21 May 2012

Facebook: The New High

At its height in 1999-2000, it had over 30 million subscribers – almost one-quarter of all Internet users in the US at the time – and was growing 25-30% annually.  By 2000, its nearly $7 billion in sales had been growing 35-50% annually in the culminating years.

At its peak market capitalization in 1999, it was worth $250 billion.  Time Warner liked it so much that, in 2000, they decided to merge with it.  At that peak, I get it was valued at 35x revenues, 138x EBITDA, 216x cash flow.*

I’m talking about one of the hottest items of the then-nascent Internet age in the late 1990s.  I’m talking about America Online.  For about $22 a month, you too could sign up to wait about 20 minutes (if you were lucky) for your dial-up modem to connect you to their online community.  It was an unstoppable business model.  Until everyone realized one day, you don’t need to pay anything for that (subscription fees were two-thirds of its revenue model then, the rest mostly ads) and it could be readily replicated away for free.

Fast forward to today…  As of year-end 2011, AOL is now down to 3.3 million subscribers (and only 36% of its revenues are now from subscription fees), out of the now 2.3 billion Internet users worldwide.  That’s down from 4 million in 2010, 5 million in 2009, 7 million in 2008… and oh yeah, the over 30 million in 2000.  With a current market cap 1/100th that of its 1999 size (since spun off from Time Warner in 2009), it is now valued at 1x revenues, 6x EBITDA, 7x cash flow.

Today the latest hot thing is now Facebook.

It IPO’d at $38 per share last Thursday, with its first day’s public trading opening around $42, declining back to $38 by the close.  Facebook boasts over 900 million subscribers, growing ~25-30% annually (down from doubling three years ago).  It has now penetrated nearly 40% of the world’s 2.3 billion Internet users (they had only about 10% penetration just three years ago).  Its ~$4 billion in sales is growing around 45% annually (recently goosed by an uptick in advertising revenue).

At the $38 IPO price, its market capitalization is about $104 billion.  I get that to be a total enterprise value of 28x revenues, 45x cash EBITDA, 62x cash flow (all 2011).*

For perspective (albeit a bit off the top of my head) more “normal” looking valuations for “older-world” businesses range around ~1-2x revenues, ~6-9x EBITDA, ~10-15x cash flow.  But valuations price growth.  Those less-lofty, broader market multiples would typically be pricing ~4-8% growth.

So the big, fat stupid question is (always is), how high is too high?  The corollary, when are we in a bubble?  The only good answer is, until there are no more fools left willing to buy it there.  Every other “explanation” is just a bunch of people trying to make money selling books.

But to slap some numbers on it, Facebook subscribers are growing at 25-30% right now.  Worldwide Internet users are growing at 10-15%.  Facebook subscribers are 40% of all Internet users.  At these current growth rates, there will be more Facebook users than Internet users five years from now.  Which is impossible.  Even for Facebook.  (Sorry.)

The point is, Facebook subscriber growth has to start decelerating dramatically at this point.  It’s just simple math.  If we run subscriber growth out at a rate declining to about 15% by 2016 (still robust), by 2019 Facebook will have 3 billion users, or 58% of all Internet users.  Right now, Facebook makes $4.70 in revenue per subscriber (up from $2.16 in 2009).  If we hold that constant, then Facebook will be generating $14.5 billion in revenues in 2019.  That values Facebook at 7x 2019 revenues.  At that point it will be a more mature business, but still growing the top line in the mid-teens.

Apple is an iconic and transformative company.  It is a mature business, but has managed to reinvent itself and remain "cool" for a few decades now.  With the explosive success of iPhones and iPads, etc., Apple’s sales grew 66% in 2011.  52% in 2010.  Apple presently trades at 4x 2011 sales.

Again Facebook, with current growth of 25-50%, debuted at 28x 2011 sales.  According to the market then, Facebook is “just” seven times cooler than Apple.  If Facebook does everything perfectly for the next seven years, it will then be at a valuation “only” nearly double Apple’s current.  Beauty, of course, is in the eye of the beholder, but can we start to see that perhaps Facebook’s present valuation is maybe a little too beautiful?

And then to compare Facebook to America Online of 1999 is, of course, absurd.  AOL was a subscription fee-based model; Facebook is mostly an ad-based model.  They aren’t in any way alike.

Other than they are both Internet-based subscriber services.  That both came to be regarded societally as a ubiquitous online utility.  And they both offer their subscribers access to their “closed garden” online communities through chat and news.  And they both offer a secondary suite of products (Zynga’s games and apps for Facebook; Compuware for AOL).  And they are both the absolute craze of their respective times.  And they both boasted explosive growth in just several years’ time.  And they were both growing off a relatively new business model only a handful of years old.  And their shares both traded, thusly, at mind-bogglingly high market valuations. 

