Is It Time To Avoid Some Internet Stocks

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

Opposite to what many might believe, Facebook (NASDAQ: FB) and LinkedIn (NYSE: LNKD) are not so attractive investments at the moment despite their market leading positions and strong brand names. What makes them unattractive is their valuations are sky-high. Yahoo! (NASDAQ: YHOO), instead, is pretty undervalued and deserves a closer look.

Below you will find the main reasons to back this hypothesis; you will discover that Yahoo! could be a turnaround case after all, while Facebook and LinkedIn hold limited upside potential at their current valuations.

Facebook: One of the most important tech companies

Facebook used to be a buy case from almost any perspective. However, recently weak financial results, the exodus of hedge funds during the first quarter, and its valuation at over 500 times its earnings and 18 times the industry average,encourage a Hold recommendation at the time.

On the bright side, Facebook is one of the largest tech companies in the world and holds a globally recognized brand name. Moreover, its website’s traffic offers great value for advertisers since average users spend more time on Facebook than on any other website on the Internet. In addition, the company collects user information, from likes and dislikes to regular activities. This data is highly valuable for other firms and allows creating user-group-specific publicity.

Going forward, enterprise advertising budgets should continue to increase, largely benefiting Facebook. As a result, analysts expect an average annual earnings per share growth rate in the 26%-36% range over the next five years.

However, the rapidly evolving web environment poses several challenges to the firm. For starters, Facebook lost its display ad leadership to Google last year and the company’s dominance is expected to persist for a while yet. Furthermore, Facebook’s revenue strongly depend on its partnership with Zynga, which accounts for 15% of total revenue. Finally, two other concerns related to the future arise: that of the company’s founder holding a majority vote, pushing shareholders into the background in terms of decision-making; and the litigation and regulation risks related to Facebook’s control of massive amounts of personal data.

LinkedIn: Largest professional network

LinkedIn is another case of an overvalued stock inflated by exaggerated market expectations. Trading at over 500 times its earnings, more than 18 times the industry average, while offering margins and returns well below its peers’ mean figures, I’d recommend holding on this stock for now.

My main concerns revolve around a few subjects. For starters, competition is growing very fast and, although LinkedIn remains the largest professional network, other sites like Viadeo seem to offer better prospects in account of their penetration in emerging economies like China. Other major concerns derive from Facebook’s possible foray into the professional social networking segment and LinkedIn’s weak and seemingly permeable security system (which recently allowed a hacker to steal thousands of passwords and other data).

However, offering an expected average annual earnings per share growth rate above 50%, you should not lose track of LinkedIn’s stock. If its valuation became more reasonable, an attractive entry point would become available for long-term investors. If this were the case, shareholders can find reassurance in the substantial network effects from which LinkedIn benefits, plenty of expansion opportunities in a market that is far from mature, limited competition, high cash generation capabilities and a steady source of revenue derived from user subscriptions. Meanwhile, some analysts recommend shorting this stock, which doesn´t seem like a bad idea, taking into account the risk-reward ratio.

Yahoo: The importance of good management

Yahoo! is the only company in this list that doesn't trade at sidereal valuations. Instead, it exchanges at about ¼ of the industry average valuation, at 7 times its earnings. Despite this fact, the company’s future looks quite bright and analysts expect it to outperform its peers. Moreover, its margins and returns are far better than those of Facebook, LinkedIn and most of its other competitors. With such a positive outlook, the stock looks like a buy and hold case.

The main reason behind this recommendation is Marissa Mayer. Ms. Mayer took the CEO position at Yahoo almost one year ago and it seems like she might pull off a turnaround for the company. During her tenure, she redesigned Yahoo's homepage and mobile email interface, as well as Flickr´s page with substantial success.

Acquisitions have also played an important role and should prove profitable in the years to come. The $1.1 billion Tumblr acquisition made last month should prove of particular importance for traffic. Analysts estimate that this site´s traffic bulks up to roughly 130 million users each month.

The other important growth catalyst that I can find in Yahoo is its advertising expertise, which will help it better capitalize the migration of publicity from traditional media to online platforms. Furthermore, its webpages' massive traffic will allure plenty of advertisers over the years to come, driving revenue and margin growth.

Bottom line

Although Facebook and LinkedIn might be undisputed market leaders in their segments, the fact is that all their success is already priced into their stocks. Opposite to these two firms, Yahoo! is quite undervalued, mainly due to its competitive disadvantage in comparison to Google, Facebook or Twitter and some erratic results in the past. But a renewed management has injected new life to this firm that trades at a very attractive valuation and offers plenty of growth prospects. I'd say, buy Yahoo! stock while it is still cheap and hold on to it - upside should be plenty.

Damian Illia has no position in any stocks mentioned. The Motley Fool recommends Facebook and LinkedIn. The Motley Fool owns shares of 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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