Facebook IPO and a Tale of Two Cities

Bloomberg survey - 79% think Facebook is overvalued - so who is over-buying all this stock?


Readers of this blog may know that we are a tad sceptical of the IPO valuation price (We wrote this in February):

So, what do we have to believe to believe that Facebook is worth the $100bn?

Firstly, you need to believe that the numbers are even achievable. A valuation of $100bn on a user base of 845m implies a valuation of c $118 per user, within a reasonable timeframe. In financial modelling that is usually taken as 5 years. There are about 2 billion people online today, most estimates think it will be about 3-3.5 billion in 5 years or so time, a reasonable estimate of the the maximum Facebook user base is probably in the region of about 1.5 bn, ie roughly double today, so let us assume the endgame is the valuation of $100bn over 1.5m people, ie about $70 per person in 5 years time. A simple approximation therefore is that Facebook needs to go from c $70/5 = c $15 ARPU, from the c $4 today. Incidentally, Google's ARPU is about $18 today. So it comes to this - do you believe that Facebook can eventually make the same sort of ARPU as Google does, and keep its current market share? Bear in mind that the next 800m people Facebook adds will have much less disposable income than the current 800,000, so the ARPU growth in ratio terms is far higher than Google had to do, as it grew from a smaller base into a wealthier market.

Secondly, long term, ultimately valuation is based on profit. Facebook has a higher profitability than Google at IPO, at c 25%. Google's IPO was c half of that and it only hit the c 25% sort of ratios c 2 years after IPO, and has more or less stayed at around that level. Google now has a c $150bn valuation on c $40bn revenues and c $10bn profit, so for Facebook to justify $100bn longer term you have to believe it can hit c $6-7bn profits, ie revenues of c $24-28bn in about 5 years, and maintaining profis at about 25%. So the question is do you believe there is a sustainable 6-7x growth in profits?

Thirdly, to believe the above two things, we pretty much have to believe that Facebook has as easy or easier a time in the next 5 years than Google has had, ie you have to believe competition and regulatory interference (little surprise the Facebook is beefing up its lobbying arm) will be at worst the same, preferably better and that it makes better use of its cash in funding its growth.

Now this is not a "proper" analysis, but it does bracket the relative IPOs and trajectories for comparison. What it boils down to is that Facebook has set a significantly higher value per dollar earned and user gained than Google, and you have to believe Facebook gets a fairer wind for the next 5 years than Google had over its first 5 years post IPO to justify the $100bn valuation. In other words, you heve to believe it is a (2x) better company than Google.

At that time we wrote that, it seemed Facebook could do no wrong (There Is No Bubble!), and we seemed to be our usual lone contrarian voice. Lets be clear - they have done some amazing things (and some less amzing, like their approach to privacy), and are run and funded by some very smart people - but nothing we have seen in the last few weeks make us change our mind, in fact as valuations go up yet business numbers go static, you have to believe even more things will go very very right right for a very long time.

But what has been interesting to watch is in the run up to IPO, an interesting split in attitude is opening up between US West and East Coast thinking, between San Fran and New York states of mind, if you like. Yes, the New Yorkers are becoming more sceptical (whats thay you say - New Yorkers are always sceptical). 79% of Bloomberg readers think its overvalued (see graphic above), Madison Avenue, the Wall Street et al are a tad sceptical aboutthe valuation into question now:

NYT on Madison Avenue:

On Tuesday, General Motors, the third-largest advertiser in the country, shut down its Facebook budget, about $10 million, saying that those ads were simply not doing enough to sell automobiles. For Facebook, the loss of $10 million is not a big deal. The company generated $3.7 billion of revenue last year, 85 percent from advertising. But the loss underlines the company’s need to convince a skeptical Madison Avenue that Facebook pages are the perfect vehicle for marketers and to convince eager investors that it can increase its advertising revenue, and quickly.

“It’s one of the most powerful branding mechanisms in the world, but it’s not an advertising mechanism,” said Martin Sorrell, chief executive of WPP, the giant advertising agency.

WSJ on Wall Street

The smart money is flying out of Facebook as the dumb money piles in. A week ago, Facebook was targeting a valuation of $77 billion to $96 billion in its IPO and early investors were already looking to book plenty of profits by selling their own shares to the public. Venture capitalists Peter Thiel and Accel Partners were planning to sell up to 20% and 22% of their stakes respectively in the offering. Fast forward to this week. Facebook has raised its target price range to as much as $104 billion. Now, some early investors want to sell a lot more.

