Facebook, Demand Media, Google and thoughts on navigating the coming Technology bust

Sure, Web 2.0 has proved transformative. Twitter has changed lives - and not just Stephen Fry's. On one level, you could say that it's Twitter and Facebook that has made the current wave of Arab revolutions possible. But let's face it, the valuations are now also approaching nosebleed territory. Most of them are private market valuations and so perhaps they need to be taken with a pinch of salt. Groupon is said to be worth USD 6 bn, Twitter  USD 3.7bn, Facebook anywhere between £33bn and a massive USD 50bn depending on whom you ask. Facebook is reckoned to have made about USD 1.5bn last year, so that's a very hefty revenue multiple. Corporates as well as investors are excited - AOL has just acquired Huffington Post for USD 315m and there's a thriving M&A rumour mill on Wall Street.  The public market has already seen a few IPOs in the tech sector, and it's given them a warm welcome.

Shares in Demand Media (Nasdaq:DMD) were marked up 35% on the IPO price when it started trading.  DMD owns a number of websites such as eHow, which has answers to such diverse questions as how to write an erotic novel and how to organise your scrunchies, health site Livestrong, and humour site Cracked.com. It's trading at something like 10x revenues. It was lossmaking last year, though it turned a profit in Q4 2010, so it does appear to be at the inflection point for profitability going forward. There don't appear to be any forecasts out there, but assuming it won't make more than 30% operating margin (Google makes 29%) then on last year's revenues, it would trade at around 30-35 times earnings. Not total bubble territory, but pretty high, particularly as there appear to be question marks over its capitalisation of content costs. (Basically, it seems to pay freelance journalists, then treat their invoices as an asset rather than a cost.). And anyway, DMD's model isn't really Web 2.0 - it's pretty much Web 1.0, put lots of stuff on a web site, work like mad on SEO, and make money from selling ads based on your traffic figures. Besides, Google has just changed its algorithm which may (the jury's out on this one) make content farms like eHow less attractive properties.

Quite a few of the other touted IPOs on Wall Street have similar failings. Damien Hoffman, on Wall Street Cheat Sheet, rightly says some are only features or niches - nice enough little companies, but they're not going to change the world in the way an Amazon, Google or Facebook has done. It doesn't take a rocket scientist to write a Facebook application after all. Again, a possible sign of a bubble - also-rans and me-toos getting big valuations because the great investing public isn't doing its homework.

What's perhaps different from last time around is that in the late-nineties tech boom, you could buy 'picks and shovels' like Macromedia (web creation software) much more cheaply than ISPs and web media. However, check out the prices of web measurement firms Nielsen (NYSE:NLSN) and Comscore (Nasdaq:SCOR). They're both mature companies, not start-ups, and they both occupy important and quite likely impregnable positions as the companies which measure and validate web traffic so that advertisers know what they're paying for. Great, growth businesses; but NLSN trades on 44 times 2011 earnings, falling to 29 times for 2012, and SCOR, which made a loss last year, is on 211 times, falling to 'only' 74 x for 2012. (That may still leave it on a PEG of less than one, of course, given the incredible rate of growth forecast.) 

So should value investors stay away from tech?

Well, former dot-com employee, now a consultant, Andrew Marshall wryly observes in an amusing piece in the Independent that "the names are getting wacky again", which for him is a clear sign of a bubble.  But there do still seem to be bargains to be found in the US tech sector - some of the majors even pay dividends these days! Some of them are a bit stodgy-looking. Microsoft (Nasdaq:MSFT) trades on an unambitious multiple of 10x prospective, though since earnings are growing at less than 10% you'd expect a low multiple. Recently, Microsoft has been doing quite well partly as a result of its own biggest failure - Vista was such a disaster that corporate upgrades to Windows 7 have been running at a higher level than with previous versions of the software. However, the low earnings growth, and the fact that Microsoft looks like losing control of the desktop (thanks to anti-monopolies rulings) and the mobile space (to Android), might make investors a little wary.

On the other hand Oracle (Nasdaq:ORCL) is still a great company. It's cleverly expanded into business intelligence, it's got into the cloud, it's moved over the past decade or so from a database supplier to a diversified major with ERM and CRM applications and a host of middleware. It has a 34% operating margin, and is getting earnings growth of 20-30%, and it still only trades at 15x earnings, which would put it on a par with quite good instrumentation and specialist engineering companies, which have much smaller markets (and much smaller impact on the world as a whole).  

But the standout bargain looks to be the great gorilla of search, Google (Nasdaq:GOOG). On 18x 2011 and 15x 2012 earnings, it's a bit more expensive than ORCL, but it's still in regular growth stock territory rather than Web 2.0 valuation la-la land. Google of course dominates search, and while its 'let a thousand flowers bloom' strategy has led to a few failures (like its attempt to get into the property portal market), it's ensured the company doesn't miss any major tech trends, and keeps relevant. Earnings growth is around 30%, giving a 0.6 PEG and putting this erstwhile go-go stock firmly into value territory.  

Fo a value investor the message seems obvious. Eschew the new, shiny Web 2.0 social media toys run by 20 year olds and youthful MBAs, and invest in boring old companies with mature business models and middle-aged managers ... like Google? So at least there's one thing that's changed since 2001!

Disclosure of interest: The Author now hold shares in Google.