Bull Vs. Bear - Facebook May Not Have The Long-Term Value

By Stephen D. Simpson, CFA | September 07, 2012 AAA

Question: Did Facebook and its investors have realistic expectations for the company's growth potential?

Bear's Response
"What's wrong with Facebook (Nasdaq:FB)?" is probably one of the most popular themes in financial/investment writing these days. The poor performance of this stock post-IPO has plenty of people speculating that there was a social media bubble (and that the bubble is now deflating), and now there are rumblings that Facebook is already on the wrong side of its growth curve. While I do think a lot of the pessimism and criticism of Facebook is overheated click-bait, I do believe that the company is growing more slowly than investors expected, and investors may want to take a closer look at some reasons to avoid Facebook.

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A Challenging Transition Is Underway
Part of the difficulty Facebook is seeing with its growth is the transition to a higher percentage of mobile access in the usage base. As investors could see in the S-1, mobile is not as profitable for Facebook and may never be. At a minimum, it forces the company to reconsider and reconfigure how it approaches this customer base. Investor expectations aren't helping matters. Similar to OpenTable (Nasdaq:OPEN) and Groupon (Nasdaq:GRPN), investors and analysts appeared to get carried away with extrapolating the initial hyper-growth into the future. Apparently, nobody stopped to consider just how much time productive adults can spend on Facebook and how many ads Facebook can cram onto the site.

How Many Opportunities Are There to Ring the Register?
Insofar as North American users are concerned, I'm not sure how much growth is left in the tank. Supposedly, more than 40% of Americans have an account and I have to wonder why anybody who doesn't currently have one would create one. That means that Facebook needs to figure out new ways to monetize the users it has, especially since it's something that can make or break Facebook.

Sponsored stories are one of the most recent examples of Facebook's attempts to create new revenue generation. Likewise, the company is looking at other sorts of new ad formats and opportunities to produce revenue. One of the key questions, though, is the efficacy of those ads - do ads on Facebook really pay for themselves in terms of driving sales for the advertisers. If Facebook goes too far with papering the page with ads, they risk conditioning users toward ignoring all of them.

Enterprise social media could likewise prove a tough nut to crack. I can understand why enterprise CIOs and senior managers do not like Facebook - it gobbles up system resources (and employee time), it creates the potential to embarrass the company and it isn't especially useful for office collaboration. In contrast, companies like IBM (NYSE:IBM) and Jive Software (Nasdaq:JIVE) are moving ahead with enterprise social media platforms that take a lot of the benefits of a platform like Facebook, but actually make it useful.

Are the Natives Getting Restless?
Closely tied to the potential for new ad opportunities is the issue of the user experience and user satisfaction. Facebook users think of themselves as customers, not product, and the company has to maintain a delicate balancing act to preserve that fiction. Along those lines, analysts and commentators have started speculating that Facebook is losing its cache. While Google's (Nasdaq:GOOG) Google+ is not a credible threat, Twitter can be.

Given that no sell-side models I've seen yet on Facebook incorporate any sort of explicit "user fatigue" function, this could be another source of potential growth disappointment. That puts more onus on the company to develop features and applications that will keep the user engaged, and that all costs money.

The Bottom Line
All of the doom and gloom around Facebook is probably a good thing for the future, as it is part of the process of washing out overheated expectations built up during the long run up to Facebook going public. That said, the basic reality still holds that investors have likely significantly overestimated Facebook's growth and now find themselves disappointed with that growth. It is not the fault of the company that analysts and investors went off the reservation with their growth estimates, there were plenty of warnings in the company's S-1, but whomever's fault it was is irrelevant - investors are now reassessing the real growth potential of Facebook and that has led to some painful realizations about the stock's value.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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

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