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Is Facebook Worth $100 Billion? Not If Competitive Advantage Period Is Halving With Each Generation Of Technology May 2, 2011

Posted by Bernard Lunn in capital markets, IPO, social networks.
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Many pundits call this “The Facebook Era”, meaning that Facebook has the same level of dominance as Google, Microsoft and IBM in their glory days. Plenty of investors seem to be backing this view with some serious $$$. The current valuation of Facebook on the private markets is around $70 billion.

That $70 billion valuation is a mighty big pair of shoes they have to fill. By the time they do an IPO they will need to show a valuation more like $100bn, to give current investors and the IPO investors a return.

We don’t have reliable earnings numbers for Facebook. That will only come when they go public and file reports with the SEC. So we can only go on revenue numbers that get bandied about. Parsing through all the reports in various blog posts, the revenue growth looks tremendous:

2009: $700m

2010: $2bn ($1.86bn from ads, balance from other lines)

That is a growth rate well over 100% which is staggering at that scale. That is $1.3bn in new revenue in one year. They talked about $1.2bn in the first 9 months of 2010. If they did $2bn in the full 12 months, it means that they did $800m in Q4, which would be an annualized run rate of $3.2bn. In other words, they would be on track to double again to $4 billion in 2011.

There is almost no reliable data on profit margins for Facebook. So we cannot do any PE or PEG comparables. But let’s assume that Facebook’s margins are similar to other large ad-monetized web technology ventures such as Google (that subject alone could be multiple blog posts, let’s just take it as an assumption for now).

If we assume that, we can do some PSR (Price to Sales Ratio) against comparables like Google, Yahoo, Demand Media and eBay. These are all publicly traded web tech companies that monetize primarily via advertising. I left out AOL, their price is very low for good reasons. Demand Media is the highest at 7.78, Google is 6.3. Let’s take Google as the benchmark. They are the current kings of the web.

Let’s say Facebook does an IPO in early 2012, showing $4 billion in revenue in 2011. To get to $100 billion, Facebook would need a multiple that was 4x Google’s. Here is the math – Google PSR is 6, 4x that is 24 and 24 * $4bn is $96bn. Google’s growth rate is around 27% (that is growth in last year, lots of debate whether that will accelerate or slow, let’s just take it as their growth rate for now). Facebook’s growth rate is around 4x that at 100%.

There is some blog chatter indicating EBITDA in 2011 of $2bn. Yes, EBITDA is not the same as net profit. Nor is blog chatter the same as audited financials. But for now, lets take that EBITDA number as audited net profit. That makes Facebook at $100 billion on a forward PE of 50. If their growth is really over 100%, that makes PEG = 0.50 which indicates a bargain.

So, with a couple of assumptions, the uncrowned King Of Social Media may be able to wear a $100 billion crown at IPO time.

One assumption relates to the fact that Facebook is still private and so we have no idea if these numbers are even close to accurate. There are no audited accounts that ordinary folk can take a look at. But lets for the moment make the assumption that those numbers are accurate.

The other assumption is more complex. Built into these Facebook projections is the assumption that Facebook can keep growing at these rates for a long time. That relates to what classic management theory calls Competitive Advantage Period (CAP) and what Warren Buffet calls “competitive moat”. To put it in simple terms, “how long can the company charge high rates for something before lots of competitors storm into the market and bring prices crashing down”? So, the big question is:

Has Moore’s Law Shortened The Competitive Advantage Period?

The big question for Facebook, which is clearly “minting money” today, is how many more years can they continue to do this? The stock boosters talk as if it is forever, that is clearly not true. But is that window 20 years? Or is it 10 years? Or is it 5 years? Or is it less than 5 years? This is fundamental to how you value the company.

A little bit of tech history helps get some perspective:

  • Wave # 1: IBM, mainframes. This lasted about 25 years from 1965 to 1990. I am counting from when the “minting money” phase started not from when the technology was invented or launched into the market.
  • Wave # 2: Microsoft, PCs. This lasted about 12 years from 1988 to 2000.
  • Wave # 3: Google, Web. This lasted about 6 years from 2004 to 2010. Now we are into current days so this is a lot more controversial. But we can see that the stock market no longer views Google as a growth company (their PEG demonstrates this), they have changed CEO and the new CEO is saying that social is the next wave they have to master (and we all know who the master of social is).

IBM, Microsoft and Google still generate huge amounts of cash. The question is the acceleration in those cash flows. That started to slow when they reached the end of their Competitive Advantage Period (CAP). If the above history is even close to accurate:

We are seeing a halving of competitive advantage window with each successive wave of technology. 

Is that some weird, ugly cousin to the virtual Moore’s Law?

We do not see this shortening of CAP in markets that are not impacted by technology. For example, Coca Cola still has great moat and that is why Buffet still owns a lot of Coke shares. The same forces that enable incredibly rapid growth – think of the time it took Facebook and Groupon to get to over $1 billion in revenues – may shorten the CAP. In other words, what Moore’s Law giveth it also takes away.

This matters if you want to invest in Facebook at a $100 billion valuation. If you can believe they will grow at current rates (around 100% a year) for 5 years and then slow to say 50% for another 5 years, that $100 billion valuation is quite sensible. But if they only have 1 year at 100% and 2 years at 50%, the numbers simply don’t add up.

If Social is the current wave, what is the next wave? Mobile is the obvious contender.

Mobile is fundamentally different. The app experience is not simply the browser experience on a small screen (like TV was more than Radio style talking heads and online news is more than a newspaper converted to HTML). From a business point of view, the App Store is the first significant addition to the monetization arsenal since Cost Per Click. The mobile phone is the one device we “cannot leave home without”, it is with us whatever we are doing. Location awareness may be the game-changing innovation that will disrupt the long-heralded local commerce market.

More importantly the growth of mobile dwarfs anything that went before. There are over 2 BILLION people with mobile phones. This is where the other big part of my theme comes in – “global”. Most of those 2 billion folks with mobile phones are outside developed markets like America, Japan and Europe. That is a good news and bad news story. The good news is that 2 billion people is one heck of a big market and it is quite likely that we will see at least another billion users soon (there are over 6 billion people in the world). The bad news is that most of them have tiny amounts of discretionary income compared to users in developed markets.

If the next wave is mobile, then the question is will Facebook dominate mobile?

Facebook clearly understand the challenge. But that is not enough. IBM understood that PC was the next wave, Microsoft understood that Web was the next wave and Google understands that Social is today’s wave. History shows that the leader in one wave never becomes the leader in another wave. So, if mobile is the next wave, then Facebook probably will not dominate that wave.

Of course, it is possible that Mobile is not another wave, it is not fundamentally different, that it is simply another way to be Social. Facebook clearly have that view. But again history is a guide. IBM saw PCs as just devices to connect to a mainframe, Microsoft saw the Web as just another feature within Windows and Google saw Social as just more stuff for a search engine to index; they were all wrong.

What do you think? Is Mobile another wave or just a feature of the Social wave? If it is another wave, will Facebook dominate that as well?

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Comments»

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