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Not Much to 'Like' About These Tech IPOs

Newly public social-networking stocks may have come off from their highs, but investors are better-served looking elsewhere for bargains.

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In the middle of 2011, the chatter surrounding the upcoming crop of tech IPOs was hitting a frenzied pace. New IPOs from  LinkedIn (LNKD) and Pandora (P) were exciting investors, and eyes were turning to the expected debuts of Groupon (GRPN) and Zynga (ZNGA) at the end of the year.

Since then, that excitement has abated somewhat and a wave of skepticism has crept in. There were concerns over Groupon's accounting standards and more broadly of the sustainability of social-networking business models. The worries have kept most of these IPOs underwater from their debuts. So does the slight decline in hype mean that it is a good time to jump into the social-networking IPO game? Absolutely not. The market remains too optimistic about all of these firms' prospects, and investors would be much better-served looking elsewhere in the tech sector for value.

Why the Hype?
So why is the market so widely optimistic about this new wave of Web companies? The answer is growth, growth, and more growth. These companies are expanding at astounding rates as users in both developed and emerging markets sign up for these novel services. As social networking becomes further ingrained in everyday life, it is easy to see a large growth runway for these firms.

This is in sharp contrast to the low- to no-growth world in which we are living. The United States is growing at a very modest rate, Europe is teetering on the edge of recession (if it already isn't in one), and even emerging markets are starting to slow, as well. For investors who worship at the alter of growth, these tech companies have seemed like breath of fresh air.

Adding fuel to the fire are bankers anxious to get back into the IPO game. The IPO market all but disappeared after the financial crisis when markets were in freefall and no one thought it was a fortuitous time to come to market. Now that the markets have mostly stabilized, there aren't many candidates to go public. The pipeline was decimated during the downturn because financing and the economic environment were so challenging.

The only firms that could really get going were those without large capital requirements. Enter social-networking businesses that only needed a handful of laptops, some rented server space, and a few engineers. These firms were then able to innovate and grow through the recession without needing access to the capital markets. Now a few years later, these firms are some of the only ones ready to be taken public. There's little wonder that bankers eager to jumpstart the IPO market have focused on the tech sector.

What's the Problem?
Even if the hype is understandable, it doesn't mean that long-term investors need to buy into it. To be sure, these are real businesses, with real cash flow and with real growth in store for them. However, there are plenty of potholes on the road ahead, and investors shouldn't be wiling to pay any price for growth.

The truth is that social-networking business models are still very much in their infancy. Lots of people are signing up for the services, but many of these companies are not really monetizing their user bases yet. Many of the websites have yet to attract some of the highest-profile advertisers to their platforms, and there is no guarantee these big spenders will ever show up. A lot of these sites, such as Groupon, are spending much of the incoming cash flow to expand the business. This might end up being a smart move; the firms might be able to get a higher return on that cash than shareholders could. But having no idea what the cost structure will look like down the road makes it hard to know where sustainable long-term operating margins will end up.

Also, don't forget about competitive advantages. Sites that look like juggernauts today might soon be yesterday's news. Disruptive technologies and new entrants can easily chip away at competitive advantages and upend business models. Assuming that profitability will improve sometime in the distant future could be a risky bet.

The market has seen some of these challenges, and many of the new IPOs have sold off considerably since their first trading day. Groupon, Pandora, and LinkedIn are all below their IPO prices, and Zynga fell below its offering price almost immediately after it began trading. Value investors might be tempted to see these declines as an entry point, but Morningstar's equity analysts caution against that. Many of these IPOs have now gone from insanely overvalued levels to being just overvalued. The recent crop would need to fall quite a bit for them to look attractive.

What to do?
So does that mean that investors should just throw their hands up and ignore the entire tech sector? Hardly. Technology as a whole appears 11% undervalued, and there are plenty of bargains to be had. Former IPO darling  Google (GOOG) is still growing at an impressive pace, and its valuation looks fairly cheap. The same can be said for Chinese Internet portal (SOHU), which currently has a Morningstar Rating for stocks of 5 stars. There are also great opportunities in slower-growth hardware stocks such as  Hewlett-Packard (HPQ) and  Oracle (ORCL). So even though the IPOs might be grabbing the headlines, investors will be much better-served by looking deeper into the tech bench to build out their portfolios.

What do you think? Are the recent social-networking IPOs a buy after the sell-off? Will next year's Facebook IPO reignite the hype for these offerings? Where are you looking for tech bargains?

Bearemy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.