Description

100%+ return opportunity shorting Facebook (i.e. Netflix above $250 and keeping the position size constant on the way down) given the company’s large market cap, stagnant underlying growth metrics and meaningful secular headwinds.

Background

Since becoming a short-selling specialist two years ago at a long/short hedge fund, I generated a 19% return during a 22% increase in the S&P 500 (significant alpha). During that time, I was able to generate significant returns from various overvalued companies including those in the social media space (Zynga, Yelp, Pandora, Groupon, etc.). Relative to all those ideas, however, Facebook has the most upside and due to its large size, a lower level of risk. 

Summary Outlook

Market viewpoint needed to generate 100%+ return: Facebook grows into a $50 billion valuation in ten years which assumes 15% earnings CAGR and Google’s current earnings multiple.

Base case with additional upside: Facebook’s growth stagnates and the company’s valuation falls below $15 billion.

Downside: Facebook follows Yahoo’s path. Yahoo still has millions of users but technological evolution often favors new entrants who then either quickly or gradually crowd out larger and less nimble online competitors.

Market’s viewpoint needed to generate 100%+ return

My 100%+ return expectation is based on the following optimistic assumptions about Facebook’s future performance:

1. Facebook earnings grow at a 15% CAGR for 10 consecutive years (rare) which implies $4 billion in normalized earnings. The estimate assumes the modest deceleration in growth continues.
2. Facebook trades at Google’s current 2012 PE ratio of 13x in 10 years. Google will likely grow 2012 earnings by 25% and 15% in 2013. Therefore I am assuming Facebook will maintain a high growth rate beyond 2022. It is worth noting that Google’s 2012 PE ratio adjusted for net cash on the balance sheet (assuming 25% taxed) is closer to 10x earnings so the comparison is extremely generous. And, if you run a screen for companies with net incomes of greater than $3.5 billion, only a small handful of companies have forward PEs exceeding 13x.

These two assumptions imply Facebook will be a $50 billion market cap company in ten years. The market cap projection is even more optimistic when you consider that global digital banner advertising (Facebook’s core business) is currently only ~$22 billion. Additionally, due to years of outperformance, digital ad spending is now proportional to time spent online (see Mary Meeker’s recent presentation and more on this below). Therefore, underlying market growth is likely to be limited.

In the optimistic scenario I just outlined, Facebook’s present value (using a 10% discount rate) is ~$19 billion or $7 per share (using the diluted share count provided just before the IPO date). Even if you assume Facebook starts to pay out $1 billion per year to shareholders (either dividends or buybacks) in five years, you could add an extra $1 or $2.6 billion in value.

A $19 billion valuation is ~16x ttm earnings (still a premium to Google and Apple) and only looks reasonable if you assume accounting earnings represent actual economic benefits Facebook shareholder receive.

Facebook just spent $1 billion or 100% of 2011 earnings (Instagram) on an acquisition that will generate no future revenues (and a further encouragement for new entrants). Therefore, it represents maintenance CAPEX (entirely defensive) from an economic standpoint (Facebook’s ttm is therefore $28/Instagram).  

Going forward, future CAPEX (defensive acquisitions like the Instagram acquisition) will be driven by the network effect working against Facebook. Facebook clearly benefits from the network effect but unlike a utility, for example, its existence does not imply barriers to entry for new entrants. In other words, Pinterest can quickly explode with popularity and take share of online minutes from any other company benefiting from a network effect.

Pinterest was just valued at $1.5 billion and its genre of social media is much more disruptive then Instagram's. Instagram was a photo-modifying app with multiple competitors that offer similar value (http://www.cultofmac.com/159755/want-to-ditch-instagram-here-are-the-five-best-alternative-apps-feature/). Furthermore, unlike Pinterest, Instagram is primarily a friends and family oriented photo sharing tool (i.e. the value is not as much a function of being universally used) so the networking effect is not nearly as powerful.

The distinction implies that Facebook may have to pay a much larger some to outbid a company like Google that is diligently working to break into the social media space. Facebook does not want to risk finding out what Pinterest plus Google+ would look like. Or, Pinterest could survive on its own and take a steady share of online minutes.   

