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Matthew Indyke and Brian Zen
Zenway Investing
Articles (23)  | Author's Website |

Facebook Loses Face in Overhyped IPO

July 06, 2012 | About:

Facebook (NASDAQ:FB) has fluctuated greatly since making its debut on Nasdaq on May 18. The price, since that time, had a wild drop from $45 to $25.52. As of June 29, Facebook sits at $31.30. Its high of $45 occurred within only a few hours of the $38 IPO. And at the conclusion of that first day, the stock closed below $38. Facebook has not reached that price level since. Bulls suggest it could be the next Apple (NASDAQ:AAPL) or Google (NASDAQ:GOOG) waiting for its big breakthrough. But the bears fear that Facebook's future in the public market could be doomed based on factors like its overvalued price and uncertain revenue sources. "These stocks just do not make sense," exclaims CEO Clem Chambers of investment website ADVFN.

Here are the reasons why Facebook could struggle to surpass its $38 IPO price for the remainder of the year:

  • IPO experts opine that Facebook's sky-high valuation is unjustified due to unproven monetization efforts on the mobile platform, the new competitive front.
  • Facebook's price-to-sales ratio of 16.60 is four times higher than the next-highest price-to-sales ratio among its competitors in the industry of internet information providers.
  • Analysts are increasingly concerned about how Facebook will make enough money, particularly with its heavy reliance on advertising, a limited and crowded market.

An Overhyped IPO

Facebook's IPO has been severely criticized for mismanagement, thanks to uncertainty surrounding the business model, leading to a sharp price decline. Facebook may be one of the most popular tools in the social networking age but the company's monetary value is a different story, especially when operating as a mobile-based web site that does not charge its users to sign up for an account.

Facebook revolutionized social networking the same way that Google revolutionized the internet search over a decade ago. And Google also did not charge users for its services. But Google appropriately valued its IPO when it went public because management knew where it was making money and how they could use it in the future. Facebook, aside from its basic communication features, has been experimenting with various mobile features and acquisitions since its inception. And those have received mostly mixed results from users. Facebook's popularity, for one thing, is based on the engaging apps from its third party developers, particularly Zynga (NASDAQ:ZNGA). However, Zynga's narrow product portfolio has been blamed for a waning interest in social games on the platform. The games are meant to add to the Facebook experience. But have they been a hit with users and do they charge in the right areas? Facebook earns the majority of its non-ad revenue from Zynga so any hint of dissatisfaction in users should suggest that Facebook's value is not as high as the IPO suggested.

Facebook appeared to heavily value its IPO on its popularity and quantity of apps while focusing less on where value was actually being created. Morgan Stanley allegedly advised the company to boost its number of shares offered by 25%. Facebook's high valuation anticipated a surge in sales from Facebook. Yet Facebook may not have the earnings and sales to justify its IPO valuation. It threatened to cost stock brokers and investors millions because they overpaid for value that wasn't there on the day of the IPO filing, as evidenced by Facebook's dropoff from the $38 IPO price.

The Peak of the Second Internet Startup Hype

The fact that Facebook is worth 16 times sales can be attributed to a market that is quick to jump onto the hottest company. Facebook may be a great company for how it has shaped our society. Investors can easily get excited when a company like those goes public. But Facebook is not a company like Apple that sells an item which people consume. Apple makes a ton of money by selling a ton of products and mobile offerings. But Facebook doesn't sell products and its mobile offerings are an uncertainty to this day. Along with an industry-high P/S ratio of 16.60, the P/E of Facebook is an outrageous 77.54. Investors should be unwilling to pay current high valuations for a shift to a better revenue-generating regime that has yet to happen. Among internet information providers, investors are more likely to consider a company like Yahoo (YHOO) or Google long before they consider Facebook. Yes, they are both more attractive investments. Google is expensive but its price is more reflective of actual business. Yahoo's price, while cheap, is also more reflective of actual business. Yahoo also has an advantage over Facebook in that it recognizes where its money is best spent, those being on added features like news and sports and less on internet searches. While internet search still exists on Yahoo, they wisely conceded that to Google to focus on other areas where they could be profitable. On the other hand, Facebook's price is a result of anticipated future growth that we don't know will happen. If Facebook employs a similar strategy to Yahoo, it can see similar success in the future.

Future Revenue Unstable and Uncertain

Facebook offers a social networking platform where we can get some news, chat a bit and get a date if we're single. But when you strip away all the yammering about social networks, what remains is this: Facebook is a lovely garden on the Internet that makes its money by selling advertising. The company recently acknowledged that it was struggling to sell ad inventory to mobile accounts. Not to mention that GM, on top of this, withdrew its ad partnership with Facebook a day before the IPO, a real sign that depreciated advertising potential was present in the company. "There's no question that the company has grown revenues significantly, but we're concerned about the level of spending that we've seen recently, and expect to continue to see," says Scott Kessler from S&P Capital IQ.

The need for Facebook to grow and invest is not a new revelation as business investment spending is designed to drive growth, be it through acquisitions, as are its plans to expand overseas and to grow its mobile business. What is unknown is the amount of money that will be spent to achieve its goal, as well as where it will be spent. Although Facebook has made a number of acquisitions to boost its mobile offerings, the lack of adequate ad coverage for the mobile platform may hurt its revenue earning capacity going forward.

The advertising growth rate has slowed significantly and Facebook is still figuring out how to pick it up again.

How Facebook May Find Future Success

Facebook has its pluses: a visionary and highly competitive CEO, a huge and loyal customer base, a talented platform development team and engaging apps. As Facebook continues to expand into new territory, the company can increase its focus on improving monetization from other app developers besides Zynga. Its massive user base and ability to track personal details make it a formidable force in the online ad market. And it can use this massive database to help advertisers target relevant ads going forward, as it still has significant growth opportunities by increasing online advertising spending. Right now, Wall Street pretty much feels the same about Facebook today as it did a month ago, which is to say, mixed. Richard Saintvilus of TheStreet.com suggests that Facebook should be fine in the long term but is likely to experience some wild swings that leave its year-end price in question. A big wild card is when Facebook might be allowed to get into China. However, China's social media market is already dominated by giants like QQ and Renren. How Facebook can muscle into an already occupied market is still a question in the air.

(Disclosure: Authors have no position in FB.)

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