Winnipeg Free Press - PRINT EDITION

Facebook flop shows value is not a 'friend'

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And they say stock market investors are rational. Reality gives the lie to that notion on a regular basis, but few repudiations are as powerful as the public offering of Facebook.

The world's biggest social media site started trading last month at a valuation of US$100 billion. It quickly sank to a mere $60 billion. Where did that $40 billion disappear to? Some of it went into the pockets of Facebook's big shareholders, who sold the stock to the public. That includes CEO Mark Zuckerberg, who pocketed $1 billion.

Some -- most -- just evaporated. It was never really wealth; it was a fleeting paper gain based on human error. A small number of investors -- fools you might say -- thought the stock was worth more than $40 per share. Reality quickly dumped a bucket of ice water on them. It's $27 per share now and sinking without a bubble.

Investors aren't rational, not collectively, at least not in the short term. Anyone who had watched previous events would know even Facebook doesn't think its position at the top of the social media heap is unassailable.

In April, the company paid US$1 billion to buy a startup called Instagram, which makes a photo app. The company had 12 employees and no revenues, but had 50 million users.

Before the deal closed, however, Facebook created its own app that essentially does the same thing as Instagram. So why would Facebook pay so much for Instagram? It clearly wasn't the technology, since it could, and did, replicate it easily.

No, it was the users Facebook wanted. Zuckerberg was worried because at the end of the day, Facebook is basically a huge photo-sharing service. Most people use it mainly to look at pictures. If Instagram could attract so many users so quickly, it was a threat to Facebook, and the company figured $1 billion was a fair price to pay to eliminate that threat.

In other words, Facebook itself, before its IPO, admitted clearly its business suffers from a big lack of barriers to entry. Barriers to entry mean the difficulty that potential competitors have breaking into an industry. Companies that enjoy the protection of high barriers to entry are worth more because they can charge more and have less risk of shocks.

Facebook doesn't. The question is, how many times will Facebook have to spend a billion to wipe out a competitor? It won't be the last time, trust me.

In some industries, taking over competition in the early stages can pay off if it leads to a monopoly or some major competitive advantage -- a moat around the business. Microsoft did so as it became the dominant computer software maker.

But there's no stopping any group of kids from putting together a cool app that can contest Facebook's market share (remember that FB is a media firm relying on ad dollars; there's only a finite number of those).

It could have to do that over and over again.

What's worse, the math works against Zuckerberg. He paid about $20 per Instagram user. But Facebook has 900 million users and a value of $60 billion, or $67 per user. Either it got a great deal for Instagram, or Facebook is grossly overvalued.

Since Instagram has no revenues, I'll venture to say Facebook didn't get a great deal.

That leaves one conclusion: Facebook is too richly valued by the supposedly "rational" market.

Fabrice Taylor is an award-winning financial journalist and analyst and author of the President's Club Investment Letter. Email him at:

fabrice.taylor@gmail.com

Republished from the Winnipeg Free Press print edition June 2, 2012 B7

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