Why Facebook Shares Could Continue To Decline Through 2013

May.24.12 | About: Facebook (FB)

Facebook's (NASDAQ:FB) IPO was only the 4th IPO to value a company at $100 billion. In fact, the $16 billion that Facebook raised is considerably more than the $1.67Bn that Google (NASDAQ:GOOG) raised in 2004 - and mind-boggling compared to the $101 million that Apple (NASDAQ:AAPL) received from investors in 1980. Even adjusted for inflation, the money that Apple raised when it listed is worth just around $270 million today.

That said, the comparisons between Facebook and Apple - or Facebook and Google are tenuous, at best. Both Apple and Google operate and have strengths in different fields; they are more readily comparable to one another, competing in areas such as smartphones, online markets and operating systems.

Facebook is, despite it recent deviations into imaging and media streaming, a Social Network like LinkedIn (NYSE:LNKD).

Other than their common ubiquity, the similarity between Facebook and the two technology giants rests in the fact that, at the times of their listings, all three were considered growth stories - companies that, by the metrics of their respective industries, could grow between 20% to 30% per year.

That's where it gets dicey for Facebook. Markets have no problem paying for growth potential, as the stock market bubble at the end of 90's will remind anyone. That said, it's instructive that the only two remaining titans from the first Internet boom - Amazon (NASDAQ:AMZN) and Yahoo! (NASDAQ:YHOO) were the only ones with realistic prospects in their heyday - in fact, the latter is weathering questions on its future.

So, the question is this: "Is Facebook a true growth company?"

At a casual glance, that appears to be the case - in the 12 months ending March 31, 2012, Facebook's number of users grew by nearly 26% to 835 million and it generated revenues of $3.7 billion.

That's impressive - but a closer look at the breakdown of the numbers leaves cause for concern. The bulk of Facebook's user growth came from emerging markets such as South and Central America (+58%), Asia (+48%), the Middle East (+28%) and Africa (+47%).

These three regions (Asia/Middle East, Latin America and Africa) accounted for nearly 80% of Facebook's growth during the period - and because of their large populations, Facebook can expect them to lead its growth going forward.

Meanwhile, the more developed market of Europe saw just moderate growth in that span - 32 million subscribers - or 16% more than a year earlier. Where it gets really troubling for Facebook is in North America, where it actually saw a mild contraction, losing 355,000 users.

Facebook fans might argue that the North America is a mature market and that the public outcry over privacy - not to mention the burgeoning popularity of Social Networking alternatives such as Twitter - contributed to the flattening of Facebook's user base.

I would argue that Facebook's performance in North America is merely a precursor to its future in other markets.

Let's not forget that Facebook listed in its 8th year of operations - 3 years older than Google was when it listed. As such, it may have come to the market at a point in time when a lot of its superlative growth - at least in developed markets - is already behind it. Consider this: 173 million users are already equivalent to half of the current population of the United States and Canada.

Even accounting for population growth, a doubling of Facebook's user base in North America would put it very close to the population ceiling. That is a huge stretch - it does not take into consideration the fact that the realistic number of people who can be expected to use Facebook is 228 million (i.e. people between the ages of 14 and 64) - which means that a doubling of Facebook's North American user base is highly improbable.

That, in a nutshell is Facebook's conundrum. If its valuation is dependent on its ability to grow its number of users (and consequently the revenues it can generate from them), then Facebook is looking at topping-out in the next 10 years - yet its Price-to-Sales (P/S) ratio of 23 rewards it for at least twice that length of time.

To illustrate: if we assume that Facebook is a "growth" company whose sales are dependent on a user base that grows by an average of 20% annually (revenues per user assumed to be equal), then it needs to have close to 5.2 billion users by 2022 - or 67% of the world's population to justify its P/S multiple. That's equivalent to adding nearly 1.2 million unique users per day for the next decade, not even accounting for age demographics.

However, let's remember that the market is giving it a premium for twice that long. If we assume that Facebook still needs to grow at least 20% annually for the succeeding decade, then we're looking at a prescribed user count of 32 billion by 2032 - but the world is only expected to have 8.6 billion people by then.

Let's contrast that with the implied expectations for its fellow Social Network, LinkedIn. Like Facebook, LinkedIn is a growth story - one that is focused on Professional/Business relationships. It currently has 161 million users, which is up from around 100 million members in March 2011.

LinkedIn trades at P/S of 16x. Subsequently, if we posit that the market is giving it a 16 year forward premium on its sales, LinkedIn will need to have -assuming a 20% growth rate per year at steady revenues per user - 617 million subscribers by 2028.

That's a reasonable number when one considers that the world's working population will have grown to 5.7 billion people in 16 years - for a penetration rate of just 10.7% - which is actually short of Facebook's current penetration rate of 12.1%. It's also worth noting that LinkedIn's current user growth rate is 61%, suggesting that it's still enjoying its best days.

Meanwhile, LinkedIn's average revenue per user is about $4.50, which is comparable to Facebook's $4.63, even though Facebook's user base is around 5 times larger. LinkedIn seems to be doing just as much with less - or that Facebook is not able to monetize its assets as well as it should.

Of course, all this is under the assumption that in the intervening years, no new alternatives to Social Networking will emerge; a huge 'If.'

Thus, with Facebook facing a very real limit on how many users it can have, it will need to increase it revenues per user to bring its performance in-line with reality - maybe to as much as $12 to $15 per user.

Facebook's decision to acquire Instagram and launch its own Streaming Video Service, FindWatchShare, to compete with Netfix may be among its first steps to find ways to better leverage its users - but it is not very clear yet how it intends to generate revenues from these investments.

In any case, it's clear that Facebook's biggest drive to boost its revenues will be through Mobile, a point that it emphasized when it amended its SEC Filings ahead of its IPO. In fact, Facebook is said to be developing its own smartphone, which would give it a more focused delivery mechanism for its various services.

Conclusion

There's really no other way to look at it: Facebook's stock is overvalued.

At a Price-Earnings (P/E) Ratio of 47, Facebook is at least two-and-a-half times as expensive as established technology giants like Apple, Google, Microsoft (NASDAQ:MSFT) and IBM (NYSE:IBM), not to mention broad indices like the Nasdaq-100.

What's more, we can't even be certain what Facebook's forward earnings estimates truly are; its own underwriters, Goldman Sachs (NYSE:GS) and JPMorgan (NYSE:JPM) revised their financial projections on Facebook ahead of the latter's IPO, prompting the SEC and FINRA to launch inquiries. That's a huge danger signal.

Given this, I believe that the decline in Facebook shares will continue over the next 6 to 8 months, possibly dropping its shares anywhere from $15 to $22.

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