Facebook: Dream Until Your Dreams Come True

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

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March 26, 2014

Facebook: Dream Until Your Dreams Come True

In its first year of trading, FB struggled to transition to mobile, delivering lackluster growth and failing to get back to its $38 IPO price. However, with its 2Q13, the company demonstrated a new ability to monetize its increasingly mobile user base, benefitting from a turning point in the acceptance of mobile, social and online video within the ad community. Moreover, we applaud FB’s strategic shift toward a suite of focused but interrelated apps, all leveraging the company’s powerful social graph. Separating previously bundled functions into distinct apps will deliver cleaner experiences for users and better context for advertisers, while co-opting a larger share of smartphone home screen real estate. WhatsApp can further FB’s ambitions, adding new users, particularly in markets where FB is weak, ideally drawing engagement to its more easily monetized services, but the deals for WhatsApp and Oculus are risky and expensive. Within this period of extraordinary growth, we believe that FB can absorb the considerable dilution from both acquisitions without risk disappointing vs. extremely conservative consensus expectations. While FB’s valuation is a significant hurdle for many investors and greatly sensitive to assumptions about longer term growth, we believe continued performance will keep investor dreams alive for quarters to come.

  • Stumbling out of the gate. In January, 2013, we published a cautious FB piece, noting that its “one app for all things” approach left it vulnerable to integrated mobile platforms and focused 3rd party apps offering cleaner user experiences and a better context for advertisers. This echoed concerns over mobile monetization and user engagement that had dogged the stock since its 2Q12 IPO and would remain a serious overhang for another 6 months. Then FB crushed its 2Q13 earnings report, sequentially accelerating sales growth from 38% to 53%, with mobile rising from 30% to 41% of total ad sales.
  • 2Q13 inflection point. FB shares rose 19% after hours on the 2Q13 numbers, and the stock has barely looked back since, up nearly 170% in less than 8 months. Sales growth accelerated further to 60% in 3Q13 and 63% in 4Q13, handily beating estimates for both quarters. While daily active users (DAU) continue to grow, up 22% for 2013, FB has excelled in raising its revenues per user via increased ad density, and higher ad prices. We believe there is considerable opportunity for more.
  • Online mobile, social, and video ads go main stream. FB’s accelerating mobile ad sales have tracked with similar stories from GOOG, TWTR, and other ad driven app companies, as the big agencies and their clients have begun to incorporate the medium more fully into their campaigns. Improved measurement tools from NLSN, SCOR and others have played an important role, as has the embrace of social media as a synergistic companion by traditional TV. Online ads are now just over 25% of global measured media ad spend, but still just 15% of total marketing and advertising budgets. With superior targeting, tracking, and interactivity, we believe online has plenty of runway to grow and that FB is well positioned to capture a disproportionate share.
  • The multi-app strategy promotes engagement. After its 2012 deal, FB kept Instagram separate from its primary platform, and since, it has more than doubled its user base to nearly 200M, all linked to FB’s social graph, driving new engagement and offering a potent venue for new advertising. With this success, FB has backed off its commitment to a single integrated app and plans to launch an archipelago of focused apps. For users, now barraged by a cacophony of disparate voices in their highly edited news feeds and inconvenienced by the multi-click process to reach functions buried in the FB app, focused apps will improve the experience and promote engagement. Users will be able to move directly to the content or services that they want, likely spending more time and making deeper use of the service in the process. Moreover, multiple FB apps will squeeze potentially competing apps off of precious smartphone home screen real estate and co-opt more engagement from platform defaults.
  • The multi-app strategy will also better serve advertisers. Users have many reasons to visit their FB news feeds – finding friends, sharing photos, playing games, viewing media content, entering discussions, messaging, checking archived posts, etc. Some of these purposes are more conducive to advertising than others, and some are suggestive of particular ads rather than others, yet FB is not aware of the purpose until the user begins to interact with the app. Separating the monolithic FB newsfeed into focused apps will provide advertisers better context for placing their ads, driving improved effectiveness. This could drive higher ad prices, greater ad volumes, and advertiser stickiness for FB.
  • WhatsApp makes STRATEGIC sense, but carries risk. Offering dramatic savings vs. carrier text messaging service, WhatsApp’s users have more than doubled YoY to nearly 450M. Moreover, those users are concentrated in many markets, like India, Mexico and Africa, where FB has relatively poor penetration. FB will look to monetize WhatsApp by pulling new users to its more lucrative apps. With small switching barriers for messaging and with the primary value driven by carrier texting rate arbitrage, WhatsApp’s hold on users may be relatively fragile, so delivering synergistic value to users across apps will be critical to building longer term loyalty and sustaining monetization. The $2.2B deal for Oculus VR is a head scratcher, and we are not sure that the deal will add value to investors in either the near term or the long run given the significant obstacles to virtual reality technology entering the mainstream.
  • FB’s valuation implies significant long term growth and profitability. We expect the deceleration in FB sales growth to be fairly gentle, with room for modest improvement in gross margins and expenses relative to sales as the rate slows. Despite our optimism, the current valuation suggests fairly aggressive expectations beyond the next 5 years – a scenario that may be subject to increasing skepticism over time. While we see not specific catalyst that could result in a significant revaluation, many investors may be unwilling to take that risk with a business that has proven volatile in the past.
  • Near term expectations appear conservative, even considering dilution. While FB may be fully valued relative to its long term prospects, the immediate expectations look extremely conservative in light of accelerating online ad spending and the company’s business momentum. We expect FB to beat consensus in coming quarters on users, engagement, ad sales per user, revenues, margins and net earnings. The biggest threat is on the EPS line, where the nearly 9% bump in shares from the WhatsApp acquisition represents significant dilution. However, we believe that the trajectory of FB’s organic business will be more than sufficient to absorb this dilution without risking quarterly misses. In this context, we believe that further outperformance is available in FB despite its valuation.

