Social media companies are currently the rage in the investment world. Many of the top social media companies have gone public and many more are on the way. It always concerns me when clients start calling to ask about a hot IPO. Usually they are curious about the hoopla and want to know whether a company is a good investment. This usually is a bad sign, a sign of an over hyped investment. I want to point out several important facts that people should consider about social media/technology companies.
It is hard not to get excited about the prospects of social media or new media companies. Many of these companies may turn out to be great investments - but many will not. There are a limited number of Microsofts, Apples, and Googles. The issue is not whether social media companies are companies that you like, but whether they are good investments that will reward their public shareholders. Today's IPOs are the most shareholder unfriendly and overvalued deals I have seen since 1999. Let me illustrate several of the issues that concern me.
1. The corporate growth ecosystem has changed. Prior to the 2000s, companies went public to raise capital because they could not raise the capital needed to grow from private investors. This money raised was used by the companies primarily to grow their businesses. When the company became successful, the public shareholders were rewarded with higher stock prices.
In the last 10 years, due to regulations and the costs associated with becoming a public company, many firms have chosen to stay private much longer than in the past. A whole new ecosystem has developed around private equity and venture capital. Now companies make trips up to the Valley (not the San Fernando Valley) to raise capital and are able to get large funding deals worth millions of dollars as well as management help from these sources.
In the past, PE and VC firms took companies public to cash out quickly, but now they have become more patient. Instead of hiring an investment bank and raising money from the public, new technology companies do round after round of private financing. By the time they sell the stock to the public, these companies are mature businesses with less upside potential. In many cases the initial valuation is in the billions or tens of billions of dollars.
2. Valuations and profits still matter. I find it worrisome when companies are valued solely on revenues. Shareholder value is created through the profits of a business. The argument for using the revenue valuation method is that these companies will continue to grow and then produce profits. Often, that is not the case. Many internet companies use the philosophy of mortgaging everything to grow revenue. They spend millions in advertising on Google, or even worse, Super Bowl ads. This is all an attempt to grow revenues exponentially at the expense of profits. This works well for the founders of the company who artfully cash out before the shareholders realize they are holding the bag for the bill.
Typically, shareholders invest for profits, however if there are no profits, these investments end up losing money. When we choose investments, we seek to invest in companies that have a price to earnings ratio, implying they have earnings. In the case of most new technology companies today, they command a price to revenue ratio of 8-10 to 1. The argument for this valuation method is that the company is growing so fast that it is worth the huge premium paid by investors. The problem is that many companies grow bigger and have bigger losses, not profits. If the business model does not work, it does not matter how much revenue the company takes in; it will continue to lose money. The truth about the stock market is that after the companies do go public they must become profitable or the stock will go down.
3. The public shareholders have no rights. This is a really annoying thing about many new tech IPOs. They take public investors money but give us no say in governance or through the boards. Often these companies only release a small amount of stock to the public shareholders and have multiple classes of stock. In essence you are blindly investing your money and you must trust that management will take care of you. I don't know how you feel after watching the film â€˜Social Network'? It seems to me that the only people taking care of themselves are the VC/PE firms and the founders, who are making out with billions of dollars. It just feels wrong putting your hard earned money into companies that continue to enrich past owners at the expense of new owners.
4. Most people have forgotten the 1990's; good companies don't always survive. There were so many exciting companies in the 90's, many of which I loved, but sadly they are gone today. A perfect example was homegrocer.com. I loved getting groceries delivered to my home. I loved the company model, plus they had great service. The company went public, built a huge distribution system and grew like crazy. I used to say to myself, "Wow, what a great company, but how do they make money?" Well, they didn't make money and today they are long gone. I keep a homegrocer.com shopping list on my fridge just to remember.
Many great companies with great ideas will go public over the next few years, but few will survive. In the end, companies must make money and be run by competent managers. Spend some time thinking about all the great companies of the 1990's that are gone. The internet is a fickle place and trends change quickly.
5. Many internet companies rely solely on advertising revenue. I am so sick of this business model. These companies create a service or membership, generate enough people to visit their site, and then sell advertising on the site to make money. This model is very risky and often unsustainable. Does display advertising really work? No one really knows. We know search ads work, but display advertising is just glorified billboards on your screen. If you ask 10 people if they remember what ads they saw on their screen just 5 minutes earlier, they will tell you they did not see any ads.
Good tech companies change the way to do business within their industry and they make money the old-fashioned way. The ad model is shaky, at best, which is the biggest problem with many internet companies.
There are many reasons investors should be cautious about the coming boom in technology IPO's. Careful research, diversification and an understanding of the business might help us find the next Google, but there are many duds out there. Gerber Kawasaki spends considerable amounts of time analyzing these companies to determine if they are good investments. We do feel that some of the new social media and technology companies will make for great investments, but we are always skeptical of the hype. We are currently following many of the stocks in this category and we are happy to discuss with you the opportunity of investing in technology. It is one of our core investment themes and one of our great American industries.
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved. Investing involves risk including potential loss of principal.
Disclaimer: Gerber Kawasaki and its clients may or may not hold any of the companies mentioned in the article. Please do not construe this article to be a recommendation to buy or sell any investment. Each client situation is different and a review of your risk tolerance and suitability is required before investing in the stock market as it involves risk. Contact us at 310-399-6397 for a full financial review to determine if investing in technology companies is suitable for your situation.