Above the Crowd

February 1, 2012:

Attached are my thoughts on the Facebook S-1 along with some quick stabs at valuation.  Brief disclosure, Benchmark Capital has a minority position in Facebook as a result of the acquisition of FriendFeed, a company that was incubated in our offices.

I thought it would be useful to look at Facebook using the scorecard from our May 24 blog post, “All Revenue is Not Created Equal, the Keys to the 10X Revenue Club.” For those that want to save time, the key point of this piece is that there is a broad disparity of Price/Revenue multiples for global Internet stocks, and that only a very small fraction of these companies achieve a multiple over 10X. We also created a list of 10 factors that public investors consider when trying to qualify if a company is deserved of such a prestigious and lofty valuation.

On a roll, these factors are:

1. Sustainable Competitive Advantage – how big is the competitive Moat?
2. Presence of Network Effects – does the model tip to a single vendor?
3. Visibility/Predictability – is the revenue consistent
4. Customer Lock-in / High Switching Costs – is it expensive to leave?
5. Gross margin levels – How much leverage exists is the business?
6. Marginal Profitability Calculation – is the leverage still expanding?
7. Customer Concentration – are there key dependencies?
8. Major Partner Dependencies – are there key dependencies here as well?
9. Organic Demand vs. Marketing Spend – is customer acquisition expensive?
10. Growth – how big will the future be?

So how does Facebook score on these metrics? As you would expect, pretty well.

Metric:	Comments:	Grade:
Sustainable Competitive Advantage	It would be extremely hard to launch a direct-on competitor to Facebook.  Look at what has happened to Friendster, MySpace, Bebo, and is happening to Orkut in Brazil.  Google+ as a FB competitor is a tough slog.	A+
Presence of Network Effects	These are about as strong as you could design. All current non-US Facebook users have immediate connections if they log-in.	A+
Visibility/Predictability	This is fairly strong as well, simply because there is no lumpiness.  There is a small dependency on Zynga that could cause variability. Also, a premium product would offer more consistency than pure ads.  That said, this is not an issue.	A
Customer Lock-In / Switching Costs	Leaving Facebook is possible, but finding an alternative with all your friends on it is not really possible.  Obviously, the inclusion of Timeline works to increase this even more by creating a permanent dependence on past content. Also, Facebook’s DAU number is staggering. Over half of all users check-in daily. That is uber lock-in.	A+
Gross Margin Levels	Gross margin has hovered between 75-80% for the last several quarters.  This is a fantastic overall gross margin. It would be great to think they have more leverage here, but as the largest Internet site in the world, this probably represents peak margins.	A
Marginal Profitability Calculation	On this one Facebook doesn’t score so well.  Peak profitability (on a margin % basis) was in Q4 of 2010, and since then spending has kept pace with revenue growth. It is likley that the team would argue they are “investing for the long-term,” but if the long term is forever, than EPS growth is permanently tied to revenue growth.	B-
Customer Concentration	Zynga is 12% of revenues, but this is fairly low and they are the only company over 10%. Plus, if Zynga stopped competing for these ad purchases, there are many, many Zynga look-alikes that would rush to fill that void. So even if they left tomorrow (which they won’t) the number would not go away completely.	A
Partner Dependency	Facebook has grown to be the largest site in the world with the help of no one. No partners. No dependency.	A+
Organic Demand	All of Facebook’s customers are organic. This is as good as it gets.  The pure stuff.	A+
Growth	Facebook grew the top line 88% in 2011. That’s quite amazing. Q4 of 2011, however, was only 55%.  People will definitely be watching this number in Q1. If growth rate hurts the company, then it’s a direct result of waiting too long to go public – past peak growth.	B

The bottom line is that these scores are fantastic. Facebook is a shoe-in for the 10X+ revenue club. Perhaps the only question is which years’ revenue you consider. If the company grows 50-60% in 2012, you end up with roughly $5.5-6B in revenue. With all the hype, assume a 12x multiple on the $6, and you end up right at $72B. You can double-check this with earnings. As operating margin is stable, 60% growth would result in $1.6B in after-tax earnings. At $72B, this is a 45 PE ratio for a company growing at 60%. At a 60 PE, you would have a $96B market capitalization. The bottom line is that the banker range looks right to me. Of course, overt and ecstatic demand for the hottest IPO of the past 10 years could easily lead to much higher speculative valuations. But it’s hard to argue that the $70-100B range is wrong. Feels quite right to me.

Here are a few other interesting things from the S-1:

1. Tax Rate. Warren Buffet’s secretary would be happy. Facebook’s tax rate is already north of 40%. Other multi-national companies typically have found a way to reduce this. Facebook is paying full-boat.
2. Model appears set. With gross margin relatively fixed, and peak operating margins over 5 quarter ago, investors should get comfortable that bottom-line growth is limited by top line growth. Management could change their attitude later, but experience suggests that founders like Zuckenburg want to invest for the long term. As a result, one shouldn’t expect these super healthy margins to go any higher.
3. Sales > R&D. It is somewhat surprising that sales expense is greater than R&D expense. The ad units clearly are not self-serve. Interestingly, this ratio is very similar for Google.
4. Seasonality. The company has more seasonality than I would have expected (geared towards Q4). The prospectus says this is tied to traditional advertising seasonality.
5. Facebook’s unique RSU program. In an effort to avoid the restrictions of 409A, Facebook long ago created an RSU structure whose shares vest on a liquidity event.  As a result, a large amount of stock (close to $1B in value) will all “vest” on the IPO. This will result in an enormous one-time, non-cash charge. What I still can’t figure out, is how this will effect the overall share count. If you know let me know, and I will append the post. If auditors and the SEC are happy with this RSU structure, I would expect to see other startups adopt it, as it avoids the restrictions of 409A.
6. Cash. Over $3.9B in cash already. And they will raise $5B more. That’s a lot of cash.