May 2012

……………Thoughts and Comments


The Circle of Life (where Life is defined as the investment markets – a very myopic view, we realize)

Have you ever been out in the middle of the ocean on a ship, and been a little sea sick?  The constant rocking…back and forth, up and down…all you can see is the never-ending sameness wherever you look…water, water, everywhere but not a drop to drink…

The markets are making a lot of investors feel the same: the gyrations, the overload of information, and yet nothing of substance with which to quench our thirst for guidance.  Q2 is just about completely in the rearview mirror.  After a euphoric rise in Q1, Q2 has been the complete opposite and we have virtually wiped out all the gains from the prior 3 months.

Greece is back in the news with worries about whether it will stay in the Euro and when it will next default.  Spain has admitted to needing a rescue of its banks and recently got about $U.S. 1.25 billion to de-stress their banks for another couple of months (maybe).

China seems to be slowing faster than expected, as are India and Brazil.

U.S. economic reports have weakened.

Wait a minute, which month are we writing about?


A Pie in the Facebook

In the past few weeks, there have been numerous articles about Facebook and its IPO.  There were numerous factors that contributed to the disastrous offering, but the bottom line is that most of the people who played got burned and then complained someone else was at fault.

The newspapers were filled with accounts of unfortunate souls who got taken advantage of: if only NASDAQ hadn’t fouled up or if the price had been more reasonable or if they hadn’t been given all of the shares they had requested (notice they requested shares, they weren’t required to play at all!), then they wouldn’t have lost money.

True, if NASDAQ had not had the problems, losses might have been smaller – at least for that day.  What about all the other days where the stock continued to collapse?  Traders live and die by the sword.  Professionals understand this, but individuals (and the newspapers) don’t seem to.  Wall Street is not your friend – they are selling to you.

Wake up and smell the roses or the coffee, whichever you desire.  There are numerous reasons not to be a trader, which we have discussed numerous times.  When you add the intricacies of the IPO market into the mix, then as is often said, “If you do not know who the patsy at the poker table is within a few minutes, it is you.”

Wall Street’s job in an IPO is to: 1) get as high a price as possible for the issuer; 2) give their best clients (if you have to ask, it is not you) a chance to make a quick profit; and 3) keep the markets stable.  If it is a hot deal, unless you are a “best client” you won’t get the shares.  If you do get the shares, then why do you think the “best clients” don’t want those shares?

Further, it was well publicized that many of Wall Street’s firms bought in privately months before the IPO and that they were all selling.  Again, why would they be selling to you?  Trust me, it isn’t because they want someone else to make money instead of them.

Finally, there is this little thing called doing your homework.  We had several clients call and ask if we planned on buying Facebook and we unequivocally said, “no thanks.”  The why is based on our research, which our very own Wende Feller, PhD., did just before the IPO.  You will note that the information was available to anyone who wanted to do the work.  You will also note that the report is fairly short – this wasn’t a terribly complicated decision.

While everyone secretly wants to say, “I told you so,” we will not fall for that trap because the markets have a way of making us all humble.  However, we will say, yet again, the reason to invest rather than trade, and the reason to do fundamental research rather than get caught up in hype is because you are much more likely to make rational decisions and are thus more likely to make money.

The moral of the story is, if you don’t want to get burned, don’t play with matches.



Facebook is a worldwide social media site with over 900 million MAU (monthly active users).[1] Only 21% of its user base is located in the U.S. and Canada, with 27% in Europe, 26% in Asia, and 27% in the rest of the world [ROW]. Quarterly MAU growth is in the mid-single digits, with Asia and ROW leading Europe and North America. About 5% of user profiles are known to be fakes or duplicates [8].

FB’s business model for generating revenue is currently a mix of 85% targeted advertising and 15% fees and payments, almost all from its 30% cut of virtual-product purchases of Zynga’s popular social gaming apps.

Investment proposition: Profitable social media play, with balance sheet positioned to grow by acquisition.


