Seeking Alpha
Contrarian, macro
Profile| Send Message|
( followers)  

It appears traders will have to wait until the first quarter of 2012 to get their hands on shares of Facebook. But why should investors have to wait another nine months to throw their kids' college funds away on a hot social networking company that trades at a suicidally high price/sales ratio? Thankfully, LinkedIn (Ticker: LNKD) stepped in to quench the market's thirst on May 18th when it "sold 7.84 million shares for $45 each, a higher price than [even] the company was expecting...earlier [that] week."

In case you're unfamiliar with the company, LinkedIn is

the world's largest professional network on the Internet with more than 100 million members in over 200 countries [and generates] revenues... from user subscriptions, advertising sales and hiring solutions.

Basically, it is Facebook for business people and professionals. While its growth has been meteoric, the company is substantially overvalued. Its price-to-earnings ratio is a mind-boggling 595, its price-to-book ratio is close to 71, and its price-to-sales ratio is 31. (Source: Morningstar) By comparison, Google's (NASDAQ:GOOG) price-to-earnings ratio is 13.2, its price-to-book ratio is 3.5, and its price-to-sales ratio is 5.5. Allow me to reiterate: the price-to-book value of LinkedIn is 71. That means the company is trading for seventy-one times the net asset value of the business (assets minus liabilities).

Despite its lofty valuation, the stock's price performance on IPO day reflects investors' appetite for companies with huge growth potential. On its first day of trading,

the stock opened at $83 and quickly rose above $90, where it stayed for most of the morning [before hitting] a high of $122.70 in late morning trading.

LinkedIn is one of a handful of social media companies offering stock to the public this year. Zynga, Groupon, and Living Social are all expected to go public in the coming months. When it comes to market, Groupon's offering could fetch up to $3 billion. Groupon, which has grown revenue from a mere $94 million in 2008 to over $713 million last year and which has already racked up close to $645 million in revenue this year, gives its 83 million subscribers the opportunity to buy coupons from local restaurants at a substantial discount. For instance, a subscriber might pay $10 dollars at groupon.com for a coupon worth $20 in food.

Though the business model is sound, the rate at which the company is expanding is costing money - a lot of money. Although Groupon pulled in $713 million in revenue last year, it actually "posted a loss of $456.3 million... nearly half of which was acquisition related." Also noteworthy is the fact that "the amount that Groupon reports as revenue is the full amount of the prepaid deals...[of which] Groupon kept just 39% last year." Furthermore, only about 25% of Groupon's subscribers have ever actually purchased a coupon from the company.

But at the end of the day, no one can deny that the company is growing at an unprecedented rate. It now boasts 57,000 participating merchants, up from 212 two years ago. Even more astonishing, the number of people subscribing to Groupon has risen from 152,000 in 2009 to over 83 million currently. This kind of growth should attract enough investors to propel Groupon's stock the first few days it is available to the public. Never mind those who say that Groupon is not 'a good investment' because it is 'overvalued.' The flood of irrationality and exuberance that will surround Groupon's IPO will almost certainly wash away any trace of reason or prudence - at least for a few days. Traders should take advantage of the opportunity. The idea is to make money, not to debate the long-term prospects of a company that sells restaurant coupons.

When the stock becomes available to the public, the disciplined trader will buy it at the open and sell it immediately if it rises too far too fast. When the shares become overvalued the savvy trader will purchase long puts on the stock (contracts that allow traders to sell 100 share lots of stock at a specified price). In this way, traders can make money on the way up, and if the timing is right, on the way down.

It will be wise to ignore those who say the average person has no chance of getting into Groupon at the IPO price. This is true (typically, only the wealthy and the well-connected get shares at the IPO price), but keep this in mind: the insiders got LinkedIn for $45. It was $83 by the time the public got a crack at it. But it was at $122.70 a few hours later. No one should complain about getting in at $83 and selling at $122--even if someone else got it for $45. The trick is to be disciplined and bailout after the first-day bonanza.

Although I believe the 'small guy' has a good chance of making money from the IPOs of hot social networking companies, the average investor can certainly be forgiven for being skeptical. After all, only a privileged few are likely to get Groupon, Zynga, or Facebook stock at or near the actual IPO price. Even if one did manage to get some shares at a price that is not too inflated, the first few days of trading in these issues are likely to be a gut-wrenching roller coaster ride that will test the discipline and resolve of even the most levelheaded trader.

However, as a recent article in the Wall Street Journal ("Is His Company Worth $100 Billion?" by Shayndi Raice) makes clear, social networking companies have huge growth prospects. One venture capitalist interviewed by Raice estimates Facebook's revenue will be around $20 billion per year by 2015. Investors are understandably excited about these businesses' growth prospects and, despite their nosebleed valuations, one simple fact remains: these stocks will likely rise on IPO day.

With so many social media companies going public this year, traders will miss a huge opportunity if they allow their fear of volatility to keep them on the sidelines. Let me reiterate that I do believe these companies are overvalued by almost any metric one wishes to use. But that won't keep investors out of the market when the companies go public, and shouts of "be rational for god's sake" won't keep the stocks from going up. In short: if traders want to make money, they need to be in these trades one way or another.

Fortunately, for the faint-of-heart (read: the rational and the intelligent), there is a good way to mitigate the risks associated with hot IPOs. First Trust US IPO Index ETF (Ticker: FPX) carries a surprisingly low expense ratio (just .60%) and even pays a dividend (.86%). To be sure, it

offers only limited exposure to the most sought-after tech IPOs and their hoped-for first-day-gains...[but] assets are spread across 25 to 100 diverse companies, providing a cushion from the kind of share-price fallback that LinkedIn experienced after its first-day pop.

With so many hot social networking companies going public in the next two years, shares of FPX could double by 2013. Investors might miss the 300% and 400% short-term gains, but with FPX, at least they'll get a piece of them.

Works Cited:

Hogan, Mike. "The Little Guy's Guide to the IPO Frenzy" Barron's. 11 July, 2011: L14-L15.

Munarriz, Rick. (2011, June 3). 3 Surprises in Groupon's Prospectus. TheMotleyFool. Retrieved July 10, 2011,

Pepitone, Julianne. (2011, May 19). LinkedIn Stock More Than Doubles in IPO. CNNMoney. Retrieved July 10, 2011

Raice, Shayndi. "Is His Company Worth $100 Billion?." The Wall Street Journal. 14 July, 2011: B1-B2.

Selyukh, A. and Clare Baldwin. (2011, May 18). LinkedIn IPO Prices at $45 Per Share, But Risks Real. Reuters. Retrieved July 11, 2011

Solin, Daniel. (2011, June 16). Why I Won't Be Buying Groupon Stock. USNewsMoney. Retrieved July 11, 2011

Information on FPX through Morningstar: quote.morningstar.com/ETF/f.aspx?t=fpx#

Information on LinkedIn through LinkedIn.com: www.linkedin.com

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

Source: Investors Should Take Advantage of Social Media IPOs