More generally, as the social media market matures, further fragmentation will naturally occur. Already, many Facebook users have 1k+ “friends” which results in significant amounts of clutter. Discovering niche social media properties are a way for individuals to further define what they want to get out of the social media concept.

Additionally, billions in VC money is now trying to finance the next big innovation in the social media space. Therefore, for Facebook to simply maintain its share of minutes it will continue to engage in CAPEX (i.e. defensive acquisitions) driven by the network effect working against the company.

Even ignoring new entrants, Google’s initial failure with Google+ does not imply the threat is gone longer-term. Google still dominates e-mail, maps and a variety of other tools that could be combined to create a more practical, content-oriented social network that could exist along-side Facebook. And, Google’s large war chest will naturally make acquisitions of high growth social networks even more costly for Facebook.

Even excluding the possibility of new, disruptive social networks, Facebook’s core business faces significant headwinds.

Advertising Revenue Potential

Expectations for significant advertising revenue growth are driven by the assumption that ad agencies have yet to “figure out” or “discover” Facebook. On this point, it is important to recognize the level of effort advertisers put forth to maximize their clients return on marketing dollars invested.

For example, conclusive research (and common sense) show that a moving visual image with an auditory component (TV commercial) leaves a much deeper psychological impression on consumers then a small, digital banner ad Facebook might try to sell. And, a 30 second TV slot leaves room for significant amounts of differentiation and variety that consumers appreciate. The deeper impression and additional variety results in more short and long-term sales (higher ROIs).

Advertisers also talk about the decision-making funnel. At the bottom of the funnel (i.e. point of decision) companies like Google place ads with high conversion ratios (search ads). Facebook is near the beginning of the funnel. Advertisers pay less for ads at the beginning of the funnel because it is harder to target potential customers. Furthermore, even if targeted correctly, translating an ad into a sales is difficult. Lastly, estimated RIOs for Facebook ads have higher margins for error and thus are less value holding other factors constant.

Ad agencies carefully study these dynamics to maximize returns for their customers much like equity investors allocate capital to companies with perceived value. As a result, the market naturally becomes efficient. The idea that Facebook ads are undervalued is not realistic given this environment.

Additionally, over the past ten years, advertising dollars have clearly shifted towards digital. However, given the current spending rates is proportional on a dollar per minute spent on line basis, the trend towards digital ad spending is likely to slow. Therefore, for Facebook to grow revenue at a meaningful rate it will have to take market share which is unlikely for due to the previously mentioned dynamic.

Given these limitations, Facebook needs to grow time spent online to grow its advertising business on a sustainable basis. In the last twelve months, average time spent per month per user online has stagnated at around 400 minutes per month. And, given the large number of popular social media start-ups, (Pinterest, Instagram etc.) Facebook faces a constant stream of threats to its “share of minutes” spent online. Therefore, unless Facebook can find a way to increase user engagement (unlikely based on existing surveys and data) its key driver of advertising revenue growth will likely trend lower in saturated developed markets.

Emerging market growth may drive user and minutes used growth but time spent online in low income countries is not as valuable as time spent online in developed countries. Therefore, revenue growth is likely to lag user growth going forward.

Furthermore, as previously mentioned Facebook’s target market is relatively small at only $35 billion and is unlikely to grow at a rate that is meaningfully higher than the broader ad market for reasons previously mentioned.

From a competitive standpoint, Facebook’s product is a commodity that advertisers use to generate additional sales. GM, for example, has little reason to care where they generate acceptable returns on investment from advertising dollars. Therefore, customer loyalty is likely to be non-existent.

Additionally, with respect to substitution risks, Facebook’s best value for many companies is free (company home pages that generate “likes” and other activities). GM, for example, canceled its $20 million deal with Facebook but kept its relatively active Facebook page.

Facebook could attempt to monetize the free side of the business but there is no easy way to measure the value of having a home page on a social media site for most companies. Furthermore, companies are accustomed to free Facebook pages so changing that mindset will be difficult. Lastly, charging companies for “likes” would create a disincentive to publicizing Facebook and damage the value users get from the network.

