I had a front-row seat for the dot-com bubble a decade ago. I started my Series 7 class in the summer of 2000, became a registered representative in the fall (talk about timing the market!), and watched as a small private brokerage, heavily focused on technology, collapsed around me.
As many pundits claim we have entered Internet Bubble 2.0, it's worth looking back on the first bubble to see what we can learn.
For one, the bubble, like most, was fueled by overstated optimism. Bill Gates forecast widespread telecommuting by 2004 and companies like Webvan, Pets.com, and Beenz.com matched flawed business models with wildly overstated assumptions of Internet adoption. At the peak of the bubble (February 25, 2000), Forrester Research projected online retail sales of $184 billion in 2004. Actual online sales in 2004? $66.5 billion, just over a third of the projection. (Forrester now projects the U.S. will reach that level in 2011, seven years later.)
The market bought the optimism hook, line, and sinker. Here is an incredible chart from Jeremy Siegel's "Stocks for the Long Run":
Note that of the nine companies, only one (Nortel) has gone bankrupt [Sun was bought by Oracle (NYSE:ORCL) in 2009 for $7.4 billion, 1/20th of its market value in March of 2000.] Not only have 8 of the 9 avoided bankruptcy, but several of the companies have actually grown. Earnings at Cisco have doubled; Oracle and Sun earn three times as much as they did separately in 2000. Qualcomm has increased earnings over 7x. Even much-maligned Yahoo! (NASDAQ:YHOO) has managed to create nearly 700% earnings growth in the ensuing eleven years, though its market cap has dropped some 80%.
To me, this is the big lesson for investors in the Internet 2.0 stocks, such as Pandora (NYSE:P), LinkedIn (NYSE:LNKD), Zillow (NASDAQ:Z), and even Netflix (NASDAQ:NFLX): success is not enough. Cisco is still a world leader in networking; but its market cap, like that of Yahoo!, has dropped about 80%. Other Internet stocks that survived the bubble and lead the pack today have not fared much better. Even Amazon.com (NASDAQ:AMZN), the world's largest online retailer, and a widely admired company, took nearly a decade to return to its valuation from the 2000 peak. eBay (NASDAQ:EBAY), another web titan, returned to 2000 levels by 2004, but has since fallen back and trades just above 2000 levels. This, despite absolutely dominating the online auction market in a manner of which investors of the era could have only dreamed. Priceline.com (NASDAQ:PCLN) has quintupled in 3 years and STILL trades some 40% off its bubble peak.
When one thinks of Zillow, unprofitable yet trading at 13 times sales, or the sheer amusement value of LNKD's Finviz page, (a P/E of 2,574!), it's hard not to hear echoes of the 2000 bubble. What strikes me as even more similar is the optimism in the description of business models. In 2000, analysts would note the projected size of an Internet business -- be it potential "eyeballs" or online spending -- and calculate the potential revenue a market leader could have in that business. The problem was that they assigned "market leader" valuations to every company in the space, failing to note that there could only be ONE winner. Google won. Yahoo! (and AltaVista and IAC) lost. eBay won. Yahoo! and uBid lost. Amazon.com won, beating out Barnes & Noble and a host of others. We are seeing the same arguments again. Bulls claim Pandora will make money because its music streaming service is fantastic; never mind that competitor Spotify has come to America or that Facebook has been rumored to get into the streaming music game for years, including a potential partnership with Spotify. Groupon is promoted for its extensive customer base and high-end revenue growth; the fact that it faces multiple competitors, including LivingSocial, and -- you guessed it -- Facebook again is soft-pedaled. If we believe that, as in 2000, there will be only one true winner in the space, the valuations applied to the sector as a whole are simply foolish. Pandora, Facebook, and Spotify won't ALL make billions on streaming music. The Groupon (NASDAQ:GRPN) model can't work for three or four different companies with multi-billion dollar valuations. And Facebook and Google will fight for local advertising dollars.
And that brings us to Facebook. While a Facebook IPO is still months away, the company has become a constant discussion in financial crisis, as speculation on its current valuation ranges from $70 billion, to $210 billion by Seeking Alpha's own Igor Greenwald (though I believe Igor is being a bit tongue-in-cheek). Many reports, including one from CNBC, put a potential valuation of the company through an IPO of around $100 billion. With estimates of $2 billion in 2011 earnings, such a valuation does not seem as bubbly as those valuations put on unprofitable companies such as Zillow, Pandora or Groupon.
That said, a potential investor in Facebook must understand the risks in the social networking space, even for a company that has been as successful in its growth as Facebook has. For one, growth is slowing overall, and Facebook is losing users in North America and Western Europe. For two, anecdotally, the site is starting to run into some troubles. A recent video going around Facebook (quickly) purports to show a woman with a spider under her skin. It is, in fact, a scam, which links users to a survey and then forwards the scam to each and every one of the user's "friends". Similarly, users have been repeatedly tagged with ads for various shoes and swimsuits (click here for complaints). It doesn't seem like much, but it matters in the context of the monstrous valuations thrown around, and the risk inherent in owning a piece of Facebook. I've used Facebook for five years, and been constantly impressed by their ability to control the site (as opposed to Myspace, in which I cancelled my account last year due to the overwhelming number of solicitations from foreign women and independent bands.) If spammers and marketers start to get around Facebook's defenses, it matters. Spam was one of the biggest killers of Myspace, helping to make Facebook the dominant social networking player.
The bull argument is that Facebook is NOT Myspace, that Facebook has offered many more features, has many more users than Myspace ever did, is run better and offers better entertainment value. This is all true -- for now. But as Google+ rolls out, as LinkedIn grows its user base, and as yet-to-be-named competitors challenge the company, there will be hurdles. And the lesson of the first Internet bubble is that a company that stumbles on any of those hurdles can see huge drops in its valuation. Want proof? Don't forget, just four years ago, deal-makers were putting a multi-billion dollar valuation on Myspace, too. It sold for $35 million last month.