Are social media stocks a bubble?
The short answer: Probably. No matter how you flip the matrix or pore into the metrics, social media stocks are overvalued.
Some, like Twitter (TWTR), are already feeling the pressure. Others, like Facebook (FB), have yet to feel the full brunt — but even so, FB will be unable to escape the inevitable burst too much longer. There’s simply not enough growth out there to justify everything that’s already baked in.
Social Media Stocks: High Spending, High Valuations … Few Profits
When it comes to social media stocks not named Facebook, it’s not hard to find stretched valuations. LinkedIn (LNKD) had a losing quarter with an uncertain outlook. Yelp (YELP) isn’t making money. And Twitter hasn’t made a dime on a GAAP basis in its entire life — with nothing to show for it, the company already has been butchered by short sellers.
And yet … LNKD trades at 50 times next year’s earnings estimates, YELP trades at 300x and Twitter trades at 45 times Wall Street’s expectations (on an adjusted basis, of course).
The thing is, these performances and valuations would be a little more understandable if LinkedIn, Yelp or Twitter were small startups … but most are mature companies, still having difficulties squeezing out a buck.
As their latest stock reports reveal, these social media companies are spending money hand over fist in R&D and capital investments. Generally, the social media model requires constant investments in new products and in the user interface. But the fact remains that what those social media stocks spend in buckets they only earn back in spoons.
Take LNKD, for example: Since Q2 2014, LinkedIn has spent nearly $650 million on R&D and still lost 55 cents in Q2 2015. Similarly, Twitter spent several hundreds of millions in R&D only to lose 20 cents per share in its most recent quarter.
And as most social media stocks have lowered their expectations for the year, it’s even unlikelier that those massive investments will turn into lucrative profits soon.
Most social media outlets have lowered their expectations for the rest of the year. Any hope that those massive investments will turn into lucrative profits seems much more remote.
A single company is bad enough, but when most of them invest heavily without any sort of adequate return, that’s a blemish on the sector.
Even Facebook Can’t Escape the Bubble
As we’ve said, Facebook has been the exception. While all the rest struggle, Facebook actually keeps growing, and it actually keeps making money.
There’s no denying that FB is superior to its peers. It’s highly profitable, boasting a net profit margin of 18% and a fair growth rate. There’s no doubt that Facebook is a great company with an unequaled understanding of the social media business.
But even the great Facebook can’t avoid being sucked into the bubble like the rest of the social media stocks. FB is finding that it has to spend more and more to keep users engaged and maintain its edge. There’s no escape; the constant need for investment will burden profits.
As illustrated above, while Facebook’s gross margin is still high, the growth in SG&A costs (which includes R&D) has outpaced the growth in revenue. Of course, this does not include all other costs such as Facebook’s recent M&A with Oculus, WhatsApp and Instagram. That suggests that Facebook’s future profitability will be lower.
Meanwhile, FB stock trades at 93 times trailing earnings and still a high 30 on next year’s estimates, taking into account a whole lot of optimism that Facebook will keep growing as fast as a startup.
But can we really expect that to happen, considering what we’re looking at above?
Of course not.
Social media stocks can be divided into two categories:
- Everyone that isn’t Facebook. These social stocks struggle to earn profits and tend to trade at a very high premium.
- Facebook. Yes, it’s profitable. But you can expect profits to diminish; meanwhile, it trades for a fairly high premium.
As a whole, this sector is at a stage where investors — who have driven prices to sky-high valuations — rightfully want to see some returns, but hardly anyone is delivering.
That is a bubble waiting to burst.
As of this writing, Lior Alkalay did not hold a position in any of the aforementioned securities.
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