U.S. Internet April 12, 2012 Carlos Kirjner, Ph.D. (Senior Analyst) • [email protected]• +1-212-823-3237 Ram Parameswaran • [email protected] • +1-212-969-2427 Amelia Chan • [email protected] • +1-212-969-2165 See Disclosure Appendix of this report for important disclosures and analyst certifications. When the final prospectus is available, you may access it here. U.S. Internet: Should You Friend Facebook? What It Is, What It Could Be, and a Valuation Framework Ticker Rating CUR 10 Apr 2012 Closing Price Target Price TTM Rel. Perf. EPS P/E 2011A 2012E 2013E 2011A 2012E 2013E Yield GOOG O USD 626.86 727.00 6.4% 29.70 38.33 45.70 21.1 16.4 13.7 NA YHOO M USD 14.99 17.00 -13.7% 0.82 0.78 0.81 18.3 19.2 18.5 NA SPX 1358.59 96.14 104.35 117.66 14.1 13.0 11.5 2.0% O – Outperform, M – Market-Perform, U – Underperform, N – Not Rated Highlights Over the next 12 to 24 months, the main question for potential Facebook investors will be this: will the company invent, or has it already invented, an "online social advertising" model that will attract large amounts of advertising spend? In today's report, we lay out our views on the nature, size and value of Facebook's business, characterize and size the (still unproven at scale) potential for social advertising, and offer a valuation framework for the company. Our objective is not to determine a specific value for Facebook, but to put in place two scenarios and their respective valuations that investors can use as yardsticks. We are planning to publish more detailed reports dealing with the business and its valuation in the next several weeks. ∑ Facebook's ambition is to make the whole Web social. We believe Facebook has two major long-term objectives: make facebook.com the site where a very large number of global consumers keep and nurture their (digital) relationships with other people, with brands and with businesses, the place where they find and consume information and entertainment, and where they transact. In other words, Facebook aims to create a social alternative to the open Web. In addition, we think Facebook also aspires to make the open Web social, by making its platform, built on top of its nearly 1 billion customers' social graph, available to third party applications. If it succeeds in its two objectives, it will be as disruptive, and potentially more disruptive, than Google. However, this vision is still (at best) a few years out and the road ahead is long and tortuous. For Facebook to have a chance to succeed in meeting the ambitious objectives we speculate it has, it first needs to establish that it can monetize its assets effectively, and "social advertising" is (at least today) the main tool for the company to build a distinctive and advantaged business. ∑ We developed a bear and a bull scenario for Facebook, based on the potential evolution of social advertising, which correspond to enterprise values of $60 billion to $100 billion. In addition, the market may attribute material option value to Facebook's business and key asset, its social graph, to reflect potential future opportunities. We think today these strategic options could be valued at $50 billion (Exhibit 2). - Bearish Scenario: social advertising is just like display. We believe that at a minimum Facebook is poised to be the largest and most valuable display advertising property on the World Wide Web. It has multiple competitive advantages that over time will allow it to capture a large share of users, impressions and revenues, even if social advertising fails to fulfill its promise. In this scenario, we would expect Facebook's 2017 revenues to reach about $14 billion, with EBITDA of $7.3 billion, and estimate its enterprise value at $60 billion. For the exclusive use of NILAY SHAH at IVORY CAPITAL on 12-Apr-2012
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Carlos Kirjner, Ph.D. (Senior Analyst) • [email protected] • +1-212-823-3237
See Disclosure Appendix of this report for important disclosures and analyst certifications.When the final prospectus is available, you may access it here.
U.S. Internet: Should You Friend Facebook? What It Is, What It Could Be, and a Valuation Framework
Ticker Rating CUR
10 Apr 2012ClosingPrice
TargetPrice
TTMRel.Perf.
EPS P/E
2011A 2012E 2013E 2011A 2012E 2013E Yield
GOOG O USD 626.86 727.00 6.4% 29.70 38.33 45.70 21.1 16.4 13.7 NA
YHOO M USD 14.99 17.00 -13.7% 0.82 0.78 0.81 18.3 19.2 18.5 NA
O – Outperform, M – Market-Perform, U – Underperform, N – Not Rated
Highlights
Over the next 12 to 24 months, the main question for potential Facebook investors will be this: will the company invent, or has it already invented, an "online social advertising" model that will attract large amounts of advertising spend? In today's report, we lay out our views on the nature, size and value of Facebook's business, characterize and size the (still unproven at scale) potential for social advertising, and offer a valuation framework for the company. Our objective is not to determine a specific value for Facebook, but to put in place two scenarios and their respective valuations that investors can use as yardsticks. We are planning to publish more detailed reports dealing with the business and its valuation in the next several weeks.
∑ Facebook's ambition is to make the whole Web social. We believe Facebook has two major long-term objectives: make facebook.com the site where a very large number of global consumers keep and nurture their (digital) relationships with other people, with brands and with businesses, the place where they find and consume information and entertainment, and where they transact. In other words, Facebook aims to create a social alternative to the open Web. In addition, we think Facebook also aspires to make the open Web social, by making its platform, built on top of its nearly 1 billion customers' social graph, available to third party applications. If it succeeds in its two objectives, it will be as disruptive, and potentially more disruptive, than Google. However, this vision is still (at best) a few years out and the road ahead is long and tortuous. For Facebook to have a chance to succeed in meeting the ambitious objectives we speculate it has, it first needs to establish that it can monetize its assets effectively, and "social advertising" is (at least today) the main tool for the company to build a distinctive and advantaged business.
∑ We developed a bear and a bull scenario for Facebook, based on the potential evolution of social advertising, which correspond to enterprise values of $60 billion to $100 billion. In addition, the market may attribute material option value to Facebook's business and key asset, its social graph, to reflect potential future opportunities. We think today these strategic options could be valued at$50 billion (Exhibit 2).
- Bearish Scenario: social advertising is just like display. We believe that at a minimum Facebook is poised to be the largest and most valuable display advertising property on the World Wide Web. It has multiple competitive advantages that over time will allow it to capture a large share of users, impressions and revenues, even if social advertising fails to fulfill its promise. In this scenario, we would expect Facebook's 2017 revenues to reach about $14 billion, with EBITDA of $7.3 billion, and estimate its enterprise value at $60 billion.
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- Bullish Scenario: the social advertising revolution. If social advertising proves to be effective in generating demand or driving conversion for a large number of advertisers and advertising dollars and drives a shift in (online) advertising similar in nature to the impact of Google and search, then we expect Facebook to reach nearly $23 billion in revenue by 2017, EBITDA of $12 billion, corresponding to an enterprise value of about $100 billion.
- Option value: the value of 1 billion users, their online time, and their digital identities. If Facebook succeeds in growing facebook.com to be a social alternative to the Web and/or in making a large portion of the Web social, turning its users' social graph into "critical infrastructure" for the whole Internet, then the company's value would be immense. We do not think it is possible to enumerate theyet-to-be-defined opportunities available to the company. Instead, we believe the best approach is to use comparables to ascribe a value to the asset that would generate them, the information in the social graph of Facebook's 1 billion users. Based on the value of other information assets, we think Facebook's "option value" premium today could reach $50 billion. As the company evolves, and if such opportunities become more tangible, this option value may increase materially.