Facebook – The Dream Remains the Same

FB has had a hell of a year. 12 months ago, the stock was languishing nearly 30% below its IPO price, with investors asking serious questions about the company’s ability to monetize its platform in an increasingly mobile world. With 2Q13, Zuckerberg and company got serious about monetization, driving ad density with gusto while sustaining growth in users and engagement. With the release of the report in July, revealing a sharp QoQ acceleration in annual sales growth from 38% to 53%, FB stock was off to the races. Today, the shares are flirting with $70, a 150% rise from a year ago, having posted further sales growth acceleration in 3Q13 and 4Q13 as well.

We had been skeptics on FB from the start, worried that the increasingly edited and chaotic news feed would begin to alienate users and muddy the context for advertising. Not only did the 2Q13 numbers render our worries moot for the near term, but subsequent strategic initiatives by the company may eliminate them entirely. With the acquisition of Instagram, FB kept the photo sharing service as a separate, focused app, leveraging its vaunted social graph behind the scenes and planning to phase in a tailored ad program. This will be a template for other focused apps – Messenger and Paper (media distribution) have already launched – giving users direct access to the specific services they want to use and giving advertisers a clearer context for their messages. We believe that breaking up the monolithic FB service will promote user engagement, increase inventory for ad placement, and yield higher ad prices, with the additional benefit of co-opting a much bigger footprint on smartphone app screens and crowding out competitive alternatives.

Meanwhile, FB is also a prime beneficiary of accelerating online mobile, social and video ad spending, as the conservative ad community increasingly includes the Internet as an important component of media campaigns. This sea change relates to new online ad effectiveness measurement tools now offered by trusted partners like Nielsen and ComScore, and to an emerging track record. This shift, evident also in the now ubiquitous social media links tied to traditional media content, gives FB a tremendous tailwind in the intermediate investment horizon.

The sticky wicket for many investors is valuation. Our analysis suggests that there is modest intrinsic upside from the current price given the company’s growth trajectory, but even slightly more pessimistic assumptions suggest significant overvaluation. Still, we believe that near term consensus expectations are considerably below FB’s most likely performance, and the risk of quarterly misses or downward revisions appears remote. Even if FB’s longer term performance proves unworthy of its current valuation, the near term growth will keep the dream alive. This growth will also likely prove more than sufficient to hide the initial dilution from the $19B acquisition of WhatsApp, a strategically sensible (a rapidly growing 450M base of users concentrated in markets where FB is relatively weak) yet undeniably risky (aggressive competition, low switching barriers, and questionable in-app monetization) deal, and the hard to fathom $2B purchase of Oculus VR

We believe that the near term risk/reward for potential FB investors today is decidedly positive, without obvious catalysts to force a reevaluation of the future potential of the company, and thus, its current valuation. Still, it is a stock that will require rigorous scrutiny for signs of shifting fortunes and changing investor sentiment, in case the dream dies.

