On the day of one of the largest IPOs in history, Facebook Inc. traded for as much $45 but later that same day, the underwriters had to step in to support the price at $38, the initial IPO price. You might remember that at that time, many people still under the illusion of the IPO's hype blamed this price reversal on technical glitches at Nasdaq. However, the downward spiral of this stock from there on was there for all to see. The smart investors' suspicion that the IPO was highly overpriced turned out to be correct. Now, as the stock is seemingly on its way to recovery and moving higher towards the IPO price again, the question is: Is the recent rally in FB justified?
With a forward P/E multiple of 46.26, Facebook has a very expensive valuation, and I do not think that Facebook will be able to grow at a level to justify this valuation. I give my reasons below.
Since Facebook went public, insiders have been rushing to sell. Even though some volume of insider selling is common soon after a privately held company goes public, some of these transactions, in this case, do raise concerns. Peter Thiel, a member of the Facebook board, the co-founder of eBay's (EBAY) PayPal and a renowned venture capitalist who was one of the angel investors in Facebook, cashed out of most of his stake in August at an average price of $19.73. He might have had his reasons, but the fact that such a famed, successful investor well known for his focus on growth was so eager to cash out does not instill much confidence.
Other high-profile sellers include Facebook co-founder Dustin Moskovitz as well as directors James Breyer, Marc Andreessen and Donald Graham. Although some of these insiders sold their shares at relatively unattractive prices, the recent rally in the stock hasn't done much to deter executives from selling their stakes. Among others, Chief Operating Officer Sheryl Sandberg and Vice President of Engineering Michael Todd Schroepfer have continued to sell their stakes throughout the recent move up; the most recent sale was on January 16th, when Sandberg sold shares worth $10,627,522. I believe that insiders selling this rally raise a red flag which is there for all to see. The question now is: What could the insiders be so concerned about?
Mobile Ad Revenue Growing, But At What Cost?
Investors were happy to hear that Facebook Inc. generated 14% of its $1.09 billion advertising revenue from mobile. However, investors must realize that this growth in mobile revenue is eating up into Facebook's desktop ad revenues, which decreased on a q/q basis for essentially the first time since Facebook started to publicly report the data. Therefore for Facebook Inc. to show real revenue growth, the revenue growth from mobile must be greater than the revenue lost from desktop after discounting the growth in active users. In other words, the dynamics of mobile ads should be such that they must be able to generate at least the same amount of revenue for a similar level of user engagement on the desktop interface. However, this is far from certain:
- Although the mobile platform is reported to have high click-through rates (CTR), the number of ads that can be placed within a mobile news feed is very limited as opposed to the desktop version where many more ads can be placed.
- Facebook's mobile ad sales are based on how often the ad is inserted into the user's mobile newsfeed as opposed to the number of times a sponsored story is viewed by the user. So a user viewing the same 'sponsored story' over and over again while browsing the newsfeed does not count as multiple paid impressions. Therefore the overall impression growth on the mobile platform could be slower than that on desktop for the same level of user engagement.
User Base Starting to Saturate
To justify such a high P/E ratio, FB has to show phenomenal growth over a relatively short period of time. However, in addition to mobile revenue woes, Facebook's user base in developed countries is starting to saturate. Statistics from socialbakers.com show that the Facebook's monthly active users (MAU) in the US, Canada, and UK have decreased over the past three months. Facebook's penetration in these markets is already above 50%, so the room for further growth in user base is limited.
Bulls would argue that the MAUs are still growing at a fast pace in emerging markets, which should drive revenue growth. That may be partially correct, but the important thing to note here is that the developed markets such as the USA, UK and Canada offer the highest Cost Per Click (CPC) and Cost Per Impression (CPM) rates and are therefore the major drivers of advertising revenue. For example, the table below shows that the average CPC in the US is almost five times the average CPC in Brazil. This is in addition to reports that average CPC across the United States and Canada fell sharply in Q3 2012. Moreover, these developed markets also have the highest smartphone penetration rates which does not bode well given the concerns with mobile advertising discussed above. With the MAUs in the higher end markets starting to stagnate, I find it difficult for Facebook to generate revenue and profit growth at a level to justify its current P/E multiple.
Average CPC (USD)
In a much anticipated announcement, CEO Mark Zuckerberg launched what he called the "third pillar" of the Facebook platform sending shockwaves across to Yelp (YELP) and LinkedIn (LNKD). A social search engine from the biggest social network makes sense but I think it is too soon to say when and how successfully Facebook Inc. will be able to monetize it. In my opinion, privacy constraints would prevent the Graph Search function from being as useful as people are excited about it. Moreover, only a desktop beta version of this tool has been launched for now, and Zuckerberg suggested that it was "hard to estimate" how long it would take to launch Graph Search on mobile, which does not sound too exciting given the trend shift towards smartphone usage.
To summarize, I think that Facebook will find it difficult to grow at a level to justify its highly expensive valuation. Insiders have been consistently selling this stock, which tells you that they are not quite ready to believe the growth story. Mobile revenue growth is cannibalistic and the user base in important higher end markets is maturing. The Graph Search tool is potentially a step in the direction, but it is far from certain how successful will it be.
Disclosure: This article was written by Dividend Pros' technology analayst. I have no positions in any stocks mentioned, but may initiate a short position in FB over 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.