Can a Value Investor Buy Facebook (FB)?

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May 23, 2012
Someone who reads my articles sent me this email:

Even if (Michael Wolff) is overblowing things in his criticism of Facebook, he poses an interesting idea: that the value of advertising in general may be falling because advertising is generally less effective.

This is where I have to disagree with the criticism of Facebook (FB, Financial). For me, there is one valid criticism – and only one valid criticism – of Facebook stock:

It’s too expensive

Way too expensive.

Fine. But a lot of stocks are too expensive.

People are talking about the dot-com bubble. This is nothing like the dot-com bubble. This is like the Nifty Fifty. And it could end for Facebook investors the way it did for investors who bought into any of the Nifty Fifty – you’ll lose a lot of money over the next few years – but the company itself will still be a solid competitive enterprise chugging away many, many years from now.

That’s very different from the dot-com insanity. It’s the difference between speculative businesses and speculative prices. Facebook is not a speculative business. It’s definitely an investment quality business. There is nothing wrong with a company like this being offered to the public. (There was a lot wrong with the companies offered to the public in the late 1990s.) There’s nothing wrong with sticking something like Facebook in a college endowment.

Other than the price.

There is something wrong with the price. But there are two parts to what makes a stock purchase an intelligent investment:

· The business bought

· The price paid

Facebook is a perfectly good investment if we’re talking about the business you’re buying. But it’s also a complete speculation if we’re talking about the price paid.

But let’s not broaden the discussion into some grander theme. It really comes down to too high a price for the stock.

Just because an IPO flops, doesn’t mean there’s something wrong with the business model.

I don’t see any reason why advertising would be less effective in the future than it has been in the past. Or why it would be less effective online than offline. If you mean a certain kind of advertising – yes, a certain kind of advertising will be less effective online than offline.

But a certain kind of story has always been less effective on movie screens.

I live a block from an Angelika theater here in Plano. The movies I see tend not to play real big in most of the country. Why? Because they aren’t the right kinds of stories to tell on a big screen where people are going to go out as a couple or a group and plunk down 10 bucks and spend two hours in the dark. Seeing old, decrepit English people staying in an old, decrepit hotel in India; or an old woman looking for her lost (not especially young) dog; or a mortician killing an old lady – these are not effective kinds of movies. The movies themselves may or may not be effective. But the kind of movie most definitely is less effective in attracting people’s attention.

They don’t have the right appeal. For one, they are about characters. And if you want to focus on characters – why not do that on TV where folks don’t need to spend a full two hours with you, don’t have to pay for the experience, and can stick with the same character week after week.

You get the point.

Some stuff doesn’t work that well in movie form. But just because we can’t make American Idol: The Movie doesn’t mean movies are an ineffective medium for telling stories. It just means you can’t put stuff made for free TV into paid theaters and expect the same results.

The same is true with ads.

Just as what makes an effective TV story may not also make an effective movie story – an effective offline ad may not make an effective online ad. And vice versa.

For one thing, I click stuff online. I don’t click stuff on my TV.

So, TV has some serious limitations. In fact, it’s hard to imagine a more limited advertising medium than TV. Even advertising directly in a book would have permanence. I don’t freeze my TV. And yet I also don’t give it my undivided attention. I can and do: change the channel, mute it, walk away from it and even talk to other people while watching it.

Oh, and I can’t interact with it directly – I can’t follow a link to your website on my TV screen. And I usually don’t have a pen on me to write anything down – who would want to advertise on something like that? Without showing me the same ad half a dozen times on TV, I won’t even remember the ad much less act on it.

These are all valid criticisms of TV advertising. Companies still use it.

There is no reason advertising spending has to be used in a certain way. Advertising as a percentage of U.S. GDP has not decreased in any meaningful way in over 90 years. It was basically the same in 1920 as it was in 2000. And, in that time, companies have been advertising in everything from:

· Radio

· Mail

· TV

· Magazine

· Newspapers

· Billboards

· Etc.

It has been sold in 30-second spots and 2-minute spots – and in certain settings even much, much longer. It has been very targeted, and it has been very general.

Different businesses have used very different ad supported models.

Newspapers made a huge percentage of their operating profit from classified ads. Today, there’s actual classified sites – that look much the same as newspaper classified – like Craiglist. And then there’s Google (GOOG, Financial). Google is essentially a classified ads company.

