- The dot.com bubble crashed in March 2000 because investing fundamentals weren't followed and high valuations were given to companies with little revenue and no profit.
- Today, tech companies are giving extremely high valuations to companies with little to no revenue generation and no profits in the foreseeable future.
- The only people to make money during a bubble are those with no emotional attachments that recognize the market is nearing a peak and can sell to recognize their profit.
"Those who don't know history are bound to repeat it."
Looking back at the dot.com bubble created in the late 90s, it's almost comical how irrational exuberance took hold and led to insane valuations of internet companies that had zero profit and little revenue to speak of at the time. The digital age was in its infancy and investors thought the sky was the limit for internet shopping sites and internet technology firms. Seemingly overnight, companies with no profit but had good "ideas" were given multi-million and billion dollar valuations. When reality began to set in that the growth over profit model wasn't going to work, the NASDAQ crashed from over 5000 to below 1500. Dozens of stocks that had multi-billion dollar valuations disappeared in just a few months.
Dot.com era acquisitions and IPOs
There is no shortage of dot.com era acquisitions and IPOs that make you shake your head looking back 15 years later. Billions of dollars were lost because investors got swept up in a massive run-up in stock price and ignored common sense investing fundamentals. Yahoo (NASDAQ:YHOO) was one company in particular that lost billions due to acquiring companies at insane valuations. Yahoo's first major acquisition was in January 1999 when they bought GeoCities for $3.6 billion. At the time, GeoCities was a fast growing website community which allowed users to create their own homepage on the internet. GeoCities was the third most visited site on the internet behind AOL and Yahoo, with 19 million unique visitors in December 1998 alone. Ten years later Yahoo closed GeoCities in 2009. Another infamous Yahoo acquisition was a $5 billion buyout of an internet audio and video streaming company, Broadcast.com. Today, Broadcast.com is probably only known to trivia buffs and Dallas Maverick fans. This was the company that made Mark Cuban an instant billionaire. Today, Broadcast.com doesn't exist and is a distant memory to everyone but the person who made money off of it, Mark Cuban. Multi-billion dollar acquisitions that made sense for Yahoo at the time are now distant memories that add no value to the company.
The IPO that seems to be the classic case study for the dot.com bubble is Pets.com. The company raised millions of dollars through venture funding, including a 54% stake from Amazon. The company was recognized nationally as the place to go to buy pet supplies and even ran a Super Bowl commercial in January 2000, with its slogan "Because pets can't drive." The company went public in February 2000 and 268 days later the company went bankrupt. During its first fiscal year (Feb.-Dec. 1999), the company earned just over $600,000, but spent over $11 million on advertising. The company fell right into the investing motto of the time, growth over profit.
Similarities in today's market
There have been no shortages of IPOs and acquisitions in the past 12-18 months that have remarkable resemblance to the dot.com era. Companies like Facebook (NASDAQ:FB), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Yahoo and Amazon (NASDAQ:AMZN) are buying out rapidly growing companies in the hope to hit the jackpot. These companies are paying hundreds of millions, even tens of billions of dollars, to acquire mobile apps and social networks. Many of the companies that are being bought out have millions of users, but no clear path to revenue growth let alone profits in the near future. Again, we see the investing motto growth over profits. At the same time, there has been a wave of IPOs from social media websites and app makers, which have raised billions of dollars for companies with little to zero profit. Does any of this ring a bell?
The return of insane valuations
Market Cap ($ B)
2014 Net Income ($ M)
Fwd. 12 month P/E
There are no shortages of jaw dropping valuations in today's market. Yelp, LinkedIn, Twitter and Zynga are just the tip of the iceberg when it comes to ridiculous valuations that are completely unsustainable. LinkedIn and Twitter have a combined market cap of nearly $60 billion dollar, but have lost a combined $291 million so far in 2014. Even in the best case scenario that these 4 companies become profitable over the next 12 months, their valuations are still through the roof and completely out of sync with the general market. Analysts and investors have high hopes for these 4 companies, but even if they meet analysts' expectation for the next 4 quarters, their P/E will still be in the triple digits. Investors are again getting caught up in the growth over profit mindset. These companies all have grand schemes to one day monetize their user base, but thus far have nothing to show for it. It doesn't mean these aren't great companies, it just needs to be understood that high flying valuations rarely pan out and if they hit a few bumps in the road, the fall can be painful.
Another interesting industry emerging is the video game developers for mobile games on smartphones. Zynga made the famous Farmville, King Digital Entertainment (NYSE:KING) created Candy Crush, and Glu Mobile (NASDAQ:GLUU) developed a Kim Kardashian game. Glu Mobile has a half a billion dollar market cap based on a mobile game for Kim Kardashian. If you look back ten years from now, I'd say it's fairly certain a company with the majority of its revenue coming from a Kim Kardashian video game is a shake your head and laugh moment. These three companies have a combined market cap around $7.5 billion. The barriers to entry are minimal in this space and end users are extremely fickle. While a company may score a big win with the next Angry Birds or Candy Crush, anyone can come along and create the next big hit, such as Flappy Bird. The low barriers to entry, lack of sustainable long-term product revenue and high valuations are again reminiscent of the late 1990s market.
