Internet stock collapse dents Silicon Valley

30 Jul, 2012

Social media companies, once hailed by their Silicon Valley boosters as world-changing businesses with limitless potential, are instead proving a sobering reminder of how investors can be seduced by Internet hype.

With few exceptions, the first wave of social media firms to trade on the public markets has delivered a disastrous performance that conjures memories of the dot-com bust of 2000.

"Farmville" publisher Zynga, which went public in December at a valuation of $7 billion, is trading around $3.15 a share, more than 68 per cent off its $10 IPO price.

Daily deals site Groupon, touted as the firm that could reinvent local commerce, has fallen from its $20 IPO price to about $7.15 in nearly nine months. Music service Pandora Media has dropped from $16 at its June 2011 IPO to around $9.50 on Friday.

And on Thursday, the 800-pound gorilla of the group, Facebook Inc, reported tepid results that shaved some $10 billion off the company's market cap. The stock has gone straight down since its botched May initial public offering and now trades at around one-third off its $38 IPO price.

"The VCs, the private equity guys at the early stages, already cashed out and made their fortunes," said Peter Schiff, chief executive of Euro Pacific Capital. "Everybody else who ran to buy the stock at the IPO at a sky-high valuation ended up holding the bag."

"A lot of these companies are going to make a quick buck and flame out," he added. "Just look at 10 years ago."

It's true that a few companies with more of a business focus -- notably LinkedIn -- have done much better. The jobs-networking site is trading at $100.82, well above its $45 IPO price from May 2011. Yelp Inc, the local reviews company, is holding above its $15 IPO price from March.

Startups in areas like data analytics and business software, such as Splunk Inc have also fared well.

But the wipe-out among consumer-oriented social media companies has raised concerns the entire sector is fad-driven. While the public companies are profitable and showing strong growth -- unlike the class of 1999 and 2000 -- it is not clear how sustainable that is.

"People just can't figure out how these companies are going to make money and justify these huge valuations," said Michael Yoshikami, founder of Destination Wealth Management.

The euphoria around Internet stocks, Yoshikami added, has faded. "It's different from six months ago," he said.

In Silicon Valley, venture capitalists fear the high-profile stock busts will take a toll on the next wave of companies trying to go public. To some extent, they say, they already have.

"It's going to have a chilling, sobering effect," said Tim Chang, managing partner at Mayfield Fund. "It's especially hard to make the argument of why a company should be valued at $1 billion or more.

Making good

On Thursday, Facebook reported its first quarterly revenues of $1.18 billion, up 32 per cent. But executives warned a quickening shift to its underperforming mobile app was eating into results, and user and revenue growth slowed for the fifth consecutive quarter. The stock was down 9 per cent in afternoon trading on Friday.

It has not helped pacify Wall Street that the tech firms' venture capital backers on Sand Hill Road in Menlo Park, California, have enjoyed big paydays via IPOs. In the case of Facebook, Accel Partners sold 49 million shares at $38 apiece, reaping enormous profits.

Insiders have sold large chunks of their holdings in Zynga and Groupon, though the top executives still maintain enormous stakes in their companies. Zynga CEO Mark Pincus and other insiders netted some $500 million when they sold a portion of their stock in April at $12 a share.

Others were less fortunate. T. Rowe Price lost $61.4 million in its Facebook and Zynga holdings over two days. Fidelity, the largest US fund, saw $126 million of its on-paper holdings evaporate over the past two days.

Facebook CEO Mark Zuckerberg, who owns just north of half a billion shares, took his lumps as well, as more than $3 billion of his paper-weath evaporated Thursday.

'Doesn't jive'

Zynga's stock went into free-fall after it slashed its 2012 outlook from 23 to 29 cents to 4 to 9 cents, blaming weakness in existing Facebook games and a delay in its pipeline.

The results widely missed expectations set by company management at the end of last quarter, when Chief Operating Officer John Schappert said the company was "excited and comfortable raising guidance for the year."

On a conference call, BTIG analyst Richard Greenfield took Zynga executives to task for not warning investors. Chief Financial Officer Dave Wehner said it was company policy to only give guidance once a quarter.

But the earnings report "doesn't jive" with executives' recently upbeat comments, Greenfield later told Reuters. A handful of plaintiffs' lawyers announced Thursday they had begun investigating Zynga for breach of fiduciary duty.

Meanwhile, Facebook's executives took a conservative approach on Thursday, declining to offer their own forward-looking predictions.

In light of Zynga's bad miss, Wall Street analysts said that the lack of forecasts sapped investor confidence.

"The entire social media space may seem like a disaster, but it's perhaps that public markets have yet to see the right stocks. Firms like Groupon, Facebook, and Zynga require very aggressive user acquisition and the Average Revenue Per User is much lower," said Steve Place, a founder of options analytics firm

"However, if we look into different verticals of the social media space there are some decent ideas."

He cited real-estate site Zillow Inc, now almost double its IPO price.

But on Sand Hill Road, the mood these days is decidedly more subdued, a focus on returning to fundamental value.

"We'll see more discipline on private investments," with more focus on the sustainability of any competitive advantage a company has, said Roelof Botha, a partner at Sequoia Capital.

"There are private companies that we are investors in that have underlying defensibility and business models for which you do want to stretch on valuation," Botha added.

At Bay Partners in Palo Alto, partners have already noticed a certain dialing-back of the swagger with which some entrepreneurs walk into their office.

"I feel a little bit of humility, a little bit of reality creep in," said partner Salil Deshpande, whose investments include Buddy Media, which was sold to for $689 million earlier this year. Early-stage entrepreneurs who a few months ago might have argued their nascent companies were worth $5 million might today accept a valuation of $1 million, he said.

Mayfield's Chang expects a hit to companies with what he calls "lumpy" business models -- less predictable, consumer-oriented businesses that rely on advertising and virtual goods, like Facebook and Zynga. Those businesses, he says, are reliant on their popularity with the public, a fickle group.

"The scariest is easy-come, easy-go revenue, kind of like Groupon," he said. "It can ramp up quick, but disappear quickly too."