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It’s a bubble!

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There’s a morbid fascination with the investment merits for online social networks. However, investors need to tread carefully before they commit their hard-earned cash to one of those investments. There’s no question there’s a market for such products. Whether it is the infamous PigSpotter keeping South Africans safe from the Metro Police on Twitter, stalking a work colleague on Facebook or using a tool such as LinkedIn for professional networking, the applications are attracting thousands of eyeballs.

While online social networks are redefining the way people connect with one another these aren’t necessarily turning into revenue. And while the initial public offerings (IPOs) are attracting billions of US dollars in capital, you have to ask whether the insanity can actually last.

“Just as was the case in the dotcom bubble, financial contortion is taking place to help investors find facts that fit the story,” warns Adrian Saville, of Cannon Asset Managers and lecturer at the Gordon Institute of Business Science. Saville adds that – just as with any other financial bubble – it’s only a matter of time before it bursts. He adds emerging markets – including South Africa, Russia and China – haven’t been exempted from this “exceptional overpricing”. In the case of Russia he points to Yandex and in China he uses the example of RenRen, which has been dubbed “the Facebook of China”.

As the attached table shows, listed social networking stocks are trading on some pretty extravagant earnings multiples.

Technology analyst Paul Whitburn, of asset management house RE:CM, has recently been cautioning investors against the frothy hype being drummed up about social networking companies. He hits on a very simple point: while many of the big name social media companies are commanding “eyeballs” they haven’t been able to convert that into revenue. Whitburn describes such valuations as “excessive”.

Apart from the valuations, Whitburn says there’s another fundamental issue being overlooked when it comes to predicting the growth levels attached to those networks – the inability to grow across multiple geographies. “That makes it difficult for social networks to grow globally and achieve critical mass in local regions. A very good example of that are social networks, Tencent in China and VKontakte in Russia, which have both not expanded beyond certain regions.”

The obvious question: If the asset management can see “bubbles” in the sector, then what’s driving the incredible demand for those shares? Perhaps the best starting point is for Finweek to take off its “investor” hat and go and ask a South African who has been living in Silicon Valley to explain some of this madness.

“People who scream bubble are typically the ones who didn’t get in on the ground level and want the whole thing to crash down on them so they can feel better about themselves,” says technology investor Vinny Lingham. He dismisses the arguments about whether social media companies are worth US$30bn or $100bn, saying many such companies are incredibly profitable. Rather, he says, the hype about those shares is driven by limited liquidity.

“People want the shares badly – but there’s a limited free float. However, there’s enough support on the downside that if Facebook couldn’t support a $100bn valuation there are more than enough buyers at $50bn,” says Lingham.

Finweek points out there’s a perception smart insiders are selling to unsighted outsiders who are plugging the shares to clients amid the hype.

But Lingham argues that isn’t the case. “Why do you think Facebook is delaying its IPO? Those on the inside are saying: Yes, sure, don’t buy any stock right now – we want them all.” Lingham adds those truly wanting to understand how to value technology companies and whether they’re worth their valuations need to get their heads around Metcalfe’s Law (see separate box) and then try and calculate whether they’re getting value for money in their investments.

What social network would Lingham be buying into if he had a choice?

“First, buying Facebook before its IPO isn’t a good idea. The market is overheated on the secondary exchange valuation at $80bn and I’ve some concerns about liquidity – as it’s going to be the biggest IPO in history. And I’m not sure where they’re going to price, because it’s a blind market and there are no financials readily available.”

His pick would be Internet radio offering Pandora, which has recently gone to market. Lingham says the Internet radio is able to cross multiple geographies and represents a genuine growth market.

It’s easy enough for a technology guy to argue for no “bubble” but is there a middle ground from financial market analysts? For investors battling to get their heads around the growth versus valuation stories perhaps it’s easiest to bring it back to a home-grown example in the form of Finweek parent Naspers, which holds direct and indirect stakes in companies such as Mail.ru, Tencent and Facebook. Tencent and Mail.ru Group make up around 84% of Naspers’s market cap, so they aren’t a bad proxy for those so-called “social media” plays.

A recent report by Citigroup technology analyst Rhys Summerton suggests that there may be. Commenting on Naspers, he says one of the challenges the business faces is the ability to appease two different sets of stakeholders: namely, one set of investors willing to pay up for Internet exposure and the group that wants to see cash.

In issuing a “buy” recommendation on Naspers – with a price target of R500 – Summerton praised its management for improved communication about the Internet businesses and the shift in focus towards organic growth, as opposed to growth by acquisition. “We welcome that approach, as we feel the adage ‘What fools do today, wise men did 5 years ago’ applies to emerging market Internet investing and that investors can now look past the valuation of potential IPOs and instead focus on the big holdings Naspers already has.”

