“I don’t know what a monopoly is until someone tells me.”
Takeaway: On conventional metrics Facebook is expensive and it has a business model in flux, but the sticky and engaged user base may actually be undervalued, even at a $100+ billion market capitalization.
At this point, there should be little debate on whether or not the Facebook IPO will be successful. The books closed ahead of schedule and the offering was upped in both price and size of issuance. We’ve also heard reports that in Asia the offering is 25x oversubscribed. These facts suggest that there is ample short-term demand by investors who want to own a piece of Facebook. This will likely ensure that the company gets a sizeable IPO pop tomorrow and in the ensuing days as index-related investors need to balance their portfolios.
Currently the most prominent question on investors’ minds relating to Facebook is valuation. That is, at the IPO price will Facebook be undervalued, overvalued, or fairly-valued? Based on any conventional valuation techniques, other than perhaps a long-run discounted cash flow valuation, there is no question Facebook is expensive.
Assuming an IPO price of $38 per share, which implies a market capitalization of just under $100 billion based on the fully-diluted share count (the company will also have $10 billion in net cash on a pro-forma basis), Facebook will be trading at 27x 2011 revenue and 19x 2012 projected revenue. On an earnings basis, Facebook will be trading at 81x 2011 EPS and 65x 2012 EPS. As the company hasn’t given 2012 guidance, we have simply projected forward the Q1 2012 revenue growth rate for the duration of the year and kept margins stable.
Compared to the five horsemen of technology, Apple, Microsoft, Google, Oracle and Cisco, Facebook will be trading at a massive premium. In fact, Google, which is the most richly-valued of those five and on some level the best proxy for Facebook given its focus on advertising revenue, is trading at a comparatively palatable valuation of 5.8x 2012 sales and 14.6x 2012 EPS. The counter case to Facebook being expensive is LinkedIn, which has a valuation of 158x 2012 EPS.
So, yes, Facebook is expensive on actual multiples, but this is also reflected in broad investor sentiment. In fact, 79% of respondents in a recent Bloomberg Global Poll of 1,252 investors, analysts and traders said Facebook doesn’t deserve a valuation so high. This was supported by a similar poll from the Associated Press and CNBC in which only 1/3 of respondents feel the value is appropriate. So, saying Facebook is expensive is far from contrarian.
Other than valuation, the other key critique of Facebook is that the company has not figured out its business model. Once again, there is validity in this criticism. Currently, Facebook has two revenue streams. The first is advertising in which advertising revenue is generated from traditional display ads and Facebook is paid based on the number of impressions delivered or the number of clicks per user. The second revenue stream is fee related. In effect, Facebook gets a cut of all fees paid from Facebook users to its development community. The game developer Zynga is by far the largest contributor in this segment and contributed 19% of overall Facebook revenue in 2011 (12% from actual fees and 7% from advertising revenue generated on Zynga’s app pages).
The dichotomy of these two revenue streams really exemplify Facebook’s key business model challenge. Facebook’s current advertising revenue stream will likely never enable the company to justify its current valuation, or at least as long as only 13% of advertisements are social based. Currently, Google’s advertising model is far and away superior to the Facebook advertising model. According to some estimates, Google’s search advertising revenue is more than 100x more per page view than Facebook’s. That said, per Nielsen Media, Facebook does generate a superior ROI to advertisers versus more traditional banner advertisements, but it is still nowhere near the return that Google gets. In fact, some advertisers rave about Facebook, while others, most notably General Motors, have completely pulled their advertising from the social network.
The struggle with the current advertising business model and inability to totally monetize the user base is reflected in average revenue per user (ARPU). In Q1 2012, according to the Facebook Prospectus, global ARPU was $1.21. This was a 12% decline from Q4 2011, albeit ARPU still grew 6% from Q1 2011. Clearly, though, ARPU is not yet accelerating at rate that Facebook would like and, as a result, the rate of quarterly year-over-year revenue growth is decelerating. As a result, in Q1 2012 Facebook grew revenue at 45% year-over-year versus an average year-over-year growth rate of 95% over the prior four quarters.
