Facebook and Zynga: The Dot-Com Bubble All Over Again?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The late 1990s dot-com bubble burst because most Internet start-ups never really figured out how to turn eyeballs into earnings. Without viable business models, the companies disappeared. Now more than a decade later it is becoming apparent that the second wave of hot Internet IPOs may face the same problem: turning users into cash.
With Facebook (NASDAQ: FB) down some 40% from its IPO valuation of more than $100 billion and Zynga (NASDAQ: ZNGA) having an even tougher time as a public company (down 80% from a peak valuation of $12 billion), the second bubble may be bursting.
The biggest reason I would not touch these stocks even after huge drops is that, as was the case in 1999, these business models are unproven from a money-making perspective. Sure, Facebook is a lot of fun, as are Zynga's social games, but the path to extracting significant profits from users of these platforms is unclear. Unlike a recurring monthly subscription model, which could see monthly revenue per user range from as low as $10 (Hulu, Netflix, Spotify, etc), to over $100 (cable television or smartphone bills), Facebook, Zynga and the like so far have not been able to put a high dollar value on their services.
Consider the recent second quarter earnings reports from both companies. Facebook booked revenue of $1.18 billion during the second quarter and reported an active user base of 955 million. Some quick math shows us that Facebook makes 41 cents per month from each of its users. For Zynga the number is even lower at 36 cents per month ($332 million in revenue for Q2, divided by 306 million users).
The question investors need to contemplate is simple: "Is this a real business?" Sure, even a few cents from a huge user base adds up to real money, but is it enough to justify current stock market valuations? I believe it is hard to argue that a company of this ilk generating $5 billion in revenue annually is worth $50 billion, but that is what Wall Street is saying Facebook is worth.
Now, yes, earnings matter more than revenue, and Facebook is quite profitable, but they are reinvesting all of their revenue, and more, back into the business (second quarter free cash flow was negative). It could be argued that such investments are required to keep users interested and coming back. The amount of steady, long-term, predictable free cash flow a social networking company can generate is very much an open question at this point. And getting 40 cents a month from each user of the world's most popular web site is hardly a ringing endorsement. It is even more worrisome when we consider that the popularity of Facebook and Zynga are already sky high, and therefore are unlikely to go anywhere but down over time.
The business model for social networks, in my mind, is so unproven that the stocks, though down a lot, remain very risky investments. A lot of things have to go right for these to make lots of money for shareholders. Bargain hunters beware.
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