Why We're Buying Facebook

Now that the dust has settled on one of the most-hyped IPOs in recent memory, we have decided to buy shares of Facebook (Nasdaq: FB  ) for our 10-Bagger Stocks portfolio. Does that make us Muppets?

We hope not. And we don't think it makes us delusional, either. We understand exactly what we're getting into here. Although we appreciate the argument that Facebook looks overvalued, we believe its remarkable journey is just beginning.

This dominant social platform has all of the qualities we look for in a company. It has a transformational technology. It has an energetic and engaged management team. And we think the market is underestimating its extraordinary potential. That's why we've decided to buy a small stake in the company.

Building something great together
Facebook is changing the world -- one connection at a time. It's created a platform to connect you with anyone you want, anywhere, anytime. With more than 900 million monthly active users and 125 billion connections, Facebook is off to a great start. There are almost 2.3 billion Internet users worldwide, so there's plenty of room to grow.

To understand the magnitude of Facebook's reach, let's see how it compares with online auction giant eBay (Nasdaq: EBAY  ) , which created a platform for buyers and sellers to transact with each other. eBay now has more than 100 million active users. It's incredible to think that Facebook has more than 9 times the reach of eBay.

I'm CEO ...
Facebook's purpose, according to co-founder and CEO Mark Zuckerberg, is "to make the world more open and connected." So maybe it's not a surprise that Facebook has become so huge. That was the plan, after all. Whether it's connecting with people, businesses, or governments, Zuckerberg wants it all to happen on Facebook.

Zuckerberg reminds us of Jeff Bezos from Amazon.com (Nasdaq: AMZN  ) . Bezos' dream was not to sell books. He wanted to create the world's best retailing platform. That purpose drives Bezos' decisions today. So when Zuckerberg says "we don't build services to make money; we make money to build better services," we can almost see Bezos nodding his head in approval.

To make his dream a reality over the long term, Zuckerberg has retained voting control of Facebook. Recently, Larry Page and Sergey Brin recommended changing the voting structure of Google (Nasdaq: GOOG  ) by adding an additional class of shares, thereby cementing their control at the search giant. All three felt it was the best way to ensure the company was run for the long term.

An investor in Facebook has to be comfortable with this structure -- and with Zuckerberg's vision. Right now, we are. But over time, Zuckerberg and his team will have to put up good numbers to prove its skeptics wrong.

Will the cash keep rolling in?
So far, Facebook continues to grow revenue and generate considerable cash flow. Consider these impressive sales figures:

Segments

2009

2010

2011

Advertising $764 $1,868 $3,154
Payments $13 $106 $557
Total $777 $1,974 $3,711

Source: Facebook's prospectus. Dollars in millions.

Total sales increased 88% in 2011. Advertising revenue grew 69% on a 42% increase in volume and an 18% increase in price per ad. Unfortunately, growth slowed in the first quarter of 2012 to 45%, worrying many investors.

Facebook has created an application platform for developers to access its 900 million users. Fees from the platform make up the revenue in the payments segment. And most of that comes from online payments for virtual goods in Zynga's (Nasdaq: ZNGA  ) gaming platform. Payments revenue increased 98% last quarter.

Ads and payments are Facebook's primary revenue drivers. They serve large and growing markets. Market-research firm IDC expects online advertising to grow from $68 billion to $120 billion from 2010 to 2015. NPD estimates that the market for virtual goods should increase from $9 billion in 2011 to $14 billion in 2016. Facebook's huge and growing member base should continue to attract advertisers over the years.

But following its IPO, many have questioned whether the company can continue to grow at such a torrid pace -- and rightly so. Average revenue per user (ARPU) grew only 6% in the first quarter of 2012 and declined 12% sequentially. That number has to pick up over time for Facebook to extend its high-growth period.

Still, the company has been able to turn $1 of sales into $0.41 of operating cash flow. That's an impressive statistic. We're confident that Facebook can deploy its hacker culture to develop ways to improve ad placement as well as devise new strategies for monetizing its growing member base.

Breaking and creating things
Costco
's warehouse retailing platform is an incredibly strong business model that creates lots of value. The company gives customers a considerable portion of that value via low prices. Costco captures its fair share of value by asking shoppers to pay a membership fee and by finding ways to make stores as productive as possible.

Facebook, although not a retailer, operates using a similar model. Its social platform also creates lots of value that the company gives away to members. It captures some value for shareholders by selling advertisers access to its growing member base and by charging developers a fee to do the same. No one knows all of the ways Facebook can continue to capture value for shareholders. But the platform is valuable and should become more so over time.

We're not betting the farm on Facebook. We're fully aware of the uncertainties and can understand why folks have concerns about the valuation.

And yes, we also know it's not likely to be a 10-bagger at its current valuation. Despite all of that, we want to own a small portion of this dynamic company that is changing the Internet and the larger world around us. Facebook's motto may be "move fast and break things," but no one can deny that it's pretty good at creating things, too.

