Facebook (FB) is plagued by maturing markets and little evidence of any emerging 'killer application' that can warrant the still very lofty valuations. We would stay well clear of this one.
We'll leave the mishaps at the introduction alone and concentrate on the outrageous price. Whoever decided that this company's shares should be valued at $38 at IPO has, we're putting it very mildly, a lot to answer for.
But is it the job of investment bankers to exploit as many gullible people with money as possible? We've heard that at Goldman they call them "muppets." The Facebook IPO has 2000 style Nasdaq tech bubble written all over it. In essence, what was promised is:
- The phenomenal growth rate in users would continue
- All the info that users voluntarily part with scores of highly personal info. That's got to be worth something in the age of precision internet marketing, right?
What they didn't tell you was that the growth rate in users, by force of the law of large numbers, is bound to decrease sooner rather than later, and well, all that hyper-personal info that's got to be worth something, they haven't yet figured out a way how.
But the IPO price was based on both assumptions working in conjunction. Growth would continue and the company would figure out a way to monetize the data better. That is basically selling hot air, even if the company manages to figure this out in the end. We don't deny this is possible, but so far they haven't. You'll be buying hope, without that, there's just rather blatant overvaluation.
- The number of average unique monthly visitors has indeed grown impressive, from 35M in 2007 to 766M last year, to 955M now However, believe it or not, there are people out there (like us) who wouldn't want to be seen dead on Facebook, and the law of large numbers will set in sooner or later. Probably sooner.
- The number of people that uses Facebook each day grew by 1/3 to 552M. That looks still relatively good, but for how long?
- Text and display ads, the bread and butter business of Facebook, is good for $992M in the quarter, 28% more than in Q2 2011. Revenue per page has actually imploded, this was 81 cent in 2007, last year it was just 29 cent. So to have more people doing more won't necessarily lead to more text and display ad revenue.
- Digital sales (mostly games) rose to $192M, but this was actually disappointing analysts (which expected, on average, $198M). There is still room for growth, albeit slower than before (unless they manage to develop the proverbial 'killer app'). Average (virtual) good per user grew from 16 cents in 2009 to $2.42 last year. Most of this is the 30% cut from Zynga, but the disappointment there doesn't prompt a whole lot of reason to be optimistic on this front either
- Mobile users grew 67% to 543M, but the well documented danger here is that this cannibalizes its biggest revenue stream due to the constraints on screen real estate in mobile.
- Second quarter costs and expenses were $1.93 billion, an increase of 295% from the second quarter of 2011, driven primarily by share-based compensation expense. As previously noted in the company's initial public offering prospectus, share-based compensation expense related to pre-2011 restricted stock units (RSUs) was not recognized in advance of the initial public offering, and as a result of the initial public offering during the second quarter, the company recognized $1.3 billion of share-based compensation and related payroll tax expenses.
- Marketing and sales expenses quadrupled to $392 million
- Excluding share-based compensation and related payroll tax expenses, non-GAAP income from operations for the second quarter was $515 million, compared to $477 million for the second quarter of 2011.
- Capital expenditures for the quarter were $413 million, a 213% year-over-year increase. Additionally, $52 million of equipment was procured or financed through capital leases during the second quarter of 2012.
Even at the depressed share price (from IPO levels), the market cap is $44.5B while the company has revenues (trailing 12 months) of just $4.33B, so the price/sales ratio is more than 10. We're not even going to mention the price/earnings ratio, in the good old Nasda 2000 tradition, that's all meaningless anyway, right?
Apart from the growth in mobile users (67%), the growth in users and revenues is around 30% year-on-year. These numbers are not nearly enough to sustain the very rich valuation, even after the 40% or so plummet in the share price from the $38 IPO level. According to Business Week, the company's US users declined 1.1%(!). US ad impressions were down by 2%. And these are the company's most profitable users.
That really is an ominous sign. Yes, mobile users are growing faster, but whether these are not cannibalizing their ad income (84% of revenue) remains very much to be seen.
What's more, lower user and revenue growth is accompanied by large increases in cost and capital expenditures (both growing deep into triple digit space). Basically, they need to spend ever more to attain decreasing user and revenue growth.
It is therefore no surprise that net earnings growth was basically flat. In fact, there was a net GAAP loss because of share based compensation. As if they haven't profited enough from the IPO.
