Facebook Is a Growth Trap

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

Facebook (NASDAQ: FB) has over 950 million users. In the past twelve months, the company has generated over $4 billion in revenue and about $1 billion in profits (excluding share based compensation charges in Q2 2012). In Q2 2012, Facebook’s monthly active users and daily active users were up 29% and 32% year over year, respectively. Additionally, at the end of June, Facebook had 543 million people using its mobile services every month. That number is up 67% year over year. Facebook is exploding, but it has an underlying problem.

The problem is that Facebook has no business moat. There is nothing that would prevent it from being cast aside like Myspace or Friendster. Yeah, it can be argued that Facebook is the cause of those other networks’ declines, but the very same thing can happen to Facebook. One of the most important questions investors can ask themselves, before buying a company, is, “What is this company’s competitive advantage?” The biggest competitive advantage of Facebook is probably its one billion users. However, as has been demonstrated by Myspace and Friendster millions of users are not a viable defense against competition.

Compounding this underlying problem is Facebook’s ridiculously high valuation (yes, even at $23 per share). Currently, Facebook’s market cap is $49 billion. Additionally, the company has close to $5 billion in stockholders’ equity. Subtracting the $5 billion in equity from the market cap gives $44 billion. Thus, using Facebook’s trailing twelve months profit of $1 billion (non-GAAP), it would take Facebook 44 years to earn its current price. It is already difficult to bet that Facebook will be around for another 10 years let alone another 44 years. Facebook would have to quadruple its profits to get that number down to eleven years. Even then, Facebook would still have the underlying problem of no business moat.

Recently, Mark Zuckerberg, CEO of Facebook, interviewed with TechCrunch. In the interview, Zuckerberg talked about Facebook’s focus on mobile devices, plan for Instagram, and plan for a search engine. Basically, Zuckerberg was very enthusiastic, but he presented no significant plan for growing Facebook’s profits or a way to protect it from competition. Yes, he plans to focus on mobile device users, who are statistically more active users. On Facebook’s Q2 conference call Zuckerberg said, “On average, mobile users are around 20% more likely to use Facebook on any given day.” Applying that increase of 20% to profits, that is an increase of only $200 million. Actually, more than half of Facebook users are already mobile users so the actual benefit is less. Regardless, if that is the big roadmap for monetizing Facebook, then investors are in trouble.

With regards to Instagram, Zuckerberg’s big plan is to keep it as an individual entity and support it with Facebook. Finally, Zuckerberg plans to challenge Google (NASDAQ: GOOG) in search. Honestly, this is a bad idea. Although Zuckerberg said that Facebook does about a billion search queries a day, Google has literally mopped the floor with the competition in search.

Currently, Google has a market share of about 85% (netmarketshare), a level it has maintained for years. In comparison, Yahoo! (NASDAQ: YHOO), Microsoft’s (NASDAQ: MSFT) Bing, and Baidu (NASDAQ: BIDU) have market shares of 7%, 4%, and 2%, respectively (netmarketshare). Yahoo tried to compete with Google in search, but eventually gave up. Yahoo’s search engine is now powered by Bing. Meanwhile, Microsoft has been bleeding money with Bing. The only one that has been faring well is Baidu, which is a Chinese search engine. Basically, it is a terrible strategy to challenge Google in search. Google has squashed every competition including the behemoth Microsoft. An ugly fate awaits Facebook if it goes down that road.

In summary, Facebook is not a good investment. The company has no moat and no sound strategy to significantly monetize its one billion users and grow its revenue. Additionally, Facebook has plenty of competition, like Google+, that threatens to pull the rug out from under the company. Finally, its valuation is insanely high. Even using the non-GAAP earnings of $1 billion, the company has a PE of 49. Will Facebook last 49 years? Probably not, it is doubtful that the company will even last another 10 years. Facebook is a growth trap.

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Alvin owns shares of Microsoft. The Motley Fool owns shares of Baidu, Facebook, Google, and Microsoft and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Baidu, 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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