Social Media Stocks Weighed By Risks

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Web 2.0 stocks are troubling in two very different respects. First, they often trade at prices that are beyond the intrinsic value of equity. Second they pioneer new business models which may not be great for investors in the long term. Taken together, investors may be paying premium for risky, poorly-proven ventures.

With thes problems in mind, investors should be particularly sensitive to valuations. Do any big-name web 2.0 stocks qualify as reasonable investments at current price levels?

Groupon Competition

Groupon (NASDAQ: GRPN) faces challenges as competition from other deal sites grows more intense. Google Offers, Amazon local, LivingSocial, Gilt City, and Bloomspot are only a few of the 142 deal sites in the United States in 2012. They have increased in number by 8% in this year alone.

In addition to the heightened competition, merchant partners have rising expectations for deal companies. 39% of merchants have also expressed disappointment in a survey conducted by Raymond James among dealers that used Groupon’s services during the fall. Although 66% of merchants were satisfied by the surge of new customers lured by Groupon promotions, only 39% were pleased with the quality of the customers.

Groupon has shown slower growth in its core daily deals segment. Revenues generated through deals offered by third-party merchants weakened from $502.9 million in the second quarter of the year to $423.6 million in the third quarter, a decline of around 16%. Revenues from the direct sale of Groupon merchandise, however, have increased. Groupon faces doubts on its reputation as the best-known name in the online coupon business, as word from the grapevine reveals that CEO Andrew Mason may soon end his term as head executive of the company.

Growth in the industry is now shifting to companies that utilize non-traditional business models. Changes in consumer taste introduced uncertainty and opened various opportunities for new industry players to attempt alternative strategies in capturing the consumer market. This year, holiday gifts have become a more reliable source of revenue for Groupon. However, close competitors such as LivingSocial have shown signs of directly competing by adopting similar strategies. Yipit estimates holiday sales to reach $150 million compared to $20 million in 2010. Yipit data product manager Unaiz Kabani said, “Groupon Goods has already become a major segment for the company, less than a year after it was launched. You’ll definitely continue to see more of this.”

Key People Leaving Zynga

David Wehner has departed Zynga (NASDAQ: ZNGA) as company CFO to join Facebook (NASDAQ: FB) as vice president of corporate finance and business planning. Wehner will be succeeded by Mark Vranesh. This departure comes less than a year since Zynga announced its IPO; and the largest maker of online games has now been dealt a major blow in its confidence of turnaround efforts, having lost at least eight other senior managers since August. Zynga has now embarked on restructuring, targeting cost-cutting and revenue boosting from games on mobile devices. It is cutting 5% of staff, ending more than a dozen titles and shutting offices as a result. The company CEO, Mark Pincus, is now struggling to retain key people as a plummeting stock price erodes the value of equity-based compensation. New executives include Barry Cottle as chief revenue officer, Chief Mobile Officer David Ko as the chief operations officer, and Steven Chiang as the president of games. Zynga remained unchanged in the New York stock report at about $2 prior to the announcement of these changes.

On the contrary, analysts were concerned. According to Arvind Bhatia, “When executives start voting with their feet it sends a more powerful message than anything the company can say. It seems more and more that the company is going to have continued issues.”

Valuation is Always the Next Big Thing

The price you pay is important because it is the denominator of stock returns. Anyone who says price doesn’t matter is not worth listening to. Given the troubles facing Zynga and Groupon, these stocks should be priced so that their valuation multiples that are clear bargains relative market averages. Other social media stocks should be priced competitively to the broader market.

The price multiples for these stocks are wildly different:

<table> <tbody> <tr> <td> <p><strong>Ticker</strong></p> </td> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>P/E</strong></p> </td> <td> <p><strong>P/S</strong></p> </td> <td> <p><strong>P/B</strong></p> </td> <td> <p><strong>P/FCF</strong></p> </td> <td> <p><strong>EPS Growth Next 5 Years</strong></p> </td> </tr> <tr> <td> <p>FB</p> </td> <td> <p>Facebook</p> </td> <td> <p>251.91</p> </td> <td> <p>12.95</p> </td> <td> <p>4.24</p> </td> <td> <p>274.12</p> </td> <td> <p>26.7%</p> </td> </tr> <tr> <td> <p>GRPN</p> </td> <td> <p>Groupon</p> </td> <td> <p>NA</p> </td> <td> <p>1.16</p> </td> <td> <p>3.16</p> </td> <td> <p>8.66</p> </td> <td> <p>27.1%</p> </td> </tr> <tr> <td> <p>LNKD</p> </td> <td> <p>LinkedIn</p> </td> <td> <p>718.73</p> </td> <td> <p>13.85</p> </td> <td> <p>13.95</p> </td> <td> <p>254.37</p> </td> <td> <p>72.5%</p> </td> </tr> <tr> <td> <p>ZNGA</p> </td> <td> <p>Zynga</p> </td> <td> <p>NA</p> </td> <td> <p>1.42</p> </td> <td> <p>0.98</p> </td> <td> <p>NA</p> </td> <td> <p>23.6%</p> </td> </tr> </tbody> </table>

At this price levels, Groupon trades at a price-to-book ratio of 3.16 and a high price-to-sales multiple of 1.16 (over the past 12 months). This is a justifiable price-to-book ratio for a technology firm, and the price-to-sales multiple is actually cheap. Unfortunately, Groupon does not have a calculable price-to-earnings multiple because it did not generate profits over the last year. Is it cheap? Yes. Is it cheap enough to justify buying a stock hounded by copy-cats? Not really.

Zynga is arguably cheaper. It is trading below the book value of its equity, which is a steal for a tech stock since many of its assets are not quantified on the balance sheet. Shares of this stock currently trade at a price-to-book ratio of 0.98, and a price-to-sales multiple of 1.42. Like Groupon, Zynga did not generate profits over the last year, so it does not have a calculable price-to-earnings multiple.

In contrast, LinkedIn (NYSE: LNKD) is just too pricey based on valuation. Shares trade at a price-to-book ratio of 13.95, a price-to-earnings multiple of 718.73, and a price-to-sales multiple of 13.85 (over the past 12 months). You should be scared of these price multiples.

Facebook’s price multiples are only slightly less scary. Facebook trades at a price-to-book ratio of 4.24, a price-to-earnings multiple of 251.91, and a price-to-sales multiple of 12.95 (over the past 12 months). These are just too high.

Wait for Deals

LinkedIn and Facebook are trading at valuations that scream “Stay Away!” Zynga and Groupon are cheap based on valuation, but risky. Of the two, Zynga is a better speculative bet.

BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook and LinkedIn and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Facebook and LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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