I started writing this article because of all the incredibly high valuations tech companies have been handing over to popular yet unprofitable start-ups. Again, there have been no shortages of insane valuations of companies that haven't even begun to produce any significant revenue, let alone profit. From Yahoo paying $1.1 billion for the blogging site, Tumblr, to Amazon paying $1 billion for Twitch, to Facebook paying $715 million for Instagram, tech companies are seemingly writing blank checks to popular website and app developers. Facebook agreed to pay $1 billion for Instagram, but it was reduced to $715 million because Facebook's stock dropped before the deal was finalized. Facebook was willing to pay $1 billion for a company that generated $0 in revenue over 2 years. Amazon recently paid an estimated $1 billion for a website that allows users to upload themselves playing video games. $1 billion was spent to watch other people play video games. Yahoo paid $1.1 billion for a blogging site that has 300 million monthly users and said it "promises not to screw it up". These deals give the 3 companies great, new, exciting assets, but not one of them is set-up to monetize users. Again, we see the investing motto of growth over profits. The problem isn't how these companies will monetize these sites; it's what users will do when a bunch of ads start popping up or the next big thing draws users to a new and more exciting site. It happened in the dot.com bubble and it can easily happen again. The barriers to entry are so small in this industry that virtually anyone can develop a new site that makes Tumblr, Instagram or Twitch irrelevant in a very short period of time. GeoCities, Broadcast.com, AOL and MySpace are just a few examples that were hugely popular during the late 90s but are now basically non-existent. While these may sound like expensive acquisitions, they are nothing compared to Facebook's most recent acquisition of WhatsApp for $19 billion.
WhatsApp is a cross-platform mobile messaging app which allows you to exchange messages without having to pay for SMS. WhatsApp Messenger is available for iPhone, BlackBerry, Android, Windows Phone and Nokia. It uses the same internet data plan that you use for email and web browsing, so there is no cost to message friends. However, the company charges a $1 download fee and doesn't sell ads. In fact, on their homepage website it says why they don't sell ads.
"Brian and I spent a combined 20 years at Yahoo! working hard to keep the site working. And yes, working hard to sell ads, because that's what Yahoo! did. It gathered data and it served pages and it sold ads. We watched Yahoo! get eclipsed in size by Google..."
WhatsApp refuses to sell ads, so there is one revenue stream that's lost. It is free to users, which is why 450 million people have downloaded the app. It generates a one-off revenue fee of $0.99 on iOS and $0.99 a year on other platforms with the first year free. During Facebook's conference call, Mark Zuckerberg said he isn't looking to drive revenue from WhatsApp in the near term, instead focusing on growth. Once WhatsApp reaches 1 billion users, then Zuckerberg plans to start monetizing. Once again, we see the infamous growth over profits investing strategy. In his comments, Zuckerberg stated,
"With WhatsApp it's about the strategic value of what we can do together. I think by it, it's worth $19bn even if it doesn't have the revenue to show for it - but it has the reach. I could be wrong - this could be the one service that gets to one billion people and ends up not being that valuable - but I don't think I'm wrong."
When you spend $19 billion on an unproved revenue generator, you can't afford to be wrong.
To put WhatsApp's valuation into perspective, I'd like to compare it to other famous companies. At a $19 billion valuation, the company is worth more than Under Armour (NYSE:UA), Whole Foods (NASDAQ:WFM), Chesapeake Energy (NYSE:CHK), Seadrill (NYSE:SDRL), Murphy Oil (NYSE:MUR), Red Hat (NYSE:RHT), O'Reilly Automotive (NASDAQ:ORLY), Intuitive Surgical (NASDAQ:ISRG), AmerisourceBergen (NYSE:ABC), KKR & Co (NYSE:KKR) and is roughly the same size as Cerner Corp. (NASDAQ:CERN), Ventas (NYSE:VTR), Dollar General (NYSE:DG), Wynn Resorts (NASDAQ:WYNN), Sony (NYSE:SNE) and Alcoa (NYSE:AA), just to name a few. These are massive, internationally recognized brands with established customers, tremendous revenue, huge balance sheets and real profits. I'm not trying to say WhatsApp will be a failure, but there is a fundamental problem when a company pays $19 billion for a company that they don't know if they can effectively monetize. While Mark Zuckerberg is exponentially smarter than me, one of these views will be proven wrong in the next 5 years, but at least I won't lose $19 billion if I'm wrong.
Pinterest and Snapchat are the next 2 companies that are receiving insane valuations. Pinterest is being valued at roughly $5 billion, yet has no revenue model, and Snapchat recently refused a $3 billion buyout from Facebook despite having 0 revenue generation. Most recently, it was reported that Snapchat is being valued at $10 billion based on its latest round of funding. These new valuations of WhatsApp, Pinterest and Snapchat actually make Instagram, Tumblr and Twitch look like steals. However, this is worrisome that investors are again being blinded by growth over profits. The exact fundamental investing flaw that started the dot.com bubble is happening again and no one seems to notice.
Looking back at the dot.com bubble it seems like common sense why the market was decimated. When you look at today's market, it's getting to the same point where investors are throwing fundamentals out the window. A company that hasn't generated revenue in an industry with low barriers to entry and no profits, but is given an extremely high valuation, was the exact reason the NASDAQ crashed in March 2000. The only people who made money in the dot.com bubble were the investors who recognized the warning signs and sold at the top of the market. People who held onto stocks because of emotional attachments lost everything. These high valuations don't mean the entire market will crash, but when there is a pull-back or a sharp correction the growth momentum stocks like the ones mentioned above will far hard back to earth. Investors in Yelp, Twitter, LinkedIn and similar stocks have likely made pretty good profits. At the very least, these investors should cash out their initial investment and let the rest ride. The only people who benefited during the dot.com bubble were investors who recognized they had decent profits and cashed them in. Mark Cuban bought the Dallas Mavericks because he was smart enough to sell high. Others lost everything but a subscription to Pets.com.