Branchout Is Exposing The Social Media Bubble

| About: Microsoft Corporation (MSFT)
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To Wall St., LinkedIn (LNKD) and Zynga (NASDAQ:ZNGA) are both classified as social media stocks, and they both happened to be priced to completely dominate their respective niches. This should be the first warning sign that a social media bubble is underway. To give just a little perspective on just how ludicrous social media valuations are, here's a glimpse at some multiples of industry leaders.

Company Current PPS 2012 P/E 2013 P/E
LinkedIn $92.05 150.9x 85.3x
Zynga $13.35 49.4x 37.1x
Groupon (NASDAQ:GRPN) $16.88 64.9x 20.6x

Not only are these social media companies trading for absurd multiples but they are doing so while pricing in monstrous growth. These forward earnings estimates are implying annual growth ranging anywhere from 50-100%. If that growth doesn't materialize, then these companies valuations will get even higher. The main issue when pricing in that much growth is a lack of accounting for competition. Unfortunately for LinkedIn, it's been the first social media IPO to be hit with this problem.

BranchOut is a Facebook app that started 2012 with only about 1 million active users. In just the past 2 1/2 months BranchOut has grown 730% to 8.3 million active users. BranchOut is very similar to LinkedIn in that it helps consumers connect to jobs via an online professional network. BranchOut appeals to a less formal crowd than LinkedIn (so an even bigger market), and most importantly it is free.

For many of LinkedIn's best services, such as messaging or getting to see who viewed your profile, you must be a premium member. This means consumers are having to pay money to get the full benefit of the product. BranchOut doesn't work like that as they've set aside making profits for now and are purely focused on marketing and driving user growth. As I mentioned before, their service is free to consumers. The amazing success they've had so far is a testament to just how easy it is to replicate something like LinkedIn with very little cost in a very small window of time. This is a perfect example of LinkedIn suffering for doing exactly what Wall St. wants it to do: monetize users.

Several social media IPOs have thus far has been thoroughly questioned in their future ability to monetize users. Monetizing users is the way that profits will grow exponentially along with user growth. For most of these new companies, user growth is impressive, but those users don't come onto the platform expecting to pay or be bombarded with ads, which incidentally are the two main ways of profiting. BranchOut is an excellent example of just how willing consumers are to jump to a platform earlier in its growth phase when the company is catering to its consumers instead of Wall St.

At the end of Q1, after BranchOut will have added close to 10 million new users, it will be interesting to see LinkedIn's growth. If BranchOut doesn't have an impact on Q1 numbers, then watch out for Q2. This phenomena has happened so quickly that it may take a while to show slowing user growth for Linked, as consumers use both platforms simultaneously. Even if BranchOut in particular never has an impact on LinkedIn's bottom line, a different social media startup will eventually.

For Groupon and Zynga this will have a trickle down effect. As shareholders slowly start to realize how low the barriers to entry are in the industry (BranchOut only had $24 million in funding), valuations will come down to normal levels. Thus far LinkedIn, Groupon and Zynga have been priced to completely dominate their respective niches, not dissimilar at all to the IPO valuation philosophy during the internet bubble.

These completely irrational valuations will not be sustained for long. Urged by insiders selling as share lock-ups expire and the prospect of increasing competition, the short lived social media bubble will soon draw to a close.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in LNKD over the next 72 hours.