The Facebook Fade

May.22.12 | About: Facebook (FB)

The largest IPO of the year, Facebook (NASDAQ:FB), is off and running. For those who were able to get an allocation from their broker at $38, congrats! For those who were able to get shares at the same price ($38) in the open market, congratulations are also deserved, I think. So now the question is: What do you do with your allocation? Long-term hold or a quick flip for the realized profits if given the chance?

Revenues streams are paramount when we are talking about IPOs, and in Facebook's case, investors are going to be scrutinizing where the money will be made and how it will be made in even greater detail. The $38 offering puts Facebook at a P/E of 107, which is most certainly at an elevated and cautious level. In order to defend that P/E, Facebook will look improve its earnings. The idea is to earn $3.8 billion from advertising and $470 million from "credits" (a virtual currency that enables people to purchase items in games and non-gaming applications on the Facebook platform). That's a total of $4.27 billion in revenue this year alone, doubling up on the 2010 figures. Margins will be at roughly 30%, working out to be $1.28 billion in earnings on that $4.27 billion. The price-to-sales multiple will hover around 37.

Facebook is also staring at some headwinds in generating that revenue. Making money on the mobile front is crucial to realizing true potential. Facebook will have to source some ideas on how to keep current users active on the mobile front, as well as increase new mobile users. In order to do this, the platform will have to be made more appealing -- i.e., minimizing the ad sizes. With a less obtrusive/cluttered view, more users will flock to the site when on the go. Luckily for the user, Facebook's main goal is customer satisfaction. This same idea may not be so ideal for those investing in the company, even though most investors are already Facebook users themselves.

Directly on the other side of keeping the user happy is how Facebook is going to keep advertisers happy. Amid rising costs, Facebook will need to address ROI for its advertisers. Without advertisers there is no Facebook, or at least a profitable one from investors' point of view. The same can be said if the users are not happy. Last year, 85% of revenue came from ads, so you can see how vital those streams of cash are to the company. If others follow General Motors' move of withdrawing its advertising dollars, Facebook will have a real issue on its hands. Already this year Facebook has seen 7.5% of its ad revenue disappear.

Based on those proposed fundamentals, specifically the P/E and P/S, and the headwinds that Facebook will need to address, its no surprise that we saw a lackluster start to trading in the shares. All the media hype and water-cooler talk was quickly hushed as syndicates had to step in and "prop up" the $38 level. Not exactly actions that should bolster confidence. In the coming days and weeks, investors will have a better understanding of Facebook's true market value as the stock market decides where the fair value is.

I'm not providing a bull or bear case for Facebook; I'm just pointing out that expectations are high and investors will expect delivery.

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