By Doug Kass 05/22/12 - 12:00 PM EDT
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This column originally appeared on Real Money Pro at 8:12 a.m. EDT on May 22.
NEW YORK (Real Money) -- Last night on "Fast Money" with Melissa Lee and the gang, we discussed -- what else? -- Facebook (FB). Let's go straight to the tape.
"This is a historic moment in which new media has truly come of age." -- Steve Case, January 2000
"The Internet had begun to create unprecedented and instantaneous access to every form of media and to unleash immense possibilities for economic growth, human understanding and creative expression." -- Gerald Levin, January 2000I likened the publicity and hype that led up to the Facebook IPO to the hoopla surrounding the merger of AOL (AOL) and Time Warner (TWX) 12 years ago. When that deal was announced, AOL's frothy price made it worth twice as much as Time Warner, even though AOL's cash flow was less than half that of Time Warner. Back then, similar to now, superlatives had been bandied about, but little substantive analysis was delivered. Both AOL and Facebook have been characterized as gateways to the Internet. But there were problems with the AOL-Time Warner merger (the largest in history) before the ink dried on the transaction. The same could be true for Facebook's IPO. Following the merger, AOL's shares commenced a steady, multiyear price decline from the high $70s to nearly $10 a share. I started the conversation with the notion that I was not surprised by the price break in Facebook's shares -- indeed, it was one of my surprises for 2012 -- and I questioned the analyst interviewed in the prior segment, who thought there was only $1 of risk in Facebook's share price (which is insanity, a mathematical improbability and a perfect example why many investors disregard Wall Street research). Superlatives, not substance, provided the backdrop of the discussion leading up to the Facebook IPO, as it was with America Online 13 years ago. A rich valuation, fundamental issues plus a continuing and discouraging Greek situation served to provide a poor backdrop for the Friday morning IPO. To me, Facebook faces philosophical, business, operational, financial and valuation headwinds.
- Philosophy: The company is run by a 28-year-old who favors a social mission above profits.
- Business trends: The rate of revenue growth is decelerating -- the latest quarter experienced 45% growth in sales, down from 55% growth in the prior quarter. Advertising, in particular, is slowing, with a 37% growth rate in the first quarter. Google's (GOOG) display ad business (which competes directly with Facebook) is growing faster than Facebook.
- Profitability: Facebook's 50%-plus operating margin seems vulnerable. With nearly 1 billion current users, the low-hanging fruit -- and I am being somewhat facetious -- might have already been picked. I suspect the next 1 billion users will be less profitable to Facebook.
- Financial: Facebook is cash flow negative now as the company spends to grow (on data centers, more employees, etc.).
- Valuation: Let's suppose Facebook's revenue growth accelerates modestly to 50% and that operating margins are sustainable. In this example, Facebook will achieve almost $5.5 billion in sales in 2012 and $8.25 billion in sales in 2013; EPS will be $0.60 in 2012 and $0.95 in 2013. At the offering price of $38 a share, these are high multiples, both absolutely and relative to other leading tech companies such as Apple (AAPL) and Google (at 10x to 11x).