7 March 2012
Should You Be Licking Your Chops Over Facebook’s IPO?
Facebook is this season's "hot stock."
Any broker lucky enough to have some to sell will tell you that.
But...should you listen?
My friend Raymond loves Facebook—and he doesn’t even have an account.
But his wife does.
“Before Facebook,” Raymond says, “my wife went to the mall every day with my credit card. Now, she stays home and plays Farmville.”
This, in a nutshell, is Facebook’s business problem: it’s free (“and always will be”). You can spend 24 hours a day on Facebook without contributing a penny to Facebook’s bottom line—and lots of people do. (In truth, you’re part of Facebook’s negative cash flow: think of all those servers they must maintain to service your account.)
Facebook has 845 million “monthly active users” who check in at least once a month—12.1% of the world’s population and 40.4% of everyone with an internet connection.
483 million of them use Facebook on a daily basis.
Very exciting numbers—but do they mean very much?
Not necessarily—if most of them are like Raymond’s wife.
When my laptop is on, my Facebook page is open. So for around 12 hours a day, Facebook counts me as an “user.” But I only I spend around a quarter of an hour on an average day actually looking at that page. And in the year or so I’ve had an account, I’ve clicked on one ad, once. Say ten or fifty cents.
I’m still part of their negative cash flow.
How about you? How often do you use your Facebook account? Have you ever clicked on an ad? Have you ever noticed the ads? Are you an “active” user like me (or Raymond’s wife)? If yes, then you’re also part of Facebook’s negative cash flow.
What about your friends? What category do they fall into? How many of them are Facebook “customers” who have actually contributed to Facebook’s bottom line by clicking on an ad or buying something for their Farmville farm?
Facebook versus Google
Google and Facebook are often compared, with good reason: they’re both exciting growth stories, free to use, and most of their revenue comes from ads. But when you search on Google, you’re presented with ads that give you options you’re actually looking for. And you can hardly avoid seeing them (unlike Facebook ads).
The difference shows up starkly in the two companies’ revenue and profits per user—and per share:
Revenue per user
Profit per user
Profits per share
Profits as % of share price
* Share prices. Google: Friday, 2 March 2012. Facebook: based on market cap of $100 billion.
Other information from Google’s and Facebook’s SEC filings.
Owning Google shares is rather like owning a rental property paying you about 5% a year on its current value, while Facebook is a million dollar house that rents for a mere $535 a month!
Of course, the excitement over Facebook has nothing to do with current returns, and everything to do with its anticipated future value.
Since anyone buying at the IPO expects to make a profit, where’s that profit going to come from? The two primary sources:
- Sometime in the future Facebook’s profits will justify or far exceed its expected IPO valuation; or,
- A quick killing from offloading their shares to the “greater fools” who missed out at the IPO.
Facebook as a business proposition
If Google’s current share price represents a fair market value for this type of business, for Facebook to offer the same return (at the expected IPO price), it must increase its gross earnings at least 7.7 times. Where could such growth come from? Three possibilities:
Growth #1: More Users. More users will certainly increase gross revenue.
Trouble is, given Facebook’s high penetration the US, Europe, and other developed countries, most of those new users will come from poorer countries—few of them with credit cards. As more people sign up on Facebook, its revenue-per-user will decline.
Assume Facebook does “connect the world”—well, everyone with an internet connection. Its users will rise from 845 million to 2.1 billion. But if the revenue-per-user falls from $4.79 to, say, $3.50, its gross revenue will barely double.
Growth #2: More $$$ Per User. 85% of Facebook’s revenue comes from ads; the balance, through companies like Zynga, from gamers who are willing pay for extra game features.
Ads. A comparison of The Wall Street Journal and USA Today ad rates tell the Google/Facebook story. The two newspapers have approximately the same circulation, but a Journal ad is 90% more expensive than one in USA Today. And the Journal has more pages packed with more ads, which means more competition for a reader’s attention.
But advertisers will pay more for a richer audience. It’s as simple as that.
Google advertisers often pay more per click than Facebook’s. But Google’s ads are like the Journal’s —finely targeted—so Google advertisers will always get more clicks per impression. And—like the Journal—Google has more ads per page, as well.
No doubt Facebook can and will increase its advertising revenue per user by, for example, improving its targeting of ads and adding them to its mobile apps. But it’s impossible to make any meaningful prediction of when that will happen or how it will affect the bottom line.
Games.Similarly, through its games Facebook represents a platform for third party developers to produce apps like Farmville.
Even though Facebook’s revenue from games has increased faster that its ad sales, it’s impossible to predict with any certainty whether that growth will continue. An appropriate comparison is with Apple’s app store—another Wall Street Journal/USA Today comparison.
Assume Facebook merely doubles its revenue-per-user. Not an unreasonable expectation, perhaps—though one made with very little certainty.
With double the users and double the revenue-per-user Facebook needs one more double just to equal Google’s current return to shareholders.
Growth #3: Turn “Users” into “Customers.” Here, we’re in Disneyland. There are many possibilities for new and different apps that could profit from Facebook’s platform. Nobody—not even Mark Zuckerberg—knows what they might be.
And whether they’d succeed or fail.
But if you and I were in the business of developing apps, where would we focus our energies?
I’m actually involved in creating such an app myself. When it’s done it will appear first...in Apple’s iTunes store. Then: Android.
Until writing this I’d never considered Facebook as a platform. Perhaps a cut-down, free version might work there. (’Nuff said.)
Obviously, Facebook is an ideal platform for certain types of apps (did I mention Zynga?). But not for most of the best-selling Apple and Android apps.
