Should Investors "Like" Social Media Stocks?

Joel Anderson |

Mark Pincus, Zynga CEOThe recent filing for a $5 billion IPO by Facebook has set the investing world abuzz once again. Social media stocks across the board like Renren (RENN), LinkedIn (LNKD), and Zynga (ZNGA) have all gotten major boosts in the wake of Facebook's pending entrance into the market. However, the debate rages on as to whether or not social media stocks are really all they're cut out to be.

“With the Facebook IPO this sector will be in play,” said Mike Bellafiore, partner at SMB Capital, a professional trading firm. “The next five years are going to bring a basketful of daily opportunity in the social-media sector, and traders are learning what causes them to move.”

Social media appears to be poised in an interesting position. Each of these companies shows tremendous potential. The increasing connectivity of the world presents opportunities to branch out into global markets, creating massive revenue streams. The inherent potential of Facebooks captive audience of 700 million users has advertisers drooling.

However, the fact remains that the belief in the long-term potential of these companies has contributed to share prices that often outpace the actual earnings for these companies. For every analyst bullish about social media stocks, there seems to be another who is equally bearish, claiming that there's no way these companies can live up to their massive valuations.

LinkedIn: A Strong Example

While some may quibble that LinkedIn is increasingly becoming a corporate recruiting website first and social media site second, it does still offer an interesting look into why social media companies have become such battleground stocks. LinkedIn offers extremely bullish outlooks for its EPS growth in the future, with an average of close to 80 percent expected over the next five years. The company also swung into a profit this last quarter, releasing an earnings report showing EPS of $0.07 and a 105-percent year-over-year gain in revenues.

However, a closer look at the stock's valuations appear to reveal that investors have already priced in these gains, and future gains, into the share price. LinkedIn has a P/E ratio of over 700, a forward P/E of over 88, a PEG close to 9, P/S of just under 16, and a P/B of over 20. All of these point towards one thing: in order to live up to its current share price, LinkedIn needs to keep growing, and growing fast. And here lies the core of the argument about social media plays: While over-priced at the moment, do they have the ability to continue growing at a fast enough rate to warrant owning the stocks for the long term?

Outlook Murky

There's no clear answer to whether or not social media can produce the sort of consistent earnings growth that investors appear to have bought into. The last couple weeks have provided ample evidence for either argument. LinkedIn's stellar earnings report prompted a nearly 18 percent gain in share price and appeared to demonstrate the potential for LinkedIn to keep pace with expectations.

However, yesterday's release of earnings for Zynga after market close appeared to tack in the opposite direction. While revenues of $311 million in Q4 of 2011 allowed for an EPS of $0.05, topping analyst estimates for $0.03 a share, the company posted a loss of $411 million for 2011 after pricey stock compensation costs ate through profits. Even without the compensations, though, Zynga would have posted profits of only $182 million, a 24 percent decline from 2010.

Bears Betting Heavily Against Social Media

Whether right or wrong, the bears appear to be doubling down on their opinions about the pending downfall of social media stocks. Lou Basenese, a former Wall Street Analyst, wrote about the potential troubles on the horizon for social media stocks: "Bottom line: The fundamentals that shot social media companies to instant stardom are already fading. That doesn’t bode well for future share prices. And when the history books are written, I’m convinced the only ones who will have profited from all the hype are going to be the investment bankers, not everyday investors like you and me."

In the same article, Basense also highlights the troubling trend at play with Zynga and Groupon (GRPN). Both companies, less than a decade into their existence, are already looking elsewhere to generate revenue streams, potentially showing holes in the business models of both companies.

More troubling for social media stocks might be the amount of short selling currently going on with their stocks. The rate at which shares in these companies were being borrowed and sold reached post-IPO highs in the last three weeks for LinkedIn, Renren, Groupon, and Zynga. In each case, while the total float short remained low, the numbers change when one considers how few shares are publicly traded at the moment. Groupon and Zynga had 2.2 and 2.5 percent of share shorted respectively, but in both cases this represented more than 90 percent of those shares available to the public. LinkedIn, likewise, has only 5.5 percent of shares shorted, but almost 70 percent of shares available to the public.

Facebook IPO Should Shed Light on Markets

While it's impossible to say whether or not these companies will be able to make the short-sellers rue their big bets, the picture should become clearer in the near future. Along with Facebook's IPO will come more transparency and a better look at Facebook's revenues. How that giant is performing on a quarterly basis will probably affect the industry as a whole, acting as a rising (or receding) tide that carries all ships with it. In a few years, it's entirely likely that more sophistication in pricing tech companies like these will remove much of the guesswork, but in the interim, social media stocks present an opportunity for fortune or ruin. If only it were easier to see which one.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
CPA Copa Holdings S.A. Class A 92.70 0.26 0.28 99,409
RENN Renren Inc. American Depositary Shares each repres 1.84 0.03 1.87 65,055
LNKD LinkedIn Corporation Class A 195.96 0.00 0.00 0
ZNGA Zynga Inc. 2.92 -0.09 -2.99 8,051,010
GRPN Groupon Inc. 3.91 0.02 0.51 7,297,304

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