An interesting positive note, though, is that ARPU globally is substantially lower than in the mature markets of the United States and Canada. Specifically, in Q1 2012 ARPU in the U.S. and Canada was $2.86, in Europe it was $1.50, and in Asia was $0.53. Arguably, this highlights the potential in ARPU, based on the current business model, to expand over time as global Facebook markets mature and ARPU reverts closer to levels in the U.S.
As noted above, Facebook’s second revenue stream of payment and fee processing really speaks to the future potential of the business model, which is to create new markets that leverage history’s largest social network / platform. In Q1 2010, Facebook generated $5 million in revenue from payments and other fees and in Q1 2012, just two years later, Facebook generated $186 million.
To date, games from Zygna have generated the majority of these fees. A large part of which comes from the purchase of virtual goods as Facebook collects 30% of the face value of user purchases from Zynga games on the Facebook Platform (this agreement expires on May 2015). Incidentally, the virtual goods industry, which did not exist before Facebook, is projected to have eclipsed $11BN in 2011 according to IDC. New industries create new revenue opportunities.
Ultimately, the true value in Facebook is in its core asset: the user base. The growth trajectory of Facebook users has been both staggering and, truly, without parallel. As of Q1 2012, Facebook had 901 million monthly active users and 526 million daily users. On a monthly basis, almost 40% of the world’s internet users login to Facebook. Despite anecdotal talk of Facebook fatigue, its daily user count grew 42% y-o-y in Q1 2012, which implies that users are both sticky and not fatigued.
Certainly, at a point the law of large numbers kicks in and user growth will begin to slow. In the U.S. and Canada, penetration is nearing 60%. Further, according to Facebook’s IPO road show video, 81% of Americans between the ages of 18 – 35 have a Facebook account. Few businesses in history have gained more than 80% market share.
Conversely, on a global basis penetration is much lower. Most notable is China, which effectively has no Facebook users. India may be a good proxy for what could happen in China as Facebook users in India have grown from 37 million to 45 million in the last 6 months. At 60 million, roughly 2/3rds of the online population in India will be on Facebook.
Most importantly, Facebook users appear very engaged. The 901 million monthly users have 125 billion friendships. Meanwhile, the 526 million daily users upload 300 million photos per day and make 3.2 billion comments or “likes” per day. Further, according to research from Nielsen Media in August 2011, the average U.S. user spent 7 hours and 45 minutes on Facebook per month. This is almost 4x the time the average user spent on Google and roughly 25% of their total online time of 30 hours per month. As the chart below from comScore highlights, this engagement is only accelerating.
Even more interesting are the mobile trends related to Facebook. According to the latest report from comScore, as of March 2012 the average mobile user spent 441 minutes on Facebook’s mobile site and 391 minutes per month on its classic site. Facebook mobile in the U.S. also reached 80% penetration of the mobile market. The downside to growth in mobile, as Facebook noted in its in IPO road show, is that it is more challenging to sell mobile advertisements. The upshot is that Facebook users are becoming even more engaged and the users who logs in both on the mobile platform and the classic platform are spending almost 14 hours per month on Facebook.
The key consideration when contemplating investing into the Facebook IPO is not the current valuation, but whether Zuckerberg (who controls more than 55% of the voting stock) has truly created a cheap option on the future value of the fastest growing social utility in this history of the world. Our guess is that most traditional media companies would actually say buying a daily user base of 526 million users, that have almost 7 interactions per day, and spends more than 8 hours per month on the site for roughly $190 per user is actually cheap. Ultimately, Zuck is going to have to sell these users more than just hoodies to satisfy Wall Street, but with a monopoly like 50%+ plus market share and growing we like his chances.
Daryl G. Jones
Director of Research