Google has a way wider moat than local newspapers did though. Because the habit is more strongly ingrained. It’s an active search. Not passive. It’s hard to imagine a better business than Google. It’s a company that stumbled into the marriage of habits and advertising.

Facebook is a terrific business. Absolutely amazing economics. Not in the future. Today. Right now. It is already a great business. Whether or not it is a durable great business is another question. But look at its operating margins. Look at its working capital requirements. Facebook has the economics of a local TV station. It just happens to have the potential to reach much of the world.

Facebook’s long-term future is entirely a question of two things:

· Habits

· Experience

The question of experience is the question of an “experience curve.” I’m not a big fan of that term. But finance people like using it. So, we’ll use it here.

What I mean is that if an army – like the Roman army – gets in the habit of campaigning every year and marching every day and building a defendable camp every night – they get good at those things. Not just any one Roman. But the collected wisdom of the group – even when they don’t know exactly why they do the things they do – leads them to automatically make somewhat smarter decisions without thinking. And over time, the institution figures out the logistics of moving tens of thousands of people and keeping them fed and dysentery free and so on just through doing that day after day when a lot of other folks are not doing it. And very often a single academy or one great genius really can’t push enough experience through the whole organization as years of seemingly mindless practice will.

Well Facebook is going to get a lot of practice. So the issue is the potential of how much you can make in the kind of advertising there will be on Facebook – and then how good they will get at selling that advertising. This is key. Because the advertisers are going to need help. They evolved in a different ecosystem of sorts. And they are not well adapted to Facebook. And they have some old habits that will need to change.

But unless the folks at Facebook are idiots they will soon know more about advertising to people through social media than anyone on the planet – much more than any ad agency does now. They will have a tremendous amount of data on people.

This is one of the big reasons why I think retailers are in a bad position versus someone like Amazon (AMZN, Financial). Amazon has the potential to assemble the same sort of advantages – informationally – that every grocery store out there has and yet it also has a pleasant shopping experience with the ability to cross sell you things you didn’t even know you needed.

That is the trifecta of retail:

· Get all the customer’s info

· Sell them stuff they don’t know they need

· Have them leave happy

This is very hard to do offline. But it happens all the time at Amazon. And so I would not want to have to compete with a company like that. Because the model of an online store is just so superior to the model of an offline store.

Facebook is theoretically a much, much better way of advertising than television advertising. Television is one of the world’s worst ways of advertising. The only reason TV advertising became so important is because TV is one of the best ways of entertaining people.

Advertising goes where people’s attention is.

The eyeballs went to TV. Because TV is the best way to entertain people in their own homes. So if you wanted to sell things to a mass audience – but talk to one person at a time – TV was the way to do it.

The article is right of course that Facebook – and let’s face it, Google – are not deriving their economic value from being tech companies. They are both advertising-supported media companies from a profit perspective. From an employee perspective it’s different. And that’s important to keep in mind. You want to know how a company sees itself. But you also want to know where it makes its money. What does it eat? What fuels the business?

It’s not tech for either Facebook or Google. They are both pretty simple media companies in terms of where they make their money.

Facebook is not a tech company. It’s a media company. There is a risk in the company – the same risk is present in Google, but probably to a much greater extent there – that the folks inside the company do not have a clear idea of what their golden goose is and instead will go off and do very stupid things.

According to Facebook’s SEC reports, the price paid for its advertising per user has been increasing rather than decreasing.

Overall, I think the idea that Facebook needs to grow users a lot to justify its valuation gets talked about too much. Growth in users is not the first thing I would look at when analyzing Facebook. It is the habitual use of Facebook that is important. You want to have a product that is used the way a local newspaper, local morning show, and local even news were once used. For some people, Facebook is already used that way.

So how much money can Facebook make advertising to each of its users?

There is a lot of growth potential right there. Even before you talk about growing the audience.

Maybe because it’s an Internet company people think users matter more than they do. Use matters. The thing I want to know more about Facebook is how people use it. Not who will be using it in five years. That really is much less important than some people are making it out to be. You’ve got enough valuable folks spending valuable time on the site now. If they’re using it the right way – it’s a very valuable media property.

Let’s think about that $100 billion IPO price.

If Facebook ever had 5% of worldwide advertising spending it would justify the $100 billion IPO valuation.

