Investors Didn't "Like" That
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It's unfortunate that investors are having to learn this lesson the hard way. However, it's rare that a technology company that's already well-established and seemingly dominating its market can make so many mistakes in such a short amount of time. I've written in the past that Facebook (NASDAQ: FB) didn't seem like a great opportunity to me, because the company waited too long to sell shares in the open market. Investors who bought on the first day of trading have certainly suffered, and after this initial earnings report, their suffering appears to continue.
Facebook was overpriced when it went public, and a disappointing first earnings report isn't helping the stock price. The company is not the hyper-growth enterprise that many might have envisioned. With revenue up 32.29%, one would expect earnings-per-share to jump by a significant amount, however EPS was essentially flat. The scary thing for investors is, this trend is likely to continue based on several factors. In Facebook's initial filings, the company said that it did not make any money on mobile usage and yet called mobile one of the future growth drivers. If mobile is going to be the company's future, that future is likely to be a lot worse than Facebook investors realize. The company hasn't figured out how to monetize mobile users, and their customized apps have gotten a lot of bad reviews. While mobile represents challenges of its own, the company created much of this issue by spending money faster than it increased sales.
Many people look at Facebook as the dominant social networking site; yet just because a site has more users, it does not necessarily mean it will make more money. Facebook now has 955 million active users which was up 29% on a year-over-year basis. With daily active users at 552 million, up 32%, it seems like the company should be doing well. The largest percentage of user growth occurred in mobile active users which increased 67% to 543 million. Here's the problem, all of these users are not necessarily engaged in the site. A perfect example is, as I'm writing this post, I'm also logged into Facebook, Twitter, and several other tabs in my browser. When I start up my browser in the morning, multiple tabs are automatically opened and Facebook is one of them. This means I am one of the active daily users, but I might only look at the actual site once or twice a day. I doubt that I'm the only person who has Facebook up on their browser who isn't interacting with the site on a regular basis. Investors need to be careful that they don't assume that greater active users are really “active.” User growth is a positive factor, but the type of expense growth that Facebook allowed in the last three months seemed a bit out of control.
The company cited share-based compensation expenses as a primary driver in expense growth. However, even subtracting this line item, every major expense category grew much faster than either revenue category. For instance, cost of revenue was up over 74%, and even without share-based compensation this cost increased 45%. Excluding share-based compensation, marketing and sales costs increased over 88%, R&D increased 150%, and selling general and administrative expenses were up over 190%. I'm sure investors in the company would say that they don't mind high expense growth if it means better future earnings growth. However, with capital expenditures up over 200% and over 24% more outstanding shares, the company already had a big challenge to grow earnings. Even if the company brings these costs in line with revenue growth, the shares look far too expensive to consider when you realize the alternatives available.
At the current price, Facebook's forward P/E ratio is about 48. With analysts calling for growth of 27.7%, the shares are already priced for perfection, and that's after the large drop that investors just experienced. In addition, I have to wonder if this future growth of over 27% is realistic. With one of their largest paying customers, Zynga (NASDAQ: ZNGA), showing disappointing earnings, this has to be a drag on Facebook's results as well. Since Zynga is only expected to grow earnings at about 23%, it makes me wonder how 12% of Facebook's payment revenue can grow at 23%, and the overall company grow at nearly 28%? With that as a backdrop and considering the two primary alternatives, this choice is a no-brainer.
Google (NASDAQ: GOOG) is usually mentioned right along with Facebook as one of the top technology companies. Whether Google+ is ever a significant factor in social networking actually might not matter. The company's core business of search and advertising is growing at a fast pace and is highly profitable. The fact that you can purchase Google shares for less than 15 times 2012 earnings estimates and you get a company expected to grow at nearly 16% in the future makes it seem like today could represent a good entry point. Another company that might not seem like such an obvious competitor is Microsoft (NASDAQ: MSFT). However, if Facebook investors expect Microsoft to sit on the sideline and watch, they are sadly mistaken. While Microsoft does not have a mentionable social presence yet, over $60 billion in cash and investments could allow the company to snatch a Facebook competitor like Twitter from others that would look to make the jump into social networking. Microsoft generates a significant amount of free cash flow, pays a 2.7% yield, and is expected to grow at around 9% going forward. As you can see, next to Facebook these two companies seem much more reasonably valued, have significant free cash flow and cash on their balance sheets. While Facebook would have been a great investment three or four years ago, buying the company today doesn't seem to make sense given the alternatives.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook, Google, and Microsoft. Motley Fool newsletter services recommend Facebook, Google, and Microsoft. 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.