Facebook and "Field of Dreams": Hoodies, Hubris and Hoopla

In mid-February, I posted my valuation of Facebook and my thoughts on what would happen at the IPO. Since the actual offering date is tomorrow and the frenzy mounts, I thought it would make sense to revisit those posts.

1. Valuation Update
In my February 16 post on the company, I attached my valuation of the company, based on the S-1 filing as of that date. Quickly reprising that valuation, I valued the equity in the company at $29/share (assigning an overall value of about $72 billion for Facebook's equity), with the following key assumptions:
a. Revenues growing to $44 billion in ten years, with a compounded revenue growth rate of 40% for the next 5 years, fading down over time
b. A pre-tax operating margin of about 35%, higher than Google's 30% and on par with Apple
c. Reinvestment (in internal projects and acquisitions) that generate a $1.50 in revenue for every dollar in capital.
d. A cost of capital of 11.42% initially, fading down to 6.50% in steady state

So, what have we learned about Facebook in the last three months that may change this valuation?

a. Facebook wants growth and will pay for it: Facebook has acquired three companies in the last couple of months, Instagram, Tagtile and Glancee. While the Tagtile and Glancee deals were a continuation of a long term strategy of buying small firms with technologies that augment the Facebook experience, Instagram represented a new front: a "more" expensive acquisition of a company that brought with it potential "new users". My guess is that a publicly traded Facebook, with access to far more capital, will continue making acquisitions with the intent of delivering promised revenue growth and that the pace (and the size) of acquisitions will pick up if (or as) internal growth slackens. That is mixed news for investors: the good news is that it increases the odds that the predicted growth in revenues will be delivered but the bad news is that Facebook may pay more for this growth than anticipated.

b. Mark Zuckerberg is lord and master of this company: While there has never been any doubt about the autocratic power structure at Facebook, the last three months have brought home that this is Zuckerberg's company. If news stories are to be believed, the decision to buy Instagram (at least at the final price) was made by Zuckerberg, with little input from the board. If you are going to be a stockholder in Facebook, you should get used to this scene being played out in small and big ways over the next few years.

c. The "Field of Dreams" business model: Finally, Facebook's value still lies in its promise, rather than in actual numbers. Remember the

, "Field of Dreams", where Kevin Costner wanders through a corn field and hears a voice that tells him that "if you build it, he will come". With Facebook and other social media companies, this line can paraphrased as "if you get the users, they (products, advertising) will come". While I do not want too much of a single story, the news story of GM abandoning its Facebook advertising should provide a cautionary note to the optimistic view that Facebook can easily convert its monstrously large user base into advertising fodder.

Bottom line: Revisiting the valuation, there is not a great deal I would change as a result of news over the last few weeks: a higher revenue growth rate (45% compounded with revenues growing to $ 56 billion) accompanied by lower margins (30%) and more reinvestment ($1.25 of revenues for every dollar invested) delivers an estimate of value that stays at the $70-$80 billion range. 

2. Pricing (IPO) Update
When I labeled this the "IPO of the century" in February, I was speaking tongue in cheek. After all, the century is young and there are other IPOs to come. While there is little that you will learn about the value of the company from the IPO process, there is a great deal that we can learn about human behavior and the ecosystem that feeds off big deals.

a. The bankers will do anything to be part of a "big deal": As you track the news stories, it is quite clear that the bankers need the Facebook deal more than Facebook needs the bankers. In fact, I am quite surprised that Facebook did not follow the Google model and bypass the investment bankers entirely and set up an auction. I think that the only reason that they chose to follow the conventional route is because investment banks are essentially doing this deal at cut rate prices and bending to Facebook's will at every turn..

b. And Mark Zuckerberg know it:  As someone who has never been comfortable wearing a tie or a suit, I must confess that I found the brouhaha over Zuckerberg's hoodie to be hilarious. I don't particularly care for Zuckerberg's corporate governance, but I, for one, have never believed that your professionalism is determined by what you wear. I am sure that Bruno Iskil, who lost billions for JP Morgan, wore a very expensive suit, while making his trades. I think Zuckerberg, in addition to mimicking one of his idols, Steve Jobs, was sending a message to Wall Street about who has the upper hand in this game.

