Friday, 25 May 2012

Facebook - A Business Analysis

Last week, Facebook launched its long-awaited IPO.  Unlike many hi-tech IPOs, investors were not treated to an instant, satisfying gain in the stock price.  Making matters worse, the NASDAQ stock exchange suffered technical difficulties in the first few hours of trading.  Some investors were not sure if they owned stock or not, making it impossible to sell before the stock fell from $38 or so to around $33 at present.  Lawsuits, not surprisingly, abound. 
But buying a stock immediately after it goes public and hoping to sell it weeks, days or even hours later for a handsome gain, is speculation, not investing.  It is virtually impossible to accurately predict the short-term gyrations of a stock over time (to perform better than chance over many repetitions, at least).  The mere fact that other, similar IPOs led to an immediate bonanza offered no assurance that Facebook would too.  The only reliable way to make money investing is to buy a stock that is cheap compared to the future earnings of the business.  Let's do what many investors did not: analyze Facebook's business and financials.
The Business
With 900+ million active users for a company founded in 2004, Facebook has been a staggering success.  The company has a clear competitive advantage: "network effects" mean most new users of a social network will join Facebook, since that's where all their friends, family, co-workers, teammates, long-lost loves, dimly remembered classmates, and others will be found.  From there, people have a chance to share photos, ideas, news, and all-important updates about the status of their dating life, morning coffee and many other deep thoughts.  Businesses, non-profits and many other organizations and institutions are also part of the Facebook community - more than just a website, Facebook functions much like a parallel internet.  There are similar networks that have a significant regional following, such as Google's Orcut in Brazil and India, and there are niche competitors in other areas, including LinkedIn in professional networking, but Facebook is likely to remain the dominant "general use" site of its kind for years to come. 
From a business perspective, Facebook isn't selling services to users, its selling users to marketers.  The sheer size of Facebook's user base, plus the rich array of information that people expose about themselves, gives advertisers and application developers a gold mine of data used to pitch their offerings.  There was a day when advertisers offered commercials to groups as large and generally defined as, say, men between the ages of 18-35, a big, baggy category that is laughably crude by Facebook's standards.  This business model operates on an "if-you-build-it-they-will-come" basis, and as long as Facebook has hundreds of millions - soon to be billions - of users humming with activity, advertisers will come.
Tech stocks are typically difficult to value, given their fast-changing nature.  However, just as Microsoft and Ebay have had long-term success thanks to "network effects," Facebook has likely "locked in" users for a prolonged period of time.  It does not resemble a bio-tech startup with a newly conceived, highly uncertain way of treating cancer, for example.  At least for the foreseeable future, there's a good chance that Facebook will remain a household hobby.
At today's prices, though, shareholders are assuming that the company will not only generate stable and steadily growing earnings, they are assuming very robust growth over a prolonged period of time.  In 2011, Facebook generated EPS of 0.43.  At the current $33, the stock trades at an eye-watering 77 times earnings (as a reference point, the average stock has historically traded for around 15 times earnings).  While a company growing quickly, with a solid competitive position and high returns on capital may justify a premium multiple, 77x is off-the-charts.
Growth, alas, has already begun to slow markedly.  2011 sales grew 88% over 2010, and net income advanced by a less sizzling 65%.  In the first quarter of 2012, however, sales growth slowed to 45% and earnings were down slightly from the same period a year ago, albeit partly due to abnormally high taxes.  The slowdown in growth is not likely a short-term blip, either.  As popular as the site is, it no longer has room for exponential growth.   Though the cyber-world is virtual and borderless, the real world is not infinite, and even Facebook can't escape its finite horizons. 
With a worldwide population of about 7 billion, 13% of every man, woman and child on the planet are Facebook addicts.  Whether it ultimately attracts 1.5, 2 or even 3 billion users, the number won't reach 4 billion or more (the company is not permitted to operate in China, cutting 1.3 billion potential users from Facebook's addressable market).  Admittedly, there is room to grow earnings per user: assuming that Facebook draws in $5.5 billion in sales in 2012, and averages 1 billion users, the company will bring in just over $5 per user for the year, a figure that presumably has ample room to increase.  In its prospectus, though, the company concedes that its rate of revenue growth will likely decline in the future, meaning that slowing user growth will not be completely offset by increased advertising sales.
It seems safe to bet that users and revenue will increase, but at a much slower rate than in the past.  Assuming that sales grow 45% in 2012, 33% in 2013, 25% in 2014, 20% in 2015, and 15% the next year, revenues would reach $12.3 billion by the end of 2016.  Assuming operating margins of 45% and a tax rate of 35%, net income would be $3.6 billion, or $1.69 per share.  Since growth will have slowed significantly by then, investors shouldn't expect a multiple of more than 20x earnings, which would be around $34 per share.  Even adding today's approximate net cash of $4 per share only increases the figure to $38, the very same number, incidentally, that shareholders paid at IPO.
In short, even assuming very strong sales growth and wide margins, the company's stock may hardly budge from today's levels.  Since it's foolish to assume such high growth, and it's doubly unwise to invest without a margin of safety, conservative investors would be wise to pass on Facebook at today's share price.

Source: IPO Prospectus which can be found on the company's website.

Here's my article exploring whether there's a more general bubble in tech stocks.

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