Won’t Get Fooled Again

Maybe Facebook wasn’t ready for its IPO in May 2012. Certainly investors were ready, champing at the bit for a piece of the company and bidding the valuation above $100B, making it the richest public market debut in history. Then Facebook began reporting quarters. Its first as a public company came in July, carrying tepid 32% top line growth, sparking concerns about mobile monetization, and sending the market cap below $50B. The next three quarters did little to assuage holders still under water from the IPO – when an acceleration to 40% YoY growth in 4Q12 had the shares flirting with the offering price, a deceleration back to 38% growth in the following quarter cooled any momentum that was trying to develop. Facebook was stuck in the minds of investors, apparently unable to translate its awesome desktop presence into a money making mobile app (Exhibit 1).

Exh 1: Facebook (NASDAQ:FB) Stock Price, 5/18/2012 (IPO) – 3/26/2014

We were a part of that skepticism, publishing a research piece (http://www.sector-sovereign.com/2013/01/january-16-2013-facebook-stuck-in-the-friend-zone/) in January 2013 that questioned the company’s ability to sustain its user engagement, and thus, its advertising growth, due to the strong hand of mobile platform kings Apple and Google, and the disadvantages of Facebook’s chaotic single “app for all things” approach in the mobile environment. First, we were concerned that a single, integrated newsfeed jumbles many different types of content together – status updates, posted photos, topical discussions, content sharing, social games, media distribution, affinity group communications, etc. – and that the increasingly confusing and heavily edited streams would lose relevance for users, particularly on mobile devices with smaller screens. We also believed that the multi-purpose newsfeed was beginning to lose context for advertisers, who could never be sure of the purpose for which they were accessing Facebook, and thus, their openness to various commercial messages.

Finally, we were concerned that the control that Apple and Google wield over their respective mobile platforms would prove a serious impediment to Facebook in monetizing its franchise in the mobile context. Apple demands 30% of revenues generated by apps on iOS, and while must-have apps like Facebook have leverage to gain better terms, the hand would still be in its pocket. Moreover, both Apple and Google routinely integrate new functions directly into their OS platforms, displacing 3rd party apps that may have previously filled the role for users. When a native function is a default, many, if not most, users adopt it, even if 3rd party alternatives are superior. As Facebook looked to monetize with functions outside its core, functions like games, e-commerce, location based services, and media distribution, etc., competing functions integrated into the OS could crowd it out. With these risks, consensus projections of 30% average growth over 5 years seemed outlandish.

For the first 6 months after our piece, the stock limped along, giving back 15% of its value as the rumblings about mobile monetization problems gained currency. Then Facebook reported its 2Q13 results.

Exh 2: FB’s Ad Revenue, 2Q 2010 – 4Q 2013

Blowout

Facebook’s July 24, 2013 earnings release was a revelation. The decelerating 38% overall sales growth of the previous quarter were answered with a stunning 53% YoY gain, with ad revenues up 61%. Mobile ad sales were up 120% and were a robust 41% of total advertising revenue. Users were up big, engagement was up big, and the stock was also up big (Exhibit 2).

Exh 3: Global Digital and Mobile Ad Revenue Share by Company, 2012 and 2013

We issued a mea culpa on our blog the next morning. Consensus had already peeled back to 24% 5 year average sales growth, and given the extraordinary acceleration of mobile ad sales, even the 30% bogie from January no longer seemed a stretch. In retrospect, there were three factors at work – one, Facebook was able to significantly increase the density of advertising content within the newsfeed with effecting engagement; two, the introduction of rich media and video advertising into the feed helped to drive higher CPMs; and three, the advertising community began to shift budgets to more broadly exploit the reach and targeting of online media (Exhibit 3-4).