And the company didn't even provide any guidance. We scratch our head, we have to admit. At the minimum, it's no surprise that the shares plummeted so rapidly. But the main question is, how could they've ever pulled of a stunt like the $38 IPO price?
We're surprised the company doesn't seem to have lost a great deal of goodwill as a result. Our fellow Seeking Alpha contributor Jacob Steinberg wrote:
Many people don't even believe the company's CEO Mark Zuckerberg actually cares about returning value to shareholders
Well, he was all too happy to take their money, a good deal of the probably from Facebook users who fell for the hype. A cynic might note that they actually did find a monetizing scheme, ripping off investors.
- People want interacting, they don't want to be bombarded with commerce
- They actually did find a monetizing scheme: conning investors. Unfortunately, they can only do that once.
Well, perhaps there is another way of looking at it. Facebook's earnings per monthly active member is only 25 cents. Surely there has to be a way to increase that number? Well, perhaps. But with ever more internet pages chasing the same ad budgets and users developing insensitivity for the ads, they'll have to pull out another rabbit from the hat.
That isn't going to be easy. We remind people that ad income is 84% of total revenue, and the opportunities for growth here are pretty dim. They have to introduce something pretty significant. Zuckerberg raved about the mobile opportunity, how in the next four or five years, five billion people will own a smartphone.
One way they're monetizing that is through sponsored stories, which:
allows advertisers to pay to highlight certain posts from others, so their friends and other members on the site can see them. Zuckerberg said this new ad product is already generating a million dollars a day in revenue, with half coming from mobile. [Business Week]
We wonder, do you really want your small mobile screen crammed up even more with this? Will users develop the same kind of insensitivity to these as they have to banner ads? Jury is still out here, but as we understand it, people come to Facebook to interact with their friends, not to have commercial interest jammed down their throats.
More promising are the games, stuff like Song Pop and Draw Something (both quizzes played with friends). But there is a lot of competition for stuff like this. One doesn't need to go to Facebook to play games with friends, as the present WordFeud craze in the Netherlands proves.
And as Zynga (the most important Facebook games platform) recently showed, this isn't necessarily a one way bet either. We think Zynga (ZNGA) itself presents better value after the recent hammering of its stock.
Perhaps the biggest potential is that they're building some sort of software platform for other companies to build applications on. We actually could see that work, sort off. But whether it will ever be able to approach anything like the Apple or Android ecosystem remains very much to be seen.
If the company remains unable to 'grow into its valuation,' investors will be disgruntled even more and the Facebook reputation will be seriously damaged, insofar as it isn't already. Unless they pull out a yet unknown rabbit out of some hat, we can't see the company grow into their valuation any time soon.
It's most profitable markets are stagnating, revenue per monthly active member is stagnating, it's most profitable product by far isn't growing sufficiently. It costs and investment to enter less profitable markets are exploding and the only business that grows with the kind of percentages to underpin its market value (mobile) could very well be cannibalizing its bread and butter product (banner and text ads).
We don't think this proposes a good deal, even at $24 or so that the shares are trading at. What you will be buying is hope that they will figure out what to do with this tremendous platform (there's little doubt the platform itself is tremendous). We wouldn't go in before valuations are more reasonable and we have at least a glimpse of that. The risk, after all, is that they don't figure it out.
And there are other risks. Users could balk at the commercialization. They could develop concerns about their privacy (and here, and we're by no means exhaustive). Like Amazon and Police (PredPol) algorithms, Facebook has it's own algorithms that allow them to predict certain behavior (like crime) with a certain degree of accuracy.
While one can only welcome the use of algorithms in preventing sexual predating of minors, these algorithms can do a lot more in the fight against crime, but whether users are ready to welcome the invasion of privacy that is unavoidably connected with that remains to be seen. While the police does already have normal access to Facebook, having comprehensive access on the basis of these algorithms would open whole new possibilities, and these involve data for which normally some kind of court action is necessary.
We see, as of yet, little reason to by the shares. Even at 2/3 of the IPO price, you'll be buying hope, while many of the most important metrics of their present business flag the consequences of the law or large numbers while the only part that doesn't (mobile) has yet to prove itself. We think that unless we see more promising growth opportunities, the shares are dead money, at best. We cannot believe the company's reputation hasn't been damaged more by the outrageous IPO price.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.