Is the dot com bubble about to burst?

Wall Street's love affair with internet stocks has soured after a series of disastrous flotations

New York

Sometimes, when a love affair ends, you can't remember what it was you ever saw in someone in the first place. That is the feeling right now of a lot of once-amorous investors who breathlessly wooed Facebook at its flotation in May and paid $38 for the privilege of a share in the social network. It is the feeling right now of Pandora Media investors, who paid $16 per share for a stake in the online radio business. It is the feeling, too, of investors in Zynga, who got shares in the online games maker at $10 a pop.

Compare their share prices as of start of trading yesterday: $20.04 for Facebook, a loss of 47 per cent; Pandora at $9.25, down 43 per cent; Zynga at $2.70, a 73 per cent wipe-out.

Fair to say, Wall Street has fallen out of love with these internet stocks, and badly. They have poisoned the prospects for others, like Twitter or Foursquare, who were waiting in the wings for their stock market debut. If excitement over the arrival of these social media companies last year threatened to bring on a new dot com bubble, it shows serious signs of popping.

The thing that all these disastrous debuts have in common is that investors were valuing the social media phenoms not on historic profits (of which there were none) or even on current revenues (of which there were precious little) but on heroic assumptions of the future growth of both. Pandora had 90 million regular listeners, 240 million people played Zynga games, and Facebook was the mother of all social networks, with 900 million active profiles. These user figures were rising very fast; it was only a matter of time until, either through the sale of advertising, or some other means, these firms would be able to "monetise" their users, in the jargon.

Just a few quarters of actual results — only one in the case of Facebook — and the heroic assumptions about these young, untested business models have had to be revised down to something more pedestrian, or pushed off further into the future, or have been called into question entirely.

The very thing that aroused investor passion when these companies floated is what has them running a mile now: when it comes to social media, things change very fast.

Take Facebook. Almost one in nine of its users is now accessing the site only on their smartphones, up 23 per cent in three months, a much faster shift away from the personal computer than anyone expected. That is important because while Facebook has worked out a way to make money by selling ads on the side of people's profiles down the side of the computer screen, there is much less room on a smartphone screen for such distractions. It is only now beginning to experiment with putting ads in users' main news feed, and promises to roll this out slowly, so as not to spam users with too many commercial messages that might turn them away.

"Facebook's challenge is in scaling up at a pace that is satisfactory to the market and satisfactory to its investors," says Clark Fredricksen, vice-president of communications at market research firm eMarketer, "but Facebook always sides with its users. The site is one of the biggest destinations on the internet. Advertisers will have to go along for the ride. But it will be slower than some people will want." According to eMarketer, mobile advertising accounted for less than 1 per cent of total ad spending worldwide last year, and it will be a long time before it challenges other mainstay global advertising channels like TV, print and internet ads. Furthermore, more than half of all mobile ad spending is on ads that appear next to search results, not the sorts of ads Facebook can sell.

Shelly Palmer, a technology consultant and the founder of Advanced Media Ventures, says investors ought to have been more sceptical, "With basically half the connected people in the world as users, they are making $1bn a year profit. Even if everyone connected to the internet was on Facebook, they would be making $2bn a year. It's simple maths. It's not a $38-a-share, $104bn-value company; it's a $7.50, $20bn company."

As for Zynga, the switch to mobile is proving even more painful. Its revenues come from the sale of virtual goods in its Facebook games, goods like cows in FarmVille or guns in Mafia Wars, but Facebook users do not play those games on their phones. Zynga is also struggling to come up with new hits. Its shares slumped 42 per cent in a single day last week, when it cut its revenue guidance for the rest of this year.

There have been other disasters in the social media space. Pandora recorded listener hours up 77 per cent in June compared with the same month last year, but its revenues have fallen shy of Wall Street hopes because advertisers are not flocking to put their commercials on air. Groupon, which brought a social media sensibility to the business of handing out money-off coupons, has lost two thirds of its value since floating last November, amid investor fears that customers will drift off and merchants will find less expensive ways to publicise their offers.

It's not all been bad news, though. LinkedIn, the professional network, is well above its flotation share price, as is Yelp, an online Yellow Pages, that posted an 89 per cent jump in advertising revenues from local businesses in the second quarter.

The problem is that where there have been investor losses, there has also been bad feeling and accusations of bad behaviour.

The founders of several of these unproven companies have gotten very rich, thank you very much, in stark contrast to newer shareholders.

When Richard Greenfield, the outspoken analyst at BTIG, wrote a note entitled Downgrading Zynga to Neutral: We Are Sorry and Embarrassed by Our Mistake, he didn't just apologise for his own disastrous buy recommendation. He professed to feeling misled by management and angrily attached a timeline that showed how, as recently as March, founder Mark Pincus had cashed in $200m from selling Zynga shares at $12 apiece. In Groupon's four years in existence, chief executive Andrew Mason has cashed out $31m, while the chairman, Eric Lefkofsky, took out $398m.

Founder Mark Zuckerberg may not have cashed in at the flotation of Facebook (though he did sell enough stock to take care of his tax bill), but plenty of early investors did, and as with all these internet start-ups, the handcuffs will soon come off these insiders and a drip-drip of extra selling can be expected to weigh further on the share price.

Meanwhile, Groupon has had to restate its accounts on several occasions and admitted material weaknesses in its ability to properly calculate and publish its results. Two California law firms filed lawsuits seeking class-action status on behalf of Zynga stockholders this week, alleging the company concealed threats to its business and sales growth.

Facebook and its directors, including Mr Zuckerberg, are being sued over allegations its bankers tipped off favoured investors that a tiny change in the small print of the flotation prospectus, which mentioned users' fast switch to mobile, actually meant a big change to the company's medium-term profit prospects. If retail punters had known how fast the world was changing around Facebook, would they have paid $38 a share? It seems unlikely.

Less than 15 months after LinkedIn kicked off investors' love-in with social media stocks, it looks like an expensive, regrettable affair.

It doesn't mean investors can never love technology again, says Shelly Palmer, but they will be looking for more stable partners in the future.

She says: "If you have a gene-sequencing company that tells you how to design personalised drugs for chemotherapy, you won't have an issue. If you have a technology that makes gasoline twice as effective, you won't have an issue. There is a place still for tech IPOs.

"But there's no space now for floating an internet service company that creates a large audience in advance on the premise that that large audience is highly monetisable. It's not obvious it will be highly monetisable."

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