Thinking Things Over May 6, 2012
Volume II, Number 18: The Facebook Phenomenon and Its Economic Impact
By John L. Chapman, Ph.D. Canton, Ohio.
Facebook, Inc. begins its investor roadshow this week in anticipation of an initial public offering on May 18. The company’s potential is virtually unlimited, though business history is replete with should-have would-have could-have stories. Regardless of its fate in the future, its economic impact has been impressive, and its success to date is a testament to the capitalist ethos still embedded in a uniquely American entrepreneurial culture.
Mark Zuckerberg may have a visage that suggests unfamiliarity with razor blades, but the youthful 27-year old college drop-out is about to be confirmed as one of the world’s richest men. The Facebook CEO, who will control about 58% of the company’s voting shares post-IPO, will have his stake valued at around $18 billion — in a company that could float at $96 billion on its opening. In a post-Great Recession economy that is still hard-pressed by continuing global convulsions, Facebook’s IPO is a ray of good news, and a testament to the possible in a world whose job-creating entrepreneurs are now prone to fear.
From a cold start in his Harvard dorm room eight years ago, Mr. Zuckerberg has grown a company that now boasts more than 900 million monthly users (488 million of them mobile), 500 million of them daily — and the firm will pass $5 billion in revenues this year. As the firm’s online roadshow prelude video details, market penetration is still in its infancy in many places around the globe (but already includes versions in 70 languages), as is revenue capture from both its customized and targeted advertising potential and fee-sharing from ancillary third-party service offerings. It is hard to see how the firm will not grow dramatically in coming years, particularly when China opens up (Facebook is currently banned there) and as global ad revenues gravitate more toward online media. Beyond enriching its founders and senior managers, though, the biggest story in the IPO of Facebook is the lesson it offers to both investors and students of public policy concerned with economic growth.
First, consider the magnitude of the firm’s accomplishments in just eight years. It is now a global brand soon to rival Coca-Cola and McDonald’s, yet has less than 3,500 employees, most all of them in California. Its first day market capitalization will likely surpass the entire U.S. automobile industry (Ford, $41 billion; GM, $35 billion; Chrysler/Fiat, $6 billion), and rival Amazon’s hefty valuation ($101 billion). It jousts with Google as being the first or second most heavily trafficked site on the Internet, long ago achieving a trillion page views per day. It has spawned 125 billion “friendship” connections, and daily takes on 300 million photo uploads, one billion comments or messages, and two billion “likes.” Facebook now boasts of more than 3.2 million actively managed small business pages, and has 100% of the Ad Age 100 (e.g., Coke, IBM, Procter & Gamble) as users and advertisers. Last year, in a sign of changing fortunes in Silicon Valley, the firm left its Palo Alto HQ and occupied the former million square foot-campus of Sun Microsystems in next door Menlo Park, with a 5-year option to buy the eleven buildings; the firm has also bought nearby acreage, has lease-hold options remaining in Palo Alto, and is well-positioned for rapid (exponential?) growth in the years ahead.
Is the stock a buy, at any point of its anticipated flotation price of $28-35 per share? Certainly investors would prefer to see $28, implying an $80 billion valuation on a firm with anticipated operating earnings of around $2 billion in 2012. The initial P/E will be well above NASDAQ market comparables in any case, and of course will not pay a dividend any time soon. The biggest question mark surrounding valuation is whether the business model can be ramped up, via advertising and fee-for-service cash flows, to generate earning to support the out-sized valuation. Further, while Mr. Zuckerberg possesses undeniable vision and tenacity as the firm’s chief product architect, it is not clear to us that Sheryl Sandberg is the right person for the de facto CEO job there.
