I'll fully admit that personal investing style lends itself towards value equities of mature companies in mature industries. Therefore, my review of Facebook (NASDAQ:FB) might have some bias, but I do also appreciate a growth story so I have followed the stock since its IPO. I would never try to compare myself to Mr. Buffett, but Buffett and I do share one thing in common: we prefer to invest in "things we know" and that leads us to avoid technology. In the case of Facebook, of which I am a member, but not an avid user, I cannot understand why the Street would place such a high premium on the growth generated by a product that seems to have limited protections from copy cats and relies on advertising revenues for the majority of its cash.
Facebook is essentially the second better version of MySpace. My guess is that people more familiar with the social networking space could even chime in with something that was similar prior to MySpace.
Let's look at the business and financials and then examine the space that Facebook dominates.
All financial data is sourced from Facebook's company summary as of July 25, 2014 on Scottrade's trading platform.
Income Statement Analysis
I think the key to reviewing Facebook's income statement, or any growth stock, is the trend as we're going to be looking for a forward valuation. Revenue growth for FB from 2009 to 2013 has been: 154%, 88%, 37%, and 54.7%, respectively. As should be obvious, growth is strong, but slowing. Using these numbers as a guide, I estimate revenue growth for 2014 at 54.7%, 2015 at 41%, and 2016 at 32.8%. I admit that there is some wiggle room here, but given how fast technology changes, I feel comfortable using previous growth to project future growth. FB could revolutionize the social networking world in the next three years and blow these projections out of the water. Or they could get caught by a competitor and greatly disappoint over the next three years. As we can know neither of these, I assume that the status quo is best for a valuation review.
I assumed a Cost of Revenue of 25%, consistent with the last 5 years. I assumed an R&D budget that would grow 15% year over year. (I am comfortable with this estimation given that FB will need to continue to innovate. The other option would be acquisition of "talent", which given the recent purchase of WhatsApp may exceed the R&D increases I have assumed. Therefore, I believe that FB could exceed these expense estimates, if not careful, and thus my earnings estimates are leaning towards generous.) I assumed an annual 10% increase in S&GA expense from 2013. I assumed an annual interest expense increase of 10%. I assumed a 39% tax rate, consistent with low end of the tax rate for the last 5 years.
Given these estimates, my resultant EPS and P/E ratios are (closing price as of 7/25/14):
- 2014 - $1.23 / 61
- 2015 - $1.89 / 39.8
- 2016 - $2.63 / 28.6
Given these estimates, FB is reasonably priced for the 2016 growth, but offers little room for capital appreciation and no dividend. Given this information, the risk towards a downside move far outweighs the reward for any possible earnings beat.
What Could go Wrong?
FB currently trades at a P/E ratio of 81.6 for the trailing twelve months. The stock is up 129% in the last twelve months. My question as an investor is: Will the market continue to place this high of a premium on FB growth. 2012, in general, was a down year for FB. As results rolled out, the stock was depressed, as I'm sure you all recall. Now that revenue and earnings are growing again, investors are increasing the premium for that growth. I'm not a psychologist and don't claim to know what the market will do (the markets are far from "rational" as some economists claim) so I don't pose this as a recommendation, but just as a question to ponder when considering whether or not to invest in FB shares. We have recently seen that Amazon (NASDAQ:AMZN), another internet growth darling with a huge P/E premium, is starting to feel some pressure to produce earnings. While FB is producing earnings, and growing earnings at that, could the market decide that the growth is not fast enough? We have seen this as recently as 2013 with Apple (NASDAQ:AAPL) as growth slowed.
FB has had net income margins of 29.4%, 30.7%, 26.95%, 1%, and 19% for the last five years (2009 through 2013, respectively). My estimates above indicate net income margin of 26%, 29%, and 30%. I can't see a catalyst that gets FB over the hump to turn around the net income margins. Some may point to the growing mobile user base and the increased ad prices from mobile that FB has been able to achieve. Again, I can see that and agree with that, but it has to come to perfect fruition for the margins to increase to the above levels. FB would have to maintain its dominance in social networking and continue to provide evidence to advertisers that their mobile platform justifies increasing prices. While this is certainly possible, it seems that the market is pricing these conclusions into the stock price as a certainty.
Finally, FB has endured multiple "issues" from the revelation of how they handle and treat user data. Privacy and the value of user information is becoming more and more important to the user. MobiSocial has its Omlet platform that is now being pre-loaded on smartphones in Asia. Syme offers encryption. MyApollo has been featured by the International Business Times. There is also Diaspora. Are any of these Facebook killers? I have no idea. Facebook became amazingly popular because of growth among teenagers, who are typically first adopters. I don't plan to even attempt to determine what a teenager will like in 2016. But I do know that assuming they will all still like FB (see what I did there?) and then investing at a premium due to confidence in those teenagers seems dangerous to me. Would I like FB at $40? YES! Do I like it in the mid $70's? Not really.
I don't see the upside and I like to get paid for taking risks.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.