As a no-growth business Facebook should trade around five times revenue.

Look at the company’s operating margins. In 2011, Facebook had revenue of $3.71 billion and operating income of $1.76 billion. That’s a 47% operating margin. At a 35% tax rate, that would put net margins around 30%. It’s pointless to talk about free cash flow right now because of Facebook’s rapid growth. But the owner earnings picture at Facebook is probably in line with something like Moody’s (MCO).

Basically every $1 of revenue turns into about 30 cents of after-tax cash. Divide that 30 cents of owner earnings by 5 and you get 6 cents. A free cash flow yield of 6% would not be odd for a big public company. Basically, that’s a P/E of 15. So that’s why I say Facebook would be worth five times revenue without adding any growth premium. (Of course an advertising supported media business with a wide moat should be able to manage 5% to 6% growth in nominal terms – basically it should match GDP over time.)

Every 1% of global advertising spending is $5 billion. So, with an enterprise value of five times revenue, a company with a 1% share of global advertising would be valued at $25 billion. This is only true if you have Facebook’s economics. Outside of local media (most of which is decaying), very few companies have anything like Facebook’s economics. Revenue is worth a lot less to them. I don’t want you to think five times revenue is the right value for all media companies – it’s not.

Facebook doesn’t really need working capital. And won’t use debt (media companies don’t need debt – they usually just use it when they buy each other up). So, that’s basically $25 billion in market cap per 1% share of the worldwide ad market you think Facebook will have.

Facebook went public with a $104 billion market cap. If 1% of worldwide advertising is worth $25 billion in market cap in the hands of Facebook, that valuation implies a 4.2% share of worldwide advertising spending.

In other words, people who bought the stock at its IPO price were betting Facebook will account for 1 of every 25 dollars spent on advertising worldwide.

Unless they think Facebook will get profits from someplace else. From someplace other than advertising.

That required 4% share of worldwide advertising gave no credit to possibilities of other revenue sources – like payment processing. Consider all other revenue sources a lottery ticket. Because of the nature of Facebook there will be more happy accidents than at other media companies. Revenue sources will appear the company didn’t really plan for. It’s a more valuable lottery ticket than at most companies. There is a much greater possibility of payoff because of the amount of experimentation that will happen without the company really having to do much.

As far as the effectiveness of advertising specifically regarding Facebook – the potential is clearly there for much more effective organizing via Facebook than any other advertising medium. This is supported by basic principles of social momentum that have been proven in research time and again. I have no doubt the potential exists to get more momentum for an idea, brand, person, act, etc., on Facebook than through any other medium on which a company can advertise. Whether this is something companies and agencies know how to do or want to do is another question.

You had 483 million daily active users when Facebook filed the original S-1. Of those, probably 80% at least are pure followers of no great import to advertisers beyond the traditional way you advertise to folks through TV, etc. In other words, more than 80% of Facebook users are just worth their eyeballs. Nothing more. It is not like talking to a crowd. But a small number of Facebook users – I’m not sure if it’s 100 million, 50 million, or 25 million – but it’s at least 25 million people are really much more valuable. Or potentially more valuable. If you know which 25 million people to try to influence you will end up getting a lot more bang for your buck.

This is one of the big problems advertisers have. Advertisers are a bad messenger for their own message. The same message delivered by somebody else would be way more effective than delivered directly from the company. Advertisers try different ways of solving this problem. But they can rarely get to the people that would be most helpful in promoting their brand simply through advertising. Some companies obviously have a ton of success influencing the influencers, but this is often through other means than advertising.

When you are advertising on TV or in a newspaper or even giving someone a coupon you may know some demographic info and some buying behavior. But you generally don’t know their influencing behavior. You don’t know to what extent they can help you beyond just getting you one sale. Facebook has that info. They have the most valuable information about the exercise of influence by individuals that anyone has anywhere. Whether they know how to use it, etc., is a different question. Whether they will share it is a different question. But they have it.

A brief detour about FICO (FICO, Financial) will explain why this matters.

You leave some behavioral breadcrumbs in your financial life that FICO can use to predict your likelihood of paying your bills in full and on time. In fact, your FICO score tells you much more than that. If anything, FICO and others have downplayed the predictive value of the FICO score outside of lending for fear of a public backlash against just what that info tells you. The truth is that the FICO score is really not just some measure of creditworthiness. It is a measure of character. It is a measure of behavior. You could duplicate a lot of the same score – you could really guess someone’s FICO score much better than you think – by gathering stuff that’s (seemingly) totaled unrelated to borrowing money.

