One of the first things I learned as a research analyst was never to waste too much time cross questioning managements of mega cap or very large cap companies and take whatever they are saying at face value. While my portfolio manager was never happy with this approach and it amounted to slacking off at work - this was a good strategy nonetheless. The geographical diversity and a large number of product lines usually makes it almost impossible for an outsider to get an accurate picture on these mega cap/very large cap companies. So, rather than guessing and making assumptions out of thin air, why not rely on the company's management to provide the relevant updates on the company's business?
Of course, blindly following management's word has some draw backs. You will miss out on Enron and Satyam shorts. Worse still, you may get trapped on the long side in wrong names. But how often do mega caps/large caps indulge in unethical behavior? Rarely. And anyways there are hundreds of sell side and buy side analysts covering these stocks, so even if you are wrong you will at least have a good company.
With this in mind, I started my analysis of Facebook (FB).
- So when I saw Facebook's $1.000 billion in operating income at the time of IPO, instead of worrying about financial engineering done so openly to arrive at this number, I thought it was "cool".
- When I saw selective disclosure during the company's IPO, I decided to look the other way. After all, which management doesn't have its favored analysts? Even if we go by past cases like Office Depot and First Solar, the penalty on such irregularities hasn't been meaningful - a couple of millions max (except in the case of Tyco where things really got messed up).
- I also looked the other way when Facebook didn't choose to provide an update on Automatic Click data (see below) and their investor relations department didn't reply to my email requesting clarification.
Some of our historical metrics through the second quarter of 2012 have also been affected by applications on certain mobile devices that automatically contact our servers for regular updates with no user action involved, and this activity can cause our system to count the user associated with such a device as an active user on the day such contact occurs. For example, we estimate that less than 5% of our estimated worldwide DAUs as of December 31, 2011 and 2010 resulted from this type of automatic mobile activity.
Source - Every 10K and 10Q Facebook has filed since IPO
No harm for analysts in assuming that automatic clicks will be immaterial for the company post 2Q2012, even though Twitter (TWTR) in its recent IPO filing has estimated it to be around 7% of traffic - a big enough number to swing the company's results and stock price one way or the other.
- I also want to believe Facebook management when it names only Google Plus as its competitor in its SEC filing even though it has added the following line in its latest 10Q:
we may take action to redirect users who send messages from within the Facebook app to our standalone Messenger app, although we currently do not monetize the standalone Messenger app.
(This indicates how big a risk messaging apps like Whatsapp, Wechat are for its business model and sell side estimates.)
- When antivirus company Norton detected that the Facebook app for Android is taking your phone number the first time you open it without even logging it or initiating any action on it, I believe it was a genuine error on Facebook's part and has nothing to do with Facebook becoming increasingly desperate thanks to increasing competition from messaging apps (Whatsapp, Wechat, LINE messenger) which uses mobile numbers for identification and doesn't require a separate login.
While it's not clear just why the app would do this, or what purpose it has for doing so, the Facebook app for Android is taking your phone number the first time you open it up. Without even logging in, the app takes your number and stores it on the Facebook servers. You don't need a Facebook account, or even initiate an action within the app. Simply having it and opening it will allow the app to take your phone number.
- I totally buy the explanation when Facebook bulls say that teens are not using Facebook because their moms are there and it has nothing to do with the convenience of not logging in, faster loading and less data usage provided by other messaging apps even though almost all of my below 30 age group friends (and not just teens) are saying otherwise and sharing more on other apps rather than Facebook.
- I also try to be positive on the company's long term user growth potential and Zuckerberg's vision in relation to internet.org although I have my doubts on how much ARPU bottom of the pyramid users can generate.
I was ready to drink the kool-aid that every Facebook investor/analyst is drinking and ignore the obvious until I saw its market cap - $140 billion. That was what Google (GOOG) used to have back in 2011, a year when its profitability (net profit) was 6.75 times more than that of Facebook in 2013. With telltale signs on Main Street that are significantly different than what is getting priced in the stock, I thought of digging deeper to figure out if I am missing something. But I just ended up getting even more bearish.
What Happened to Mobile OS?
