Why Facebook Clearly Belongs in the 10X Revenue Club
Posted on February 1, 2012. Filed under: Facebook, Internet, IPO, Uncategorized, Venture Capital, Web/Tech | Tags: Facebook, IPO |
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:
- 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.
- 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.
- 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.
- Seasonality. The company has more seasonality than I would have expected (geared towards Q4). The prospectus says this is tied to traditional advertising seasonality.
- 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.
- Cash. Over $3.9B in cash already. And they will raise $5B more. That’s a lot of cash.
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47 Responses to “Why Facebook Clearly Belongs in the 10X Revenue Club”
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Awesome Bill!
Johan Brenner
February 7, 2012
[...] of it has focused on revenue and growth; some of it on control and corporate governance, some on valuation and how reasonable or not it is likely to be, and a little on whether or not the IPO represents the [...]
Facebook – Run from the Bulls? - The Review Blog
February 5, 2012
[...] of it has focused on revenue and growth; some of it on control and corporate governance, some on valuation and how reasonable or not it is likely to be, and a little on whether or not the IPO represents the [...]
Facebook – Run from the Bulls? | Toppli
February 5, 2012
[...] of it has focused on revenue and growth; some of it on control and corporate governance, some on valuation and how reasonable or not it is likely to be, and a little on whether or not the IPO represents the [...]
Facebook – Run from the Bulls? | |
February 5, 2012
[...] of it has focused on revenue and growth; some of it on control and corporate governance, some on valuation and how reasonable or not it is likely to be, and a little on whether or not the IPO represents the [...]
iPhoneNation.com: Apple News and Technology Insiders – Facebook – Run from the Bulls?
February 5, 2012
[...] of it has focused on revenue and growth; some of it on control and corporate governance, some on valuation and how reasonable or not it is likely to be, and a little on whether or not the IPO represents the [...]
Today’s Links « Great apps
February 5, 2012
[...] of it has focused on revenue and growth; some of it on control and corporate governance, some on valuation and how reasonable or not it is likely to be, and a little on whether or not the IPO represents the [...]
Aughavey Computers - Aughavey Computers Cookstown
February 5, 2012
[...] of it has focused on revenue and growth; some of it on control and corporate governance, some on valuation and how reasonable or not it is likely to be, and a little on whether or not the IPO represents the [...]
Solydaritas Forever
February 5, 2012
[...] of it has focused on revenue and growth; some of it on control and corporate governance, some on valuation and how reasonable or not it is likely to be, and a little on whether or not the IPO represents the [...]
Facebook – Run from the Bulls? | Social Media News and Web Tips
February 4, 2012
[...] of it has focused on revenue and growth; some of it on control and corporate governance, some on valuation and how reasonable or not it is likely to be, and a little on whether or not the IPO represents the [...]
Facebook – Run from the Bulls? - Just another ReviewMonsters.net Sites site - Test
February 4, 2012
[...] of it has focused on revenue and growth; some of it on control and corporate governance, some on valuation and how reasonable or not it is likely to be, and a little on whether or not the IPO represents the [...]
Facebook – Run from the Bulls? | Startup Help
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.
alex
February 4, 2012
[...] last few days — I read a few, but largely (tried) to ignore most of the analysis. But I just read Bill Gurley’s post today as a result of a Tweet by Rich Barton — awesome [...]
Facebook S-1 Analysis by Bill Gurley - Drew Meyers Blog
February 4, 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.
Carl
February 3, 2012
[...] * Bill Gurley: Why Facebook clearly belongs in the 10x revenue crowd [...]
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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.
Grant Halloran
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!
andy idsinga (@andyidsinga)
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.
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.
Alex
February 3, 2012
[...] Google currently trades for a forward P/E (according to yahoo!) of 11.75x and an ev / trailing sales of ~4x. Apple trades for under 10x forward earnings and an EV / sales of ~3x. Both of them have significant net cash balances, so the market is actually valuing their core businesses at less than that earnings multiple, but we’ll ignore that for simplicity. Applying those multiples to facebook would imply a valuation of $50B on the low end and ~$70B on the high end. But remember- those are the valuations FB would deserve at the end of 2013/beginning of 2014 (assuming, of course, this rather rosy scenario comes to pass). Assuming a simple 10% discount rate for the next two years, FB would be worth closer to $41B on the low end and $58B on the high end. ***Update- this valuation puts FB a little over 10x P/ trailing sales. I quite liked this post on why FB should be worth 10x sales*** [...]
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[...] Why Facebook Clearly Belongs In The 10X Revenue Club [...]
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February 2, 2012
[...] Overall, the Facebook S-1 IPO filing is straightforward and detailed. The revenue and profit growth of Facebook over the past eight years is astounding. For potential investors. the fact that Mark Zuckerberg single-handedly controls the company makes for an unusual situation. Facebook deserves to be in the 10x revenue club. [...]
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