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Mark Zuckerberg will have his first public interview since Facebook’s IPO in May at the TechCrunch Disrupt conference in San Francisco.  He will be speaking for almost 30 minutes starting at 2pm PST. 

This appearance is one of the most highly anticipated tech CEO interviews in recent history, due to the stock price’s move since the IPO and the silence by the company imposed by the “quiet period”.  Tech industry pundits and tech investors will likely be glued to what he will say (or not say).

With that in mind, I think these are 10 Top Issues people would like to see him address tomorrow.

1)   Long Term Vision.  While we’ve all seen his letter to shareholders in the S-1, I think people would like to see him expound on his the long term vision of the company.  How, specifically, can FB become the “open graph” platform for social and what’s the company’s competitive edge vs other “platforms”?  What will Facebook look like in 5 years and how do they get there?

2)   Business Optionality.  Much has been written about what businesses Facebook COULD expand into quite easily, such as: pd search, ecommerce, subscriptions, other payments, etc.  Which of these options would make the most sense, and why hasn’t more already been done in achieving leverage of Facebook’s massive user base outside the core?  How far out are these realities?

3)   Core Ad Business.  The bears on Facebook state that it’s just not a good platform for advertising monetization, since users aren’t in the shopping mind frame when they visit.  GM compounded this thesis during the IPO.  What are the metrics he can site to disprove this thesis; bigger picture, why is a social platform a good environment for advertisers / consumers?

4)   Mobile.  With over 50% of Facebook’s user base accessing via mobile (and growing), what is his vision on how FB can monetize this traffic, both in the near term and longer term?  Does the mobile phenomenon change that value  / potential of Facebook or how does FB even use the trend to its advantage?

5)   Partners.  Given the global trend to mobile and tablets, does it make sense to form closer partnerships to help capitalize on the trends (Apple, Amazon, Google, Samsung, Netflix, Spotify, content, etc).  If not, how can Facebook execute on this trend or accelerate their process without large partnerships?

6)   Vertical Integration.  Most of Facebook’s larger competitors are vertically integrated with software and hardware (Amazon: kindle, Apple: iPhone, Google: Nexus, etc).  Is Facebook at a disadvantage not having this vertical integration?  If not, why not when the others have felt compelled to head this direction?

7)   Instagram.  The price tag for Instagram was expensive on any measure.  Most seem to think it was likely a good move.  However, what was it specifically that he saw which made the move so urgent and strategic?  How did Instragram threaten Facebook, and what prevents others (Path, Pinterest, etc) from posing similar threats?

8)   Competitive Threats.  Which company does he see as the greatest threat to Facebook?  Clearly Google’s size and social intiatives pose some risk, but what about other ecosystems like: Apple (gaming / app center), Amazon (gaming / apps / content streaming).  One may argue that even more advanced HTML5 websites can offer gaming platforms, that would further weaken FB as a major platform / distributor of games.

9)   Costs – While FB may have a great vision on how it can grow new businesses, fortify its competitive advantages, offer new advertising products, and grow into its original $100b valuation, what will be the necessary cost structure to get there?  Can the company keep margins near current levels, or will the necessary investment make FB a less profitable company?

10) Thiel Stock Sale – A lot has been written about why Peter Thiel sold in the first window, with the stock already down 50%.  As an investor, many can excuse the sale.  However, as a director of the company, some can read it as a bad signaling issue.  How can investors get comfortable that he didn’t sell because he sees a bad outlook, or that other insiders won’t be selling large amounts of shares as the other windows unlock?

Robert Peck
President, CoRise Co.

Our CoRise office is located in midtown NYC, and as I was walking buy a BestBuy this morning I noticed a very long line.  I wondered if I’d missed some tech announcement, some release of a new product.  I knew it wasn’t the iPhone 5 or a new Kindle….maybe some Samsung phone?  I wasn’t sure.

So I immediately went to Twitter and searched for #BestBuy.  I didn’t even have to search for #BestBuyNYC of #BestBuyMidtown or any other combo.  The top Tweets were all about how Best Buy was having a signing today by Cher Lloyd (sad to say I dont know her).  However, I knew what was happening immediately.

In comparison, I went over to Google and searched for Best Buy – I saw what you’d expect: BestBuy.com, other store locators, other retailers, etc.  Then I went to Google News to refine my search on more timely topics.  All I saw were topics about former CEO Schulze trying to buy the company back. Google was completely unhelpful for real time news flow.

