Facebook Still A Long Way From Providing A Margin Of Safety

Oct.31.12 | About: Facebook (FB)

Trading at $21.94 Facebook Inc. (NASDAQ:FB) has a market capitalization of about $53 billion. This is down considerably from the IPO price, where speculators took a 1999-esque approach to piling in on the belief the stock just had to spike from the IPO price. Facebook's management and the investment banks managing the deal provided plenty of alcohol to these already drunk market participants by increasing the share offering, and raising the offering price. Before and after the IPO, I argued that Google Inc. (NASDAQ:GOOG) would be a far better play at their respective valuations, and I still believe that to be the case today, despite Google's rise and Facebook's decline.

Facebook's trailing twelve month revenue is just over $4.6 billion, and is growing at a rapid rate. The company is also making strong improvements in its technology offerings, and its ability to monetize the shifting nature of the online advertising market. These facts lead me to be quite bullish on Facebook the company, but even at this somewhat "discounted valuation" Facebook offers very little margin of safety, and only reasonable upside. To illustrate this, let's take trailing 12 month revenue of $4.635 billion and grow that by 30%, 25%, 20%, 15%, and 10% respectively over the next 5 years. Assuming that Facebook's performance will be somewhat comparable to Google's, we will assume 30% and 25% operating and profit margins respectively.

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Using these figures as seen above, in year 5 net income would be $2.858 billion. Putting a generous 20 times multiple of those earnings would give Facebook a market capitalization of about $57.16 billion. Facebook would have grown its already robust cash balance significantly in this time, but I think the multiple is fair when you look at where various technology companies trade upon maturation. $57 billion is scarcely higher than the current price, leaving very little upside for investors. Now if Facebook can maintain an elevated growth rate over a 10-15 year period, the stock could offer a good value at current prices, but you could say that about most companies. Value investing requires a reasonable margin of safety, and even if I give Facebook a 70% probability of maintaining its leadership position in the social media market, the attractiveness of it as an investment was non-existent at the IPO price and marginal at best currently.

While I would certainly make the argument that Facebook's business is improving in many areas, there is still a lot that can go wrong for the company. There are a number of companies leveraging social networking in a successful manner, and some are in direct competition with Facebook. There is only so much time and energy that users are willing to spend on an online profile, so any decrease in market share could have a considerably detrimental impact. The shift to mobile creates tremendous uncertainty into the monetization of Facebook's huge user base. If the company fails to keep the user experience really enjoyable when it incorporates mobile ads, users could leave in droves. There is a great deal of well-funded and technologically savvy companies that would be willing to offer fewer advertisements, for just a small piece of Facebook's market leading market share. In addition, if Facebook follows the path of companies such as Salesforce.com (NYSE:CRM) and Amazon (NASDAQ:AMZN), share issuances will continue at an accelerated rate, diluting owners of the company.

On October 23rd, Facebook reported 3rd quarter earnings that were viewed quite positively for a company that has been quite disappointing since going public. Revenue of $1.26 billion, including advertising revenue of $1.09 billion, was up 32% and 36% respectively YoY, despite a negative currency impact. Ad revenue growth comprised of a 37% increase in the number of ads delivered and a 7% increase in the average price per ad. The company ended the quarter with 1.007 billion people using Facebook, up 26% from last year at the same time. 584MM people accessed Facebook each day on average in September, and there has been considerable growth abroad in countries such as Japan, Brazil, and India. Payments and other fee revenue was up 13% YoY to $176MM, but this was down 9% sequentially primarily due to weakness in Zynga (NASDAQ:ZNGA). GAAP expenses were up 64% YoY to $885MM and GAAP operating income was $377MM. GAAP net income was still a negative $59MM, down from $227MM of profit last year. Facebook like many technology companies likes to eliminate stock compensation as an expense, but this accounting practice is ridiculous, and while it may accurately portray cash flow, it should not be used to make it look like the business is vastly more profitable than actual real world results show it to be.

The biggest question plaguing Facebook has been the transition towards mobile computing, and the impact that has on advertising, and the monetization of that advertising. CEO Mark Zuckerberg portrayed the transition to mobile in a very positive light through explaining that mobile allows Facebook to reach way more people than desktop, mobile users tend to use Facebook more than desktop users, and lastly Zuckerberg believes that the company will be able to better monetize mobile per amount of time spent on it in comparison to desktop. I think Zuckerberg is more likely correct than wrong in his views on the future of mobile advertising, and the rapid improvement in Facebook's mobile platform is impressive.