Price set for IPO            $ 38.00                         Net profit margin (Q1 2012)      19.38 %

P/E (ttm)                          83.66                         Free cash flow/share (ttm)        $ 0.35

Leverage                            1.13                         ROE (ttm)                               23.05 %

Interest coverage             30.44


Assuming that FB continues with its current slightly straitened margins (resulting in part from having to woo more advertising), a fair value of $38 at a 30 trailing P/E (higher than Google’s 19 P/E due to recent higher revenue growth) would require revenue growth of ~265%. To achieve this by FY 2015, FB has to grow revenue at ~35% annually. While this is a slower growth rate than it has shown in the past, FB is into the tech-adoption cycle of decaying growth rates, and has serious risks (discussed below) of flattening or decreasing revenues.

Losing fee revenue from Zynga in 2013, with no other loss of MAU, would result in a fair value of $17.05 at a P/E of 30 in FY 2013.

Reasons to Invest

  • Largest and most pervasive social media play. Facebook’s MAU is ~9x the size of Twitter’s 100 million [1], while professional networking site Linked-In reports a full user base of only 161 million. Facebook’s LIKE functionality is also integrated broadly across news and other web sites.
  • ·
  • Solid engagement ratios. FB’s 20-30% proportion of “power users” [2] is high compared to the classic 90-9-1 metric for social engagement [3], in which no more than 10% of visitors to a site are engaged users.
  • ·
  • Minimal debt and high ROE. FB avoids debt financing, yet even with extraordinarily low leverage post-IPO, its most recent 12 months of income would have given an ROE over 23%.


  • Future ad revenue growth may be limited and slow. Ad revenue per MAU has not grown since Q2 2011 (except for a seasonal spike for the Q4 holidays in North America and Europe). More than half of FB’s ad revenue comes from North America and another 27% from Europe.
    • MAU growth in emerging markets (8% in Q1 2012) outpaces MAU growth in the developed world (5% in Q1 2012). More than half of FB’s user base is in emerging economies, where disposable income, while growing, is much lower than in the developed world. Ad revenue per MAU in Asia is just 43 cents, versus $2.23 for North America. FB promotes this gap as an opportunity for advertisers; but 1:9 is a convincing ratio for Asian household income to U.S. household income.
    • Major advertisers have cut back on FB advertising. GM dropped FB entirely. JCPenney was one of several to abandon FB stores. Anecdotal evidence suggests that users become adept at ignoring ads, which may explain why FB is touting a feature that allows advertisers to make users’ mentions of the product more prominent in the user’s friends’ timelines [6].
    • Mobile FB use is growing, to the point that about half of its users now access FB from the mobile site. However, advertising on the mobile app is more limited than on the regular site.
    • Fee revenue is threatened. Zynga has announced its intention to separate from FB and establish itself as an independent social gaming service [4]. Zynga is by far the dominant social gaming developer on FB; fees from rivals are negligible.
      • Zynga’s MAU of ~240 million represents about one-quarter of FB’s MAU. Although the defection of FB’s most popular game apps would not result in the loss of all these users, it is likely to create some FB attrition and would surely reduce daily visits to FB.
      • Zynga’s MAU has been moving with the 200-240 million range for two years, suggesting that the ability of social gaming to increase social engagement has been fully tapped. Revenue per MAU has roughly doubled in that time period, due to Zynga’s strategy of cultivating “whales,” the 2.4% of players who purchase goods [5].
      • FB is experimenting with charging users to make their postings more prominent in their friends’ timelines, a move that’s likely to alienate some users [6]. FB co-founder Sean Parker argues that FB’s most engaged power users are also those most likely to become frustrated with the site and shift to Twitter or Google+ [7].
      • MAU includes people who never visit FB site, nor use FB Mobile. FB’s offering documents disclose that its calculation of MAU includes people who LIKE an online article on a non-FB site. Using the LIKE button on an external site requires a log-in to FB but no further FB exposure.