If you knew someone’s:

· Driving record

· Sexual history

· Substance (ab)use record

· Criminal record

· Employment record

· Etc.

It wouldn’t be very hard to tell if they are more or less likely to default on a loan. A group of people who present as quite boring in terms of driving, sex, drugs, crimes and jobs are people you should lend to.

A group of people who present as quite exciting in terms of driving, sex, drugs, crimes and jobs are people you shouldn’t lend to.

This is common sense. But when you can aggregate it and use it on a large scale it becomes economically meaningful.

It’s probably less important than people think which data someone gathers about your behavior – if it’s financial or non-financial. What matters is the insight into your behavior. Risk taking is both a basic and pervasive trait. It shows up in all different actions throughout your life. What FICO can give you is a measure of risk taking. People with low FICO scores are people who misuse risk. What credit bureaus have is very valuable because no one is going to submit to the best way of evaluating creditworthiness which would be some sort of multi-hour, detailed, taped, polygraph interrogation of all aspects of your risk taking history including quite personal questions. No one will do that. But the credit bureaus’ data combined with predictive analytics (the FICO score) can counterfeit that experience. It’s a short cut.

Influence is pervasive too. And it’s possible to figure out how influential somebody is.

Facebook is going to know more about influence than anyone on the planet over time. And advertising is applied influence. So it seems to me that if Facebook does reasonably intelligent things over time it’s going to learn more about influence – have more practical knowledge about how people really influence each other – than anyone knows now.

That will just be a side effect of the company going about its business. So, it seems hard to me to believe that a business like Facebook is going to fail because it can’t figure out how to monetize eyeballs.

Charlie Munger says stocks are valued partly like bonds and partly like Rembrandts.

I tend to think the failure of the Facebook IPO was a failure of its Rembrandt value. I never buy into IPOs. But on the numbers, I really can’t say Facebook looked especially overvalued as a new public company. IPOs aren’t known for being done at sensible prices. And certainly not at prices value investors like.

Yes, Facebook was offered at something like five or six times what the company would be worth if it had no future growth potential. If it was only going to grown in line with worldwide GDP. In that case, it’s probably worth about 80% less than what it was offered to the public at.

But Facebook obviously does have some growth potential.

I would not take the bet that the S&P 500 will outperform Facebook shares over say the next 5 or 10 years. That isn’t a bet I would feel comfortable making.

Facebook’s operating margins are much more defensible than those of the S&P 500 as a whole.

I think value investors have been too dogmatic about Facebook. I’m not sure most have even seriously looked at the situation. Thought through the business or the valuation. They’ve just had this knee jerk reaction against an IPO and an internet company and an insanely high P/E ratio.

I’m not especially fond of any of those three things.

But we shouldn’t let one bad mark – price – cloud our judgment on other aspects of the situation.

Facebook is obviously a great business. It has a huge competitive advantage. If it is a durable competitive advantage, Facebook will justify the price at which it went public – over time.

As far as the idea that digital/web advertising is useless...

If you pitch the right product to the right person in the right way, you can run an effective ad on the inside of a pudding cup. Technology will never change that.

I understand when people say the economics of movies will change in a way that makes a $150 million computer-animated movie unprofitable to make. That’s perfectly valid. But that’s not the same thing as saying stories won’t work because of some tech change.

Ads really are as basic as stories. They work in much the same way.

You’ve got to get us interested in getting some sort of info.

Outside of needing to eat and drink and sleep – I’m not sure there’s anything as basic as stories. And I put advertising in that same category. We may tell ourselves we go about our day thinking about what we need and don’t need – but that’s not exactly true. We go about our day flitting from one thing that catches our attention – that interests us.

And a good ad will get our interest. It’ll catch our attention. It really isn’t medium specific.

I ride a bus every day. And I’ve seen some very effective advertising on buses. I don’t mean the sides of buses. I mean on the bus. They have these square cards no bigger than a single poster. Some of those ads work. And I’ve seen effective ads run before a movie in a theater too. And we’ve all seen TV ads – probably very expensive TV ads – that don’t work at all. I remember one ad where it took me four viewings to realize they weren’t advertising their competitor’s product.