Facebook has over a billion users, including 600MM on mobile, up from 376MM last year. Facebook is also the most widely downloaded app on most smartphone platforms, allowing the company to transition fairly smoothly, at least in terms of users from desktop. Zuckerberg points out that a desktop only Facebook user has a 40% likelihood of using Facebook on a given day, but the mobile user has a 70% likelihood of using it. Formatting ads on mobile is much different in that they can't just be on the side of the screen like they are on desktop, so companies like Facebook and Google are finding ways to deeply integrate the ads with the user experience. This process is tricky, and for many users, including myself, it can be quite annoying when not done properly. There were similar issues though on desktop when online advertising was in its nascent stages, so I have very little doubt that mobile advertising cost per click [CPC] and cost per 1,000 impressions [CDM] rates will improve as the model becomes more transparent and battle-tested. Mobile ads have many of the same capabilities to generate quick action from users, such as signing up for a newsletter or making a purchase, but it also allows users to make phone call or SMS to schedule an appointment or make an inquiry.

After 6 months of ramping up the mobile advertising business, Facebook is now generating 14% of ad revenue from mobile, and this number is likely to increase dramatically on a quarterly basis. With over a billion users, Facebook's primary concern is on monetization, and protecting its market share to emerging competitors such as Google Plus. One could look at the experiences of Myspace or Friendster as prime examples of how fickle users can be, when something new and exciting emerges as the technology of choice for the right demographics. Shortly after Yahoo (NASDAQ:YHOO) lost market share to Google in Search, many market participants, including myself unfortunately, believed that the sustainability of a competitive advantage was not likely to be strong in that market, because other companies could likely create an even better algorithm just as Google had done to Yahoo to win market share. As the internet has matured, innovative companies such as Google have increased their competitive advantages by expanding into emerging growth areas such as mobile, while making other investments such as the purchase of Youtube, which gave Google considerable scale and breadth in the types of advertising solutions that it could provide to clients. Facebook must follow the path of Google as opposed to resting on its laurels like Yahoo and arguably Microsoft (NASDAQ:MSFT) have done until very recently.

Application developers are engaged in a modern day gold rush, as few barriers to entry create the opportunity to develop the next hot technology. While this is both good and bad for Facebook, Zuckerberg believes that app development will continue to shift more towards a social, sharing environment, which should be quite beneficial for Facebook where there is the best opportunity for friends to connect with one another. One thing that was alarming about the Facebook IPO was the company's reliance on Zynga for gaming revenue. Zynga's financial performance has been truly abysmal, as has its capital allocation, Facebook saw a 20% payment revenue decline this quarter compared to last year from Zynga. The rest of the games ecosystem has been growing, and YoY was up 40%. Zynga now only accounts for 7% of total revenue, which is down from 12% last year at the same time.

Earlier in the year, Facebook acquired Instagram for about $1 billion. This price seemed quite rich for a company that really generated no revenue, but Facebook has a strong balance sheet, and seems to be leveraging it in what it hopes to be a fruitful way, similar to Google earlier in its existence. At the time Facebook agreed to acquire Instagram, the company had 27MM registered users, and this number has now ballooned to over 100MM. I'd expect to see similar tuck-in acquisitions moving forward, but there is a lot of risk of Facebook overpaying. Thus far Mark Zuckerberg has been ahead of the curve in terms of innovation, so I believe he should be respected, but for an investor looking for a considerable margin of safety, this should raise some red flags.

Facebook has been increasing its technological offerings, such as its Mobile App-Installs offering, which assists developers in creating and distributing apps on a global basis. The company also is rolling out Facebook Exchange, and a product it refers to as Custom Audiences. The goals of these products is to make it easier for advertisers to leverage the immense knowledge that Facebook possesses in terms of its users preferences and interests to create a customized advertising experience. I believe that this knowledge is really unique to companies like Facebook and Google, and should not be underestimated. COO Sheryl Sandberg pointed out that Custom Audiences can allow an automaker to advertise to customers when they are actually looking for a car, which obviously is quite an efficient and powerful advertising method. The question of whether these companies would be violating privacy laws is one that I am not qualified to evaluate, but legislation in this area should be monitored closely for someone is considering investing in this arena. In addition, Facebook is launching its Gifts program to allow friends to send personalized gifts for birthdays or special events, and the benefit is that Facebook stores addresses, phone numbers, and payment info making the process quite easy.

Stock prices tend to change much more quickly than the intrinsic value of the underlying business, and it is safe to say that Facebook is far closer to intrinsic value than it was at its IPO, but I'd like to see the stock around $15-$16 before I'd really start to get serious about it. The same logic caused me and many other value investors to miss out on Google from its IPO price, but this conservatism has helped far more than it has hurt. For examples of this, look no further than the disasters of Zynga, Groupon (NASDAQ:GRPN), and 95% of the tech IPOs in the late 90's. To actually invest in the company, I'd want to see more of a track record in terms of shareholder friendliness, because I was quite disenchanted with the obvious fleecing of unsophisticated investors during the IPO process. This is certainly a stock that I'll keep on my radar and hope that at some point, investors overshoot on the downside, allowing for a solid buying opportunity.

Disclosure: I am long GOOG, YHOO, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.