Facebook (FB) will be ringing the opening bell anytime now. The hype and hysteria that will ensue will surely be of epic proportions. The bulls and bears are licking their chops, ready to pound the other into the pavement and prove that their side of the debate is the right side. In this day and age, it's easy to get caught up in the "noise" that surrounds a certain group of polarizing stocks. Facebook has already joined that group, and is perhaps the highest profile, most polarizing company since Apple (APPL) came to town.
With the great debate going on as to whether Facebook is worth $200 billion, $20 billion, or somewhere in between, I thought it would be valuable to take a look at the last "Great Tech IPO." This would be none other than Google (GOOG), which went public in 2004 raising just under $2 billion with an initial market cap of less than $25 billion. Less than a decade later the company is worth close to 10 times that, and both retail and institutional investors alike are making sure they don't miss out on "another Google." But before we get into the numbers, let's take a brief look at some fundamental similarities and differences between these two tech titans:
- Both have "visionary" CEOs who were also co-founders of the company
- Both currently rely on advertising as their main source of revenue
- Both have created an "ecosystem" where entrepreneurs can participate and share success (Facebook Platform, Android Apps)
- Both have strong brand power
- Companies have overlapping features (social network, instant messaging, photo sharing, etc.)
- They both are caught up in what I call the "Technology Food Chain" where it looks as if Google is trying to catch Apple in the hardware business, while Facebook may be looking to steal search and defend social from Google -- and Microsoft (MSFT) is somewhere in the middle of it all
- Google remains more of a directory while Facebook is a destination (you go to Google to find something, you go to Facebook to spend/kill time)
- Google has moved into hardware while Facebook has thus far remained strictly software
- Google is a relatively mature company looking to build on its business model, while Facebook is still in its infant stages and has yet to figure out their core business model
- Google has crossed the 1 billion user mark, while Facebook is not far behind at 900 million -- however, users spend a far greater amount of time on Facebook per day (nearly four times as many hours per month, according to a Nielsen report)
Now that we have some of the fundamentals out of the way, it's time to jump right into the numbers. I took a multifaceted approach to this comparison. I first went all the way back to 2003 to see how Google was able to grow its revenues and operating income in the quarters leading up to, and then following, its initial public offering. Then I continued this approach all the way into the present day, keeping track of its margins along the way. This allowed me to compare Facebook to not just the Google that we know today, but the Google of the past -- the one that shocked investors as it ran from $100/share in its public offering to over $700/share only three years later.
In terms of valuation, the Facebook as we know it today falls somewhere in between the "2004 Google" and "2012 Google." However, in terms of revenue and operating income, the numbers show that the Facebook of today is not much different than the Google of 2004, the only difference being that investors are more tech-savvy than they were eight years ago and are willing to pay a far richer valuation than they initially did with Google when it went public. This limits the future upside of Facebook, and explains why Google experienced such a rapid acceleration in share price and valuation. People were sleeping on Google, while they are wide awake and richly valuating Facebook.
The table below shows the comparables in terms of revenue, revenue growth, operating income, and gross margins. I was able to line up their financials in a way that made it a more apples-to-apples comparison, more so than if one was to compare the two companies as they are in the present day. That means that Google's first quarter in the table shows its financial metrics as they were in Q3 2003, while Facebook's comparable quarter would be Q1 2010.
Click to enlarge all images.
- In terms of quarter-over-quarter revenue growth, both companies are growing at relatively the same pace, with the edge going to Google at 19% vs. Facebook at 16%.
- However, if we look at the standard deviation of the revenue growth, we will see that Google was growing at a much more consistent, less volatile clip than its social networking counterpart. I think we can expect this kind of trend to continue with Facebook, as I believe it has yet to figure out its business model, while Google's model was already established and at this point it was only a matter of scaling it. Facebook recently saw a 6% decline in sales; however, it could make a major move -- i.e., partner with Amazon in a revenue sharing e-commerce venture and see an upwards of 50%-100% revenue growth quarter over quarter.
