On the face of it, an immense community of more than 900 million monthly users is remarkable by any measure. These users are constructing their "social graph," building new habits in the way they communicate with friends and acquaintances while sharing applications and content. More than half of these users interact with the Facebook (FB) platform each day.
Advertisers have dipped their toes in the water, spending more than $3.1 billion last year on a platform that we would characterize as immature and prepubescent--many agencies and marketers aren't certain how to measure return on investment for their ad spending. Still, Facebook is capturing data and online/user activity in a comprehensive way about which competitors can only dream. We expect the company to capture a massive share of the online advertising market while developing new revenue streams through local advertising, payments, and commerce. In spite of our bullishness, we expect revenue growth to be highly variable.
Although we believe optimism is warranted, the market might not appreciate several near-term challenges facing the company. Facebook's 901 million monthly active users only tell part of the story, as more than 500 million users interact with the Facebook platform every day. The company is already wildly profitable by most standards and generated $3.7 billion in revenues and 47% operating margins in 2011 on the back of strong growth in advertising ($3.2 billion) and other revenues ($550 million), which consist primarily of payments to third parties, including Zynga (ZNGA).
We expect the company to translate its immense user base and competitive advantages into massive growth in revenues and cash flows over the long run, but the ability to further monetize current users represents a significant hurdle which Facebook must overcome. These challenges notwithstanding, we expect the stock to trade well above our fair value estimate after the IPO, though the focus on short-run challenges might lead to stock price declines and ultimately create a very interesting buying opportunity for the shares at a later date.
Even though Facebook's first-quarter results reflected seasonal weakness, the firm's revenue growth and profitability is commendable. Quarterly revenues declined 6% sequentially, demonstrating that social advertising is already subject to the same seasonal weakness the broad advertising market experiences, as shown in Exhibit 1. Still, Facebook's revenues of $3.7 billion in 2011 increased by 88% versus those in 2010, and the firm's operating margin was 47%, the highest of any company on our Internet coverage list. This remarkable profitability certainly demonstrates the efficiency of Facebook's business model. Notably, sales and marketing expense was 11.5% of revenues, compared with 22.5% for Yahoo (YHOO) and 12.1% for Google (GOOG) in 2011.
Although we don't expect Facebook to expand its operating margins, the current level of profitability allows the firm to continue to reinvest in the business to stave off competition, produce innovative forms of advertising, and support new revenue streams.
Most importantly, we believe that Facebook's real opportunity lies in its future potential for revenue growth as it has only just begun to transform the advertising industry. At a high level, we believe there are several levers for revenue growth that Facebook can exploit.
Future Growth Prospects
Growth in market share (High Growth)
We believe the marketing data that Facebook is gathering through the world's social graph will fundamentally change the advertising landscape. As advertisers have continued shifting spending to online media, large tranches have remained offline (particularly in TV advertising) because of traditional considerations including brand-building objectives and broad reach. We believe Facebook will take market share from companies selling offline advertising as advertisers flock to where the users are most engaged. We expect Facebook to be a dominant player in the online advertising market, particularly in the display advertising tranche.
New Revenue Streams (High Growth)
We believe new prospects, including payments, local advertising, and mobile advertising, represent multi-billion-dollar revenue opportunities for the firm. Currently, Facebook is earning substantially all of its revenue from placing advertising within the Facebook environment and through Facebook Credits (payments) that customers use to buy virtual goods in social games. While Magid Advisors has estimated that $2.3 billion was spent on virtual goods in 2011, an even-larger opportunity comes in processing payments for platform partners. Facebook can capture spending on virtual goods in games and physical goods for e-commerce sites connected to the Facebook platform.
Facebook also has the opportunity to combine loyalty programs and rewards with Facebook credits and advertising, providing a full product suite to its merchants. To provide some additional context about the market opportunity, eBay's (EBAY) PayPal unit processed $118 billion in transactions in 2011, generating $4.4 billion in revenues. With respect to the market for local advertising, we expect the bulk of spending will coalesce around Facebook and Google. Facebook could offer a full suite of services to a merchant, including lead generation, brand building, coupons, transactions, payments, and customer service. We also believe that Facebook could partner with a search engine to offer search engine advertising. Although we do not believe such a move would disrupt Google's dominance, we believe Facebook could easily generate a meaningful amount of revenue in the same way traditional portals (such as Yahoo and AOL (AOL)) earn search revenues.
