Facebook Has A Growth Problem

May.20.12 | About: Facebook (FB)

On May 18, 2012, Facebook, Inc. (NASDAQ:FB) finally opened to a furious day of trading with over 580 millions shares exchanging hands. However, FB closed at $38.23, just pennies above its IPO price. This means that those who bought on the public market are most likely in the red. However, this also means they did a near perfect job of pricing the shares to maximize capital raised which benefits the pre-IPO investors.

FB's current equity market capitalization is a staggering $104.8 billion, the highest market cap on its IPO day of any American company. Rival Google, Inc. (NASDAQ:GOOG), despite having about a ten times the revenue and net income of FB, is not even worth twice as much. This difference is reflected in FB's staggering PE ratio of 105x. When one considers that the S&P 500 trades at around 14x earnings, it is clear that FB has lofty expectations. Growing at 50% per year, it would take FB another 5 years to drive its PE down below 14x, and that assumes no appreciation in share price.

A later start than its predecessors

Comparing FB valuation to other companies is risky for another reason - size. At time of IPO, FB has the highest revenue and substantial net income relative to its predecessors. In comparison, with GOOG went public in August of 2004, it had just $1.5 billion of revenue and $105 million of net income for the previous year. At first glance, an investor might say this is a good thing - FB is much more established and secure. However, size is a detriment to companies with high valuations. FB has already worked through its earliest years when growth can be stratospheric.

Exactly how many people are on the internet?

Despite a solid track record to date, FB needs to keep adding members to sustain its growth and justify its valuation. However, growth has been declining rapidly from double digits in 2009 to more anemic single digit growth leading in 2012. Furthermore, with just over 7 billion people and 2.3 billion internet users in the world, there is a ceiling to user growth. The following chart details the quarterly membership figures including three quarters of projections.

Worldwide User Growth

Quarter End Monthly Active Users (MAU) Q/Q growth Daily Active Users (DAU) Q/Q growth Ratio (DAU/MAU)
Q1 2009 197 NA 92 NA 46.7%
Q2 2009 242 22.8% 108 17.4% 44.6%
Q3 2009 305 26.0% 144 33.3% 47.2%
Q4 2009 360 18.0% 185 28.5% 51.4%
Q1 2010 431 19.7% 234 26.5% 54.3%
Q2 2010 482 11.8% 257 9.8% 53.3%
Q3 2010 550 14.1% 293 14.0% 53.3%
Q4 2010 608 10.5% 327 11.6% 53.8%
Q1 2011 680 11.8% 372 13.8% 54.7%
Q2 2011 739 8.7% 417 12.1% 56.4%
Q3 2011 800 8.3% 457 9.6% 57.1%
Q4 2011 845 5.6% 483 5.7% 57.2%
Q1 2012 901 6.6% 526 8.9% 58.4%
Q2 2012P 967 7.3% 570 8.4% 59.0%
Q3 2012P 1,037 7.3% 612 7.3% 59.0%
Q4 2012P 1,113 7.3% 657 7.3% 59.0%
Click to enlarge

Source: FB S-1 Filing, Author estimates and calculations. Projections are based upon the average of the previous 4 quarters for MAUs and estimates for ratio of DAU/MAU. Note recent annual growth is around 30-40%.

In addition, FB is not yet in China, eliminating 0.5 billion internet users from consideration. When FB enters China it will face competition from several established Chinese social networking sites, including Renren and Sina. FB faces competition from Google+ as well as more regional sites including Orkut (owned by GOOG) in Brazil, Cyworld in Korea, and Mixi in Japan.

Capturing more revenue from existing users

Fortunately for Facebook, user growth is not the only performance driver. FB derives the bulk of its income and revenue from ads on pages generated by apps, direct advertising from developers, and fees related to FB's payment infrastructure. In 2011, Zynga, Inc. (NASDAQ:ZNGA) contributed 12% of revenue directly while advertising from its app pages contributed another 7%. FB's ability to generate net income is essentially driven by the collective time its users spend on the site. As FB users spend more time on Facebook, they enable larger revenue. The following chart shows annual revenue per MAU.

Revenue per User

Year MAUs Worldwide Revenue ($ Millions) Net Income ($ Millions) Revenue Per MAU ($)
2007 58 153 -138 $ 2.64
2008 145 272 -56 $ 1.88
2009 276 777 229 $ 2.82
2010 518 1974 606 $ 3.81
2011 766 3711 1000 $ 4.84
Click to enlarge

Source: FB S-1 Filing, Author calculations

So while MAUs are growing, the more important metric of revenue per MAU is also growing rapidly. So projecting forward: if FB had 1.5 billion MAUs each enabling $10 of revenue per year with a 30% net margin would give FB a net income of $4.5 billion. This would provide a PE ratio of 23x based on today's market capitalization. In comparison, GOOG is at 18x and Apple Inc. (NASDAQ:AAPL) with enormous profits and a track record of staggering growth is at 13x.

So what does an investor do?

I think FB has a growth problem relative to its valuation: it will be challenging to grow fast enough and there is possibly insufficient space to even support the required growth. Furthermore, looking down the road, as restrictions lapse and shareholders can sell additional shares, there might be significant downward pressure on the stock. FB has to also deal with an increasingly mobile world. However, even with a tepid first day of trading and my view of potential overvaluation, I would be reluctant to short FB right now. The key metrics of revenue and net income per MAU have shown solid growth suggesting the valuation is not completely silly. FB now has approximately $10 billion in cash which enables the development of new services to generate revenue or synergistic acquisitions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.