Above the Crowd

Why Facebook Clearly Belongs in the 10X Revenue Club

February 1, 2012:

Attached are my thoughts on the Facebook S-1 along with some quick stabs at valuation.  Brief disclosure, Benchmark Capital has a minority position in Facebook as a result of the acquisition of FriendFeed, a company that was incubated in our offices.

I thought it would be useful to look at Facebook using the scorecard from our May 24 blog post, “All Revenue is Not Created Equal, the Keys to the 10X Revenue Club.” For those that want to save time, the key point of this piece is that there is a broad disparity of Price/Revenue multiples for global Internet stocks, and that only a very small fraction of these companies achieve a multiple over 10X. We also created a list of 10 factors that public investors consider when trying to qualify if a company is deserved of such a prestigious and lofty valuation.

On a roll, these factors are:

1. Sustainable Competitive Advantage – how big is the competitive Moat?
2. Presence of Network Effects – does the model tip to a single vendor?
3. Visibility/Predictability – is the revenue consistent
4. Customer Lock-in / High Switching Costs – is it expensive to leave?
5. Gross margin levels – How much leverage exists is the business?
6. Marginal Profitability Calculation – is the leverage still expanding?
7. Customer Concentration – are there key dependencies?
8. Major Partner Dependencies – are there key dependencies here as well?
9. Organic Demand vs. Marketing Spend – is customer acquisition expensive?
10. Growth – how big will the future be?

So how does Facebook score on these metrics? As you would expect, pretty well.

Metric: Comments: Grade:
Sustainable Competitive Advantage It would be extremely hard to launch a direct-on competitor to Facebook.  Look at what has happened to Friendster, MySpace, Bebo, and is happening to Orkut in Brazil.  Google+ as a FB competitor is a tough slog. A+
Presence of Network Effects These are about as strong as you could design. All current non-US Facebook users have immediate connections if they log-in. A+
Visibility/Predictability This is fairly strong as well, simply because there is no lumpiness.  There is a small dependency on Zynga that could cause variability. Also, a premium product would offer more consistency than pure ads.  That said, this is not an issue. A
Customer Lock-In / Switching Costs Leaving Facebook is possible, but finding an alternative with all your friends on it is not really possible.  Obviously, the inclusion of Timeline works to increase this even more by creating a permanent dependence on past content. Also, Facebook’s DAU number is staggering. Over half of all users check-in daily. That is uber lock-in. A+
Gross Margin Levels Gross margin has hovered between 75-80% for the last several quarters.  This is a fantastic overall gross margin. It would be great to think they have more leverage here, but as the largest Internet site in the world, this probably represents peak margins. A
Marginal Profitability Calculation On this one Facebook doesn’t score so well.  Peak profitability (on a margin % basis) was in Q4 of 2010, and since then spending has kept pace with revenue growth. It is likley that the team would argue they are “investing for the long-term,” but if the long term is forever, than EPS growth is permanently tied to revenue growth. B-
Customer Concentration Zynga is 12% of revenues, but this is fairly low and they are the only company over 10%. Plus, if Zynga stopped competing for these ad purchases, there are many, many Zynga look-alikes that would rush to fill that void. So even if they left tomorrow (which they won’t) the number would not go away completely. A
Partner Dependency Facebook has grown to be the largest site in the world with the help of no one. No partners. No dependency. A+
Organic Demand All of Facebook’s customers are organic. This is as good as it gets.  The pure stuff. A+
Growth Facebook grew the top line 88% in 2011. That’s quite amazing. Q4 of 2011, however, was only 55%.  People will definitely be watching this number in Q1. If growth rate hurts the company, then it’s a direct result of waiting too long to go public – past peak growth. B

The bottom line is that these scores are fantastic. Facebook is a shoe-in for the 10X+ revenue club. Perhaps the only question is which years’ revenue you consider. If the company grows 50-60% in 2012, you end up with roughly $5.5-6B in revenue. With all the hype, assume a 12x multiple on the $6, and you end up right at $72B. You can double-check this with earnings. As operating margin is stable, 60% growth would result in $1.6B in after-tax earnings. At $72B, this is a 45 PE ratio for a company growing at 60%. At a 60 PE, you would have a $96B market capitalization. The bottom line is that the banker range looks right to me. Of course, overt and ecstatic demand for the hottest IPO of the past 10 years could easily lead to much higher speculative valuations. But it’s hard to argue that the $70-100B range is wrong. Feels quite right to me.

