The success of the recent LinkedIn and Pandora offerings, the heady multiples for cloud services stocks like Open Table and Netflix, and the rumored valuations for innovators still private, like Facebook, Groupon, Zynga and Twitter, have prompted the media to raise the tech bubble alarm. Given that tech stocks in aggregate trade at an all-time discount to the S&P500, that 20% of large cap tech stocks trade at single digit multiples on future earnings with double digit free cash flow yields, and that the companies leading the charge to the portable, cloud-based future, Apple and Google, trade at multiples below Proctor and Gamble with PEG ratios less than 0.35, the possibility of froth in amongst a small group of next-gen web stocks strikes us as a poorly fitting analogy with the indiscriminate and market ranging exuberance of the year 2000.
At first glance, some of the froth appears to be transference from investors thus far unable to buy a piece of Facebook and settling on the next best thing, resulting in valuations that presume very strong growth and profitability. That said, history suggests that tech companies on the right side of a wave of change can deliver against even the most aggressive expectations, making it premature to dismiss nosebleed multiples out of hand. Some of these companies will prove to be worth the money. How, then, to distinguish contenders from pretenders?
Target Market. An obvious consideration in assessing the value of early stage companies is the potential market that they might address. For example, Facebook addresses a larger market (all human beings) than does LinkedIn (all business professionals). Of course, narrower ambitions may also suggest a greater likelihood of success and there is always the possibility of expanding scope down the line – Amazon has successfully expanded far beyond its origins as an on-line book purveyor. Nonetheless, potential must be a consideration in valuing emerging internet businesses.
Critical Mass. For internet-based competitors, most barriers to competition kick in with scale. From a crowded field, one player emerges with sufficient size to begin pressing its advantage. Google beats Yahoo and Altavista to the mark and takes off. Same for Facebook overtaking MySpace. In contrast, Groupon is fending off competition from LivingSocial and Yelp, with Google and Facebook gearing up – arguably, none has reached the level of critical mass. Companies with clear dominance in a market are obviously more valuable than those in the midst of a fight for survival.
Barriers to Competition. How easy is it to displace an early market leader? History says it can be very difficult – Microsoft’s dominance of PC software is an obvious example. One factor in a company’s permanence at the top is the existence of network effects – business advantages that geometrically expand with market share. Facebook users are unlikely to switch loyalties, unless a rival could easily replicate one’s circle of friends. A competitor to OpenTable would need to gain the cooperation of a critical mass of restauranteurs in a city to displace it. Another key issue is control of proprietary technology or content. Apple used its proprietary audio file format as major barrier as it built its dominant iTunes music franchise. Netflix has begun to finance the production of proprietary content to augment the non-exclusive licensed programming that is still the basis of its streaming service. Cumulative investment – e.g. in infrastructure, in R&D, in brand-building, in distribution, etc. – is also a considerable obstacle for rivals. Google’s massive network of data centers give its various services – e.g. search, YouTube, etc. – substantial speed advantages.
Sizing Up the Next Generation. We evaluated a range of public and private companies that are vying for leadership in the socially connected, media streaming future along these criteria. In reverse order of valuation:
- Facebook – With an expected IPO valuation exceeding $100B, projected 2011 revenues of $4B+ and profits of $1B+, THE social network is the 2000lb gorilla in this category. Its target market is the more than 2 billion current Internet users and the $1.5 Trillion market for global advertising, so it is ambitious. Given that it is believed to have more than 700M users, it would seem that it has exceeded the necessary critical mass. Finally, the barriers to switching are high. Facebook’s value to users is largely contingent on the participation of their friends – switching would entail leaving friends behind and re-establishing connections elsewhere. With less than 2% of the global advertising market currently captured by the Internet, we believe Facebook is extraordinarily well positioned to sustain exceptional revenue growth from its huge base of users.
- Groupon – Groupon is rumored to be seeking a valuation of up to $30B in its planned IPO with sales growing rapidly from the $2.5B run rate delivered in 1Q11, but on-going losses at the bottom line. The company’s business model addresses the $200B spent on non-measured advertising in the US, and it has established a 50% share of the still nascent local discount deals market. However, the recent dramatic market share growth of rival Living Social, boosted by big deal with Amazon, suggests that critical mass has not been established. Against that, the looming entry of web giants Facebook and Google to the space and the potential for price competition to draw disgruntled merchants to a competitive offer, suggest that the switching barriers are less than substantial.
- Zynga – This pending IPO is expected to be filed this week, with a forecast valuation of $15-20B. Projecting revenues of $1.8B and profits of $630M for 2011, Zynga has successfully piggybacked on Facebook’s user base, showing at least one way that social networking can be monetized. While video games are a $52B global market, Zynga’s games address a different demographic that is likely incremental to the more fast-twitch console oriented experience at the core of the market. Critical mass is also a difficult call, as games are inherently hit driven. Certainly Zynga has established a content model that it has replicated through multiple iterations and monetized admirably. Nonetheless, it would seem that the door is still open for future rivals to offer compelling alternatives that stop Zynga’s momentum in its tracks.
