Why I'm bearish on Facebook

Why I'm bearish on Facebook

It seems a convenient coincidence that the last time I wrote in depth about Facebook (RivSec: FB) and the social network craze, it was a year ago to the day. On that day, I discussed in detail the IPO (Initial Public Offering) of social networking peer LinkedIn (RivSec: LNKD), which had only just listed.

Recently, we have been talking about Facebook on Virtually Live and the overwhelming view from the Rivkin Report has been surprise at the incredible valuation being placed on the company leading up to the IPO. The initial performance of Facebook stock, while in no way confirming our views, does bring to light how much doubt surrounds Facebook’s future. Of course, the IPO itself has been a comedy of errors from the opening day delay in trading to the contract loss of General Motors (RivSec: GM) only days before the IPO. Probably none more so in my view than the downgrade of earnings forecasts by Morgan Stanley only hours before the IPO; the same Morgan Stanley that was the lead underwriter of the IPO! It should be noted that Morgan Stanley (and other underwriters apparently guilty of the same act) is now under investigation, and according to experts, this has never happened before. And of course, this earnings forecast downgrade comes after the price range for the IPO was raised from US$28-$35 to US$34-$38, and the final float price set at US$38.00 per share.

For those who have somehow missed the trading since it listed, Facebook traded as high as US$45 on its opening day as the first day’s enthusiasm peaked, but by day’s end was back at around the listing price. Two nights ago, and without the protection of the underwriters holding it up, the stock fell ~11% to US$34.03 and overnight fell a further ~9% to US$31.00. That means shareholders paying as much as US$45 on day 1 are down ~30% in less than a week!

Rather than use this mess as an opportunity to say ‘I told you so’, realistically this is a drop in the ocean if I am to be proven right. LinkedIn, the subject of my ire last year, also performed terribly after its first day before recovering as time passed. I think for this social networking ‘bubble’ to be proven, it will take many years. And unlike the dot com bubble, Facebook and other social networks will always remain economically viable and highly profitable businesses, but nowhere near to the extent that current pricing suggests, at least in my view.

Take the numbers released with the prospectus. At the listing price, Facebook was trading up to 100 times 2011 earnings depending on what metric you use (in this case, I’ve based it on the 2011 US$1bn net profit after tax). Google (RivSec: GOOG), in comparison, was trading at 18 times 2011 NPAT. Put another way, Google’s revenues are ten times those of Facebook and profits are 11 times as large, but Facebook was being priced at well over half the market cap of Google (with a current market cap of US$195bn versus a market cap at listing price for Facebook of just under US$110bn).

Facebook has shown incredible growth but the company is in its infancy in terms of exploiting its advertising, and I expect that is why the company (and sector) is getting such crazy valuations. When I wrote last year, Facebook had roughly 600 million members and in a year, that has swelled to around 950 million people. So clearly its member numbers are still growing strongly, but in my view, the number growth is of a far less valuable member. Remember that the best markets for advertising would be the main commercial markets such as the US, the UK, Japan etc, and these nations’ populations have been early adopters of the service. So while there is still a chance for strong growth in member numbers, profitability per member should go down as numbers go up.

Additionally, while Facebook has already been advertising on its pages for a while, there is evidence to suggest the advertising is just not as effective as it is on Google’s pages, and logically speaking (and from my own experience) it makes total sense to me. General Motors walked away from its relatively small account last week, and I think there will be more companies taking their advertising dollars elsewhere. Even Mark Zuckerberg himself has been wary about over-advertising on Facebook’s pages due to fears of the product becoming less ‘cool’, and I think that is a valid concern. Additionally, the move to mobile computing (and the use of tablets and smart phones) has meant a greater number of Facebook users now view their pages on mobile devices which so far have proven difficult to display effective advertising on.

Finally, Facebook has found it hard to demonstrate where, outside of advertising, it will be able to generate revenues. The only area in its current plan is payment processing, which it already makes good money out of, but in the scheme of things, it is hard to see this contributing much to a US$100bn business. EBay (RivSec: EBAY), for example, the owner of PayPal, which is arguably the leader in internet payment processing (taking out the credit card companies of Amex and Visa), has a market cap of US$50bn, but has a huge head start in market share and has the online auction side of the business as a huge contributor. LinkedIn as well has spread its future revenues and stands to make good money from the recruitment side of the business, but in Facebook’s case, there has been no evolution from advertising.

So while there may be some respite in the short term for weary Facebook shareholders, over the long term, we remain big time bears on Facebook and the sector. The internet has been the birthplace of some of the great companies of this century, and while I put Facebook into that category, I think it would still be a huge success story at half that price and at least offering logic behind its optimistic pricing.

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