Here are a few other interesting things from the S-1:

  1. Tax Rate. Warren Buffet’s secretary would be happy. Facebook’s tax rate is already north of 40%. Other multi-national companies typically have found a way to reduce this. Facebook is paying full-boat.
  2. Model appears set. With gross margin relatively fixed, and peak operating margins over 5 quarter ago, investors should get comfortable that bottom-line growth is limited by top line growth. Management could change their attitude later, but experience suggests that founders like Zuckenburg want to invest for the long term. As a result, one shouldn’t expect these super healthy margins to go any higher.
  3. Sales > R&D. It is somewhat surprising that sales expense is greater than R&D expense. The ad units clearly are not self-serve. Interestingly, this ratio is very similar for Google.
  4. Seasonality. The company has more seasonality than I would have expected (geared towards Q4). The prospectus says this is tied to traditional advertising seasonality.
  5. Facebook’s unique RSU program. In an effort to avoid the restrictions of 409A, Facebook long ago created an RSU structure whose shares vest on a liquidity event.  As a result, a large amount of stock (close to $1B in value) will all “vest” on the IPO. This will result in an enormous one-time, non-cash charge. What I still can’t figure out, is how this will effect the overall share count. If you know let me know, and I will append the post. If auditors and the SEC are happy with this RSU structure, I would expect to see other startups adopt it, as it avoids the restrictions of 409A.
  6. Cash. Over $3.9B in cash already. And they will raise $5B more. That’s a lot of cash.

69 Comments

  1. Mark February 1, 2012

    That’s what I am trying to understand is what is the total share count thus what is the PPS being asked for? The article from NY Times has it at $53@$100B but the share count is only 1.8B and I believe does not factor in the RSU. As a shareholder from buying on the secondary would love to know why they did not disclose the offering price as well as total share count from liquidity to determine my cost-basis was profitable or not.

    Reply
    • Eliot February 2, 2012

      Forgive a novice/naive question, but where will the top-line growth come from? Pool of total ad $s can’t expand at nearly these rates, or if it does for Fbook it must be at other sellers’ expense, right?

  2. Yo Shibata February 2, 2012

    Good list of evaluation criteria for B2B/B2B2C services.
    Talking about Japan, not only the criteria #10 (Growth potential) is the reason why there’s very few X10 revenue club services in Japan. When the market size is limited, #7 and #8 (independency from limited number of customers / partners) could be difficult to achieve. Also, conservative user attitude toward new web services is negative to #9 (Cost per user acquisition) and all these prevents development of new services, which, in the end, leads to negative #7 / #8. Vicious cycle.

    Reply
  3. Jeff Matthews February 2, 2012

    Bill,

    Well said, as usual. Regarding the selling expense, and knowing their sales effort has had to go up against the Google machine, would it seem logical the high selling expense should decline as a ratio over time?

    Also, there are a couple of typos that alter the meaning, just FYI:

    1. “All current non-US Facebook users have immediate connections if they long-in.”
    2. “So even if they left tomorrow (which they won’t) the number would go away completely.”

    JM

    Reply
    • bgurley February 2, 2012

      Thanks! I wrote this alone last night with no editor.

  4. Nasir Zubairi February 2, 2012

    Nice post. I agree. I think FB valuation is fair, if not possibly cheap. Even looking at the math and using some assumptions about EBITDA growth (40%/annum next 5 years, 9% thereafter), Capex and capex growth ($1b in 2011, 40%), depreciation (10% of Capex), WACC = 11% (Equity beta assumed at 1.2, market risk premium at 7.5%), the $100bil valuation seems sane.

    Reply
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  6. Lee Hower (@leehower) February 2, 2012

    Great analysis as usual Bill. I’m still working on my own.

    On the RSU issue, I haven’t been able to untangle precisely how that will impact the FD share count. What I did see was that FB generated about *$1 billion* in cash in 2011 from the exercise of options/RSUs (“proceeds from the sale of common stock”). Obviously the basis in a lot of the employee equity is high given the rapid rise in the company’s own enterprise value.

    Reply
  7. Aaron Klein February 2, 2012

    Great analysis, though I’d have to say that 12% of revenue coming from Zynga is more than a small dependency.

