Social Networking Bubble: The Skepticism Is Warranted

Includes: LNKD
by: Harm Diaconescu

After LinkedIn's roaring debut, with the company trading as high as $122 on the opening day, the stock seems to have settled down from the volatility which made it from a high-frequency trader delight into a more well-established price channel. P/E estimates hover into eye-popping, four-figure territory, and the near-term outlook remains negative.

Investment Underground posted a concise and well-reasoned article outlining some of the challenges the stock is facing and cautioned against short-term investment, but what's the broader IPO outlook in light of LinkedIn's opening gambit and immediate fall-out?

The first point to make is that LinkedIn's IPO was, as far as the company was concerned, an unmitigated success. After revising its original price range from $32 - $35 to $42 - $45 (Reuters) traders doubled-down, taking the company's estimated worth to about 7B. Other social networking outfits have taken notice from the low-float IPO and have immediately positioned themselves to take advantage of the enthusiasm (SeekingAlpha.) GroupOn, Zynga and Pandora have all made announcements.

But there's skepticism afoot: Roger Martin, the dean of the Rotman School of Management at the University of Toronto, outlined in the Washington Post, the absurd expectations baked into the current outlandish LinkedIn valuation: 

LinkedIn management doubled real revenue earned from $120 million in 2009 to $243 million in 2010 and converted a loss of $4 million to a profit of $16 million. That represents real and immediate value created for shareholders and a foundation for future growth. But $16 million is a long way from $560 million.

Even if LinkedIn is able to dramatically grow over the next three years, assuming heady growth rates in which revenue doubles and net income triples each year, it would earn $48 million on $250 million of revenue in 2011, $144 million on $500 million in 2012 and $432 million on $1 billion in 2013.

All told, that averages out to $208 million a year. By almost any measure that would be impressive growth. But, given current expectations of $560 million per year in shareholder value creation, that impressive growth would work out to a three-year expectations deficit of more than $1 billion. In other words, LinkedIn could grow net income 27 times over three years and still massively disappoint the market. To meet current expectations, it would have to generate 82 times profit growth in the same period.

Maybe this is the next Google. Except that even Google grew net income only 29 times in the first three years after its IPO. So maybe this is the next Google, but tripled!

Being "three times the Google" is a lofty aspiration for any company but in particular for one dabbling in social networking, a space plagued by serial failures and have-beens. One needn't bring up the specter of MySpace or Friendster, but I've found that doing so sobers up conversations about LinkedIn or Facebook's long-term prospects. Financial press has piled on--witness a Bloomberg piece warning very specifically about an impending IPO bubble.

Monday brought reports that Facebook is looking to launch its IPO ships against the turbulent market seas as early as October, aiming for a $100B market cap. Wall Street Journal immediately picked up on the chatter.

But before rushing to place buy orders, consider the following: there are signs that Facebook has already crested in the U.S., with what appears to be a 6% drop in users in the month of May. A follow-up post includes further data which clouds the picture, but there appear to be trends forming, with US and UK user bases either flattening or retreating from peaks earlier in the year.

Worldwide growth remains strong--but monetizing traffic from let's say, Pakistan is likely to prove significantly harder than doing so for domestic or European sources.

All things considered, Facebook's IPO will doubtlessly raise an obscene amount of cash and offer many options for profit--mostly on the side of those betting against it. One hopes that once reality checks in, the downturn will not drag sectors or even broad indexes along with it.

As for LinkedIn, those looking to establish short positions in the equity should look at an attractively high-yielding opportunity: selling September 17th $85 calls for a net of $6.50 per contract yields an annualized rate of 30.59% (for comparison purposes only.) This implies a break-even price of $91.50, a 22% upside from current price, a very tough climb for a stock on the receiving end of a lot of scrutiny and yes, well-warranted skepticism.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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