∑ The potentially large but still largely unproven opportunity for Facebook lies in becoming the social platform of the whole Web. If social advertising proves highly effective to advertisers, the monetization opportunity available to Facebook would go well beyond facebook.com to include the whole Internet. Facebook could be in position to provide social information on or serve targeted social ads to 1 billion Internet users across the whole Internet. Facebook's current strategy clearly reflects its ambition to create and capture this broader opportunity: it has built a platform based on the Social Graph, which it has made accessible to third parties through the OpenGraph API and through social plug-ins. Facebook is not only a very large Internet publisher, it is in fact an attempt to make the whole Web social, turning Facebook's social graph into "critical infrastructure" for the whole Internet, just like Google's search today.
∑ There are four major risks we believe Facebook investors must consider: the company's ability to balance monetization and customer experience, competition, particularly from Google, the regulatory risk, particularly privacy regulation in the EU, and governance. While they all are in theory manageable and the early signs are positive, these risks do increase the level of uncertainty associated with the long-term trajectory of the business and should have a non-trivial impact on Facebook's multiple over time.
Investment Conclusion
We believe the cash flows from online advertising alone justify an enterprise value between $60 billion to $100 billion for Facebook, depending on the degree to which social advertising works, that is, the extent to which it generates ROIs that are better than current alternatives to a large number of advertisers. In addition, we expect the company to be valued at a premium to the value of these cash flows, given the strategic options created by its unique assets, particularly the social graph of about 1 billion users. We currently believe the premium could reach $50 billion, but it will in the end depend on the market's confidence on the company's ability to find and capture new opportunities to monetize the social graph.
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Details
∑ We think Facebook's strategy has two main planks (see Exhibit 1). First, it seeks to grow the importance and relevance of facebook.com, and make it the site where a very large number of global consumers keep and nurture their (digital) relationships, with other people, with brands and with businesses, the place where they find and consume information and entertainment, and where they transact (or at least originate many of their transaction). In other words, Facebook aims to create a social alternative to the open Web.
∑ In addition, we think Facebook also aspires to make the open Web social, by making its platform, built on top of its 1 billion customers' social graph, available to third party applications. If it succeeds in its two objectives, it will be as disruptive, and potentially more disruptive, than Google. However, this vision is still (at best) a few years out and the road ahead is long and tortuous. For Facebook to have a chance to succeed in meeting the ambitious objectives we speculate it has, it first needs to establish that it can monetize its assets effectively, and "social advertising" is (at least today) the main tool for the company to build a distinctive and advantaged business.
Exhibit 1Facebook's Strategy: Make the Whole Web Social
Source: Bernstein analysis
∑ Our bear and bull scenarios for the evolution of social advertising on the Web and the associated revenue trajectories for Facebook yield enterprise values for Facebook of $60 billion and $100 billion. In addition, the market may attribute material option value to Facebook's business and key assets, its
• Social relationships• B2C relationships• Entertainment• E-commerce
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.
.
.
.
.
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Social Graph
Social Plugins
OpenGraph API
Authentication(FB Connect)
Open Web
:: Facebook.com ::
“Socialized” Open Web
1) Expand Facebook.com 2) Make all the web socialFacebook Objectives:
:: Facebook platform ::
2
1
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audience and the social graph, to reflect potential future opportunities they may enable. We think this option value could range between zero and $50 billion (Exhibit 2).
Exhibit 2Facebook Enterprise Value – Bear and Bull Scenarios and Option Value ($ billions)
Source: Bernstein analysis and estimates
∑ Which scenario plays out depends largely on Facebook's ability to monetize its key assets. It has two assets with very high potential value: its large and highly engaged user base of nearly 1 billion consumers and the demographic, behavioral and social graph data it has collected about its users. It is the latter, the social graph, that makes Facebook truly distinctive from other large Web properties such as Yahoo! or YouTube, for example. The social graph is a computer representation of individuals and objects (photos, places, articles, songs, brands, Web pages, etc), which make up the nodes of the graph, and actions (friend, like, read, listen, check-in, play, etc), which make up the edges of the graph connecting the nodes (Exhibit 3).
∑ In our view, the extent to which Facebook will be able to monetize the social graph is the key investment controversy related to the company. Facebook's social graph will have massive value if social advertising, that is, advertising that uses social graph elements either for targeting or on the ad itself1, proves to be highly effective "at scale," that is for a large number of consumers and advertisers, corresponding to a large amount of advertising dollars. In turn, this will give Facebook the scale and
1 One example would be a Verizon FiOS ad that says "Craig Moffett likes Verizon," to one of Craig's Facebook friends. A full list and description of the ad formats offered by Facebook can be found athttp://ads.ak.facebook.com/ads/FacebookAds/Premium_Guide_2.29.12.pdf; https://www.facebook.com/business/sponsoredstories/; https://www.facebook.com/business/ads/
60
100 100
Bear Scenario Bull Scenario Bull Scenario with option value
0-50
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resources to extend its business to other opportunities it may be well positioned to capture. In other words, the bullish Facebook thesis is primarily a thesis on the effectiveness of social advertising.
∑ The early, anecdotal evidence on the effectiveness of social advertising is compelling but far from dispositive. The fact that specific campaigns, advertisers, or verticals are seeing positive results in a handful of occasions, while encouraging, does not mean that this success is "scalable" to billions of dollars of advertising spend.
Exhibit 3An Illustration of the Social Graph
Source: Bernstein analysis
∑ In view of this uncertainty, we believe investors considering a stake in the company should think of two scenarios for the evolution of social advertising and Facebook's value: a world where social advertising does not perform fundamentally better than display-as-we-know-it, and a scenario where Facebook and social cause a fundamental shift in how advertising dollars are spent, similar in nature (if not in magnitude) to the effect that Google and search had on the performance and direct response advertisingspend pool over the last 10 years or so.
∑ In addition to the two scenarios depending largely on the evolution of social advertising, the market is likely to attribute a premium to Facebook based on other potential options it may have to monetize the rich data set and the engagement of its nearly 1 billion users. Over time, as consumers use Facebook with a growing set of applications, for varying purposes, and with increasing frequency, their Facebook profiles will be akin to their digital identities: (curated) repositories of data, interactions, preferences, and history that uniquely reflect individual users. Access to this large and rich dataset may lead to a slew of new business opportunities, which Facebook may seek to capture directly or through applications developed through third-parties. Some of the opportunity areas could include payments, credit, banking, games and entertainment, content distribution, e-commerce and consumer electronics. We believe the
Play
Friend
Macy’s
CityVille WSJ
Starbucks
Food Spotting
Check-in Like
Read
ShareSpotify Share
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best way to value these yet-to-be-defined and impossible to enumerate opportunities is to ascribe a value to the asset that would generate them, the information in the social graph of 1 billion Facebook users. Based on the value of other information assets, we think Facebook's "option value" premium could reach $50 billion today.
