silicon valley’s bubble is bursting

You’ve probably heard by now that last week was the worst opening week in stock market history. But even that horrid headline doesn’t quite capture the sheer scale of the carnage. In five days, the S&P 500 fell six percent, the Dow fell 6.2%, and the NASDAQ fell 7.3%. Small caps fared even worse than the major indexes, with the Russell 2000 shedding 7.9%.

And yet, as ugly as 2016 has been so far, I still see overvalued stocks everywhere I look, especially here in the Bay Area.

Last year’s big story was the outperformance of the (mostly Silicon Valley-based) FANG stocks. Local “unicorns” were also all over the news. San Francisco’s Uber saw its valuation soar past $50 billion even though it has lost money every year of existence. Not surprisingly, office and apartment rents soared in the region. San Francisco is now the most expensive city in America. Oakland isn’t far behind.

Unfortunately, this party is about to end. Abruptly. And the harshest wake up calls will likely come for companies, public and private, that are dependent on advertising for most of their revenues.

Among social media stocks, Yelp and Twitter come to mind. Yelp is now $24 and Twitter is sub-$20. I’ve written about both companies before, and I’ve made no secret that I have long believed that they are wildly overvalued. I believed that early last year when they were both above $50 and I am still convinced of it now that they are trading near all time lows.

First, while both have growing revenues, neither is cheap. In fact, even after steep declines over the last year, Twitter and Yelp remain grotesquely expensive. Yelp’s market capitalization is $1.8 billion vs. 2015 revenues and ebitda of $545 million and $75 million. Twitter’s market capitalization is $13.4 billion vs. 2015 revenues and ebitda of $2.2 billion and $535 million. Is it really any wonder why all the rumors of an acquisition for one or both companies never panned out?

Second, like far too many Silicon Valley companies, Yelp and Twitter have huge annual noncash stock based compensation charges. Yelp’s non GAAP 2015 earnings per share was roughly 36 cents, yet its GAAP eps was roughly -.18. Twitter’s 2015 non-GAAP eps will be roughly 40 cents, while its GAAP eps will be a loss of 90 cents. I don’t think investors understand what a burden these option grants represent. They don’t just eat into a business’s bottom line, they are also massively dilutive.

Someday—perhaps sooner than later—investors will value these companies on traditional metrics like price to sales, price to ebitda, and eventually price to GAAP earnings. If that occurs in the next 12-18 months, both stocks could easily decline another 50 percent.

Finally, the consensus that digital advertising will grow much faster than advertising on traditional channels (cable, billboards, magazines/newspapers and radio) might be wrong. Why? Impact, or a lack thereof. Just as stock investors will inevitably begin to evaluate social media companies as actual, rather than aspirational businesses, advertising clients will begin to demand real results for the money they are spending. As I travel around the country meeting with executives, I’ve been hearing from more and more people that advertisers are increasingly questioning the value of online campaigns (beyond Google placements). Call it the ad-blocker effect. It’s real, and it’s a big problem for already marginal businesses like Yelp and Twitter.

In 2016 spending on digital media advertising is expected to come in around $68 billion, which would surpass spending on TV advertising for the first time. Social media ads are expected to bring in around $14 billion of that total. However, if this negative perception increases—and I think it will—digital media advertising, especially at non-subscription companies like Yelp, Twitter, and numerous dating sites will disappoint. That’s when things could get very, very ugly. Forget about flat or declining user growth. When topline revenues slow, the party will officially be over. Watch out below.


4 thoughts on “silicon valley’s bubble is bursting

  1. Roy C

    With you having experience in Houston and oil, especially during the downturn in 84, I was wondering if you would be willing to share your thoughts on the current oil environment. I know there is a current excess supply of approximately 1 million barrels per day impacting price and that may increase with the lifting of Iranian sanctions. There are rumors that the Fed has instructed financial institutions to halt the mark to market of energy related credit, opting to force asset sales and restructurings to avoid forced bankruptcies. Personally, I see the recent rally in oil as nothing more than a dead cat bounce. Anyway, I would love to hear your thoughts on oil and CFR’s heavy exposure to the oil patch. Thanks.

    Reply
  2. Dave C.

    Scott, you are spot on with your assessment of advertising spending. Something is very fishy with the projected ad sales bandied about by the Unicorns. It’s exactly the same situation as the last dotcom bubble (anyone remember Pets.com SuperBowl ad ?) I’m convinced that online ad spending, especially with Facebook, is a form of legalized gambling !

    Reply
  3. Pingback: cash is king: two good bets in the gaming sector | the confessions of a contrarian investor

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