Is Facebook an attractive shorting opportunity at current levels? We think the answer is yes, and here's why.
The stock trades with a premium valuation despite major growth challenges, and the social media industry is becoming fragmented as competition picks up.
Shares of Facebook Inc. (NASDAQ:FB) are currently priced for the best possible scenario. Despite trading at more than a 35% discount to its IPO price, Facebook is still valued at roughly 42 times earnings estimates for this year. This, despite the fact that earnings are only expected to grow by 7.5% in 2013.
There is basically only one reason a stock should trade at this type of premium valuation: expected growth.
It makes sense for investors to pay a premium for companies with high growth prospects because eventually, the company's earnings will grow into the current inflated price.
But in Facebook's case, the growth prospects clearly don't match up to the optimistic valuation. Looking at the future prospects for earnings, and the competitive risks the company faces, it appears that investors are treating Facebook with way too much optimism, and are setting themselves up for disappointment.
Where Will Future Growth Come From?
To justify paying 42 times earnings for a company like Facebook, you have to be able to make a SOLID case for long-term growth.
The biggest challenge that we currently see for Facebook is the fact that the company already has 1.1 billion active monthly users. So in terms of potential subscribers, the low hanging fruit (users in developed nations with internet access) has already been picked! There simply isn't room for significant long-term subscriber growth because Facebook has already saturated the market.
Sure, the company can continue to add new users as a larger portion of the emerging market population comes online. But for the most part, the affluent internet users are already well acquainted with the internet, and those who are likely to use Facebook have already taken the plunge.
So if earnings growth can't come from a significant increase in new subscribers, Facebook will have to grow profits by further monetizing its existing subscriber base. But there are significant challenges with this growth assumption as well…
One problem area for the company is that users are increasingly migrating their Facebook usage to mobile devices.
Mobile accessibility was supposed to allow Facebook to capture a larger portion of user's time (and thus give Facebook more opportunities to serve advertisements). However, increased mobile usage has led to shorter increments of time when users are actually engaged with the site, and it has been challenging for the company to use the smaller screens to effectively serve ads.
So even though Facebook has been successful in capturing a major chunk of time subscribers spend on their mobile devices, the company has not been able to effectively monetize this outlet.
At this point, Facebook is looking for additional ways that it can increase the amount of time that users spend on its site. Facebook's latest project appears to be a news aggregating service which tailors news articles for mobile devices.
I can't think of a project that is father off base from Facebook's core strengths! The company's website was built as a social gathering place where individuals can communicate and share life experiences. Adding a news reader service simply dilutes the brand. (Plus, the news aggregation business is already a saturated market!)
In its quest to further monetize its reader base, Facebook risks alienating its core user base, and making itself more vulnerable to competition (we'll get to that in a moment).
From an earnings growth perspective, there are basically two major challenges:
- Subscriber base saturation: Facebook can not dramatically expand its user base
- Monetization challenges: It will be tough to make significantly more money from its existing base of users
Rising Competition Will Stifle Further Growth
In addition to the internal growth challenges the company faces, the company also has to deal with threats from outside competitors.
Chief among these competitors is Google+, the Google Inc. (NASDAQ:GOOG) version of Facebook. Google+ may have started out as a fringe concept, but the social media platform is quickly reaching critical mass. At last report, Google Plus had 359 million active users - now 1/3 of Facebook's active subscriber base.
As Google+ continues to expand, there will be more incentive for users to defect away from Facebook. Social media is all about the network effect, and now that Google+ has a wide and active user base, it will become more attractive to additional users who may have overlooked the concept to begin with.
Google has some very strong natural integration features that will help it to woo users away from Facebook. Think about the synchronization with YouTube, GMail, and all of Google's other personally customizable features.
Fragmentation of the social media market is a significant risk for Facebook. If users become more willing to pick and choose which social media platform they want to use, it will further diminish the monopoly that Facebook has historically enjoyed.
To counter the threat from competitors, Facebook has to make significant investments in subscriber acquisition costs, as well as continually adding new functionality to its platform. The company already spent $1 billion to purchase Instagram, and the jury is still out on whether the acquisition will be accretive or not.
High costs to bring in new subscribers, or to build out (or acquire) new functionality, will detract from near-term earnings. With near-term earnings weighed down by costs and growth challenges, investors will continue to be hesitant to pay a premium price for Facebook's stock.
How Low Could Facebook Potentially Trade?
When the investment bank analysts set a target price for Facebook, they typically look several years out into the future to determine what future earnings could be. Setting aside the natural bias that these analysts have to offer bullish opinions (does anyone really believe that the Chinese firewall between investment banking and research departments works?), it is next to impossible for these analysts to accurately determine what the company will earn in 2014… not to mention farther down the road.
Even 2013 estimates are unreliable at this point, but if the $0.57 consensus number is correct, the stock is trading at about 42 times forward expectations.
Also, recent revenue trends may be flashing a warning sign. For the last quarter, Facebook posted a sequential drop in revenue, and also saw its year-over-year revenue growth rate decline. Revenue estimates for upcoming quarters also indicate a gradual deceleration in year-over-year revenue growth, which raises questions regarding long-term profit assumptions.
As the broad market falters and economists worry about how interest rate increases will affect the economy, investors are increasingly embracing a "risk off" mentality. As risk tolerance declines, valuations for growth stocks should contract.
A valuation of 20 times this year's earnings estimates is still a respectable valuation for a "growth company" which currently has an installed subscriber base of 1.1 billion users. Of course, if Facebook's stock trades down to a multiple of 20 times earnings, the stock would be priced at $11.40.
Of course any deterioration in this year's earnings expectations could cut the potential price even further (both due to lower estimates and a lower PE multiple). But even using the current consensus of estimates, we can make a plausible case for Facebook losing 50% of its value.
Looking at the price action for Facebook, a series of lower highs and lower lows indicates a loss of momentum from the late 2012 rally, and implies that institutional capital is rotating out of the stock.
At this point, we are looking for attractive spots to build short exposure.