One of the most-hyped IPOs in recent history was Facebook (FB). Prior to listing, Facebook was the hottest ticket in town, with some believing that the stock would come to rival Apple (AAPL) and that Facebook founder Mark Zuckerberg would supplant Google's (GOOG) Sergey Brin and Larry Page as technology's most notable young leader.
Then the wheels came off.
In the weeks leading up to its IPO, the stock was mired in controversy related to its regulatory filings with its lead underwriter, Morgan Stanley, eventually paying a $5 million fine while neither admitting nor denying allegations of wrongdoing.
More importantly, since Facebook listed on May 18, 2012, the stock has floundered, with its IPO day closing price still remaining as its all-time high. Indeed, since listing, the stock has lost 25% and, in the year-to-date, the stock has been essentially flat, rising by 1.1% and trailing the Nasdaq composite's return in the same period by 7%.
Since then, Facebook has attempted to bounce back, most notably (and recently) with the long-awaited Facebook Phone - called the First - a $99 handset featuring Facebook Home and built by Taiwanese OEM HTC.
The device isn't exactly cutting edge - it runs a slightly older version of Google's Android operating system with Facebook Home essentially serving as a launcher application - that is, Facebook Home essentially serves as the interactive shell around which users can interact with the device. The device is no iPhone killer - in fact, its performance trails that of some mid-level handsets produced by HTC.
The idea behind the device is clearly to make it affordable and have just enough features to make it attractive to as many Facebook users - or even first-time smartphone buyers - as possible.
Moreover, ostensibly because Facebook realizes that the HTC First is unlikely to displace either Apple's iPhone or Samsung's Galaxy S series as the top smartphone devices, it has made Facebook Home available on the Google Play store - meaning that any of the millions of Android device users can run Facebook Home provided they are running the last two generations of the Android operating system and there are reports that Facebook intends to bring its Home app to iOS.
Evidently, Facebook intends for the lynchpin of its mobile strategy to be independent of dedicated device sales or it would have made Facebook Home exclusive to the HTC First. Facebook is clearly taking a page out of Google's playbook. Android - an open platform available to OEMs of various devices (not just smartphones and tablets but also televisions and printers) - has consistently trumped the market share of iOS - a platform exclusive to Apple-made devices.
Clearly, Facebook's dive into mobile has not gone as well as it had anticipated and, in our view, investors have been right to keep away from the stock, specifically for the following reasons:
1. It's Still Overvalued. Part of the reason for Facebook's decline has been attributed to its high IPO price - at its original listing price, it had a P/E ratio of 54x forward earnings estimates at the time. Fast-forward to nearly a year later and it's still trading at a premium valuation of 34x forward earnings, despite the fact that the average earnings estimate has been reduced by 13.6% and its stock has fallen by 25% since listing.
Facebook is expected to grow revenues by 31% in 2013 and 27% in 2014 - a good number, especially when compared with its industry peer group - but that group includes search engines line Google, a company we liked enough recently to write about, and Baidu (BIDU) whose businesses extend far beyond maintaining its own social networks.
A more appropriate comparison is with LinkedIn (LNKD), a social network bent towards business/professional networking.
LinkedIn is expected to grow revenues by 54% in 2013 and 40% in 2014 - and it already generates more revenue per user at $7.45 to Facebook's $6.27. That's 19% more revenue per user despite having 80% fewer users.
What's more, LinkedIn has begun expanding its offerings to take advantage of its potential as a way for businesses to reach professionals. Given this, it is easy to see why LinkedIn enjoys a Price-to-Sales premium of 20.2x to Facebook's 12.5x - there just isn't enough meat to Facebook's revenues just yet.
This is a gap that Facebook clearly would like to close and it is clearly betting that Facebook Home is one of the answers.
2. Mobile Not Going So Well So Far. Unfortunately, while it is still early-goings, the early returns have not been good for Facebook Home - the majority of early adopters have given it poor reviews on the Google Play store - more than half have given it a 1-star review (out of 5) - which could dissuade others from adopting it until it garners better feedback.
At the same time, the non-exclusive nature of Facebook Home could work against it. In its current incarnation, it is just another app and there is no particular impetus, especially given its early poor performance, for mobile users to prefer it over other Facebook applications built by other developers, including Apple and Google. Currently, with Facebook's relatively open APIs, any developer could reasonably attempt to create a rival platform with which users can customize their Facebook experiences.
That is dangerous because it means that Facebook is effectively not in charge of its own platform; rather, it is effectively just another aggregator of information from facebook.com.
3. User Base Not Really Impressive. The big number for Facebook has always been its supremely large user base but, with over 1 billion users, Facebook is very nearly at the limit to how many more it can reasonably expect to add.
As it stands, one of every six people on the planet has a Facebook account, yet, as we have already pointed out, it is still unable to generate much revenue from them.
To give it a starker perspective, consider Verizon (VZ), another company which we liked enough to write about. It has 98.2 million subscribers and an average revenue per account of $1,762 per year (annualizing its 1Q 2013 ARPA numbers) - that is well over 281 times what Facebook generates per user. To be sure, the comparison is not perfect but it does illustrate how far Facebook has to grow its revenues for it to rightly claim that it is fully monetizing its user base.
In many ways, the story of how much potential Facebook has is similar to the China story. With a population of 1.34 billion people, China has always been the big market that multinationals would like to harness, yet this has proven more difficult than imagined, as Apple's experience illustrates.
It's the same way with Facebook - it is incredibly difficult to generate revenue from that many people for the simple reason that not everyone on the network may wish to buy the same product or even be relevant to marketers.
In that sense, while Facebook Home is a commendable attempt to get around the company's monetization woes, it might be that Facebook should follow LinkedIn's approach and focus on specific niches that can generate more revenue, rather than attempt a one-size-fits-all strategy, as Home clearly was meant to be. That, or Facebook will eventually have to bite the bullet and embrace ads in the same manner that Google has.
Given this, we remain lukewarm on Facebook's stock and would not recommend it to investors. If sales of the HTC First and adoption rates of HTC Home disappoint, we anticipate as much as 20% downside for the shares.
Disclaimer: Black Coral Research is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.