“Dislike” - 7 Reasons Why the Facebook IPO has Collapsed

Evan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

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(Image from New York Times)

Amid all of the hype over the world’s largest social networking site’s disappointing results in its Initial Public Offering (IPO), investors are wondering why the stock has collapsed so quickly, and whether or not this is the end of Facebook (NASDAQ: FB) as we know it.  I will pinpoint seven reasons why Facebook’s stocks have plummeted, and then answer the million dollar question: Is Facebook at the beginning of the end?

1.) Facebook doesn’t sell a tangible product

Facebook is an internet tech company, but unlike Apple (NASDAQ: AAPL) or Amazon (NASDAQ: AMZN), Facebook doesn’t have a tangible product that it sells.  Apple is known for its amazingly cool gizmos, such as iPads, iPhones, iPods, and Macs, while Amazon is the world’s largest online retailer and sells the Amazon Kindle.

What exactly is Facebook known for?  Well, it’s known for “likes,” wall posts, photo albums of your great-aunt’s vacation to Cancun, and games such as FarmVille.  Facebook doesn’t offer a “tangible” product and therein lies the problem.  It’s known for the service it provides (social networking), not for the “products” it sells.

Facebook’s revenue is derived mostly from online advertisements, with 70% of the company’s net worth derived from ad transactions.  Every time someone clicks on one of the ads, it gives Facebook a little bit of money.

Another source of income for Facebook comes from online gaming.   Facebook is partnered with Zynga (NASDAQ: ZNGA), which offers 17 online games to Facebook users.  This generated 12% of Facebook’s revenue in 2011.  Recently, Zynga’s stock has been doing fairly poorly as its earnings report missed expectations, and its stock price has tanked 69% since its own IPO late last year.  Compare that with Facebook’s decline of 38%.  Reality is setting in for both Zynga and Facebook.

Although Facebook’s business model of selling ad space and not products is similar to much of what drives Google (NASDAQ: GOOG), the internet search engine relies on providing ads that relate to what people are seeking, and thus intending to buy.  Facebook has not established that same direct link from users' sessions to their current purchasing decisions.

In short:  Facebook, unlike Apple or Amazon, doesn’t have a solid product line.  It’s known for its free services, but when things are billed as “free,” there is a problem for the company--because there is a cost.  Unfortunately for Facebook, it turns out that they’re having trouble transferring those costs to someone else.

2.) The “product” they sell, nobody wants

A major issue is arising for the social media giant.  A lot of users are not keen on “buying” the staple “product” Facebook offers - the advertisements.  Non-mobile users don’t typically return a large click-through rate.

However, there is some slightly encouraging news for Facebook in that mobile ad click-through rates are very good.  Although the sector is in development, mobile ads (ads seen on cell phones) get 13 times more clicks than non-mobile ads (desktops/laptops, etc.).  Facebook needs to focus on this sector as it is a key engine for its growth.

Look at Apple.  It has products that people love to buy and use.  With Amazon, it is a one-stop shop over the internet to buy almost anything one could think.  Facebook doesn’t have those same advantages.  Although its growth in the mobile sector is encouraging, Facebook still has a long way to go with its “products.”

3.) Facebook is free to use

As Facebook usage skyrockets, the revenues do not.  Why?  Quite simply, Facebook is a free service.  It is more difficult to monetize usage when that usage is inherently free.  The question is, do users want to be customers?  Online game companies are able to make profits by charging their subscribers only a few dollars a month.  Some people would be willing to pay a similar fee for social networking if it meant not having to look at ads or get their posts promoted. 

Facebook has promised that it will always remain free.  However, it can generate revenue by offering special features for a small fee.  This is a potential business opportunity that Facebook has already started to experiment with.  Facebook is testing out a new pay-to-promote idea which publicizes people’s posts and “stickerizes” them on their friends news feeds.

 

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This has the potential to be a nice chunk of change for Facebook.  The company, as previously mentioned, has over 900 million users worldwide.  If one in ten decides to highlight one post a year, that’s $160 million in additional annual income for Facebook.  Social networking “addicts,” who rely on Facebook to grow and maintain their social circle, will probably pay to highlight far more than one post a year, because it’s worth it to them.

Apple doesn’t have this issue of being “free” to the user because it is a company with a slew of high quality products.  More importantly, most of the time, in order to get what you want on your i-device, you have to pay for it in the iTunes store.  The same concept applies to Amazon – in order to get products you want, you have to pay for them.  Amazon is a giant internet retailer, after all.