And I can definitely tell you I’ve seen effective online advertising – because I know I’ve made purchases based on online advertising. Last week I spent $100 because I was exposed to a display ad for probably five seconds before clicking it.

It was a very effective ad. It singled me out as part of a special group, told me I’d save money, and that I had a limited time to act. It worked. And you probably could’ve run it in print half a century ago using the same exact appeal and it would’ve worked there too.

So I wouldn’t worry about the ineffectiveness of online advertising.

I would be more worried about some lab testing a pill you pop in your mouth that tastes great in your brain – bypasses the buds on your tongue entirely – and nourishes you thus putting Coca-Cola and Kraft and Chipotle out of business than I would be worried about ads not working on the net.

(For the record, I’m not especially worried about either. But food we actually chew has a higher risk of obsolescence than advertising.)

An ad where you are the target and the aim of the ad is right – it’s very hard not to be intrigued by that.

Now, that doesn’t mean advertisers always know the right target, aim for that target in the right way – or have a good way of paying for the right advertising.

Probably the best advertising I was ever exposed to in my life was when a friend said to me – about the movie Memento, which I’d never even heard of: “You are going to love this.” With the emphasis on you. That’s the right appeal. It works better than a trailer, better than a poster, better than a critic’s review. But only a friend can make it.

I make my livingwriting on the Internet. If I can’t succeed writing on the Internet in the future, it won’t be technology’s fault. It’ll be mine. Writing for any medium is really just about the connection between the teller’s mind and the target’s mind.

And that’s all advertising is too. I don’t see any reason why – with practice – the tellers can’t get good enough to figure Facebook out. If you’ve ever seen some of the first stuff that was written for movies or TV – it’s really, really bad.

Astonishingly bad. They basically just threw a play up there. But then things changed – to the point where 100 years later, most of what you see on a movie screen is stuff that wouldn’t play that well in other media. Some people may wish it was otherwise. But the point is that the folks who create movies got better at knowing specifically what works differently in movies than – say – on a stage.

Advertisers will go through the same learning process online.

People take time to learn. Facebook will take time to learn its business. And advertisers will take time to learn how to advertise on Facebook.

I’m not worried about that.

I’d only be worried about three things at Facebook:

1. User habits

2. Management behavior

3. Price

Before investing in Facebook, I’d like a lower price. This is a typical value investor complaint. And it’s definitely true here. Facebook stock is (still) too expensive for me. That doesn’t mean it’s overvalued – just that I’m not willing to pay the current price

Second, I wouldn’t buy any stock in an IPO. That’s just a basic psychological thing. You don’t want to buy under the illusion of time scarcity. So I can’t imagine any scenario where I would ever buy a stock when it is first offered to the public.

But what if the price was right? What if Facebook were trading at – let’s say – 5 or 10 times revenue. That would be cheap enough that I’d have to really consider the business.

What would I focus on?

User habits are key. I don’t use Facebook. So I don’t know enough about this. If I was considering an investment in the company, I’d spend about 90% of my research time on studying user habits.

Management behavior. I’d like to know more about how Facebook sees itself. If we’re talking about Zuckerberg, this doesn’t seem like a tough task. He’s definitely easier to “read” than 99% of the CEOs you’ll come across.

I wouldn’t spend much time on this.

There are so many sensationalized secondary sources about Facebook and Zuckerberg that I think it’s pretty hopeless to try getting info out of a narrative that’s become so contaminated by storytelling by now.

Basically, I’d just focus on the durability of Facebook’s moat.

I’ll be interested to see when long-term options on Facebook start trading. In the long-run, you’re not going to either make a little money on Facebook or lose a lot. You’ll either lose a lot (pretty fast) or you’ll do well over time. It’ll either be something that blows up in a couple years or is a good buy and hold forever stock.

It is, however, worth mentioning that this is a stock where literally everyone knows more about the product than I do. Like I said, I don’t use Facebook. So this is never a stock where I could never “buy what I know.”

The bottom line for value investors is that the stock is way too expensive – as almost all IPOs are – to consider right now. But I think the negativity on this stock (especially from value investors) has been way over done.

One neat thing about an IPO is that you get to read a nice, long description of the business filed with the SEC. It’s called an S-1. And you can have great fun reading it. It’s window shopping for value investors.

You can find Facebook’s S-1 here.

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