News Analysis date published New: 
Friday, February 17, 2012 - 11:30
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Friday, February 17, 2012 - 15:44
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Friday, February 17, 2012 - 11:30

Should You Invest in Groupon, LinkedIn and Other Hot Social Media Stocks?

Friday, February 17, 2012 11:30 AM

The social media freshmen are entering their sophomore year. LinkedIn (Nasdaq: LNKD), Groupon (Nasdaq: GRPN) and Zynga (Nasdaq: ZNGA) have shaken off the post-IPO jitters, so now investors have the clearest picture yet of how large these companies can grow in the coming quarters and years.

[block:block=16]I've written before about the dangers of investing in IPOs right out of the gate, especially for these social-media darlings. But now that the proverbial smoke has cleared, can we can get a clear view of the path ahead for these companies, and are shares even worth your investment?

As a quick recap, LinkedIn, which operates a social media website for professionals, has been surging after fourth-quarter results were released. Meanwhile, daily-deal website Groupon and Zynga, which makes popular social media games for Facebook, pulled back after their numbers came out. Still, none of these stocks are bargains in terms of projected near-term results. Each stock trades for at least 50 times projected 2012 earnings and at least five times projected 2012 sales.

Take a look at the table below. I've included other recent IPOs for comparison's sake.

At this point, investors need to ask themselves three key questions:
Is each company building a sustainable platform to avoid becoming just another flash in the pan?
What kind of five-year growth are they capable of achieving?
And what will profits look like when they reach maturity?

A real business model?
With a market value of just under $11 billion, Groupon is the most richly-valued business model here. And perhaps for reasons associated with a possible need to raise capital in coming quarters, Wall Street's analysts are generally effusive about the company's long-term prospects.

Is this business model here to stay?

Not only are Groupon's dozens of rivals working to steal market share in many local markets, but the merchants that use the service are expected to absorb a loss on these deals (or at best a miniscule profit), and they can hardly be considered to be willing long-term participants. The whole point of a Groupon promotion is to be a teaser, bringing in new customers who may not have visited the store before. It is not a way for companies to figure out how to lose money on every sale.

To me, this still seems like a circa-2011/2012 business model that people will be reminiscing about by mid-decade. Yet the current large market value seems to ignore this possibility. It's also worth noting that Groupon, which used very aggressive accounting prior to the IPO, appears to continue to pump up its numbers. For example, the company derives a cash flow figure that capitalizes many costs that should be immediately expensed. That $0.83 a share 2013 profit forecast is a fiction only accountants could love.

At least LinkedIn has the feel of a real business tool and not just a social fad. The site now helps people represent themselves in a way that personal blogs once did, and is seen as an essential tool for anyone who believes that social networking is a path to career advancement. And due to the automated nature of its business model, LinkedIn is positioned to generate solid profit margins as sales rise, unlike Groupon, which must pay an army of staffers to oversee all of the deals that are offered.

Zynga may be the most dubious long-term business model. Not only does the company need to keep coming up with winning games (as existing popular games can have a fairly short shelf life), but the company is vulnerable to consumers deciding they want to spend their time on other leisure pursuits than Facebook games.

It's not so troubling that Zynga trades for 37 times projected profits. It's that the company is worth $8.5 billion. In contrast, Hasbro (NYSE: HAS), which is a member of my $100,000 Real-Money Portfolio, has been in business since 1923 and had $4.3 billion in sales in 2011, yet is valued at about half as much as Zynga.

In other words, Zynga is worth twice as much as Hasbro. On an equivalent price/2012 sales basis, Zynga is worth six times more than Hasbro. And unlike Hasbro, Zynga now looks like a great growth story, but I've got a hunch that Hasbro will still be an important toy and game maker long after Zynga has flamed out.

What kind of growth?
The second question is hardest for investors to gauge. In the early phase of the life cycle, these companies can double sales annually. By the time they are prepping for an IPO, sales are rising 50% annually. A year or two after the IPO, 30% growth looks to be sustainable. But it's completely unclear whether these companies are only in the early innings of growth or actually a lot closer to the end.

Groupon is expected to have $3 billion in sales by 2013. Does the company's market really grow beyond that? Or does anyone who wants to use Groupon already doing so by then? Is Zynga at risk of not growing at all if it fails to deliver hot new gaming titles? Investors should be asking these questions, although you rarely see them in analysts' reports. To be fair, Wall Street analysts have no idea either, so they simply pencil in strong growth in perpetuity.

What kind of profits?
I'm a fan of LinkedIn's business model, but am reflexively cautious about any recent IPO that is already worth $9 billion. Let's say you're bullish on the stock and think it will rise from the current $90 to $145 in the next five years (which is about 10% annual compound growth). And let's assume LinkedIn meets the current expectations for 2013, boosts sales by 20% in each of the next three years, and EPS rises by 25%. Here's what LinkedIn would be doing by 2016...

At $145 a share, the company would be valued at around $14.3 billion, or more than six times projected 2016 sales. Said another way, the stock would be valued at almost 70 times projected 2016 profits. Even if the stock price went nowhere and sat at $90, then shares would still be worth more than 40 times 2016 profits.

Risks to Consider: These are frothy stocks and they may be unwise to short if the market "melts up" from here.

Action to Take --> These are exciting companies that have quickly built a sizeable following, but it's crucial not to confuse their popularity among consumers with their real-world valuations. These companies should grow at a fast pace in 2012, but their stocks are quite vulnerable to the eventual, inevitable cool-down in growth that all businesses see as they reach maturity. With this in mind, I think it's wise for most investors to avoid these stocks until their valuations come back down to earth, if ever.

[Note: You can also follow along with my $100,000 Real-Money Portfolio trades free for a limited time. Simply click on this link to sign up.]

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of HAS in one or more of its “real money” portfolios.