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Connecting the Dots: Watch Out: Facebook’s Skyrocketing Expenses Signal Trouble

 -- Published: Thursday, 6 November 2014 | Print  | Disqus 

By Tony Sagami 

I used to think that nobody could spend money faster than my ex-wife, but I was wrong. Mark Zuckerberg is putting her to shame.

How much attention did you pay to Facebook’s quarterly results last week? For the average investor, the answer is probably not too much, because Facebook only dropped by 6% when it told Wall Street to dial down its lofty expectations.

The problem wasn’t the third-quarter results, because Facebook actually delivered some pretty solid numbers. However, when it comes to stocks, the future is more important than the past, and Facebook delivered a cautious outlook for its future.

The big disappointment was Facebook’s forward guidance that revenues for Q4 and for 2015 would be below Wall Street expectations. Facebook warned that its Q4 revenue would fall between $3.6-$3.8 billion, a 40-47% higher year-over-year increase.

40-47% growth may sound impressive, but it is far below its historical growth rate—and more important, below what Wall Street was expecting.

The growth problem is simple; it is just the law of large numbers. Facebook has already captured most of the world’s social network addicts, so its best growth days are behind it.

FACT: Facebook increased its monthly active users to 1.35 billion as of September 30, 2014, a pathetic 14% increase. That is woefully inadequate for a company that is trading for 85 times earnings.

Moreover, Facebook is having very little success at converting very many of the 600 million WhatsApp users, making it appear that it pissed away the $22 billion it paid for it.

Not only is the WhatsApp acquisition not delivering growth synergies, WhatsApp is bleeding money. WhatsApp lost $232 million in just the first six months of 2014.

Even more insulting is the miniscule amount of revenue that WhatsApp generated in the first half of the year: $15 million!

Hmmm. I’m a cheapskate and I am certainly not “hip” when it comes to the hottest social media trends, but paying $22 billion for a company with $15 million of sales and $234 million of red ink sounds like a disaster to me.

The slow growth and wasteful acquisitions aren’t the biggest red flag I see at Facebook. What worries me the most is the explosive increase on the expense side of Facebook’s financial statement.

In 2013, Facebook had $3.2 billion of operating expenses. However, Facebook now says that operating expenses for 2014 will increase by 45-50%, up from a prior outlook of 30-35%.

Worse yet, CFO David Wehner warned 2015 will be “a significant investment year,” and said that it expects expenses to increase by another 55-75%! Let me make sure you absorb those numbers.

Q4 Expenses: up by 45-50%!

2015 Expenses: up by another 55-75%!

Using the low end of those forecasts, that means that 2014 operating expenses will rise from $3.2 billion to $4.6 billion in 2014 and then to $7.2 billion in 2015!

Even at the low end (45% in 2014 and 55% in 2015) of those forecasts, operating expenses at Facebook are going to at least double from last year. That’s some serious spending!

Zuckerberg controls 55% of the voting shares of Facebook; that means that he can do whatever he darn well pleases. If you’re a Facebook shareholder, your only choices are to go with the ex-wife type of spending or vote with your feet.

To truly see the big social networking picture, don’t forget to connect the dots with two other Internet behemoths—Amazon and Twitter—that just reported worse than expected results.

The news at Facebook alone is enough to keep Facebook on my short list of stock market dogs, but it becomes even more compelling when you connect the dots between Facebook and troublesome news at other high-flying Internet stocks.

That doesn’t mean you should rush out and short any of those stocks tomorrow morning. As always, timing is everything; but when the stock market turns ugly, I expect Facebook and its social networking cousins to be some of the very worst performers.

30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.

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