Adding everything together leaves us at a maybe four times gross revenue projection—giving Facebook a potential business value of around $50 billion. And that’s based on very optimistic assumptions that would take years to play out.
Google’s market cap today is $201 billion. Facebook’s business value could be a quarter that...in five, ten or more years.
Would you pay $100 today to maybe get $50 back sometime between tomorrow and 2022?
Would a “Warren Buffett clone” buy Facebook?
We know Buffett himself has no interest in Facebook at any price: he’s repeatedly said valuing internet and hi-tech businesses is outside his circle of competence.
But assume a Warren Buffett clone who does understand the business. Consider just one of Warren Buffett’s favorite questions: Would I want to buy the whole company with its current management in place?
Mark Zuckerberg answers this question in his Letter included in the SEC filing when he says:
“Simply put: we don’t build services to make money; we make money to build better services.”
“We think this is a good way to build something,” Zuckerberg continues—and it is. But then he states that he believes “These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits.”
But Buffett wants his money in companies whose managers are busting their guts to make their shareholders rich. That’s not Facebook management’s primary motivation so our imaginary Warren Buffett clone would pass.
A related reason he’d walk:
Facebook is customer-unfriendly
Facebook makes unpredictable, unannounced and usually unwanted changes to its interface. The latest is “Timeline,” which will soon become compulsory.
I hate it. So do 92% of Facebook’s users according to a survey of 4,000 users carried out by security firm Sophos. The other 8% say “they’ll get used to it.” Hardly a ringing endorsement.
To me, it’s as if Apple suddenly recalled all its iPads and replaced them with a clone of the discontinued HP TouchPad. Except not even 8% of iPad owners would “get used to it.”
TimeLine is not the first time Facebook gave its users no choice.
In his Letter, Zuckerberg talks about Facebook’s “Hacker Way”:
“Instead of debating for days whether a new idea is possible or what the best way to build something is, hackers would rather just prototype something and see what works.”
Too often, that prototype is “tested” on Facebook itself. In Facebook’s “hacker” culture, if you haven’t changed anything yet, you haven’t arrived.
Another example of its customer-unfriendly attitude: Facebook is repeatedly criticized for what many users consider violations of their privacy—the new “TimeLine” interface being yet another one.
In business, ignoring your customers’ concerns (or meeting them only halfway) and constantly changing things with no or inadequate warning is the exact opposite of “how to win friends, influence people, and add to the bottom line.”
This attitude opens the door to Facebook’s greatest danger: competition from a customer-friendly company. Which could be Google with its Google+.
Google+ (or someone else) doesn’t need more users than Facebook to skim the cream off Facebook’s business.
Consider a Mac/PC comparison. The Mac has just 7% of the laptop market—but Apple rakes off 35% of all the profits made by the top ten laptop makers. (Apple also sells 91% of all computers costing over $1,000—and with just 8.7% of the cellphone market, its iPhone takes 75% of the profits.)
A Facebook competitor highly-focused on, say, the business market, could similarly cream off the high end of Facebook’s potential revenues.
845 million people use Facebook because their friends do. While this “network effect” could favor Facebook indefinitely, the highest numbers in the business in no way guarantee the highest revenues or profits.
In sum, Facebook doesn’t add up as an investment at its expected IPO price.
Is the “Sir John Templeton Way” the best way to profit?
Undoubtedly, there are speculative profits to be made. But how to identify them in advance?
Everyone around you may be excited about Facebook’s IPO. But it doesn’t follow they’ll all put their hard-earned money on the table.
For example, if you buy in at $71.53 per share, do you know that you can sell them to your friends who missed out the next day at $80 or $100?
Obviously not. (For all you know, you’ll be ecstatic to dump your new stock for $50. Who can say?)
The secret to successful investing and speculation is to only put your money down when you know exactly what you’re doing and the odds are in your favor.
Imagine, for a moment, that you’re wearing the shoes of graffiti artist David Choe. He painted the walls of Facebook’s first headquarters. Offered payment in cash or stock, he took the stock.
Today, that stock is worth some $200 million.
If you were David Choe, what would you do with your Facebook stock the day the company lists?
My guess is your answer falls in the range: sell between half and the lot.
Facebook has made several people billionaires and hundreds more millionaires. Right now you can bet they’re all considering whether to:
- Diversify their investments;
- Cash in some or all of their “lottery tickets”; and/or,
- Raise money to buy that mansion, yacht, and Ferrari they’ve always lusted after.
Meanwhile, the venture capitalists who helped finance Facebook in the early days—like Peter Thiel with over $2 billion in Facebook stock (his original investment: $500,000)—will be considering what percentage of their holdings they should sell.
Much of their holdings, however, are in options or “RSUs” (Restricted Stock Units), which cannot be sold until the restrictions expire.
Those restrictions began expiring March 1.
In addition to the expected $5 billion worth of Facebook stock being offered at the IPO (assuming a $100 billion valuation), unknown billions more stock will be offered for sale either at the IPO or shortly thereafter.
Using these characteristics of internet companies is how famed investor Sir John Templeton cleaned up from the 1990s internet bubble.
He sat completely on the sidelines until after the January 2000 market peak. Then, he shorted 84 different internet stocks. He initiated those short positions eleven days before the “lock-up” periods on the restricted stock of each company expired—and triggered a tidal wave of selling. His total profit: $86 million.
Facebook may (or may not) offer a similar opportunity—if you know what you’re doing.
Too many people invest with their gonads, not their brains. So whether Facebook’s share price will go up, down or nowhere on the day it lists is a total unknown. The only thing we can know with certainty is that the only people who’ll profit, guaranteed, from the IPO are the existing shareholders.
For most of us, there are greener (and far safer) investments fields just about everywhere else. — Mark Tier
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