Serious Mobile Threat

Investors are aware mobile trends create a problem for Facebook but few understand how serious the threat actually is. And, I my personal opinion, Facebook’s recent amended S-1 offered a very benign description (relative to typical risk disclosures) of a significant and quantifiable threat.  Currently only, ~$500 million is spent on mobile display ad spending. Excluding Google and Apple’s dominate positions, Facebook’s market opportunity is only $290 million. Even if this market grows by 3x and Facebook gains a 15% share, the long-term market opportunity is well under $1 billion.  

Additionally, the market is unlikely to grow by 3x for two main reasons. First, ROIs are relatively low for mobile ads. Therefore, advertisers pay less for the space. Second, due to screen size, the opportunity to place ads is more limited. There is hope that advertisers can one day figure out how to generate higher RIOs from mobile ads but the inherent limitations just described imply the upside is seriously limited. Given these issues, minutes users spend on Facebook’s mobile platform are meaningfully less valuable then minutes users spend on non-mobile platforms (tablets fall somewhere in-between).

Mobile Usage Trends

There are three main drivers of mobile usage trends. First, smart phone penetration continues to grow. Second, smart phones processing capabilities have consistently improved (the shift away from Blackberries, 4G, Samsung/Apple, etc.). Third, users are utilizing smart phones to more efficiently deal with the steady stream of social content coming from Facebook.

Many people now habitually surf the Facebook news feed or respond to message / friend requests during meetings, presentations, elevator rides or other events. The trend is motivated both by a desire to kill time and to free up future online time (which is limited for most people advertisers want to reach) for web activities that are better suited for non-mobile activities (see the surge in YouTube traffic for example or Netflix streaming movies). The result is both lower revenue per minute and fewer minutes spent on Facebook in the long run.

Additional Advertising Upside?

During the IPO process, observers floated the idea that Facebook could derive significant revenues from the “word of mouth” aspect of advertising. Currently, there is little evidence “friends” on Facebook discuss purchasing habits in a meaningful way. Most people like to keep their social life separate from their economic activities and Facebook is not changing that (technologically typically meets human needs as opposed to changing them). Economic dialogue online typically occurs on sites like E-bay, Amazon.com or the many niche blogs that review various categories of products.

Even if there is a meaningful amount of economic dialogue on Facebook, monetizing word-of-mouth activity is not easy. Either Facebook can pay users to recommend products (social media multi-level marketing?) or charge companies for world-of-mouth generated sales on Facebook (hard to prove).

Other Revenue Sources

Facebook generates some revenue from its payments business. Much of the revenue comes from digital goods sold on platforms like Zynga. But, the growth has slowed meaningfully as the market matures and users shift towards mobile platforms.  

Facebook could attempt to compete with Amazon.com but as previously mentioned, social and economic dynamics do not typically mix. Without gaining an edge from its social network, Facebook would be forced to compete with Amazon.com on cost which implies very little in the way of profits.

Overall, the big risk to improving monetization is damaging the user experience. Most people don’t like being sold on products in most social settings. And, privacy is a much more sensitive issue in the social context relative to, for example, online marketplaces.

Social Media Failure in South Korea

As David Einhorn mentioned a few weeks ago at the Ira Sohn conference, social media networks in Asia have failed to achieve meaningful success despite longer histories. There are a number of case studies (HBS, ect.) that document the failures.

Base Case

Based on previously mentioned issues, I expect Facebook’s revenue growth to slow materially. If mobile trends are strong enough and overall usage growth remains stagnant, revenue and profit growth could go negative. But, to give Facebook credit for near-term upside, I value Facebook at the same multiple as Google.

Downside

Facebook’s downside is what Yahoo is today. Millions of people still use Yahoo on a daily basis but history shows that large tech companies frequently become victims of new trends. Sometimes it is death by one thousand paper cuts. Other times, firms get marginalized relatively quickly (MySpace). No one can predict whether Facebook will be forced down these paths but rational investors need to acknowledge the possibility.

I expect the market to price in an aggressive version of the best case scenario which implies $7-10 once the stock settles. As the fundamentals become clear to investors in the next few quarters and the underwriter analysts become more “objective” the price could fall well into the single digits.

Risks

Facebook finds a way to increase it’s the value it provides to advertisers.

Facebook develops new ways to generate revenue.

Facebook develops a strategy to re-accelerate underlying usage growth trends.

Disclosure: I am short Facebook

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