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Facebook (NASDAQ:FB) is the world's biggest social media company, with a market capitalization of over 64 billion dollars. The company raised money from the stock market in one of the biggest IPOs in recent times. The stock was offered at ~$38 during May 12, 2012 and subsequently halved to reach a low of $17. The reasons for the sharp sell-off were concerns about overvaluation and ability to monetize its Internet traffic. Though these concerns have not gone, the stock has rallied by almost ~70% to reach ~$30. Apart from the earlier concerns, a new one that has been added is of users leaving social media, because it has become too intrusive. Facebook has been desperately trying to generate more revenue through new avenues. But the biggest problem with this strategy is that the more Facebook tries to monetize, the more it will alienate its user base. Also using the user data beyond a point for commercial uses might invite the wrath of the government and regulators. The company has a long history of getting into problems on privacy issues and has had to backtrack more than once.

Why we would sell Facebook

  1. Competitive barriers are not as high as they are made out to be - The Company's Facebook website is its entire business model. The company has little competitive barriers in terms of patents, global distribution network etc. The biggest asset is that users have invested a lot into their Facebook accounts in terms of adding relationships, photos etc. However, the rise of newer social networking sites such as Pinterest and communication services such as "WhatsApp" makes us think that the switching barriers might not be as that high.
  2. Social Media Competition is increasing - The company faces increasing competitive threats from rival technology companies especially Google (NASDAQ:GOOG). While Google Plus has not got a lot of traction in terms of time spent, this social network has still managed to get a lot of users, thanks to Google's influence. LinkedIn (NYSE:LNKD) is also a threat with 300 million users and a better monetization model.
  3. Lack of new products and services - Facebook has been found wanting to introduce new products and services that would "wow" its users. The new "Graph Search" function failed to set the world on fire, despite a huge build up to the event. The technology industry requires constant innovation. We have not seen a lot of innovation in case of Facebook.
  4. Internet 2.0 Companies can fade fast - While we don't think that Facebook will meet the fate of some of the failed social media companies, the risk is always there. Facebook did not pioneer the social media concept. There were other companies like MySpace and Orkut, that were more successful earlier. However, these networks disappeared as Facebook grew into its market leading position. There is always the risk that a new social media star can eclipse Facebook. Some of the other Internet 2.0 stocks like Groupon (NASDAQ:GRPN) and Zynga (NASDAQ:ZNGA) have declined by more than 80%, as investor frenzy has subsided.
  5. Privacy Concerns - Facebook has landed into a number of privacy controversies ever since it became a big player. The management does not seem to be learning from the numerous mistakes it has been making. The Instagram goof up was the latest one, in which the company had to hurriedly reverse its decision. Till now, the government and regulators have not intervened, but going forward Facebook will come under increased scrutiny.
  6. International governments may clamp down on Facebook - No government wants data on its citizens to be held by a foreign entity. Facebook has managed to garner a massive amount of data about foreign citizens (US users form only about ~15% of its user base). Pakistan has already started its own "Facebook," though it is running into problems now.
  7. Valuation is expensive - Facebook stock is trading at ~$30 now, after a sharp 70% rally from its recent lows. The company trades at a P/B of 4.5x and a P/S of 16.7x, which is much higher than the industry average. The company trades at a relatively expensive forward P/E of 38x and a P/CF of ~54x.
  8. User Growth has flattened out - Facebook has grown at a spectacular pace in the last 5 years as users have grown exponentially, thanks to the network effect. However, user growth is flattening out if not declining. The stock value is now dependent on Facebook monetizing its user base by selling products and services. If the market starts seeing weakness in monetization, then the stock could dive pretty quickly.
  9. Lack of a Hardware/ Software Platform - Facebook lacks a platform compared to other companies like Google (Android), Apple (NASDAQ:AAPL) or Microsoft (NASDAQ:MSFT). Today these companies include Facebook as an application in their platforms because of its popularity. However, if Facebook popularity reduces, then these companies could reduce easy Facebook accessibility, which would compound Facebook's decline. We saw how the market treated Zynga after it lost its exclusive deal with Facebook.
  10. One Trick Pony - Facebook is a one trick pony with its fortunes dependent on its social media site. Other big technology companies have multiple products and services to bank on. This dependency increases the risk of holding the Facebook stock.
  11. Management has yet to prove itself - Mark Zuckerberg, the 28-year-old CEO, has yet to prove whether he can match the big boys of the cut throat technology world. The No. 2 manager COO Sheryl Sandberg has also not done anything great till now. Compared to Facebook, other technology giants have established top management teams.

Upside Risks

  1. Monetization faster than expected - Facebook is increasing its attempts to monetize the Internet traffic and has doubled revenues in 2011, from the year 2010. The company realizes that it has to monetize fast in order to remain in the game. The company is already earning 14% of its revenues from mobile advertising.
  2. Strong Partners in an anti-Google alliance - Facebook has aligned itself with Microsoft and Yahoo (NASDAQ:YHOO) against Google. Currently all these companies want to end Google's vice like grip on the non-Chinese Internet space. There is a growing perception that Google has become too big and powerful for its own good. There have been anti-trust investigations and privacy penalties against Google in the recent past. Facebook could become the leader in leading the anti-Google alliance and benefit from strong partnerships as a result.

Stock Price Performance

The company does not have a long operational history, but has shown high volatility during its short life as publicly-listed security. The company is currently trading roughly in the middle of its $17-$45 range. The stock has run up quite sharply in the past quarter going up by ~56%, however the stock is still giving a ~22% loss to its IPO investors. During the same period, LinkedIn and Google have returned 13%, while the NASDAQ has given an 11% return.

Summary

We think that Facebook should be sold after a sharp ~70% rally from its all-time lows. The company faces significant risks in monetizing Internet traffic. The stock at the current price does not seem to be discounting those risks. There are both short-term and long-term competitive threats from both known and unknown competitors. The technology industry is a fast changing dynamic one and a leader can quickly turn into laggard. The recent examples of Nokia (NYSE:NOK), HP (NYSE:HPQ), and Dell (NASDAQ:DELL) should serve as reminders of this fact. The management of Facebook is an unproven quantity and the repeated privacy controversies are not doing its reputation any good.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Facebook: Peak Social Media Stock