In the following article, I will discuss five companies that are facing high pressure from competitors, have business models that have low barriers to entry, are overvalued compared to peers, and have weak earnings power. These five companies do not pay dividends and thus are easier to short than dividend paying companies. Based on my analysis below, all of these factors make it likely that these stocks will decrease in value over the next several months. Investors should be careful when adding them to their portfolios.
Netflix (NFLX) is trading around $113 per share at the time of this writing, has a 52-week range between $62.37 and 304.79 per share and 55 million shares for a market capitalization of about $6.2 billion, with an enterprise value of $5.8 billion. Netflix has an inflated price to earnings ratio of 26.8 and a price to book value of 9.6 compared to 18.6 and 3.8, respectively, for the industry. In addition, Netflix is facing strong competitive pressures after a number of companies have entered or are about to enter the movie streaming business causing the DVD shipping business to become obsolete.
With content costs rising and Netflix incurring significant costs related to expansion in new markets and a constant demand for investing in new technologies, the company's profit margins are likely to deteriorate in 2012. Because of competitive pressures, Netflix has little pricing power and a recent price hike was not received well by its subscribers and subsequently investors.
Finally, in November of 2011, Netflix issued $200 million of convertible shares that can be converted at $85.80 after the initial six-month holding period expires in April of 2012 thus potentially diluting current shareholders and offering new shares at relatively low prices. All this makes Netflix a company that could tumble in value over the next 12 months as it has already done so in the past year.
Baidu (BIDU) common stock is priced around $135 per share at the time of this writing with a 52-week trading range of $100.95 to $165.96 and 349 million shares outstanding for a market capitalization of $47 billion and an enterprise value of $45 billion (the company has $2 billion of cash net of long-term debt). Baidu has a very high valuation with a price to earnings ratio of 45 and a price to tangible book ratio of 25 compared to 25 and 10.6 for the industry, respectively. Baidu has an earnings before interest, taxes and depreciation margin of 55%, higher than the industry average of 22.2%. However, there is an increasing competition in the Chinese market from foreign search engines and also the Chinese economy may be slowing down making the company margins vulnerable.
On February 16, 2012, in its fourth quarter and fiscal 2011 press release, the company announced that it expects revenue between $666 to $688 million for the first quarter of 2012, which is inline with the average Wall Street analyst's estimate. The rich valuation of Baidu and its large share in the Chinese market suggest that there is little room for the company to grow and it is susceptible to missing growth goals in the coming quarters due to competition and slowing economy in China. Investors in this search engine should be prepared for a downward stock revaluation.
From internet movie streaming and web searching, I am focusing on LinkedIn, the largest internet career-oriented social networking company. LinkedIn (LNKD) is trading around $92 per share at the time of this writing, near its initial public offering price in May 2011 of $93 per share and half-way between its low and high since the IPO of $55.98 and $122.70, respectively. The company has 98 million shares outstanding (but only 10.8 million are currently trading) for a market capitalization of $9 billion.
There is a risk of LinkedIn starting trading more of its shares as only about 10% of the company's common stock is floated on the market. As most of these shares are owned by insiders, there is a real risk that the shares will be sold at an opportunistic time which may be damaging to current shareholders. In addition, LinkedIn has less than ten years of operational experience and less than one year as a public company. The first few public years are usually most volatile for companies and it will not be a surprise if the common stock stumbles in the next 12 months.
While LinkedIn is growing fast, its valuation is so rich (its price to earnings and price to cash flow ratios are in the hundreds) that any increase in competition or a misstep by the company would seriously undermine this high valuation. Investors are better served until LinkedIn has several more years of operating history as a public company or risk a volatile ride.
My fourth selection which may suffer a downward pressure is another technology company. Salesforce.com (CRM) is trading around $144 at the time of publishing, has a 52-week range from $94.09 to $160.12 per share and 136 million shares outstanding for a market capitalization of $19.6 billion and an enterprise value of about $19.5 billion. Salesforce has a price to tangible book ratio of 31.8 compared to 9.8 for the industry and an earnings before interest, tax and depreciation margin of 5.8%, significantly lower than the industry's average of 36.9%.
On February 24, 2012, the company announced that it was raising its fiscal year 2013 revenue while still expecting a loss of $0.55 per share. The stock went up almost 10% in a single day and this positive news should be already priced in the stock. Fundamental risks at Salesforce still exist in the face of increased competition after a tumultuous merger and acquisition period in the cloud computing area. The return to healthier profitability margins is still not certain as the company has high costs associated with investments in new technologies. For now, investors should stay on the sidelines and reconsider buying the stock if it breaches the $100 per share price again.
The last stock that I will discuss here and that may tumble is the Chinese equivalent of Facebook. Renren (RENN) is selling at about $5 per share (its 52-week low and high are $3.21 and $24, respectively) and has nearly 400 million shares outstanding for a market capitalization of $2 billion. Renren has negative earnings per share and an operation margin of only about 5%. The company is highly censored in its main market, China, and is facing significant pressures from other social networks based in China and possibly by Facebook.
Renren generated $34 million of revenue in the quarter ended September 30, 2011, giving it a price to sales ratio of about 17 compared to a price to sales ratio of 3 for the industry and 1.3 for the S&P 500. Its price to sales ratio is comparable to that of LinkedIn (discussed above) but LinkedIn has less competitors and a larger user base and exposure to developed markets versus Renren's exposure to mostly Chinese consumers which are still lagging in income and spending.
In conclusion, Renren will report results on March 8, 2012 and while they might be better than estimated, it is very likely that the shares will tumble in the next several months if Renren fails to meet the stringent growth goals implied by the stock's current valuation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.