One popular rumor going around says that, based on the subpar post-IPO performance of both Groupon (NASDAQ:GRPN) and Zynga (NASDAQ:ZNGA), Facebook's shares may underperform expectations when the company finally goes public later this year. Admittedly, investor enthusiasm for internet IPOs seems to be waning after reaching a frenzied pitch last summer when professional networking giant LinkedIn (NYSE:LNKD) saw its shares more than double in their first day of trading. As Mark Zuckerberg readies the company he founded in his Harvard dorm room for a record-breaking IPO (now expected between April and June of this year), it is important to remember that Facebook exists outside the realm occupied by Groupon, Zynga, LinkedIn, Zillow, and all the other internet companies that comprise 'tech bubble 2.0', a not-so-flattering reference to the internet bubble of 2001.
Through its enormous success, Facebook has inadvertently created a new speculative mania in internet stocks. Facebook is not part of the hype, it is the hype--it single handedly engineered a new marketplace for internet IPOs by creating demand for the stock of internet start-ups. Therefore, the success or failure of Facebook's IPO does not rest on investors' appetite for internet IPO's midway through 2012. It is rather the other way around: appetite for internet IPOs after this summer depends upon Facebook's success as a public company, and that, in turn, depends on Facebook's ability to do what any public company must do to survive - remain profitable.
In 2011, profitability was a non-issue for internet companies seeking to go public. Investors, hungry to get their hands on shares of any internet company they could as they anxiously awaited Facebook's offering, snapped-up stock in one unprofitable internet start-up after another after another. In some cases (notably Groupon), the companies selling the shares were not just losing money but hemorrhaging it, with no sustainable business model to fallback on (recall that Groupon's business model resembles a ponzi scheme in many respects).
All that will change in 2012 however, as investors will get the answer to the big question: Is Facebook profitable? Whatever the answer is, it will have huge implications for all internet internet companies who seek to go public in the future. Before Facebook's IPO, investors could rationalize their investments in nonprofitable internet companies by reference to Zuckerberg's social network -"It's ok that the company isn't making money now because it can grow and make billions, just look a Facebook." What happens to that rationale should Facebook prove to be a unprofitable company is the subject of much debate.
Fortunately for Facebook bulls and its existing shareholders (who no doubt already know how the company's financials look), a favorable verdict has already been handed down on the issue of Facebook's profitability. According to CNBC's Julia Boorstin, the company pulled-in $3.8 billion in ad revenue during 2011 and generated operating profit of $1.5 billion. That translates to a 40% operating margin. By comparison, Google's operating margin during the fourth quarter of 2011 was 33%. The issue then, is not whether the company can make money, but whether it can continue to make money.
Going forward, Facebook must maintain not only its extraordinary revenue growth, but its margins as well in order to avoid going the way of Yahoo, which has found it difficult to survive in a market dominated by Google (NASDAQ:GOOG) (Yahoo's trailing twelve month operating margin was just 16.55%). For now, Facebook's revenue growth is extraordinary although it is slowing. Revenue grew 100% in 2011, down from 200% in 2010, while Google's revenue grew just 29% last year.
While some analysts argue that Facebook is overvalued at 80 times earnings, investors should note that according to Forbes, "Google's 2004 prospectus reveals that its IPO price of $84 valued Google at a p/e of 80...[and] its price has risen nicely since its...IPO from $84 to $580." However, at its current price, Google trades for just 20 times earnings, suggesting that investors are not willing to pay 80 times earnings forever. Facebook then, must maintain its margins and revenue growth to ensure that any premium investors are willing to pay for its shares is justified.
The are other reasons to like Facebook's chances. According to the Wall Street Journal, documents revealed that the company had over $1 billion in cash on its books as of 2010, double what Google had when it first offered shares to the public. Additionally, the site has over 800 million members, making it an indespensible resource for advertisers.
Maintaining Facebook's current growth and organizational culture may be more difficult once the company is public. The company's young CEO, who has a reputation for social awkwardness, must now face investors every three months on conference calls and will need to keep employees focused on quality and innovation during a time when many of them will become millionaires via stock options. Whether Zuckerberg is up to the task remains to be seen, although he has demonstrated that he is "cognizant of the task ahead of him...[by] practicing with dummy scripts for earnings conference calls...[and] professionally auditing his financial statements," according to The Washington Post.
In the final analysis, Facebook appears poised to perform well as a public company. It is profitable, its revenue growth rate and operating margin are, for the time being, well ahead of Google's, it has a substantial amount of cash on hand, and it certainly has enough name recognition to whip investors into a frenzy. A first-day pop is virtually assured. The real question facing investors is whether the average trader can get the shares anywhere near the actual IPO price. Whatever the case, don't expect this IPO to disappoint. Google beware: Facebook cometh.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.