Caveat Emptor: Facebook Shareholders May Get 'Zucked'

A new term was introduced into the financial lexicon recently, to get 'Zucked'. The term was coined by investors in the Facebook (FB) IPO. Participants in the IPO have brought legal action against the company stating they were misled. The U.S. Senate Banking Committee has vowed to investigate assertions by investors they were hoodwinked. The stock is down over 27% since the IPO.

There have been several articles written in regard to these developments so I won't rehash the details. Suffice it to say, copious amounts of Facebook shares were sold at the high end of the price range. This maximized the windfall for CEO Mark Zuckerberg and other insiders and fashioned a far-fetched valuation for the company. Nevertheless, Facebook devotees argue that the company will eventually validate its sky-high valuation by leveraging its enormous user base and colossal amount of data collected.

I see three major headwinds to this thesis. First, 1.7 billion shares are due to hit the market as staggered lock ups expire. A majority of the locked up shares will hit the market prior to the end of 2012. Second, I question the number of current and future users of the site willing to be leveraged. There may be a mass exodus if privacy settings are changed once more or intrusive advertising methods are implemented. Finally, I submit the bulk of the prime advertising demographic accesses Facebook via their smartphone. This is the proverbial Achilles heel for Facebook. The company is currently unable to display advertising on smartphones. In the following sections I will expound on these issues which are the crux of my bear case.

Lockup Expiration Pressure

Facebook's stock is currently burdened with billions of shares poised to be released from lockup in 2012. There are 1.7 billion shares of Facebook currently locked up. 271 million shares will be available for sale in 74 days. A majority of shares, 1.2 billion, will be released from lockup in mid-November. A small portion of shares are scheduled to be released from lockup past the end of the year. The release of shares from lock up prior to the end of the year is important due to the fact that capital gains tax rates are expected to rise in 2013. I believe this is why the IPO was scheduled for May. Zuckerberg has maximized profits on the IPO at every turn. I surmise the fact that capital gains taxes are expected to rise in 2013 has been anticipated and planned for accordingly.

I expect the stock to experience significant pressure as the lockups expire. Zynga (ZNGA) had a rough day recently as the end of another 325 million share lockup expired. Additionally, the company lost mobile gaming CTO Laurent Desegur to startup Game Closure. Zynga is down nearly 40% from its IPO price of $10. Groupon (GRPN) recently dove to new post IPO lows on share lockup expiration day as well. The decline adds to the sizable losses Groupon saw ahead of the expiration, which allowed approximately 600 million shares held by insiders to be sold for the first time. These events do not bode well for Facebook's post lockup share price prospects.

Problematic Leveraging of Current Users and Data

This section is based purely on my personal opinion and anecdotal experience with Facebook. I joined Facebook last year prior to my 30 year reunion rolling around. Many old high school friends encouraged me to join. During the first few months I was logged on constantly as I reconnected with old friends and shared photos. After I had made contact with most old friends, my activity has dropped off substantially. I seldom click on an advertisement and never actually purchased anything. Several times I've been prompted by friends that my privacy settings have been changed by Facebook. It seems they employ an 'opt out' rather than 'opt in' strategy regarding these changes. This has made me wary of sharing anything of importance on Facebook and certainly not my credit card information. Furthermore, some of my friends who were loyal Facebookers bought in at over $40 on the day of the IPO and have turned sour on the company after taking losses. Any news of Facebook somehow leveraging their data at this point may lead to a mass exodus of even loyal users. Finally, since the implementation of the timeline, the service has become somewhat cumbersome. I'm in the Facebook-is-a-passing-fad camp and may soon go the way of My Space.

Mobile Advertising Dilemma

Facebook's S-1 Filing included the following statement:

We do not currently directly generate any meaningful revenue from the use of Facebook mobile products, and our ability to do so successfully is unproven.

What is even more concerning is that the dominant smartphone demographic according to the Pew Institute is 18-49 age group. This makes a significant majority of Facebook users in the prime advertising demographics inaccessible. Companies may begin to question the value proposition in advertising with Facebook. General Motors (GM) is a recent example of this. According to rumors on the street, Facebook is scrambling to solve the mobile advertising dilemma by introducing a Facebook phone. Personally, I think the idea of a Facebook branded phone optimized to display mobile advertising is a huge mistake. The smartphone competitive environment is unforgiving. I don't see it happening. Apple (AAPL) is the king of the hill with the new iPhone 5 rumored to be introduced in the near future.

Conclusion

Mark Zuckerberg has basically thumbed his nose at Wall Street by stating he will not strive to meet quarterly revenue or profit expectations. Zuckerberg stated in a letter to investors:

Our culture also prioritizes our user engagement over short-term financial results, and we frequently make product decisions that may reduce our short-term revenue or profitability if we believe that the decisions are consistent with our mission and benefit the aggregate user experience and will thereby improve our financial performance over the long term.

Zuckerberg has not pulled any punches. His actions have been deliberate and transparent. Zuckerberg will maintain controlling interest in the company with his shares having 10 times the voting rights over the ones he was letting the public buy. This way insiders will be able to unload a majority of the locked up common shares and still retain control of the company. I would avoid the company until June of next year after the final tranche of locked up shares are released.

Don't be fooled into thinking you are getting Facebook at a bargain basement price simply because its down significantly from the initial IPO offering price. It makes no difference where a stock has been, it matters where its going. There are too many unanswered questions at this time. It will be interesting to see if Zuckerberg and company can pull this off. As far as I can see the deck is stacked against them. I'm on the sidelines for this one. Its a "No Touch" in my book.

Use this information as a starting point for your own due diligence and research methods before determining whether or not to buy or sell a security. If you choose to start a position in any stock, I suggest layering in at least a quarter at a time on a weekly basis at a minimum to reduce risk and setting a 5% trailing stop loss if you wish to minimize losses even further.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.