullish sentiment, analyst excitement, and very positive news flow - everything a speculator and momentum player wants to see.

GOOG's earnings pop sent FB jumping to a fresh all-time high at $54.22. I sold my last bundle of call options into that pop for yet another fantastic return (once again making me wistfully think about the possibilities of being a FB bull again). The last dip came thanks to a sudden burst of pessimism from the U.S. government's wrangling over the budget and was a classic exhaustion of bearish angst. Accordingly, I was more aggressive than I have been to-date but still not aggressive enough in loading up on call options.

FB earnings are coming up October 30th, and I fully expect the stock to have plenty of heft running into those earnings. Any analysts who have yet to raise targets and ratings will likely rush to do so ahead of those earnings to avoid getting caught behind the curve. According to Schaeffer's Investment Research there are only three more stubborn analysts left who need to get on board the train and upgrade from hold to a buy or strong buy. The market has generally obliged these analyst upgrades with more fuel for the stock. Given 24 of the 27 bullish analysts are already at "strong buy," most of the remaining fuel will have to come from ever higher price targets and more upwardly mobile valuation tolerances.

I think playing options that expire AHEAD of earnings (October 25th vintage) are a sufficient way to play the remaining pre-earnings run-up - best bought on dips of course. Buying call options expiring after earnings will just cost unnecessary premium in extra implied volatility and increase the risk side of the trade. I hope to do an update on the potential earnings play in the days preceding earnings. At that time, I will probably add a little more to the short position and buy November and/or December call spreads.

Click to enlarge

From dog to run-away momentum-filled rocket: FB has gained 56% POST July earnings

Finally, a quick note on Groupon (NASDAQ:GRPN). After spending most of 2012 being extremely bearish on GRPN, in early December, 2012, I made GRPN a key "January effect" stock in the face of a steep sell-off that sent the stock to all-time lows. The stock looked like it was on its deathbed, but the company's valuation had also become dirt cheap: a pretty good combination for betting on the January-effect that tends to lift many stocks that large institutions are forced to dump and abandon before year-end. By the time I wrote, GRPN had already made an impressive recovery off all-time lows. Fortunately a small dip immediately followed that post which provided a decent entry point. Because of my short-term call, I sold after the New Year's bells rang.

Since then, I have watched GRPN slowly grind higher all year. GRPN's valuation remains at the lower-end of the internet family. I am long overdue to review the company again. When I do, I strongly suspect I will be pleasantly surprised (correct me now if needed!). In the meantime, momentum is strong with the 20-day and 50-day moving averages (DMAs) gently guiding the stock ever higher.

Click to enlarge

A sustained recovery year for Groupon, a former dog of the internet stock club

Source for charts: FreeStockCharts.com

Be careful out there!

Disclosure: I am long YHOO, MM, ZNGA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am also short FB, long puts on P