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The Apotheosis Of Bubble Finance—-The Once And Future ‘Faceplant’, Part 2

This is a syndicated repost published with the permission of David Stockman's Contra Corner » Stockman’s Corner. To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.

Indeed, the so-called social media stocks represent the very essence of the bicoastal Bubble Finance prosperity of Wall Street and Silicon Valley.

The truth is, Facebook——along with Instagram, Whatsapp, Oculus VR and the 45 other testaments to social media drivel that Mark Zuckerberg has acquired with insanely inflated Wall Street play money during the last few years——-is not simply a sinkhole of lost productivity and low-grade self-indulgent entertainment. It is also a colossal valuation hoax, and one that is heading for another “Faceplant” when the third great financial bubble of this century comes crashing down.

Why? Because at bottom, Facebook (FB ) is just an Internet billboard. It’s a place where the idle mostly idle their time, like millennials in or out of their parents’ basement. Whether they grow tired of Facebook or not remains to be seen, but one thing is certain.

To wit, FB has invented nothing, has no significant patents, delivers no products and generates no customer subscriptions or service contracts. Its purported 1.8 billion “MAUs” (monthly average users) are fiercely devoted to “free stuff” in their use of social media.

Therefore, virtually all of its revenue comes from advertising. But ads are nothing like a revolutionary new product such as Apple’s iPhone, which can generate tens of billions of sales out of nowhere.

The pool of advertising dollars, by contrast, is relatively fixed at about $175 billion in the U.S. and $575 billion worldwide. And it is subject to severe cyclical fluctuations. For instance, during the Great Recession, the U.S. advertising spend declined by 15% and the worldwide spend dropped by 11%.

And therein lies the skunk in the woodpile. Due to its sharp cyclicality, the trend growth in U.S. ad spending during the last decade has been about0.5% per annum. Likewise, the global ad spend increased from about $490 billion in 2008 to $575 billion in 2015, reflecting a growth rate of 2.3% annually.

Yes, there has been a rapid migration of dollars from TV, newspapers and other traditional media to the digital space in recent years. But the big shift there is already over.

Besides that, you can’t capitalize a one-time gain in sales of this sort with even an average market multiple. And that’s saying nothing about the fact that FB’s recent $360 billion market cap represented a preposterous multiple of 225 times its $1.6 billion of March 2016 LTM free cash flow

For the June 2016 LTM period, in fact, its multiple was infinite because its free cash flow was actually negative $1.5 billion.

In any event, the digital share of the U.S. ad pool rose from 13.5% in 2008 to an estimated 32.5% last year. But even industry optimists do not expect the digital share to gain more than a point or so per year going forward. After all, television, newspapers, magazines and radio and highway billboards are not going to disappear entirely.

Consequently, there are not remotely enough advertising dollars in the world to permit the endless gaggle of social media space entrants to earn revenue and profits commensurate with their towering valuations and the sell side’s hockey stick growth projections. In social media alone, therefore, there is more than $1 trillion of bottled air.

In fact, in a milieu built around the concept of “free stuff” the massive amount of speculative VC capital that has entered the social media space is certain to drive customer acquisition and service costs ever higher and margins to the vanishing point.

The fact is, none of the social media competitors, not even Facebook, have a permanently defensible first mover advantage. That is evident in the current tally of 140 so-called venture capital “unicorns”. Each has a private pre-IPO “valuation” of $1 billion or more, or at least did until recently when the drought of IPOs has begun to puncture the fantasy. Even then, the group is still “valued” at $500 billion in the rarified precincts of Silicon Valley.

But the unicorns are sowing forces that will eventually eviscerate FB’s massively bloated valuation.

First, they are hatching new competitors for advertising dollars like there is no tomorrow. On-line advertising revenue, in fact, is the business model of virtually the entire social media space.

Secondly, and more importantly, they are burning VC capital by the tens of billions attempting to find “users” and customers and attain business viability by buying mobile advertising from…….yes, Facebook!

As we learned from the dotcom bust, when freshly minted companies start taking in each other’s laundry in Silicon Valley things get way out of whack. Capital morphs into revenue and “burn babies” temporarily and deceptively appear to be a booming new customer base.

That is, until the bubble implodes, new capital flows dry up, start-ups disappear en masse and revenue from their purchases of equipment, services (e.g. Amazon’s cloud services) and advertising vanishes.

And that get us to the ludicrous hockey sticks on which FB’s current valuation is based—even as the end-of-bubble handwriting is already on the wall.

