Facebook's (FB) stock price has finally soared past its initial IPO target. Facebook is currently trading at ~$50 which is good enough for a monster one year return of 130%. The stock has been on a tear and everybody is merry. Basically, I'm here to suggest that if you made money holding your Facebook shares, good for you and cash out while it's hot. Why? It's all about the valuation, not Facebook. Facebook is great company. The valuation is not. Sometimes we confuse the two.
What do the IPOs of Facebook, Zynga (ZNGA), and Groupon (GRPN) all have in common? They all had excessive initial valuation. With the Twitter (TWTR) IPO coming soon, we can already hear Wall-Street marketing drums going to work. Goldman Sachs, the lead underwriter, will be pricing the company for the offering, not valuing it. A stock has a price and a value. Very often they are not in sync with each other. Like the companies mentioned above, Twitter is a nice successful story but its valuation is out of whack.
First, this article will briefly review the factors that lead to an over valuation of Facebook. Second, with the Twitter IPO coming soon, I want to point out the lessons learned from these IPO flops.
Corporate Facebook is an incredible company. The Facebook story is even more beautiful: another giant IT born out of a dorm room by a Harvard dropout. Facebook is profitable and is expected to remain so in the future. Mark Zuckerberg has built one of the great wonders of the Internet. Facebook has reconnected friends, created relationships, transformed the way we communicate, and is now the favorite tool used to overthrow dictatorships around the world. The list of Facebook's accomplishments can go on and on. It's one of the most popular websites in the world with over 1.2 billion users and counting. I don't think it will stop here. I believe Mark Zuckerberg has greater ambitions for Facebook as he's entering the mobile hardware business.
Below are Facebook and Twitter's mission statement:
"Facebook exists to make the world more open and connected, and not just to build a company," - Mark Zuckerberg, source: Facebook IPO Letter
"The mission we serve as Twitter, Inc. is to give everyone the power to create and share ideas and information instantly without barriers." - @Twitter, source: P.91 for the S1 filing.
These are two very noble missions but such poetic statements do not guarantee they are investment worthy. You should not base an investment decision on how sexy a company is. My take is that you should research these IPOs like you would if you were buying a used car. The car looks good on the outside, but how does it look under the hood? You should be a skeptic, be curious, ask questions, and go beyond the surface to better understand these highly marketed IPOs.
FB Brief IPO Recap - A Bubble in the Making
Don't worry, this is not another article on how terribly the Facebook IPO flopped. Instead I focus on how the Facebook mania was formed. People were interested in the "next big thing" story. Investors were told Facebook was going to reinvent the world and you could be a part of it. The bankers set a price of $100 million and the media gobbled every bit of it. Wall-Street needed a good story to get the mom and pop investors back in the game. That's when they crafted a nice sales pitch: "Don't worry about the numbers, this time it's different, don't be a pessimist, FB is revolutionizing the way we communicate, what if you could have bought Google (GOOG) when it came out? This is your chance!"
Statements like these are common. You didn't have to watch infomercials at 2 am to learn the next get rich quick scheme. The media were so addicted to this IPO story that they were pumping it day in day out. The buildup was so strong that I had my friend's mom calling me to inquire about how she could buy some stock. This is a lady that has no clue what stocks are and didn't have a Facebook account. Like a lot of people, she certainly didn't want to miss the get rich train because there's no way these nice TV "experts" could be wrong. This is a testimony that the marketing machine has worked. Then the big day came and the stock totally collapsed out of the gate. Who won? This IPO was beneficial to the insiders, the initial investors, the venture capitalists, the investment bankers, and corporate Facebook with all the cash it brought in. Of course the people who got hurt were the last people in line, the mom and pop investor folks who wanted a piece of the action.
I watched a lot of CNBC/Bloomberg during the month leading up to the IPO and did anyone question the numbers? The only number they talked about was how fast the $100 billion market would jump to $150 billion. If you observe closely, they talk only about the company itself, despite the fact that the stock price and its relation to the company's value and future profits are far more important considerations. You must remember that CNBC is in the rating business. People love a good story. A good story means stronger ratings. Facebook was a fantastic story. It had all the elements to keep someone glued to the TV. The Facebook story is part controversial, part exciting, part disturb the status quo, part dramatic, part successful, part give the finger to Wall Street, and throw in a young successful anti-authority hoody-wearing Harvard drop out and partner him up with the crazy guy from Napster and there: you have a sexy story to bounce off investors around the world to feed their imagination about the company's prospect. What works in Hollywood does not guarantee success in your portfolio. Please CNBC, don't bore "Joe the Plumber" investors with statistics, ratios, data, and calculations of Facebook's fair value: the things that matters the most in the investment decisions process. The people who did their investing homework stayed away from this Wall Street poisoned gift.
