Bull Vs. Bear - Facebook And Its Investors Had Unrealistic Expectations

By Will Ashworth | September 04, 2012 AAA
Question: Did Facebook and its investors have realistic expectations for the company's growth potential?

Bull's Response

How low can it go? Very low, according to Daniel Salmon, BMO Capital Markets analyst, who lowered his price target on Facebook (Nasdaq:FB) from $25 to $15 August 31, due to concerns about future lock-up expirations and a lack of revenue growth. As of the August 31 market close, Facebook shares are down 52% from the $38 offering price. At this point it's easy to be a bear and for that reason, like a true contrarian, I'm going to make a case for buying Facebook at these prices, because its problems are only temporary. Eventually the sun is going to shine on the champion of social media. Here's why:

Back in May, I had dinner with a friend who wanted to know if buying Facebook stock at $38 was a good idea. I told him that it was doubtful that he could get his hands on any shares, but even if he could, I advised against buying its stock for at least 12 months until the dust settled and investors knew more about where it was headed. Generally I'm opposed to IPOs, because they usually drop below the offering price within 12 to 24 months, making them speculative investments designed to provide liquidity to existing shareholders and not to line the pockets of those late to the party. It's just the nature of the beast.

Henry Blodget, who knows a thing or two about ridiculously-priced IPOs, has written extensively about Facebook, and while you might not respect his past, he does an excellent job of pointing out all the reasons why its IPO price of $38 was too high. As part of my argument for buying Facebook below $18, I'll examine some of his points as they relate to its future potential:

Facebook's Growth Rate Decelerating Rapidly

Its revenues in 2009 grew 186% to $777 million. It grew by 154% in 2012 and by 88% in 2011. In the first six months of 2012 ending June 30, it grew 38% to $2.2 billion. Market researcher eMarketer predicts Facebook's revenues in 2012 will grow 36% to $5.04 billion. The bad news is that eMarketer expects Facebook's ad revenues come 2014 to be growing by just 24%; the good news is that its non-advertising revenue (Facebook Payments) will account for as much as 17% of the total. While investors are getting all twisted over its inability to generate mobile ad revenue, its payments business is slowly building into a significant contributor. The company believes that 15 million users bought virtual or digital goods in 2011 out of a user base of approximately 800 million. If Facebook moves the dial from 2% of users to 10%, it adds as much as $3 billion in total revenue. That's a big wildcard.

Facebook Was Going Public at an Astoundingly High Price

When you break it all down, Google (Nasdaq:GOOG) went public at 81 times earnings compared to 91 times for Facebook. On a price-to-sales basis there's no comparison (8.5 times for Google versus 23.7 for Facebook) between the two companies. Clearly Google was growing faster when it hit the starting line back in 2004. Cut Facebook's offering price in half, however, and there's really no difference between the two.

Facebook's Operating Margin Was an Astounding 50%

Well, actually, it peaked at 52.3% in 2010. In 2011, it shed 500 basis points and at the halfway mark of 2012 it was down to 45%. In hindsight, it's easy for Blodget to suggest that its margins had nowhere to go but down. Unfortunately, investors didn't have this luxury. However, 45% is still an unbelievable number. Google's operating margin in 2004 was 20% and today sits around 30%. Sure, you can make the argument that Facebook's operating margin is going in the wrong direction while Google's is going the right way, but that fails to acknowledge that Facebook's is and was superior by a wide margin.

Mark Zuckerberg's Unprecedented Control

I'm definitely not a fan of dual-class share structures. Like everything in life, however, there are always exceptions. Reuters blogger John Abell argued at the end of July that Zuckerberg is in over his head and needs to focus on product strategy, leaving the business operations to a more seasoned executive. That's just plain poppycock. Zuckerberg was smart enough to develop and grow Facebook into a multibillion dollar business and yet the minute the stock drops in price, albeit a huge one, he's no longer capable of leading the charge. The man's only 28 years old; he's still learning how to be a CEO. Frankly, the fact that he knew enough to structure the business so his vision wouldn't be watered down by some MBA, do-it-by-the-numbers type is laudable. Some things in life are bigger than the almighty dollar and the fact he's not kowtowing to impatient investors tells me he's the best man for the job.

The Bottom Line

Peter Thiel, one of the original investors, sold 20.6 million shares for almost $400 million in August after the 90-day lock-up expiration. Between the IPO and these most recent sales, Thiel has just 5.6 million shares remaining from his $500,000 investment. The media speculated on his reasons for selling. Wouldn't you? Zuckerberg could drive the business into the ground and Thiel would still make out like a bandit. It's a smart business decision in my books. Never scoff at a profit.

Facebook should never have gone public at $38 a share. The expectations were too high. In mid-November, the largest number of shares under a lock-up agreement hit the market and will undoubtedly send the shares tumbling further, perhaps into single digits. Unless the third quarter report is a disaster, I'd be buying come Thanksgiving.

At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

Don't forget to read the Bear Side of this debate and weigh in with your opinion below.

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