Click to enlargeOn May 17th around 2 p.m. a call came in from a friend, he said he had just received a call from his broker, who asked him "what he wanted to do about Facebook's (NASDAQ:FB) IPO." The response was intricate and subtle;
"wouldn't touch it with a hundred foot pole ..."
The advice was to consider buying Western Digital (NYSE:WDC) instead if he had to buy something. Sensing that the answer may have been a bit curt, the following email was sent shortly after the phone call:
"Thu 5/17/2012 2:02 PM
Dear (name omitted),
Thank you for the call just now. To be clear… and further to your question - would NOT buy IPO tomorrow or any other IPO for that matter. Have no idea where the price will go in the near term - but do know that the issue does NOT represent any sort of value for a buyer tomorrow.
Next, I would fire your financial advisor for two reasons:
1. For suggesting such a highly speculative investment such as FB, for which he will receive a commission but you will jeopardize your principal.
2. He is asking you what "you want to do" instead of explaining to you the rationale behind the suggestion - in other words he is getting paid while you do the thinking…
FB filed with the SEC here:
they had 4.5 B in net working capital (tangible current assets available to buttress the stock price tomorrow) at YE 2011 they had only 668 M in earnings (which declined 12% in Q1 2012) - at a 100 B market cap (expected) - owners tomorrow would need 150 years to regain their investment (100 B / 668 M in annual earnings).
Take the following value vs. speculative case of LinkedIn (NYSE:LNKD) and Western Digital
…a little food for thought:
- LNKD is a social network which recently went public and has many similarities with FB
- WDC has been around for 40 years of successful and profitable operation
- WDC costs about 1.5 B less than LNKD
- WDC returns 60 x the profit to owners (and the TTM net figure is about to double)
- WDC has 14x the operating cash flow (despite ~500 M is flood recovery costs)
- LNKD trades at a ~1800% premium over equity
- WDC trades at a 36% premium over equity (and even that is overstated, b/c they have conservative entries for intangibles)
- Where do you think the data for those 910 M FB users is stored? It's not at LNKD - it's on little silver platters made by a company called WDC - the "cloud" wouldn't exist without them
- At today's price and 2012 earnings it would take less than 3 years for WDC to repay for it's entire market cap - that's like buying a house, renting it out and the rent being so high it paid for the whole house in 2.9 years.
- Read more here: Silver Platters, Annie Oakley and "The Sidelines"
Remember you don't need a lot of activity to do very well investing - you do well by being right."
In a follow up email May 21st, 2012 at 11:52 a.m. we wrote simply:
"It would worth checking on the prices of these three concerns during Q2 earnings season (mid to late July)."
Reading Facebook's S1 It seems the company would like for the reader and prospective investor to confuse "users" with "customers." At the top of the filing are some nice pictures with what has to be at least 20 pt. font, for those who are less inclined to read. Further down are the important numbers, which needless to say are in a much smaller font.
The debacle that became known as "the Facebook IPO" is by now well known and ongoing - however the following video (courtesy of SNL) demonstrates with a few laughs that the strategy employed by investment banks is not new.
One thing did jump out on the Facebook S1 - 250 M photos uploaded a day, that's just over 91 B photos per year. And those 845 M active monthly users with cameras in hand, are uploading them from home where they are plausibly also stored and perhaps also backed-up to a local storage device which may be mirrored to an account on the cloud - meaning that sampling of 91B photos may actually be stored on up to four different locations.
It is certain that Facebook is amplifying data storage demand. This thought seems to be confirmed by Seagate Technologies (NASDAQ:STX) recent press release "...to protect, share and save nearly every aspect of one's digital life."
Where in the world could all of those mirrored images be stored? The Arctic Circle?
Estimates of Facebook server count by 2010 was over 60K and Google almost 1 M, surely those numbers have grown substantially. These companies need hardware, a lot of hardware. Assuming these servers are raid arrays, they may have 4-6 HDD's per server. With that sort of scale, and the finite life spans of HDD's the cost per GB is extremely relevant especially as it relates to any discussion of the application of SSD technology. This gives rise to an interesting thought, for the "hyper scale" data center; could [OpEx] be just as critical as [CapEx]?
Facebook has invested more than $1 billion in the infrastructure that powers its social network (according to the S1 above). The company spent $606 million on servers, storage, network gear and data centers in 2011 alone, and expects to spend another $500 million this year.
