Thursday, 24 May 2012

Schadefreude as post IPO Facebook sells-off

Early investors in the over-hyped social networking portal Facebook could not be happier: they managed to cash out most of their stakes while the company was in the extremely overvalued price range. The recent initial public offer raised $16 billion, at an initial price of $38. According to that share price, the internet company was valued at $104 billion, with a price earnings ratio of almost 100 times the expected profits of 2012. Google, a proven internet advertising and search engine giant is valued at 13x earnings. Is Facebook still overvalued ?

Facebook background

The valuation of Facebook based on prices of shares traded on secondary markets reminds of an exponential function: in 2008, the internet company was valued at $3.75 to $5.00 billion, in 2010 it reached $11.5billion, based on the prices on SecondMarket, a private company trading platform, and in 2011 Goldman Sachs raised $500 million for 1% of the company, thus estimating the total worth of Facebook at $50 billion. Based on new-age metrics such as the number of active users, the percentage of internet visits out of total visits and the number of pages visited, Facebook could seem a good bet. At the right price. 

Even though, by many accounts, the increase in average Facebook accounts and active users has been stratospheric, growing from 100 million in August 2008, to 500 million in July 2010 to 901 million, the last pre IPO reported figure, the company continues to suffer from the "internet company dilemma": it is easy to attain extremely fast growth of non-paying users, but it is increasingly difficult to translate these into revenues. As Facebook`s main revenue stream comes from targeted online advertising, it is in direct competition with more established mammoths like Google. 

But even though Google may have less information about its users than Facebook does, Google has a far bigger advantage: it posts some of the ads when people are legitimately looking for the advertised product or service. For example if you Google massage parlour, Google may include an ad of a local massage parlour, whereas Facebook would have to work out based on your information if you are included in the target population. It is harder for the social network to ascertain if you have a genuine interest in the ads they publish and this is proven by the way lower click through of 0.041% and an average cost per click of $0.8 while Google has an average click through of 2% and cost per click of $1.2. Another problem with Facebook`s strategy is that most of its ad revenues are from the United States and Canada region, where the average revenue per user is $2.86, whereas the global average is $1.21. Most of the growth in users stems from Asia and the Rest of the World regions where average revenues per user are $0.53 and respectively, $0.37. 

One interesting business opportunity is brokering for in-game digital goods: from tractors to gems or special powers. Any game or platform that uses Facebook to distribute its content is charged 30% of its revenues. Take Zynga, the creator of Farmville, for every in game item or credit purchased by a user, it has to give Facebook a cut. There are good growth opportunities in this sector, but it currently accounts for a tiny part of its total revenues: $557 million out of $3.7 billion.

Facebook IPO and Nasdaq problems

The Facebook IPO was not a very successful one: main street saw a 20% depreciation of the IPO price, Morgan Stanley was forced to defend the IPO $38 level, with great costs for its trading division, and over-hyped investors saw some of the bubbly valuation deflate. As discussed in a previous article, besides Linkdin, recent internet company IPO have disappointed.Groupon, Zynga, Pandora, Youku, Dangdang, Home away and Friend Finder Networks are deep in red ink.

Back to the Facebook IPO, Nasdaq acknowledged massive technical glitches which caused heavy delays in the execution of buy and sell orders, not to mention defective trades. It even admitted that had it foreseen all the problems investors would encounter, it would have called off the IPO. From WSJ:

Nasdaq said it can't promise customers they will be compensated for losses due to its IPO system failures.

"We don't ultimately know whether everyone will get a dollar on the dollar," Mr. Noll said, saying the ultimate payouts will depend on regulatory approval and sign-off from Nasdaq's own board.

The exchange operator has been in touch with Facebook since the IPO blunder last week, according to Mr. Noll, and those conversations were "ongoing," he told brokers on the conference call.

When asked why Nasdaq hadn't tested for the high levels of order cancellations that it said drove the technical problems with Facebook's IPO opening, Mr. Noll said on the conference call that exchange officials believed they had sought to address such potential issues.

What next ?

The price seems to have stabilised near the $32 mark, about 20% below the IPO price. According to a ZeroHedge article European financial institutions have seen an overwhelming demand of so called put warrants (similar to put options), with the put to call ratio at 70/30 as of the 24th of May. This signals that retail investors are considering a further major downturn in the social network stock price. While the company boosted high active users growth rates in the past, it has reached relative saturation on its most profitable markets: USA and Europe.

It has to develop new ways to boost the profit per user, rather than rely on expanding its user base. Until it comes up with something consistent, a valuation of 71 PE ratio and a PEG ratio of 1.8 imply way to many risks. I don`t know what the market expects, but in a time when the average PE of the SP500 is close to 13.5, a fairer valuation of Facebook`s net income streams would be at close to 30x PE, and a price of $16 given its current profits. It hasn`t reached its mature stage yet, it still has some growth potential, but the current metrics only reflect AAPL style hype.

1 comment:

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