Bubble 2.0 Is Popping

Includes: FB, GRPN, GS, MSFT, P, YELP, Z, ZNGA
by: Simit Patel

I've discussed Bubble 2.0 -- the new crop of social media companies that have enjoyed sharp appreciation in the private markets, often funded by Goldman Sachs (GS) -- numerous times before, observing how many of these companies have outlandish expectations, no profits, and a flawed growth strategy that focuses on user acquisition rather than increasing key metrics such as revenue from assets or revenue per customer. The companies that I lump into Bubble 2.0 are Facebook (FB), Zynga (ZNGA), LinkedIn (LNKD), Groupon (GRPN), Yelp (YELP), Zillow (Z), and Pandora (P); others in the IPO pipeline include Twitter, Foursquare, AirBnb, and Spotify.

There are some signs, however, that the bubble is beginning to pop. This could be an opportunity for short sellers looking for a quick profit, or a sign for bulls to take profits and close their position. Here are the indicators:

Groupon Accounting Disaster. Two hallmark aspects of bubbles are (1) an increase in the money supply and (2) some type of fraud. Money supply, as measured by MZM, continues to soar to new all-time highs, passing the 10.8 trillion mark in March 2012. And in terms of fraud, concerns over Groupon's accounting methodology have been around since before its IPO and still are; GRPN revised its Q4 2011 earnings this past Friday, noting that it had not set aside enough money for customer refunds. Its share price plunged 17% on Monday in response.

Groupon isn't the only one who has raised some eyebrows with its accounting methodology; a milder example can be found with Zynga. But that the market has signaled such a harsh response to Groupon's earnings revision suggest the market may be paying attention and ready to act accordingly.

Concern From Facebook Investors. There is also a growing concern surrounding Facebook in two regards: (1) perceived disinterest from Facebook CEO Mark Zuckerberg in dealing with shareholders and (2) Facebook's admission that a lawsuit from Yahoo (YHOO) regarding patent infringement could have a "material impact" on the firm. At the same time, in spite of all the hype that involved a major motion picture, Facebook's growth is slowing. For a company eyeing a 100 billion valuation with profits of $1.5 billion, this implies a P/E ratio of over 65 -- quite a bit for a company with declining growth.

If the IPO pop on Facebook is its top, that will be especially important, as Facebook is the mothership of Bubble 2.0. If Facebook goes down, it is going to take a lot of bullish sentiment on the whole sector with it.

Zynga Secondary Offering Shows Insiders Exiting. Zynga is having a secondary offering of 43 million shares at $12 per share; nearly half of those shares are coming from directors and executive officers (other sellers include venture capital funds and accredited investors), which I think illustrates that those shares may be a bit overvalued, and that the shareholder and management incentives may be diverting. Zynga is my favorite of the bubble 2.0 crowd in terms of the one I regard as having the best chance for an immensely profitable future, but it is still reporting negative earnings and investing heavily in scalability. In general, I think this is the big mistake the Bubble 2.0 companies are making, and a mistake that is faciltiated by the influx of capital that fuels bubbles; they focus too much on scalability to justify massive valuations, and often lose the ability to generate self-sustaining, organic growth in the process. This is what we saw in Bubble 1.0 with the collapse of firms like Kozmo and UrbanFetch. I do not think it will be terribly different this time around.

Rapid Price Appreciation. As I noted in my previous article on what to short, investors looking to hedge themselves against a broad market collapse may look to find opportunities in shorting Zynga and LinkedIn in particular, as both have witnessed some very sharp appreciation in price year to date. And while I don't believe a market crash is likely and that US stocks as a whole will head much higher, I think now would be a good time to exit positions in Bubble 2.0 in favor of other bullish sectors -- namely those related to energy.

As I noted previously, the real opportunity in social networking is in overcoming Peak Everything -- but unfortunately, the candidates in place are not really headed in that direction. If anything, Google (GOOG), Amazon (AMZN), and Intel (INTC) are the ones best positioned to make a meaningful economic impact on the world at large, and thus are still some of the safer long-term opportunities, relative to the Bubble 2.0 crowd, for value investors focused on the Internet technology sector.

On a positive note, Bubble 1.0 did manage to give us Amazon; if there is a corollary here as to which company can survive and thrive after Bubble 2.0 collapses, I think it is Zynga, Foursquare, or some other company developing a core competence in gamification. I regard gamification as the prime disruptive technology of social media, and thus the most important development Bubble 2.0 will ultimately give us. Those who do the best job of gamifying all aspects of our lives will, in my opinion, have the best chance of re-configuring how our society is connected (which ultimately helps us resolve "peak everything") while also being positioned to intermediate markets of all kinds.

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

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