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May 2, 2012 9:09 pm
Your 3,000 “friends” will not care if you buy at the wrong price and it does not matter whether you liked the movie. Ahead of this month’s planned initial public offering, investors need to start thinking about Facebook the stock – not Facebook the cultural phenomenon. What sort of company is it, and how to value it rationally?
The IPO is expected to raise $10bn or more, making it the biggest tech offering ever, but its significance is greater than that. Its success or failure will be interpreted as a judgment on a generation of companies that aims to wring profits from online social life, and as a measure of an uncertain market’s risk appetite. The feverish atmosphere surrounding the debut makes it all the more vital to take a step back and assess Facebook as just another business.
Being Microsoft and Google
Valuing Facebook is particularly tricky because its impressive – but hardly flawless – present performance is an imperfect guide to its future. Instead, shareholders wanting to place a bet on the business need to think carefully about two fundamental questions.
First: will Facebook become a part of everything that happens on the internet rather than just one digital tool among others? To justify the lavish valuations being suggested, the company must attain a position across the internet similar to the one Microsoft once held in personal computing. Ownership of the operating system, the browser and the document software made Microsoft the water in which all computer users swam: often invisible, perhaps not particularly loved, but immensely profitable. Computing must become deeply social, and Facebook must own that social dimension – and make it pay.
Second: can Facebook change digital advertising as profoundly as Google has done in the past decade? Within internet search, Google enables advertisers to target customers based on their searches – that is, based on their explicit intentions. Returns to advertisers are measurable and high. Facebook aims to do for users’ social connections what Google did for their intentions. Whether users will co-operate remains to be seen. If not, Facebook will not live up to the hype.
Like the margins
Facebook has achieved a lot. Revenues grew 88 per cent last year, from a $2bn base. Operating profit margins were almost 50 per cent. That is amazing. Five years ago, when Google was growing at a similar pace, its margins were much lower, and remain so. Even Microsoft touched Facebook’s current margin levels only in the late 1990s, when revenues were running at $20bn a year. That said, growth is not moving upwards in a straight line. Facebook is not adding users or advertisers fast enough to obscure seasonal ups and downs. Advertising revenues – 84 per cent of the total in the past year – were lower in the first quarter than in the fourth in the past two years.
The Lex column first appeared in the 1930s. Unfortunately the mystery of how it got its name died with its founder Hargreaves Parkinson, later editor of the FT. One explanation is that it derives from the phrase de minimis non curat lex (the law is not concerned with trifles) and was a knowing jibe at a rival column signed Autolycus – Shakespeare’s “snapper-up of unconsidered trifles”. From the start, Lex has stood up for investors with intelligent and provocative analysis, cutting through the hype surrounding the big financial news events of the day
And Facebook has not solved the problem confronting all internet media companies: low barriers to entry and vicious competition. Friendster and MySpace? Gone. One might think Facebook is too big to follow. But it spends as if facing mortal threats. It boasted that photo-sharing was a core service yet last month suddenly shelled out $1bn in cash and shares for Instagram, a photo-sharing start-up. So it seems low natural barriers to entry might require the constant building of artificial ones out of real money.
And while it is easy to start a social network, it looks expensive to run a big one. Real assets need to be bought. Capital expenditures amounted to 30 per cent of revenues, or $1bn, at Facebook last year, and chewed up nearly half of revenues in the most recent quarter. Free cash flow return on assets is strong but Google’s is twice as high.
Return on assets should improve as Facebook grows. But even if capital expenditure falls relative to revenues, operating cost trends do not reassure. In spite of annualised sales well over $4bn, there is little sign Facebook is increasing its revenues faster than its cost base.
Finally, management. Facebook sits in the palm of 27-year-old chief executive Mark Zuckerberg who will control more than half the voting shares after the IPO. That level of trust in a single person is troubling. Still, nothing is being hidden from investors in this regard.
Your mom is not cool
So much for Facebook today. Before turning to the future, remember the immutable laws of finance. Stratospheric growth never lasts. Returns fade. New threats emerge.
Hence that first big question: can Facebook burrow into all aspects of computing and stay there, as Microsoft did – or will it give way to the next new thing? Clearly, social networks are unstable in their early years. But once they reach a certain scale they become more resilient. Any communication tool that is already popular has an advantage in attracting new users – the “network effect”. Software designers will aim their best new stuff at the biggest platforms – a phenomenon from which Apple and Android are benefiting in mobile computing.