That concept is further unpacked by Steve Meintjes, head of research at Imara SP Reid, who says investors should ensure they understand where the business is in its growth cycle. A clue for investors is the amount of money being allocated to the development costs of the business. “The game has now changed slightly, with the company entering a phase of focusing inwards and looking to grow some of the many investments it’s made over recent periods. While management has said it will still be willing to make acquisitions if it finds the right business at the right price, in large part those are more likely to be bolt-on investments to improve businesses it currently holds rather than a business it will look to build up from scratch.”

Commenting on a decline in second half earnings and his “hold” recommendation on the stock, Meintjes says: “It’s still a good company, with enviable holdings. But while it reverts to growth and development – which will be accompanied by subdued earnings performance – we’d prefer to take a conservative approach.”

Summerton’s comment about being an early mover has been recognised in the case of LinkedIn, which has in many ways been perceived as the “ugly sister” to the likes of Twitter and Facebook and yet has done a lot of the hard yards pre-IPO.

“What part of spending a decade of building a business with more than 100m users nobody hyped that represents one of the few large-scale working examples of a freemium business model screams BUBBLE to you people?” asked Techcrunch journalist Sarah Lacy in a recent editorial accompanying the LinkedIn IPO.

The argument is while some businesses were grabbing the headlines as glamour stocks there are many high quality technology companies that aren’t always perceived as “sexy” but survived the first “social media bubble” in 2006 and have come through with genuine revenue models.

While there’s no doubt online social networks are here to stay, the past five years has proved there’s very much a “flavour of the moment” appeal to such companies. That means there will always be a broker punting you stock at the “next big thing” or a would-be investor knocking on your door for venture capital. With that in mind, you might want to remember a very simple observation made by Whitburn: “It seems the people who understand the business models best are selling to less informed investors.”

ZINIO

Have Finweek, can travel

I HAVE TO ADMIT I’m a bit old school: I still like the feel of a newspaper as I page through it on a Sunday morning. It never occurred to me that reading magazines on my laptop or tablet could be really enjoyable. In an attempt to be more tech-savvy (and not fall behind the whiz kids) I’ve decided to subscribe to the digital edition of Finweek on Zinio.

Not familiar with Zinio? It’s the world’s largest newsstand and bookstore and offers more than a mobile reading application. Zinio has expertly created digital issues of the magazines we love and delivers exactly the same material we get in print – plus exclusive features, such as interactive graphics and videos for your iPad, iPhone, laptop and Android.

Basically, you can buy Finweek or any other popular magazine and read it on the screen of your choice. Zinio is great because it also allows you easy and affordable access to international content.

On the SA Zinio website – http://za.zinio.com – you’ll find Finweek in its “news” section under “business news”. You have several buying options: from a single issue of the magazine to a full annual digital subscription (50 issues) for only R782,89. If you prefer the Afrikaans version of the magazine it’s also available digitally. The registration process on the website is straightforward and only takes three minutes.

Buying online is just as simple and convenient: add the item to your basket and then proceed to check out. It’s literally a matter of seconds before you receive your digital issue of the magazine in your inbox. Then click on the cover and let the reading begin!

The digital navigation is uncomplicated and even a Stone-ager like me can easily page through and navigate the Finweek digital edition. No more queuing at Exclusive Books or a CNA outlet to buy the latest issue. Every issue of Finweek is available on my mobile, so I carry it with me wherever I am – in an airport lounge or sitting in my doctor’s waiting room, and we all know how horrible the manky hand-me-down magazines at the doctor’s can be.

DEIRDRE DU PREEZ

Social networking

History of a social ‘net’

New technologies meet old brains

THE STUDY OF social networks goes back to the 1800s. And it’s worth mentioning that because the fundamentals haven’t changed much. Communications are now much easier and we’re able to speak to a multitude of people globally in milliseconds. But we’re still people with brains who haven’t come very far over the past couple of centuries.

It’s fascinating to see how cutting edge social networking tools are still subject to the constraints of our monkey brains. For example, studies have revealed the maximum size for social groups of human beings is around 150: more for some people, less for others. That capacity – referred to as “Dunbar’s number,” after Robin Dunbar, the anthropologist who first studied it – is hardwired into our neo-cortex regions after millennia of evolution. And that holds true whether you’re talking about a Stoneage rural village or Twitter. We just can’t work in organisational groups larger than that.

So as we look back on the rise of Web 2.0 and social networks such as Facebook, LinkedIn and Twitter it’s useful to remember the dynamics haven’t changed much. We have new tools to communicate with but we’re still people – used to building our social networks around campfires and, more recently, office cocktail parties.

The Internet is, of course, a communications tool. That’s what it was designed for by the United States military. So the technology we’re talking about is also rather old. However, it hasn’t always been very easy to use – and that’s the fundamental difference between early networks and their more modern equivalents. The early days of the World Wide Web – invented in 1989 – were very much a one-way street; you received information into it if you had the technological know-how, but most people were only able to send information out.

