It just hit me this morning. Facebook (FB) is nothing more than a 21st century version of IBM’s (IBM) CompuServe. That service itself never really made much money, but the way CompuServe did make money was through advertising at the bottom of every page.
So I’ve been sitting here wondering why I haven’t invested in Facebook stock. After all, advertising businesses can make a lot of money. But then I remembered that there are serious problems with pure-play advertisers.
The bottom line is that advertising doesn’t solve a problem. That’s what Mark Cuban always says — does the product solve a problem? Well, in the case of FB, not really.
So my ambivalence is that Facebook stock is driven by a nice and growing advertising business, but what is its long-term value and vision? Without a problem to solve, it’s “just” an advertiser. Not that this is a terrible thing, but then it should be valued as an advertiser.
There are pure-play advertisers, but they’ve been selling forever, and are diversified. Facebook is new to the game. What happens in a huge financial downturn? Everyone got clobbered in 2008 and ’09. Facebook wasn’t really ramped up by then. What happens next time?
What if Facebook stock isn’t the same thing in five years that it is today? What if some new platform comes along?
Facebook stock reported earnings recently. Let’s see what those numbers tell us in regards to advertising.
Facebook Stock Earnings
Revenues hopped 39% year-over-year to $4.02 billion. Actually, they increased 50% after accounting for the strong dollar. That growth is admittedly a lot better than most advertisers, but 95% of Facebook stock revenues are advertising, so… yeah, FB is an ad play and that’s it.
I think mobile technology is going to play some role for FB in the future. We see that mobile revenues grew to $2.9 billion, a 75% increase year-over-year. That growth speaks to the overall dedication of the business to mobile technology, and reflects the user experience.
However, two points about mobile need to be made. First, in terms of subscribers, mobile growth is admittedly pretty impressive. Monthly active users increased 21% to 1.3 billion. FB says 968 million people are using it daily, which lends credence to the fact that it is a vital part of a lot of people’s lives. Should I be impressed that this number climbed 17%? Yes, considering the Law of Very Large Numbers would say growth should be less.
Second, mobile ads now account for almost three-quarters of ad revenues, and that’s an increase from last year’s 63%. I seriously worry about an advertisement business that is this poorly diversified.
Here’s a metric that people should talk about more: average revenue per user. Cable and satellite companies use this metric. This is the one you want to watch for in each report. ARPU increased to $2.76 in the second quarter from $2.24 in the year-ago period. That 23% increase came on a decline of 55% in ad impressions. That means that fewer ads are being purchased. How can this be? Because the cost of ads rose by a whopping 219%.
This means that advertisers who find value in FB are really finding value in FB and willing to pay higher prices, while advertisers who aren’t having luck are moving on.
I don’t like this development, either — once again, it shows a lack of diversification.
I also think it’s telling that net income declined by almost 10% to $719 million. Despite these really good growth numbers, Facebook stock is making less money.
Bottom Line on Facebook Stock
Having now re-assessed Facebook, I see my gut was right. Unless and until FB asserts itself with some new revenue streams, I’m not comfortable buying into a narrowly-diverse pure-play advertiser.
As far as valuation, I can’t say it’s unreasonably valued. I give FB a 10% premium for its brand name, and free cash flow — all on analyst estimates of 27% long-term growth. However, fair value is about $66 — about 30% lower than current prices.
Again, it’s not unreasonable for a growth stock, but I’m not just loving the business model.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he did not hold a position in any of the aforementioned securities. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