More importantly, it occurred to me that my behavior was changing.  I had known to search at Twitter for realt time information and assumed Google would be worthless.  The fact my behavior / intuition has already changed is a bad signal for Google.  They’ve already lost my mind share for real time news.  Inertia is a powerful force, and it’s very easy to merely repeat what your’e used to (ie only using Google for search).  The fact my inertia has shifted is not good for Google in the long run and they risk serious disruption.

It is more & more clear that Google should buy Twitter.  Not only would it augment search, but it would bolster Google’s social offering AND give Google more data (we all know how Google likes data)….

I’m at a loss why this hasnt happened already – the only thing I can think of is valuation disagreements.  BUT I think it’s inevitable…..

Bob Peck
President CoRise

The $7B Incremental Revenue Potential

At my company, CoRise, we do a lot of postulating, like “What if…?”   Yesterday, I read a really poignant piece yesterday by Henry Blodget on the possibilities of search revenue for Facebook.  It’s a thought-provoking piece and I recommend reading it here.  This piece really underscores the “optionality” that has made me positive on Facebook before.  Recently, I spent a good deal of time reaching out to industry pundits to get their opinions on the prospects for Facebook.  We discussed many topics, possibilities, and the challenges for Facebook to overcome.  The one resounding theme that most agreed with was: In the near term Facebook will have to overcome hurdles (ie. the transition to mobile), but with the audience size they reach and the talent at the company, the company has a tremendous long term opportunity that they should be able to execute against.  Of course, execution will be everything.

The challenge in investing is trying to look passed the current picture to predict what could be.  For example, “how big could revenues become?”, or “how large could margins be”? or “what competitive moats does the company have around its businesses?”  These are all important questions that investors ask, but usually the most difficult one is “how big could revenues become?”.  This is so hard to estimate because it requires thinking about what FUTURE businesses the company might enter, not merely extrapolating the current businesses.  For example, before 2007, did investors think Apple would have a phone, let alone a tablet?  And unfortunately, investors need to think about the potential opportunities BEFORE they announced – otherwise it’s too late.

This type of thinking has led me to ponder what various business extensions / partnerships / new revenue lines could the company be considering.  Facebook is filled with smart people and they are clearly thinking about these issues – it would be ignorant to assume they are not.  So I wondered, “If I were working at Facebook in the C-suite, Corporate Development or Business Development, what would I be trying to do?”  The following are some areas that I think would make sense for Facebook to be looking into – each one has a few things in common:

    1) it does not harm the user experience (and hopefully augments it),

    2) it provides a greater utility for a partner / advertiser,

    3) it is a large opportunity, because of the large audience reach of Facebook,

When one sums up the magnitude of these opportunities, it can be staggering – the total can be in the many billions of revenues (FB is expected to only have $5b in revenues this yr).  Further, most of these opportunities have huge margins, falling directly to the bottom line.

Potential Opportunities for Facebook

1)   Search – $3B Revenue Opportunity 
What if Facebook focused on search?
  According to AdWeek, Disney and Zynga are already testing the new beta service FB is rolling out.  Henry Blodget does a great job covering this in the article I cited above.  Based on the ~500m users that live on Facebook and the ~1.6b searches done each month, he calculates that Facebook could generate ~$1b of incremental revenue immediately.  Further, he calculates that with some tweaks, it could balloon towards $3b of revenues per year.  The best part, it would be almost 100% pure margin (just like it is for AOL today).

2)   Commerce – $1B Revenue Opportunity

What if Facebook made a real push into commerce?  I’m not saying that Facebook should start taking on inventory, but what if Facebook cut a deal with Amazon for example and opened up “Facebook Stores” where inventory from Amazon and its affiliates could be viewed / bought.  Amazon would love to tap into Facebook’s ~500m monthly visitors.  Doing some simple math, if only 2% of FB users shop at the store per month and spend an average of $50, that’s $6b on gross revenue per year.  Assuming Facebook gets the typical 15% commission, that almost $1b / per year in pure margin revenues for Facebook (20% boost to current revs)!  And that ONLY assumes a 2% shopping rate of users.

3)   Payments – $1B Revenue Opportunity

What if Facebook signed a deal with a credit card company like American Express to offer a discount on Payments for developers?  Facebook could incentivize its developers to prefer Amex, with Amex giving a discount to FB developers.  It would be a win for everyone: Amex would get access to FB’s users & developers; developers could offer lower prices to their gamers to augment usage; and FB would drive more game development and users engagement.  Payments is still small for Facebook (~$800m runrate), but it’s growing >60% and this could add an accelerant.  Further, FB could gain access to AMEX’s legion of small businesses, expanding its reach and engagement.  So if the discount on apps encouraged users to sign up for an Amex card (for example), FB could receive a customer referral fee.  If just 2% of the user base signs up, at a typical $100 customer acquisition fee, FB could have another $1b business.  There are many ways payments for Facebook could blossom, and this is merely exemplary.