∑ As Facebook evolves and some or all of these opportunities become more (or less) plausible or concrete, investors will likely attribute a higher (or lower) "option value" premium to the business.
∑ We discuss the details of these two scenarios and of the option value below, hoping they will help investors exercise their judgment on their relative likelihood, and hence determine a specific enterprise value for Facebook. We will be publishing our own view in the upcoming weeks.
The Bearish Scenario: social advertising is just like display and Facebook is worth $60 billion
∑ Even if the promise of social advertising fails to materialize, Facebook will still be a major force in online advertising. We estimate that its nearly 1 billion monthly average users (MAUs) correspond to about 60% of the global Internet users outside China (Exhibit 4), where Facebook is blocked, and roughly 80% of US Internet users.
Exhibit 4Facebook Monthly Average Users (MAUs) as a % of Global Internet Users* (millions)
* Include fixed and mobile Internet users.
Source: Company reports, Bernstein analysis
∑ Facebook is among the leading sites globally and in the US across usual engagement metrics such as pages viewed, and time spent online (Exhibit 5 and Exhibit 6)2. Facebook corresponds today to 14% of the total time spent online in the US and 15% of pages viewed. With this scale, engagement and the information it has about its users, it is highly likely that Facebook will be the leading display advertising site in the world, even if the promise of social advertising does not materialize.
2 These Exhibits are based on ComScore data that only capture fixed Internet usage.
2,100
550
1,550
920
Global Internet users China Internet users Global Internet users ex-China Estimated Facebook MAUs (April 2012)
59%
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Exhibit 5Engagement Metrics for the U.S., Feb. 2012, as a Percentage of Total Fixed Internet Users
Exhibit 6Engagement Metrics Worldwide, Feb. 2012, as a Percentage of Total Fixed Internet Users
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∑ We estimate that in 2011 the global display advertising market3 was approximately $37 billion (Exhibit 7), and that Facebook captured about 9% of the market, with $3 billion dollars of advertising revenue (Exhibit 8).
∑ In the display market, Facebook has multiple competitive advantages, in addition to its scale and the high engagement of its users, which we believe have not yet been fully played out:
- Its penetration among certain highly sought demographic groups (e.g., young adults between 15 and 44 years old) makes Facebook even more attractive to advertisers (Exhibit 9).
- Facebook's ability to target relatively large populations across multiple demographic and interest criteria makes it one of few Web sites that fulfill the needs of advertisers seeking scale, "targetability" and brand safety (which is ensured in Facebook's case since the advertisers know where the ads will appear). Facebook standard ad-buying interface4 offers 9 different targeting variables – location, age, gender, general interest, demographic interest, relationship, languages, education, workplace (see Exhibit 10 for a graphical depiction of the different targeting variables offered by the standardFacebook ad units interface5) - and the scale of the property allows advertisers to reach large numbers of people even in relatively narrow demographic, behavioral and interest groups.
Exhibit 8Breakdown of Facebook's Revenue Sources ($ millions)
Source: Company reports, Bernstein analysis
- Facebook offers advertisers the ability to target users according to several broad categories (Exhibit 11) or according to "precise interests targeting". As an illustration of the latter, Facebook reaches an
3 There is no widely accepted definition of what formats are included in the display advertising category. Some sources will include video, while other won't. Some will include mobile, while others won't. None will include contextual text ads served through, e.g., AdSense for Content, which we believe are more like display ads than like search ads. Exhibit 6 tries to lay out clearly what we include in the display spend addressable market.4 Which can be accessed through www.facebook.com/ads/create5 We believe advertisers who purchase through the API have much greater targeting flexibility
3,711
3,154
557
100
457
Facebook Total Revenues Advertising Revenues Payment Revenues Payment from others Payments from Zynga
82%
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estimated 36,780 males living in Canada or the United States, between the ages of 18 and 35, and who like "skydiving" or "I love skydiving", and who are single or in a relationship (Exhibit 12).
Exhibit 9Facebook Penetration by Age and Gender, % of Total US Population*
*Note that penetrations in this exhibit are of total US population, and not just online population. In addition, we used comScore usage statistics that capture only fixed Internet users
Source: comScore, U.S Census, Bernstein Analysis
- As another example, Facebook can target 98,000 engaged, 18 years-and-older females in the New York City area (Exhibit 13); it can target 6,119,500 18-35 years-old, unmarried men who enjoy outdoor fitness activities, and who live in the US or Canada (Exhibit 14).
- Finally, and importantly, we believe Facebook can deliver display impressions to an advertisers' target demographic at scale more accurately than most other properties on the Web, as all Facebook users are logged on, and due to the site's terms of use and user authentication procedures6. Facebook refers to its users' "authentic identities."
- Across the Web, on target delivery of advertising to specific demographics varies widely, and is often quite low. For example, Nielsen applied its latest online audience measurement tool, OCR (Online Campaign Ratings), to a recent online campaign by a manufacturer of women's personal care products, targeting 25 to 54 year old females (F25-54), across multiple publishers with a total of 30 million impressions. The results show extremely wide variation of on-target delivery of ads across the sites (Exhibit 15). The least accurate site delivered only 19% of the impressions to the target demographic, while the most accurate delivered up to 40%. On average, only 25% of impressions were delivered to the target demographic (F25-54), and a stunning 47% of impressions were actually delivered to male users. Another large campaign across 14 Web properties targeted males between the ages of 18-24 for 6 months, delivering over 170 million impressions. Data from Nielsen's OCR showed similar discrepancies in on-target delivery and in fact suggests that such discrepancies are uncorrelated with the size or the number of impressions delivered by the sites (Exhibit 16).
6 There are certainly fake profiles on Facebook. Nevertheless, the fact that users are always logged on and authenticated through email or mobile phone, dramatically improves targetability of display advertising.
77% 86%
77%
58% 52%
82% 80% 86%
66%
53%
15-24 25-34 35-44 45-54 All Ages
Male Female
Average Facebook penetration across all ages ~ 52%
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- While in its S-1 Facebook claims it can reach on-target delivery in the range of 90% to 95%, we are skeptical that these are typical for all demographics and interest groups (we believe for that certain demographic groups such as gender and age the quality of the targeting is higher than for other data).
- However, we think Facebook has in general, much better on-target delivery than most sites on the Web, an increasingly important competitive advantage as measurement of Web campaigns improves. We believe one of Facebook's underappreciated achievements was to "solve" the Internet user-identity problem. The fact that users are logged on and authenticated to some degree (far from perfect but much better than nothing), gives Facebook the potential to deliver targeted advertising with much better performance, and become the main provider of federated identity across the Internet through Facebook Connect. By offering federated login to other sites, Facebook acquires those sites to its network, enables them to become "social," and learns more about its users Web usage habits.