Exh 4: Digital Video versus Facebook CPMs, 2013

Exh 5: TV Households and Average Number of Televisions

Mad Men

The third point is a big one. We believe that Facebook will see a substantial secular tailwind, as the advertising community catches up to the reality of shifting consumer behavior and the targeting and behavior tracking advantage of digital advertising. The ubiquitous Nielsen ratings have shown the television audience largely static over the last few years. We believe that the Nielsen methodology does not adequately address the likelihood of increasing passive viewership – instances where a television is on, but no one is paying attention to it. With the average number of televisions per household now above three, and myriad distractions from digital media, we believe that the incidence of passive viewership may be ballooning (Exhibit 5). Certainly, the assertion that Americans average more than 8 hours of TV viewing per day – an estimate that has been fairly static despite the obvious increases in time spent on the Internet (not to mention, without adequately accounting for the time spent at work, school and other fairly obligatory activities). Add in that even if someone is actually watching the program, they may not be paying any attention to the commercials – 2nd screen activity is rampant and DVR ad skipping is on the rise – and the value of traditional TV advertising is in decline. We wrote about these factors in depth in our “War on TV” series this past summer (http://www.sector-sovereign.com/2013/07/july-2-2013-the-war-on-tv-part-iii-reductio-ad-absurdum/).

Despite clear signs of deterioration in the size and quality of the TV audience, the TV networks have demanded, and for the most part, received, increasing rates for advertising. We believe that this dynamic is unsustainable, reminiscent of the newspaper industry, where ad revenues grew to a peak in 2006, despite falling circulation and the rise of internet based alternatives, before plummeting 60% in just three years (Exhibit 6). While we are not predicting such a violent inflection point for TV, the evidence that the 30-second prime time spot is no longer worth what it once was worth continues to pile up to the point that even stodgy conservative advertising buyers are noticing.

Exh 6: Annual Newspaper Advertising Spend versus Circulation, 1950-2012

Exh 7: US Ad Spend by Major Media Category, 2010-2013

Meanwhile, online ads are hot. In contrast to TV ads, the messages can be precisely targeted to EXACTLY the segment that the advertiser wishes to reach (including those with pre-qualified interest), the advertiser can be relatively sure that the audience is actually seeing the ad (or typically, they don’t have to pay for it), and each viewer can be individually tracked post-impression to measure its effectiveness. Despite these substantial advantages and the explosive growth of mobile, social and video apps, advertisers have been cautious in moving their budgets toward online, waiting for a track record to develop and for trusted 3rd party observers to corroborate the claims of digital media companies (Exhibit 7).

Exh 8: Global Measured Media Advertising Spend, 2013 vs. 2016

Wait For it …

The wait may be over. Nearly a year ago, Nielsen, that flawed but trusted arbiter of TV ad audiences, launched a digital product to track audiences for online vide advertising. Meanwhile, online metrics from digital measurement companies like ComScore and eMarketer have grown more sophisticated with time. By July, Facebook had posted its big 2Q13 on its way to delivering further acceleration over the second half of the year. Other companies that rely on mobile, social and video advertising – in particular, Google and Twitter – posted big sales growth in the second half. eMarketer recently projected that global mobile advertising spending would grow 75% in 2014, to $31.5B – a meaningful chunk of the estimated $137B in digital advertising, and a real threat to the roughly $200B spent on TV advertising worldwide in 2013 (Exhibit 8).

Six years into a global economic malaise, advertising is becoming more of a zero-sum game. The size and trajectory of online ad spending will require a hit elsewhere on the media dial, and the biggest, and perhaps most appropriate, target is TV. This year’s Upfronts, the May/June events where media companies traditionally pre-sell advertising for their fall schedules will be watershed events. With broadcast network primetime ratings off nearly 5% YoY for the ’13-’14 season, advertisers may be justifiably cautious in committing to bigger buys and higher rates (Exhibit 9). That the digital video platforms, like YouTube, Hulu, Yahoo, and others, have also begun hosting their own events in the same timeframe will add to the drama. An inflection point for TV would open the door for digital spending even wider.