On the other hand, the firm has — for the most part — a very strong Board of Directors, and there is every expectation the key members of the Board, including Accel’s Jim Breyer, Netflix’ Reed Hastings, Internet icon Marc Andreessen, and middle market M&A veteran Erskine Bowles will remain post-IPO for a period of growth. Additionally, revenues from advertising and service fees are likely to grow, potentially substantially enough to protect already-healthy 30-40% operating margins. $600 billion was spent on advertising in 2011, but only 12% of that was online, and only a small fraction of that for mobile users. Facebook, which had less than $300 million in revenues in 2008, went cash flow positive in September 2009 and was up to $3.7 billion in revenues in 2011.
The reason ad revenues may well explode is both due to increased gravitation toward online and mobile media, and advertisers’ demands for customized, targeted personalization in their campaigns in a hyper-competitive and networked world. Facebook claims that a wedding photographer in Minneapolis spent $1500 last year on a campaign targeting females in the Twin Cities between the ages of 24-30 who listed their status as “Engaged”; he generated many sales leads from this and had a personal best earnings year of $70,000 as a result. Mass customization of messaging on digital platforms is still in its infancy, but Facebook is now in the enviable position of being a virtual duopolist (along with Google) in possessing so much user information that can be exploited and tailored to individual demand curves. And vis-a-vis Google, Facebook arguably has far higher quality information about individuals, or to say it differently, a higher degree of profitable exploitability per user. For mobile applications in particular, we are moving toward a world where Facebook will take user preferences, match them to location, and offer pinging services — tailored and customized offers on-the-spot (e.g., a Facebook user from Chicago who has “Liked” a steak-house chain is in Houston on business, and will receive a text as to the nearest restaurant there in town, with a special dinner offer). The possibilities here are — literally — endless, and for Facebook investors, there is comfort in knowing the firm is now a quasi-monopolist in offering such future services, with substantial entry barriers for others trying to replicate these revenue capture opportunities.
Additionally, Facebook has the option to invade at least some of Amazon’s turf, and Google’s as well (or, offer new services to compete with firms like Match.com), but the converse is not necessarily true (though Google is looking as though it seeks to build social connection platforms now). But at the least, the firm earned more than $500 million last year in very high margin fees from third-party application developers, predominantly game purveyors. This is in line with Facebook’s conscious — and correct, from a strategic perspective — decision to be the core “connector” platform for a whole ecosystem of service providers. Again, the growth potential here is virtually limitless, and it is here where Facebook may well engage in partnerships with existing online service providers or be able to compete with other vendors, given its ready universe of what will soon top a billion users. In the modern world, having a lock on a distribution channel — that has in this case already imposed significant entry barriers on others trying to compete against what is now a de facto “Facebook standard” — allows a firm to then control the content flowing through the channel. Depending on the industry, a proprietary channel can be as valuable as proprietary content; Facebook in some ways may be said to tap into both, a fact of singular importance for competitive positioning and future valuation (and indeed, Facebook is already aggressively exploiting these opportunities by building online links to literally thousands of other sites, such as, say, the New York Times; if it be said that Coca-Cola wants to be in every retail location in the world, Facebook equally wants to be connected to every online page in the world, apparently).
From a public policy perspective, the lesson here is clear as well: the spontaneous trial-and-error of entrepreneurs leads to all sorts of outcomes, often after the entrepreneurs themselves have changed directions in sense-and-respond exploitation of opportunities to serve unmet needs. There are no such visionaries inside central planning boards of governments; neither the relevant information nor the incentives are in place for such opportunity discovery to take place.
Further, Facebook is but the latest example, following Amazon, Google, and others, of information-age services being offered alongside the co-optation of economies of scale and scope. The economics of “network effects”, where the value of an asset increases as more users are attached to it, are well-known; and they offer one answer, through the phenomenon of increasing returns to scale, to a world starved for economic growth through gains in efficiency and productivity. It seems to us as though investors have every reason to be bullish on Facebook’s prospects long term, and we must say, we can only hope that governmental organs in Europe and the United States do not pursue oversight of ‘FB’ as it grows, as they once did of ‘IBM’ and ‘MSFT’ in bygone days. For as those two behemoths learned, “all glory is fleeting” applies to businesses as well as commanders of Rome’s legions.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at email@example.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.
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