A couple of years back Mark Zuckerberg was planning to launch Facebook's mobile operating system. His greatest worry was that Facebook might end up being just another app on the mobile smartphone user rather than a platform. Now Facebook has actually ended up being just another app on a smartphone competing with others and there is no sign of Facebook's mobile operating system (we do have "Facebook Home" instead). Zuckerberg's worst fear has come true - yet the stock is at an all time high. And this is not all - the competition from other apps is increasing every passing day for the company.
Facebook as an integrated Utility
While Zuckerberg is aiming to convert Facebook into a Utility platform with multiple usages rather than some cool app - users are just not buying this proposition. Users prefer individual apps for specific usage - Wechat, Whatsapp, LINE Messenger, Facebook Messenger for messaging/sharing with close friends; Instagram, SnapChat for photo sharing; Twitter for sharing outside their network; LinkedIn (LNKD) for professional networking. Facebook's value proposition as a utility and platform is just not resonating and this indicates an existential crisis for Facebook.
Now, one may try to justify the company's valuation saying that Facebook might fight back with its messenger app and acquiring other companies. However there are multiple problems with this argument.
First, if Facebook fights back with its messenger app and starts moving users from the Facebook app to Facebook Messenger app (likely), it will significantly affect its financials as it does not currently monetize its messenger app. Given the competition in messaging app marketing it might be a long time before we see any monetization.
Second, Facebook Messenger is not really a leader in its market. Whatsapp already has 400 million users and Wechat and LINE messenger are also growing fast. Facebook is actually at a disadvantage because of its separate login requirements and not using mobile numbers for user identification. Facebook has tried to correct it by taking mobile numbers without permission, allowing users to login using just mobile numbers and posing as just another messaging app to confuse users. All this make it clear that being an old web2.0 company doesn't give Facebook any advantage in the messaging app world.
Third, the new apps are actually reducing the market size. Whatsapp is expecting ARPU of just 99 cents per year. Facebook earns more than that in a quarter.
Fourth, if you are justifying current valuations based on any speculative acquisitions - think again. $140 billion valuation for the company's ability to buy rivals to offset its declining core business?
Inherent Risk in app business
All of us have seen what happened to Zynga (ZNGA) thanks to its dependence on Facebook. We all know what happened to Demand Media (DMD), thanks to its dependence on Google. Facebook is steadily moving in a position where Zynga and Demand Media were.
Facebook is becoming just another app on Android (80% market share). One really needs to be naive to think Google is not going to mess up with Facebook - its immediate rival. The apps are an inherently risky business dependent on platforms. They should trade at a significant discount to platforms. As the market realizes Facebook's transition from platform to just another app - its valuation multiple is bound to compress.
Market is increasing the argument
One of the arguments offered by the company's management is that even if Facebook's share of overall usage is declining, the time users spend on the internet is increasing and the net effect is positive (for the time being). This is an argument we have heard again and again but it never really works. We all know what happened to BlackBerry (BBRY) and MySpace. There is nothing to suggest that it will end differently for Facebook.
Is Facebook Really Fooling Wall Street?
Facebook has already fooled Wall Street once at the time of its IPO when it knew very well that mobile usage will adversely affect its results in the near term but it didn't disclose it to the majority of the investors. It was a short-term issue so no harm done. But what we are talking about now is an existential crisis. It's surprising that not a single analyst questioned management on the increasing competition on the last earnings call. While I do understand (and was once an adherent follower of) analysts depending on management to do their (analysts') work, I don't think it will be a good strategy in this case.
Facebook is no Google in terms of corporate governance; its core business is under significant threat and valuations are insanely high. If not more, the least analysts can do is to talk with 10 people in their 20s (20 to 29 age group, not the fickle teens) on the apps they are using instead of Facebook. Probably that would bring them closer to reality and help them understand why some of the surveys are showing that Facebook is not only declining but is dead and buried. They can also question management on the competitive landscape (ask them to disclose individual app key metrics - Facebook versus Facebook Messenger) and read SEC filings closely to get a sense on the changing landscape and what there is to come (a shift of users from Facebook to Facebook Messenger app).
Post that, I don't think many analysts will be able to model growth beyond 2014.