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Saturday, September 25, 2010

What's Facebook Worth? Is Yahoo or Facebook a Better Investment?

We continue to have a large backlog of topics to share on CS$. YET, we remain intrigued by the Market's disdain for Yahoo (YHOO) relative to the rising popularity of (and infatuation with) Facebook. For now, we continue with this theme. Interestingly, Bloomberg BusinessWeek's cover story this week is even about Facebook:
While we don't think Facebook's rapid growth is finished, it is worth noting that magazine cover stories often signal tops/bottoms. Research supports this conclusion - see Are Cover Stories Effective Contrarian Indicators? (abstract available, fee required for full report) or read Jeff Matthews' excellent 9/7 post, Here They Go Again: “The Death of Housing”.

Per our first post on Facebook (Game Over for Yahoo?), we too are now on Facebook and think highly of the site. We concur that the community platform is driving a shift in Internet/media consumption habits. As an example, set up a "fan page" for CommonStock$ense where -- as with our Twitter feed -- we sometimes share news or other items of interest more frequently than here on CS$.

BUT, does this mean we'd rather own or purchase a piece of Facebook today? OR, what if we could have co-invested alongside Microsoft (MSFT) in October 2007 when it purchased 1.6% of Facebook for $240 million, implying the widely reported enterprise value of $15 billion for Facebook at the time? The question assumes we are, or were, able to invest in Facebook.

We'll come back to this question. First, let's look at the social media sharing phenomena. The other week we Tweeted a popular Yahoo! headline, [Reggie] Bush forfeits Heisman, a slight variation from our normally business-oriented Tweets. We shared the news as part of our Yahoo/Facebook analysis and chose this story because we anticipated plenty of sharing via Facebook and Twitter, both of which are options at the top of the article. However, we also observed something strange:
  • 2.5 hours after Yahoo published the article: 726 Facebook shares and zero Tweets:
  • 6 hours after posting: 1,507 Facebook shares and zero Tweets:
  • Finally, 13 hours, 23 minutes after posting: 1,843 Facebook shares and zero Tweets:
Zero Tweets? Really? We thought this didn't make sense and that, perhaps, the Tweet button (from Tweetmeme.com) might not be working. SO, we clicked on it, and it worked just fine:

We then clicked Tweet and, sure enough, Tweetmeme.com Tweeted the story. BUT, for some reason, the Tweet counter on the Yahoo page didn't update. Apparently, we found a "broken" Tweet counter. So much for our sharing illustration. Alas, things don't always work perfectly on the Web (see also: Facebook Outage [on Thursday] was Biggest Ever via CNN).

Nonetheless, the Facebook counter worked and does show significant sharing of Yahoo content via Facebook. Also, fortunately the Tweet counter appears to be working fine for other Yahoo stories:

Where are we headed with this thread? Per the graphic we shared on 9/11, Facebook leads "sharing" and the self-perpetuating community appears evermore powerful. For this reason, sites like Yahoo, CNN.com, and many other sites now include the ability to shares articles via Facebook. Some even use the Facebook user login for comment posting.

No question, Facebook has done a fine job becoming fairly ubiquitous and it seemingly behooves other companies to enable content sharing. How has Facebook achieved its current, admirable market position? By sponsoring and enabling a large ecosystem of third party application developers -- we found this image on AllFacebook.com (please see link for larger, full image):

The developer community across all three of these platforms is as busy as ever, although Facebook has a nice lead over Apple's (AAPL) iPhone platform and Google's (GOOG) Android platform. In our view, all of the activity is positive for the economy as technological innovation and new areas alleviate concurrent creative destruction in "old media" sectors. New jobs are being created in technology, advertising/PR, management, etc., with a multiplier effect sweeping across all kinds of companies racing to incorporate Web-based services and social media into their business strategies (here and abroad). This is fantastic news and, per our prior posts, should mitigate fears that the sky is falling for the U.S.A.

NOW, let's get to back to our valuation question and investing. The title of the Bloomberg BusinessWeek cover story, Facebook Sells Your Friends, is true to what the company is working toward: monetization of it's half billion plus users. Here, we'll ignore privacy issues and how users feel about this effort, which represent important topics for consideration when evaluating the business model.