- Netflix – Unlike others on this list, Netflix has been public for nearly a decade. However, its status as a Web2.0 darling began with its introduction of video streaming in early 2007 and the geometric rise in its share price which began in earnest from the start of 2009. Netflix is now valued at nearly $14B on trailing sales of $2.4B and a YoY growth rate of 45%. Its primary target market is the $100B US Cable industry, although it also targets international markets. While Netflix dominates the current streaming movie subscription business, the target is much broader and largely undeveloped. Without proprietary access to content or a differentiated delivery infrastructure, we believe barriers to switching are modest and that competition from the likes of Apple, Google, Amazon and even Facebook could be formidable.
- Living Social – Living Social inhabits much the same space as Groupon, offering deals on behalf of local merchants in a growing roster of cities, addressing the same $200B target market for local advertisning. Its 2011 sales are estimated at $1B, with a projected IPO valuation of more than $10B. A well publicized deal with Amazon at the beginning of 2011 accelerated the company’s growth, allowing it to gain ground on market pioneer Groupon. Ultimately, Living Social’s rapid growth is a bit of an indictment, demonstrating that neither company has reached critical mass and that switching costs are far from insurmountable. Combined, the projected Groupon and Living Social valuations would be the 20th largest technology stock capitalization, despite the likelihood of aggressive competition and the absence of profits for either company.
- Twitter – Twitter is on pace to reach 200 million users by year end 2011 and is serving more than 1 billion tweets per week. Growth in users and usage is prodigious, with particular emphasis on the 182% annual growth in users from mobile platforms. While it has been stoking adoption, Twitter has not been focused on revenues, as total sales for 2011 are expected to be well below $200M. Despite the lack of monetization to date, we believe Twitter is well positioned to pick up a slice of the global advertising market – 25% of its subscribers follow product brands on the service, with two thirds of those intending to purchase. The user base is also much better educated and higher income than Facebook, significantly valuable to advertisers once management focuses on driving sales. We also see Twitter as having very significant switching barriers in its amassed audience and content, and its technical platform. While current valuation estimates of ~$10B are modest relative to more developed monetization platforms, we believe the uniqueness of the platform and its potential as a vehicle for advertising are poorly appreciated by investors.
- LinkedIn – LinkedIn’s May IPO was a big success, and although the stock pulled back some 30% from its opening price, it has retraced most of that drop with the recent positive initiations from analysts at the firms in the underwriting group and is valued at about $8B. Thus far, LinkedIn has not been able to monetize its services very easily and total 2010 revenues were just $243M with $15.4M in net income. LinkedIn has 100 million largely well-off, well educated and professionally employed users and is adding about 1 million users per week. The target market – global business professionals – probably numbers well less than 1 billion worldwide, even if the definition is stretched to its limits but is very attractive to advertisers. LinkedIn is likely past critical mass vs. its current peers, but is potentially vulnerable to market entry from Facebook or to a lesser extent, Google, which is also able to reach LinkedIn’s target market.
- Pandora – Pandora’s share price has boomeranged from its offering at $17, down to $13 and back over the course of two weeks, returning to a valuation of just over $3B. Revenues in 2010 were $137M, up 160% YoY. US radio industry revenues were $20B in 2010, including satellite, with another $4B in industry revenues from the sale of digital music files. Pandora has 90 million registered users and 30+ million regular users, but likely has not reached critical mass. Switching barriers are an issue for Pandora, as Apple, Google and Amazon are all launching cloud-based streaming media services that will compete directly with Pandora, while favorable royalty rates to recording companies will need to be renegotiated over time. The key will be whether or not Pandora’s “music genome” process, which purports to deliver music selection unusually well suited to listener tastes offers a truly sustainably differentiated service. If not, it is difficult to imagine the company holding off its much larger rivals.
- Open Table – Open Table was the first of the social networking IPOs to hit the market, and has performed admirably since, up nearly three-fold since the May 2009 offering to a $2B market cap. The addressable market – restaurant reservations around the world – is likely well above $1B per year, with 2011 sales estimated at nearly $150M on nearly 50% annual growth. With 37% of North American reservation taking restaurants on board and 9% of all reservations placed through its system, Open Table appears to have established critical mass, with no significant competitors. Switching costs are fairly high, as Open Table supports its partner restaurants with proprietary software and a well conditioned base of diners. The platform appears to have expansion opportunity outside of North America and could be expanded to support a range of other reservation driven businesses.
Summary. Looking at the business models of these “Web2.0” stocks, we are most comfortable that Facebook, Twitter and OpenTable will be able to sustain their leadership in their pursuit of their target markets. Each of these companies is pursuing an attractive target market opportunity, and each has established critical mass that strengthens the natural barriers to competitors. While investors may be concerned about the ability to monetize these strong competitive positions, we believe that this is a strategic choice, critical to establishing critical mass, and that new sources of revenues can be easily tapped. We are more skeptical about the other companies in this note, as we believe each is likely to see vigorous rivalry from strong competitors that will erode market share and pressure margins