 4)   Distribution (Open Graph) – $1B Revenue Opportunity

  • App Center – What if Facebook charged developers for app downloads?  Facebook is a massive platform that can provide distribution for almost any consumer-facing product.  In June, Facebook just started rolling out its new AppCenter (it’s primary distribution arm).  This is where free apps can be downloaded and played by users.  Facebook does not monetize this directly yet, but it could by taking a percent of in app advertising, charging per download, or by letting developers pay to appear higher in the search for apps.  So if 10% of FB’s 500m users download 10 apps per year and FB charge the developer $1 per app, that would generate $500m (10% bump on revenues).  The developer is happy because they have a new customer and FB benefits for its distribution.  But what if FB also offered incremental ways for developers to stand out from the sea of apps?  Would the developers be willing to highlight their app vs the others (ie think how eBay allows for sellers to “bold” or “color” their listings for a fee).  This could add significantly to this bucket of revenues.  Of course advertising opportunities only augment this possibility.

 

  • Subscription Services – What if Facebook charged subscription services for new users it signs up?  Earlier this month, Facebook rolled out Subscription services in the app center – initial customers are Zynga and Kixeye.  Techcrunch did a great piece, on how Facebook could earn millions if it collects the typical 30% surcharge for its distribution of Spotify.  What if FB can get 5% of its 500m users to start a monthly subscription to Netflix, Spotify, Hulu, satellite radio or other digital services?  Assuming an $8/mo subscription price and maybe only a 20% cut of the revenues, FB could generate $500m in annual revenue.  Now what if FB applied that to more traditional media, like magazines, newspapers, cable’s “TV anywhere”?  This could become a multi billion dollar business itself. Reed Hastings, CEO of Netflix, is on FB’s board and recently bought $1m in stock – maybe he understands this?

5)   Apple – $1B Revenue Opportunity

What if Facebook and Apple formed a tighter alliance?  Apple is in need of a social strategy, with its Ping product not taking off and with reported negotiations between Twitter hitting a snag.  Why does Apple need Facebook?  Apple sells hardware – it’s a one time sale and then the customer is gone.  Apple is looking for a network effect, aside from the integration of its various devices.  It does not provide a compelling reason for its customers to come back each day and engage.  What would that be worth to Apple on product reinforcement basis alone?  What about an advertising angle for Apple (especially on mobile with its ad service rumored to not be doing as well as Apple would like).   It could benefit the Apple app store / iTunes as well.  So what if Apple integrated FB more tightly and the network effect of social connections created a small lift to sales (ie there was a benefit to users being on similar hardware, access to iTunes, or being mobile)?  Apple sold ~50m units last quarter (ex iPod) or 200m units per year just straight lining.  If they had a 5% lift to sales of these units (10m units) and we assume a $700 mixed ASP, that would generate an incremental $7b to Apple.  If FB takes a 15% commission (referral fee), that could drive another ~$1b in annual revenue.  This ignores any lift from advertising, where Apple could hone its mobile ads based on social information.  Now, what if FB did this with other hardware vendors as well?

There are many other businesses that I think are also ripe for FB to provide a better service to its users while simultaneously monetizing.  However, I think the sketched out above ~$7b revenue opportunity paints the larger thesis: There is a tremendous opportunity in front of Facebook, based on its large, active user base.  What if the company executes on this while continuing to augment the consumer utility?  How would the company’s financials could look vs today?  The risk of course is that the company doesn’t execute and collapses under its own weight.  The company’s valuation has come down significantly to ~16x ‘12 EBITDA and 9x ’12 revenues, according to analyst estimates.  However, without new businesses, that is not cheap given the declining revenue growth.  

To be long here on Facebook, I think an investor must ask themselves, “What if….?”

 

Disclosure: I own FB shares.  My firm has not done any work with Facebook.