According to Brendan Collins, the Vice President of Enterprise Storage at HGST:
"Storage is no longer an interchangeable, one-size-fits-all commodity. Increasingly, it is the critical foundation and enabler for your entire infrastructure as the need for online or cloud data storage grows exponentially. Analysts predict 80 percent of net new apps will target the cloud and over a third of all IT spending will move off premise by 2013. Fueled by mobile and enterprise applications and "big data," the amount of unstructured and "semi-structured' content is far outweighing the structured data that storage solutions and tools were originally designed to store, protect and manage…"
New HDD's use less Power:
"One of the most significant costs in data centers is power and cooling. New 4TB hard drives available on the market use 24 percent fewer watts per gigabyte than lower capacities and support multiple power modes to reduce power consumption by up to 59 percent…"
And finally on the benefits of Increased Capacity and Density:
"Storage density is dictated by the capacity of the HDD and how many HDDs you can integrate into rack-mounted servers and storage solutions. Massive 4TB drives provide 33 percent more capacity than the previous generation 3TB HDDs. With this higher capacity, a fully loaded standard 19-inch rack can provide up to 2.4PB of data storage. There are two ways to use this capacity advantage: lower TCO by upgrading HDDs and reducing the number of servers, racks, cables and networking gear, or keep expenses flat and quadruple storage capacity… "
Although the changing design of data centers requires capital investment up front, the OpEx savings (probably the more important factor) associated with the newest drives seem to easily justify the investment in CapEx.
HDD's have customers with deeper pockets than connoisseurs of iPads, because they are customers of the enterprise, of the cloud. And that is to say nothing of when Big Love meets Big Brother.
A relationship blossoms
Even if Facebook and its Investment Bankers were involved in a bit of monkey business during the run-up and launch of the IPO, to the company's credit they still have gathered nearly a billion users who upload an endless stream of content and then proceed to organize it. Facebook is willing to broker the relationship between the input device (e.g. iPad) and the enterprise cloud (.e.g server farm) with relatively small profit.
Facebook's services appear to be at first "free" to "users" (that is to say if the "user" places zero value on their time). However, storage for the company's ever-growing database is not "free," costing ~1 B just in equipment to date. Based on some quick back of the envelope math there's about a 60% chance that your Facebook data, wherever it may reside is being stored on a Western Digital drive.
Facebook therefore is a very low cost, albeit large conduit for organizing information that is stored in the cloud. Hardware suppliers to the cloud, like Cisco Systems (NASDAQ:CSCO), WDC and more recently Apple (NASDAQ:AAPL) (an iPad is nothing more than remote access to the cloud) have tangible profits, because they produce tangible hardware, while the brokers (a la Facebook), have to subsist on the crumbs that fall from the table, with the expectation being that they will sell enough targeted ads one day to make up for all the effort.
FB has also provided quite a diversion in its IPO - millions of prospective investors watched this albatross, selling at ~100x earnings, and well in excessive of 10x book, and did not compete to buy shares in well run company's with long operating history selling far below intrinsic value, which are basically in the same general business - that is to say storing large amounts of information about you in a cold dark warehouse somewhere.
For money managers, and WDC itself (committed to taking back 1.5 B in shares), nothing could be more helpful, or conveniently timed, than having millions of retail investors out of the way watching a two letter ticker symbol, while they vacuum up shares in what amounts to a printing press for money.
It's just a letter
Apparently John Coyne, CEO of WD (set to earn ~3B EBITDA in the next 12 months on a sub. 7.5 B enterprise value) does not feel the same way as Mr. Zuckerberg who issued a letter to investors in advance of the FB IPO. To the critical reader, or those whose job it is to protect the interests of investors, the letter is suspect and should be handled with caution.
The following is a short review of some highlights form the February 1st, 2012 letter:
"Facebook was not originally created to be a company. It was built to accomplish a social mission - to make the world more open and connected."
There are easier ways to have a social mission that require much less complexity. Simply look at the figures throughout history who have effected enduring change - none of them were CEOs of major companies - this is a long shot and unconventional approach. Besides the conventional wisdom is that the original drivers behind the creation of Facebook had little to do with "social mission."
"At Facebook, we're inspired by technologies that have revolutionized how people spread and consume information. We often talk about inventions like the printing press and the television - by simply making communication more efficient, they led to a complete transformation of many important parts of society. They gave more people a voice. They encouraged progress. They changed the way society was organized. They brought us closer together."
But it is not clear that there has been any real strides in technology or invention in the operation. Take for example, one of the more recent features Facebook launched that tracks users activities in real time at the upper right hand corner of the screen, it is the central dynamic feature on the pages. We located a patent application (METHODS, SYSTEMS AND APPARATUS FOR DISPLAYING USER GENERATED TRACKING INFORMATION) dating to 2007 that offered the same approach and even showed the user tracking information in real time in precisely the same spot on the screen - the upper right hand corner. The detailed claims of that patent describe precisely what the "new" Facebook feature offers, only the patent was published about five years earlier.
