Bubble 2.0

In recent months, you’ll no doubt be aware of rumblings from the financial press that we’re entering a new technologies financial bubble around social media. Fuelled in part by recent strong valuations put on a series of social media companies all heading towards public flotation this year, including Facebook ($75bn), Twitter ($7.7bn), discount service Groupon ($25bn) and social game manufacturers Zynga ($10bn), these rumblings came to a rolling boil after an article in the New York Times published in March openly drew worrying parallels between the current valuation levels of social media companies and the dotcom boom of 2000.

The article pointed out that recent investments in these companies had dramatically raised the implied value of many online businesses over the last couple of years to potentially unrealistic and unsustainable levels.

The NYT observed that the top 24 dotcom businesses looking to go public in 1999 accounted for $70.96bn market capitalisation. In March, at time of writing, they noted that, at a combined market capitalisation of $71.3bn, the social Big Five’s valuations had already exceeded the valuation for the top 24 dotcom businesses in 1999. And we all remember how that ended. Since then, alarmingly that figure has shot up, now standing at a whopping $126.7bn.

However, high valuations do not a bubble make and there are several key differences between the 1999 crash and today’s social media boom.

The first important difference between the internet boom and dotcom crash of the 1990s and the current effervescence around social media is the nature of the technology. While the 1990s heralded the beginning of a brand new internet era, coupled with an exuberance around the imagined possibilities of this new technology and a rush to get untested new businesses to market, the current crop of internet businesses are emphatically not start-ups. They have had time to come to maturity and bring established audiences and proven business models to their public offering. They are also generating dramatic revenues, which in the case of Facebook reportedly reached levels of around $2bn in 2010 and is set to double this year.

Historically, the 1999 dotcom boom should be seen as similar to other retrospective new-technology inspired booms, including the steam engine and railroads in the 1840s, automobiles and radio in the 1920s and transistor electronics in the 1950s. In each case, optimism surrounding these game-changing technologies and their ability to produce profit saw dramatic investment into these sectors, without any real understanding of what the new markets around those technologies would be.

The invention of the steam engine provides a good example of how this kind of new technology bubble has historically worked. In order for the railways to generate profit, massive investment was required to lay tracks and build stations. In the rush to cash in on the projected profits, too many lines were built and there simply wasn’t the traffic to make them all profitable. As a consequence, many of the first wave of transport providers failed and it wasn’t until the initial rush to build was over that the true value of the railways began to be realised.

Within years whole new industries had evolved to capitalise on the way the railways had changed behaviour, allowing consumers to spend their leisure time, connect with family and friends and distribute goods and services around the world. In many ways these were the original social businesses.

Similarly, the 1990s saw huge infrastructure investment in the internet, from laying cables for carrying the data to the development of 3G technology that would eventually allow the internet to move to our phones and other more personalised devices. Except that when the building was finished, only a paltry 248 million people had access to the internet. And once they got online the service was slow and patchy (remember dialup?), the sites that existed were interesting but unspectacular and the technology was clunky and unrefined. Most importantly, our habits online had yet to be defined. For example, putting credit card details into a website was seen as fraught with risk and for most of us the internet remained, for some time, nothing more than a useful research tool.

Another key difference to 1999 is the proven quality of the businesses coming to market. In 1999, the prevailing belief was that the first companies into this brave new online world would be the ones that benefited from the new markets and new consumers it created. The key to cornering these markets was awareness and market share.

‘Growth before profits’ was the slogan of these upstart start-ups and the 2000 Super Bowl saw ads run by 17 internet companies running $2m, 30-second ad spots, pushing their brands as they lurched towards public investment. The upshot of this risky strategy was that most sites burned through their investment capital before they’d ever made a sale and many ended up filing for bankruptcy within months of going public.

Some 12 years on, the internet is a very different place. In the intervening years technology has caught up with the infrastructure created by the internet boom. Personal computer penetration globally has risen dramatically to more than two billion users and the proliferation of mobile smartphones has truly made the internet portable.

We have also created a model for internet business in the intervening years. It has become apparent that being first to market is no replacement for being best in market (Netscape or Boo.com, anyone?) and those companies that survived the dotcom bust have evolved into huge and unprecedented businesses. The likes of Amazon and eBay have shaped our online habits and created the technology that has allowed a multi-trillion dollar, global e-commerce industry to exist.

In the same period, Google has rewritten the rules about what an internet business can be. Despite spending several years (like Amazon) not creating any revenue at all, the search behemoth has established itself as the first truly international, global proposition, currently valued at around £200bn. What’s more these revenues have been generated by entirely online products and advertising, proving once and for all that if you have a large enough audience, for a sufficiently desired product, there will come a point at which you can monetise it.