At my firm CoRise, we are very interested in the changing capital markets (see our post on the convergence of media & finance here).  I agree with many others that the traditional views of markets, capital access, and information are all changing right before our eyes.  Howard Lindzon of StockTwits has written about the influence of the Industry pundits on research, weakening the market’s reliance on research from Wall Street firms.  Ian Sigalow of Greycroft has written about the new “kingmakers” of companies shifting from investment banks to prominent VCs.  We continue to think about how new market places, technology, information dissemination, and social media are transforming how markets trade.  Many models have been developed around this trend, from companies like eToro and RoboInvest, where an individual can follow a portfolio manager. Crowdfunding and the JOBS Act are changing how nascent companies raise capital.  StockTwits provides a whole social commentary and data around stock sentiment and expectations.

As a former investment analyst, I am always wondering how new forms of technology can provide any insight into what the markets are thinking about a stock and whether a stock is better or worse positioned to rise.   Of course, whatever new technology I looked at, I would always use it as just a piece of my investment mosaic.  In fact, one data point can merely be an indicator of where I needed to further research to verify my investment thesis.

As part of my investment thesis process, I used to look at not only the official estimates coming from First Call, but I’d also gather the “whisper numbers” to see where investors (ie “the buyside”) were as well.  “Whisper numbers” have a derogatory connotation, implying that the actual results have been pre-disclosed to some investors ahead of time.  However, in practice, the term “whisper numbers” really means estimates that investors are deriving themselves based on their own work on the stock.  This “whisper estimate average” can be very important, as it can shed a light on what the crowd thinks vs just the investment banks.  This leads me to thinking how can i harness a social network for additional insight?

Estimize is a social network where investors and independent boutiques enter in their own assessment of what they think a company will earn when it reports.  The consensus can differ significantly from the official Wall Street investment bank estimates (ie First Call) – in a sense, Estimize has built an Internet based “whisper number” aggregator, replacing the need for investors to manually call around to each other to compile their own average estimate.

This sounds great in theory, but how about in practice – If I look back over the last 7 quarters for $AAPL (ie back to FQ4 ’10), Estimize’s consensus EPS estimate has differed from the actual EPS result by ~8.5% vs Wall Street’s estimates have differing by over 17%.  So, with Apple’s earnings rapidly approaching (7/23), lets see what Estimize’s community thinks.  While the Street is looking for $10.32 of EPS, it seems the community is looking for $11.42, or ~10.5% higher.  On revenues, the community is looking for ~5% higher, estimating $39.2b.

So in summing it up, it looks like the crowd is calling for a better quarter from Apple than the Street thinks.  However, there don’t’ appear to be any anomalous variation from historical differences, implying that any such beat wouldn’t be egregious.  As I mentioned in the beginning, while incorporating social media data can be insightful, this is merely one data point in an investor’s mosaic.  However, should intra-quarter data in a quarter indicate an anomalous diversion from historical differentials, it could provide a clue for an analyst to dig deeper.  With that, let’s see how the results come in…..

Disclosure: I am not personally predicting Apple’s quarter and have no position in AAPL or any securities mentioned.

At CoRise, we are big believers in Second Screen technology, from the social, advertising and technology point of view.  We see this as an intersection between the confluence of devices and TV.  The following is a link and the text of my post in the Economist on the phenomenon….

http://www.economistgroup.com/leanback/new-business-models/why-the-future-lies-in-second-screen-technology/

JULY 11 2012
 

Why the future lies in “second screen” technology

At my company, CoRise, we meet with a lot of companies to discuss the convergence of various industries, media forms, technologies and markets. One obvious area of confluence is in digital media, where there are four large spheres of utility: social, information, entertainment and commerce. These spheres have traditionally been very distinct, and it was easy to place a company within one of these spheres. However, the landscape is changing rapidly and these spheres are no longer distinct, but morphing into each other (we have an interesting report on this topic on our website).

An area where we think one can certainly see confluence is in home entertainment, between the TV and tablet/smartphone markets, often referred to as “second screen technology”.  We are seeing a major shift in adoption of tablets, laptops and smartphones being used alongside the TV. Astoundingly, the tablet market has only just been born, but there is tremendous growth. According to Mary Meeker at Kleiner Perkins, almost 30% of US adults use a tablet, up from only 2% three years ago. Another astounding fact is that according to Nielsen, 45% of tablet and smartphones owners in the US use their device while watching TV daily!

While much of this usage is associated with checking email or communicating with friends on social networks about topics unrelated to the TV content, according to Nielsen, consumers are starting to interact with content on the TV, whether it be to view more about an ad (20%), to learn more about the program (30%) or to just discuss the show with friends. 