Exhibit 10Facebook Standard Targeting Advertising Interface
Music Music (All), Alternative, Children's Music, Christian & Gospel, Classic Rock, Classical, Comedy, Country, Dance/Electronic, Hip Hop/Rap, Jazz/Blues, Metal, Pop, R&B/Soul, Reggae, Rock
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Exhibit 15Discrepancies in the Targeting of Display Ad Impressions – Actual Campaign Data
Source: The Nielsen Company, "Online Campaign ratings"
Exhibit 16Discrepancies in the Targeting of Display Ad Impressions
Source: The Nielsen Company, "Online Campaign Ratings"
40%
34%29%
27%24%
19%
Publisher A (3% of impressions)
Publisher B (33% of impressions)
Publisher C (7% of impressions)
Publisher D (2% of impressions)
Publisher E (2% of impressions)
Publisher F (52% of impressions)
Weighted Average on-target delivery percentage = 25%
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∑ In view of its scale, engagement and its yet to be fully exploited competitive advantages, we believe that even if social advertising does not take off, Facebook would still accelerate the growth of the display advertising market and capture a growing share of total spend. Indeed, in this scenario we would expect that by 2017, the global display advertising market (defined to include the ad formats shown in Exhibit 7) will reach $69 billion and Facebook will likely capture 18% share of global spend, or $12.6 billion (Exhibit 17).
Exhibit 17Display Ad Market and Facebook Share ($ billions)
Source: Bernstein analysis, MagnaGlobal, IAB, company reports
∑ In addition to display advertising revenues, we expect that revenues from the sale of virtual goods by social game companies such as Zynga will continue growing, but at a decreasing rate, and estimate they would reach $1.1 billion by 2017.
- Zynga accounts for nearly 82% of Facebook's non-advertising revenues (Exhibit 8), and its games attract several times more users than the next app publishers' (Exhibit 18), many of which do not monetize as well as Zynga. We believe Zynga's growth on Facebook will slow down for two reasons: first, we think the acquisition cost of an incremental user to Zynga, that is, a user who is not a current or recent Zynga gamer, has increased materially since Facebook decreased the "virality" of gaming on the platform in mid-2010.
- For exactly the same reason, we do not believe investors should assume the emergence of new, at scale social game publishers on the Facebook platform beyond Zynga. We think the ability of new social game publishers to reach scale economically within Facebook was very much curtailed as Facebook drastically reduced the "virality" of games to maintain the quality of user experience, increasing the (new) customer acquisition costs for game publishers.
- Indeed, Zynga's MAU numbers (Exhibit 19) show a drastic slowing down over the last 5 quarters compared to the 3Q10 growth rate. Second, we believe that, over time, Zynga will take steps to shift some of its user base away from Facebook. We suspect this will occur slowly and as new users are acquired and new games released, but will likely further slow down Zynga's growth within Facebook.
33.4 37.6
41.8 45.8 49.6 53.2 56.4
3.2 4.5
6.0 7.7
9.4 11.0
12.6
2011 2012E 2013E 2014E 2015E 2016E 2017E
Google, Yahoo & Others Facebook
Facebook share = 18%
Facebook share = 9%
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- We estimate overall payment revenues to reach $1.1 billion by 2017, with Zynga still accounting for 82% of the total (Exhibit 20).
Exhibit 18Monthly Average Users for Different Applications Publishers on Facebook.com, updated April 7, 2012
Source: www.appdata.com
Exhibit 19Zynga MAUs and YoY Growth Rate
Source: Bernstein analysis and estimates, company reports
Developer Monthly Average Users (MAU)Zynga 285,571,592
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Exhibit 20Facebook Payment revenues and contribution from Zynga ($ millions)
Source: Bernstein analysis and estimates, company reports
∑ As a consequence, we estimate that in this bearish scenario Facebook would generate total 2017 revenues of $13.7 billion, EBITDA of $7.3 billion and operating income of $6.5 billion (Exhibit 21). Using a simplified long-term DCF (Exhibit 22), we arrive at a valuation of $60 billion for our bearish scenario. This corresponds to 13 times 2013 estimated EBITDA of $3.9 billion.
∑ Of course, the EV we calculate is dependent on our choice of WACC. As an illustration, if we set the WACC at 11%, the EV for the Bear case would be $52 billion, and $58 billion for a WACC of 10%.
Exhibit 21Facebook.com income statement : Bear case
Source: Bernstein analysis
* Excluding an estimated $968 million in compensation expense associated with "pre-2011" RSUs
457 520 558 620 754
820 872 100
114 123
136
166 180
192
557
1,064
2011 2012E 2013E 2014E 2015E 2016E 2017E
Zynga Payments to Facebook Facebook Payments Revenues (other sources)
Zynga contribution to Facebook payment revenue = 82%
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Exhibit 22Facebook.com : DCF Valuation : Bear case
Source: Bernstein analysis
The Bullish Scenario: social advertising takes-off, the social Web emerges, Facebook's social graph becomes a ubiquitous, critical utility, and Facebook is worth about $100 billion before a premium for strategic options
∑ While becoming the largest display advertising property on the Web, with an estimated enterprise value in the vicinity of $50 billion is not something to be sneezed at, the distinctive near and medium term revenue generating potential from Facebook stems from the value of the social graph and the (still unproven at scale) potential it has to drive a fundamentally better (i.e., higher ROI to advertisers) form of online advertising based on social.
∑ As we discussed above (Exhibit 1), we think Facebook aspires to become a ubiquitous platform for social applications and advertising across the whole Web, fixed and mobile.
∑ The foundation of the Facebook Platform is the social graph (Exhibit 3). The Platform gives applications access to users' social graph, allowing the applications to become "social." Applications can be running within the Facebook site (e.g., Zynga's FarmVille, Spotify or the Coca-Cola page within Facebook), on an external Web Site (e.g., www.spotify.com or www.nytimes.com showing users which songs their Facebook friends are listening to or which stories they have read), or as an app on an Android or iOS mobile device.
∑ As a consequence, the Platform brings two benefits to Facebook:
- First, it increases the functionality and attractiveness of facebook.com as third party applications will presumably enrich the experience of Facebook users, driving further engagement. In addition, to the extent that third party developers monetize their applications within Facebook, e.g., Zynga selling a virtual cow, developers are currently and will likely continue to be required to collect payment for their virtual cows (or similar) with Facebook Credits, Facebook's payment mechanism. In this case, Facebook will benefit financially by charging a fee (currently, the fee Facebook charges developers is typically 30%).
- Second, the Platform extends "social" interactions to the whole Web and to mobile apps. Since the information in a user's social graph is the key element required to make the Web social, success will turn Facebook's social graph into critical infrastructure across the Web. Importantly, if advertising with
Facebook DCF Valuation($B)
Sum of PV of cash flows (2012 - 2025)29,692PV of Terminal Value 21,839Net Cash 3,908Enterprise Value 55,438
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social components turn out to be highly effective, then Facebook will be well positioned to serve social ads to publishers across the whole Web7.