According to the article, estimated 2010 revenue is $1.4 billion, up from estimates of $600-700 million in 2009 (per other sources, including Mashable and Wikipedia). Clearly, this is tremendous growth and the company is finding ways to monetize its gigantic, growing traffic. Folks are happy in Silicon Valley and the euphoria is spreading throughout the Web-dom -- for reference, please see this 9/21 WSJ article:
However, remember that what matters to an owner of a business is NOT revenue but net income (and free cash flow), and the ability of the business model to sustainably grow this earnings stream over time (of course, we need growing revenue for the latter to materialize). THUS, the key question for Facebook is: how much revenue is advertising-based versus "pass through" back to developers/content providers? We're not sure, although the Mashable article cited above included some estimates:
  • Inside Facebook broke down Facebook’s estimated 2009 revenue into four key areas: brand advertising, Microsoft advertising, virtual goods and performance advertising.
  • The biggest income stream seems to have been performance advertising, which likely accounted for more than half of Facebook’s 2009 revenues at $350 million. Next was brand-based advertising, which accounted for an estimated $225 million in revenue. Microsoft advertising came in at $50 million and virtual goods income was only $10 million according to these numbers.
Based on this information, the lion's share is apparently advertising-based, although the estimated $10 million for virtual goods seems strikingly low -- perhaps "apps" are somehow captured in the other buckets? Aside from the mix question, the other major unknown is margin. BUT, let's envision a scenario:
  • Imagine Facebook reaches one billion users in one to two years and generates average revenue of $5 per user per year, generously above (2x) an implied $2.55 for 2010 ($1.4 billion divided by average 2010E users of 550 million). This brings us to annual gross revenue of $5.0 billion. If we assign a net margin range of 10-20% (anyone's guess - potentially too optimistic), we derive estimated net income of $500 million to $1.0 billion. This means Microsoft (MSFT) paid a healthy 15-30 times 2011-12E net income when it purchased 1.6% of Facebook back in October 2007.
Facebook is an amazing growth story. YET, forecasting is incredibly difficult, particularly in such a dynamic market such as the Internet. Further, per our simple example, Facebook's implied $15 billion valuation in 2007 already baked in significant future growth. Fortunately, for early investors and Microsoft, the company is, at least, growing into the 2007 valuation as adoption continues around the world.

STILL, we come back to what we shared the other day: we can buy a forlorn Yahoo at an implied FCF yield of 15% or only 6.6 times free cash flow (backing out Yahoo! Japan and Alibaba.com stakes, assuming no tax implications, and assigning NO value to the stake in the Alibaba Group).

We'll take this all day long, especially with significant embedded value in the Alibaba Group holding that should increase over time. We should mention that there is a wide range of values floating around for the Alibaba asset, with $7.5 billion midpoint per Reuters and almost double the implied $4.6 billion EV for the core Yahoo properties (per our prior analysis). Put another way, just like picking up 50 cent dollars, we are literally getting free assets when the values of all Yahoo parts are considered (actually, better than free - $4.6 less $7.5 = negative implied EV of $2.9 billion)! If this isn't the goal of investment research and investing, we're not sure what is. Whether or not Yahoo strives to monetize any of the hidden value in the immediate future or not (e.g. convert to cash for reinvestment elsewhere or other returns to shareholders), the value is there.

Given the head scratching public market discount, common sense would suggest that billions of private equity dollars looking for a home should be extremely interested in Yahoo, a leading franchise that generates fairly steady free cash flow. That said, a sizable control premium would be required to win the business.

MOREOVER, did we mention that comScore released August traffic data for the top 50 U.S. properties the other day? Yahoo was number one, slightly edging out Google as Fantasy Football season kicked in. From the release:
  • Top 50 Properties: Yahoo! Sites ranked as the #1 property in August with 179.0 million visitors, followed by Google Sites with 178.8 million and Microsoft Sites with 165.3 million. Viacom Digital jumped 7 positions in the ranking with 81.5 million visitors, while iVillage.com: The Womens Network also climbed 7 spots to 35.3 million visitors. Facebook.com was the number four property with 148,048 million visitors.
  • Sports Sites Hike as NFL Season Begins: With the start of the NFL season, traffic to Sports sites picked up during the month reaching 123.5 million visitors, a 5-percent gain versus July. Yahoo! Sports, known as a popular destination for fantasy football, ranked #1 in the category with 48.2 million visitors, representing a 23-percent increase from the prior month. FOXSports.com on MSN ranked second with 26.2 million visitors, followed by ESPN with 25.4 million visitors. NFL Internet Group doubled its audience versus July, grabbing the #4 spot with 19.5 million visitors, ranking as the top gaining property for the month.
AGAIN, we can purchase the leading U.S. Internet property at an implied 15% FCF yield plus very valuable hidden assets? Seems too good to be true... except, it's not.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long YHOO.

© 2010 Jeffrey Walkenhorst
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