With 900m active users, Facebook looks dominant already. But investors must consider the possibility that, like most products, its usefulness will peak and decline. Many of the connections users have formed could cease to be of interest. The network starts to carry more noise than information. People look for something more interesting. Social networks have inherent stabilisers as they grow but may also have a big destabiliser: boredom.
This problem is compounded, it seems likely, by the ever-increasing probability that your mother (or father or teacher) is on Facebook. That is, as user numbers increase, it becomes less cool. The company would argue it does not need to be cool. Once its user base reaches a certain size, it becomes irreplaceable. Should Facebook attain a stable monopoly on social networking, it would be easy to dream of a time when searching for information, reading news, watching television, writing a document or talking on the telephone are activities conducted on the Facebook platform or given a social dimension imported from and controlled by Facebook. It is this picture that makes some analysts think the company could be worth $100bn or more. Certainly, the potential revenue pool is enormous.
But users may not stay loyal for ever. True, all the data that make up a user’s identity – comments, pictures, likes, connections with friends – are in effect owned by, and trapped on, Facebook. The company has carefully made it costly to leave. The question is whether the costs are high enough to prevent flitting among the networks and tools that have not been invented yet. It is hard to quit using Microsoft’s software or Google’s search engine, not just because of network effects but also because almost everyone needs to do things those tools make possible. Competitors are more expensive or not as good. Facebook simply is not essential to life or work in the same way.
And remember that Facebook was developed at the tail-end of the PC era. As the smartphone ascends, the company is already playing catch-up with competitors born and bred on mobile devices. Naturally, Facebook could survive without monopolistic control of the social dimension of computing. But it would need to spend aggressively to protect market share, implying lower margins.
Your corporate friend
Monopoly or not, can Facebook deliver a better internet ad?
The worry is that its model is just too creepy. From the IPO filing: “Advertisers can specify that we show their ads to a subset of our users based on demographic factors and specific interests they have chosen to share with us ... We offer advertisers the ability to include ‘social context’ with their marketing messages. Social context is information that highlights a friend’s connections with a particular brand or business, for example, that a friend Liked a product or checked in at a restaurant.” To translate: we will harvest information about you and use it to help advertisers sell you things, or (creepier still) help advertisers “join the conversation” with you and your friends.
Now, this may have some pleasant repercussions. Advertisers could end up offering stuff people actually want. And privacy protection features will be put in place. But the issue is whether what Facebook does to increase the value of the data it collects makes users enjoy Facebook less and use it less. Users might start to think they are the product not the customer. Not a fun feeling.
The contrast with Google is striking. If Lex types “HP 12C calculator” into Google, it is setting itself up to see a certain kind of ad alongside search results. Indeed, users often have commercial intentions when they search. This is absolutely not the case on Facebook. And if the company cannot target ads without turning off users, revenue growth will slow, and soon.
So one metric worth following is growth in revenue per user. The numbers do not look good. There is still double-digit growth but there is a clear pattern of deceleration. Revenue growth is coming more from adding users than from making ads work better. If this continues, that is a signal of serious tensions in Facebook’s business model.
What’s a friend worth?
How to put all this into a Facebook valuation? To justify the big numbers being tossed around – $100bn and up – several things must happen in the next five to seven years. The business needs to become much less capital intensive (inclusive of acquisitions) over time, as Google and Microsoft have done. That is the easy part. But margins must also stay near today’s level of about 50 per cent – which would be uncharted territory. And sales would have to grow at least sixfold in this period.
The latter is certainly possible. For comparison, when Google had the same revenues as Facebook has now it took just seven years for them to increase another 10 times. That magnitude of growth took a decade at Microsoft when it too earned about $4bn a year back in 1993.
The conclusion is this: it is hard to imagine the required levels of growth or margins if Facebook does not become ubiquitous or cannot deliver on the promise of a superior sort of internet advertising. If it cannot, a $100bn-plus valuation will be about as meaningful as having 3,000 friends.
Facebook valuation calculator
Facebook is going public, but what is really worth? This interactive calculator is a basic two-step discounted cash flow model to help illustrate how variations in key assumptions can change the potential market value and share price of an IPO.
Enter your projections for Facebook’s sales growth, ebitda margin, and capex-to-sales ratio to see how these key assumptions affect the potential market value of the social networking firm’s offering.
When you are satisfied with your model, you can share your Facebook valuation by clicking the Twitter button above the charts.
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