∑ The Platform extends Facebook into third-party applications, Web sites, and iOS and Android mobile apps, and gives applications and Web sites access to a user's social graph data:
- The Facebook Platform allows applications to interact with the social graph of users logged on to Facebook. Perhaps the best way to think of this is that when a user is logged on to Facebook, Facebook gets extended into other applications through "Social Plug-Ins". For example, a "Like" button on a Web page such as YouTube, allows a user to interact with Facebook and his or her graph from YouTube's page. When the user "Likes" a YouTube video, in YouTube's site, that event is recorded in the user's Facebook social graph and shared with the user's friends. This is mechanically very simple to implement (which explains the fast proliferation of Like buttons across the Web) and requires no authentication and user permission8, since the user is interacting with his or her own Facebook graph through another application (and the application does not have access to the user graph).
- Second, Facebook allows applications to access a user's social graph, through the OpenGraph Application Programming Interface (API), after authenticating the user (e.g., through Facebook Connect) and obtaining the user's permission to share data from the user's social graph. Applications can access a user's social graph information (in line with a users' permissions) and use that information within Facebook (e.g., in a brand's page or as game within Facebook9), or outside of Facebook, e.g., in a third party Web site. While more complex to implement, as it requires user authentication and permission, using the API allows applications to create much richer, customized social experiences.
∑ How large could social advertising be? It is relatively early days when it comes to social advertising. Some of the early successes of certain campaigns and advertisers are encouraging, but not at all dispositive.
∑ It is not hard to find a couple, a dozen or fifty cases when social advertising performs "well." One just needs to talk to or read the marketing decks of any of the hundreds of companies in the Facebook ecosystem. For example, one oil company managed to acquire hundreds of thousands of "Likes" to its Facebook page (a pre-requisite and enabler for Facebook viral marketing) at much lower cost than before through social advertising. An educational institution used Facebook advertising to acquire qualified leads at a cost per lead 30% below its average acquisition cost. Another advertiser reported to us that their experience suggested that the effectiveness of sponsored stories was more than double that of regular Facebook ad units. These many examples are certainly positive indications of the potential of social advertising. However, because the ROI of certain social ads is hard to measure and the evidence we have is still anecdotal and highly variable across campaigns, advertisers and verticals, it is unclear how much companies will be willing to spend in social advertising to advertise their brand, to acquire "Likes" to their Facebook page to increase their Facebook reach, or to drive traffic to their own Web site.
∑ In our view there are three important uncertainties investors should consider:
- First, whether or not social advertising will deliver attractive ROIs to advertisers "at scale." For Facebook to disrupt the advertising world (on and offline) in a way akin to what Google did, it needs to offer ROIs to a broad swath of advertisers that are materially superior to alternatives, on and offline.
7 In theory, Facebook could allow publishers access to a user graph through the API's and enable them to decide which ad to publish to a given user. We believe privacy concerns will instead lead Facebook towards an ad network model.8 The users must, of course, be logged on to Facebook.com9 Games generally use Facebook Canvas as a way to interact with users without leaving Facebook)
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- Second, for Facebook's platform strategy to work in a way that allows Facebook to monetize it directly10, social ads yield to third party publishers needs to be comparable to or better than their current best alternative, including contextual display ads served by, e.g., Google AdSense. While our discussion with ad buyers and analytics firms suggests that performance metrics (CPMs, CTRs, CPCs11) for Facebook ads and for AdSense display ads vary materially across properties, campaigns and verticals, there seems to be widespread agreement that "typical" performance of social ads (Exhibit 23) is still not on par with AdSense. We believe AdSense metrics today are often several times higher than the CPMs implied by the numbers in Exhibit 23. For example, our industry contacts suggest CPCs for AdSense are in general in the range of $1.50-$2.50, about 2-3 times the typical CPC for Facebook. In addition, AdSense publishers often get CTRs 1.5-2 times higher than the Facebook CTRs reported on Exhibit 23. These imply that, on average, Facebook CPMs (and hence yields to publishers) are much lower (roughly 3-4 times) than AdSense, and therefore unattractive to many third party publishers. For Facebook's platform play to work broadly, it will have to improve (CPCs, CTRs ) CPMs materially from the levels reported in Exhibit 23 to compete with AdSense.
Exhibit 23CTR and CPC for Facebook Advertising Across Verticals
Source: Webtrends, 2011
10 The platform strategy will also bring indirect benefits to facebook.com, as it would, for example, augment the social graph with information about users activities across the Web, presumably improving ad targetability within Facebook.com11 CPM= cost per mille, is the price to an advertiser of one thousand ad impressions; CPC=cost per click, is the amount an advertiser pays a publisher every time a user clicks on the advertisers' ad; CTR=click-through rate is the rate at which users click on ad impressions. CPM=CPC*CTR, modulo a constant.
$ 1.27
$ 1.30
$ 0.67
$ 0.79
$ 0.82
$ 0.80
$ 0.67
$ 0.54
$ 0.56
$ 0.38
$ 0.53
$ 0.50
$ 0.37
$ 0.50
$ 0.29
$ 0.26
$ 0.36
$ 0.31
$ 0.25
$ 0.12
-2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50
HealthCareInternet and Software
Conference and EventsGrocery Stores
TelecommunicationsFinancial ervices
Local ServicesHousing and Real Estate
MiscConsumer Packaged Goods
RestaurantsRetailers
CosmeticsStartups
Non-profitsAutomotive
TravelE-Commerce
Media and EntertainmentTabloids and Blogs 0.165%
0.154%0.089%
0.077%0.082%
0.086%
0.065%0.066%
0.070%0.072%0.074%
0.021%0.028%0.029%
0.029%0.030%0.033%
0.058%0.058%
0.011%
CPC >> << CTR
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- Third, even if ROIs of social ads turn out to be better to advertisers, a big if, it is unclear whether advertisers, particularly brand advertisers, will have the tools to measure social advertising ROI accurately. In other words, Facebook's success depends on ROIs being better and on advertisers being able to measure and determine that somewhat unambiguously (so that they can act and shift budgets). We believe that this may turn out to be a challenge for Facebook.
∑ In our bullish scenario, social advertising disrupts the existing advertising landscape and triggers material shifts of budgets. The last time this happened was when Google radically improved search and the associated monetization mechanism, so we will use Google's revenue trajectory as a benchmark for Facebook's potential trajectory. However, in view of the challenges above, we think it is plausible to assume that social advertising spend growth will be slower than the growth trajectory of Google's revenues, for two reasons.
