What's Bigger: Facebook Or Its Potential IPO Valuation?

Feb.27.12 | About: Facebook (FB)

By John Kocsis

This year is set to be the largest for IPOs since the dotcom boom, and the potential offering that has investors wide-eyed for a record-setting 2012 is a website that is probably open in your browser right now. That is, of course, assuming you are afflicted with a case of "Facebook addiction." Statistically speaking, you probably are. Mark Zuckerberg's brainchild now boasts over 800 million members, a consumer base that has investors salivating at the thought of a $100 billion valuation. The only concern that skeptics have of Facebook's moneymaking model is that no one - Zuckerberg included - is entirely sure what that model is exactly, or what it will be for years to come.

Prospective investors in Facebook are certain of one crucial belief. They view the site as a transformational venture that will continue to change the way the world works. Just as the construction of railways historically provided infrastructure for the transportation of goods beyond the means previously available, Facebook could be the biggest platform through which products are distributed on the World Wide Web. While the world's peoples have diverse interests that result in a wide range of favorite sites set as homepages or saved in bookmarks, they generally all share one common "favorite." They all have Facebook.

The universality of Facebook provides onlookers with hope that Facebook can expand beyond its current revenue streams. At the moment, the company's profit is derived both from its advertisements and from its take on Facebook Credits -- what critics have deemed the "Facebook tax," the 30% take of funds from any purchase made on the site's varied third-party applications, from games to social shopping. While Facebook groups that vow to boycott the site should it move to a pay-for-membership model flourish, more than 12 million users actually do pay for virtual goods each month. While this plan is not one suited for immense growth, it has added credence to the contested notion that Facebook can be hugely profitable.
Of course, are not looking at Facebook's current revenue streams as much as its future ones. The company has made news in the past year through acquisitions and announced plans to act as a conduit for the direct conveyance of services. These services range from a heavily hyped video streaming capability for paid movie rentals that compete with those of Netflix (NASDAQ:NFLX), to Facebook's own online music store to compete with Apple's (NASDAQ:AAPL) iTunes. Last year, Facebook bought the publisher Push Pop Press, foreshadowing advancement into the e-reader market. Obviously, these products are all already available elsewhere in the online world, but investors and Facebook agree that these services need not be mutually exclusive with social networking, a tool that already boasts the largest forum for the discussion and viral reach of the latest news, music, movies and books. Critics of the massive Facebook valuation predict that social networking's primary functions will eventually migrate out of browsers on computers and onto mobile phones. Facebook's management fundamentally disagrees with this early obituary, but they've also proactively invested heavily in their Android and iPhone applications. Currently, it is fighting to replace traditional texting services with its Messages app. Facebook also has the potential to tap into the heavily guarded Chinese market. A successful connection with the 500 million Internet users in the Middle Kingdom could act as the panacea to Facebook's slowing user growth.

Traditional investors who recognize the merits of Facebook still fear some of the numbers they could see in this upcoming prospectus. A possible $100 billion valuation would equate to a 105 for Zuckerberg's Facebook. Google (NASDAQ:GOOG), which boasts a well-proven and cash-generating core search and ad business as well as a plethora of other potentially game changing growth divisions such as the Android and Google Music platforms, only trades at an earnings multiple of 22. Analysts who would dissuade against a comparison between Facebook and Google point to a key difference in these two Internet giants. Google's users visit the search site to find specific products, services, and online content, while those on Facebook are there mainly to interact and connect with friends. Facebook's position as a source of distraction and entertainment has meant significantly lower clicks and sales for advertisers on the site, reducing Facebook's potential as a purely ad based cash-cow. Advertisers have attempted to circumnavigate this concern by aiming to create viral social campaigns, but this has yet to match the success of Google's direct ad-serving platform.

Those looking to combat the nay saying of traditional analysts wary of the dotcom boom and less-than-stellar start to Groupon and LinkedIn's public lives protest that Facebook's fundamental numbers alone make it worth considering. Unlike comparable Internet start-ups, Facebook has zero debt. It operates with $952 million in profit, an enviable 28.6% profit margin from its $3.33 billion in revenue. Facebook has $3.5 billion in cash and cash equivalents, making implementation of new revenue streams more than just an unrealistic ambition. Facebook's user base continues to grow, especially in many large emerging markets like Turkey and Brazil, despite persistent complaints about privacy concerns.
Still, even optimistic investors worry about the high volatility of online preferences, the dagger that brought Facebook to the web's forefront after the fall of another former Internet success story -- Myspace, the social network now owned by Justin Timberlake seemed to have a bright enough future to impel Rupert Murdoch's News Corp. to purchase $580 million in equity in 2005. A decline in the next two years as users switched over to Facebook, caused the one time treasure of social networking to be offloaded for just $35 million in June 2011, essentially wiping out all of News Corp's investment. In a nascent field like social networking, it is near impossible to predict the innovations that will eventually replace the current conventions. Investing in Facebook carries this significant risk. It is quite possible that an unforeseen competitor emerges to win over customers dissatisfied with Facebook.

Although Facebook should and will remember the fate of its predecessor, its prospects of being a solid force in the upcoming days of Internet usage are strong. The team with the most creative workforce and widest online presence - the aforementioned Google - has tried to market what it believes to be a superior social network, Google+, with little comparable success. Even if Google's social networking has turned out to be an arguably superior product, users have not rushed to begin their Internet social life anew on a different platform. People all around the world are much more invested in Facebook than they ever were in MySpace, a site that focused primarily on vivid self-expression through artistic themes and music preferences, and only ever saturated the far more capricious demographic of 18-34 year olds.

All in all, Facebook maintains a secure position in a rather solidified marketplace. A MySpace-like transition from Facebook to Google+ or another social networking site would involve moving photos, videos, contacts, and gaming accounts. There is little incentive to migrate from the place that already hosts hundreds of friends with whom users have already connected and would have to reconnect on a different platform. Because of this unique and powerful competitive advantage, the company has room for tremendous growth, and even considerable error. Facebook faces conditions with limited downside. The media is even providing exposure by describing it as a combatant in the war on tyranny, as evidenced by its role in the Arab Spring. And so, while Facebook in its current form certainly doesn't generate the cash flow to justify a $100 billion valuation, it is a fundamentally sound company with an ambitious management team that has the potential to exceed even some of the most ambitious forecasts. It will be an exciting ride to see how Facebook's story plays out in the coming years.


I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.