Exh 9: Big 4 Broadcast Total Viewers through week 26, 2013 v 2014

Exh 10: Facebook Revenue, by Region Q2 2010 – Q4 2013

Facebook is clearly making hay while the sun shines. Revenues per user grew 40% YoY or more in each major geography during 2013, accelerating at least 1700bp in each case (Exhibit 10). This astounding acceleration in monetization was masked somewhat by the ongoing mix shift toward lower revenue Asian and ROW users, but demonstrates advertiser willingness to pay higher prices and user willingness to accept much higher ad density without effecting engagement. Given the strong mobile advertising market dynamics, the move to higher CPM video ads, and new opportunities to monetize via Instagram and other services, there is not a lot of reason to expect Facebook’s momentum to flag now.

How Do You Keep’em Down on Farmville …

For most of its life, Facebook had continued to expand its functionality while maintaining a single monolithic web site. On the expansive real estate of a desktop browser tab, kept open at all times and just an easy click away, this made sense – Facebook was a platform. On a mobile device, where the app must be opened fresh every time it is accessed and where the screen is a limited resource, this strategy was problematic. To use a function on Facebook – to play a game, to send and receive messages, to read an article, to chat about a TV show – meant an extra click to open the main app before getting at the job at hand. Meanwhile, specialized 3rd party app providers were chipping away at many of these functions, while the mobile platform owners, Apple and Google, were busy devising ways to carve out the most lucrative opportunities for platform monetization for themselves (Exhibit 11).

Exh 11: Major Social Networks and Numbers of Users, March 2014

At the same time, Facebook’s Swiss Army Knife approach yielded another problem – user news feeds were getting cluttered, necessitating heavy editing by Facebook’s algorithms, particularly as ad content increased. Users were growing confused – important content was missing from their feeds to make room for a cacophony of Facebook curated notifications, invitations, shared media, updates, and ads. Not only did this create a potential risk for user engagement, but it also eroded the context for advertising. A user visiting just to check a message or post a photo is less receptive to advertising that one that is using the app to fill down time by browsing the news feed – Facebook had no way to tell one type of visitor from another until after they were well into their activity, losing an opportunity to more accurately target advertising.

The Facebook Archipelago

Facebook flirted with establishing its own mobile platform. While rumors that the company would launch its own smartphone OS proved unfounded, in 2011, it worked with HTC to deliver a phone that integrated access to Facebook apps directly from the HTC Sense “skin” that its partner added atop the Android OS and included a dedicated Facebook key that provided instant access to content sharing functions. These phones were notable flops, but Zuckerberg and company were back again in the spring of 2013 with its own downloadable “skin”, called “Facebook Home”, that replaced the Android lock screen and home screens with versions that put Facebook functionality front and center, while complicating access to Google’s own suite of apps. Once again, HTC launched a phone that featured the skin, and once again, it proved to be a flop. It was time for a different approach.

While Facebook’s public rhetoric remained loyal to the single app concept, there were signs that the fealty was softening. Facebook launched its own messaging-focused app in 2011 – allowing users to split off that functionality from the main app. A year later, after the $1B acquisition of fast growing photo sharing app Instagram, Facebook pledged to keep the service separate and did, achieving synergies by linking it to the “social graph” behind the scenes – offering a single login, facilitating sharing across both services, cross-marketing engagement, and eventually, launching advertising. In contrast to the Facebook Phone and Home, Instagram has been an unqualified success – attracting new users, driving engagement and offering a new, context-specific advertising platform.

Exh 12: Facebook’s Archipelago of Mobile Apps

By the 4Q13 conference call, management was ready to announce a course shift. Instagram would be a model for new apps that would peel off pieces of the mother ship service and offer them as focused experiences for users and clear context for advertisers. A new organization, Facebook Creative Labs, had been formed to pursue opportunities within the new strategy, and its first fruit was announced at the end of January. Facebook Paper is an iOS app that aggregates media content – both socially linked and curated by editors – and serves it to users based on their revealed interests within a bold graphical interface while facilitating further sharing (Exhibit 12). The initial reviewers have raved.

We are enthusiastic about the potential for the new model to boost user engagement with focused experiences, find new users drawn to more narrow interests, and to deliver more valuable context to advertisers, earning higher prices and broader demand. Moreover, by offering numerous related apps each with their specific use case, all levered to that social graph, Facebook can populate swaths of valuable real estate on user smartphone home screens with its icons, relegating possible would-be alternatives to the ignominy of the app drawer.

