Thursday, January 06, 2011

Is The Online Social Network Sector Another Investment Bubble?

You know a trend is becoming important when both the Wall Street Journal and the Economist mention it within the same month.

In this case, the trend is a resurgence of bubble-like valuations in online social networking companies.

Back in September of 2007, the Journal's Dennis Berman wrote an excellent piece concerning the online communities business, about which I posted here. Berman's piece covered a lot of territory, but my concluding observations and quotes from his piece (in blue) were,

"At some point, the questions about Facebook the business will eclipse the praise of Facebook the social phenomenon. And once that point hits, Mr. Zuckerberg will be less able to dictate the terms of how fresh capital is put to use."

Mr. Berman pulls no punches. From his initial description of the now-essentially-defunct GeoCities, to the likely fate of Facebook, his superb writing uncovers a wonderful, timeless story of business innovation, absorption, mismanagement, the rise of new competitors, and the continuing weakness of the underlying business model.

Aside from the marvelous business strategy expose, Mr. Berman makes it hard for the reader to avoid asking the question,

"If no other, larger firm, had bought, or bought stakes in, GeoCities, or was trying to buy or invest in Facebook, would Bohnett and Zuckerberger realize millions in wealth simply from the profitability of their businesses and business model? Or would they become, like Amazon, long on initial market value gains, but short on realized profits?"

That last passage came to mind immediately as I read the Economist's piece on the current frothiness of social networking site valuations. It referenced Groupon rebuffing a $6B offer from Google, Twitter being valued at $3.7B, and Facebook's private offerings valuations rising 77% in just three months. Of course, the big recent news is Goldman's funding a private offering for Facebook, with the shares to be allocated among its most-favored clientele.

Holman Jenkins, Jr., of the Journal, made the Facebook private offering the subject of his column last week, supporting Zuckerberg's choice to remain private and take time to mature before going public.

Perhaps Berman's observations of three years ago are outdated and no longer germane. Then, again, the collapse of the late 1990s technology valuation bubble came after many pundits disregarded the need for profits. Facebook is reputed to have annual revenue in the low billions thanks to ad revenue and a share of sales from games through its site. Still, I wonder if they really have solved the challenges about which Berman wrote so eloquently.

An older veteran CEO with whom I spoke recently was dismissive of Facebook and other online businesses as genuinely value-creating. I'm not quite so sweeping in my scepticism. For example, it's clear what value Amazon and Google have managed to create. I can sort of comprehend Groupon's appeal, although I continue to wonder how profitable it is, and/or what its growth prospects are, or what the long-run financial costs are to the businesses granting the discounts. Twitter doesn't seem to be a viable business.

Facebook continues to confound. Is global social networking truly a value-added proposition and business model on a par with Google's search and related ad businesses? Is online gaming via social networking really so novel and profitable?

Or is Zuckerberg merely enjoying the latest, most profitable round of social networking hype?

One thing may be a positive, however. That is, Facebook, Twitter and Groupon, at present, are not public. So any frothiness that subsequently deflates, with concomitant value destruction, will be absorbed by wealthy, so-called 'sophisticated' investors, rather than the general public.

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