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Let me ask every reader first, what is Facebook's (NASDAQ:FB) greatest strength? Is it the best way to communicate with friends and family? It cannot be as Skype (owned by MSFT) with 33%+ international call market share, Snapchat, Viber and Whatsapp with 200 million+ active users all demonstrate that thriving alternatives exist. Is it the best place to store and share photos? If that were so, why are sites like Flickr (owned by YHOO), Imgur and cloud-storage sites like Dropbox and SkyDrive continuing to proliferate? Is it the best place to share your idle thoughts and give status updates? It cannot be that as Twitter with 400 million tweets per day and Tumblr with over a 100 million blogs are thriving. What about sharing your "likes?" This cannot be true either as Reddit and Pinterest approaching from different angles continue to gain popularity. Is its success because it is the place one goes to find reviews of local businesses? That cannot be true either, for if one searches for the answer, they get responses from sites such as Tripadvisor (NASDAQ:TRIP) or Yell.com. Personally, I find "HERE" (owned by NOK) does the job for me admirably. So just what is Facebook's greatest strength?

Facebook's Real Greatest Strength

What is most admirable about Facebook is that it combines all of the previously mentioned services into a coherent whole that is not available anywhere else on the internet in one place. It then uses its inbuilt services such as Instagram and Facebook Home to help create the world's largest social network. The number of its "Monthly Active Users" (MAUs) is thus proudly showcased as the first statistic in all of its earnings slides to investors.

Monthly Active Users

(click to enlarge)

Source: Facebook Quarterly Earnings Slides Q1-13

These figures are then used by Facebook to sell its capabilities to advertisers which generate 85% of its revenues. While it is probable most of them are aware of the scale of Facebook, they are really incentivized to advertise on Facebook because it can segment these growing MAUs into large discrete demographics to achieve better returns on investment for them.

Softness behind the figures

So why might this be its greatest weakness? I believe Facebook has very limited financial incentive to work out if its MAUs are actually made of legitimate users or "fake profiles." Advertisers thus may not be achieving the level of targeting they perceive to be. As long as Facebook is paid per click in advertising campaigns, it benefits financially regardless of whether the click is genuinely meant or is by an automated "bot" impersonating a genuine profile on Facebook. This is deeply problematic as with revenues of just over $5 billion in the last 12 months, its market capitalization is heavily dependent not on actual revenues, but the potential for Facebook to convert its MAUs into decent revenue streams in the future.

Of course, this does not mean Facebook is misrepresenting. What it does mean is that unless we ask it the right questions, Facebook only has very limited incentive to figure out the true answers. Thus in its latest 10-Q filing, it estimates "duplicate accounts" on December 31st, 2012, at 5%, "misclassified" accounts at 1.3% of MAUs and "undesirable" accounts at 0.9%. Cumulatively this comes to 76 million illegitimate profiles. This is a fall from its 10-Q 6 months ago where it estimated internally that it had 83 million illegitimate profiles.

Taking this into account, I would like every reader to ask themselves if they genuinely believe that the following graph below is accurate.

MAU Linear growth

(click to enlarge)

I really struggled to produce the above graph because Facebook, despite its number of fake profiles being just as important as its number of MAUs, has produced just 2 data points since floating. These are for June 30th 2012, and December 31st, 2012. I thus had to do estimations for Q3 2012 and Q1 2013 extrapolating from these sole data entries.

So the natural question arises of whether it is genuinely believable that Facebook's MAUs which show a nice steady linear progression are somehow not matched by a slow and steady rise in illegitimate profiles. For sure, Facebook will claim to be making strides in removing them. If this were genuinely the case, that it indeed had materially impacted on these numbers, I would have expected to have seen some variation in MAU growth over time which is suspiciously linear. I would also have expected Facebook to make a bigger deal of its advances, yet it remains suspiciously silent.

Other companies have undertaken genuine purges of bots and illegitimate profiles with much more drastic results. For example YouTube (GOOG owned) in December 2012 removed 2 billion views from its videos. This was sufficient to have a major impact on the website with some channels such as Sony/BMG briefly going from 850 million views to a mere 2.3 million. One can also note drastic effects from purges of illegitimate profiles on games with monthly subscriptions such as EVE Online amongst others which have a clear financial incentive to prevent manipulation of numbers.

Yet most pertinently from the point of view of every Facebook shareholder, it does not appear to put much effort into calculating this figure. As Facebook puts it:

…these estimates are based on an internal review of a limited sample of accounts and we apply significant judgment in making this determination, such as identifying names that appear to be fake or other behavior that appears inauthentic to the reviewers. - Facebook 10Q Q1 2013

There are a number of troubling issues that arise from the above statement. Most glaringly, it appears that a high degree of human discretion is required to ascertain if a profile is illegitimate or not. With Facebook employees carrying out this judgment call, it can lead to biases towards under-reporting especially as bots are deliberately designed to appear authentic and fool observers. We also do not know the margin of error, which is statistically larger for limited samples. We thus need more information on how these studies were carried out including how the samples were determined.

There is a risk for all investors that at some point a clever technical analyst will work out exactly what the percentage of fake Facebook profiles are using a larger sample size and with methodological controls to ensure an accurate independent assessment can be made. I suspect this number will be found to be much higher than Facebook's public figures. Its share price will then experience a strong downward push as the market digests this news.

