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.
|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:
- 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.
- 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.
- 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.
- Seasonality. The company has more seasonality than I would have expected (geared towards Q4). The prospectus says this is tied to traditional advertising seasonality.
- 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.
- Cash. Over $3.9B in cash already. And they will raise $5B more. That’s a lot of cash.
As you likely know, I am a big believer that the IPO can play a key role in the development of a company’s life. Moreover, I have argued that many in our ecosystem have an unhealthy anxiety regarding the dangers and consequences of being public. Lastly, I have argued that the IPO window is wide open for great companies – something I still believe today. All that said, I have been quite surprised by the recent trend in companies that file and then chose to delay. If you are going to file the S-1, it is imperative that you are prepared to follow through. Standing too long in the middle of the financial equivalent of the river Styx can have severe consequences.
Why is this a bad thing? The longer a company remains on file without pricing, the more questions arise about “why” the company may be struggling to move forward. Did they miss their numbers already? Are they having cold-feet? Are they not ready? Do investors not like the company? Have the bankers lost their belief on the company? Employees may begin to wonder the same thing. As you are in a quiet period, it may be difficult for you to respond to concerns through the press. If you then take the added step and “pull” your IPO, you now risk being considered a “broken” deal and potentially a “broken” company. Potential acquirers will certainly see it that way. These problems can be especially acute in Silicon Valley, where competition for talent is intense. Lastly, to file and not price is to give up all the benefits of being private with none of the gains of being public. You have been exposed, but you have nothing to show for it.
There are many things that can cause delays in filed IPOs. The most common factor is unexpected questions from the SEC that cause iteration and re-filing. This is especially true of the SEC questions that require the auditors to revisit their original assumptions. Shaky investor sentiment as a result of a weak broader stock market can cause both investors and bankers to have “cold feet.” There may also be concerns with valuation and dilution. If your company looks like it is going to price at a 30% discount to what your bankers conveyed on filing date, you may not want to suffer unexpected dilution. Lastly, there may simply not be enough demand for your IPO – which is an amazingly tough position for your company.
The attached table shows the # of days from pricing to filing for some recent IPOs as well as the days on file for Zynga, GroupOn, and Kayak. These five companies had an average pricing-filing span of just under 100 days. Two of the IPOs in which Benchmark was lucky enough to be an investor (Zillow and ServiceSource) had particularly good showing on this “pricing-to-filing” metric with 93 and 94 days respectively. (*Just added Bankrate, which had an error-free 62 day filing to pricing window). GroupOn is starting to move outside this ban, but recent news suggests they may be back “on track” with a target date of late October (this would equate to 150 days on file). Zynga’s IPO is listed as “delayed” on Yahoo Finance while standing at 75 days. Kayak, a leader in the travel search space, had been on file for 301 days – a precarious position for any company.
While many of these potential causes of delay appear external and “out of your control,” there are in fact many things you can do to minimize the number of days between filing and pricing.
- Don’t start the process until you are ready. This certainly includes knowing your business is performing well, but also includes having the auditors ready, having your financials in order, having a strong CFO and general counsel, having your BOD ready to go, and generally being prepared for what is about to happen. Talk to other CEOs who have kept the process on time, and find out how they prepared.
- Pick a banker who understands that you are sensitive to filing-pricing timing. Some bankers will tell you this metric is not critical. You own the problem if you are stuck in a filed but un-priced company. You should tell the service provider what is important to you, not the other way around. Great investment bankers have a strong understanding of SEC process, SEC rules, and may even have an ex-SEC representative on staff. These things matter, and you should be able to tell whether or not they matter to your banker. Also, find out before you file if your banker believes in you and your business. If you are defending your business to your banker “after” filing the S-1, you had a clear sequencing problem.
- Watch out for “wedding planners.” IPO are expensive and as such, they tend to attract “service providers” encouraging you to purchase the “royal package” at every turn. The argument, just as with a wedding, is that you only do this once, and therefore; expense should be of little concern. There are two problems with this logic. First, companies about to be public should not be carelessly wasting money. Second, the “royal” package takes more time and slows things down, and will inherently contribute to extending the pricing-filing window.
- Pick experienced professionals in every slot. There are many constituencies that are involved in your IPO process – auditors, valuation firms, compensation firms, external counsel, underwriter’s counsel, bankers, analysts, even these whacky constituents known as “printers.” You want professionals who know how to get things done, which is very different from the “wedding planners.” Think Harvey Keitel as Winston Wolf from Pulp Fiction. “I solve problems.” Facilitation is key.
- Intentionally target a smaller offering. Many investment banks will encourage larger offerings (see point 3). While this serves them well, it may be at odds with maximizing the probability of a successful pricing. Less supply means less demand is required to pull off a successful offering. A smaller offering also will make all shareholders less sensitive to dilution and therefore pricing. Once again, do not file if you do not plan to price, and this includes all prices in the planned offering range.
- Don’t disrespect the precious nature of an open window. The four companies above were on file during a very strong IPO window, and as a result had seemingly error-free processes. Being prepared to go when things are good means avoiding the situation where you file, and the global market melts down in your face. If (1) your company has the numbers to be public, (2) your company is ready and prepared to be public, and (3) the IPO market is healthy and the window is clearly open and you still chose to wait to go public than you are accepting the timing risk of the future. As Geddy Lee of Rush says, “If you choose not to decide, you still have made a choice.” Growth can slow, markets can turn, new competitors can show up. Going public too early clearly has risks – but so does waiting too long and missing your opportunity.
IPO markets will always have “pulled” and “delayed” IPOs. This is simply the nature of the beast. An open IPO window attracts two types of companies – those that should go public, and those that “need” to go public for capital reasons. Portions of the “need” group will always fail to find supporters, and therefore you should not view delays and withdrawals as signs of a weak IPO market. That said, certain delays can and should be avoided. If you are stepping up to the plate for an IPO, be ready, be prepared, and be committed to seeing it through. Don’t submit an S-1 if you don’t plan to price. Waiting on file for extended periods of time can be catastrophic.Read Full Post | Make a Comment ( 9 so far )