SETTING THE STAGE FOR MY BULLISH OPINION ON FACEBOOK

Ok. I know publically coming out with a big target on “hot IPO” may seem sensational, self-serving or even cliché.  However, if you give me 3 minutes of your time, I think you’ll see my logic on why I think Facebook ($FB) is a good long-term investment.  As an ex-Wall Street Institutional Investor ranked analyst, I’ve written on many stocks and IPOs before, including: LNKD IPO (here), BankRate IPO (here), and even a piece on Facebook back in 2007 where I argued Yahoo! needed to buy Facebook (here) for $6-7b.  Importantly on Facebook, I think when one looks at the company’s potential, it’s paramount that one thinks bigger picture and longer term – this post is predicated on this.  So for the short term traders looking to play the IPO (and next few days post the IPO), this post isn’t for you.  My opinion on Facebook: I’m think that should investors buy the IPO, that they have a reasonable chance at doubling their money in a few years.  Many very intelligent friends of mine in the industry may disagree with me, but let me go through my logic…

First, some history. While I have been on Wall Street since 1992 and an equity analyst since 1997, I am now the President of a new, boutique merchant bank named CoRise (link).  At CoRise, we focus on big picture, tectonic shifts in the digital media landscape.  One of our most read research reports (here), looked at the digital media landscape shaped by 4 main areas (we call “Spheres”), each anchored by a large company – they are: Information (Google), Entertainment (Apple), Commerce (Amazon), and of course Social (Facebook).  (Microsoft could also be here, but we break them across the various spheres, given their many business). There are many other players in each sphere as well, but we merely point on the behemoths.

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Each one of these companies is bigger than just their size: they are platforms; they are ubiquitous; they are changing our world; they are disrupting traditional industries; and they are colliding into each other’s historic domains (pls see our piece to better understand).  Companies of this importance / magnitude are very rare – and eventually their market capitalizations reflect their uniqueness:  Amazon – $100b, Google $200b, Apple $525b, Microsoft $250b, Facebook $???  It’s very hard for me to imagine that Facebook doesn’t settle in between these market cap ranges over time, as the company expands (further) into new businesses embodied in the 3 other spheres: ecommerce & payments, entertainment, and information.  In the essence of being succinct, below I point out my Top 5 reasons I’m bullish on Facebook long term, as well as my Top 5 concerns.  There are an endless number of items for each list, but I think these items sum up the major points.


5 MAIN REASONS I’D WANT TO OWN FACEBOOK FOR THE LONG TERM

1 – Facebook is a Force Majeure @ 900m Users– As we depicted in our Four Spheres model above, Facebook dominates one of the largest forces on the Internet, Social.  It clearly embodies everything we do that’s social from posting pictures, to sharing our real time thoughts, to connecting with old friends, to making new friends.  It reflects how we behave offline and exemplifies how social behaviors pervade much of what we do on a daily basis.  Facebook is the king of one of human’s most basic communication needs – sharing.  Further, the company has managed to expand outside its own website or app.  With things like Facebook Connect, Facebook IS becoming our online identity.  We “Like” items across the web and log into sites using our Facebook ID – not only is that ubiquity powerful, but so is the knowledge Facebook accumulates about us.

2 – Business Optionality Seems Limitless – So while Facebook is dominant in one of our most basic human needs to be social, it’s also growing from its roots.  This is the hardest part of Facebook to value because it’s business opportunities / optionality seem almost limitless.  Much as we depicted in the confluence of the digital media spheres mentioned above, Facebook is already expanding into new areas, like Payments.  However, what is most difficult to capture in any valuation model is this optionality.  Will Facebook offer more in media consumption (think books, movies, music, subscriptions)?  Will it extend further into commerce (both online and offline)?  Will Facebook take Payments much further than where it is now (they have applied for “money transmitter licenses” in the US)?  What would a Facebook phone mean to the company’s offerings and monetization capabilities?  And while the company has an open platform for gaming, what about proprietary content creation (like YouTube does)?  Lastly, as we depicted in our Valuation of Networks piece, what value can Facebook provide as a distribution mechanism?  The obvious areas would be things like movie / music premiers.  But what about taking it a step further and the network disrupting capital markets.  Facebook is merely a connection of people, providing information flows – isn’t that capital markets (see our piece on the confluence of media and finance here)? Lastly, Facebook is disrupting information (search) – we can more quickly rely on our social graph for product recommendation / personal questions / ideas & suggestions.  AND, all of this information is beyond Google’s crawlers – known as the “Dark Web”, this is what scares those that reside in the Information sphere.

3 – Mobile Monetization is Just Starting – Facebook grew revenues ~45%  in the most recent quarter – that’s impressive.  However, what is most astounding, is that >50% of its monthly users visit the platform via a mobile device and these users haven’t been monetized yet.  Facebook is just starting to monetize >50% of its user base!  Imagine the lift in the financials from not only growing the users, but by merely monetizing over one-half of the current un-monetized base.  Facebook has struggled somewhat in mobile, but its recent efforts and acquisition of Instagram should help.

