Networking Mania

Networking Mania

Fyodor O. Minakov

In the late 1970’s, two snarky, unkempt misfits – Steve Jobs and Steve Wozniak - gripped the public’s attention, and never let go as they turned a garage-based operation into the world’s second largest company.  Every few years since the inception of the digital age, some pretender to the tech maven-revolutionary throne has come out of the woodwork. Fuelled by media attention and the “cool” factor, “new tech” companies have preyed on the same raw human emotions that three hundred years earlier made Dutch shoemakers trade their life savings for a chance to own a single tulip bulb.

The road to El Silicon Valley may have been be paved with gold for the few that made it, but those same streets were also littered with the corpses of the many more that didn’t make it. With the world’s focus turned to the Greek debt crisis, or the national debt ceiling, or Chinese inflation, or some other cause for worry arguably vastly more important to the global economy than tweets, pokes, or deals of the day, investors have either forgotten about, or have chosen to ignore the mini-bubble growing in our own backyards. This bubble will not end global economic progress, nor freeze financial markets, but will redistribute money more efficiently than Lenin’s grain requisitions officers ever could: from your pockets directly to Wall Street. The only transactional costs will be broker’s commissions.

LinkedIn, the social media site that allows you to “connect” with your unemployed friends, and that hedge fund guy you met at a frat party that’s making big bucks, went public on May 19^th 2011 while you were desperately combing through the job market, and your messy morning dew for an opportunity to wear your best suit on a Tuesday morning. The company is worth big money too, $8.5 Billion Dollars, or $90 per share. To give a sense of perspective, that’s about five times as much as RadioShack. LinkedIn, which boasts at least one hundred million users, has placed a valuation of $85 on every single one of its users. No, that’s not how much revenue it intends to generate from each of its users on average. If the company’s price is justified, this is the amount of profit that it hopes to make off of every one of its users sometime over the course of the next two decades. With profit margins at 5%, that means that if the company remains in business for twenty years, at current profit levels, and with one hundred million subscribers, it will need to make $85 in revenue annually from every one of its users, adjusted for inflation.

Many investors, mirroring the bold claims of the talking heads of the financial media, believe that this price is reasonable, and granted, the number of users may double, or even triple. Value investors have been warning us since the inception of the term to stay away from stocks that trade at price to earnings multiples that are too high. A price to earnings multiple is the amount of profit earned by a company per share of common stock. Generally, the rule of thumb is don’t buy companies with a P/E ratio of over 20 unless there is a very good chance that revenue will increase, margins will increase, or some other drastic change is expected on the horizon. Benjamin Graham, the famed value investor and Warren Buffett’s mentor, put it more succinctly: don’t buy anything with a P/E ratio greater than 16, everything else being equal. LinkedIn’s P/E ratio is currently around 1,000.

Imagine for a moment that your son or daughter opens a lemonade stand, an honest business that will probably produce consistent returns of $1,000 every summer that may vary a bit as a function of the summer heat. Let’s say your kid is an average 21^st century American who will remain unemployed until he or she is twenty five. Let’s further imagine that this lemonade stand remains profitable for fifteen years, and maintains inflation-adjusted returns of about $1,000 per year. Now imagine that you really, really believe in your kid, who comes home one day, showing you the day’s profits of $10, and explains to you that “His proprietary software applications and technologies enable his company to perform large scale real-time data and computational analyses on lemonade consumption patterns.” And, as if this were not impressive enough, he or she then tells you that “Lemonco categorizes and queries large sets of structured and unstructured data to personalize relevant information, to adjust for appropriate amounts of bitter-sweetness, and that of its key personalized recommendation features typically involves the processing of over 75 terabytes per day!”

Now, for a final stretch, imagine buying that lemonade stand for $1,000,000. LinkedIn has had over four years to monetize its significant user base. It hasn’t, and its profits, while perhaps projected to grow modestly, consistent with advertising and job market functionality, assuming that it maintains a near monopoly over work-related social networking, remain stable. LinkedIn’s operating margins are currently at about 5%, which means that for every $1 of profit, the investors as a whole are entitled to five cents before taxes.

Now, you might ask yourself the question, why on earth is the share price so high if the company is worth so much less than analysts and insiders claim? LinkedIn, however, may be publicly traded, but the majority of the company remains in the hands of its original owners. In other words, the overwhelming majority of the company hasn’t yet been floated on the open market. In fact, only about 8% of the company trades publicly. The vast majority of the shares outstanding are not publicly traded A shares, but privately held B shares. These B shares are identical to the A shares except for two important differences: They can be converted into A shares by their owners eventually, on a 1 for 1 basis, and they hold ten voting rights for every share outstanding. In sum, even if one shareholder bought every single one of the 7.82 million A shares outstanding, the “terms” of their purchase would entitle them to .9% voting rights. That’s like saying to a person, you can vote, but unless, 49.2% of the insiders agree with you, your vote counts for nothing.

The reason why your kid’s lemonade stand isn’t selling for $1,000,000, and LinkedIn is, is two-fold. On the one hand, there is the specter of human greed, the same market mania and media hype that created the first stock market bubble in the late 1990’s. On the other hand, and this is key, LinkedIn is overvalued because the consortium of hedge funds, private equity groups, and special interests that have, and will continue to profit from this pie in the sky have made it so. A group of a few institutional investors own the majority of all outstanding shares, which leaves a minority (defined as people that own 5% or less) of shareholders with a fraction of the company. Furthermore, 30% of the 8% float represents short interest, or investors that borrowed the shares, expecting them to decrease in value so they can buy back later on the cheap. These short purchases have in effect done a great deal to create artificial demand for the stock.

Eventually, over the course of the next few years, the remaining B shares will be converted, voting rights will be transferred, and the current owners will sell out. When this happens, unless bubble mania continues unabated, though there are good indications that it might, the reality of disappointing earnings figures will pummel the stock, and you, the investor will be caught holding the empty bag where that perennial trickster Mr. Market, told you to put all of your money.

LinkedIn must not be singled out as the lone stick of bubblegum. There’s a whole pack that will hit the markets with IPO’s in the coming years. Facebook is currently projected to be worth $100 Billion, that’s more than McDonalds. Groupon is projected to be worth $6 Billion, Living Social, $1 Billion, Twitter at $10 Billion, and Zynga, the company that produces the online game “Mafia Wars” will sell for $1 Billion. The bleed through might not stop with your wallet. As demand for web engineers grows, companies in Web 2.0 are hiring, driving up costs, wages, and helping the otherwise lackluster U.S jobs market. When people wake up and smell the Jamba Juice, the effects might be worse than imagined.