Why Facebook is Now a Classic “Turnaround Stock”

It may be one of the fastest reversals of fortunes we’ve seen with an initial public offering (IPO) in quite some time. 

Before its May 18 IPO, Facebook (Nasdaq: FB) was growing its user base like wildfire, and investors couldn’t wait for a chance to tap into that hot growth trend. Then, right after the stock went public, Facebook’s growth streak and advertising business started to crumble, cutting the newly-issued shares in half within weeks of their debut.

Investors who had insisted on owning a stake in Facebook ended up either disgusted with the company or with their decision. Those who knew buying the stock wasn’t worth the risk were breathing a sigh of relief as Facebook’s numbers started to wane. 

Ironically, both groups may be missing a more important fact — the problems that sent the stock tumbling have largely been resolved. This hated stock is now positioned to regain lost ground and actually make money to investors.

That was then…
Facebook’s primary source of revenue is advertising sales. The company charges advertisers a small fee to place a banner ad somewhere on every Facebook page. As Facebook users browse the site and click on more pages, the more advertisements they’ll see, and the more apt they are to click on one of those ads. Of course, the more users Facebook can garner, and the more often they visit the site, the more ad revenue Facebook can generate.

That’s what made the opportunity so exciting to investors all the way through the company’s IPO. For one thing, the user count was 33% higher at the end of this year’s first quarter compared with the first quarter of 2011, and was on pace to reach the 1 billion mark sometime in the fall. Moreover, those users spent on average twice the amount of time per month on Facebook compared to other websites such as Google, according to digital marketing and communications agency Twist Image. 

Revenue was another reason investors were crazy about the Facebook IPO. While revenue growth rates were slowing in the first quarter of 2012, they were only slowing because the company had gotten so big. And the even-slower growth rates were still impressive. In the first quarter of this year, year-over-year revenue grew 37%.

Between the growth in the number of users and the amount of time those users were spending on the site, Facebook quickly became a seemingly “no-brainer” investment. 

Unfortunately, by the time Facebook went public, the site’s user growth rate fell, as well as the number of visits those members were making to the site. 

By June, third-party measurements noted that more than one-third of the social network’s members were spending less time on the site than they had just six months earlier. About 80% of Facebook users confirmed in a poll that they had never actually purchased anything based on the ads they viewed at the site. Some studies say the number is even higher than that. Even those who were still visiting the social media site as often as they had been were spending less time there, as it was not smartphone-friendly at a point in time when mobile phones were becoming the most-used means of connecting to the Internet.

No wonder advertisers started to bail.

And while some may consider it “too little, too late,” the fact is Facebook has addressed the bulk of the issues that made the stock such a disaster right out of the gate.

…And this is now
For starters, the company completely revamped the way it sells advertising space. More specifically, it’s now focusing on real-time bidding.

Real-time bidding (RTB) for online-ad slots isn’t exactly new, but it is a growing method of buying online ad space. RTB allows advertisers to set the price they are willing to pay to target specific users, making it far more effective for advertisers to match consumers to the appropriate ad content. The advertising industry is expected to spend a total of $2 billion on RTB this year and $5.1 billion by 2015, according to information technology researcher IDC. 

Facebook only introduced real-time bidding — dubbed Facebook Exchange — in June. But advertisers are already seeing a much better return on their Facebook ad investments than other real-time bidding systems. Though the results vary, advertisers are reporting the new bidding arrangement drives response rates that are anywhere from twice as successful to more than six times as before.

Simultaneously, Mark Zuckerberg finally recognized the company was missing the boat by not being smartphone-friendly. 

Don’t get me wrong, smartphone users can access Facebook, but the social media site isn’t optimized for such devices. That’s a problem. Though most users still visit the site using a computer for an average of 391 minutes per month, mobile phone users are on the site for an average of 441 minutes per month. 

Yet, mobile phone and tablet Facebook users only view about two ads per day, while computer-based Facebook users view an average of 5.5 ads per day. The issue has since been addressed, and smartphone users are going to see more ads now, which means more clicks and more revenue. 

Few investors may see it, but these two simple tweaks could help the company overcome its biggest stumbling blocks.

Risks to Consider: Though it’s compelling to see a company acknowledge and correct mistakes, the two big errors that were corrected within the past few weeks should have been avoided altogether in the first place. One has to wonder how easily the company could wade into similar mistakes again. 

Action to Take — > There’s no question Facebook is going to be a dominant destination on the web. But it doesn’t have to be the world’s most-visited website in order to bear fruit for investors. Based on the improved ad-revenue metrics and better functionality for smartphone users — against a backdrop of disgust with the stock — now may the ideal time to sneak into a Facebook position based on value. 

All things considered, you could make a plausible case for Facebook shares growing 30% to 40% between now and the end of 2013. By then, this could quite possibly be market‘s most talked-about turnaround story.