The market went crazy for Facebook Inc (NASDAQ:FB) again this past week as it allegedly delivered strong numbers across the board, sending the stock soaring. Yet when the data is really unpacked, and we examine what Facebook’s business and very existence is all about, investors are crazy to be buying it at its present valuation.
If you’ve ever watched NBC’s “Shark Tank,” then you know Mark Cuban often asks entrepreneurs one very simple question: “What problem does your product solve?” He asks because sustainable businesses derive from solutions to common problems.
Now ask yourself, what problem does Facebook solve?
Answer: Nothing. If Facebook vanished tomorrow, a solution to a common problem would not vanish with it. That’s because Facebook is nothing more than a bulletin board that allows advertisers to post along with people. Facebook is nothing more than a pure-play digital advertiser.
So agrees private equity fund manager Ovadia Ovi Levy, manager of KPL Capital in Naples, Florida. Levy is short Facebook and thinks investors should head for the exits.
“That’s the dirty little secret that everybody knows but nobody wants to admit to. In the history of the stock market, show me one pure-play advertiser before Facebook or Alphabet Inc (NASDAQ:GOOGL) that ever traded at 84x earnings and 18x sales.”
He’s correct. At its height, world-class pure-play advertising firm WPP was valued at $20 billion on sales of $15.6 billion – or 1.3x sales. Facebook is valued at 17.8x sales.
Levy says to concentrate on the only three things that matter about Facebook’s business: 1) its active user base, 2) the size of the advertising market, and 3) how much of those advertising dollars it gets.
There have always been questions about how many people are truly using Facebook. One analysis from 2013 suggested that 10% of Facebook accounts weren’t real. Another suggests as many as 140 million. Now that we are in election season, it is reasonable to consider that many accounts have been opened strictly for political purposes and will go dormant after the election.
Facebook itself discloses on Page 4 of its 10-K that measurements of daily active users (DAUs), mobile DAUs, monthly active users (MAUs), mobile MAUsand average revenue per user (ARPU) has its problems, “our estimation of duplicate or false accounts may not accurately represent the actual number of such accounts.
Nor can age demographics be relied upon.
“Our data limitations may affect our understanding of certain details of our business. For example, while user-provided data indicates a decline in usage among younger users, this age data is unreliable because a disproportionate number of our younger users register with an inaccurate age. Accordingly, our understanding of usage by age group may not be complete.”
Levy says, “This is not to suggest that Facebook is stuffed to the gills with phonies, but a healthy skepticism toward how many accounts are real is wise. More to the point, the question is how many of these accounts are of value to advertisers. If Facebook can’t provide an accurate number on real accounts, then advertisers cannot rely on any reporting. Therefore, they would be more likely to offer less money.”
Levy makes a great point. When we dig into the 10-K, we find that Facebook itself isn’t so sure how many people are actually engaging with the platform.
“Monthly Active Users (MAUs). We define a monthly active user as a registered Facebook user who logged in and visited Facebook through our website or a mobile device, or used our Messenger application (and is also a registered Facebook user), in the last 30 days as of the date of measurement. MAUs are a measure of the size of our global active user community. “
“So all someone has to do in order to be counted is log in ONCE in a month, and that may simply be by using Messenger and not the actual Facebook platform. Claiming they have 1.59 billion MAUs is, to me, not terribly impressive since there is really no disclosure regarding if users are logging on once or 300 times each month. How can this be a useful metric without that information?” Levy asks.
Facebook tries to solve that problem by offering DAUs, which is the same metric but measured if someone logs in once a day or more. The same problem exists. We don’t know if it is just once or more, on just Messenger or the platform or both.
“Facebook doesn’t even know if these connections are even made by humans,” Levy asserts. He’s right about that. On Page 19 of the 10-K:
“Some of our metrics have also been affected by applications on certain mobile devices that automatically contact our servers for regular updates with no user action involved, and this activity can cause our system to count the user associated with such a device as an active user on the day such contact occurs.”
Facebook offers no disclosures on how many minutes per day, or how many page views, the average user consumes.
Bottom line: Neither Facebook, nor its advertisers, actually know how many users are truly engaging with the platform at any given time.
Levy says that advertising is not a sector where there exists unlimited capital. “There is not an infinite amount of money allocated to the advertising market. That amount is limited, and only in 2015 did spending finally pass pre-recession levels.”
Moreover, for every big YOY increase in a place like India, a country like Russia sees a huge YOY decline. China is irrelevant because Facebook is restricted there. Growth in the UK is strong, but the US is pretty stagnant at only 1.4%.
In short, the maximum ad spend the world sees in any given year is about $600 billion, and that’s a fairly static number. The US accounts for about 30% of that, the giant Chinese market is unavailable, and another 14% of the market is search advertising which Facebook doesn’t even have a presence in.
Worse, the advertising market is linked to economic cycles. Advertising pulls back heavily in recessions but returns slowly afterwards. Levy points that out that, “Right now, there are serious concerns about global or regional recessions. Real GDP growth is forecasted to be weak in the US and even weaker in many developed countries.”
Bottom line: The advertising pie is finite and the trend seems more likely to call for reduced spending than increased spending.
The issue for Facebook is proving to the advertising community that it deserves more of that pie from one year to the next, especially in years when overall spending is declining.
That, in turn, means providing advertisers with reliable data on Facebook’s usage which, as noted above, is not reliable.
The shift in spending from other media to internet is not growing much anymore. Advertisers have always diversified their spend across media, and will continue to do so since other media are not going away.
Page 42 tells another alarming story.
“In 2015 compared to 2014, the average price per ad increased by 140% and the number of ads delivered decreased by 38%. The increase in average price per ad was driven by a product change related to certain non-News Feed ads during the third quarter of 2014, which decreased the number of ads displayed but increased the prominence of each ad. Average price per ad was also driven by a mix shift towards a greater percentage of our ads being shown in News Feed. The reduction in ads delivered was driven by factors including the product change described above as well as the shift in usage towards mobile devices where people are shown fewer ads as compared to personal computers.”
Facebook says that 80% of its ad revenue comes from mobile ads, where fewer ads are shown. Thus, Facebook is selling more expensive space to advertisers who want those mobile eyeballs.
Until they don’t.
Levy highlights the problem. “Facebook is not only reliant on advertising for95% of its revenue, but 80% of that revenue is coming from mobile. That lack of diversification makes it exceptionally vulnerable should advertisers find some other platform to move those finite dollars to.”
Bottom line: Facebook has little diversification in its revenue stream.
Questionable Future Growth
So given that Facebook has a finite set of dollars it must fight for, further limited by geographic availability of its product, with little diversification, in the face of possible recession, and no idea just how many people are actually engaging with its platform, I think it is nuts to rely on 50% revenue growth for much longer…much less 35% net income growth (to $3.688 billion).
As for Levy, he says definitively, “The market now puts a $319 billion price tag on Facebook stock, meaning it trades at a current P/E ratio of 84. This valuation is not deserved, and I’ll go one step further. This valuation is impossible – absolutely impossible – to sustain.”
Indeed, all growth companies slow down. The problem is that the market is valuing Facebook as an internet stock instead of what it is – an advertiser. Inevitably, a recession will hit, spending will decline, a new platform will tickle advertiser fancies and they’ll shift money around. Growth will decline to the mean. Facebook will certainly have a share of global ad spend, but not grow it at the rate it presently is.
That will push the stock price down significantly as the P/E ratio inevitably contracts.
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