(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)
Facebook is by far the most attractive short I have seen with a market cap in excess of $1 billion. The current valuation implies Facebook is one the highest quality and fastest growing companies in the world. In reality, the company has a poor track record of monetizing user activity, and its growth trend is unimpressive.
Furthermore, all of the sustainable long-term trends (mobile and emerging markets) work against Facebook. Additionally, the short-term trends (user growth pre-saturation and ad price increases) will likely be exhausted in the next 1-2 years. Combining these two dynamics implies that Facebook stock could fall by up to 80% in the near-term.
Facebook’s largest and most profitable user group (U.S. & Canada desktop) saw a 2% decline in page views as of last quarter. And, a recent Reuters survey indicated 35% of Facebook’s users are using the site less. Even before the temporary trends fade, Facebook is already exhibiting negative underlying growth trends. Furthermore, at some point, the market will price in the risk that Facebook could be at the early stages of the “reverse network effect.” A 2% loss of Facebook’s desktop page views could result in, for example, 6% declines in overall usage.
Unlike Zynga, Facebook’s track record on separating customers from their money (a key measure of a company’s financial attractiveness) is very weak. Facebook’s anticipated ad-based strategy to improve revenue generation runs counter to well-established behavioral trends. Facebook users continue to view ads as an annoyance (the customer is always right).
According to Facebook’s 2Q figures, both the U.S. and Europe are experiencing only small rates of growth (sub 1% in the U.S.). And, on a page view basis, usage dropped by 2% in the second quarter (U.S.). Unfortunately for Facebook, average revenues per user (ARPU) are $11.50 in the U.S., $5.61 in Europe, $1.49 in Asia, and $1.56 in the rest of the world. Based on these figures, Facebook would need an 18% surge in Asian users to offset the 2% page loss view of Facebook users in the U.S. Right now, most of Facebook’s growth is coming from ultra-low ARPU regions of the world. India’s digital ad market, for example, is currently only $410 million.
Declining Asset Summary
On the “declining asset” issue there are: 1) usage levels slipping in the U.S. and Europe; 2) 35% of users using the website less; 3) due to growth in emerging markets and mobile the mix shift is heavily negative for overall revenue levels; 4) assuming internet ad spending has stabilized, the surge in ad spending on video could be a drain on Facebook’s revenue numbers; 5) the surge in user data and targeting capabilities imply the value of Facebook’s data and targeting capabilities are declining in value.
Valuation and Conclusion
Now that Facebook’s user growth is concentrated in lower ARPU regions of the world, usage increase-driven revenue growth will likely decelerate enough to bring Facebook into the 20% growth range. Furthermore, unless Facebook’s mobile ad program surges into the billions, Facebook’s total revenue growth will drop into the low teens. The problem with predicting any growth for Facebook longer term is the fact that the sustainable trends all work against Facebook while the temporary trends are somewhat positive. An investor could rationally assume Facebook’s financial performance is within 6-12 months of peaking.
Given the attractiveness of the Facebook short, I am recommending hedge funds take a concentrated 5-10% Facebook put option position. If Facebook trades at Google’s valuation, the total fund return will be between 50-100% depending on the time and strike price structure of the position. In a market with rising correlations, 1-3 positions in puts/calls will have largely the same movement patterns as 25-35 positions. Given the comparable risk in the 5-10% option strategy it makes more sense to choose the alternative with more upside (more details below).
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John Pulliam's full short thesis on Facebook is 13-pages long and includes an in-depth valuation and strategic analysis. If you're interested in taking at look at the real thing, email email@example.com for more information.
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