c. Investors are replaying an age-old phenomenon: Individual investors are clearly caught up in the mood of the moment, lining up to get allotments of Facebook shares. Is it a bubble? Who knows? If those who forget history are destined to repeat it, it sure looks like a replay of events from the past, and for those who do no remember them, I have a reading suggestion.

d. The insiders: While I don't assume that insiders are infallible, it is telling that they are heading for the exits at the same time as individuals are piling in. Is it possible that they think that the stock is being priced at the top end of the value range? Do they not trust Mark Zuckerberg? Inquiring minds want to know and i guess we will find out as events unfold.

Bottom line: I don't think that there has ever been an IPO where investment bankers have had more information (from private share market prices to institutional investor feedback) to work with, when pricing the stock, than this one. I would be very surprised, if the stock were overpriced; the bankers and the company have too much too lose. I would be equally surprised if the stock were dramatically under priced; a pop of 50% or even 25% would reflect very badly on the bankers' pricing skills. In short, this is shaping up to be a Goldilocks IPO, at least in the initial hours: a pop of about 10-15% (just right for both the bankers and the company). The question is how long the pop will last. This company is too big and too public to stage manage in the weeks after the IPO. If the pop fades quickly, perhaps even by the end of trading tomorrow, I think it is a very bad sign for the momentum game in all social media stocks. 

3. Investment strategies
So, what should investors do about Facebook? You can play the IPO game, and I have described some of the ways you could do it, in an earlier post.  Generically, here are the four strategies you can adopt:
a. Short term buy: It may be too late for you to get in at the offering price, but if you believe in the short term momentum story, you can buy right as the market for Facebook opens tomorrow morning, hope to ride the crest of the price move up as other investors doing the same and exit before they do.
b. Short term sell: If you think that the hype is overdone and that disappointment will set in very soon, you can sell short right after the market opens tomorrow, especially if it does not open with a significant pop, with the intent of covering in the next week or two.
c. Long term buy: You may be a believer in Facebook's potential and its capacity to dominate the advertising market and to sell products to its users. If so, you should buy sometime in the near future and hold for the long term. How long will you have to wait to see profits? It depends on how quickly Facebook converts its potential to large revenues and profits... could be a year.. could be five..
d. Long term sell:  If you do buy into my "Goldilocks IPO" scenario and come up with an estimate of intrinsic value close to mine, though, the investment with the best odds of success on Facebook would be a "long term, short" position on the stock.

Bottom line: I think that the hype is overdone, that disappointment will set in sooner or later and that the stock has far more downside than upside. You can put me in the last group (long term sell) though I am still searching for the most efficient (and least costly) way to execute this. 

4. Broader implications
Does the Facebook IPO have broader implications for the overall equity market? I have heard arguments that a successful Facebook IPO will lead to a rebirth of faith in equities among investors and be a shot in the arm for financial service firms. I think that is nonsense.

• If Facebook does launch successfully tomorrow and the stock price goes up 10%, 20% or even 30%, I don't see how it will cause risk averse investors to come back to stocks. In fact, it will probably feed into their suspicion that the stock market has become a casino that they cannot trust their savings in. 
• As for investment banks, a successful Facebook IPO may bring in some fees and commissions but it will not be a reflection of their skills at pricing or deal making. This is a stock that priced and marketed itself, with little or no help from the investment bankers.

In the same vein, a failed IPO (and I will leave you to define what failure means) will have implications for the pricing of social media companies but not much more.

Bottom line: Facebook, in spite of its ubiquitous presence in our lives, is just one company and not a very big one (at least in terms of revenues and earnings) yet. The market will obsess about it tomorrow but it will move on very quickly to the next worry, fear or fad.