Idea

FACEBOOK INC ( FB ) - $27.72

Posted on 06/03/12 10:58 PM by jcp21

Description
100%+ return opportunity shorting Facebook (i.e. Netflix above $250 and keeping the position size constant on the way down) given the companys large market cap, stagnant underlying growth metrics and meaningful secular headwinds. Background Since becoming a short-selling specialist two years ago at a long/short hedge fund, I generated a 19% return during a 22% increase in the S&P 500 (significant alpha). During that time, I was able to generate significant returns from various overvalued companies including those in the social media space (Zynga, Yelp, Pandora, Groupon, etc.). Relative to all those ideas, however, Facebook has the most upside and due to its large size, a lower level of risk. Summary Outlook Market viewpoint needed to generate 100%+ return: Facebook grows into a $50 billion valuation in ten years which assumes 15% earnings CAGR and Googles current earnings multiple. Base case with additional upside: Facebooks growth stagnates and the companys valuation falls below $15 billion. Downside: Facebook follows Yahoos path. Yahoo still has millions of users but technological evolution often favors new entrants who then either quickly or gradually crowd out larger and less nimble online competitors. Markets viewpoint needed to generate 100%+ return My 100%+ return expectation is based on the following optimistic assumptions about Facebooks future performance: 1. Facebook earnings grow at a 15% CAGR for 10 consecutive years (rare) which implies $4 billion in normalized earnings. The estimate assumes the modest deceleration in growth continues. 2. Facebook trades at Googles current 2012 PE ratio of 13x in 10 years. Google will likely grow 2012 earnings by 25% and 15% in 2013. Therefore I am assuming Facebook will maintain a high growth rate beyond 2022. It is worth noting that Googles 2012 PE ratio adjusted for net cash on the balance sheet (assuming 25% taxed) is closer to 10x earnings so the comparison is extremely generous. And, if you run a screen for companies with net incomes of greater than $3.5 billion, only a small handful of companies have forward PEs exceeding 13x. These two assumptions imply Facebook will be a $50 billion market cap company in ten years. The market cap projection is even more optimistic when you consider that global digital banner advertising (Facebooks core business) is currently only ~$22 billion. Additionally, due to years of outperformance, digital ad spending is now proportional to time spent online (see Mary Meekers recent presentation and more on this below). Therefore, underlying market growth is likely to be limited. In the optimistic scenario I just outlined, Facebooks present value (using a 10% discount rate) is ~$19 billion or $7 per share (using the diluted share count provided just before the IPO date). Even if you assume Facebook starts to pay out $1 billion per year to shareholders (either dividends or buybacks) in five years, you could add an extra $1 or $2.6 billion in value. A $19 billion valuation is ~16x ttm earnings (still a premium to Google and Apple) and only looks reasonable if you assume accounting earnings represent actual economic benefits Facebook shareholder receive. Facebook just spent $1 billion or 100% of 2011 earnings (Instagram) on an acquisition that will generate no future revenues (and a further encouragement for new entrants). Therefore, it represents maintenance CAPEX (entirely defensive) from an economic standpoint (Facebooks ttm is therefore $28/Instagram). Going forward, future CAPEX (defensive acquisitions like the Instagram acquisition) will be driven by the network effect working against Facebook. Facebook clearly benefits from the network effect but unlike a utility, for example, its existence does not imply barriers to entry for new entrants. In other words, Pinterest can quickly explode with popularity and take share of online minutes from any other company benefiting from a network effect. Pinterest was just valued at $1.5 billion and its genre of social media is much more disruptive then

Catalyst
Catalysts Further revenue deceleration will naturally compress Facebooks multiple. And, investors could begin to price Facebook based on its current revenue growth which would also imply multiple contraction. Advertisers continue to voice concerns over Facebooks value. Facebook makes, as rumored, additional defensive acquisitions. Other social networks surge in popularity. Investors begin to apply a discount to Facebook shares if the CEO prioritizes social significance at the expense of shareholder value. Due to natural cultural shifts, social media becomes less relevant to internet users. Speculative: Based on David Einhorns comments at the Ira Sohn conference, he could be short Facebook (plenty of shares available and with great liquidity). A Green Mountain type presentation could be on the way. Or he could find his way onto Facebooks earnings conference call and ask a few general questions about Facebooks business. Massive selling pressure after the lock-up expires (see Zynga and Groupon).

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