Aside from that, absolutely no similarity whatsoever.

I am of course being a bit facetious.  But only a bit.  28x sales is ridiculous.  It is.  It just is.  Turn off CNBC.  Pay attention.  There was a time, maybe five years ago, where 5x or 10x sales for fast-growing tech or Internet-based stocks was considered “nose-bleed”.

Now we’re chatting once more about 20-30x sales valuations.  The last time we got there… was the dot-com bubble of the late 1990s.  A bubble that peaked in mid-2000, with the tech-laden Nasdaq Composite Index’s peak.  From there the Nasdaq proceeded to crash ultimately almost 80% – a decline as severe as the 1929-33 stock market crash – and still is only half its peak after over a decade later.

The difference now, versus the late 1990s, is the bubbles only exist in a handful of hopefuls – the poster child right now being Facebook.  The overall market – unlike the late 1990s – is not expensive.  It has just clawed its way back to rather normal looking valuations that it had already achieved, pre-financial crisis by 2007.  To embellish, the S&P 500 Index P/E, in 2007 and now, is a very average looking 13-16x.  By 1999 that was over 30x – its highest ever.  In other words, the entire stock market of the late 1990s, unlike now, was expensive.  This is a possibly important caveat that may allow ridiculous individual overvaluations to persist longer than they otherwise should.

A valuation of 20-30x sales though, prices in everything good that could possibly ever happen to a company – whether it happens or not.  For Facebook, it means that mobile app users, growing at 50% annually (read: faster than overall Facebook user growth), won’t cannibalize ad revenue for it anymore, as Facebook admits it is a risk in their public filings.  (Ads can’t presently be shown on smart phone Facebook apps.  Thus that app use generates no income for Facebook.  Facebook does not control that.  Mobile users are more than half the size of total Facebook users.)

It also prices in no weariness; no boredom with the “new toy”.  No risk that the kids won’t think it cool one day anymore (ala MySpace).  No annoyance for the huge uptick in ad presence on your timeline.  On your banner.  On your photos.  On your news feed.  Its valuation relies weightily – if not solely at this juncture – on the fact that there is no other place for nearly one billion users to otherwise go.  For now.

After all, as subscriber growth now decelerates, increasing ad volume (and/or ad fees) must compensate.  This comes at the risk of annoying either subscribers, advertisers, or both.  And who knows if others will follow GM’s recent decision to leave advertising on Facebook because not enough people clicked on their ads.

But it is a risk.  And 20-30x sales valuations do not account for that risk.  Such a valuation also prices in the assumption of successfully breaking into brand new markets, like the Chinese for example.  Or Klingon or Vulcan or Romulan for that matter.

None of the aforementioned is impossible, or even improbable (well, maybe the interstellar bits).  But the world is a fragile place still in the wake of the financial crisis.  It is not a place where the benefit of the doubt is typically given to publicly traded companies.  20-30x sales gives all that and more to Mr. Zuckerberg and his management team.

They have done a spectacular job in the past several years fulfilling the American dream – running a small, upstart private company, with focus on finding new rounds of private capital investment to fund, while it grows an unprofitable model into a profitable one.  That’s what they have several years of proven experience in.

But they are a public company now.  As I write, they have exactly one business day’s experience in delivering, to the penny-plus-one, quarterly results to a herd of frenetic public investors.

20-30x sales places consummate confidence in them that they’ll continue to deliver for many, many more years to come, with never a misstep.  And that they’ll be naturals at their brand-new and yet to be proven fiduciary duties toward maximizing value for all public shareholders – irrespective of the fact that the insiders still hold 95.9% of the vote (Zuckerberg 55.8% himself).

But Facebook is different from most companies.  It is a revolutionary and transformative icon of society.  And to that, Facebook should command a higher than otherwise market valuation.

So was America Online, by 1999.  And it did as well.  Right up until it didn’t.

Like I said (even facetiously), Facebook is no America Online.  But at 28x sales, before jumping in, is it not prudent to give them, say three reported quarters, to show us they know how to behave like a public company?  Let the hype blow over?

Especially with Europe’s now two-year slow motion train wreck debt crisis, China’s real estate and banking sectors teetering, our own unresolved fiscal drama and while globally wallowing in a soft economic depressive state?

I think you know the answer.  Unfortunately though, even "smart" people can be trampled by the crowd.

* Total enterprise value (“TEV”), as a multiple of these measures.  TEV is the equity market value, diluted and adjusted for in-the-money granted stock options assumed exercised, plus debt, less cash on the balance sheet.  EBITDA is earnings before interest, tax, depreciation and amortization expenses.  Cash EBITDA is EBITDA, adding back non-cash stock compensation expense.  Cash flow is cash EBITDA, less capital expenditure.

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