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Technology: the internet bubble


FT: Joe Kennedy, head of the latest young internet company to light up the stock market, has made the trip from Silicon Valley to Wall Street before.

As president of E-Loan, an online mortgage lender created during the late 1990s dotcom boom, he had a front-row seat for one of the great investment bubbles. E-Loan’s stock market value soared to nearly $3bn following its 1999 listing before falling rapidly back. The company was eventually sold after the dotcom crash for a 10th of its peak value.

Last week, the 51-year-old was back, this time for the initial public offering of Pandora, the loss-making online music service of which he is chief executive. Asked how his most recent internet vehicle compared with the last, Mr Kennedy demurred. “Each of my children is different, and I love all my children equally,” he said.

 

Advertising

The social networking and mobile internet sectors have yet to devise a form of advertising as well suited to their formats as the “sponsored links” that turned Google’s search service into gold.

 

Facebook encourages users to “friend” brands, potentially opening the way for a more direct relationship between companies and customers. Twitter has toyed with “sponsored tweets” that insert advertisements into messages.

 

Worldwide spending on social networks will reach almost $6bn this year, $3.1bn of it in the US, according to research firm eMarketer. Mobile advertising is small but growing fast thanks to rapid take-up of smartphones. It will reach $3.3bn this year but grow to $20.6bn by 2015, according to online consultancy Gartner.

Perhaps. But the investors who have been clamouring for stock in US internet companies such as Pandora– whose value last week briefly climbed above $4bn, a heady price for a business with revenues of only $119m last year – are certainly betting that his newest online offspring will turn out to be a higher achiever than most of its elder siblings.

Pandora is part of the first cohort of consumer internet hopefuls to hit the stock market since the crash more than a decade ago. Most have had far longer to prove themselves as businesses than those of the first wave.

Riding a boom in social networking and mobile internet access, they also stand to benefit from changes in online behaviour that look likely to disrupt the power of the first wave of internet companies to dominate the web, and to throw up new dotcom fortunes.

But if expectations are high for these newcomers – nicknamed the “social media” wave – the reality so far looks decidedly mixed. Few have yet made it to the stock market, but public filings made to prepare for listings, including by discount coupon company Groupon and internet phone service Skype, have provided the first real insights into their businesses.

Based on the evidence to date, investors and other industry experts say the number of significant new companies likely to emerge from the latest internet boom is small.

“Social is big, but most of the benefits… will accrue to a small number of platforms, led by Facebook,” says Roger McNamee, a prominent technology investor who has assembled a large stake in the social networking site.

And, for many, the prospects of producing sustainable profits look as doubtful as they did for the dotcoms a decade ago. “You have companies that aren’t profitable, which makes it hard to value them,” says Ryan Jacob, portfolio manager of the Jacob Internet Fund, a specialist US mutual fund. “But they’re growing at much faster rates even than the 1990s. That’s the conundrum.”

One leading Silicon Valley investor sums up the euphoria about these consumer internet companies that is washing over Wall Street this way: “People will look back and say this was the peak of expectations.” Even Facebook – which has signalled it is working towards an IPO early next year – will take years to prove it is really worth that much, this investor says.

It took last month’s red-hot IPO of LinkedIn, a social networking site for professionals, to ignite stock market enthusiasm for the latest generation of US internet listings. The group’s shares jumped by 170 per cent when trading began. Tempted by instant profits, investors drove shares in Pandora up by more than 60 per cent from an already lofty valuation level, though they quickly dropped back.

A mania for new Chinese internet stocks – starting with the IPO late last year of Youku, a version of the YouTube video site – was already apparent. Its market value soared to more than $7bn this year, despite the fact that it registered revenues of less than $60m in 2010.

 

E-commerce

Smartphones and social networks promise to free online commerce from static web pages and change the way that consumers choose which stores to visit and what to buy.

 

With the heavily discounted coupons it offers to encourage people to try new restaurants or tanning salons, for instance, Groupon has drawn many local merchants to online commerce for the first time. It is now racing to expand before copycats around the world catch up. The US market for online “daily deals”, worth $873m last year, is likely to grow to $3.9bn by 2015, according to research company BIA/Kelsey.

 

The location awareness of smartphones has made them a tool of local commerce too, making it possible to attract people nearby with special offers.

Renren, called by its promoters “China’s Facebook”, ex¬perienced a similar meteoric rise after its IPO last month. Its value rose to $9bn, despite the fact that it produced revenues of only $76m last year. Both stocks have since fallen back heavily, with Youku falling 60 per cent from its peak; and Renren by 70 per cent.

Behind this investor stampede lies a hunger for growth. Before the Linked¬In IPO, Niklas Zennström, co-founder of Skype, calculated that there were only 13 publicly traded technology companies worldwide with sales of more than $1bn that were growing faster than 25 per cent a year.

The social media boom promises to unleash a new wave of high-growth businesses on the public markets. “This just hasn’t happened for such a long time,” says Egon Durban, an investor at Silver Lake, a private equity firm that led a $2.75bn buy-out of Skype in 2009, before selling it to Microsoft for $8.5bn this year.

Growth is a commodity that some of the latest newcomers have in spades. With revenues running at an annualised rate of $2.5bn after barely two years in business, Groupon, for example, has already earned itself a footnote in history as the fastest-growing tech company yet seen.