Now that the Twitter IPO has been announced, it's consuming a disproportionate amount of CNBC's airwaves. The mania is not as crazy as the one for Facebook, but you can see the machines going to work. Whose interest is CNBC serving? Is it serving the interest of its viewers? Or is it serving the interest of its advertisers such as optionMonster, eSignal, the banks, and E-Trade?
Warning - Another Empire Vision in Sight
"Jesse, you asked me if I was in the meth business or the money business. Neither. I'm in the empire business." - Walter White from Breaking Bad
Facebook is on its way to become a victim of the empire building effect. At first, Facebook had a very focused single mission. Today Facebook has bigger dreams than just being a social network website. As mentioned above, I believe that behind the scenes, Mark Zuckerberg wants to be "one". I don't think he is satisfied with just having a nice website. Instead I believe he has a vision where everyone is using a Facebook phone, maybe with some form of Facebook credit currency in there. It might not be obvious today but it always starts small. It started as a university student's face directory, to buying Instagram for $1 billion, to selling cell phones. I can't blame him and that's what investors expect out of him. It's extremely important to have a vision when you are a leader. The problem is not the vision, but the focus. Many great leaders lose focus of their main mission. Facebook might one day become a victim of trying to be too many things. Tons of companies fell for that trap. Remember Microsoft (MSFT)? Bill Gates' vision was to have a PC in every home. While that part of the vision was accomplished we all know the rest of the Microsoft story. MSFT was trying to be everything, everywhere, and as a result it lost focus of the game. Other than the Xbox, everything it attempted to accomplish was a total flop (music, mobile, social networking, search engine, tablets, browsers, etc…). Microsoft is not the only company to fall for the empire building effect. Yahoo! (YHOO) was a victim too. What started as a basic search engine is now I don't know what. Can anyone tell me what Yahoo! does? The old AOL Time Warner (AOL) also falls in this category. Today I sense a little bit of that empire vision with Facebook entering the hardware market, a market with no experience and out of its main mission.
The issue here is not grandiose ambitions. The issue is capital allocation. This is where most big companies fail. All the companies I mentioned above are probably excellent operators but terrible capital allocators. Microsoft is the perfect case. MSFT is an excellent company with giant cash flows but awful capital allocation. MSFT is gobbling overpriced companies only to write them off. Most of these companies have success in one field and believe they will be able to replicate that success in other fields. Is Facebook entering the lower margin smart phone industry the best use of Facebook's cash?
Photo Credits: ATT.com HTC First Black
The Real Threat to Facebook
You can feel a Facebook "fatigue" brewing. Facebook lost its "mojo" feeling. The Facebook honeymoon period has been over for a while and now it's getting treated like a big corporation that is too entrenched in people's lives. Investors are pressuring the company to address the Facebook "fatigue"; the fear that people are losing interest in the service. I'm personally one of them. I'm tired of Facebook but I can't log off. Facebook has this stickiness to it. I can't immediately change social network provider because there's nobody on Google+ (active users). The cost and time of changing is too high. FB is a now a utility, not a fun cool platform. But the real threat to Facebook is not people like me.
The real threats to Facebook are the teenagers. The real threat to Facebook is my 14 year old cousin and his friends. He has a FB account, but he is never on it posting pictures. My 14 year old cousin and his friends are on to other programs such as Snap Chat or Vine. Young people do not want permanent records of their life online. Teenagers don't want to mingle and have fun with their parents on FB. Facebook is perceived as your parents' "social network." Mom and dad are not on Snap Chat. You want to find out what is the next big thing? Observe what the teens are up to. They are the future. Final words of warning: Let's not forget what happened to MySpace, MIRC, AOL, and ICQ. Remember how fast they disappeared? Just like them, at the time of their peak it seems unrealistic to think they would be out of our lives.
Price vs Value
People always want to know where the outlook is good. We all go outside on sunny days. The obvious concept in practice is to avoid following the herd. The crowd in this case consists of the majority of buyers who continuously flock to the hot stock whose prospects look best. Oddly, this behavior translates poorly into investment success. If you do the same thing as everybody else you will have the same results as everybody else. It's hard to separate yourself from the crowd, to go against the crowd, there's a psychological barrier that pulls you back in. Being part of the herd = being comfortable, it's warm to be in the herd and your opinion is the same as everybody else. Because we don't like rejection we follow the consensus of the herd. Going against the crowd = being told you are wrong, and that could go on for a long time. Going against the crowd might also mean you have to bear some pain for a while. You need to be tough emotionally and psychologically if you are going to have contrarian bets.