Don't forget to follow us on Twitter, @TenBaggers, for all of the latest information relating to the portfolio. And don't forget to add Facebook to your personalized version of My Watchlist so you can track its progress.

John Reeves owns shares of Google. David Meier owns no shares in any of the companies mentioned. The Motley Fool owns shares of Amazon.com, Costco, and Google. Motley Fool newsletter services have recommended buying shares of Google, eBay, Costco, and Amazon.com. The Motley Fool has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (17) | Recommend This Article (20)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 24, 2012, at 10:12 PM, jr0718 wrote:

    Can you be so kind give analysis about the lock up period in November? CNBC said there would be 1 billions shares available. Should investors wait for that time to pass before jumping in? Thank you.

  • Report this Comment On May 24, 2012, at 10:22 PM, vv234 wrote:

    My question is if you are so confident about FB, why didn't you buy it when it was on sale a couple of days ago?

    Now you saw other people has begus buying it, you suddenly become confident?

  • Report this Comment On May 25, 2012, at 10:28 AM, tkell31 wrote:

    Lol, thanks for the heads up to short FB.

  • Report this Comment On May 25, 2012, at 10:31 AM, MKArch wrote:

    Facebook is in the business of selling banner ads that have a below average click through rate. There is nothing revolutionary about their business in fact it's another Yahoo and well on it's way to being valued so. The reason why Zuckerberg is telling you he doesn't care about the business he only cares about the user experience is because there is no straight forward logical way to monetize tons of people only out for some cheap voyeuristic fun. Zynga is an interesting model for monetizing social media but they're working on migrating to their own platform. My money is litterally on Zynga and I'll bet they sport a greater market cap than Facebook five years from now.

  • Report this Comment On May 25, 2012, at 10:35 AM, TeaLeaves wrote:

    Can you elaborate on the "transformational technology" that facebook supposedly has? Among MySpace, Friendster, Facebook and others of their ilk, FB got lucky, that's all.

  • Report this Comment On May 25, 2012, at 10:36 AM, SimchaStein wrote:

    And why can't FB develop games like Zynga does? Or any other 'ride' in its Billion user amusement park. (It is an amusement park - a virtual one).

  • Report this Comment On May 25, 2012, at 10:39 AM, MKArch wrote:

    BTW when Bezos told analyst he was sacrificing near term profits for the long term it was based on a "business plan" to get to the point where he had a scale advantage. IMO Zuckerberg is just telling analyst he doesn't know how else to monetize his subs and is more interested in worrying about what he does know how to do in enhancing the user experience than worrying about what else he can do to monetize cheap voyeristic entertainment.

  • Report this Comment On May 25, 2012, at 10:54 AM, MKArch wrote:

    They could develop games as well but in reading Zynga's latest 10K the sense I get is you need to be extremely focused in this new business and constantly innovating, constant new titles and updating existing. They make their money selling rewards but only a tiny fraction of their users currently buy them so there needs to be intense focus on improving this system in addition to finding creative ways to work advertising into the games. Zynga has a big head start here and I don't see any indication that Facebook is going to full bore into this space. Halfhearted experimentation isn't going to work IMO. They need to go full bore and then they have some catching up to do. Even if FB does this they're still way over valued. My call on ZNGA having a higher market cap than FB is more about the magnitude of FB's market cap collapse than ZNGA's appreciation.

  • Report this Comment On May 26, 2012, at 11:48 AM, bexleydave54 wrote:

    The IPO valued Facebook at 135 times current earnings (compared to Google, valued at 10 times earnings and General Motors, who have sensibly stopped advertising on Facebook, valued at three times earnings). You really can fool some of the people all of the time - please check out my snake oil sale on eBay.

  • Report this Comment On May 29, 2012, at 7:26 PM, bordereiver wrote:

    OK, now I can say I bought some FB at a little over 33. One reason I did so was Morningstar set a FV of 32. Yes, I like to see value people saying something like 32, not 64. The Morningstar commentary, surprisingly, was as bullish or more than MF. Of course, they too preach long term plays, so I know I won't get rich soon. And I will buy a bit more if can get it under 32, hopefully under 30.

  • Report this Comment On May 30, 2012, at 11:18 PM, TmyM wrote:

    Why does everyone quote the FB statistic of having over 900M active users? On my FB account, there are about 200 friends and only 4 appear to be active, i.e. post more than once a month. So with a 2% activity ratio, maybe there really are only 18M active users. And this doesn't even include the fact that I have two FB accounts, both of which are mostly inactive. So maybe the true number of active users is much lower than 2%

    Short this dog on its way to zero.

  • Report this Comment On June 04, 2012, at 9:04 AM, StopPrintinMoney wrote:

    FB (*currenlty*) leads the trend. Not the industry.

