Facebook Stock Analysis: Strong Sell

| About: Facebook (FB)

On May 18, 2012, Facebook (NASDAQ:FB) went public at $38 per share. Immediately at the opening bell, Facebook shares gapped up to their all-time high of $45. From there, shares collapsed to $25, before drifting back north to $32 over the next thirty days. By all accounts, as I had previously forecast in Thanks, but No Thanks, Facebook's limited history as a publicly traded corporation effectively highlights the necessary evils of capital formation.

It is not my goal to tap-dance upon the proverbial grave of Facebook stock. I, however, wish to challenge portfolio managers who would opine that Facebook shares are undervalued simply because of a steep drop in nominal price. Facebook stock remains a strong sell because of the wide gulf in share price and market capitalization for the corporation.

Facebook's Initial Public Offering

By its very definition, the initial public offering is a necessary evil rife with competing interests. Facebook insiders, as is typical, angled to sell shares at the top of the market and raise sufficient cash to finance ongoing operations. Alternatively, prospective investors were set to bid low in order to improve their chances for locking in future profits. Meanwhile, the Big Banks played both sides of the fence against each other to collect fees and call it a day.

Predictably, Facebook's recent price action exposed multiple cracks beneath the foundation of high finance. The immediate boom and bust pattern of these shares are indicative of a lose-lose situation. Facebook left money on the table to finance operations, while legions of new investors effectively bought in at the top. After the drop to $32, Facebook shares are still priced to perfection and change hands at a wildly expensive 72 times earnings. At these levels, Wall Street remains out of touch with economic reality. A reversion to actual business value is inevitable to take place, where Facebook investors are led upon a grinding decline towards zero.

Facebook Business Model

Facebook is the capstone event for today's all-encompassing Web 2.0 Movement. The Web 2.0 Movement relies upon creating personalized niches within the greater social sphere. Smartphones, tablets, personal computers, and high-speed connection technologies have all evolved to accommodate this historical explosion in socially driven Internet traffic. At minimum, Facebook is the common denominator that unites award-winning Internet prose, off-the-cuff political rants, online dating, and gaming together, before disseminating information between the appropriate channels. As a marketplace for information, Facebook is a brokerage between online advertisers and its burgeoning customer base of 901 million monthly registered users.

For Facebook to pitch itself as an economically viable space for advertising dollars, it must establish a solid presence as an accurate indicator for consumer behavior. Facebook, however, is more so closely related to a public relations campaign for regular folks. Alternatively, the Google search bar is a thorough examination of the human id.

Most likely, the typical Facebook buddy list is composed of ex-girlfriends, current flings, Uncle Frank, former college professors, work colleagues, law enforcement officials, and grandpa. To remain palatable to such a diverse group of acquaintances, most Facebook users will limit their profiles and status updates to vanilla information. Ironically, Facebook's popularity in terms of head count may lead to its own undoing as a viable aggregator of information. Without user transparency, large corporations will curtail ineffective advertising campaigns through Facebook social media.

Prior to Facebook's May IPO, Federal District Court in California combined 21 separate privacy cases into one lawsuit against the company. The lawsuit sought $15 billion in damages and claims that Facebook is in violation of the U.S. Wiretap Act and U.S. Federal Trade Commission law. On Wednesday, June 27, Facebook settled the case and agreed to amend its terms of use to alert customers that their personal information is to be shared with third-party businesses. Users will have the ability to control the distribution of information gathered to generate ads. Additionally, parents will have the authority to block certain advertisements from being shared with their children. According to economist Fernando Torres, these actions may contribute to $103 million in lost revenue for Facebook.

Further, increased smartphone usage poses a serious threat to Facebook's ongoing profit potential. According to Nielsen data, time spent web browsing through mobile devices has increased by more than 50-percent annually in recent years. Obviously, more ads can be jammed onto the 27-inch screen of an Apple iMac, in comparison to a 3-by-5 inch iPhone Facebook application. Be mindful that Dick Costolo, CEO of social media rival Twitter, has repeatedly blasted Facebook's troubling lack of sophistication within the mobile realm.

The stage is set for egregious earnings misses at Facebook. By "miss," I am speculating that Facebook can never hope to match the wild quarterly growth estimates necessary to justify its lofty valuation. At 70 times earnings, any earnings miss will precipitate significant price declines.

The Bottom Line

Prior to the IPO, Facebook brass pulled out all the stops to monetize this website. Instead of improved profitability, Menlo Park chutzpah only succeeded in alienating its staunchest supporters. Within months of going public, Facebook had managed to force feed the Timeline feature to its user base, while quietly laying out plans for its Instagram purchase. The Timeline feature lacks the basic chronological order of vertical scrolling, and thusly comes off as an attempt to crowd the space full of ads. In the case of Instagram, Facebook opened up its checkbook to put down $1 billion to buy a business with 13 employees and zero dollars in revenue. Over time, such arrogance from the top will eventually trickle down to a loss in Facebook share value.

According to limited S-1 registration data, growth at Facebook is already slowing down at the worst possible time for its latest shareholders. At the top line, Facebook recorded $777 million, $2 billion, and $3.7 billion in revenue between 2009 and 2011. On the bottom line, these revenue figures translated into $229 million, $606 million, and $1 billion worth of net income during the same time frame. Broken down further, Facebook tallied $205 million in Q1 2012 profits, which is down from the $233 million in net income for the year-over-year period.

These S-1 figures do appear stellar on a nominal basis. Fundamentally, Facebook sales and profits expose a classic bubble when juxtaposed against a $90 billion corporation trading for 70 times earnings. Super investor Peter Lynch believes a stock to be fairly valued, if it carries a price earnings to growth ratio of one. According to this metric, $32 Facebook shares should be the mark of an enterprise that remains on track to nearly double its earnings each year. Working with limited data, we cannot expect Facebook to grow its annual net income by more than 50 percent. Behind this generous logic, Facebook stock is not much more than $15 per share, or less than half of its current value.

Facebook stock is still a strong sell.

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