Should You Be Bullish On Facebook?

| About: Facebook (FB)

By Matt Doiron

Former hedge fund manager and current CNBC host and investing personality Jim Cramer has been bullish on Facebook (NASDAQ:FB), which recently received an upgrade from Jefferies and BMO Capital Markets. While the stock is well above its lows, the current stock price is still under $25 and therefore significantly off its IPO price of $38. The 10-Q for the first quarter of 2013 showed that Facebook has continued to increase its revenue- the top line grew by 38% versus a year earlier- but that operating costs were also up strongly (including a near doubling in R&D expenses) and as a result operating income was about flat. The small increase in earnings was explained entirely by a lower effective tax rate. We would note that part of the increased costs was due to higher share-based compensation, and due to this as well as higher depreciation Facebook actually recorded a large percentage increase in cash flow from operations.

Even though adjusted earnings per share numbers look fairly consistent over the last several quarters, Wall Street analysts are expecting EPS to rise to 77 cents for 2014. Even with this increase, however, Facebook is currently trading at 32 times forward earnings estimates. So far, the company has had trouble converting its strong revenue numbers into earnings and so we're skeptical that net income will grow enough to justify the current valuation. In addition, while we wouldn't put too much weight on reports that users are losing enthusiasm for the social network (as versions of these stories have been around for years) it is a concern to be aware of.

Facebook had actually been one of the most popular tech stocks among hedge funds at the beginning of 2012, according to the database of 13F filings from hedge funds and other notable investors we maintain as part of our work developing investment strategies (we have found, for example, that the most popular small cap stocks among hedge funds outperform the S&P 500 by 18 percentage points per year). However, a number of funds, including billionaire Stephen Mandel's Lone Pine Capital, dumped the stock in Q1 and so it no longer made our list. D.E. Shaw, a large hedge fund managed by billionaire David Shaw, reported a position of 7.6 million shares at the end of March though this was down slightly from three months earlier (find D.E. Shaw's favorite stocks).

Peers for Facebook include Google (NASDAQ:GOOG), owner of the competing general social network Google Plus; LinkedIn (NYSE:LNKD); social gaming company Zynga (NASDAQ:ZNGA); and Chinese social network Renren (NYSE:RENN). Google has been experiencing double-digit growth rates on both top and bottom lines, as its search business continues to be a strong growth engine. However, markets are already pricing in high growth as the stock carries a trailing P/E of 26. Investors seem even more optimistic about LinkedIn, which after rising 75% in the last year now trades at 81 times forward earnings estimates- results have been good in terms of growth rates but we still don't think that the stock is a buy given its valuation.

Renren and Zynga, meanwhile, are both unprofitable on a trailing basis and are both expected to experience net losses this year as well. Zynga has actually been reporting lower revenue than a year ago, and a large share of its market capitalization is cash. It's possible that the company could become an acquisition target, but that would be a very speculative reason to buy and if anything we might want to look at shorting Zynga. As for Renren, revenue grew by 45% last quarter compared to the first quarter of 2012 and losses per share were considerably smaller than expected. The company has reported a sizable cash hoard, though we would at least want to wait to consider it until profits turned positive.

Social related companies in general seem to be carrying too high valuations for us to get involved at this time. In the case of Facebook we also wonder if the exodus of hedge funds during Q1 should be taken as bearish for the stock, and certainly with recent financial results looking weak we would avoid investing at this time.

Disclosure: I am long GOOG.

Business relationship disclosure: This article is written by Insider Monkey's writer, Matt Doiron, and edited by Meena Krishnamsetty. They don't have any business relationships with any of the companies mentioned in this article and they didn't receive compensation (other than from Insider Monkey and Seeking Alpha) to write this article.