Facebook Will be Gone in 10 Years

(Note: A previous version of this post incorrectly calculated the estimated Facebook share price with a P/E of 45. The post has been updated with the correct figures.)

One of the earliest memories I have is of my dad's CB (Citizens Band radio) that he had in his bedroom. I vaguely remember him talking about how everyone had a CB and it was a great way to talk to people. Eventually this fad faded and our CB was put in a closet to collect dust. Fads come and go. This is what I think of when I think of Facebook (NASDAQ: FB).

Way back in the middle part of the decade, MySpace was all the rage. Everyone was getting on to MySpace. I signed up and was a regular user of the site myself even though I never really heard from anyone. I used the site to listen to music and as a portal for some news. News Corp. (NASDAQ: NWS) thought so much of MySpace that it paid $580 million for the site in 2005.

As time went on, I started seeing people posting phrases such as Follow Me on Facebook. I knew then that people were migrating to the next big social media thing. The migration didn't bode well for News Corp., who was owner of a website with a dwindling active user base. A little over a year ago the company sold MySpace to Specific Media for an estimated $35 million. The site had 29 million unique visitors in May 2011, down from 70 million in May 2009. The site had 24 million unique visitors in May of 2012 in the United States versus 157 million for Facebook. It is a fad that will fade for Facebook as well.

Facebook's fundamentals were excellent even before the IPO. Pre-IPO cash on hand was $3.9 billion giving the company a cash to stockholder's equity ratio of 74%. The $6.7 billion in proceeds from the IPO would bring this amount to 202% of equity. Its pre-IPO total debt to equity ratio is only 30%. Adding in the IPO proceeds would have made the total debt to equity ratio 13%.

I still believe that Facebook as a long-term investment is shaky at best. First of all, approximately 12% of their revenues are generated by ad and fee revenue from a game platform called Zynga (NASDAQ: ZNGA). Zynga makes games such as Farmville, Cityville, and Zynga Poker. Games are a luxury that people can do without in tough economic times. After a while people get bored with them and move on, just like they did with MySpace. Popular video games don't strike me as a foundation for long-term investment success.

Another reason I believe that the long-term performance of Facebook's stock is limited is that it already had a high rate of penetration and the stock is already overvalued. Its stock is currently trading around 78 times earnings. Facebook has over 900 million monthly active users. Over 2 billion people worldwide are on the Internet, which means they already have penetrated half the Internet global population. I ran two scenarios involving two different levels of P/E ratios: one with a multiple of 45, which was the multiple of Microsoft during the '90s, and a P/E ratio of 10, which is the current P/E of a number of tech stocks such as Applied Materials and Dell.

*Source-Yahoo Finance **Assuming 2 billion monthly active users within the next 5 years

Of course these scenarios involve a lot of assumptions. By dividing 2011 revenue of $3.7 billion by 900 million users you arrive at $4.39 per user. Assuming that Facebook can maintain this rate per user and they manage to increase their monthly active user base to 2 billion, which in 5 years could still be half of the Internet population, their revenue will be around $8.7 billion. Given a 30% profit margin, that works out to be $2.6 billion in net income, or about $1.28 per share. Multiply $1.28 by 45 and you have $57.60 per share 5 years from now or 13.19% per annum.

This would be great if they can maintain a high multiple and a unit revenue base of $4.39 per monthly active user, but I think that's unlikely because ad revenue has come under pressure in recent years. This is also assuming users would continue to be active on the website and aren't bored and wanting to move somewhere else. Also a threat to all of this is the company's problem of monetizing its mobile site. With more and more of the Internet becoming mobile, this could present a real challenge. If you look at the P/E 10 scenario, which I think is more likely, the stock price will be $12.80 per share, less than half of its current price.

Facebook's stock having a high valuation combined with increasing pressure on Internet ad revenue and a big chunk of its model being based on online games gives me pause. Given Facebook's high level of penetration, it's going to become a matter of increasing revenue per user, which is becoming increasingly difficult to do. Once it has the whole world in its hands where else is it going to go? I also wonder if Mark Zuckerburg is going to treat this company as a business or a social experiment.There is also talk of the next big thing such as Pinterest. I am already seeing people talking about it on Facebook. MySpace redux. Ten years from now, given all these elements, I think Facebook will become the proverbial CB that will be tucked away in a closet.

Bibliography:

MySpace Sells to Specific Media for $35 million @Cnet.com

Facebook Form S-1A Registration Statement Filed May 9, 2012

Facebook Form 424B4 Prospectus Filed Pursuant to Rule 424 Filed May 18, 2012