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Faltering Facebook Is Still a Sell

After touching $32 just before earnings, Facebook (NASDAQ:FB) has faded about 13% to under $28.

And chances are, it could keep falling.

Facebook earnings, reported at the start of the month, showed the social network grew its mobile ad revenue in a big way — taking a 23% share of the pie vs. 14% of revenue previously.

But its expenses also climbed rapidly, and in this earnings season when margins are key and cost containment seems like the only way for many companies to grow profits, that worried many investors. The “investment” in engineers and data centers caused profits to decline from the same period in 2011.

With Facebook stock, it seems, investors have to believe that there is growth at the end of all this spending — growth that not only offsets some declines in its PC-based ad business, but provides a meaningful uptrend for the bottom line and for share prices.

That seems tenuous at best. Here’s a short list of my concerns:

First, Facebook has a forward price-to-earnings ratio of roughly 35. That’s twice Yahoo (NASDAQ:YHOO)’s P/E of about 17.7 and significantly higher than AOL (NYSE:AOL) at 21.5 — two digital media properties fighting to figure out mobile, digital advertising and other similar issues. Neither is a 1-to-1 analogue with Facebook, but consider that both stocks are up more than 40% in the last year while FB is almost 28% in the red across the same period.

You have to believe growth will fill in the gap. But even with Facebook’s rosy forecasts, the company will not eclipse its 2011 earnings peak until fiscal year 2014. Yes, revenue is on the rise but Facebook continues to spend big, whether it be the $1 billion buyout of Instagram or the roughly $800 million-plus it spends on servers and storage annually to support its users’ photos and personal info.

The growth question is troublesome because Facebook already boasts 1.06 billion monthly users, so getting even more people on board seems a tall order. That means the only opportunities Facebook really has is to increase engagement, increase margins or create new channels or experiences for existing users.

Engagement? Well, that trend could be more of a negative than a positive. Plenty of reports hint anecdotally at a trend of users checking out of the social networking service for reasons that include “too much drama,” among other things.

Margins? Well, as mentioned we just saw the company’s earnings decline thanks to spending. And Q2 and Q3 were actually running in the red. Check out this chart from TechCrunch to see the trend lately. So much for cost containment.

Which leads us to the last option of a new channel or user experience. Facebook rolled out its “social graph” with little fanfare. It wasn’t a Google (NASDAQ:GOOG) killer with true search potential, and it seems a novelty without much appeal to users after the initial splash. But hey, at least comical social graph searches like “married people who like prostitutes” in your network are good for a laugh.

If all this weren’t enough, the elephant in the room remains the risk of disruption. Facebook execs admitted the following laundry list of concerns in their latest annual report:

  • “users increasingly engage with other products or activities”;
  • Facebook leaders “fail to introduce new and improved products” or go with products or services “not favorably received”;
  • continued mobile miscues;
  • “changes in user sentiment about the quality or usefulness” of Facebook products; and
  • “new technologies” where Facebook can’t capitalize as well.

You get the picture.

So there you have it. There is growth on the revenue side, to be sure, but profits are harder to come by and the company faces real long-term risks despite its reach.

I’m not saying Facebook will disappear, or even that there isn’t modest upside from here.

But FB stock seems awfully speculative, a bit overpriced and way too risky as technology continues to evolve.

Seems to me like there are opportunities elsewhere.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing he did not own a position in any of the stocks named here.

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