Whether such growth can be turned into profitable and sustainable businesses is a different matter. Only five to 10 “market-leading, cash flow-generative, high-growth companies with strong brands” are likely to emerge worldwide from the current generation of internet concerns, says Mr Durban. The rest, he adds, will be “concept stories” – the sort of companies that talk ambitiously about the size of the market opportunity before them, or the ways they might make money, but never live up to the promise. “The key is picking the right companies. That’s where it gets tricky.”

Many – including some household names with tens of millions of users – have yet to show they can live up to their potential. Skype has only recently embarked on a concerted effort to find ways to make money from its 145m active users, nearly 95 per cent of whom use its service free of charge. According to one person familiar with its finances, Twitter, which has yet to make moves towards an IPO, is likely to produce revenues of only $100m this year. The microblogging service is a by-word in internet circles for a company that has proved unable to turn its popularity into a paying proposition.

But it is Groupon’s disclosure of its financial performance – made at the start of this month when it filed in the US for a public share sale, expected within the next few weeks – that highlights most starkly the chasm between long-term potential and current economic reality that afflicts some of the most promising upstarts. Almost as head-turning as the company’s growth were the huge costs of marketing campaigns to sign up customers that have landed it with big losses.

 

Freemium

Attracting users with a free service, then encouraging them to pay for something extra, has become a standard business model for the new consumer internet companies. Zynga, widely seen as the most successful of the lot, makes money by selling “virtual goods” to people who play its free games – cash machines and sports car dealerships in CityVille, for example.

 

The virtual goods business may sound insubstantial, but it generated $7bn globally last year, according to InStat research. Consumer subscriptions for premium levels of online service, such as additional storage for personal photo collections and similar new “cloud” services, are likely to reach $6bn by 2016, according to Forrester Research.

Showing the disdain for financial convention typical of an earlier generation of dotcom entrepreneurs, Andrew Mason, Groupon chief executive, wrote an open letter to potential investors downplaying traditional measures of profitability. While internet companies from the first bubble tried to distract Wall Street with optimistic statistics such as growth in the number of “eyeballs” they were attracting, Mr Mason came up with a new financial yardstick. The best view of performance, he wrote, could be obtained by ignoring the cost of acquiring subscribers and “certain non-cash charges”. Applying Groupon’s preferred measure turned last year’s $420m loss under US accounting conventions into a $61m profit.

Self-flattering measures such as this are widely derided in investment circles as “income before ex¬penses”. Lise Buyer, an IPO adviser who worked for Google on its 2004 stock market listing, says: “Any time a company has to come up with a new operating metric to show it’s profitable, investors should be suspicious.”

The prominent Silicon Valley investor puts it more bluntly: “It defies belief. These guys have invented a new way of accounting. The losses are unconscionable.”

Yet Groupon still enjoys the backing of some of the tech world’s leading investors, among them venture capitalists New Enterprise Associates and Accel Partners. And its high-risk, expensive grab for dominance of a promising new area of online commerce invites direct comparison with a leading name from the dotcom boom: Amazon.

The internet retailer was denounced by some financial analysts in the late 1990s for the heavy losses it sustained in a dash for growth, leading to warnings that it could even face bankruptcy.

Platform tax

In the technology world, creating a platform on which other companies build their applications – just as Microsoft did with Windows – has always proved the surest route to profits. Facebook has emerged as leading platform among the new generation of companies, though LinkedIn, Twitter and Skype all have platform aspects.

 

Facebook lets other internet concerns write services that run on top of its own. By linking to the site’s underlying “social graph” of connections, a games company can let players interact with their friends. Facebook requires purchases to pass through its credits system.

 

“Facebook is the new Windows and Zynga is the first company to build a really big business on it,” says Roger McNamee, a Silicon Valley investor.

Even Groupon’s doubters concede that a successful IPO, intended to raise $750m, would buy it time to try to consolidate its early lead and build a more sustainable business model. Nonetheless, turning a company that burns through cash into a disciplined profit machine, while at the same time maintaining headlong growth, would be an impressive management feat.

All this has served to throw an even stronger spotlight on Facebook, whose stock market debut is anticipated as eagerly as Google’s, but which continues to wait in the wings. The site has indicated it will publish details of its financial performance by early next year, when US regulations force the move – an occasion it has hinted heavily will coincide with an IPO.

“It won’t take investors long to figure out that Facebook is in a league of its own,” says Mr McNamee. The company’s shares already change hands in private sales that value it at $80bn, and most investors expect it to be worth more than $100bn when it finally goes public. This is less than $30bn short of the stock market value, excluding cash, of the mighty Google itself, the most highly valued internet company.

Only Zynga – the maker of online games, to which players gain access through Facebook, and which is expected to file for its own IPO shortly – is likely to have built a strong enough business on the back of the social networking boom to be able to ride on Facebook’s coat-tails, he adds.

Meanwhile, for most companies scrambling to catch the latest consumer internet wave as it breaks on Wall Street, it is too early to tell how pervasive recent investment euphoria will become, or how long it will endure. “In the last bubble, the disconnect bet¬ween stock prices and fundamentals lasted for three years,” says Ms Buyer. “A lot of people made a lot of money with seemingly ridiculous bets.”

For investors in Pandora, reality has set in far faster. Despite soaring after Mr Kennedy struck the bell of the New York Stock Exchange to open trading last Wednesday, the shares had by the end of the week fallen back to about half their peak.

Whether it comes sooner or later, the day of reckoning is impossible to avoid.