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:

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.