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Can Investors Trust Facebook?

|Includes:Facebook (FB)

Though I'm new to Seeking Alpha, I have been a long-time observer of the high-flying technology stocks, hoping to find an attractive short among the bunch. My first article focused on Pandora, but now it's time to turn to the best of breed social media company, Facebook (NASDAQ:FB). Unfortunately, Facebook is not a short either, but it is a very interesting company with a bright future in mobility.

When it comes to trusting Facebook, I'm not talking about the company's privacy or security, but rather management when it comes to capital allocation. Facebook made its first major splash in 2012, acquiring image-based mobile app Instagram for $715 million in cash and stock. Facebook only recently announced plans to monetize its big acquisition, with advertisements coming shortly.

Facebook has done a wonderful job growing mobile advertising revenue on its own platform. Advertising revenue jumped 34% sequentially to $882 million-an impressive figure, especially when considering mobile advertising was non-existent when the company went public.

Since Facebook has been so good at mobile advertising, it's reasonable to expect that success to extend to Instragram. Facebook already knows the proper balance between user-generated content and advertising, plus, plenty of Instragram users already follow companies, so relevant paid advertising won't be out of place. Instagram falls right in Facebook's sweet spot.

Mobile advertising seems poised to drive Facebook's revenue expansion for years to come.

$3 Billion for SnapChat…?

I have no doubt about Facebook's ability to make money. However, capital allocation troubles me. Reports say SnapChat rebuffed Facebook's $3 billion acquisition offer, but I'm curious as to why Facebook even considered offering $3 billion for SnapChat.

True, Facebook's initial offer for Instagram was valued at $1 billion even though Instagram had yet to generate a penny of sales. However, the path to monetizing Instagram was fairly straightforward. Unlike SnapChat, Instagram also achieved an incredibly huge network effect with some users gathering tens of thousands of followers.

SnapChat is a social mechanism, but it is drastically different from Facebook and Instagram in its scope. Users, mostly teens, communicate directly with each other rather than make posts available to the world. It is the anti-Twitter (NYSE:TWTR). In fact, its popularity is dependent on its privacy and short shelf life (anything embarrassing is going to disappear in seconds, unless the receiver takes a screenshot).

SnapChat's most obvious path to revenue, and what Facebook knows best, would be advertising. But I do not think users want to receive SnapChat ads because it invades the private nature of the product. On top of privacy invasion, SnapChat screams low barriers to entry. Unlike Facebook, Twitter, or LinkedIn, networks that grow stronger as users invest more time in them; the nature of SnapChat is transience. A new program could easily come along with very low switching costs, especially since it can be linked to existing contacts.

The other avenue SnapChat could pursue would be membership model. It's hard to imagine teens paying for a membership to anything, let alone a social networking device, after years of receiving everything for free. Thus, I do not think this is viable.

Executives are reacting to lower teen engagement

I remember watching Facebook's stock price in after-hours trading when it reported third quarter results: a spike, followed by an immediate dip when CFO David Ebersman shook the financial community by saying:

"Our best synopsis on youth engagement in the U.S. reveals that usage of Facebook among U.S. teens overall was stable from Q2 to Q3. So we did see a decrease in daily users specifically among younger teens."

Facebook really doesn't want this to occur because today's younger teens fall into tomorrow's lucrative 18-35 advertising demographic. Teens have the most time to spend on social networks, so any decline in popularity at Facebook means another medium is gaining steam.

It's safe to assume younger teens would prefer not to share their online activity with their parents and elders, a problem many twentysomething Facebook users did not encounter since the network was closed-off to students in its infancy.

However, there could be other reasons for a decline in young teen activity. Seasonality comes to mind. It's been a while since the Detroit Bear dealt with a summer vacation, but it would make sense that teens would interact less online when schools out. Young teens have a number of summer activities that serve as distractions, and as I recall, teens interact more during the school year because they see their peers daily.

SnapChat may grab young teens attention at the moment, but something else may grab it tomorrow. Facebook shareholders shouldn't want management to sacrifice over $3 billion for a company with wildly uncertain revenue prospects.

Shares still have room to the upside

Management's decision to bid for SnapChat, if true, causes me to worry about the company's long-term future. In the long run, management teams that allocate capital effectively tend to produce superior returns for shareholders.

That being said, I think shares have upside. The Street is drastically underestimating Facebook's ability to ramp-up earnings. Facebook could earn $1.50 per share in FY2014, and a "conservative" (for a social networking company) 40x earnings estimate generates a price target of $60. This figure implies upside of more than 20%.

In the spirit of Buffett and Graham, the Detroit Bear demands a large margin of safety, so 20% upside simply isn't enough for Facebook to earn a position in my portfolio. If a major sell-off causes shares to dip below $40, then I will be a buyer. However, if Facebook does eventually overpay for SnapChat, I would be very cautious about holding the name for the long-term.

Stocks: FB