4 – New Geographies & Multiple Market Sizes  –  Facebook currently doesn’t operate in one of the largest markets in the world: China.  Further, the company is also restricted from other countries like Iran, North Korea and Syria.  Aggregating these markets provides enormous opportunity for the company to reach new users, beyond its current 900m base (over 500m Chinese Internet users alone).  Of course the company would face competition and possible regulatory restrictions, but the target market would be tremendous.  Further, we clearly can not pigeon hole Facebook’s target market opportunity to just the ~$500b of world wide advertising.  With possible expansion into commerce, payments, and entertainment the market size opportunity could be multiples of the current one.

5 – Rolling out New Products and Reaching New Advertisers – While the company will continue to roll out new user products and new advertiser products to improve the platform, I think a few recent tweaks are worth mentioning.  First, as I pointed out above, over 50% 0f Facebook’s users access Facebook via a mobile device, which has historically not been monetized.  However, in March the company rolled out a new ad product, enabling sponsored stories in user’s mobile News Feeds – the attempt to monetize mobile has begun.  Second, late last year, the company increased the minimum price threshold to advertise in their auction system.  Third, the company just expanded its Open Graph in Q1 to include more types of sharing.  Lastly, while Facebook does not break out its advertising revenue by size (i.e. small advertisers vs large brand advertisers), it has been speculated that a vast majority of the ad revenue is from smaller advertisers – this mean that the large Brand focused advertising dollars are largely underpenetrated and present a huge opportunity.

5 CONCERNS AN INVESTOR SHOULD CONSIDER

1 – Facebook is a Controlled Company – Even after the IPO, only one person controls the company: CEO Mark Zuckerberg.   While he has done a fantastic job thus far and has surrounded himself with top talent, I don’t usually like to see such levels of control.  Further, Facebook is technically a “controlled company”, which means that the board of directors doesn’t have to have an independent majority or a compensation committee.  A long-term investor is therefore giving up some control here and trusting in the company management, Mark Zuckerberg in particularly.  A short term investor is even more at risk, as the S-1 is very clear about its leaders not managing the company for short term goals.

2 – Competition from Many Areas – Following the Internet for many years, I have always been focused on competition and barriers to entry.  Facebook has done a tremendous job, but its faces competition from within the Social sphere, from the other spheres, as well as from traditional industries (see picture).  In fact, one could argue that Facebook’s “hasty” acquisition of Instagram was an acknowledgement of the flank it had failed to protect and a large liability in the growth of mobile.  Any long-term investor must keep a close eye on the changing competitive landscape, particularly in the fast paced world of the Internet.

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3 – Market Penetration Limits – My bullish thesis is predicated on the expansion into new geographies, new products, and new markets.  If Facebook isn’t able to execute on some of the new opportunities, then the optionality in my model declines.  A long term investor in Facebook is betting on the company’s expansion and new opportunities are critical.  Some bears may point to the sequential decline in advertising revenues of 7% as a warning sign.  I think it can be explained by seasonality and weakness in Europe for now.  Monthly Active Users (MAUs) and Daily Active Users (DAUs) have also been declining as some markets (ie US) reach a more full penetration.  Also, the Ad revenues per month per MAU have been relatively flat yoy – this should grow with better ad products (ie mobile).  Payments growth has been robust though, growing ~100% y/y.  It is very important to watch these trends, as the company must do some or a combination of 3 things: 1) accelerate users, 2) improve monetization per user, or 3) expand into new target markets.

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4) How “Monetizable” is a Social Platform? – There has been a long debate that social platforms aren’t the best places for advertisers to monetize.  The thesis goes like this: the users are on the platform for a specific task like reading about their friends or posting their photos – they are not in the shopping frame of mind.  However, with over $3b of advertising revenues last year that grew almost 70%, I think this argument is overly emphasized.  But, it does raise the question: what is the monetization potential for advertising on a social platform?  This is once again a major reason why Facebook should continue to diversify revenues, as it continues to perfect its advertising paradigm.

5) Inter Company Relationships – I break this point into 3 parts 1) Currently, Facebook’s first non-advertising revenue stream is dominated by one customer, Zynga.  Zynga accounted for 15% of Facebook’s revenue in Q1 2012 (down from 19% a year ago).  Approximately 2/3rds of the revenues from Zynga were payments based, and this was almost all of Facebook’s payments revenues.  While there is an obvious symbiotic relationship here, it is only wise for Facebook to continue to diversify its revenue streams further to eliminate dependence.  2) There is a major patent war going on in technology, which is predicated on “mutually assured destruction”.  Yahoo is in the midst of a big fight with Facebook and it’s important that Facebook navigates this costly landscape astutely.  3) Arrogance with advertisers.  We have heard the stories of how back in the late 1990s, Yahoo’s salesforce was “difficult to work with” from an advertiser point of view.  I think it’s important that Facebook not repeat the mistakes of Yahoo, by appearing arrogant and condescending to advertisers.