This new trend has not gone unnoticed by the content, distribution and marketing industries. Apps like Yahoo’s IntoNow or Shazam allow consumers’ iPads to “hear” what is on the TV, and then synch the application to it. Consumers can then view more information in real time on additional information about the TV show or discuss the show with their friends – it’s the new way to have a TV party around popular programming.  Further, it’s not constrained by geography and it’s free.

Marketers are also able to take advantage of this new trend, offering more product information for their advertising clients. Consumers can see an ad for a car on the TV, and then play with the ad on their iPad, manipulating a 3-D view of a car with their finger tips and viewing pertinent information. This is called “engagement” by the advertising community, and it’s their holy grail.

This is already happening, but where do we go from here?  We think voice interaction (e.g., Apple’s Siri) will become more ubiquitous as a form of navigation and personalization. Gesturing will also become more common (e.g., Microsoft’s Kinnect). But these trends will not replace the second screen; they will merely enhance the experience. Lastly, data sharing between devices will unlock even more functionality and a better experience for the consumer.  Customized ads based on sex, location, preferences and past interactions will not only create a better experience for the consumer, but also a better ROI for the advertiser.

We are firm believers that this is the future, the only question is how fast we will get there. However, with the explosion of tablet and smartphone growth, it isn’t that far away. The confluence will create opportunity for some companies and risks for others, but the one winner either way will be the consumer. 

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.

Yesterday was a pretty typical Friday for me.  I was trying to compile the items that I wanted to read over the weekend that I hadn’t had a chance to read during the week.  Knowing the Facebook IPO was almost upon us, I figured it would be good to get the latest copy of the the Facebook S-1 (yes, I know, “fun weekend”).  I was out of the office so I stopped into a Staples to quickly use one of their computers to find and print the document.  In fact the store manager told me to just send the PDF and he’d print it for me. It seemed simple enough.

I was trying to minimize the time I would spend on the computer, as Staples pricing per minute can be somewhat pricey.  First stop, of course, was Google.  It’d be simple and quick – I should be in & out of Staples in my allotted 15 minutes.  Surprisingly though, I was having a tough time finding the document in an easy to print PDF format.  I found many other documents of versions of the document, like the HTML version on the SEC website, John Battelle’s post from February to the older PDF version of the S-1 back then, Silicon Alley and ATD links to older versions or the the SEC HTML website.  I tried many different incarnations of search strings (including a hyphen in “S-1”, not including it; limiting results to the last week, not limiting; searching for “IPO” instead of “S-1”; etc.  But astoundingly, I couldn’t find the PDF of the most recent version (dated May 3).  This is one of the highest profile IPOs ever – SURELY, someone had PDF’d the most recent version and posted it!

My simple 15 minute task was starting to take much longer and I was a little baffled on how I could get a PDF of the latest filing to give to the Staples manager (amazingly, staff at Staples isn’t allowed to just go to a web page for some reason – they need a PDF).  After pounding my head against the wall it occurred to me: try Twitter.  Now I know this could sound obvious.  But for me, Twitter has become my REAL TIME search engine and of course my new feed.  For general searches that aren’t real time, I always go to Google – why wouldn’t I?  Don’t we all?

So I went to Twitter and searched for the latest Facebook S-1 in a pdf format.  I typed in 4 key words and hit go.  The top result had a bit.ly link to exactly what I wanted.  I was done in 15 seconds flat.  Wow – it was a revelation for me.  Twitter, in this example, had REPLACED my need for Google – it was BETTER than Google for me in this example.

It got me thinking….I know I go to Google for general searches habitually.  But what if my habit starts to change because of a better experience on Twitter?  How could Google stop this?  Can Google ever possibly replicate the experience I am able to have on Twitter due to its “crowdsourced results”?  If Google doesn’t have this data, isn’t just more & more of the Web’s content falling into an area not findable by Google (ie “the Dark Web”)?

Of course Google can just pay for the Twitter fire hose, like it has done before.  But if people don’t view Google as a true source of real time search, news feeds, and “crowd sourced search results”, will the web traffic flow to Google or Twitter?  I know this isn’t a novel idea, but it seems to me that Twitter is a major threat to the basic general searches of Google – its core bread & butter.  Facebook saw a shift in behavior occurring around Instagram, partially for its mobile prowess, and realized it needed to capture that traffic.  Like Facebook, Google too must reflect on how Twitter is impacting its ecosystem (as well as the mobile presence it has).  It may lead to only one logical conclusion: Google must buy Twitter.

Robert Peck, CFA
President CoRise Co., LLC