- First, to the extent that social advertising will be a solution to brand advertisers, the lack of well-accepted and understood performance metrics, analytics tools and ROI evaluation processes for Internet brand advertising will slow down the shifting of dollars from other brand advertising media (e.g., print or TV) or from other marketing spend pools. Measurement of ROI in brand advertising campaigns in general is more of an art than a science (certainly when compared to measuring ROI for direct response), often involving complex, non-transparent attribution models and indirect metrics such as GRPs (gross rating points). While direct response, including search advertising ROI can be computed on the basis of metrics with clear and somewhat unambiguous connection to value creation (e.g., leads, conversions, sales), Internet brand advertising faces all the issues of brand advertising, plus the fact that even some of the indirect metrics used in other media (such as GRPs) are not well-accepted currency in the Internet. This could change, e.g., if Nielsen's efforts such as OCR and XCR to extend the GRP currency from the TV world into the Internet and create a unified, cross-medium GRP metric, succeeds12.
- Second, for social advertising to attract a large portion of performance advertising dollars, it would have to outperform Google's paid search. Paid search sets a high ROI bar, it is a major driver of traffic to most commercial Web properties, and hence advertisers will be reluctant to shift budgets quickly unless the alternative is demonstrably much better. In fact, we think Google's strong incumbent position in Internet performance advertising will lead Facebook toward making a bet on prioritizing brand advertising dollars.
∑ In 2004, Google booked $3.2 billion in revenues, which was nearly evenly divided between Google Websites (primarily search on google.com) and the Google network revenues (primarily AdSense for search). Thus, in 2004, Google's advertising revenues were roughly in line with Facebook's in 2011 ($3.15 billion). In the 15 years following 2004, we forecast that search at google.com will grow nearly 3700% (~30% CAGR) to revenues of $58 billion (Exhibit 24). Given the limitations we outlined aboverelated to the rate at which brand advertising effectiveness can be measured and budgets shift, we will assume that for the next 15 years social advertising revenues at facebook.com could grow 75% as much as google.com revenues are expected to grow in a similar time span. In other words, we will assume that the shifts in ad budgets due to social advertising are 75% of what we have seen due to search (Exhibit 25). This assumption is very important for valuation purposes, and we provide a sensitivity analysis below (Exhibit 29).
12 We believe this explains why Facebook is one of Nielsen's OCR early publisher partners
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Exhibit 25Estimated Google.com search revenues vs. Facebook.com revenues 15 years after booking $3B in revenues
Source: Bernstein analysis
∑ In this bullish case, revenues come also from the Facebook Platform, as third party sites would also seek to publish social ads served by Facebook (given that the underlying hypothesis of the bullish case is that social ads perform better than typical display). The parallel here again is Google, but in this case AdSense, which account for the vast majority of Google's Network revenues. Therefore, in the bullish case for the Facebook Platform, we assume its revenue trajectory, which we expect to start to be
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meaningful in 2013, will grow at 75% of the growth rate we expect to see from Google Network revenues in the 12 year period between 2003 (when Google's Network revenue was around $600 million) and 2014. Again, this number is an important driver of the bull case valuation and we will show a sensitivity analysis below (Exhibit 29).
∑ These two assumptions lead us to 2017 revenues of about $22 billion for Facebook, with EBITDA of $11.9 billion (Exhibit 26). In 2013 under this scenario, we would see an EBITDA of $4.5 billion, a 46% CAGR versus 2011. Given that in 4Q11 advertising revenues grew 44% year-on-year, down from 77% in 3Q11 and 69% for all of 2011, this is quite aggressive. However, the premise of the bull case is the emergence of social advertising as a major disruptor of the advertising space, and we think this could occur in the next two years, given Facebook's scale and the experience it (and the ecosystem) have accumulated in 2011 with social advertising. It is an aggressive case in our view, but not implausible.
∑ With this revenue trajectory, our long term DCF model yields an enterprise value of $100 billion for Facebook (Exhibit 27).
∑ Of course, the EV we got in Exhibit 27 is dependent on our choice of WACC. As an illustration, if we set the WACC at 11%, the EV for the Bull case would be $93 billion and $105 billion for a WACC of 10%.
Exhibit 26Facebook.com income statement : Bull case
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Exhibit 27Facebook.com : DCF Valuation : Bull case
Source: Bernstein analysis
∑ Is the advertising pool big enough for two big fish(es)? Perhaps the first hurdle the bullish estimates above need to clear to be judged plausible is to establish whether or not there is enough money in the addressable market for Facebook to grow that large. We think this indeed the case.
∑ Exhibit 28 shows that in our bullish case, Facebook's $22 billion 2017 (gross) revenues would account for less than 13% of our current forecast of total online advertising spend, which we estimate at $165 billion. Google, whose 2017 (gross) revenues we expect to reach $90 billion, would account for about 54% of our current forecast. For comparison, Google's 2011 revenues were $38 billion, while Magna Global estimates that the 2011 global online advertising spend reached $79 billion, so Google is already48% of the total online spend, while Facebook's advertising revenues corresponded to roughly 4% of online revenues, for a total of 52%.
Exhibit 28Google and Facebook 2017E Gross Revenues vs. Addressable Market ($ billions)
Source: Bernstein analysis and estimates
Facebook DCF Valuation($B)
Sum of PV of cash flows (2012 - 2025)50,080PV of Terminal Value 45,968Net Cash 3,908Enterprise Value 99,956
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∑ In the bullish Facebook case, Google and Facebook's gross revenues would account for about two-thirds of the total online advertising spend or, to be more precise (and our reason for being this pedantic will be clear soon), two-thirds of our current estimate of the total online advertising spend. We find that aggressive but plausible. It becomes even more plausible if we take into consideration the fact that the size of the advertising market in general and the online advertising market in particular are not independent of Facebook's trajectory if we assume that social advertising will be a major disruption.
- If online social advertising becomes a higher ROI (brand) advertising medium than other current alternatives such as print, radio, out-of-home and TV, then we would expect the 2017 online advertising spend to be higher than our current estimate of $165 billion. How much higher? It is hard to tell precisely since some of the social advertising spend would likely be funded partly by what would otherwise have been display spend, and partly by influx of dollars from other media. Our best estimate is that the online advertising spend could grow to about $180 billion, so that Google and Facebook would account for 60% of total online revenues in 2017, up from 52% today.
- Of course, incremental online advertising spend has to come from somewhere. While in the near term it is highly likely to come from other advertising media, with a five year horizon we believe there is astrong chance that money will flow into the online advertising budget from other elements of the much larger marketing budget (e.g., coupons, events, promotions). We estimate that the overall marketing budget of consumer companies worldwide to be in the order of $1.2 trillion by 2017.
∑ The assumption that Facebook will grow at 75% of the rate at which Google grew (both the main site and the network) was an important driver of our valuation for the Bull Case. Exhibit 29 shows a sensitivity analysis of the estimated enterprise value for Facebook as we vary the 75% independently for facebook.com and for the network.
Exhibit 29Sensitivity of Facebook Enterprise Value to Facebook.com and Facebook Network Revenue Growth
Source: Bernstein analysis
Facebook.com rev. growth as a % of Google search 15-yr growth
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Looking at comparables
∑ While one could argue with some merit that Facebook is unique (and in some ways more unique than others), it is helpful to contrast our bear and bull valuations with the closest comparables (see Exhibit 30), including Google at the end of 1Q05, when its revenues were roughly in line with Facebook's 2011 revenues. We have added the $473 million in capital leases to Facebook's 2011 capex to calculate its capital intensity.