    It’s a great partnership though. I’d rather have it than not. :)

    Reply
  8. Eyal S. Goldwerger February 2, 2012

    It’s amazing how any ad driven business exhibits the same weighting of sales expense and seasonality, not matter how profitable or how pronounced technology and product are in its strategy (so is ours). It’s very illuminating.

    I am very intrigued whether RSU will take off. it’s been on the back burner in the labs, perhaps this will give it the seal of approval to be more widely adopted. It would certainly be refreshing to break free of the 409A shackles, the sigh of relief would be heard from coast to coast..

    thanks for a great post

    Eyal Goldwerger
    CEO, TargetSpot

    Reply
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  10. glennkelman February 2, 2012

    I didn’t think there was much interesting left to say about Facebook’s S-1, but Bill you nailed it.

    Reply
  11. jr February 2, 2012

    Re: taxes. It won’t be surprising to see them begin to adopt the standard practices of most multinational tech companies.

    They’ve already set up their international offices in Dublin so the Double Irish/Dutch Sandwich arrangements are only a matter of time.

    Reply
  12. Pingback: Why Facebook has far greater revenue growth potential than most people think

  13. Tom Foremski (@tomforemski) February 2, 2012

    And there’s mobile: 420 million users in December and Facebook has no ads to serve, that’s a large new business that’s not being monetized yet…

    Reply
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  16. David Wells February 2, 2012

    Interesting post Bill. I don’t disagree with how you’ve thought about valuation, but my question is what the run-rate of growth is:

    845MM users represents ~12% of total world population (~7B). If you back out under-age (therefore not computer users) and over 65 (same issue), total available population, is ~4.6 billion potential users. At 845MM users, they are nearing 20% saturation. This does not adjust for internet/computer accessibility or poverty. As well, the S-1 did not disclose a user-churn figure (from what could tell) which would further limit the potential pool of available users.

    Even if we assume penetration grows to 2.3 billion (or 50% of potential), at current RPU of $4.39/user, that implies total topline revenue of $10.1B or 173% total growth. Therefore the bigger question in my mind is how do they grow RPU and monetize their user base further? This is further complicated by how sticky the product is. People are already using it a tremendous amount, but are not paying for it.

    While it don’t disagree that it is highly profitable, with rev growth showing a slow down, and the strangely high cash balances, my question as well is why can’t they deploy that cash more aggressively to accelerate growth. If they have pro-forma $9 bil in cash (and an arguably under-levered balance sheet), why can’t they grow more aggressively?

    Likewise, you are starting to see legitimate contenders arise that are taking traffic away from FB, like Pinterest and Tumblr. Both are highly social forms of media, but are eyeballs that are existing outside FB. They also address different questions for users that FB tried to. What do I find interesting, attractive, desirable, presented in a way that makes the user feel like a magazine editor. FB is not well suited to that type of engagement with the user.

    Reply
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  18. Justin February 2, 2012

    Good analysis. I’m not sure they deserve such a high grade for sustainable competitive advantage though. Couldn’t you give similar marks on many of those criteria a few years ago to MySpace or Friendster? Look where they are now. Like I’ve heard before, maybe Facebook’s biggest competitor hasn’t been invented yet.

    Reply
    • bgurley February 2, 2012

      Fair point, but neither of those every reached this scale.

  19. Well written article, but I could not disagree with your valuation more. I would rather play with Apple even after it has already eclipsed $450.00 at share with a 12.96 P/E ratio than ever touch this IPO, Facebook will succeed in the short term thanks to hype (like articles such as this) & then come back to earth when it is simple becomes unrealistic to maintain growth when you already blanket 800 million users.

    Reply
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  27. Alex February 3, 2012

    Thanks for informative post, Bill. In regards to your question about how the RSUs will affect the share count, there was an article in the CPA Journal over the summer that addressed this very question. They also provided a hypothetical income statement as an example. From reading through the article and the note below from the S-1, it looks like all of the pre-2011 RSUs will vest on the IPO and will increase the overall share count immediately and the post-2011 RSUs will vest and increase the share count on a schedule with a 1/4 of them vesting every year.

    http://josefrashty.com/uploads/2/8/9/2/2892636/tcpa.pdf

    This was taken from the S-1:

    Dilutive securities in our diluted EPS calculation do not include Pre-2011 RSUs. Vesting of these RSUs is dependent upon the satisfaction of both a service condition and a liquidity condition. The liquidity condition is satisfied upon the occurrence of a qualifying event, defined as a change of control transaction or six months following the completion of our initial public offering. As of December 31, 2011, such a qualifying event had not occurred and until it occurs, the holders of these RSUs have no rights in our undistributed earnings. Therefore, they are excluded from the effect of dilutive securities. Post-2011 RSUs are not subject to a liquidity condition in order to vest, and are thus included in the calculation of diluted EPS. We excluded 4 million and 2 million shares issuable upon exercise of employee stock options for the years ended December 31, 2009 and 2010, respectively, and 3 million Post-2011 RSUs for the year ended December 31, 2011 because the impact would be antidilutive.

    Reply
  28. andy idsinga (@andyidsinga) February 3, 2012

    re “Customer Lock-In / Switching Costs” – I’ve thought about this in the context of my own use of facebook – which has declined dramatically over the past year.

    Thing is – to use other social networks more, there is no requirement to leave facebook – usage can easily drop off to the point where it is an alternative to email (get a notification, read, respond, done).

    Facebook seems to be teaching the masses how to use social networks in the same way AOL taught the masses how to use the internet.

    Your posts are always awesome Bill – thanks!

    Reply
  29. Grant Halloran February 3, 2012

    An interesting analysis but overly optimisitic I think. This isn’t a hard business to value from a DCF perspective. FB sells ads. There is a finite and predictable amount of media spending every year globally. Track out some assumptions about FB’s share of global media over the next 10 years. Assume some reasonable expense levels (forgot what MZ wants to do, within a couple of years FB will conform to what analysts think is reasonable), and then assume that marketers will find other channels of promotion that don’t exist now, I.e. in ten years time FBs share of media spend will be less than it is in 5 years. Thats just the way it works for all advertising channels. That basic analysis will tell you if the company should be worth 25, 50 or 100b now. Ignore the hype.

    Reply
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  31. Carl February 3, 2012

    Of course you think the valuation looks right; you’re a venture capitalist with a vested interest and you’re hoping that a high valuation for Facebook will wash across all other companies in which you’re invested.

    Reply
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  33. alex February 4, 2012

    This is an outstanding assesment of facebook’s position, and most of it is very accurate at present. That being said, one could easily draw a few different conclusions. At the 100b valuation level, FB actually trades at 25x revenue, which is substantially over the rich ’10x’. I personally find that while there is a huge moat to getting into FB’s business, the possibility exists for the entire model to become stale. Not a replacement, but rather long term abandonment. I spend very little time there now, personally, from a peak of several hours a week. The final conclusion I come to is, considering the company grew revenue by 88%; and allegedly will trade at 45x earnings or more, one simply must love Apple that grows nearly as fast and trades at closer to 15x earnings.

    Reply
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  44. Johan Brenner February 7, 2012

    Awesome Bill!

    Reply
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  51. XY Trader April 16, 2012

    Combine the S-1 with the other inevitable things to come for Facebook, and I’d be willing to pay 80x earnings on this company. Microsoft is going to unload their cash drain of a search engine Bing. Facebook will gladly take it from them for a fraction of what its worth. With a powerful search engine, combined with phenomenal customer information, they will easily take 20% market share from Google within 2 years. With just 20% market cap going into Facebook from Google, add on another $40 billion to their worth. It’s a no brainer.

    I’m telling the flip side of the story. Telling people how Wall Street has been gaming the system for years at the detriment of the individual investor. http://xytrader.wordpress.com/

    Reply
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  53. Taylor O May 30, 2012

    Why is following tax rules legally and also efficiently something wrong that Facebook should not do? Trying to pay maximum taxes is misallocating investor’s money. Locating in a regulatory friendly geography that makes it easier to operate and innovate strikes me as the real moral high ground of the issue.

    Reply
  54. Taylor O May 30, 2012

    Major Partner Dependency: While Bing and Zynga, hardly count as major partners what if the “Major Partner” in effect is the thousands of app developers? Like iTunes I don’t think that should be ignored. Facebook must keep developers on whole relatively happy (ie somewhat favorable enough deal terms and traffic).

    SCA: In hindsight, the SCA of previous tech juggernauts has proved not to last.Yes, it will be difficult to mount a challenge, but in a 10-20 year time frame is it possible that Facebook is disrupted, especially with the transition to new form factors? Certainly.

    Reply
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