  • Report this Comment On June 04, 2012, at 8:02 PM, Darwood11 wrote:

    Buying FB is reminiscent of buying GLD. It may continue "upwards" but then again, it may not.

    FB is dependent upon advertising royalties, which seem to be shrinking. If I want to "roll the dice" for a stock based on advertising, which would I choose; Google or Facebook?

    At this point, I'd go for Google.

  • Report this Comment On June 07, 2012, at 2:54 PM, Darwood11 wrote:

    If FB stock keeps falling, even I may be tempted!

    Just kidding. I buy individual stocks based on long term performance potential. FB doesn't get my attention.

    The second reason I buy individual stocks is because of great management. Again, I'll take a pass.

    The third reason I buy companies is because they provide necessary products, are run by an upper management with some scruples, and because that upper management is willing to share in the rewards. FB fails. Didn't a lot of people get zuckered into this while the Zuckerberg sold (or was that bailed) at $38 or so?

    Sorry, if I want a company that provides a cache product at a very high price, made by near slaves overseas, I might as well buy AAPL.

  • Report this Comment On June 08, 2012, at 9:08 PM, skypilot2005 wrote:

    http://www.smartmoney.com/invest/stocks/facebook-is-a-buy-at...

    • JUNE 5, 2012, 4:07 P.M. ET

    Facebook Is a Buy at $20

    Burton: In the meantime, buy these tech stocks.

    Facebook Inc.'s stock offering may have killed the next wave of IPO stars and burned individual investors, but one veteran technology-sector investor is willing to give the social-media icon a second chance -- at $20 a share.

    "Facebook (FB: ) at $20 is worth a look," said Walter Price, co-manager with Huachen Chen of the $1 billion Allianz RCM Technology Fund [RAGTX] , which has bested its technology-category average return on a three-, five- and 10-year basis, according to investment researcher Morningstar Inc.

    "Facebook is something we want long term, but when you bring out the stock at $100 billion [market valuation] and that's our price target in three or four years if they execute well, what is your upside?" Price added. "If they execute well, they can go back to $100 billion in three or four years."

    "Facebook's market value as of Monday's close was about $75 billion (including restricted stock and unexercised options); at $20 a share, the company's market cap would be in the neighborhood of $55 billion."

    Good Luck FB Shareholders

    Sky

  • Report this Comment On June 08, 2012, at 9:18 PM, skypilot2005 wrote:

    http://www.smartmoney.com/article/SB100014240527023038796045...

    • MAY 17, 2012, 4:26 P.M. ET

    Here Are 10 Reasons Not to Buy Facebook Before You Buy It Anyway

    I'll just list #s 9 & 10:

    "(9) Krispy Kreme. It's one thing to have a product that everyone loves. It's another thing to make money.

    Investors care only about the latter. Ask Krispy Kreme's former chief executive, Scott Livengood, about how things went after the company reported its first loss as a public company in 2004. Mr. Livengood was out in less than a year, and he had been selling doughy cakes covered in sugar.

    (10) The ceiling. We may already have hit it with Facebook's valuation.

    Consider that Facebook's 88% growth rate last year was something the company acknowledged was "unsustainable." Or that 10% to 15% of revenue comes from Zynga(ZNGA) and other game companies that use the Facebook platform.

    Or everything in this list: skeptical advertisers, a young management team about to become amazingly rich, a history of social-network flameouts, deep-pocketed competition and the privacy issue.

    It should give an investor pause, right?"

    I hope the authors aren't part of the Fool's Stock Advisor "Team". I pay for that.

    Sky

  • Report this Comment On June 08, 2012, at 9:30 PM, skypilot2005 wrote:

    http://www.smartmoney.com/article/SB100014240527023038796045...

    • MAY 17, 2012, 4:26 P.M. ET

    Here Are 10 Reasons Not to Buy Facebook Before You Buy It Anyway

    "(9) Krispy Kreme. It's one thing to have a product that everyone loves. It's another thing to make money.

    Investors care only about the latter. Ask Krispy Kreme's former chief executive, Scott Livengood, about how things went after the company reported its first loss as a public company in 2004. Mr. Livengood was out in less than a year, and he had been selling doughy cakes covered in sugar.

    (10) The ceiling. We may already have hit it with Facebook's valuation.

    Consider that Facebook's 88% growth rate last year was something the company acknowledged was "unsustainable." Or that 10% to 15% of revenue comes from Zynga(ZNGA) and other game companies that use the Facebook platform. Or everything in this list: skeptical advertisers, a young management team about to become amazingly rich, a history of social-network flameouts, deep-pocketed competition and the privacy issue.

    It should give an investor pause, right?"

    Those are the only two I needed.

    Fool on

    Sky

    Only buying less than 50 P/E stocks at the moment...

    I double checked to make sure the authors are not on the Stock Advisor Team. I pay for that.

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