- Facebook's current revenues have fallen significantly behind Google's of the same comparable quarter. This can be partially attributed to its volatility in earnings mentioned above, where a 57% quarter over quarter nicely pulls up the average growth. But if it is early in the revenue cycle, it has less of an impact than if it was to average a consistent 15%-20% quarterly growth over the long term. Instead, sales growth has stalled and operating income is on the decline. This revenue slowdown can also be a factor of Facebook still trying to figure out its core business model, which I have alluded to many times throughout this piece.
- Looking at the margins, we see that as Google was able to scale and it was able to significantly boost margins, nearly doubling them in less than eight quarters to a respectable 34%. Its long-term average over a 36-quarter span has been 31%. Facebook, on the other hand, was the benefactor of juicy 45%-60% margins early on. However, it experienced a slew of additional costs related to its efforts to scale, and we are seeing a downtrend in margins, with the latest quarter a 25% decrease compared to Q4 2011. This is a concern moving forward, and if we see its margins fall in line with Google's long-term average, they will need a lot of additional growth to make up the difference. Any efforts to invest in different business activities and shifts to the current business model will likely result in a further negative impact on its margins.
- I noted when Google went public in the chart because this gave it access to much-needed capital that was able to fuel growth and acquire major value drivers like YouTube. We might see a similar scenario with Facebook, which is building a war chest to fuel growth and move into unexplored realms (e-commerce, enterprise, content, etc.)
Those looking to get long Facebook here need to understand that they should not be buying the company based on the business model and profits that it currently has today. They also need to understand that Mark Zuckerberg is very much taking a long-term approach to building his company. Furthermore, they need to also comprehend that even with the vast earnings potential Facebook has in the future, much of that is already priced in at the current valuations. This will not be a five- or 10-bagger like Google was. If that were to happen, it would have to surpass Google, Apple, or even Exxon and become the world's largest company.
Those who bought Google at the IPO knew exactly what they were buying into -- the world's largest Internet search engine that made money by selling advertisements that correlated with what people were looking for. They knew the business model and knew the opportunity that awaited them. Those who are buying into the Facebook IPO understand one thing -- they are buying the world's largest social network. But I am not sure that investors, or even Facebook itself, has figured out what it's core business model will be. Right now it is advertising, but many people, myself included, are not convinced that is where it will make its money in the long run. I happen to believe that it has a great opportunity to disrupt the commerce space, in addition to the enterprise space. However, either of these thing shave yet to develop. With this great unknown, there is a great amount of risk (and potentially great reward) that awaits us in the future.
If you believe in Zuckerberg like the Apple fanatics did Jobs, and believe that Facebook has built itself a base that will enable it to leverage its number of users and time spent on the site to create a large amount of value, then Facebook seems to be worth the risk at $75-$100 billion. If we do a simple probability analysis and figure there is a 50% chance that Facebook can surpass Google, and the other 50% chance that it's worth significantly less than the IPO price ($50 billion), we get the following (positive) outcome:
.50 * (-$50b) + .50 * ($100b) = +$25b
However, understand that since Zuckerberg is taking the long-term approach, there may be some very disappointing quarters in the near future as management sacrifices short-term profits for long-term value. This will not bode well for the lofty expectations Wall Street has built up for the company. For the long-term bulls (such as myself), this means there will be plenty of buying opportunities in the future. For those buying now, there could be some downside or, at best, lack of exuberance in the short term.
Also of note is that the timing of this offering is not the best. The market is already tired from its torrid rip off of October lows. Europe remains a complete mess and Facebook is not invincible; it will be affected by a broad market sell-off. If investor's risk appetite starts to move to risk-off, Facebook is not a particularly "safe" investment and we could see shares move south right along with the rest of the market. For now, I plan on watching the mania from the sidelines, but if I see an opportunity I like, I will definitely strike. Nevertheless, those investors looking for returns similar to Google's will be severely disappointed and should align their expectations accordingly.