WhatsApp Doc?

Facebook’s $19B deal for WhatsApp was audacious. Setting aside the eye-popping price for a moment, bringing the messaging market leader under the Facebook banner offers intriguing synergy, but also carries substantial risk. First, the potential rewards. WhatsApp has 450 million active users, concentrated in geographic markets (India, Mexico, Brazil, etc) where Facebook has relatively poor penetration, with the number of users having more than doubled in the past 12 months. The usage statistics are extraordinary – 19B messages sent per day, 600M photos uploaded per day, 200M voice messages sent per day, 100M video messages sent per day. While WhatsApp’s well-publicized line-in-the-sand against advertising on the platform muddles the monetization story, the messaging platform could prove an effective vehicle for introducing new users to the broader Facebook application family with its robust advertising program. If WhatsApp can drive 200M+ new long term Facebook users at a $10 annual ARPU and minimal incremental costs, the $19B purchase price might be money well spent.

On the flip side, WhatsApp is essentially a rate arbitrage against the high cost of carrier text messaging services. The customers are buying “free” and there is no guarantee that WhatsApp’s plan to monetize by charging its users $1/year is feasible. Moreover, the messaging space is highly competitive – the Chinese WeChat, the Korean Kakao Talk, and the Japanese Line all boast more than 100M users and offer the same or better functionality than WhatsApp (Exhibit 13). The switching costs are fairly low – with the free apps levering smartphone contact lists and notifications, it is not that difficult to get one’s friends up and started. Moreover, carriers in each market could potentially squelch the arbitrage by dropping text message charges and increasing the price of data plans. While such a move does not seem to be in the economic self interests of carriers today, the future could hold surprises. If WhatsApp loses share, if the growth of messaging app usage flags, or if Facebook is unable to draw new, valuable customers from the WhatsApp base, then the $19B purchase price will have been excessive.

Exh 13: Major Messaging Applications by Users

Virtual Insanity

Facebook’s $2.2B deal for virtual reality headset developer Oculus VR is more of a head scratcher. Mark Zuckerberg talks of VR as the next major communications platform, imagining the virtual experience of courtside basketball seats or of sitting in a classroom of international students. However, Zuckerberg’s glib remarks dramatically understate the VAST technical and ecosystem challenges to making any of it real. First, real time immersive social experiences will be hugely problematic. Users of virtual reality technology cannot tolerate latency – delays of more than 20 milliseconds between head movement and the response of the display induce nausea in most users of the technology. For localized games, this threshold can be achieved, but with distance and internet routing induced latency for social applications it appears impossible.

Second, the mobile computing era has been about untethering the resources of the internet from the desktop. Facebook itself is exploiting this move, integrating the use of its apps within the fabric of daily life. Wearables, touted by many as the next step, will work to extend this paradigm by making it easier to access information and applications without the disruption of pulling out a smartphone. Virtual reality makes a 180 degree turn back to stationary computing. With real life visual and aural experiences entirely replaced by a computer generated environment, the user MUST remain stationary in a comfortable seat and CANNOT interact with others, unless they are also plugged into the VR world. This is extremely limiting.

Third, Oculus content today is limited to a library of fairly rudimentary games and edutainment programs. Going further will require building a vibrant and growing ecosystem of content developers and enthusiastic users. This is easier said than done, even with Oculus’s buzz and Facebook’s resources. Throw in the near certainty that gaming powerhouses Sony and Microsoft will one day add their own VR solutions to their dominant PS and Xbox platforms, and the success of Oculus, even within the relatively narrow world of hardcore gaming is nowhere near assured. Gaming history is filled with buzzy and well funded failures.

We think it is very unlikely that virtual reality will be a primary interface mode in this or even in future eras of computing. The technologies may be valuable in improving the quality of “augmented” reality solutions, like Google Glass or heads-up vehicle displays, which overlay computer generated information onto the real life visual field. It may also find high value, but limited, markets for non-real time, individually consumed content, such as games and recorded interactive infotainment. To this end, we believe that it also very unlikely that Oculus adds any significant value to Facebook as an investment.