Accel Partners plans to sell up to 28% of its shares.
Peter Thiel plans to sell as much as 50% of his stake.
Goldman Sachs will also sell as much as 50%, up from 23% previously.
DST Global and Mail.ru will dump up to 40% of their shares, up from 23% previously.
Tiger Global will sell up to 50% of its stake. Previously it planned to sell 7%.

Company insiders aren’t increasing planned share sales. CEO Mark Zuckerberg still plans to sell 6% of his stake. Other Facebook executives like COO Sheryl Sandberg and CFO David Ebersman aren’t selling any shares at all.

And there are other early investors that aren’t increasing their share sales. T. Rowe Price for instance is holding on to what it has. Another interesting wrinkle is the comparison with previous tech IPOs. At Groupon, insiders and early investors didn’t sell any of their stake in its IPO. LinkedIn’s IPO similarly saw very little selling. At Zynga, insiders and early investors sold just 7% of their stakes on average. Early investors know Facebook as intimately as anyone. That they are selling so much of their stakes should discourage public investors from chasing the stock when it opens.

One can argue that Olde New York Establishment is a bit fuddy duddy whn it comes to the New New Things, but principals bailing out of their own company shares at IPO time is not a good sign in any market. The MIT Review (Boston) is even more to the point:

Farhad Manjoo has pointed out that for Facebook to maintain its share price, it needs to figure out how to increase its revenue by a factor of ten. Going from $5 per user per year in advertising revenue to $50 per user per year is about as likely as Facebook going from 1 billion users to 10 billion, which I suppose is the other way the company could increase revenue proportionally, even if it requires an alternate Earth's worth of additional human beings.

So! Either this IPO is, as the Wall Street Journal has suggested, the biggest shell game in the history of stock offerings, pushed along by those who want to cash out their shares in the company at the expense of unsophisticated investors who are piling on, or Facebook has a plan.

The MIT review thinks facebook doesn't have a plan, but their only way out of such an Overvaluation Impasse is to become a bank:

Forget Square, the credit card processing dongle for mobile devices produced by a company headed by Twitter alum Jack Dorsey. What the payments industry needs is a fast follower with serious reach and the desire to vanquish every other player in this space.

Or, as Dan Hon, interactive creative director at Wieden and Kennedy recently told me, "It would be really interesting if Facebook launched a credit card. In fact, it would be terrifying."

Hmmm..they could almost be honorary Londoners .

And then you go over to the West Coast, where excitement is palpable. If New York is going "hang on", San Fran is going "Paaaarty" This is what its all about, the biggest IPO since Google, a megaboost for the Great Startup Dream. A quick visit to Techmeme shows all the usual crowd are like totally boosting up, ready for blast off - TechCrunch is waxing lyrical about overnight sleepathon hackathons, and how they are Big in Brazil and Bangkok, that Eduardo is a bad lad, and how the Big Bad Government is a fly in the future ointment. Nary an economic analysis in sight. GigaOm is hopefully pointing to where the Missing Ad Billions may come from, others say there will never be another deal again like Facebook for the small investor,

Venturebeat is singing the praises:

This week, Facebook’s IPO will be the largest venture-backed IPO of all time, and not in the subjective Kanye West sense. If, as expected, the company’s valuation creeps toward $104 billion, it would be four times larger than Google’s 2004 IPO.

Facebook will also have earned the distinction of raising the most venture capital of any venture-backed company in the U.S. — a grand total of $2.2 billion from some of the biggest names in venture capital around the world. This is almost double the amount raised by the second-place company in this category, Clearwire, a wireless broadband service provider that raised $1.2 billion. It’s also exactly double the amount Twitter has raised to date, $1.1 billion.

Also, Facebook breaks the record for most companies acquired pre-IPO. To date, Facebook has bought 13 other startups, only two more than Twitter, which is the second-most acquisitive company that is still privately held.

I guess what you think of it all depends on where you are sitting. My concern is more "who is over-buying", given that the smart money is either very sceptical or bailing out. My cynical side (yes, dear reader, it exists) suspects its the dumb money in the main (that's your and my pension funds, by the way....)

But for the Bubble-Watching Analyst in me, it is a fascinating tale.