All of which casts the current crop of social media companies in extremely favourable light. While Groupon has hit the jackpot with a social sales strategy that allows users to find a ‘deal of the day’ on products and services based around a group-buying dynamic, creating revenues of $3-4bn this year, Zynga has turned hundreds of millions of users onto its Facebook-driven games platform. Twitter and Linked-In have created sizable niches as, respectively, a pioneering news and communications platform and a professional jobseekers and business networking community. Meanwhile, Facebook has managed to entice one in 11 people on the planet to create a user profile and spend an average six hours a month on its site. In the US it has surpassed Google as the number one visited website and one in three of all online ads appear within its pages. With stats like that it hardly seems ridiculous that current valuations put Facebook at around a quarter the size of Google.

Size and reach notwithstanding, however, the social sites have a further trick up their sleeves that is making them irresistible to investors – data. Or rather ‘ad-tech’ as it has become known in Silicon Valley. In a truly digital age, these companies’ ability to harvest, quantify and package user interactions, likes, dislikes and online behaviour is becoming what most believe will become the most powerful marketing tool ever created.

While Amazon can now make recommendations to buyers based on previous purchases and Google can target ads based on current search recognition, Facebook allows the targeting of ads based on personality and opportunity, often before the individual targeted has even fully realised a need. Consequently the young woman who updates her status from ‘In a Relationship’ to ‘Engaged’ can expect to start seeing localised ads for wedding services, hairdressers and dress shops appearing alongside her news feed within hours.

Needless to say, this kind of targeted advertising opportunity has brands and advertisers falling over themselves to tap into these social graphs. Whole disciplines of digital advertising and PR have grown up in recent years to help brands manage and benefit from these online conversations. And social media sites hold the keys to internet advertising, a $26bn business in the US in 2010.

Even more tantalising to brands is the possibility that consumers can become virtual sales staff in these environments where a personal peer recommendation of a product or service holds far more sway than a traditional TV advert ever could. It probably won’t be long before, in your chosen social network, you will be able to rent films or buy music based on your friends’ recommendations. You might even be able to play them at poker for real stakes too.

At that point the commercial value of these online communities will become phenomenal. When that happens, will you really be able to say you’re glad you didn’t buy shares in Facebook when you had the chance? 

However Jon Hawkins is less sanguine – he fears a bumpy ride ahead...

Get one thing straight – even if the mooted bursting of the social media bubble were to take place, it’s unlikely to be on the scale of the 2000 dotcom implosion. As Stephen Hobbs points out, today’s internet businesses – those that City and Wall St traders and venture capitalists are clamouring over, at least – are the products of an infinitely more mature, more refined and better understood web. LinkedIn’s IPO in May certainly got pulses racing; initially priced at $45, the shares opened at $83, hit $120 then closed at $94.25. The price has now gradually dipped to around $63.

To draw comparisons between, say, early social networking site theglobe.com (launched in 1995; IPO in 1998; shares rose to 854% of initial share price; fell below $1 in 2001 and de-listed by Nasdaq) and Facebook would be pointless, but that doesn’t mean a lot of very clever, very wealthy people don’t risk losing a lot of money betting on today’s generation of online businesses. Among the big-name players apparently queuing up for a slice of the social media pie are JP Morgan and Goldman Sachs, the latter having invested $500m (and created a special-purpose vehicle to raise $1.5bn of outside investment) in Facebook, while a JP Morgan technology fund was rumoured to be eyeing up a $200m stake in Twitter.

Neither of these US giants would be sniffing around the internet if they suspected a social media bubble was on the horizon, and yet the media has pointed out several areas for concern, not least in the hefty valuations slapped on some of the companies.

More than the large figures themselves, though, it’s how they’re arrived at which is of most concern. Take Facebook, for example – it’s usually valued at around $75bn, yet 2010 revenues were around $2bn, a price to sales ratio of around 37.5 (for reference, Google’s price-to-sales ratio is around 5). Of course, valuing based on revenues doesn’t give a complete story, which means that $75bn factors-in an awful lot of growth potential.

So the news that Facebook user numbers in the UK, US, Canada, Norway and Russia fell for the second consecutive month may set alarm bells ringing. In May alone, the number of users in the US fell by almost 6 million, from 155.2 million to 149.4 million (although the site added 11.8 million users globally over the same period).

And herein lies perhaps the biggest challenge facing the social media luminaries – while the web has matured and stabilised, the sheer rate of change remains astonishing. While many sites will survive, with varying levels of success, others will surely fall by the wayside, and the figures being bandied about suggest some people are going to lose a lot of money. Pre-IPO valuations of Groupon – a group discount website, let’s not forget – have hit $25bn in some quarters; roughly the same as BSkyB. Even if we’re not quite looking at dotcom redux, that’s one bubble you wouldn’t want to be in if it bursts.