Increase in Internet Users (Low/Medium Growth)
Facebook has more than 900 million registered users representing nearly 40% of the global population of Internet users. The wild card for Facebook is China. Currently, Facebook is blocked in China, and it's unclear whether the company will be able to successfully launch there. Disregarding China, we expect growth in Internet users to be much slower than it was a decade ago when companies like Google went public, limiting the growth opportunity for Facebook.
Growth in Time Spent (Low Growth)
Without doubt, the amount of time spent on Facebook is astounding, with the average user logging more than 400 minutes per month according to the latest report from ComScore. This heavy engagement helped Facebook earn more than $7 per daily average user in 2011. However, as established media companies continue to put more content online and Web companies such as Yahoo, Google, and AOL invest heavily in online media, we expect competition for attention to chip away at the time spent on Facebook. Even startups such as Tumblr and Pinterest are successfully expanding their audiences.
Increase in Ad Unit Pricing (Low/Medium Growth)
Ad pricing has increased dramatically during the course of the last year, with cost per thousand impressions (or CPMs) rising by more than 40%, and costs per click (or CPCs) increasing more than 20%. Unfortunately, this pricing growth has been driven solely by demand without a great deal of ROI measurement, according to our due diligence. We would expect some volatility around pricing until the analytics industry matures and advertisers feel comfortable that they can measure the success of their advertising dollar.
Valuation
Using our discounted cash flow valuation model, our preliminary valuation is $32 per share, representing an enterprise value of approximately $71 billion. Our valuation represents a multiple of 59 and 71 our 2012 earnings-per-share and free cash flow estimates, respectively.
In modeling Facebook, we forecast 10 years of financial statements. Admittedly, there is a great deal of uncertainty about the ultimate growth trajectory and profit profile of the company, but the exercise is important to us for several reasons. First of all, we believe the company will reach its structural maturity within 10 years whereby it has normalized operating margins and cash flow yields. Secondly, understanding the size of the revenue opportunity at the end of our explicit forecast period helps further quantify our level of optimism about the firm's revenue potential. Although we would not feel comfortable about our level of precision in forecasting the absolute level of revenues in three years, we do feel our 10-year forecast results in a fair representation within a range of possible outcomes.
The key value drivers in our model include 1) revenues of $40 billion in 2021, 2) operating margins of 32% in 2021, and 3) forward returns on invested capital of more than 50%. Facebook's revenues would still be meaningfully lower than Google's, according to our forecasts, but profitability metrics would be similar. We expect Facebook will have to continue investing in sales and marketing, which would drive additional operating expenses. Furthermore, the company will have to increase its revenue sharing with third parties for an advertising network, and we would also expect local and payments businesses to have higher cost structures than its existing business.
Our valuation is approximately at the midpoint of the initial filing range of the company's IPO. Given a wide dispersion of possible outcomes, we would recommend that investors avoid this IPO if it were to trade substantially above $32. Furthermore, we wouldn't recommend investment unless it traded at a meaningful discount to our fair value estimate. Given what we believe to be some near-term headwinds which could lead to much slower growth and a potential stock price decline, investors might get an opportunity to invest in this company at an attractive valuation at a later date. We highlight our high fair value uncertainty rating given the wide range of potential outcomes for Facebook's future financial results.
Risks to Our View
Lack of Standards or Best Practices for Advertisers to Measure ROI
The most common theme we heard in talking to advertisers and agencies was the lack of standards and clear ROI in running social advertising campaigns. If agencies and advertisers are not able to develop acceptable tools for measurement, growth in social advertising might stall and the value of Facebook will be as generic as any other website that drives traffic. Although we expect the industry to successfully evolve in the way that the search industry did nearly a decade ago, the challenge with measuring ROI in social advertising is admittedly greater.
Concerns About Capital Allocation
The concern about capital allocation becomes even more paramount because CEO Mark Zuckerberg controls approximately 55% of the voting shares of the company. Recently, the company acquired Instagram, a social-networking site for sharing photos. Although the purchase only represented approximately 1% of the value of Facebook, it has been reported that the deal happened with very little involvement from the board of directors. If Zuckerberg loses discipline in allocating the company's capital, there can be no guarantee that any such mechanism would prevent the company from destroying shareholder value.
