Facebook and Twitter: Hedging the bets
I am not a big user of social media. I have a Facebook page, which I don't visit often, never respond to pokes and don't post on at all. I tweet, but my 820 lifetime tweets pale in comparison to prolific tweeters, who tweet that many times during a month. That said, I have been fascinated with, and have followed, both companies from just prior to their public offerings and not only have learned about the social media business but even more about my limitations in assessing their values. The paths that these companies have taken since their public offerings also offer illustrative examples of how markets assess and mis-assess these companies, why management matters, and the roller coaster ride that investors have to be willing to take, when they make bets on these companies.
In its brief life as a public company, Facebook has acquired a reputation of being a company that not only manages to make money while it grows but is also able to be visionary and pragmatic, at the same time. In its most recent earnings report on January 27, 2016, Facebook delivered its by-now familiar combination of high revenue growth, sky high margins and seeming endless capacity to add to its user base and more importantly, monetize those users:
The market's reaction to this mostly positive report was positive, with the stock rising 14 per cent in the after market.
I first valued Facebook a few weeks ahead of its IPO and again at the time of its IPO at about $27/share, laughably low, given that the stock is close to $100 today, but reflecting the concerns that I had on four fronts: whether it could keep user growth going, given that it was already at a billion users then, whether it could make the shift to mobile, as users shifted from computers to mobile phones and tablets, whether it could scale up its online advertising revenues and whether it could continue to earn its high margins in a business fraught with competition. The company, through the first four years of its existence has emphatically answered these questions. It has managed to increase its user base from huge to gargantuan, it has made a successful transition to mobile, perhaps even better than Google has, and it has been able to keep its unusual combination of revenue growth and sky-high margins. Prior to the prior year's last earnings report, in November 2015, I was already seeing Facebook as potentially the winner in the online advertising battle with Google and capable of not only commanding a hundred billion in revenues in ten years but with even higher margins than Google. The value per share of almost $80/share, that I estimated for the company in November 2015, reflects the steady rise that I have reported in my intrinsic value estimates for the company over the last five years. If anything, the story is reinforced after the earnings report, with revenue growth coming in at about 44 per cent and an operating margin of 51.36 per cent.
The value per share that I get for the company, with this narrative, is about $95/share, just a little bit under the $102/share that the stock was trading at in February 2016. As with my other valuations in this series, I ran a simulation of Facebook's value and the results are below:
At the prevailing price of $102/share, the stock was close to fairly priced on February 12, at least based on my inputs.
I am sure that there will be others who will put Facebook under a microscope to find its formula for success, but there are two actions that are illustrative of the company's mindset. The first was its afore-mentioned conquest of the mobile market, where it badly lagged its competitors at the time of it IPO. Rather than find excuses for its poor performance, the company went back to the drawing board and created a mobile version which not only improved user experience but provided a platform for ad revenues. The second was the company's acquisition of Whatsapp, an acquisition that cost the company more than $20 billion and provoked a great deal of head scratching among value minded people at time, since Whatsapp had little in revenues and no earnings at the time. I argued at the time that the acquisition made sense from a pricing perspective, since Facebook was buying 450 million Whatsapp users for about $40/user, when the market was pricing these users at $100/user. That acquisition may have been driven by pricing motivations but it has yielded a value windfall for the company, especially in Asia and Latin America, with more than 100 million Whatsapp users just in India.
It is true that Facebook's latest venture in India, Free Basics, where it had partnered with an Indian telecom firms to offer free but restricted internet service, has been blocked by the Indian government, but it is more akin to a bump in the road than a major car wreck. At the risk of rushing in where others have been burned for their comments, I am cynical enough to see both sides of the action. Much as Facebook would like to claim altruistic motives for the proposal, the restriction that the free internet use would allow you access only to the portion of the online space controlled by Facebook makes me think otherwise. As for those who opposed Free Basics, likening Facebook's plans to colonial expansion is an over reach. In my view, the problem with the Indian government for most of the last few decades is not that its actions are driven by knee jerk anti-colonialism, but that it behaves like a paternalistic, absentee father, insisting to its people that it will take care of necessities (roads, sewers, water, power and now, broadband), while being missing, when action is needed.
On a personal note, I was lucky to be able to buy Facebook a few months after it went public at $18, but before you ascribe market timing genius to me, I sold the stock at $45. At the time, Tom Gardner, co-founder of Motley Fool and a person that I have much respect for, commented on my valuation (on this blog) and suggested that I was under estimating both Facebook's potential and its management. He was right, I was wrong, but I have no regrets!
If Facebook is evidence that you can convert a large social media base into a business platform to deliver advertising and more, Twitter is the cautionary note on the difficulties of doing so. Its most recent earnings report on February 10, 2016, continued a recent string of disappointing news stories about the company:
The market reacted badly to the stagnant user base (though 320 million users is still a large number) and Twitter's stock price hit an all time low at $14.31, right after the report. The positive earnings may impress you, but remember that this is the reengineered and adjusted version of earnings, where stock based compensation is added back and other sleights of hand are performed to make negative numbers into positive ones.
