Since the epic failure of Facebook's (NASDAQ:FB) IPO, the company's struggles and stock price collapse have been well-documented by the national media. Now, the company is reeling from a Bloomberg report claiming that Facebook fought to withhold investment risks from the SEC prior to its IPO. Perhaps even more damaging is a recently filed patent infringement lawsuit against Facebook and four other social and business networking companies that risks further devaluation of the company.
On October 3, 2012, Bascom Research, LLC, a wholly-owned subsidiary of Document Security Systems, Inc. (NYSEMKT:DSS), filed a patent infringement lawsuit in the U.S. District Court for the Eastern District of Virginia against Novell (NASDAQ:NOVL), LinkedIn (NYSE:LNKD), Jive Software (NASDAQ:JIVE), Facebook and BroadVision (NASDAQ:BVSN). The lawsuit claims these companies utilized patented technology, owned by Bascom Research, which provides the means to organize data and relationships as well as share data in a computer network.
Facebook earns 84% of its $1.18 billion quarterly revenue from advertisements hosted on its social networking platform. If DSS were to win this lawsuit, the court could award billions to DSS. This figure would be derived from a percentage of Facebook earnings, as well as up to triple damages for the alleged willful infringement of the DSS-owned patent. The other four companies in the lawsuit are clearly threatened as well, but Facebook is still in IPO damage control mode and has the most to lose. While Facebook could certainly win this case, it will incur substantial litigation expenses and going to trial always poses the risk of losing, compounding the financial risk. Settlement is the most likely of scenarios, which could still cost Facebook hundreds of millions.
The company has already nose-dived from its IPO of $38 per share to a low of $17.55 per share. The stock's 45 percent free-fall, which eliminated $49 billion in market capitalization, rates as the worst IPO performance in the last five years. In addition to the DSS patent lawsuit, Facebook is already plagued by dozens of lawsuits stemming from its IPO. Investors sued the company due to technical issues involved with the company's IPO, as well as insider trading accusations claiming that Facebook forewarned analysts that the IPO may underperform.
Facebook is also facing significant risk from a growing percentage of mobile users, which negatively impacts the company's revenue as these users see fewer advertisements than those using a PC or tablet. Of the social network's one billion worldwide users, approximately 600 million of them access Facebook through a mobile device. Knowing full well the ramifications of this trend, Facebook hesitantly provided this data to the SEC only eight days prior to its IPO.
Another major risk for Facebook is its partial reliance on gaming company Zynga Inc. (NASDAQ:ZNGA) to meet revenue objectives. Facebook offers users the ability to play Zynga's games through its social network, which increases revenue potential through more advertisements. The link between the two companies became evident when Facebook shares dropped 8.5 percent after Zynga failed to meet earnings estimates in July. Through deliberations with the SEC, Facebook was forced to acknowledge that Zynga is now offering the same games on its own website, as well as other websites. This could have serious consequences for Facebook as users no longer need to access the social network to play Zynga games, driving advertisement revenue down further.
Facebook's second quarter 2012 financial results are also concerning. The company's year-over-year operating margin dropped from 45% to -63%. Revenue decreased from $407 million in Q2 2011 to a -$743 million loss this quarter, while net income also decreased $397 million in the last year. The primary reason for this substantial decrease in revenue is Facebook's inclusion of share-based compensation and payroll tax expenses that had accumulated over several years, and reported in gross in Q2 2012 results. Therefore, the depth of the revenue loss should ease in Q3, but the GAAP requirement to include these expenses in future financial results will prevent investors from seeing the earnings they are accustomed to seeing.
Lastly, there is a growing concern that Facebook is losing its appeal to America's youth. A report from Business Insider showed that Facebook usage among age groups 12-17 and 18-24 is down 42% and 25% respectively. Remaining popular with America's youth is critical for Facebook to avoid being just another temporary fad, like MySpace was a decade ago. All of these risks considered, investors looking to buy Facebook shares at a rock-bottom price should be patient and see if the aforementioned lawsuits and user trends drive the company down even further.
Additional disclosure: The writer is not a licensed broker or investment adviser and therefore cannot recommend that you buy, sell, or hold any security. While every attempt was made to verify the information in this report, much has been derived from public sources and cannot be guaranteed for accuracy.