| SATURDAY, SEPTEMBER 22, 2012
Still Too Pricey
Facebook has a business model in need of a radical change and a still-rich $61 billion market value. What's not to "like"? Plenty.
The rapid shift in Facebook's user base to mobile platforms—more than half of users now access the site on smartphones and tablets—appears to have caught the company by surprise. Facebook (ticker: FB) founder and CEO Mark Zuckerberg must find a way to monetize its mobile traffic because usage on traditional PCs, where the company makes virtually all of its money, is declining in its large and established markets. That trend isn't likely to change.
Success in mobile is no sure thing. The small screens on these devices don't give Facebook much room to configure ads without alienating users. And the way that mobile users access Facebook, through applications on iPhones, iPads, and Android devices, may diminish the time users spend at the Website while handing greater power to Apple (AAPL) and Google (GOOG), which dominate the apps business.
AT ITS CURRENT QUOTE, Facebook trades at 47 times projected 2012 profit of 48 cents a share and 36 times estimated 2013 earnings of 63 cents. Compare that with Google and Apple, two proven technology growth stories, which both trade for about 16 times estimated 2012 earnings. Facebook is valued at $61 billion, or $53 billion excluding its estimated $8 billion in cash. That's more than 10 times estimated 2012 revenue of $5 billion. Google trades for half that valuation.
What are the shares worth? Perhaps only $15. That would be roughly 24 times projected 2013 profit and six times estimated 2013 revenue of $6 billion, still no bargain price. Wall Street's consensus estimate for 2013 shows earnings rising 31%, to 63 cents a share.
That pro forma number is generous because it ignores Facebook's very significant stock-based compensation. The company has been issuing gobs of restricted stock to engineers and other key employees in the hot Silicon Valley job market to prevent them from being lured away to the next hot tech start-up—the next Facebook.
Facebook issued $1.4 billion of restricted stock in 2011, or nearly $500,000 per employee. So far this year, the company has doled out $1 billion of restricted stock. Facebook's reported stock-based compensation expense—based on the amortization of several years of stock grants—could total 20 cents a share next year. Subtract that from the 2013 consensus earnings number, and the shares trade at 50 times earnings. At $15 they would still be valued at a rich 35 times earnings.
TECHNOLOGY IS THE ONLY MAJOR industry where companies routinely encourage analysts to ignore stock-based compensation expense—and most comply. This dubious approach to calculating profits is based on the idea that only cash expenses matter. That's a fiction, pure and simple. As Warren Buffett has said, companies could take this to the extreme, pay all their expenses in stock and claim to have no costs.
Facebook's restricted-stock grant was so large last year that it may have exceeded its cash compensation costs. CEO Mark Zuckerberg seems to have a cavalier attitude, saying in a recent interview that "the way we do compensation is that we translate the amount of cash that we want to give you into shares" and give more stock to employees as the price declines.
Ours is admittedly an outlying view on the stock. Only one of the almost 40 Wall Street analysts covering Facebook, Dan Salmon of BMO Capital Markets, has a price target of $15. Most are in the high $20s or $30s. Many of these firms initiated coverage of Facebook with price targets in the $40s.
Barron's, it bears noting, never bought into the pre-IPO hype. We published two skeptical stories on Facebook, first when it filed for its IPO in February, and again right before it went public in May ("Mad About Facebook!" May 14). Our take was that the stock looked very richly priced at $35 to $40 and that investors should consider Apple and Google instead. (Both are up about 25% since then.) "Connect with your friends on Facebook. Stay away from the stock," is how we concluded the article.
THE BULL CASE FOR Facebook is that Zuckerberg & Co. will find creative ways to generate huge revenue from its 955 million monthly active users, be it from mobile and desktop advertising, e-commerce, search, online-game payments, or sources that have yet to emerge. Pay no attention to depressed current earnings, the argument goes. Facebook is just getting started.
Facebook now gets $5 annually in revenue per user. That could easily double or triple in the next five years, bulls say. In a recent interview at the TechCrunch Disrupt conference, Zuckerberg said, "It's easy to underestimate how fundamentally good mobile is for us." His argument, coming after Facebook's brand-damaging IPO fiasco and a halving of the stock, was something only a mother, or a true believer, could love. This year Facebook is expected to get 5% of its revenue from mobile. "Literally six months ago we didn't run a single ad on mobile," Zuckerberg said. Facebook executives declined to speak with Barron's.
"Anyone who owns Facebook should be exceptionally troubled that they're still trying to 'figure out' mobile monetization and had to lay out $1 billion for Instagram because some start-up had figured out mobile pictures better than Facebook," says one institutional investor, referring to Facebook's April deal for two-year-old Instagram, whose smartphone app for mobile photo-sharing became a big hit (and at the time had yet to generate a nickel in revenue).
Facebook's initial profit report in July didn't cheer Wall Street, as second-quarter revenue rose 32% to $1.18 billion while expenses, excluding stock-based compensation, were up 60%. The company projected similarly large expense gains in the final two quarters of the year, as it ramps up infrastructure and other undisclosed spending.
That surprised many investors who figured Facebook's business model was so powerful that it would generate operating leverage, meaning revenue growth would outpace expense growth. The Street now projects that Facebook may not hit $1 a share in profit until 2015. And that doesn't reflect heavy stock-based compensation. And who knows if that $1 a share estimate, which may require a doubling of revenue, is even achievable.