  1. Ben Parr, Twitter Has 100 Million Monthly Active Users; 50% Log In Every Day, (October 17, 2011).
  2. Pew Internet & the American Life Project, Why Most Facebook Users Get More Than They Give, (February 2012).
  3. Jakob Nielsen, Participation Inequality: Encouraging More Users to Contribute, (October 2006).
  4. Tim Sandle, Zynga, Makes of FarmVille and CityVille, Leave Facebook, Digital (March 4, 2012).
  5. Matt Lynley, How Zynga Pampers the People Who Spend Thousands of Dollars on Its Facebook Games, (March 5, 2012).
  6. Geoffrey A. Fowler and Shayndi Raice, Facebook Gets Religion for Revenue, Wall Street Journal (May 17, 2012).
  7. Emma Barnett, Facebook Power Users “Have Gone to Google+ and Twitter,” The Telegraph (October 18, 2011).
  8. April Dembosky, Facebook Reveals ‘Fake’ User Accounts, Financial Times, (March 8, 2012).


Q2 Earnings – Looking Back to See Ahead

Q2 earnings will start in about 30 days so we figured we would look back at the past couple of quarters to get an idea of what may lie ahead.

For the past two quarters, we have seen a gradual reduction in the quality of earnings.  While revenues grew by 12% in Q4 2011 and 10% in Q1 2012 (using the S&P 500 index for our information), earnings have been growing more slowly because margins have gotten weaker.  Net margins are down an average of 250 basis points in the past two quarters.  At the same time, most of the revenue and earnings growth is coming from price increases rather than increased demand.

On top of this we would note that much of Asia, Europe, and the Americas have been showing indications of slowing demand.  Oil, which was at $106/barrel in May, is currently trading around $84/barrel, along with copper, which is down 13% in the past month.  The only thing that seems to be rising right now is food prices.

Speaking of which, we have finished doing work on retail sales and consumer debt.  Debt is broken up into two areas: revolving debt (credit cards) and non-revolving debt (auto, student and mobile home loans).

Revolving debt peaked in July 2008, as can seen in chart 1.  But as can be seen in Chart 2, people aren’t buying as many televisions and other neat toys:  a greater percentage of retail spending is now going to paying for gasoline and food.

Non-revolving debt has ballooned since it last peaked in July 2008. The vast majority of the new debt is for loans for college.  The growth is not among 18-year-olds but for people trying to reinvent themselves to get jobs (average age between 35 and 49).

With the public spending focused on surviving and with no change in the direction for economic solutions in Europe or the U.S. (which is a fancy way of saying the politicians have done nothing constructive) and economic issues showing up in the emerging markets, we do not see broad industry groups getting much stronger this next quarter.


Sectors to Watch

Energy: Oil prices, as we noted earlier, have dropped close to 20% in the past month.  Natural gas is off of its lows, but still a long way from $4.00.  Coal has been equally beaten here in the U.S.  Interestingly, as demand for coal and natural gas is still very high throughout the rest of the world, prices are much higher around the world than in the U.S.

We think this will continue for a while and are not ready to jump in yet.

Utilities:  What is bad for energy stocks is good for utilities.  The sector has been a laggard until the end of May, but has recently picked up a little steam.  Economic sluggishness will prove beneficial to these stocks.

Industrials: Industrials are down 7% in Q2.  While there is still some pain left here, this group is very mixed with some stocks quite cheap currently.

Precious Metals:  Gold stocks took it on the chin in Q2 after a great Q1.  The U.S. dollar is currently traders’ safe haven.  This can last for a while, but the combination of inflation and lack of credible government action to control spending and address debt reduction will make this a winner in the long run.

Silver is an industrial metal and will continue to be impacted by the combination of inflation and weak economies.

Fixed Income:  The ten-year treasury has dropped from an average yield of about 1.95% for the past six months to a 1.57% yield.  Every time someone predicts rates can’t go lower, they do.  We believe this is money running to the U.S. for safety.  Short term this is true, longer term, inflation here is going to be an issue, but this can continue for a long time.

Short-intermediate corporates still provide the best risk/reward for most investors and we continue to hold our positions and add to them when we get the opportunity.

The Bottom Line:

This is and will continue to be a stock-picker’s market and a trader’s market.  We continue to keep a diversified portfolio with stocks, bonds, real estate and cash.


Alan E. Rosenfield                                                                                                                         Managing Director


June 2012


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