Are we in the next dot-com bubble?

Some tech stocks have become ridiculously overvalued. Is your favorite about to tank?

By StreetAuthority Oct 7, 2013 3:41PM
Image: Damaged laptop (© Jason Stang/PHOTOLIBRRAY/Photo Library)By David Sterman

For years, (AMZN) has been known as the ultimate "story stock."

Investors have been asked to overlook the e-commerce giant's relatively unimpressive cash flow metrics, assuming that the company will eventually deliver the bottom-line numbers that mature companies deliver.

How large is the disconnect? The company delivered an all-time best $2.9 billion in free cash flow back in 2009 -- and won't even revisit that peak until 2015, according to Merrill Lynch. Amazon's $146 billion market value is roughly 50 times greater than the 2015 free cash flow projection.

To put that in context, a mature company such as Ford (F) generated an average annual free cash flow of $6.5 billion over the past four years and is valued at around 10 times that figure.

Of greater concern, Amazon is no longer the only "story stock" around. The top 10 or 15 Internet stocks have been on such a tear that they too are increasingly disconnected from any fundamental value.

The 40% gain over the past six months for the PowerShares Nasdaq Internet ETF (PNQI) is especially impressive when you note it's filled with large companies that already sported hefty market caps.
So what do these stocks look like in the context of 2014 and 2015 forecasts? The multiples are quite high.
To be sure, many of these dot-com companies are in the midst of an impressive growth spurt, thanks in large part to the impressive gains in mobile computing. The rapid growth in smartphones and tablet computers has paved the way for solid traction in mobile advertising and mobile transactions.

And it's wise to assume that the heady growth can last at least a few more years. That's why you need to look at how these stocks are valued in the context of 2015 projected results. By then, some of these companies' most impressive growth rates are likely to be behind them. And on the basis of 2015 forecasts, it's hard to get a grasp on their stunningly high multiples.

Facebook (FB), for example, trades for more than 20 times projected 2015 free cash flow, making the stock something of a bargain in this group. I recently argued that the social media giant deserved its solid second-quarter gains, but it's hard to justify any further upside.

But the real mania is taking place among the smaller dot-coms such as Pandora (P), Zillow (Z) and LinkedIn (LNKD). Their current valuations are so stretched that investors must be assuming that these companies will keep growing at a torrid pace for many years to come, eventually justifying their current valuations.

That makes this a good time for a reality check on their futures. Pandora, for example, will see stiff competition from Apple (AAPL), traditional radio chains such as Clear Channel, Spotify and perhaps smaller upstarts we haven't heard of yet. Moreover, investors are ignoring the profit challenges in this industry. Pandora is unlikely to generate even $50 million in free cash flow by 2015.

In a similar vein, my colleague Michael Vodicka laid out concerns around real estate firm Zillow, noting that the company is "battling a highly fragmented and regional market, intense competition and an industry with very few barriers to entrance." And it would likely be many years before Zillow's EPS appears reasonable in the context of the current $88 stock price.

The question for investors: Is all of this a redux of 2000, when the dot-com boom famously imploded? Not for companies like Google (GOOG), Facebook, Priceline (PCLN) and eBay (EBAY), as they have strong moats, high levels of recurring revenue, and the cash flows to back up their cause. It's the smaller dot-coms that are looking awfully bubbly. Investors appear so eager to latch on to companies with high revenue growth potential that they are increasingly ignoring the more sobering margin and profit structures those companies possess.

Risks to consider:
As an upside risk, these are high-beta stocks, and a market surging to fresh all-time highs could take them higher in the near-term.

Action to take:
Many of these net stocks are now "priced for perfection," meaning they must deliver stellar third-quarter results, strong enough to lead analysts to raise their forecasts. These companies simply can't afford a hiccup, as their nosebleed valuations would prompt investors to punish them if their earnings fail to measure up.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

More from StreetAuthority

Oct 7, 2013 6:58PM
Yep, it will be deja vu all over again with a bunch of leading the way...back to the run up in the late 90s to 2000.
Oct 7, 2013 6:40PM
We are still Knee Deep in the Derivative bubble which in turn has created the ongoing Credit bubble. That has allowed for so-called investors to buy on Record Margin which then allows companies like Amazon to see their Stock price rise. It's all Smoke and Mirrors and has been for decades.
Oct 15, 2013 2:11PM
Where's Apple? It's a social network stock too!
Oct 9, 2013 9:33AM
This is the 2nd half of Dotcom crash. It will happen very very fast too!
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