STABLEBOY SELECTIONS

The Internet Bubble saw extreme valuations for any company doing business on the Internet. eToys.com, for example, reached a valuation of 150X revenues and an infinite multiple of book value. Think about that for a minute. In September 2008, Lehman Brothers–one of the most established investment banks in the world–could not raise equity at even a small fraction of book value. Even if you took David Einhorn’s view that the book value was overstated, it would still have made sense to raise equity at one-twentieth of book value. The new investors would have done pretty well in retrospect, and the company would not have gone bankrupt. In September 2008 people were so scared they wouldn’t pay anything for Lehman Brothers equity. And yet eight years earlier this same investing public had gladly paid an infinite multiple of book value to own the equity of a business with a history of substantial losses.

Why were things so crazy back then? Let’s apply Deep Throat’s view of the world to this. There’s got to be a perfectly reasonable explanation for craziness, right?

The “reason” behind eToys.com’s valuation was that the market assumed that selling toys over the Internet would be very disruptive to established industry players like Toys R Us and FAO Schwartz. Since eToys didn’t have to deal with the huge overhead of running retail stores, it could undercut competitors. Sounds like a good idea on paper. But there are two obvious problems: (1) ANYONE can use the Internet to his advantage. It’s not proprietary at all. Of course Amazon.com had a first-mover advantage over Walmart, but eventually Walmart set up its own online store and came closer to parity with Amazon; and (2) even though it is cheaper to buy things online, it is human nature to want to walk out of a store with something TODAY.

This is obvious to us now, but could you have seen the danger of bad logic while the Bubble was growing? If you have to be really scientific about it, the answer is no. You would be like David Hume and say, “Well, this is the first time the Internet has ever become mainstream. There is no precedent for this. Therefore we cannot know what the potential is for Internet companies, and therefore we do not know whether their stock prices are rational.” If you go back to the concept that the Internet is not proprietary and use COMMON SENSE (which seems rare in frothy markets, especially if you are too scientific to risk inferring things), you would have realized the danger immediately. At least you would not be crazy enough to pay 150X revenue for this business. You might pay 10X.

I think the real reason for eToys.com’s huge valuation was its association with the Internet. After Jim Chanos (one of the best short sellers) was proven wrong in his bet against AOL, the Internet Bubble exploded. Anything even remotely associated with the Internet reached enormous valuations.

Fast forward to the present, because now there are concerns of a similar bubble in social networking sites. (Since interest rates are so low, this is all the more reason to be careful–people throw caution to the wind when rates are low.) Here we do not have the benefit of retrospection. This makes it more fun to talk about. Here is my take.

I am one of the many critics of Groupon’s business model. In my opinion it does absolutely nothing proprietary. A group of smart software engineers at Company X, Y, Z could design a similar service. Moreover the retailers I’ve talked to who participate with Groupon actually lose a fair amount of money. A retailer who uses Groupon is typically offering a 75% discount on its product/service. (If you get $40 worth of hair services for $20 via Groupon, Groupon takes $10 and the retailer takes $10.) And the retailers don’t know whether taking a loss is justified, because they can’t tell whether the boost in customers from using Groupon has any long term effect.

Worst of all, Groupon itself pays huge customer acquisition costs, which explains why it lost $100 million last quarter. Here’s an excerpt from the S-1 filing:

“Marketing expense consists primarily of online marketing costs, such as advertising on social networking sites and through search engines, and to a lesser extent, television and print advertising. CityDeal also records costs associated with customer acquisition and affiliate arrangements in marketing expense on the consolidated statement of operations. Online marketing expense is recognized based on the terms of the individual agreements, while other marketing expense generally is recognized in the period in which it is incurred.”

You can’t make this shit up. Groupon advertises itself on Facebook. Facebook has already rolled out Facebook Deals. Facebook Deals is FREE for retailers to participate. So why doesn’t the market realize that Facebook could advertise Facebook Deals and send Groupon to oblivion? Facebook has 690 million users worldwide–that’s a whopping 1 out of 10 people. Groupon has only reached 80 million users.

I believe Groupon is overpriced. Like eToys.com, it has first-mover advantage. But nothing it does is really proprietary and it loses a substantial amount of money.

If we are in a bubble, I want to own Facebook. Deep Throat was telling me that he didn’t see how it could grow into its $80 billion valuation. Well, I think it takes much less imagination to defend Facebook than Groupon. It’s just common sense.