February 2012

Facebook, the social media giant, recently announced plans to sell $5 billion in stock in an initial public offering (IPO) this spring. This article is our assessment of the Facebook offering and a description of the salient aspects of it we think potential investors should consider. It is not a recommendation to buy, sell, or not to buy any security. It is for informational purposes only and is not investment advice. Orion Capital Management LLC only provides investment advice to its clients under a written advisory agreement. Now, with that said, let’s dig into the details . . .

The Company
Famously born in Mark Zuckerberg’s dorm room at Harvard eight years ago, Facebook is the world’s dominant social networking site. At the start of 2012, it had 845 million users worldwide, 12% of the earth’s 7 billion human inhabitants. The company, which benefits hugely from its network effect, has a powerful financial model. In 2011 it generated revenue of $3.7 billion and about $1 billion in profit, reflecting an extremely efficient business model featuring high margins and very little need for capital. The assets of the company are essentially a bunch of people sitting in some warehouses and their computers; in other words, Facebook has a tremendously scalable, asset-light business model. Given how large and entrenched the company is with its users, it will be very difficult for a competitor to make a successful frontal assault against it in the near term. As time goes by other companies may make inroads, but Facebook, by and large, will be difficult to compete against.

The Offering
The expected value of the firm at the IPO is a range of $75 billion to $100 billion. For reasons explained later, I expect the stock to price at the high end of this range. Thus, the following discussion will assume a firm value of $100 billion—needless to say a staggering sum for an eight year-old company with a mere 3,200 employees.

Facebook to New Shareholders: No Control for You!!!
Facebook plans to sell $5 billion worth of Class A shares. The company has a dual-class structure for its stock, with the Class B shareholders having 10 votes per share and the Class A holders having just one vote per share. Class B holders will likely have around 70% of the voting power once the Class A shares debut. With founder Mark Zuckerberg slated to own 36.1% of the Class A shares and 57.1% of the Class B shares, new stockholders will have no ability to control or even to influence the company.

Facebook is already huge . . . in market value, at least.
One reality worth considering for stockholders who buy after the IPO is that Facebook, which apparently waited as long as it could to go public, has already been phenomenally successful before it offers shares to the public. While the company is itself very young, its runaway early growth and resulting eye-popping valuation serve to reduce the potential long-term upside for new stockholders. For IPO investors beginning their involvement at a $100 billion valuation to double their money (and assuming no share dilution, which is highly unlikely) the company would have to tack on another $100 billion of market value—a not so trivial increase.

Probably the closest thing to the upcoming Facebook IPO that investors have seen is the Google IPO in 2004. Like Facebook today, Google at that time had a very large share of its nascent but rapidly growing market (which for Google was/is internet search). When Google IPO’d in 2004, it had an initial market value of $24 billion. Now, eight year later, Google’s business has grown tremendously and its market value is nearly $200 billion. Shareholders who bought in the IPO and held their shares since are up about 730%. For Facebook to replicate the same rate of return it would have to become a $830 billion company in the next eight years. As of this writing the largest public companies in the world are Apple ($437 billion) and ExxonMobil ($408 billion). Google investors had the advantage of starting at a much lower market value. Consider too that Google’s business—in terms of revenues and profits—is today almost exactly ten times as large as Facebook’s. Should Facebook garner half of Google’s value when its actual business is only 1/10th the size?

Small Float
Only $5 billion of stock (the float), a mere twentieth of the expected $100 billion value of the firm, will be sold to new shareholders. Given the huge number of people familiar with Facebook, there will likely be significant early demand for the stock from enthusiastic Facebookers. Thus it will likely not be too difficult for the underwriters to find a relatively small group of investors willing to pay a premium price for the stock. Moreover, investors with a bearish view of the company (the so-called “shorts”) will find it very difficult if not impossible to find shares to borrow to sell short—in other words to bet that the stock will decline. Given these factors, it would be prudent for investors to expect volatile trading in the shares after the IPO.

IPO Lock-Up Expiration
One day new shareholders might want to circle on their calendars is the date of the IPO lock-up expiration. An IPO lock-up is a period of time beginning at the IPO—typically 90 or 180 days—during which company insiders are forbidden to sell any of their shares. When the lock-up period ends, insiders are free to sell their shares. The purpose of the IPO lock-up is to keep the market from being flooded with sell orders right after a company goes public. With Facebook’s small float of $5 billion worth of shares, there will technically be 19 insider shares that could be sold for each new share sold to investors in the IPO. Needless to say, when all those newly minted Facebook millionaires look to get some hard cash for their stock after the lock-up expires the stock could come under significant pressure.

Internet Going Mobile: A Challenge for Facebook
In 2011, for the first time, global unit sales of smartphones surpassed unit sales of personal computers. People, especially those outside the U.S., are increasingly accessing the internet via their mobile devices—smartphones and tablets. This presents a challenge for Facebook, which in the last year derived 85% of its revenue from online advertising. Display advertising works fine on a large screen, but on a smaller mobile device the medium is not nearly as compelling. People accessing the web via mobile devices, are in my opinion, not likely to be too enthusiastic about display ads hogging their small screens. Perhaps Facebook can somehow adjust its advertising to work better on mobile devices, but that remains to be seen. It will be a vital task for the company, however, as many new internet users around the world connect exclusively on their mobile devices.

It’s Tough Being Public
Once Facebook is public, it may have difficulty retaining and motivating its key employees, virtually all of whom have recently become fabulously wealthy. Many will have ambitions to go out and start their own companies. Even Randi Zuckerberg, Mark Zuckerberg’s own sister, resigned her post as director of marketing at Facebook in August 2011 to (what else?) start her own social networking company.

Another tough aspect of being public for Facebook will be its required financial reporting. Facebook members will get to see just how much Facebook is making from selling their personal information and opinions to advertisers. Some people won’t mind, but with others it may not sit so well that their information is putting ever more money into Mr. Zuckerberg’s pocket. In coming years I expect users to begin to care more about their online information and to take steps to try to better control it. Government regulators in both the U.S. and Europe seem poised to jump in on the side of consumers. The more control over their own information Facebook users have and the more regulations that support them the less valuable will be Facebook’s primary revenue-generating product—its own users’ information. If companies that advertise on Facebook find it increasingly difficult to drill down to a very specific segment of consumer, they are likely to pay less per ad.

Where to From Here?
Facebook has already captured a massive worldwide audience and globally it accounts for about one in seven minutes of all time spent online—a simply remarkable statistic. But it will not be able to keep adding new users at it historical rate because it will run out of people. Worldwide, there are only 2.3 billion people online today and China, where Facebook is blocked, accounts for 500 million of them. Thus, for Facebook to succeed as well as a business as it has as a networking website it will have to find new and innovative ways to wring more revenue out of its existing user base.

One thing I find remarkable about the Facebook offering is how, like no other large IPO I have seen, investors have deemed future hyper-growth a foregone conclusion. Many small promising companies have come public in the past with extremely high valuations, but rarely does a mega-capitalization company come public with a valuation of 25 times revenues and 100 times earnings. Given Facebook’s current business momentum, strong growth for the next several years appears highly likely—but it will have to be for the company to support a $100 billion valuation and for new public shareholders to ultimately earn a decent return on their investment. In business, as in nature, once you are already big it becomes increasingly difficult to maintain a rapid rate of growth.

Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email: thoms@orioncapitalmgmt.com

About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm manages investment accounts for both institutional and private clients.

Disclosure:
This document is for informational purposes only and nothing in it is to be construed as an investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.