I have been bearish on Facebook (NASDAQ:FB) since its IPO at $38 in May. Indeed, since then my analysis has become steadily more bearish as a result of the Q2 earnings numbers and an admission from Facebook itself about bogus accounts and claims made by customers regarding bot-driven advertising. As a result, I recently slashed my target price from $7.30 a share to $5. There is a possibility that I might increase that estimate of fair value, but only if founder Mark Zuckerberg quits as CEO.
The speed at which the shares will fall is a technical matter. I cannot call it with any certainty. It will be driven by the lockup expiries over the next four months. I am sure you are aware that on Aug. 16, lockups of over 286 million shares, owned by investors who had paid as little as 50 cents a share for their stock, expired. And large numbers of those investors (notably Facebook non-exec. Peter Thiel) cashed in their chips as soon as they could. Having already stuck $640 million into his bank account from sales made at the IPO, Thiel has turned $500,000 into $1 billion of cash. He has now sold 36.8 million shares, and holds just 5.6 million.
Between now and Christmas, another 1.71 billion shares will be freed from lockup. I do not expect quarterlies out on Oct. 12 to provide much reason to buy, and thus with the free float set to have increased by 276% between the IPO and the end of November, there is every reason to expect material short-term weakness. But I shall not attempt to call the exact pace of the decline.
The stock price will, however, fall. You may note that my valuation of $5 is rather different from that of most Wall Street analysts, including those employed by firms that made such a packet organizing this IPO. Some of the "experts" on the Street still reckon this stock is worth $40 plus. How do our models vary? It is simple. The Street experts base their valuations on Discounted Cash Flow Models stretching out many years and making some pretty heroic assumptions about growth in revenues and, more importantly, cash flow generation. I would argue that it is quite impossible to forecast revenue and cash flow generation numbers even six months out, let alone half a decade in the future.
I have always been skeptical of the ability of Facebook to monetize its customer base. Having worked for a failing dot-com during the last boom, I remember all too well how analysts became obsessed with "eyeballs" and ignored the more critical metrics' relation to the conversion of customers into cash generation. I rather thought that we had learned our lesson last time, but that was before folks started buying into the New Media hype and believing that "this time it will be different." It never is. The problem Facebook has always faced is that most of its customers are teenagers/students/young people in the West or live in the developing economies. As such, the customer base is not sufficiently focused to be really attractive to advertisers and, rather more critically, most of the customers do not have much of a disposable income. As such, for me the key metric in determining what growth Facebook can deliver is not eyeballs (there is no point gaining another 50 million customers if they mostly have minimal disposable income), but revenue per customer.
And this is where it gets worrying for Facebook. Rather naively, I have always assumed that at some stage a sense of ennui would set in among Facebook customers in that the whole experience seems rather tedious and unstimulating to me. I wonder if that will indeed be the case and whether over a five-year period we will see this company losing affluent mature Western customers and replacing them with poorer Oriental ones. We shall see. But of more immediate concern is the increasing number of folks accessing Facebook by mobile devices rather than via PCs -- it is just harder to generate click through revenues via a cell phone. This seems to be the driver of falling RPU metrics in Q2.
And, of course, since then we have had a series of "issues" that must raise real question marks over the ability of Facebook to attract -- indeed even maintain -- advertising clients. An admission made in a 10-Q statement on July 31 that 8.7% of Facebook accounts are ones that cannot generate any advertising click-throughs (since they are either duplicates, belong to pets, or are bots) was pretty humiliating. But it was the claim made at the start of August by Limited Run (a New York startup) that 80% of the clicks it had paid Facebook to deliver came from bots that were clearly not going to make a purchase. This matter has not been cleared up with any great degree of success by Facebook. Given these various controversies and the appalling post IPO surrounding Facebook generally, if you were in charge of a marketing budget, would you go to your boss arguing that you should start giving Facebook some of your business, give it more of your business, or give it less? No one ever got fired for playing it safe.
As such, I can see no way that one can make any meaningful forecasts for growth in revenues, but it seems unlikely that Facebook will do much to trim the growth in its cost base as it seeks to deliver the growth metrics that investors crave. Faced with that, I opted to value Facebook on the basis not of uncertain forecasts but historic numbers. My initial inclination was to value it on an earnings multiple that was marginally above the long-term average range of the Dow (13-22), given the potential for premium earnings growth. That allowed me to justify a valuation of $7.30 a share. My later view was that such was the uncertainty about earnings growth that valuing it toward the bottom of that range ($5 a share) was perhaps fairer.
However, in both analyses I ignore cash on the balance sheet, which is worth, perhaps, another $2-$3 per share. My conservative assumption was that there was a real risk that post-IPO lawsuits might eat into this, but also that with Zuckerberg clearly still calling the shots, he would "invest" much of his cash pile in whatever he deemed necessary to grow the core business. I am unconvinced that such a strategy would deliver a material return.
However, it strikes me that I should again look back to the last dot-com boom (and bust) and to the case of a U.K.-listed company, Lastminute.com. Like Facebook, it had youthful and charismatic founders (Brent Hoberman and Martha Lane-Fox) and its IPO attracted the sort of wild-eyed enthusiasm one only sees in the final stages of a bubble. Lane-Fox stepped aside not too long after the IPO and a newer management team appeared to recognize that the Lastminute business as it stood was not really viable. It was certainly not worth anything like the market cap. And thus the cash raised at flotation, plus some paper, was used to buy a series of other businesses, which, in the end, created a real entity of value. Investors lost money but not everything.
It is hard for a founder to accept that the business model must change. Harder still to accept that what is his or her baby may not be the key driver of growth and where investment is needed. It strikes me that Zuckerberg does not "do humility" very well. But I sense that pressure must be mounting on him to step aside and assume a more honorary title, bringing in a "professional CEO" -- at which point I would be inclined to add back Facebook's cash pile into my valuation.
For now I retain a $5 fair value target. But if Zuckerberg quits (soon), I shall increase that target. For now, with the shares at $19.15, the debate is academic -- the stock is a clear sell.