Why You Should Not 'Like' Facebook

Jun. 6.12 | About: Facebook (FB)

Facebook (NASDAQ:FB) is suffering from a clear case of "special snowflake syndrome." The Facebook IPO generated far more media attention than most IPOs simply because Facebook is more visible than the vast majority of companies going public. I can't think of an IPO since Google (NASDAQ:GOOG) that attracted more attention -- or really, any IPO that ever involved public discussion of the CEO's attire.

But just because we all like Facebook as a service doesn't mean we should like it as an investment. Facebook has tumbled over 30% since its IPO (and almost 40% from the intraday high), but I don't think that we've seen all of the downside priced out yet. Here's why.

1: The Generational Gap/Limited Domestic Growth

Just about everyone in America has a Facebook. And that's a problem for two reasons.

  1. Obviously, Facebook can't domestically sustain the growth rate it's had since inception.
  2. Due to the law of scarcity, Facebook isn't viewed by kids as something "cool" anymore. Because everyone (read: PARENTS) is on Facebook.

The second point is the one that bears more discussing. Think Facebook's still hip? Think again. When Facebook bought Instagram, there was public outcry from Instagram users who didn't want to go on Facebook. Teenagers are increasingly turning to social media sites like Twitter and Tumblr. This is important, because as a social media site, Facebook's primary attraction is the ability to keep up with friends. If you're fourteen and none of your friends uses Facebook, you won't either. (Personal experience: I can attest that my nephews, who campaigned for years before their parents finally let them get on Facebook, have all but abandoned the site.)

This teenage flight has compounding effects. I know a lot of parents who set up a Facebook for the express purpose of keeping an eye on their kids -- and as their kids flee Facebook for other sites, the parents will follow. Not to mention, of course, that the next generation of teenagers will probably view Facebook through the same lens today's teenagers view MySpace: as something dead and gone.

Without a growing userbase, Facebook will have a hard time growing revenue.

2: Facebook Advertising

In the S-1 letter, Zuckerberg publicly announced that Facebook is in the business of making money only to build better services -- they aren't interested in making money.

Well, if he's interested in building better services, he'd better do something about the Facebook ad program. Pronto.

GM pulled ads from Facebook, and they're not alone. Recent reports have suggested that ads on Facebook are largely ineffective. This shouldn't come as a surprise to anyone -- tell me, when's the last time you bought anything because of a Facebook ad? Or clicked on a Facebook ad? Or noticed a Facebook ad for any reason besides its irrelevance to your interests?

As someone who has a little experience in building websites, I know exactly why Facebook advertising doesn't work. It's because "traffic = money" is a false equation perpetuated by vague generalizations about Web 2.0. It's only targeted traffic that brings in money. If your visitors are interested in a sportscar, they aren't going to be buying a Prius.

Facebook "tries" to target ads based on interests, but that too is a failure. I routinely receive advertisements about Justin Bieber concerts and merchandise, even though I have never 'liked' Justin Bieber or so much as mentioned him in a post.

Even when the targeting does "work," there's no guarantee that the targeted users will actually have the wherewithal to purchase the advertised products. Teenage boys (the category most likely to "like" sportscars and thus most likely to receive the targeted ads that General Motors (NYSE:GM) pulled) aren't going to be buying a Camaro anytime soon.

But even assuming their targeting did work, they'd have another problem -- users aren't on Facebook to buy something. If a user runs a Google search for "cheap barbecue grills," they're most likely looking to buy a cheap barbecue grill. When they log on to Facebook to complain about their boss or post vacation photos, they're not in a buying mood.

And that's why conversion rates for Facebook ads are so low.

3: Dim Prospects for International Growth

Facebook is currently the dominant social network in the United States. (Though, as I established in point 1, that dominance is declining.) But in other countries, the story isn't quite the same. Local language competitors are offering them a stiff challenge, and that doesn't even begin to cover the bureaucratic nightmares they might face in countries like Russia and China.

Indeed, Facebook is well aware that its own revenue projections are based on a rosy scenario of future expansion. In the S-1, Facebook cautioned investors with the following:

"We do not know if we will be able to find an approach to managing content and information that will be acceptable to us and to the Chinese government.

"In the event that access to Facebook is restricted, in whole or in part, in one or more countries or our competitors are able to successfully penetrate geographic markets that we cannot access, our ability to retain or increase our user base and user engagement may be adversely affected, we may not be able to maintain or grow our revenue as anticipated, and our financial results could be adversely affected."

The quote speaks for itself, especially when you put it in the context of my next point:

4: The Facebook P/E ratio is ridiculous

Facebook's P/E ratio is 82.80 at the time of this writing. While this isn't quite as extreme as the P/E of 575 boasted by LinkedIn (NYSE:LNKD), it's still a cause for concern. Historically speaking, tech stocks with high P/E ratios have not been treated kindly. As a general rule, even if the companies do succeed in growing earnings, their stock lags the general market because the high P/E ratios are unsustainable. This argument applies to Zynga (NASDAQ:ZNGA) as well.

Conclusion: Facebook has limited growth potential, and Facebook stock even less potential.

The exuberance surrounding the Facebook IPO was more irrational than anything I've seen since the tech bubble. Even though Facebook has fallen over 30% since the IPO, I still strongly believe that it is overvalued. Until and unless Facebook can improve on its monetization strategies, I won't be putting my money anywhere near it. Even if they do continue to grow earnings, expect the stock to underperform over the next decade as the P/E ratio falls to a more reasonable level.

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