Exhibit 30Potential Comparables to Facebook
Source: Bloomberg, FactSet, Bernstein analysis
∑ Our bear case EV of $60 billion and estimated 2012 EBITDA of $3.2 billion (a figure that excludes the charges associated with the expensing of the pre-2011 RSUs, whose vesting is conditioned on the IPO) corresponds an EV/EBITDA multiple of 19 times, materially lower than Google's multiple around 3/2005 when its revenues were similar to Facebook's 2011 revenues, and its revenue growth and EBITDA margins were also similar. We attribute this difference to the fact that for the next several years Facebook will have higher capital intensity than Google had at the time (Facebook investment in PP&E, including the value of capital leases, were about 29% of 2011 revenues, versus Google's investment of 10% of revenues in 2005), and the long-term growth expectations of search at the time, which the market cap numbers show clearly underestimated Google's potential, but we think were more aggressive than our view of the display market in the bear case, as we expect Facebook revenue growth rate to decrease to 31% in 2013 and 26% in 2014.
∑ Our bull case EV of $100 billion and estimated 2012 EBITDA of $3.3 billion corresponds to an EV/EBITDA multiple of 30 times, again a premium over Google's 3/05 numbers and all other comps in our list, except LinkedIn, which some might argue is the closest comp for Facebook. Whether or not Facebook should trade at a premium or at a discount compared to LinkedIn depends in large part on the value the market will ascribe to future opportunities the business may have, in other words, the option value created by the company's assets.
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The Option Value of Facebook's Assets
∑ It is possible, and in fact we believe likely, that the market will attribute some value to Facebook based on the options it has to use its assets and capabilities to enter new businesses and pursue new opportunities. Some of the commonly mentioned opportunities include payments, credit, banking, content distribution, and consumer electronics (e.g., the Facebook mobile phone).
∑ In fact, as we pointed out above, Facebook's platform could turn out to be a major disruptive force in the Internet. If facebook.com indeed becomes an alternative to the open Web to a large portion of its users, which will likely exceed 1 billion in the next 12 months, and/or succeeds in its drive to make the whole Web social thus making its platform "critical infrastructure" to the whole Internet, it will be in position to capture value from a wide range of interactions and services on the Internet, including and likely beyond the aforementioned ones.
∑ We don't believe it is possible or helpful to try to guess which markets Facebook could enter, the business models, and how success would look like. There is too much uncertainty. For example, we are highly skeptical that in July 2004, roughly one month before Google went public, anyone could have guessed that Google would own anything like YouTube13 (which was founded in 2005), the largest (short-form) video site on the Internet. We estimate that today YouTube contributes $10 to $15 billion to Google's enterprise value.
∑ Instead of trying to guess the future business opportunities the company will pursue, we propose to size the option value associated with Facebook today by trying to assign a value to Facebook's most distinctive asset, the data in the social graph of its nearly 1 billion users.
∑ There is a market today for consumer information. It is different from Facebook and what it does today in many important ways (e.g., the specific uses of the data, regulatory oversight, how the underlying data are generated and aggregated and what the data are, etc). There is really no reason to believe that Facebook will use its social graph data in similar ways. However, we believe that studying this market is helpful is getting an estimate of the potential value for Facebook's social graph data.
∑ The main companies in that market are the credit bureaus, Experian, Equifax, TransUnion, Innovis, their international counterparts (e.g., CIC in Japan), FICO, multiple companies in the consumer data business such as Acxiom, Targus, Rapleaf, as well as business units of larger companies such as Pearson (which owns ChoicePoint). While these companies are in multiple lines of business, their core asset is the consumer information. We estimate that these companies have an aggregate enterprise value of roughly $42 billion (Exhibit 31), and that their main asset is the information they have about roughly 600 million consumers worldwide. Of course, someone's utility payment history is very different from their list of friends. However, it is possible that one's list of friends will turn out to be, over time, more, equally or nearly as predictive of the likelihood that someone will default in their mortgage as their utility payment history.
∑ Since Facebook will likely reach 1 billion users by the end of 2012, and (importantly) assuming that the EV per user is roughly the same as we seek to value the data in the social graph, we get a valuation for Facebook's strategic options from the social graph of up to $50 billion (Exhibit 31). One could argue that Facebook's social graph could become even more valuable than that, as the credit bureaus have to pay for data acquisition and royalties, while user's give Facebook their information and the credit bureaus are under strict regulatory scrutiny that limits how much value they can extract from the data they have. Of course, the reverse is also true, as one can argue that the data the bureaus have are (at least as far as we know) more valuable and that using the EV of real businesses to value an information asset is a stretch.
13 To be sure, the counterpart to that is the emergence of Facebook to displace MySpace and all the Schumpeterian risks associated with being an Internet company
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We sympathize with all the objections, but believe this provides a useful benchmark to investors to think about the option value for Facebook's key assets14.
Exhibit 31Aggregate Value of Worldwide Credit Bureaus and Implied Value of Facebook's Social Graph
Source: Bernstein analysis and estimates
∑ We recognize that this $50 billion number may very well prove way too low in the future (if the company succeeds in its objectives of making the whole Web social), or way too high, if social advertising fails to attract advertising dollars "at scale," and Facebook ends up without the resources to pursue its more ambitious objectives. We also recognize the differences between the types of data, business models, regulatory environment, and, importantly, the ability to grow and enrich the dataset between the credit bureaus and consumer information companies and Facebook. However, we think this comparison provides a helpful yardstick for investors trying to size the value of Facebook's key asset.
What Should Be Facebook's EV/EBITDA multiple?
∑ We think investors seeking to value Facebook should ask and answer three questions:
- Do we believe15 Facebook will succeed in its ambition to transform the Web?
- How much do we believe in the potential of social advertising to attract (brand) advertising dollars and Facebook to grow revenues compared, e.g, to Google's history?
- How much credit do we give Facebook for the option value associated with the social graph and other businesses it may enter?
∑ Investors who think the market will ascribe a value to Facebook that implies a high probability of success in transforming the whole Web will have no trouble coming up with a bull case way above the $150 billion enterprise value we get by adding our bullish case valuation of $100 billion to the full option value of $150 billion, particularly if they are very long-term investors. For example, LinkedIn is tradingat 47 times EV/EBITDA and with our 2012 EBITDA forecast of $3.34 billion (excluding the impact of the vesting of the pre-2011 RSUs) for Facebook, that gets to an EV north of $157 billion...and once you
14 And it is not very different from assuming that Zynga, RenRen, Groupon, or even Google are comparable to Facebook.15 To be more precise, investors should ask themselves what they believe the market will believe…
Estimated population covered (millions) 650EV/person ($) $ 56.8Estimated 2012 MAUs for Facebook (millions) 920Implied Value for Facebook social graph ($ billions) $ 52
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believe the whole Web will be social and Facebook will be the engine behind this transformation, this number may actually prove small.
