More Users = Less Profits?

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 all too easy to get caught up in the hyperbole of financial commentary. If I had a nickel for every time I heard a company was revolutionizing an industry, I would never have to work again. Investors need to remember that a company can produce a product that everyone likes, but that doesn't automatically make it a sure fire investment. The best example I see in the market today is Facebook (NASDAQ: FB).

Common Sense And The Social Landscape
Facebook does have some advantages in being the first to reach its size. For instance, Google's (NASDAQ: GOOG) Google+ offering has a hard road ahead. To be blunt, I have a Google+ account that I literally never use. I have a tab open on my browser to my Gmail all the time, but I never share anything on Google+ and I don't plan on it. The reason is simple, everyone is already on Facebook and they aren't all on Google+, so why do I need another account? 

Some people have suggested that Microsoft (NASDAQ: MSFT) and their redesigned Outlook.com portal could be a real challenger to Facebook. According to Microsoft though, their Outlook site is the only one of the big three E-mail sites that allows you to connect to Facebook, Twitter, and LinkedIn. In addition, they suggest only Outlook.com and Yahoo Mail allow you to chat with Facebook friends. It seems Microsoft is going after Gmail and Yahoo Mail more than Facebook at this point.

All this being said, Facebook has limitations as well. For instance, a site like Yelp (NYSE: YELP) is more useful if you want to look at user reviews for companies. While you can post information about companies on Facebook, the site isn't designed for an easy search of company reviews. In addition, when most users sign into Facebook, they are more interested in what their friends and family are doing than writing a review of a company.

More Users Means Nothing If You Can't Monetize Them
So far one of the biggest problems Facebook has is, they have tremendous user growth, but their costs and expenses are rising even faster. The company reported they now have over 600 million daily active users, and that mobile daily active users “exceeded” this number. With revenue up 40%, investors should be happy right?

There are just a few problems. First, Facebook's income before taxes actually was down 2.88%. The driving factor behind this decline was, the company's operating margin declined to 46% from 55% last year. While this operating margin beats Microsoft at 36.22%, Google at 25.97%, and Yelp's negative margin, this is a significant drop in one year. A large part of this lower margin was due to total costs and expenses that jumped 82.16%. When a company grows revenue by 40% and spends 82% more to do so, you know the bottom line is going to suffer.

The most disconcerting number in the company's earnings report was, while advertising revenue grew 41%, payments and other fees were flat on a year-over-year basis. Since many have argued that Facebook's future could lie in payments, selling goods and services, and other features, this lack of growth in areas other than advertising seems to punch a hole in that theory.

Mobile Is Heralded As The Future And Facebook Should Be Worried
Many people took Facebook's increase of 57% in mobile active monthly users as a positive sign. Let me dispel that myth right now. Relative to their competition, Facebook is arguably in the worst position for mobile success. 

Think about their competition's business models. Google rules mobile search and they get paid per click. Even if the company makes less on advertisements, they still are able to make money. Their YouTube, Gmail, and Google Maps properties are all suited well for use on mobile devices. Microsoft's Windows 8 system works across PCs, tablets, and smartphones. Yelp's business model works perfectly on mobile devices because potential customers can read reviews of businesses while they are out shopping for goods and services.

What do users do on Facebook mobile? Honestly, 99% of the time they update their status, upload pictures, or check-in. Facebook makes exactly nothing off those actions. In addition, the Facebook app shows much less advertising since there isn't enough screen real estate for side bar advertisements. Instead, the company must use in-line advertising. While this would seem to be more targeted, the company can't possibly show as many in-line advertisements as they would on the full Facebook web page.

Avoid The Craze
Facebook doesn't appear to be the huge opportunity that many financial commentators would have investors believe. The company's stock still commands a forward P/E of 47. If analysts earnings growth target of 29% is correct, this wouldn't be a huge deal. However, based on early results, this appears too optimistic. Even on a non-GAAP basis, the company's EPS grew by just 13% in the current quarter. To reach 29% growth, they will have to massively cut expenses and the opposite has been occurring. By comparison, the only company in this space that looks more expensive is Yelp at over 109 times earnings. 

Investors looking to make a good long-term investment should avoid the Facebook craze and look to Google or Microsoft. Google still sells for under 18 times forward estimates, and generates significant free cash flow. Microsoft pays a yield over 3%, and generates so much free cash flow that 34% of their market cap. is just the cash and investments on the company's balance sheet. Facebook is a great service, but without huge changes it doesn't appear to be a good investment.


MHenage owns shares of Microsoft. The Motley Fool recommends Facebook and Google. The Motley Fool owns shares of 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus