Facebook in the Secondary Market: Investors Will Learn the Hard Way

by: NYC Trader

A recent transaction of Facebook in the secondary market, 165,000 shares at $25/share, valued Facebook at $56 billion. At their expected $2 billion 2010 revenue, that is a whopping 28x revenue (Apple’s (NASDAQ:AAPL) stock trades at 4x revenue and Google (NASDAQ:GOOG) trades at 8x revenue). The company reports to have more than 500 million unique users and the goal is to generate heavy revenues through credit sales (games) and advertising. I was a bit skeptical, so I decided to do a little analysis myself.

Firstly, the Time Person of the Year reported to have heavy growth. I found that user growth has actually slowed tremendously, 250% in 2007, 107% in 2008, 152% in 2009, and only 51% in 2010. Furthermore, the unique visitor growth is even more alarming (96% from Dec 08-Dec 09 and 13% from Dec 09-Dec 10). This suggests that the Facebook member and visitor rate is plateauing and Facebook’s recent hire of a Google “social” guru Paul Adams suggests that Facebook has realized that their memberships are approaching peak levels and the most likely weight now is to create a more interactive environment for current members. This is quite a shift in strategy, however, and whether or not it will work before we begin seeing a slowdown or a loss in memberships remains to be seen.

The below model analyzes Facebook according to its expected 2010 revenues. 30% operating margins (industry blend) would then equal $600m and at 35% tax, profits would translate to $390m for 2010. At $25/share, investors are paying out the absolutely enormous 144x earnings for the Facebook stock. To receive a comparable 20 P/E to industry, Facebook would have to increase revenues by 400% and profits by 700%.

Additional risks: As the Facebook social model has moved away from a specific social network to a broader model, there is a risk that smaller players may enter the market and take share (i.e. another original Facebook model based on the college network). Additionally, many investors are hoping that Facebook can add China to its model. With the Chinese government extremely at odds with what Facebook stands for (open communication), I don’t see this happening any time soon.

Conclusion: I would value this stock in the $14-$16 levels. This is an extremely crowded trade with lots and lots of risks and unless Facebook can expand its current revenue model by many billions, the growth is not sustainable and investors will learn the hard way. On the other hand, the movie was really good.

Disclosure: I am long AAPL.