The Facebook bubble

It's now official: News Corporation is finally selling MySpace. And it's highly possible the company won't even fetch the $US580 million it cost them back in 2005, with some analysts expecting a sale price possibly as low as $US50 million for Rupert Murdoch's big social experiment. What a difference five years has made to the original superstar of social networking, who only a few years ago was heading towards 300 million subscribers, but ended up with almost one third of that at the end of last year.

Now it's all about Facebook. And in stark contrast to MySpace, the growth in Facebook's valuation over the last year has been phenomenal. Last March, based on private transactions of its shares, Facebook was reckoned to be worth around $US11.5 billion – about the same as when a group of Russian investors took a $US300 million stake in the company a few months earlier. By June, following an investment from Elevation Partners, the company's valuation had doubled to $US23 billion. Then in November, one of Facebook's key initial investors, Accel Partners – who bought stock in the company at a valuation level of around $US100 million – sold a chunk of its holdings that pegged Facebook at $US35 billion. Facebook's value had tripled in around eight months – but there was still more to come.

In early January when Goldman Sachs appeared to dodge SEC rules to invest in the company – creating a single special purpose vehicle allowing multiple investor clients to appear as one, ensuring Facebook did not have to make its financials public – the deal reportedly placed Facebook at around $US50 billion.

Although many were shocked by the huge valuation indicated by the Goldman deal, it wasn't out of line with the valuation levels indicated by ongoing auctions of Facebook's stock on SecondMarket, the New York alternative investment market. By mid-January, trades on that market indicated Facebook's value had climbed to around $US70 billion, and it has hovered around there since. Goldman and all of Facebook's other investors would no doubt be smiling.



In the same time that Facebook's valuation grew from $US11.5 billion to $US70 billion its user base grew by around 25 per cent, going from 400 million to 500 million users. Some are even beginning to question whether Facebook's user growth is slowing, although Mark Zuckerberg said last year that it was "almost guaranteed” his company would reach one billion users.

But with all these big numbers it is interesting to put them in perspective. At that kind of valuation it means Facebook is worth more than Boeing, Visa, Nike, Dell, Nokia, Ford, Sony and Starbucks. And it's heading towards eclipsing McDonalds, Disney, Pepsico, HP and Intel. All of those companies have proven revenue models that deliver that vital thing to support a valuation: cash.

For Facebook, it means that every user needs to generate around $US140 in value for the company. But given more than 100 million Facebook users are in Indonesia (second largest user base after the US), Turkey, Philippines, India and Mexico, some users might need to generate more cash than others to account for the subscriber mix. And then add that around half of the users only log in once a month and it's looking like all those Facebook addicts are going to have to generate some hefty cash – somehow.

A look at Facebook's high-level numbers compared to some big-ticket deals in internet history indicates that Facebook is going to have to start extracting high levels of value from its users pretty quickly.



But can Facebook succeed in monetising all those users to justify its valuation level, unlike many that have failed before it? Is advertising revenue going to deliver all that cash that will drive the company to such dizzy valuation heights? It seems like the problem of actually monetising all that time spent staring at a screen is still the fundamental problem that needs to be solved. Such long-term problems would hardly be too troubling for Facebook's current investors while the popularity wave keeps rolling, but if the company eventually goes public it will be crucial.

Doing some boring old traditional discounted cashflow valuation calculations probably shows that Facebook needs to reach Google-like annual revenues of around $US30 billion pretty quickly to deliver on its $US70 billion valuation. And if it's all from advertising, they better work out quickly how to make Facebook less about being friendly and more about targeted selling. Or maybe there are new revenue models that just haven't presented themselves yet? Indeed, there seems to be social media, online advertising and other new web analysts constantly talking about the huge untapped revenue potential of Facebook.

But that sounds a bit like how it sounded working in Silicon Valley in 1999 and 2000. And looking at the regular financial metrics, comparables and cash-flow based valuations back then also raised similar questions – questions that were generally answered by believers with "you just don't get it– new revenue models will emerge that we can't even imagine right now!”.

If it is indeed advertising that is going to drive Facebook, they will need to start using all those friends to sell things – and hope they don't make their friends feel used in the process. With Google we know that each time we search for something they are going to try and sell us the very thing we are asking them about. While analysts will spend much time putting forward why Facebook can translate all those users around the world into cash, the real proof will be in whether Facebook can actually do it over the next five to ten years. And their valuation implies they have to do it in a very big way.

Twitter will also face a similar challenge. No doubt, Twitter's valuation will also be climbing rapidly as it brings in new institutional investors. Last week it was reported that JP Morgan Chase was looking at an investment in the micro-blogging site that would see it valued at $US4.5 billion. It was also reported last month by the Wall Street Journal that both Google and Facebook were considering acquiring the company for around $US8 billion-$US10 billion. And that was all in Twitter's BS days – Before Sheen, that is.

But if Facebook is worth around $US70 billion and Twitter almost $US5 billion, what might YouTube be worth? When Google bought YouTube back in 2006 for $US1.65 billion many thought the internet search-leader was going crazy. Even Google CEO Eric Schmidt admitted in 2009 in a deposition that he believed YouTube was worth $US1 billion less than what they paid for it. Back then YouTube had around 72 million worldwide users, making the deal worth around $US23 per user. Google does not directly report YouTube's financials, but according to analysts at Citigroup the video site delivered around $US1 billion in gross revenue during 2010.

But to really get crazy and party like it's 1999, we'd need to get towards the $US200 billion that AOL approached before it merged with Time Warner. Although with AOL's annual revenue of $US5 billion back then it seems that Facebook isn't far off a similar valuation to sales multiple – if Facebook makes it to $US80 billion it could reach the dizzy heights of AOL on that metric at least. Unfortunately for AOL, they've gone from the $US200 billion club to the $US2 billion club in the last decade. And Yahoo – also a member of the $US200 billion club back in 2000 – is now sitting on the outer of the $US20 billion club.

Undoubtedly, Facebook has a huge challenge ahead of it to translate its reach and popularity into the serious ongoing cashflows needed to justify its rising valuation levels. Even so, the way appetite for the stock is going, Facebook could challenge the $US200 billion peak valuation levels reached by AOL and Yahoo! around ten years ago – and possibly even before it gets to an IPO. If it does, that would make it as big as Google is right now. And Goldman certainly won't be disappointed with that – even if things might unravel down the track.

For now, if the bubble was to burst it would only be for big institutional investors. And given Goldman will be eyeing off some big underwriting fees for what could eventually be a huge IPO (Goldman also handled Yahoo!'s IPO), it's highly likely the bubble – and the value of their shareholding – will keep growing. But whether Facebook can grow to deliver the kind of cash needed to make it a valuable long-term stock after it goes public is still a big unknown. If it can't, there's a very long way to fall – and much further than MySpace. Having said all of that, what the heck: who wants a piece of the Facebook IPO? I wonder if Rupert Murdoch would be interested.

Andrew Harris is an independent telecommunications consultant who has advised on fibre, wireless and satellite business planning, financing, M&A and bankruptcies for operators, banks and governments worldwide since the late 1990s. He does not currently advise or hold shares in any companies mentioned in this article.