"I don't understand management teams that don't explain how they are going to spend shareholder money," says Michael Pachter, an analyst at Wedbush and a Facebook bull. "Facebook is saying, 'Trust us.' Investors don't need to know about every pencil, but they want to know the strategy." So far, Facebook has said little, and the company lacks the credibility and track record of Google, Apple and Amazon.com (AMZN).
FACEBOOK GENERATES almost 85% of its revenue from advertisements, much of it from ads on the right side of the screen when users visit the site on PCs. Ads are likely to remain its mainstay for some time to come. But in a troubling sign, last week online research firm eMarketer, after cutting its estimate of Facebook's revenue, projected that Google would top Facebook in online display-ad revenue this year.
Facebook conceivably could charge modest subscription fees to its users of, say, $1 a month and generate $5 billion or more of annual revenue, even with significant user attrition, but the company has ruled that out. "It's free and always will be," the Facebook log-in page says.
Facebook's chief operating officer, Sheryl Sandberg, has acknowledged the company's ad "challenge." On the July earnings conference call, she said, "That's mainly because we're a completely new kind of marketing. We're not TV. We're not search. We're a third medium."
It's not easy to measure the effectiveness of this third medium because its ads are often more about brand building than transactional. "Facebook's jumble of activity centers on communications with a roster of friends, a core activity where commercial intervention may be less welcome," writes Paul Sagawa of Sector & Sovereign Research.
As Facebook was trying to win over sometimes skeptical advertisers with desktop ads, its users were moving to mobile devices. Facebook's response has been advertisements that it euphemistically calls "sponsored stories" based on products or services recommended by a user's Facebook friends. Yet these ads, which appear in the user's "news feed"—comments, pictures, and videos from friends—may be alienating users and driving them away from the Website. Some appear again and again, stating that a particular friend "likes" Wal-Mart or Target. A recent lawsuit actually challenges this practice, arguing users ought to be compensated as paid spokesmen or allowed to opt out and not have their names attached to sponsored stories.
"If the mobile ads were well targeted and creative, that would be a good thing, or at least not an annoying thing. But the ads seem untargeted and not very creative," says Rich Greenfield, an analyst at BTIG in New York. "Facebook seems to be proud to have the biggest and most disruptive ads on mobile devices. I struggle with the idea that bigger is better. It's not a great user experience. If consumers are upset with this, it could result in a reverse spiral down."
Greenfield, who now has a Neutral rating on the stock after urging investors to avoid it at the IPO, says Facebook's mobile strategy has him "getting more concerned, not less" about its outlook. He points out that 11% of Facebook users accessed the site only through their mobile devices in June, up from 9% in March. That percentage is likely to grow.
Most of those mobile-only users probably are under 25, and it's within that group that Facebook is seeing reduced usage on PCs. Evercore Partners analyst Ken Sena estimates that domestic PC users spent 12% less time in August on Facebook than they did in the same month a year earlier. His estimate is based on data from comScore, which measures U.S. Internet traffic. Sena's analysis shows that the declines were sharpest among users aged 12 to 17 and 18 to 24, which saw drops of 42% and 25%, respectively. Time spent on Facebook by PC users aged 55 and older was up sharply.
An aging demographic isn't good with a youth-focused ad industry. Will young people continue to be attracted to a social networking site frequented by their mothers and grandmothers? Some of the decline in desktop usage is being offset by mobile access, but it's not easy to assess the combined impact.
Paul Sagawa says Facebook's mobile problems go beyond the small screen size. "The paradigm shift to the app model is unequivocally bad for Facebook," he wrote in a recent report. "Facebook is designed to be open all the time, to be visited in the gaps of the day or as a platform in its own right, bridging to a variety of activities related to the social network." The app model, he says, disrupts this approach. Users open a mobile app for a reason and close it as soon as they are finished. "Why use Facebook to play a game, read an article, manage your photos, stream music, or shop," he wrote, "when you can select a specialized app directly." Moreover, Apple and Google, which control most mobile operating systems, siphon away some of the revenue from Facebook apps.
The app model may favor more specialized sites like Twitter, Pinterest, Yelp (YELP), LinkedIn (LNKD), and Trulia (TRLA), the real-estate Website that had a hot IPO last week. Facebook, Sagawa says, ought to create more specialized apps, like Instagram by Facebook, Facebook chat, or Facebook messaging tied together by a common user name and password.
IN COMING MONTHS, FACEBOOK'S share price could be depressed by significant sales by holders subject to expiring lock-up restrictions established at the time of the IPO. Already, co-founder Dustin Moskovitz has sold 7.5 million shares, or 5% of his stake, and early investor and director Peter Thiel has sold 20.1 million shares, or 80% of his holding (see table, Major Insider Sales Since IPO).
Some 234 million shares (including options and restricted stock) become available for sale on Oct. 29, followed by another 777 million on Nov. 14. That's a lot relative to the current float of as much as 692 million shares, representing the 421 million sold at the IPO and another 271 million shares on which lock-up restrictions already have expired. The total share count is 2.65 billion.
Zuckerberg's recent decision not to sell any of his 504 million shares for at least a year reduced the potential flood of shares, but his decision shouldn't have been seen as a surprise. As CEO and controlling shareholder, Zuckerberg would have had a hard time selling any stock without a serious negative market reaction.
Even with the sharp drop in its share price, Facebook remains a richly valued bet on the company's ability to wring a lot of revenue from a huge and potentially fickle user base. Facebook's mobile woes aren't likely to go away. Stay away from the stock. It could be heading to the mid-teens.
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