by John Jagerson | June 1, 2012 2:00 pm
Recommendation: Facebook‘s (NASDAQ:FB) $38 IPO price was based on subscription interest, not long-term fundamentals. Look for Facebook’s valuation to eventually come in line with other tech giants based on true growth rates. We recommend allowing FB to come down 30% from the IPO price before timing a new entry. Traders at the $26 per share level could see a bounce similar to what we have seen with recent IPOs once the hype has cooled off. A situation like that represents a reasonable risk/reward trade-off.
Writing about Facebook as an investment is a risky business, not only because it’s so soon after the IPO and its manic introduction but because offering opinions on it right now is like dangling meat scraps to rabid wolves — with you as the meat. It’s tough to find neutral opinions about the company, its way of doing business or its impact on users’ lives. With FB’s public debut serving as such a lightning rod, perhaps it’s advisable to follow the rule of thumb when discussing politics or religion: better not to bring it up in polite company.
But not here. Call it a masochistic streak or a numbness to the risk, but the new issue is garnering, and demanding, too much attention to not offer a bit of commentary. Many brokerage firms are talking about the FB IPO as one of the first signs of life from average retail investors since before the 2008 crash. It had one of the highest rates of retail interest of any IPO, with well north of 20% of all shares going to retail allocation. That’s saying something.
An IPO that brings the still shell-shocked and the still skeptical out of the woodwork, the burned investors who still cast a wary eye toward Wall Street, the disillusioned among the 99%-ers, the Tea Partiers and everyone in between … well, that deserves a closer look.
As with other delicate topics, we’ll try to take a Switzerland approach and not take sides. Instead, we’ll discuss pros and cons, and whichever sides speaks to you, then perhaps some information here will help you make a sound decision.
By way of disclosure, we’re steering clear of FB, at least for the time being but most likely for quite a while. There’s too much emotion at this point. And if our experience has taught us anything, it’s that staying dispassionate is one of the few weapons you have to protect your money as a retail investor.
Be mindful of the large gulf between the value of FB to users and the value of FB to investors. Once emotion exits the equation, FB will be graded similarly as other stocks, and you will be able to know if it presents value to you as an investor.
That said, and with only a handful of trading days under its belt (alas, not much in way of technicals to analyze yet), here are several issues to digest if you are considering FB.
It’s still Zuckerberg’s company. CEO Mark Zuckerberg has shown remarkable tenacity in retaining control as FB has grown, and it’s questionable to what degree he will a) be answerable to shareholders in the traditional public company way, or b) work to appease shareholders and meet their demands. If investors begin clamoring for higher growth rates or more innovative ways to pull revenue out of FB’s user base in ways that veer from Zuckerberg’s vision, which direction would he go?
The answer is likely found within FB’s eight-year history to this point. Of course, having a maverick at the helm who bucks tradition is a double-edged sword. A management team that runs a company with its own agenda and shows less regard to investors’ concerns than usual can be a blessing or a curse. It may result in unique innovation and stellar blowout quarters, or it may result in eventual shareholder lawsuits. Sometimes it ends up with both.
But however you cut it, an investment in FB is, to a large extent, a wager on Zuckerberg’s talents, his vision, and, perhaps most important, his priorities.
Is Facebook a service company first, a money-making enterprise second? Speaking of Zuck’s priorities … what if we’re seeing a new breed of technology-based companies in which money isn’t the bottom line? Many beloved sites form part of the backbone of our online lives, sites we’d never want to see go away. But we wouldn’t want to invest in them, either: Wikipedia, Craigslist, your favorite blogging sites.
Wall Street is driven on the expectation that companies seek to maximize profit. Virtually every metric we have for evaluating a stock’s worth has this assumption built into it in one way or another. Either FB will eventually find its way into this profits-first mold, while not disrupting the essence of Facebook’s ecosystem, or it will be one of the largest public companies to challenge Wall Street dogma — and will probably quickly learn that Wall Street isn’t the place for it.
