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Social media seems unstoppable these days, and there is good reason for that. Growth for many of the companies in the sector has been astounding, in many cases handsomely rewarding shareholders. However there is some doubt as to whether this is Bubble 2.0, or if this time around fundamentals really justify the current valuations. We stand somewhere in the middle, thinking a quote from Dickens' A Tale of Two Cities describes almost perfectly the current social media landscape, "These are the best of times, these are the worst of times". Just like during the French revolution power and dominance can, and in many cases does, shift very quickly. Therefore investors in social media companies must be aware that while valuations and traditional due diligence are still important, assessing the durability of the competitive advantage is critical. Despite the fact that many companies in the sector have embedded wide economic moats, they must keep reinventing themselves to stay relevant. If they don't, they risk going downhill at breathtaking speed. Examples are too numerous to name them all, but here we include a sample of some well-known companies in this category:

  1. Bebo, which was bought by AOL (NYSE:AOL) in 2008 for $850 million, and was sold two years later for an undisclosed sum (which was reportedly under $10 million).
  2. Myspace was bought by New Corporation (NASDAQ:NEWS) in 2005 for $580 million, just to be resold in 2011 for approximately $35 million.
  3. ICQ, which at a time was the most popular chat service available was sold to AOL in 1998 for $407 million. In 2010 AOL sold ICQ to Digital Sky Technologies for just $187.5 million.
  4. GeoCities was purchased by Yahoo! (NASDAQ:YHOO) for $3.57 billion in stock in 1999, only to be shut down ten years later.
  5. Friendster was once considered the top social network before quickly losing ground to Myspace, and later to Facebook. It has recently been reinventing itself as a social gaming platform.

Our intention is not to discourage investments in social media companies (we actually think many of them have wonderful economics), but rather to point out how important it is that the company have great management. That it respond quickly to changes, and that it have a culture that keeps it reinventing itself to stay relevant.

In fact there are also several examples of companies in the space that have managed to remain good businesses for several years now. In the professional career space Monster (NYSE:MWW) and Career Builder (part owned by Gannett (NYSE:GCI) are still relevant and have pretty decent economics. In the entertainment side Flickr and YouTube seem to have been good acquisitions for Yahoo! and Google (NASDAQ:GOOG) respectively (although not enough information is provided in the public reports of the companies to assess exactly how well these two acquisitions are performing).

With that in mind we can proceed to analyze the new crop of social media companies. We'll give a quick description of their business models, and point out some of their strengths and weaknesses.

OpenTable Inc (NASDAQ:OPEN)

OpenTable has a very interesting business model, and offers an attractive value proposition for restaurant owners. It operates an online restaurant reservation system, and makes money charging restaurants a monthly fee for the use of their system, plus one dollar for every customer they send to the restaurant ($0.25 if the reservation was originated from the restaurant's own website). Most of the revenue comes from the per seated customer charge. This is attractive for restaurants because they pay for concrete results, as opposed to traditional advertising where it is difficult to measure the ROI. What makes OpenTable's economics so attractive is that it tends to be a natural monopoly. Diners prefer to search only one reservation website (where most restaurants are available), and restaurants only want to use one reservation system (the one that sends them the most customers). Despite those advantages OpenTable does have some weaknesses. One of their competitors, Livebookings, is stronger in Europe, and competition in the USA is also intensifying by the likes of Eveve and Urbanspoon. Growth has decelerated in the most recent quarters, and the valuation seems rich and does not provide much margin of safety. Also their previous CEO resigned to pursue opportunities in venture capital.

Zillow Inc (NASDAQ:Z)

Zillow is among the largest online real estate information platforms. They provide vital information about homes, real estate listings and mortgages through their website and mobile applications. They have attractive economics thanks to the strong network connecting homeowners and potential buyers with sellers and real estate agents. Their website attracts many visits with services that include estimates of home values and rental prices.

The main risk with Zillow is if it fails to attain a dominant market position. There are several competitors with strong market shares like Trulia and Realtor.com, and Zillow's current valuation already reflects an expectation from investors that growth will continue to be strong for at least the next few years.

Zynga Inc (NASDAQ:ZNGA)

Zynga develops free online games that are played by hundreds of millions of users around the world. Most of the revenue comes from selling virtual goods that are used in the games (e.g. avatars and artwork). In contrast with many other Internet IPOs Zynga is currently profitable and growing. There are however important weaknesses that have to be addressed. One is that most revenue comes from just a few paying customers, although this could also be seen as an opportunity to improve monetization with new strategies. Our main concern is the over reliance on the Facebook platform, which brings more than 90% of Zynga's revenues. Facebook is currently keeping 30% of Zynga's Facebook revenue, and there is some concern that it might try to increase the percentage in the future or promote in-house games.

LinkedIn Corporation (NYSE:LNKD)

LinkedIn is a social network focused on helping people and companies make professional connections. It is very difficult to evaluate an investment in this company because they are growing revenue incredibly fast, have an enviable 80%+ gross margin, and at the same time they are trading with an astronomical p/e ratio, and TTM p/s of around 16.

If they can keep the amazing growth for at least a few more years they could end up being a good investment. If on the other hand growth decelerates shares could depreciate quite rapidly. Growth could be at risk if other social networks are able to efficiently integrate professional networking functionality to their platforms. Google+ is already attempting to do this, and there are some applications trying to leverage the Facebook platform for this purpose (such as BranchOut and BeKnown).

Groupon Inc (NASDAQ:GRPN)

Groupon makes money by getting merchants to offer great group deals, which it then promotes on its website, mobile applications, and through email to its subscribers. For its trouble Groupon gets to keep 50% of what customers paid for the coupons. Despite the huge cut, the company is still not profitable. Although it is true that they are making big investments in marketing to maintain growth. In fact growth has been one of the main selling points to investors, since the company has been one of the fastest growing companies on record. Another positive is their widely recognized brand. Nevertheless, it is our opinion that these positives are not enough to justify the current valuation, or cancel out the weaknesses the company has. Its Achilles' heel is the low barrier to entry for competitors, which has resulted in many copycats appearing around the world. Also worrisome is that some merchants feel they did not get much value from running promotions with Groupon. Most merchants offer promotions with the hope that customers buying the coupon will later return and pay the full price. In many cases this does not happen, and instead Groupon subscribers simply jump to the next deal. In addition insiders have been cashing out, and the SEC had to cut off some aggressive accounting practices. For these reasons we would not recommend an investment in the company.

Angie's List Inc (NASDAQ:ANGI)

Angie's List is a company that serves a very useful social purpose, but that seems to be operating with a flawed business model. Prove of this is that they have been losing money for a long time. Their mission statement is to help consumers purchase "high cost of failure" services in a fragmented local marketplace. To do this they sell consumers subscriptions to the site, which then allows them to read and write reviews on plumbing and electricity professionals among others. This is probably one of the biggest weaknesses in their business model, since a paid subscription model increases user acquisition costs and increases the vulnerability to competition from free recommendation services such as Yelp. We are not convinced the company can reach profitability any time soon, and would not suggest investing in it at the present time.

Due to the winner takes all economics of the sector it is very likely that an investment in these companies will result in either extremely strong returns, or a huge loss on the investment. For that reason we would recommend the more risk adverse to instead benefit from the growth of social media indirectly. For instance, investing in diversified companies that are helping grow and improve the computing infrastructure used by Internet companies (see our article What We Can Learn From Buffett's IBM Position).

Source: What Everybody Ought To Know About Social Media