We've written a lot about Facebook (FB) at TradingFloor.com, and our analysts have respectfully agreed to disagree about whether it is a good investment. Personally, I believe that investment case for Facebook might be good despite all the negative comments about valuation. Before we go into the technology behind Facebook, which is important in order to understand the growth perspective, let us first look at the rough financial numbers, which I believe support a positive Facebook valuation.
Facebook has grown net income available to common shareholders to USD 668 mn. in 2011 from USD 122 mn. in 2009. Revenue has grown to USD 3.7 bn. from USD 0.8 bn. in the same period. That stacks up to a net profit margin of 18 percent compared to Google's (GOOG) 8.4 percent when it IPO'd. (I made a bad mistake not investing in Google, which colors my outlook on Facebook today) Annual growth has naturally decelerated from 205 percent to 80 percent in 2011.
The company released Q1 numbers recently. Let us look at those for a moment.
Monthly active users are up 33 percent YoY. Daily active users are up 41 percent YoY. So engagement (or stickiness) is increasing. Monthly mobile users now total 488 million. No other companies get even near this reach in mobile with consumers. Revenue came in at USD 1,058 million for the quarter up 45 percent YoY (2011 growth rate was 80 percent) so growth is coming down. And maybe a bit too fast compared to Google's past trajectory. Revenue was down 6.5 percent QoQ but this is no worry as there is seasonality in the Q1-over-Q4 growth rate in advertising (see chart below for Google's seasonality). The trailing 12 months revenue was USD 4,038 up from 3,711 in Q4 corresponding to an annualised growth rate of 40.2 percent. Net income fell 11 percent YoY with the main drivers being explosive growth in expenses related to marketing and sales (with stock options as a heavy contributor) and R&D. Both groups are directly linked to current and future growth so from my point of view it is not a worry given it is one data point.
The trailing 12 month net income available to common shareholders is now USD 652 million and with an expected valuation of USD 75 bn (my view given sentiment and their growth numbers), Facebook will IPO with a P/E ratio of around 115, which is a bit over Google's IPO valuation. Facebook's price-to-sales ratio is then expected to be around 18.6 which is very high. As I have said, the difference between Facebook and Google is in the growth rate at the same point in time. This tells us that the upside is probably less for Facebook over the next 2-3 years than what was the case with Google. The longer term question is how Facebook's year-over-year growth rate contraction will evolve compared to Google's. That will ultimately have a huge influence on its future valuation multiples and stock return to investors. This automatically leads us to a discussion about technology and management.
Why Facebook might turn out to be a winner stock
Most skeptics of Facebook attack the investment case from a valuation angle. This is flawed as pointed out in yesterday's discussion about growth and its impact on valuation, earnings and stock returns. To understand the growth component as something other than an exogenous variable coming from the macro economy or industry, which is how most old school value investors view it, you have to view growth potential as an endogenous process. Growth comes from within not from outside. It is like combustion in a car. It is the engine that pushes the car forward not the wind from outside. And what is the fuel for the growth engine? Two compounds: technology and management. I believe 100 percent that those two compounds are interconnected and they cannot prosper without each other. Now let us attack Facebook's future from a technological and management point of view and then work backwards to the growth potential and then finally the potential stock return.
I have a large network within the software and Internet industry as I have been in the industry myself. All people I speak to are amazed about Facebook from a technological perspective. Most people never think about how smooth Facebook's web and mobile application runs but I can tell you this: it is an incredible engineering accomplishment to deliver this seamless user experience. The algorithms running beneath the hood of Facebook - "knowing" what content and information you likely want to see - are also something that makes the site technologically superior. Then we have the effects of size. Facebook has the critical mass in most global markets, which makes it difficult for competitors to enter the game as the switching costs for most users are enormously high. Most software people I talk to say Google+ has no chance of being a success and it will probably fail as Google Wave did. I could tell you more on technology but we have to move on to the management component.
In this article and related video (go 1:50 into the video) you will understand why Facebook is an unbelievable company from a management point of view. It innovates and understands user/customer experience better than Google and then works backwards to the technology (as suggested by Steve Jobs in the video). Where Facebook focuses on one thing and then integrates the things it does not focus on through technology partnerships, Google wants to build everything from scratch and wants to build everything (search, music, phone software, OS software, office suite, maps, books, movies, social networks etc.). The fact that Facebook is not afraid to take some bold moves to change the entire interface of Facebook several times, despite loud criticism, tells you that Facebook management wants to innovate and since the changes have never failed it also tells you its leaders understand the future better than the past. To use a Wayne Gretzky quote (often used by Steve Jobs): "I skate to where the puck is going to be, not where it has been". In essence, Facebook has a superior technology/product and an incredible management that dares to innovate.
Facebook has a plethora of opportunities for growth
While the growth momentum is naturally slowing down at Facebook I think most investors totally underestimate the plethora of opportunities for Facebook to monetize its social network and thus extend its abnormal growth rates. It is already growing its Facebook Credits business rapidly to now account for 15 percent of total revenue. And as Facebook more and more becomes the infrastructure upon which other companies spread their businesses, the possibilities are endless.
Think also about what Facebook calls F-commerce, where companies sell products through Facebook in a viral way. Facebook acts as an intermediate and takes a cut on the transaction. Pretty powerful I would say. Another idea comes from the Danish IT company Atosho, which has developed software to buy an item directly through its advertising banner - cool right? So, say you see an Amazon ad on Facebook for an e-book you want. Instead of going to Amazon you stay on Facebook and the banner unfolds with the item and payment solution. You type in your credit card information (if you have not already stored it on Facebook's servers) and click buy. The banner disappears and you are still in Facebook ready to do other things. This F-commerce interconnection with payments could be huge. There may be endless possibilities for Facebook.
All this is key to understanding why growth can be abnormal high for a lot longer than most people expect. If I had told you back in 2004 that Google's annual growth rate would be 27.4 percent and only touch 13.1 percent YoY for a short period you would likely have laughed at me. If you believe that Facebook can deliver a 20-25 percent annual growth rate from today and until 2020, which I tend to believe, then you might make a higher return on Facebook shares than on the S&P 500 despite of the lofty valuation. Let me show you the dynamics.
The chart below shows you the sales and net income figures for 2009 to 2011 and then current Wall Street forecasts for 2012 to 2015. If Facebook goes public with a market value of USD 75 billion and 12 months trailing net income of USD 652 million the P/E ratio will be 115. If Facebook is able to grow net income to USD 3.4 billion in 2015 with a YoY growth at around 31 percent at that time then based on Google's historical valuation-to-growth Facebook might have a P/E of 40 in the beginning of 2016. This should correspond to a market value of around USD 136 billion (40 x 3,400). With 3.75 years to the beginning of 2016 and a starting market value of USD 75 billion in May 2012 the annualised return works out to be 17.2 percent. S&P 500 will likely not return that in the same period (my view). So even if Facebook goes public with a P/E ratio of 115 it can still be a good investment depending on the trajectory of its YoY growth contraction, expected P/E ratio in 2016, IPO market value etc.
All these calculations are based on my valuation expectations and Wall Street EPS forecasts, so every investor should use his/her own judgment before investing. An investment in Facebook may not be suitable for every investor given your current portfolio and risk profile.