The transformation of the Web in the 21st century from an information portal to an information platform that just about anyone can upload content to, changed everything. This fundamental transformation was coined ‘Web 2.0’ by Irish journalist and publisher Tim O’Reilly.

In the pre-Web 2.0 days, people communicated using email and other direct systems. Nerds, however, were able to do so much more using Internet relay chat (IRC) and bulletin board systems.

The original bulletin boards (BBS) were run more as a hobby than anything else. Enthusiasts would host the BBS software on a computer and others would dial into it using their modems. Once connected, users could read news, upload or download software and other content and interact with other users of the BBS system.

There is an argument to be made for bulletin boards and modern social networks – which are pretty much the same thing as far as I’m concerned. It’s a central point where a group of people can upload information to share with others. The only difference between early bulletin boards and Facebook is the barrier to entry – and, of course, the support for more modern technologies like video chatting. Friend – or buddy – lists also weren’t much of a concern to early online social networkers, as there were very few secrets to be kept; users generally shared everything with everyone.

The first, mass-market Web 2.0 social networking platform was Myspace, established in 2003 and enjoying a heyday from 2007 to 2008. It was the beginning of something new. A place that anybody could access and use to arrange groups of connections. News mogul Rupert Murdoch saw the next big thing emerging and bought Myspace for US$580m – one of the worst investments he ever made.

Things changed fast. Facebook, established in 2004, began to take hold of the market when it was opened up for anyone to use in 2006. Twitter was established in 2007 and began to grow in popularity with social networking aficionados.

Skip ahead three years and Myspace was sold last month to Specific Media and pop star Justin Timberlake for a paltry $35m. Facebook is the new king of the social jungle – for now.

This year also saw the first major social network IPO, with LinkedIn listing on the New York Stock Exchange. It doubled its share price in the first day of trading and had quadrupled it by the close of the second day. Many who remember the dotcom bubble burst of 2000 believe they’ve seen that all before. And Facebook is expected to list next year.

SIMON DINGLE

TRADING

So you want to invest in social media companies?

BUBBLE OR NO bubble, South African investors invariably want to know how they can participate in some of those listed counters. The obvious first answer is to call your broker and buy Naspers shares on the JSE. You get a bit of Facebook, Tencent and Mail.ru as well as a number of other interesting emerging market plays. Having said that, you’re dependent on the decision-making abilities of Naspers as a whole on buying good social media properties rather than the founding flair of Mark Zuckerberg to make you rich.

Another option is to wait for the listing of investment holding company Blackstar Group on the AltX. The company holds Facebook shares worth US$400 000 in a business called FBDC Offshore Investors LP. Small cap analyst Keith McLachlan, of Thebe Securities, describes Blackstar as one of the purest plays to access Facebook but says he’s interested to see what the group does with its shares post the initial public offering (IPO).

For the more sophisticated investor keen to trade offshore, many local stockbroking platforms now offer the opportunity to trade in those markets. That gives access to listed plays: for example, LinkedIn and RenRen.

John Vorster, a director at PSG Online, says while such big name technology plays have been making the headlines in the financial news, clients haven’t rushed to put money into them. “I think what we’re seeing is the clients who are most interested in offshore exposure tend to be older and more mature or are being guided by financial advisers with a very low risk profile and, for that reason, are looking at traditional blue chips like Unilever, Volkswagen and Nestlé.”

Vorster adds technology companies such as Microsoft and Apple have proven popular with clients who can’t find value in local technology stocks, but points out those businesses have extensive trading histories.

For those keen to participate in the more speculative side of many of those counters – and who have an appetite for some risk – the IDX Futures products from Investec may be worth a look. These products are structured very similarly to rand-denominated single stock futures (SSFs) and are listed on the SA Futures Exchange (Safex).

Investec acts as the liquidity provider for the instrument and does the broking and settlement. These products aren’t for the average retail investor, as they require roughly 10% of margin – which translates to between R30 000 and R50 000.

“Importantly, this is a cash-settled future – meaning the stock will never be delivered to the client and the actual rand will never leave our shores,” says Richard Swain, of Investec Capital Markets, “That then enables private investors locally to participate without any restrictions associated with the foreign currency allowance due to National Treasury dispensation.”

Asked what strategies are proving popular with investors, Swain replies the unbundling of the potential Naspers/Tencent crossholding arbitrage: Tencent currently makes up more than 80% of the market cap of Naspers, leaving little valuation of the local assets in the company. Other popular stocks include long positions on the likes of Google and Apple and long the more cash-flush US/European consumable industrial shares, such as Coca-Cola, and Johnson & Johnson.

MARC ASHTON

 
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