Are The 4 Leading Social Stocks A Buy?

by: Helix Investment Research

For years, regular investors have been locked out of being able to invest in the booming social media, networking and gaming sector. All of the leading companies in the sector were private, available only to venture capitalists and accredited investors. But now, many have gone public, inlcluding LinkedIn (LNKD), Pandora (NYSE:P), and Groupon (NASDAQ:GRPN), and most recently, Zynga (NASDAQ:ZNGA). Before we continue, we should note that the two leaders in the social sector, Facebook and Twitter are still private. However, there is a way to invest in them. GSV Capital (NASDAQ:GSVC) is a public investment fund that we have profiled earlier this year that holds shares in Facebook and Twitter. But it is a very volatile stock, and valuing its portfolio of private companies is virtually impossible on a daily basis. We will focus on the 4 social companies mentioned above. Below, we will look to see if these 4 social stocks are a buy.

LinkedIn: This is as close to a Facebook proxy as one can get. At its simplest, LinkedIn is a professional version of Facebook, used by millions to look for jobs. The company is the world's largest professional social networking site, with over 132 million members. And with 2 quarters of results as a public company under its belt, we are starting to see some trends. In the second quarter of 2011, its first as a public company, LinkedIn reported GAAP EPS of 4 cents/share on revenue of $121 million. Revenue grew 120% from last year and membership grew 61% from the previous year. And in the third quarter, LinkedIn reported a GAAP loss of 2 cents/share, on revenue of $139.5 million, which grew 126% from the previous year. The swing to a GAAP loss was due to aggressive investments LinkedIn has made.

Management is playing a delicate balancing act between current profitability and future growth. The company's gross profit margin currently stands at 84% and its adjusted EBITDA margin is at 18%, despite the continued heavy levels of investment. We are also encouraged by LinkedIn's efforts to expand and retail its user base. On the conference call, CEO Jeff Weiner noted that the company has revamped its profiles for students and recent graduates, leading to their membership on LinkedIn to more than double in the past 12 months. We are encouraged by this, for LinkedIn is doing all the right things to make its members stay on the site, discovering how useful it is, driving success for its members and profitability for the company. LinkedIn is aware of concerns about its spending, which were brought up many times on the conference call. CFO Steve Sardello explained that:

Our long-term model is the target plus-30% EBITDA margins. And if you looked at that the profile under that, the sales and marketing aligned is somewhere in the mid-to-high 20% range which is somewhere between the SaaS company and a web-based company. So we're in a period time right now because of the SaaS nature of our business models because of some the decency of the market that we're entering where there is higher ratio there. And so if you look at look at for example in the U.S., our investment cycle, we target to be a plus-60% contribution margin business. We're much closer there in the U.S. Europe is about maybe a couple years behind the U.S. And then if you go to Asia, it's maybe two to three years in terms of that cycle of increasing margins. So our long-term plan is to obviously scale back down, but we're always going to look at the opportunity in front of us. And I think it's part of the cycle we're in right now. And a major part of our revenue stream is a subscription based model which is recognized over a time period.

LinkedIn's margins will increase over time, but for now the company is in spending mode, ramping up hiring to scale the business more effectively. So is LinkedIn a buy right now? There are several competing factors affecting our recommendation. On the one hand, LinkedIn is projected to grow EPS by over 71% from 2011 to 2012 and revenue by around 60%. Such growth is very impressive and difficult to come by in our current market. But, even with these growth rates, LinkedIn trades at a 2011 P/E of 235 and a 2012 P/E of 137. And in a market as volatile and macro-focused as ours currently is, it is almost always high-flying stocks such as this that come crashing down first.

Furthermore, there are millions of shares waiting to be sold as soon as the next lock-up period expires. And although the Reuters average price target of $83.58 represents upside of almost 18% from current levels, we would wait until things in Europe settle down and more shares come into the market.

Pandora: Pandora, the largest internet radio service, became public in June, and since then the stock has fallen deeply below its IPO price of $16/share, and is currently over 34% below its IPO. Like LinkedIn, Pandora has 2 quarters of public financial results under its belt. In the second quarter, the company posted a GAAP loss of 4 cents/share on revenues of $67 million, which grew 117% from the previous year. In that quarter, mobile advertising reached half of the company's overall advertising, and it captured 3.6% of all radio listening in the US. In the third quarter, Pandora posted yet another record quarter, posting breakeven results on a GAAP basis on revenues of $75 million, which grew 99% from the previous year. The company's share of US radio listening also advanced to a record 4.3%. Critics have often contended that the very nature of the music business makes it impossible for Pandora to ever be consistently profitable. We do see some truth to this argument.

Pandora's costs, in essence, rise alongside its revenues. More listeners equal more ad sales, but also more royalty expenses. Critics seize on that point, claiming Pandora can therefore never make money if costs always rise with revenues. But we disagree. We think Pandora's unique insight into the habits of its listeners allows it to target ads much more effectively than traditional radio, thus earning more in ad sales. Traditional radio stations have to target ads to a far wider demographic, thus diluting their value. But Pandora has no such constraints. Though consensus estimates call for losses in both 2012 (2 cents/share) and 2013 (1 cent/share), we think Pandora will be able to post consistent profits after that time frame. The Reuters average price target currently stands at $15.65, representing upside of over 48% from current levels. Pandora stock is trading as if it will never make a profit, but we disagree, and would take advantage of current market skepticism to build a long term position in the company.