As with Facebook, I first valued Twitter in October 2013, just before its IPO and arrived at an estimate of value of 17.36 per share. My initial narrative for the company was that it would be successful in attracting online advertising, but that its format (the 140 character limit and punchy messages) would restrict it to being a secondary medium for advertisers (thus limiting its eventual market share).The stock was priced at $26, opened at $45 and zoomed to $70, largely on expectations that it would quickly turn its potential (user base) into revenues and profits. However, in the three years since Twitter went public, it is disappointing how little that narrative has changed. In fact, after the most recent earnings report, my narrative for Twitter remains almost unchanged from my initial one, and is more negative than it was in the middle of last year.
Since the narrative has not changed since the original IPO, the value per share for Twitter, not surprisingly, remains at about $18. The results of my simulation are below:
My estimate of value today is lower than my valuation in August of last year, when I assumed that the arrival of Jack Dorsey at the helm of the company, would trigger changes that would lead to monetization of its user base.
So what's gone wrong at Twitter? Some of the problems lie in its structure and it is more difficult to both attract advertising and present that advertising in a non-intrusive way to users in a Tweet stream. (I will make a confession. Not only do I find the sponsored tweets in my feed to be irritating, but I have never ever felt the urge to click on one of them.) Some of the problems though have to be traced back to the way the company has been managed and the choices it has made since going public. In my view, Twitter has been far too focused on keeping Wall Street analysts happy and too little on building a business. Initially, that strategy paid off in rising stock prices, as analysts told the company that the game was all about delivering more users and the company delivered accordingly. The problem, though, is that users, by themselves, were never going to be a sufficient metric of business success and that the market (not the analysts) transitioned, in what I termed a Bar Mitzvah moment, to wanting to see more substance, and the company was not ready.
Can the problems be fixed? Perhaps, but time is running out. With young companies, the perception of being in trouble can very easily lead to a death spiral, where employees and customers start abandoning you for greener pastures. This is especially true in the online advertising space, where Facebook and Google are hungry predators, consuming every advertising dollar in their path. I have said before that I don't see how Jack Dorsey can do what needs to be done at Twitter, while running two companies, but I am now getting to a point where I am not sure that Jack Dorsey is the answer at Twitter. As someone who bought Twitter at $25 late last year, I am looking for reasons to hold on to the stock. One, of course, is that the company may be cheap enough now that it could be an attractive acquisition target, but experience has also taught when the only reason you have left for holding on to a stock is the hope that someone will buy the company, you are reaching the bottom of the intrinsic value barrel. The best that I can say about Twitter, at the moment, is that at $18/share, it is fairly valued, but if the company continues to be run the way it has for the last few years, both price and value could move in tandem to zero. Much as I would like to hold on until the stock gets back to $25, I am inclined to sell the stock sooner, unless the narrative changes dramatically.
Valuing Facebook and Twitter after valuing Alphabet is an interesting exercise, since all three companies are players in the online advertising space. At their current market capitalization, the market is pricing Facebook and Google to not just be the winners in the game, but pricing them to be dominant winners. In fact, the revenues that you would need in ten years to justify their pricing today is close to $300 billion, which if it comes entirely from online advertising, would represent about 75 per cent of that market. If you are okay with that pricing, then it is bad news for the smaller players in online advertising, like Twitter, Yelp and Snapchat, who will be fighting for crumbs from the online advertising table. This is a point that I made in my post on big market delusions last year, but it leads to an interesting follow up. If you are an investor, I can see a rationale for holding either Google or Facebook in your portfolio, since there are credible narratives for both companies that result in them being under valued. I think you will have a tougher time justifying holding both, unless your narrative is that the winner-take-most nature of the game will lead to these companies dominating the online advertising market and leaving each other alone. If Google, Facebook and the smaller players (Twitter, Yelp, a private investment in Snapchat) are all in your portfolio, I am afraid that I cannot see any valuation narrative that could justify holding all of these companies at the same time.
Closing on a personal note, I have discovered, during the course of valuation, that I learn as much about myself as I do about the companies that I value. In the case of Facebook and Twitter, I have learned that I hold on to my expectations too long, even in the face of evidence to the contrary, and that I under estimate the effect of management, especially at young companies to deliver surprises (both positive and negative). I sold Facebook too soon in 2013, because my valuations did not catch up with the company's changed narrative until later and perhaps bought Twitter too early, last year, because I thought that the company's user base was too valuable for any management to fritter away. I live and I learn, and I am sure that I will get lots of chances to revisit these companies and make more mistakes in the future.
This article first appeared in Aswath Damodaran's blog.
(Aswath Damodaran is a professor of finance at the Stern School of Business at NYU.)