Facebook earnings could sink the stock

We may see a user decline in the US and Europe -- which would be brutal for investors.

By InvestorPlace Oct 29, 2013 2:27PM
Facebook logo (© Daniel Acker/Bloomberg via Getty Images)By Jeff Reeves

iplogoThird-quarter numbers from Facebook (FB) will hit the market Wednesday after the bell, and investors should expect fireworks.

Facebook stock may gap up on strong results and a continued migration to mobile. But if Facebook earnings miss the mark, the high expectations and rich valuation could result in a crash for the stock.

Thus far in 2013, Facebook earnings have been strong, with the up about 90% year-to-date and up about 170% in the past 12 months.

So will Facebook earnings keep that trend going, or will this be the end of the road for the stock?

Bear case for Facebook earnings

Facebook earnings have shown its most valuable users in the U.S. and Europe are flatlining.

facebook earnings users geography`
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Take these two images from the second-quarter numbers, showing how Facebook is seeing momentum slow to a crawl in its most lucrative segments.

A rollback in U.S. users would be a bad headline, yes -- but more important, it would be a significant dent to margins since American Facebook users are by far the biggest revenue drivers for the company.

Facebook stock bulls will contend that user growth isn’t necessary to see bigger profits, and that simply monetizing users better will provide growth going forward. However, the idea of monetizing users better even as Facebook pushes them to mobile is counterintuitive.

Mobile devices have a smaller screen and display fewer ads, meaning Facebook naturally makes less money here, not more. Consider that about 41% of ad revenue came from mobile last quarter, but 71% of its users were on mobile -- 819 million users out of 1.15 billion total.

FB earnings
Click to Enlarge

This is not a problem unique to Facebook earnings, of course. Google (GOOG) increasingly is fighting against declining ad rates, as are content kings Yahoo (YHOO) and AOL (AOL). Part of the decline is secular, as internet ad rates are dropping across the broad, but it’s also in large part due to the lack of effectiveness and reach in mobile, too. As more users go to their smartphones or tablets to consume content, the less effective advertising is for internet stocks like Facebook and others.

When you throw in the frothy valuation for Facebook stock right now at a forward price-to-earnings ratio around 50, it’s clear that there are risks of a big downside move.

In defense of Facebook earnings

Of course, it’s worth noting that Facebook continues to catch fire overseas -- so even if Facebook needs five or six users abroad to replace the revenue from each U.S. user, there is huge potential to not just cover any rollback in subscribers but add significant growth.

And don’t forget that the biggest reason Facebook is up strongly year-to-date is a gap up after earnings in July that showed big progress not just on mobile but on profits and revenue. Facebook earnings expectations were trounced by almost 36% and the stock exploded as a result. Given that a number of analysts have been increasing their earnings forecasts lately, that’s a good sign.

And the short interest in Facebook stock is a third of what it was back in November 2012, so the bears are clearly clearing out.

Oh and don’t forget there’s Instagram revenue that will soon be baked in, too. That won’t show up this quarter but will surely start adding fuel to the stock in 2014.

On the whole, I’m skeptical of how Facebook will fare as its U.S. and European users roll back. However, it’s important to remember that the site is growing fast and has a lot of potential to get smarter about mobile and advertising margins.

This earnings report will show us what Facebook looks like on all fronts, and it should be a big deal.

Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. As of this writing, he did not own a position in any of the stocks named here.

More from InvestorPlace

Oct 30, 2013 10:48AM
Oct 30, 2013 1:17PM
I asked my kids if they were on facebook much lately. They replied, "Nobody is on it anymore. We use twitter and instagram". I bet Facebook gives number of accounts, but how many of those are no longer used?
Oct 30, 2013 12:14PM
I'll buy a few shares of Facebook, when I can get it for about 10 cents a share; the colors will look nice on one wall in any room I have.
Maybe MSN will allow people to comment on all their sites once Facebook is gone.
Oct 30, 2013 1:41PM
So many  negative responses everyone is on FB every smart phone has an app for it and it grows by a lot everyday. There continue to be other social nets developing but unless they link to FB they are never going to be nearly as successful , Saying it is out dated or becoming obsolete is a huge fallacy, those who've stopped use of it nearly always return to it , usually because the other site they chose to use instead does not connect them to the people or apps they need . FB is not just a website it is fast becoming a necessity for people to connect with employers, friends, family or co-workers.
Oct 29, 2013 2:50PM
My teacher always said "Whatever goes up, must come down"
Oct 29, 2013 9:53PM
facebook is the past.Skype is the future with 4g lte
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