Groupon: As a new public company, Groupon does not have any quarterly results that can be used to determine performance, so we must examine other factors to determine if Groupon is a buy. As the largest daily-deals network, Groupon enjoys benefits from economies of scale, allowing it to build a critical mass of merchants. Furthermore, Groupon has been focusing more and more on tailoring Groupons to specific locations and preferences. Should this work, we think Groupon will be able to retain customers more and drive increased Groupon sales. The Reuters consensus EPS estimate for 2012 is 26 cents/share on revenues of $2.3 billion. Groupon is now valued at around 89 times 2012 EPS, a relative bargain in the social sector. Competition in this sector is fierce, for launching a daily deals site does not require much work. There are hundreds of sites, including giants like Google and Amazon.

The latest rumor is that PayPal will be launching a Groupon competitor. But over time, we think that competition will be less of an issue than bears think. Facebook and Yelp have already pulled out of the market, due to an inability to gain traction. Groupon's scale creates a cycle, where it can offer the best deals to consumers due to its leading relationships with merchants, thus driving higher traffic to those merchants and cementing its status as the deals company that can deliver the greatest value to merchants. Low barriers to entry do not necessarily mean a lack of profitability. Online shopping is a prime example of that. The only thing stopping consumers from shopping at Amazon (NASDAQ:AMZN) is a click of the mouse. But why would anyone shop somewhere besides Amazon? The company's scale, network, and merchant relationships (all of which Groupon has) make it much more difficult to leave the company than it would seem at first glance. Groupon's own data backs this up. The company is either the leader or a close second in most of its 45 international markets.

So is Groupon a buy right now? We do not think so, for two reasons. The first is that we think there are better places to put money to work in the internet sector. While we do think Groupon has a sustainable and profitable business model, the risks are not worth it. Secondly, insiders control 58% of Groupon's voting power, and while over the long run they have a vested interest in a rising share price, outside shareholders can do little to influence the company in the short run, thus making this company a more riskier investment. The Reuters average price target for Groupon is $25.50, representing upside of around 10.67%. At current prices, Groupon isn't a buy, but should the price fall due to market volatility, we would be more willing to recommend the shares.

Zynga: This is the newest social company to go public, raising $1 billion in its IPO, the largest internet IPO since Google's in 2004. Yet Zynga became a broken IPO on its very first day of trading, closing at $9.50, 5% below the offering price. The irony here is that this allows retail investors to get an even better deal on an IPO than institutional investors who participated in the offering. But should they? Unlike many social IPO's this year, Zynga is profitable, even if profitability has declined as the company has ramped up investments in growth. Furthermore, the 5% drop is not necessarily a bearish sign. Zynga sold a bit more stock than the average social company, offering 14% of its stock, whereas LinkedIn offered less than 10%. Less scarcity means less of a "pop." While the stock may be below its IPO price, we do not think this means retail investors should invest in it. Zynga has several risks that tarnish its appeal as a social company. The first is its proximity to Facebook. Facebook is both Zynga's greatest asset and its greatest liability.

Zynga has tied itself to Facebook, allowing it to leverage its growth. But this leaves Zynga at the mercy of Facebook, which is able to dictate terms to Zynga. Facebook changes its service terms very often, and it is feasible that any of those changes could hurt Zynga. Secondly, even though Zynga is profitable, its profits come from a tiny sliver of its users. In many SEC filings, Zynga details this as one of the primary risks in investing in the company. Its profitability is almost completely dependent on these paying players, and the only real way to increase profitability is to increase the amount of paying players. The third risk we see with Zynga is the absurdly lopsided structure of the company's stock. Zynga has three classes of stock. Class A shares (the publicly traded oncs) have one vote per share. Class B shares have 7 votes per share, and Class C shares have 70 votes per share. By itself, this is unusual. Google, the poster child of executive control, only gives its Class B stockholders 10 votes per share. And at Google, there are only 2 classes of stock. Mark Pincus, Zynga's founder and CEO, controls 36.2% of the votes, by holding all Class C stock and some Class B stock. That is an extremely high degree of control. For Class A stockholders, it gets even worse. Combined, Class B and Class C stock represent 98.2% of the voting power at Zynga. So even if an investor were to control every single Class A share, they would have only 1.8% control of Zynga.

These 3 factors make us see no reason to invest in Zynga. The company is wholly dependent on Facebook (94% of revenue is derived from Facebook), has all of its profits coming from a small subset of players, and has an absurd voting structure. In addition, competition is fierce, with Electronic Arts (ERTS) making inroads in the social gaming space. Zynga's profits are entirely hit-driven, and should one of its games flop, it has no reliable franchises to fall back on like EA and Activision Blizzard (NASDAQ:ATVI) do. Furthermore, growth at Zynga is slowing, and that is not something we like to see at social companies. Unless there is a precipitous drop in Zynga's stock price, we see no reason to invest in a company where our shares give us no say in the company's future.

The social sector is one that will, over the long run, be very profitable, and the slow but sure IPO'ing of the leading social companies allows for that premise to be validated. And while we wait for the IPO of Facebook (and to some extent, Twitter), there are many other social companies on the market. We think LinkedIn and Pandora represent the two best investment opportunities. Pandora will be profitable, as it will be able to extract higher advertising rates due to its ability to target its listeners. And LinkedIn will be very successful due to its ability to attract and retain its members. Groupon, in our opinion, will be successful, but there are better investment opportunities out there. We see no point in investing in Zynga, for the company faces far too many risks to justify an investment. There is an ETF for investing in the social sector as well. The Global X Social Media Index ETF (NASDAQ:SOCL), which, as we have profiled before, is an ETF that invests in a variety of social companies both in the US and abroad. Investors looking for a diverse basket of social stock should consider that ETF. Social companies have revolutionized the way we work, play, and communicate, and will, over time, hand investors great profits.

Disclosure: I am long GOOG, AMZN.

Additional disclosure: We are long GOOG and AMZN via the PowerShares NASDAQ Internet Portfolio, an ETF that tracks a basket of internet stocks that trade on the NASDAQ.