In the Short Run

Once the WhatsApp deal closes, its owners will control nearly 9% of Facebook (including the $3B in restricted shares included in the deal). While the company is already profitable, its contribution to Facebook earnings is almost certain to be very small. The $2.2B deal for Oculus may well be a dead loss for investors, with the new shares to be issued accounting for a not entirely insignificant 0.8% of the combined companies, including WhatsApp (Exhibit 14). With little profit added to the mix, the resulting dilution would appear to be a potent recipe for quarterly disappointment and negative revisions.

Exh 14: Facebook Post Transaction Shares and Cash Impact of WhatsApp and Oculus Acquisitions

Exh 15: Facebook Revenue Forecast, SSR versus Consensus 2014-2018

We are not so sure. While there is no masking the dilution, consensus appears to be dramatically underestimating Facebook’s revenue and profit potential for 2014. The median estimated revenues for 2014, are for 44.5% YoY sales growth, coming off of a year where growth accelerated every quarter from 38% in 1Q to more than 63% in 4Q. Given that momentum, and the beneficial sea change in the advertising market, we suspect that consensus will prove woefully short on the top-line – we have modeled 52% growth for Facebook ex-WhatsApp/Oculus and believe that our assumptions are conservative (Exhibit 15). Assuming our 5% cushion on sales is appropriate, and believing that Facebook may well deliver surprise on gross margins and expense levels as well, the company appears capable of absorbing the dilution while still hitting its marks on EPS (Exhibit 16). Once integrated, the economics of the two acquired companies will then be safely hidden from view, with only the higher share count to remind us of their impact. In 2015, the current consensus offers an even softer target. Odds are, Facebook will skate through these expensive deals without really paying the piper.

Exh 16: EPS Dilution impact of WhatsApp and Oculus Acquisitions, FY 2014

But What is it Really Worth?

Facebook carries lurid multiples of more than 20 times its trailing sales and more than 100 times its trailing earnings. Despite its most recent quarter’s 63% sales growth and 700% EPS growth, value investors are left shaking their heads in disbelief and raising analogies to the Internet bubble of 2000. We have some experience with that prior bubble, having pointed out the impossible demand assumptions built into the valuations of the network equipment darlings of the era. Despite a natural skepticism, we are not so concerned with Facebook’s valuation today.

Exh 17: SSR Facebook Revenue Drivers and Assumptions, 2014-2018

First, Facebook’s growth is driving by shifts in advertising, a more than trillion dollar global market, once you include non-media spending like direct mail and couponing (Exhibit 17). Against that opportunity, Facebook’s current $8 billion revenue base is still small, with much room to grow and significant secular tailwinds. Second, Facebook’s business model is inherently high margin and cash flow rich, and the balance sheet is pristine. None of the cash burn, excessive inventory, or debt that sunk the stalwarts of the Internet bubble. If anything, we believe Facebook’s business model has room to be leaner, with higher margins and better cash flow returns in the future. Finally, the risks – and there are risks, particularly from future competition – are mostly well in the future.

Exh 18: SSR WhatsApp and Oculus Revenue Drivers and Assumptions, 2014-2018

Our five year cash flow model implies a fair value of about $72, including the negative impact of the dilution from the WhatsApp and Oculus VR acquisitions (Exhibit 18). Our projections expect Facebook to easily exceed consensus in both sales and margins over the next 3-4 years, but we have applied a conservative 1.5% growth assumption to the terminal value. Changing that assumption to 2% raises the fair value calculation by more than 10%, while reducing it to 1% drops the target to roughly $65 (Exhibit 19-20).

Exh 19: Facebook Valuation Sensitivity Analysis, Beta versus Terminal Growth Rate

Unfortunately, the appropriate assumption for Facebook’s growth rate five years from now is essentially unknowable. As long as the company can keep topping its near term targets, and we believe that it can, the market is likely to keep the dream alive. In that context, we expect Facebook to outperform for the foreseeable future, even to the point that it could eventually become egregiously overvalued. By our analysis, we are not close to that point today.

Exh 20: Facebook Base Case Valuation

Note: Share assumptions base on existing options exercised and a continued RSU award/vesting program growing at a rate of 1.87%
Source: SSR Analysis

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