Behind BMO’s cold-eyed 'underperform' recommendation on Facebook

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My colleague David Parkinson wrote an earlier blog post about Facebook – or, more specifically, what analysts are thinking about the stock now that the so-called quiet period has ended and the underwriters can express their views on it. BMO Nesbitt Burns strayed from its peers with an "underperform" recommendation and a price target of just $25 (U.S.).

This bearishness, of course, begs an explanation.

Analyst Daniel Salmon argued that much of his dissatisfaction with the stock derives from the situation that Facebook finds itself in, rather than with Facebook itself.

For one thing, the company's share of the world's internet population grew so fast that it is now facing slowing growth in the number of Facebook users. His estimates show the numbers will rise 22 per cent in 2013 and slow to just 16 per cent in 2014, which is hardly the sort of growth that can justify some of Facebook's sky-high valuation numbers.

To be sure, there are specific growth opportunities available to Facebook, including Japan and South Korea, where penetration rates are still below 20 per cent. As well, China is still a no-go zone for Facebook, but Mr. Salmon assumes it stays that way.

Facebook also faces a number of challenges related to increasing advertising prices, which is a big issues given that the company generates about 85 per cent of its revenue through advertising. "This is hardly a Facebook-specific issue; rather, we increasingly believe that the entire advertising industry is seeing long-term secular pricing declines," Mr. Salmon said. "It's a simple matter of supply and demand."

Still, he readily agrees that there are a number of initiatives that Facebook can take that, if successful, could shift his opinion on the stock.

"Recent initiatives that could prove our thesis wrong include new demand from Facebook Exchange, the functional launch of a Facebook ad network (with one partner only so far, Zynga), new fees for the currently free brand pages, and the new subscription option for Credits, which could be a precursor to a paid, 'personalized newspaper' service," he said.

But with one of the lowest Facebook target prices among analysts – implying a downside of 34 per cent from the stock's IPO price – Mr. Salmon doesn't sound very hopeful.