I want to add a thought to my Facebook commentary that I posted earlier this week. Part of the reason why Facebook has seen its price climb from a low of $17.50 in 2012 to $97.54 now is that overall profits have climbed from $1.25 billion to almost $3 billion over that time frame. When people see the five-year charts of Facebook reporting 28% annual profit growth, they use it to talk themselves into paying a ridiculous valuation for the stock.
But what often goes unnoticed is this: Facebook makes most of its money from advertising revenues, and the 2010-2015 measuring period only captures an improving economy in which companies increased the amount of money earmarked for ad companies.
The current excessive valuation of Facebook probably reflects the fact that Facebook shareholders have never experienced what it is like to own an ad-reliant company during a recession.
Take something like CBS. It receives 60% of its revenues from companies that want to run advertising on its network. During the early 2000s, profits at CBS were between $1.38 and $1.88 per share. The stock hit a high of $35. When 2009 came around, profits were down to $0.53. During the first quarter of 2009, it only made $0.08 per share in profits. The $1.06 annual dividend got cut to $0.20, and the share price plummeted to $3.
You might look at the $43 current price and just figure the $3 share price was a good buying opportunity that was another example of Mr. Market’s irrationality. I’m not so sure. When CBS saw its profits fall from $1.3 billion to under $300 million, there was a concern that legacy advertising contracts would make it difficult to be profitable when it was time to renewal during the lower-priced environment. CBS carried $7.5 billion in debt against profits that had fallen to $280 and were quickly plummeting, and I am not sure shareholders would’ve come out okay if the first quarter of 2009 repeated itself a dozen times.
Side note: CBS is one of the worst companies at executing stock buybacks I’ve ever studied. They’re almost as bad as the fast-food company Sonic, though not quite as bad as the megabanks. When the stock fell to $3, CBS was diluting the stock. Now, it regularly borrows to reduce its stock from 629 million shares to 490 million shares even though the balance sheet is already highly leveraged and the price of the stock is not cheap.
So why do they do it? Because it’s the only way to increase earnings per share. CBS makes $1.3 billion per year now. It made $1.3 billion in profits in 2012. It made $1.3 billion in profits in 2007. It retires stock in the $40s and reissues stock at $4. That’s not how you get rich. Given the leverage of the balance sheet, I would feel uncomfortable owning a sizable position in CBS stock given how quickly advertising profits disappear during the bad times.
This is not exclusively a CBS phenomenon. General Electric, which owned NBC during the recession, saw its network advertisements fall by 58% during the worst of 2009. A popular lifestyle blogger removed Google Adsense ads from his site in entirety because the income dropped so much it wasn’t worth the eyesore for readers. Early in the recession, a popular finance blogger sold his site in part due to burnout, but also because revenues were starting to drop and he wanted to get out before the valuation of his site stumbled. The average website needed to grow its website by 17% annually between 2006 and 2009 just to make as much revenue in 2009 as 2006.
Facebook is not immune from these forces. Advertising profits are volatile even in good times, and hit especially hard when corporate America enters a recession. Companies don’t think twice about cutting advertising budgets 20% to 60% during bad times in an effort to prop up earnings per share figures in the short term. Facebook’s rapid growth has come during a five year period when user growth has been saturating industrialized markets, and the advertising rates have been growing. These have been ideal conditions. Paying 100x earnings for a stock doesn’t work out when these excellent conditions persist, and I am wary of what will happen to Facebook shareholders during a legitimate recession if advertisers cut their budgets to within hailing distance of what we saw in 2008 and 2009.