By Farai Mapfinya, Equity Analyst - August Newsletter

Cloud computing and social networking platforms are widely considered to be the current major trends in the information and communication technology (ICT) landscape.

In an effort to remain relevant and to gear for future growth, leaders in the ICT game have been scouring Silicon Valley and other tech innovation hubs for social networking and cloud type assets.

This has led to stretched valuations reminiscent of the dot-com bubble at the turn of the century. Stretched valuations notwithstanding, some start-ups have rejected sizeable bids from major technology companies, believing their companies to be potentially worth more than the figures offered, and are demanding higher prices or opting instead for an Initial Public Offering (IPO).

The first half of 2011 saw a string of ICT IPO’s coming to market at valuations we believe to be unjustified, given that these companies are often barely in profit. For instance LinkedIn, a business networking site, debuted on the Nasdaq trading at a trailing PE of a very high 1 314 times and a price-to-book ratio of 132 times. This compares to an overall Nasdaq PE of 24 times, and average price-to-book of 3.5 times.

Another example is the Chinese social networking site Renren, which trades at an EV/EBITDA of 350 times against an industry average of 40 times. And Youku, China’s answer to YouTube, priced its IPO at $13 and currently trades at $39, despite reporting a loss for the quarter to March 2011.

For those that have not listed, implied valuations from private capital-raising are equally demanding. Of note is controversial two-year-old group discount buying company Groupon. After declining a $6bn offer from Google, Groupon’s capital-raising implies a valuation of $30bn. Like LinkedIn, Groupon is still struggling to post a profit with losses of $450m in 2010 against losses of $6.9m and $2.2m in 2009 and 2008 respectively.

A similar picture emerges with Facebook. Though it is privately held, capital-raising and auctions through SharesPost places a value of $35 per share, implying an IPO value of $84bn. This remains short of the $100bn mark for which Facebook is reportedly aiming for before floating its shares.

Nevertheless, there are success stories from companies, which have been able to monetise their subscriber bases and generate profits. A notable example is the Naspersheld Chinese internet service and online gaming portal, Tencent. With a solid 12-year history, Tencent has grown its user base to 670 million and the latest results reflect revenues of US$3bn, a net profit of US$1.5bn and a net margin of 41%. Tencent trades on a trailing PE multiple of 37 times, still elevated relative to the overall market.

Generally, however, cloud computing and social networking start-ups need to find a way to rapidly and significantly increase their sales and profits to justify their valuations. Failure to do so potentially puts valuations in bubble territory.

This article was taken from Mastermind, the official monthly newsletter of Sanlam Private Investments, a division of Sanlam Ltd. Issue 48, August 2011. Visit the SPI Website