Start-up company space , for example, is being vacated all over the place in San Francisco and real world consumer products companies like the mighty Proctor & Gamble have already decided to stop paying exorbitant rates for Facebook’s ineffective targeted mobile advertising.

Nevertheless, Merrill Lynch is currently projecting that Facebook’s $16.6 billion of ad revenue in 2015 will grow by 84% to $30.5 billion by 2017.

But what would happen if it turns out that the central banks have not abolished the business cycle after all? Assume that the growing signs of global recession materialize in a downturn between now and then, and that results in a advertising reduction of about half as severe as the Great Recession.

Accordingly, this time the world ad spend would drop by only 5%, not 10-15%, to about $545 billion. Furthermore, assume optimistically that the digital ad share gains another 2 points per year, rising from 26% of the global add spend last year to 30% by 2017.

Under those perfectly sober assumptions, digital spending would rise by about $15 billion over the next two years from the $150 billion level achieved in 2015. And the non-search share of that gain where FB competes—that is, the portion outside of Google’s near monopoly— would be about $7.5 billion.

In short, the Wall Street hockey brigade is essentially projecting that FB will pick up 200% of the available new ad dollars that would likely materialize under an even moderate global recession scenario.

But that isn’t even the half of it. Even a hint of recession would knock the props right out from under the monumentally bullish financial market bubble that has been fueled by the Fed and other central banks since the 2008 crisis.

History leaves little doubt about what happens then. The massive amount of venture capital pouring into Silicon Valley and the social media space would dry up in no time; and the “burn baby” advertising spend by the unicorns and other start-ups would quickly vanish.

So instead of growing at 40% per year, there is a very distinct possibility that FB’s sales will slump to the single digit range not too many quarters down the road.

Stated differently, Facebook is a valuation train wreck waiting to happen. It is spending tens of billions on acquisitions of companies that do not even have revenues and ramping up its internal operating costs at staggering rates of gain.

This means that when ad spending hits the recessionary skids in the months ahead——look out below. Its stock price will crater.

In short, Bubble Finance hype is the sum and substance of Facebook’s crazy valuation and its modus operandi. But its founder, controlling shareholder and CEO, the brash young Mark Zuckerberg, is no Bill Gates. Not by a long shot.

Gates was a true business genius who created an essential component—desk top operating systems—- of the internet age. By contrast, Zuckerberg happened to be hanging around a Harvard dorm room just as the central bankers of the world were cranking up their printing presses to warp speed.

The hallucinatory sense of grandeur that accompanied Facebook’s IPO eight years later in May 2012 has been on display ever since. But Zuckerberg’s madcap M&A frenzy—culminating in the insane Whatsapp deal——may well become the defining moment for the third and final bubble of this century.

To wit, Zuckerberg paid the stunning sum of $22 billion for a social media outfit that had just $10.2 million of revenue. The purchase price thus amounted to 2,150X sales.

And while you are at it, just forget about the fact that Whatsapp actually lost one-half billion dollars during the year prior to the deal’s close in October 2014.

Then again, the way you lose such staggering amounts of money on virtually no sales is quite simple. That is, you adopt a business model that even the most intellectually challenged hot dog stand operator would not have contemplated before the age of Bubble Finance.

Namely, plow headlong into a huge business operated by the biggest telecom companies in the world. In this case, one which generates $20 billion in annual billings for the wireless carriers. And the key to grabbing market share in that brutal neighborhood: offer your service for free!

That’s right. Whatsapp is just a text messaging service that challenged the paid SMS services of AT&T, Sprint, Verizon etc. by reducing the transmission charge from $10-20 per month to, well, nothing.

The CEO of a competitor succinctly explained why this tactic works,

It always comes down to the economics,” said Greg Woock, the chief executive of Pinger. “Free is a compelling price point.”

Yes, it is. Not surprisingly, Whatsapp free messaging service had gone from a standing start in 2009 to 400 million users by 2014. Now that’s the kind of “growth” that social media bubble riders can get giddy about.

But it amounted to this: Facebook paid $55 per user for a business that had 13 cents per user of revenue.

But never mind. Having virtually his own legal printing press—–FB issued $17 billion of freshly minted stock to pay for most of the deal—-Zuckerberg explained it this way:

‘Our strategy is to grow and connect people. Once we get to 2-3 billion people there are ways we can monetize’.

In fact, Whatsapp now has nearly 1 billion users, but still no revenue and has actually eliminated a minor annual user charge.

If this sounds vaguely like the dotcom mania in early 2000, it is and then some.

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