So, as time moves forward, Facebook needs to find more ways to make money and show investors that they can generate real, solid revenues.  Charging to be a part of Facebook would probably generate poor publicity and wouldn’t be good for its public relations.  There are other ways, however, for it to get around this hitch and generate revenue; Facebook just has to find out how to do so. 

4.) NASDAQ Trading Glitches and Stock Jitters

Zynga and Facebook have been on the receiving end of some trading glitches on the NASDAQ.  On the first day of Facebook share trading, the NASDAQ computer system delayed trade notices of the Facebook IPO.  This was after NASDAQ postponed Facebook's opening by 30 minutes.  For about the first 20 minutes, the exchange did not confirm trades placed by brokers.  They were unable to see the results of their initial orders for more than two hours.

The glitch came from NASDAQ’s program known as “IPO Cross,” started in 2006.  IPO Cross is a pre-IPO auction process which lets traders place orders and agree on an IPO price before the stock is officially launched.

Facebook initially blamed this glitch for its heavy stock decline during the first day of trading.  This might have been one of the issues, but it is clear that Facebook’s difficulties are more than stock trading glitches.

The trading glitches are seen by some as masking the “stock jitters” that investors have over Facebook.  All stocks can be subject to wide fluctuations based on quickly changing events or information.  In this fast-paced, instantaneous world, the initial NASDAQ problems caused a lot of investor concern.  But now, some investors are looking at the short-term, possibly temporary issues with Facebook’s valuation.  News about Facebook is coming out all the time.  Thus, the stock is currently subjected to these jitters. 

5.) Investors filing lawsuits

The social network giant has yet another issue looming ahead. Facebook is facing dozens of lawsuits from disgruntled shareholders.  Facebook seeks to consolidate the more than 40 lawsuits it faces, while NASDAQ is pleading to keep the lawsuits it faces distinct from Facebook’s. 

Shareholders filed suit over Facebook’s alleged improper financial disclosures, while other legal motions were filed against the NASDAQ over the glitches previously mentioned.  If you’re trying to build a successful company, having forty lawsuits straight off the bat after a botched IPO certainly doesn’t help.

6.) Facebook is a highly overvalued stock – for now

Consider this…Facebook has a price/earnings (P/E) ratio eight times that of Apple.  The Facebook IPO started off with too high of a price for many investors.  Until Facebook delivers a strong revenue generation model, there is no way for the company to live up to its IPO valuation.  Usage of the site is growing much faster than revenues are.

The latest earnings report for Facebook shows revenue of $1.18 billion, and a net loss of $157 million.   Facebook has lost about $34 billion in market value since the IPO.  The company is currently not adequately persuading investors that it can sustain and build real revenue from almost a billion users.

Facebook’s growth, although it clocked in at 32% this quarter, has slowed from this point last year and the year previously.  This is a big concern for a newly public company, and is why investors aren’t thrilled with the results.

The company itself had effectively warned investors before its IPO that Wall Street expectations were too rosy.  Analysts also caution that the stock might be volatile because Facebook has not offered its outlook for the rest of the year, a concerning sign.  Although Facebook itself is a growing business, its stock has little margin for error given the lofty expectations and rich stock valuation.

7.) More public shares are on the way

The last thing Facebook needs is a blizzard of new shares hitting the market.  Well, that is what is going to happen over the next few weeks as a torrent of new shares will further decrease the stock price.

Facebook is going to open up nearly 1.7 billion shares, which is four times the number now trading.  Starting next month, lock-up provisions that had prohibited employees from selling their holdings begin to expire.  Dispirited shareholders will have yet another headache to deal with as more shares flood the market, decreasing the value.

About 268 million shares will be released in mid-August, an additional 192 million shares in mid-October and the largest slug (more than 1.2 billion shares) in mid-November.

Zynga stocks slid 7.9% when its lock-up holds expired.  Online coupon website Groupon Inc. gave back 8.9% when its locked-up stocks were released.  Typically, companies only lose about 1-2% of stock value when their locked-up shares are released in the market.  Facebook’s drop might be even more pronounced as they might have to deal with panicked sell-offs.

So now, the million dollar question:  Is this the beginning of the end for Facebook?  After all, AOL and MySpace began their marches into irrelevance years ago and have faded into the background ever since.  MySpace is still alive, albeit on life support, and AOL has been sticking around for a little while.

Facebook, however, may not share the same fate.  Some investors are hung up over Facebook’s current issues.  Give it some time.  Although it is currently struggling, Facebook will probably stick around for at least a couple more years as a culturally relevant social networking site.  Facebook might become a lucrative investment in the future, but only time will tell.


EvanBuck has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Amazon.com, Facebook, and Google. Motley Fool newsletter services recommend Amazon.com, Apple, Facebook, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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