Between May 2012 and today, Facebook's share value has fluctuated between ~$18 and ~$52 a share. During that time period did the underlying value of Facebook change with the same hyperactive frequency? The answer is no. This brings me back to a comment I made earlier, there's a value and price for every company. There are many factors that can make a price deviate from its notional value, such as the public perception, the investing environment, liquidity, and knowledge among other things.
Obviously investors are valuing Facebook for its future growth. You buy Facebook today because of its future potential of generating strong cash flow. But at this point, are you willing to pay 24x sales for Facebook? I can't frame these metrics around my head. Whether or not you believe the current valuation is warranted, this valuation will lead to volatility. With that kind of valuation, you should only expect perfection.
The last couple quarters were better than expected and that helped the stock get out of its downward trend. The chart below illustrates that Facebook has been increasing their revenue at fast rate but is it good enough to justify a 24x revenue multiple? Some people will argue that Facebook will grow into its multiple. That rationale is playing the speculation game. I suggest that you take a Warren Buffett test: Assuming the stock market closes for 5 years, will you be comfortable holding Facebook? If Facebook missed its quarterly target, a lot of people will be jumping this ship pretty fast.
The Bull Case for Facebook
Because of its superior growth FB can justify a higher multiple than most tech stocks. It's growing fast, faster than Apple and Google, and it's making progress in the mobile market, which is the next emerging frontier in advertising. FB's mobile platform strategy seems to be successful. Some call it the "fat finger effect", others call it innovation. I believe it's a mix of both. There are also big markets that Facebook hasn't made a dent in, such as China and Russia. Its user base, its biggest asset, is worth gold. It's probably the richest mine of data ever collected on individuals. Where else could a marketer target with such precision an 18-25 year old white Catholic male that likes Disney movies? I don't think Facebook has fully exploited the richness of their user database. Facebook's market cap is ~$120 billion. With 1.2 billion users, that's about $100 per head. I don't know about you, but I don't think my profile is worth $100.
Conclusion and Advice - Don't Try To Short
The history of bubbles has repeated itself over and over again. The fantasy of making easy money will always sell. A good story gets us emotionally, and we, as humans, make decisions based on emotions. Nobody knows when the bubble will pop and ruin the party. It's very hard to short a stock that everybody loves. It's not wise to go against hot money. Take Tesla (TSLA) for example. Tesla is a company that sells twenty thousand cars a year and is worth ~$22 billion. In comparison, GM sells 10 million cars a year and is worth ~$50 billion. I thought Tesla was overvalued at $100 a share, and then it exploded up to $150 a share, then Elon Musk, CEO of Tesla, suggested that it was a good idea to short his own stock and as a result the TSLA skyrocketed to $194 a share. Markets are irrational. What is it going to take to crash this thing? (One car on fire will do it). There's a lot of pain in there if you are trying to short it. The flow of hot money might short squeeze you. If you are serious about shorting on Facebook, I suggest you buy a long term put option. But again don't fight the market.
What I am suggesting is that if you have been riding the FB wave, don't be greedy and cash out some of your gains. If you don't hold any shares, stay put, you are not buying a bargain. If you buy a piece of FB today you are helping a smart seller cash out his profits. The time to buy Facebook was when nobody wanted it. You missed the boat and move on to the next opportunity. The only way to make money is to buy a stock below its intrinsic value. Put your emotion aside and ask yourself if Facebook and Mark Zuckerberg is the proper place to put your hard earned money to work?
If you are studying the idea of participating on the Twitter IPO, please do your homework. I can't tell you if the Twitter IPO will be a Zynga or a Tesla. Sometimes it's higher prices that lead to higher prices. The lessons here are simple but hard to put in action. Successful investing is hard work and time consuming. That explains why only a few people are successful. You need to do what others are not doing. Be a skeptic when people talk about sexy stocks at your next BBQ. Ask questions, be curious, learn about the company, learn about the industry, read the company filings, what stimulates its sales activity, the types of pressures it faces to sustain profits, measure its performance over time in relation to its competitor. Having this information is the best way to create a psychological barrier for decision making. Like anything else in life, the price of success is paid in advance.
Additional disclosure: As with all of my article the opinions are my own and you should do your homework make your own best judgments about the company. (I know that this resembles the boilerplate disclosure that you see in every email that you get from your broker but I really mean this and I am not saying it to avoid getting sued.)