Thursday, 26 July 2012

Can Facebook really treble it's sales?

You know what's cooler than a billion...? $12 billion

Facebook is currently minting a cool $1bn a quarter or a touch over $4bn a year (and bear in mind that's high margin business with a good cash conversion). In reality though, that's pocket change.

Facebook's valuation implies it should be making much more than a mere $4bn. Let's say three times more in fact.

Even after its post-IPO crash Facebook's shares ares trading on a cool 15x annual revenues. Now two things determine a stock's Price/Sales rating - 1) how profitable (and predictable) those sales are and 2) how fast those sales will grow.

As a rule of thumb, each 10% of operating margin equates to around 1x sales of valuation (e.g. an IT Services company making a 10% margin trades at 1x sales across the cycle; a software company making a 25% margin 2.5x). Facebook makes a roughly 50% operating margin (still pretty damn good; near-monopolists Microsoft and Oracle only manage 40%) which would equate to 5x Price/Sales.

However that's way off the current 15x sales rating. In short the market is clearly assuming longer-term revenues much greater than $4bn. Crudely applying the ratio between operating margin and sales, if Facebook is worth $60bn and its operating margin is 50% the market is saying it should be able to do a cool $12bn of revenues.

The question is how does Facebook get there. There are two ways to grow revenues - get more customers or charge them more. In this post I'll look at the first question - with 901m monthly users (and counting), where does Facebook find more customers?

Why you should always read IPO prospectuses

The place to start is the IPO prospectus.

Now IPO prospectuses are surprisingly useful documents. On the one hard they are a sales brochure, with every number and nuance minutely plotted by lawyers and bankers to present the candidate in the best possible light to bolster its valuation (and the capital raised). Think estate agent brochures, but with numbers rather than fish-eye lenses.

On the other hand however they are legal documents where  every statement in it needs to be independently verified. This means play too fast and loose with the facts and you open yourself to a lawsuit. Revered UK fund manager (and slightly less revered Chinese fund manager) Anthony Bolton places specific weight on offer documents for precisely that reason. I am tempted to agree - often you find little nuggets of information not always disclosed in (unaudited) quarterly press releases.

I daresay Facebook is a case in point (most recently amended prospectus here, with the document as originally filed here). For example buried in the footnotes (TIP - always read these documents from back to front. The interesting stuff is always in the footnotes) it remarks the Mark Zuckerberg awarded an unknown family member $9m to compensate them for initial working capital. Next time remember that when a family member comes to you wanting to start a business.

Why Facebook will look East

But there's also a surprisingly juicy amount of data on Facebook's user base - specifically Monthly Average Users. For example the table below shows the rise in Facebook's user base by region, now up to 901m in total:

Like any stupendously large number, its always good to place this into context. I calculate that 901m is a measly 13% of the world's population or more interestingly about 40% of internet users. The chart below shows how Facebook's penetration of internet users has progressed over time:

That bad news is that in the US Facebook is up to 70% user penetration, which means its pretty close to saturation. The good news is that penetration lags significantly behind in emerging markets such as Asia so there is clearly room to grow there (and NB that this does not include China where Facebook remains blocked - it China were to open up that would mean another you-know-how-many-billion extra potential users).

Of course the flip side of that is that Facebook's average revenue per user (ARPU) is much lower in Asia and poorer countries. It currently mints an annualised $11.44 of revenue per users in the US & Canada, but a measly $2.14 in Asia. Or to put it another way in the chart below I plot Facebook ARPU versus GDP/head. Unsurprisingly Facebook makes less money per user in poorer regions:

Pulling this all together I've arrive at the two charts below. The chart on the left shows Facebook's user base (blue), internet users who do not user Facebook (red) and non-internet users in the population (gray). It is basically a treasure map showing where un-mined Facebook users are buried.

The chart on the right shows the same data, but multiplied by the ARPU. In essence the blue is now Facebook's current revenue per region, the red is the revenue it would make if it had 100% penetration of internet users, and the green if it had 100% penetration of the global population (unlikely, but lets just say this has never been a company with small ambitions). Again it paints a similar picture, but also factors in the lower spending power of Asian users.

So that's one answer. Go East. If Facebook is going to triple its revenues to meet market expectations, it cannot do that just with users in North America and Europe. It needs to access new markets, in particular China (now where have we heard that one before?).

But the other solution is to charge more for customers, to get that ARPU number up (and believe me getting ARPU numbers up will be a BIG focus on Facebook's Q2 results call this evening). But we'll leave that question for another day...

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