"Simply put: we don't build services to make money; we make money to build better services."
This line almost sounds like a riddle. Which came first, the chicken or the egg? Is it "social mission" or is it "services" if the end is not "money" than what is the end of the "services?" Let's call it the "for profit social mission service," although we still don't know what the service is for, we just know as investors that it's not "to make money." Wonder if the VCs and other investors feel the same way or even care now that most have exited - or if that was the driver for retail investors on the day of the IPO - how many were interested in better services? Did they have the same detachment from monetary gain that is reported in the letter?
Some other people recently brought about social change, and how services are handled, there have been thousands, including one severely burned, and ultimately dead fruit cart man in Tunisia - he brought about historic change, even revolution, his ideas about profit were also not very lofty, but unfortunately he never had a liquidity event for his somewhat less complex business which was comprised of only a cart and some fruit - in fact it was his poverty that lead to change, because stock in his business was not "worth a lot" before its "IPO" and he did not live to see how it would enrich investors, who arguably numbered in the tens of millions vs. just "tens." You could say he had a sort of "social mission."
"And we think this is a good way to build something. These days I think more and more people want to use services from companies that believe in something beyond simply maximizing profits."
So is the company seeking users or customers? The average user of Facebook does not think about this - to them Facebook is free (although in reality it is not), just like Google (NASDAQ:GOOG) and virtually all of the other services that have "users." In fact, there is another industry which uses the word "user" to describe its clients and they have similar habits to the Facebook crowd - however that industry is usually truly non-profit. The thought begs the question if Facebook employs behavioral psychologist.
"As I said above, Facebook was not originally founded to be a company. We've always cared primarily about our social mission, the services we're building and the people who use them. This is a different approach for a public company to take, so I want to explain why I think it works."
Did Facebook really "always" care about a "social mission" - is that an accurate description of the founding drivers?
"I started off by writing the first version of Facebook myself because it was something I wanted to exist."
They say the DNA and culture of a company is set early on. Lawsuits are common place for established companies in such a litigious society, but unusual to have so many similar in only the first year of existence.
"This is how we think about our IPO as well. We're going public for our employees and our investors. We made a commitment to them when we gave them equity that we'd work hard to make it worth a lot and make it liquid, and this IPO is fulfilling our commitment. As we become a public company, we're making a similar commitment to our new investors and we will work just as hard to fulfill it."
This sentence directly contradicts the aforementioned - here is a translation which may be useful:
"We made a commitment to them when we gave them equity that we'd work hard to make it worth a lot and make it liquid…"
"We made a commitment to early investors when we gave them equity that we'd work hard to make them at least fractionally as rich as the inner-circle and make it easy for them to sell their huge blocks of shares along with the core group to a less knowledgeable investing public whose odds at seeing a return on their investment anywhere nears ours is basically zero."
If social mission and better services were really the target, the IPO could have been fairly priced. For example, consider the case of Craig Newmark, the founder of Craigslist - he is truly not interested in profits (turned down a 5 B buy out offer in 2008), and provides arguably at least as useful a service to society at decidedly little profit to himself. In fact fruit cart vendors would probably have a use for Craigslist if only they had access to it, but would likely find little profit in the use of Facebook.
The Facebook gang who got "rich quick" is now asking retail investors to consider getting rich "very very slowly", as in by the time their great-grand kids go to college. Why? To lock-in profits, and a thoroughly ridiculous return on invested capital at a premium that can never be justified.
For example, if the intent were truly to get the public anywhere near the same deal as the early investors, Zuckerberg could have simply come out and said, look this thing is huge already, economies of scale means it will be tough to grow in the future at the same rate we grew at in the past. Let's put a reasonable price tag on this thing like $6 per share (which would be indicative of a P/E and P/B ratios that would be in line with blue chip tech giants who have been enormously profitable for a long time, even though FB has not been), that way I have a chance at fulfilling my stated objective of making new investors rich while I'm still walking this earth. After all when the company's market cap. exceeds 100 B, the combined retained earnings of the last 8 years equaled only 1.6% of that. If the same growth calculus persists for the next 8 years (a mathematical impossibility, because there are not enough people in the world), would the retained earnings double as well to a whopping 3.2 B? Either way at $6 a share all the insiders get fabulously wealthy at reasonable valuations, and the public has a fair shot at doing pretty well too.