FB’s IPO size implicitly changes the rules of the game. It was the fourth-largest market cap offering in U.S. history and second-largest in amount of money raised. Note the other IPOs that were similar in size. Visa (NYSE:V) (in March 2008) processed nearly $2 trillion in credit and debit purchases in 2010 and has over 650 million cards in circulation — in the U.S. alone. GM (NYSE:GM) (in November 2010) is the world’s largest auto maker by number of vehicles sold in 2011. You would be hard pressed to find two companies that leave less doubt as to how they make money.
Hence, the significant uncertainty about how FB will monetize its user base, currently at one-seventh of the entire global population, means the expectations of the FB experience might have to change in the near future.
Does FB have true peers? Other tech giants that have shown as much innovation or more than Facebook are currently trading at not just cheaper multiples, but dirt-cheap multiples. Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) are less expensive on a valuation basis than many nontech companies with lower growth rates. For FB to justify its multiples and meet its implied future growth rates, it has its work cut out for it.
GOOG currently sports a price-sales ratio of 4.9, while AAPL’s is 3.5. FB has a P/S of 25.9. Forward P/Es are similarly divergent: GOOG and AAPL show 12.1 and 10.4, respectively. FB exhibits 56.7.
If GOOG and AAPL, with their robust growth rates and established markets, are guidelines for the Street’s eventual valuation expectations for FB, the stock has some rough sledding ahead of it. After all, a dollar earned from FB isn’t any more special than a dollar earned from AAPL.
Pulling rabbits out of the … hoodie. Buying FB in the open market — aside from short-term trading that ignores fundamentals — is banking on its future creativity. As it stands, FB’s revenue model is selling ads — highly targeted ads based on tons of user information freely offered by the people being marketed to. However, if this remains the sole or primary source of revenue, it’ll make FB a media company with social networking only the means to the end as far as Wall Street is concerned. It will be graded by time-tested metrics, tailored slightly to its business model.
However, if FB can figure out how to turn its unique networking platform into something more than ad-selling — how to use its potential for data aggregation, broad-based collaborations or new services available only through FB that users would happily pay for in the same way they pay for phone or cable — then the Street will have to reevaluate its models to account for FB’s extremely sticky 900 million user base.
Currently, with a $4 billion top line, FB is making only 37 cents per month from each user, or $1.11 per quarter. No doubt, there’s is potential for significant growth. But to realize the kind of growth rates implied in the IPO pricing, new revenue streams are going to have to materialize. It’s difficult to imagine that ad selling — even highly targeted ads — will accelerate to the degree needed to support these valuations. Lots of gold is buried in Facebook’s hills, but digging it out in traditional fashion could turn the landscape ugly.
It will hinge largely on Zuckerberg and FB’s hacker ethos to sleuth out ways to mine that gold without disrupting the social intimacy and personal choice that keeps Facebook alluring to its users. If FB becomes a pure ad seller, even a premier ad seller, the IPO price will turn out to be way too rich. But if it figures out how to extract its riches without disturbing its beauty, then the current price may eventually be seen as a bargain.
The FB culture: long term over short term. Investors who did receive some allocation in the IPO and were looking for a quick, handsome gain will get no sympathy from FB if the stock keeps heading south. Zuckerberg & Co. have always emphasized their concern for realizing long-term vision over making appeasements to short term obstacles. (Note how every new change to Facebook’s layout or news feed is met with resistance and grumbling from users, but eventually helps bolster long-term growth rates.)
For what FB wants to accomplish, boosting the IPO price to $38 in the final stages before trading was a strategic move. Its motive was to raise more cash for its projects, not help speculators get an quick outsize return. In this sense, the IPO was perfectly in line with FB’s philosophy. As Zuckerberg said in a letter prospective investors: “We don’t build better services to make money; we make money to build better services. And we think this is a good way to build something. These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.” (Italics ours.)
That’s a crucial admission, and you should be sure you’re aligned with it if you decide to invest in FB for the long haul. (See #1 and #2.)
If you’re looking for fast money, FB could burn you. But if you have faith in FB’s long-term future – with a commensurate steely resolve to ride out the swings, big pullbacks in the stock could be opportunities to make you look crazy like a fox.
Tread carefully, and know exactly what you’re buying.
– John Jagerson and Wade Hansen, SlingShot Trader
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