While this may seem overly dramatic, I believe one of the many reasons Facebook's share price fell following its 26th July Q2-2012 earnings release was precisely because this was the first time we discovered that there were millions of illegitimate profiles on Facebook.
Facebook Share Price Change

(click to enlarge)

Source: Google Finance

Google Trends Fake Profile Spike
(click to enlarge)

Source: Google Trends

The second graph in particular is interesting as it charts how news reports involving fake Facebook profiles spiked shortly after Q2 2012 earnings were released. This was however as noted before, just Facebook's internal estimates based on a limited sample. I do not believe this problem has gone away even though it is no longer being reported as much in the media. Thus there is a sizeable risk, to any current shareholder, that if this figure is revealed to be higher based on better assessments that Facebook's shares will fall again in the same manner they did in July 2012.

A possible solution

There is a simple way for Facebook to eliminate this problem. Instead of monetizing its end-users by turning them into recipients of targeted advertising - it should consider treating them as its clients. Facebook should immediately move to a "freemium" model whereby its users pay extra fees in exchange for additional benefits. This could include for instance charging for its mobile apps. For extra functionalities such as being able to have more Facebook friends; or for having an advert-free experience. Properly targeted, this will remove the fake profile problem as it will make it financially unviable for such profiles to be maintained on Facebook. It will also remove any systemic inbuilt bias there may be towards inflating the true MAU figure. Of course if this is improperly handled, its MAUs will go into drastic decline. Just because this is difficult however does not mean that it should not be done.

The alternative which is what it is doing right now is a gradual inflation of MAUs with a concordant slow rise in its revenues. While its YoY revenue percentage growth is decent, with revenues increasing from $5 billion, they are nowhere near the revenues of the typical $67 billion company.

So is its valuation justified?

I was inspired to write this piece after reading this recent excellent Seeking Alpha article. I respect the author's technical analysis a lot. On my side, I would ask Facebook shareholders if they believe this statement:

If the company can grow revenues by 25% over the next three years it could achieve annual revenues of $10 billion in 2015. If net earnings could recover to previous levels, being around 25% of net revenues, earnings could come in around $2.5 billion for the year, making forward valuations much more acceptable at roughly 6 times annual revenues and 24 times earnings. - The Value Investor

Therefore, to justify its valuation the company revenues will have to grow 25% per annum over the next 3 years while its share price will simultaneously have to stagnate for 3 years to achieve a reasonable P/E of 24.

I do not believe this will happen with its current strategy. Eventually Facebook will run into an unavoidable obstacle where it will have to work out its true incidence of illegitimate profiles. It will then recognize that it cannot monetize its consumers any further through the serving of adverts alone, especially as its MAU numbers are static or declining in key markets. It will then be forced to change strategies to achieve its objectives, probably shifting to a more refined freemium model. The path to this will be very rocky with limited upside potential for Facebook shareholders over the next three years.

Alternative Investments

Thus while I believe that Facebook is an excellent all-in-one social network. I believe the MAU issue presents too great a risk for investors long on the stock to ignore. For investors looking to shift out of Facebook, I believe there are currently several alternative investments which have the potential to provide much better returns.

To establish a selection for investors, I created a list using "Google Stock Screener" based on the following criteria:

A. It is a company listed on the NASDAQ (so that people shifting away from Facebook stay on the same exchange).

B. It is worth between $10bn to $67bn. This means it is a large-cap but is worth less than Facebook as of today.

C. It has delivered 5 years of 25%+ EPS growth. This means it has been a proven growth story, unlike Facebook which is reliant on its earnings potential only.

D. Its P/E ratio is between 0 to 40. It is therefore still reasonably priced and is naturally making profits year on year.

E. Its institutional shareholding is above 36%, the current Facebook figure. Interestingly but not surprisingly, there isn't a single stock on the NASDAQ with an institutional shareholding under 36% which has a greater market capitalization than Facebook at present. That should raise alarm bells.

Finally, I used my personal discretion to select only companies which are based primarily on information-technology to enable a better sector comparison with Facebook.

Using this filter, I found 7 companies which i believe all offer better prospects than Facebook. I have listed them below and ordered them based on their 5 year EPS growth rate.

Company Name

Symbol

5 year EPS growth rate

Market Cap

P/E Ratio

Institutional Percent held

Baidu.com

BIDU

75.19

31.25Bn

18.47

62.11

Priceline.com

PCLN

55.41

36.11Bn

26.16

97.94

CA Inc.

CA

53.77

12.59Bn

13.94

65.46

Yahoo!

YHOO

47.64

29.02Bn

7.63

74.99

Seagate Technology

STX

33.07

15.08Bn

5.55

80.59

Symantec Corporation

SYMC

30.67

17.26Bn

15.93

91.89

Broadcom

BRCM

27.58

20.78Bn

25.69

73.23

Stats taken from Google Finance and correct as of 7th May 2013

I would ask every Facebook shareholder if in 3 years' time looking at the list of those companies above, they feel Facebook will genuinely outperform each one of those prospective buys. Personally I find Yahoo to be an especially interesting buy as just like Facebook it was originally a much hyped stock. Thus its market capitalization is around the same as 5 years ago, but unlike Facebook it now has proven year on year revenue growth which means it has grown into its valuation giving it a very intriguing P/E of just 7.63.

Final thoughts

On a final note and to give full disclosure, I no longer use Facebook. I deleted my personal account over a year ago. Most of my friends and family have done likewise. I use Whatsapp to communicate with friends, Skype and Viber to call my family internationally, I share photos via SkyDrive and I put my idle ruminations on Twitter. I like all of those services and I feel they manage my privacy at a level I can control better than I could on Facebook. My opinion is only anecdotal, but I do not feel it coincidental that independent research regularly shows a fall in UK and US usage rates. Luckily for Facebook, its linear growth in MAUs appears to have successfully countered the decline in these key developed markets. Do not count on this continuing.

Source: Facebook's Greatest Strength May Be Its Greatest Weakness - Buy Something Else

Additional disclosure: Personal principles mean I do not short any stock.