Projections & Valuation

Valuation will of course be the most debated part of the IPO.  Many investors will focus on the short term multiples like 21x Enterprise Value to trailing Revenue, or 34x trailing EBITDA and 76x trailing earnings.  However, given the rapid growth of the company, it’s more appropriate to focus on some forward multiples, particularly a few years out (not just off 2012 estimates).

So, I’ve modeled out what I think are reasonable topline and bottom line projections for Facebook given recent growth rates and margins.  While it is relatively easy to apply decaying revenue growth rates to the historicals, the hard part is to account for the revenue optionality (ie new, and yet unknown products) Facebook may introduce.  The most accurate way to do this would be to project the known businesses at common declination rates and then project new revenue streams that represent new products to layer on top of the revenue projections.  As I’ve mentioned, there could be many new revenue streams, each with its own magnitude, growth profile and margin profile.

So without having any inside insight into the company’s near term and long term product roll out, I need to make adjustments to account for the optionality.  This comes in 2 forms: slower decay rates to my revenue projections and a higher multiple in valuation.  Using this approach, I think the company can approach $20b in revenues in the next 4 years, with the majority of the revenues still advertising based.  This would only assume a ~2% penetration of the global ad market for Facebook’s ad revenues, which I think can prove conservative.  I project that the non-advertising revenues will grow to be substantial (to account for many options in new businesses) but would still be less than 50% of the total revenues and represent a fraction of the large target markets they would address.

Next, I projected out the margins and bottom lines.  The company has had GAAP operating margins come down from 52% in 2010 to 47% in 2011 and 36% more recently as it bulks up for the IPO.  Plus, in the S-1, the company projects costs will rise as a percent of revenues, further pressuring margins.  So while the long term margins will be more driven by leverage and the margin profile of new businesses, I try to be conservative and project GAAP operating margins in the low 30%s.  My EBITDA margin projections decline to a still healthy mid to high 40%s.  Facebook is a full tax payer, but I decline the tax rate over time as I think more revenues will come from abroad, with lower tax rates.  Further, I also accrete the share count each year from the ~2.5b currently to allow for options etc.  Lastly, I also decline the capex as a percent of revenue from its very high level of ~30% this year to a more reasonable run rate of mid to high teens in the outer years.

Whats the takeaway? Facebook shares worth ~$80 in 3 years.  Using these assumptions, I think Facebook can generate ~$20b in revenues in 2016 with ~$10b in EBITDA and approaching $2 in EPS.  So what would a fair value of the shares be at that point?  I look at a stock’s value as a Central Tendency of Value, which is a fancy way of saying I look at multiple valuation methods and see what comes out as a median.  If I apply a 10x revenues multiple, I derive and a target just over $80 for the end of 2015.  A 20x EBTIDA multiple would also imply a similar target.  Applying a 40x multiple on earnings and FCF would imply targets in the mid $60s and $70s for 2015.  The median of these 4 valuation methods, imply a ~$80 target in 3 years for Facebook stock.  This would imply a Compounded Annual Growth Rate (CAGR) of >25% – this is a fine return by any investor’s goals.

Are these applied multiples fair though?  I think so for 3 reasons:

1) Comparables. Companies that are platforms or that have large network effects usually garner a premium multiple due to the robust growth potential and defensibility of their business.  Think of the higher multiples as a multiplier to average industry multiples to account for these attributes. Taking a look at come comparables, platform & high growth companies like Baidu, Mail.ru, Zillow, and Mercado Libre all have revenue multiples higher than 10x.  On EBITDA, major platform companies that have multiples near of greater than 20x include: Amazon, Alibaba, Baidu, SINA, and more.  On earnings, Amazon (and others) have a > 50x PE multiple to account for its dominance and growth.

2) Accounting for Optionality.  As I mentioned above, there are 2 ways to account for the optionality of future unknown businesses: slower revenue growth decay rates and a higher multiple.  The higher end multiples are allowing for the optionality of the businesses we don’t know yet and assume will develop.  In fact, in 3 years, the multiple may actually be a little lower, but it would be applied to a higher revenue or EBITDA figure as these new businesses come online.

3) Fast Grower.  Even under just my current assumptions, the company is still growing very fast in 2016 (>30%), and a premium multiple is applied to account for the above market growth.

So in wrapping up my analysis, I think a long-term investor stands a good chance at doubling their money in the Facebook IPO within 3 years.  Of course, this is predicated on the optionality of new business lines, that only a company with a strong platform, network effect, and vision.  I think Facebook, as one of our 4 main spheres is one of those companies.

Disclosure:  My firm CoRise has no relationship with Facebook, but could possibly in the future at some point.

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