Facebook is Hot–But the Future, Maybe Not

Facebook is Hot–But the Future, Maybe Not

Facebook has been on a roll this year, with its stock up stock up 54%. With the company delivering third quarter revenues increase of 59.0%, the Morgan Stanley brokerage issued a buy recommendation on FB stock at $75 a share with a target of $90. However, now that Facebook has already captured most of the world’s social networking fanatics, revenue growth may soon slow and fanatic investor may bail out quickly at the sign of any financial disappointment.   

According to an article by Shareaholic, which analyzed traffic from more than 200,000 worldwide websites between September 2013 and September 2014, the world’s largest social network now drives more than a fifth of the overall traffic. That number includes direct traffic, social referrals, organic search and paid search to websites. Over the last year, Facebook referrals were to other websites were up more than 115%.

But Facebook is trying to cool speculative interest in the stock by warning that stock brokers’ revenue and earnings expectation are unrealistically high. Management predicts fourth quarter revenue ending December 31 will be up at the $3.6 to $3.8 billion level. Although that equates to a 40% to 47% jump, the rate of growth is slowing.   

Facebook’s stock is currently trading at 85 times its current earnings. Put simply, if Facebook earnings do not rise, it would take 85 years of income to equal the stock valuation. Traditional stock analysts would say that the company would need to grow by 85% to justify the stock price. But Facebook’s active users grew by only 14% in the third quarter ending September 30, to 1.35 billion.

Facebook did make a big acquisition by spending $22 billion to buy the very hip messaging company WhatsApp and gain access to its 600 million users. But very few of those users are converting to Facebook, and the relative start-up is actually losing money each month. For the first two quarters of 2014, WhatsApp had revenue of only $15 million and a loss of $232 million. Annually, that loss is approaching half a billion dollars.

Facebook had $3.2 billion of operating expenses in 2013 and it is now predicting 2014 operating expenses will increase by 45-50%, versus earlier estimates of a 30% to 35% rise. 

FB’s Chief Financial Officer David Wehner said that because 2015 will be “a significant investment year,” operating expenses will increase by another 55% to 75%.

Note that revenue is expected to grow much slower than expenses for 2014 and 2015. Optimistically, using the lower end of the company’s forecast means that operating expenses will rise from $3.2 billion in 2013; to $4.6 billion in 2014; and then to $7.2 billion in 2015. That works out to expenses growing by 225% in just two years.

Over half of Facebook’s shares are held by founder Mark Zuckerberg. He may be making investments to build the company for the long term. In the short term, Facebook seems headed in the direction of sacrificing profits while the business is growing rapidly. Most high-growth industries peak in earnings before they peak in revenue. 

Facebook investors should be aware of the stock prices of supposed Internet leaders Amazon and Twitter. Both disappointed investors and their stocks have been hammered. With expenses growing faster than earnings at Facebook, any more bad news could cause a frantic FB sell-off.

Disclosure: Chriss Street has not had a long or short position in Facebook stock in at least the last 90 days.