Facebook's Fall

Aug. 6.12 | About: Facebook (FB)

In my May 25th article on Facebook (NASDAQ:FB), written shortly after the company's ballyhooed and subsequently beleaguered IPO, I compared the value that the newly public Facebook was commanding to a similarly valued basket of industry leaders. The comparison was to a list of American blue chips - ConocoPhillips (NYSE:COP), Home Depot (NYSE:HD), United Parcel Service (NYSE:UPS), Visa (NYSE:V), Altria (NYSE:MO), United Technologies (NYSE:UTX), Simon Property Group (NYSE:SPG), Occidental Petroleum (NYSE:OXY), CVS Caremark (NYSE:CVS), and Hewlett-Packard (NYSE:HPQ) - a group that on average had the same enterprise value as Facebook at that time.

The comparison presented a stark contrast between these mature industry leaders and the social networking wunderkind. Of course, Facebook's equivalent valuation was based on an anticipated rapid growth trajectory rather than realized results. The launch price of the IPO, which valued the company at roughly 4x the EBITDA and earnings multiple of these developed businesses proved overly optimistic.

Just one quarter into its new era as a public company, the enterprise value of Facebook has fallen nearly in half, dropping $35 billion. For investors trying to frame what Facebook's new lower relative valuation should be, I have again compared Facebook to widely known and held American businesses, recreating a list of ten companies with the same enterprise value as Facebook after its rapid descent.

Click to enlargeSource: Bloomberg, 8/13/13 & 5/25/12; All Ratios Trailing 12 Months; Est. EBITDA is Bloomberg Estimate for current fiscal year.

Placing Facebook against a basket of companies with similar enterprise values is just a simplistic "sniff test." Monsanto (NYSE:MON) is a leading global provider of agricultural products. DirecTV (DTV) is the world's largest provider of digital television entertainment services. The company's twenty million subscribing U.S. households pale in comparison to Facebook's presence, but the social networking site does not effectively translate this reach into recurring revenue. Apache (NYSE:APA) is one of the world's top independent oil and gas exploration firms, but has only 35% of the oil equivalent proved reserves (2.99 billion BOE) of ConocoPhillips (8.4 billion BOE), a company which Facebook was valued equal to just three months prior. Danaher (NYSE:DHR), a science and technology leader, operating in medical, industrial, and commercial markets produced $16.1 billion of revenue in 2011, which is more than Facebook has generated in its lifetime.

Nike (NYSE:NKE), the global sports apparel leader, has built the type of sustainable global brand that Facebook would like to emulate. Kimberly-Clark (NYSE:KMB), the consumer products giant, boasts 1.3 billion people worldwide that use its products daily, a figure greater than Facebook's impressive member figure. Emerson Electric (NYSE:EMR) is a diversified global manufacturer, widely recognized for its engineering capabilities. First Energy (NYSE:FE) and American Electric Power (NYSE:AEP) meet the energy needs of 6 million and 5.3 million Americans respectively each day. Praxair (NYSE:PX) is the largest industrial gases company in the Americas.

Of course, the fact that the social networking leader trades at a three times higher trailing earnings multiple than this group tells only a portion of the story. The Facebook valuation bakes in a much higher future growth rate of revenues and earnings, and while the market's expectation of that trajectory has cooled over the past three months, it will still exceed the broader market substantially over future periods. The tech darling did produce a much higher growth rate than these companies in its first quarter as a public company.

Collectively, the aforementioned charted group above posted just 6% sales growth and 0.7% earnings growth in the most recent period. (Emerson Electric and FirstEnergy are yet to report.) Through Friday, August 3rd, 409 of the 500 S&P 500 constituents have released earnings. Earnings growth is up only slightly at 0.05%, and top-line sales have fallen by 0.5%, driven by large declines in the energy sector due to lower commodity prices in the second quarter.

The question for Facebook is the length and trajectory of this above market growth rate. Revenue grew 36% year-over-year. Advertising revenue in the first quarter surprised slightly to the upside driven by the company's newly launched Sponsored Stories in the News Feed, which saw click-through rates multiple times those of ads on the right hand of the screen. Facebook bulls also point to its nascent mobile monetization efforts as a source of future revenue growth.

Emerging bears on the Facebook story in the near-term will point to lock-up expirations that will disconnect the share price from operating performance over coming periods. Intermediate term issues include operating expense growth and potential margin pressure as the business expands and headcount and infrastructure investment are increased. Overarching issues include the omnipresent issues with privacy, security, and regulatory risks in current and potential markets, and the control of a chairman and CEO with no experience running an increasingly complex organization.

The tremendous change in the valuation of Facebook in just three months warrants putting this new lower valuation in a broader context. With the wide dispersion of future outcomes in the earnings growth rate of the company given the evolving business platform, it is very difficult to model the share price using traditional methods like discounted cash flow analysis. Even the company is at least outwardly uncertain about the way forward, eschewing specific forward guidance on its first quarterly earnings call. Absent mechanical and quantitative tools at arriving at an appropriate valuation for the firm, qualitatively the value of Facebook is effectively a call option on its ability to translate users into recurring revenue streams.

If the company can outperform the market's expectation for user monetization and revenue growth, then the stock will regain its lost luster in dramatic fashion. If the company fails to translate users into meaningful revenue and earnings growth, then this company is still wildly overvalued at the current multiples. While the significant drop in valuation has made this option cheaper, the valuation still feels high to me relative to even this lower valued peer group of companies. I hope an updated presentation of the Facebook valuation against a backdrop of notable companies helps frame this story for Seeking Alpha readers.

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