∑ However, those who believe Facebook will not enjoy the benefit of the doubt long enough, given their investment horizon, will then have to make a judgment on the other two questions. Exhibit 32 shows a range of EV/(NTM EBITDA) multiples depending on the relative likelihood of the bear versus bull scenario, and on the "optionality premium" associated with potential new business opportunities. The ultimate multiple ascribed to Facebook will in the end depend on the implicit answers the market will give to each of these questions.
Exhibit 32Potential EV/(NTM EBITDA) Multiples Under Different Scenarios and Premiums for Optionality
Source: Bernstein analysis
Four Major Risks: Balancing Monetization and User Experience, Privacy Regulation, Competition from Google, Regulation, and Governance
∑ Facebook faces all the usual risks associated with doing business in the Internet, where the barriers to entry are very low, and with rapidly growing companies with many (uncertain) opportunities. Of course, it is possible that a new site, application, or platform will emerge and drive fundamental change in consumer behavior online, making Facebook much less relevant. And one does not have to make up new ideas to imagine that happening. This could very well happen due to the success of existing companies. Whether it is (or was, given the acquisition by Facebook) Instagram growing an alternative social environment around photo exchange, or Pinterest first becoming a "social wish list or shopping cart," and growing from there (if it does not get scooped up by one the online giants before that), or Twitter capturing brand advertising dollars and competing effectively with Facebook, or Personal succeeding in its attempt to convince consumers to safeguard and selectively monetize their information in a vault, thus raising the possibility that consumers will attribute value to the data that today they share with Facebook in exchange for the service, living with the risk of Schumpeterian creative destruction is normal course of business for Internet investors.
∑ We have tried to incorporate these risks it into our analysis, to the extent that we could, by setting a terminal growth rate of 0% in our long term DCF model (Exhibit 22 and Exhibit 27)16. This risk is not
16 We call it the creative destruction terminal growth rate
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unique to Facebook, of course, and one could argue that given its size and growth rate, as well as the strong network effects associated with its business, the risks are real but limited.
∑ In addition, there are material execution risks, as the company seeks to grow its customer base, sales and marketing capabilities, infrastructure, and R&D at a pace rarely seen. Again, this is not a Facebook specific risk and par for the course in Internet investing.
∑ However, we believe there are a few risks that are Facebook-specific and should be the focus of potential Facebook investors, of which the most important are the issues associated with balancing monetization and user experience, the risk that privacy regulation could disrupt the company's ability to monetize the social graph, and competition, primarily but not exclusively from Google.
∑ Balancing Monetization and User Experience. In the not-so-distant past, Facebook saw user experience compromised due to the high virality of certain applications (e.g., Zynga games such as FarmVille) and took steps to protect the user experience by decreasing the frequency and number of updates delivered to people in, e.g., a FarmVille players social graph. Those steps had strong consequences on the growth rate of game publishers within Facebook as we discussed above, and on the associated revenue trajectory. It is a clear illustration of the challenge the company faces balancing user experience and monetization.
∑ While there is much hope surrounding new social ads such as sponsored stories, including stories inserted into a Facebook users' Newsfeed, perhaps the most valuable real-estate in the site, these tend to be more intrusive to the user experience, potentially generating contention between the quality of the user experience and Facebook's ability to monetize that user's engagement effectively. It is unclear whether and how Facebook will be able to scale up advertising monetization on the site while preserving the quality of the user experience, in ways similar to what Google achieved with its remarkably simple yet highly effective design of its search engine response page. This may become particularly acute for certain important and valuable user segments such as young adults, who may be heavy users, and hence with many friends (a dense graph) and within the reach of many advertising campaigns, and who are also attractive targets to many advertisers. This is difficult to quantify and model, but it seems to us it is a fundamental problem Facebook will have to address. Of course, Facebook can limit the inventory available to advertisers and seek to compensate that limitation through increased pricing, but it is not clear to us this is a recipe of success to a business with its ambitions.
∑ Privacy Regulation. Privacy regulation can affect all Internet companies, but Facebook is probably disproportionately exposed to legislative and regulatory action in privacy. In the US, Facebook is subject to the requirements of a consent decree17 that put material constraints on its ability to share certain types of consumer data (particularly PII, personally identifiable information) with third parties. The FTC-Facebook consent decree is nearly identical to the FTC-Google consent decree, suggesting that they provide a strong indication of the agency's current thinking and framework to balance consumer privacy and innovation in the Internet. While there are several bills in the US Congress, some with support from the administration, dealing with consumer privacy, including specifically online privacy, our reading of the current proposals suggests that they are primarily targeted at the overall "cookie ecosystem," companies whose business is the trading of consumer information. We do not think the bills currently under consideration would create material incremental (given the requirements of the consent decree) limitations on Facebook.
∑ The situation in Europe requires separate analysis, for two reasons. First, because Europe has had, and will continue to have stricter laws and regulations on consumer privacy. Second, because Facebook is an American company, which, like Google and other Internet companies, will, over time, compete for value
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with European stakeholders across the value chain (e.g., CE manufacturers and telcos). Privacy regulation is a great tool for policy makers to favor one or another set of stakeholders in the name of consumer protection.
∑ One can imagine, for example, a regulator trying to create a rule that says that if a user agrees to share his or her data with an application, data about the users' Facebook friends cannot be shared with the application or application developer unless those friends opt-in. This could have material negative impact on Facebook's ability to monetize the social graph. While not impossible, we think this scenario is currently unlikely.
∑ Our current view is that Facebook's huge success and popularity, as well as the growing global ecosystem surrounding it, including both start-ups and established brand who see it as an increasingly important advertising channel, and lack of clear direct competitors in Europe, make it highly unlikely that we will see proactive regulatory steps with the objective of curtailing Facebook's commercial success. To be sure, highly unlikely is not impossible and Facebook's potential investors should pay attention to the European privacy regulation landscape going forward.
∑ Competition: We believe Google's entry into social and focus on Google Plus, as evidenced by its preeminent role in Larry Page's letter to shareholders and the new incentive structure the company put in place seeking to drive employees to make products "more social" is a reaction to the potential disruption that Facebook could cause across the Web (see Exhibit 1) and across the advertising ecosystem.
∑ On the user side, the growth of facebook.com as an alternative to the open Web should be a concern to Google as it might have negative impact on search query growth rates. It is impossible to evaluate with any precision the past impact of Facebook on the demand for search since we do not have a "control" (we can't really tell what would have happened to query growth if Facebook did not exist). The data we have suggest that query growth was robust over the last several years, despite Facebook's fast growth. For example, we think Google's (fixed) search queries grew more than 60% over the last two years as Facebook engagement mushroomed from 2% of US Internet users' aggregate time online to about 16%.
∑ However, if facebook.com continues to become a larger and larger portion of users' time and, importantly, activities on the Internet, outside the open Web and out of reach of Google's indexing and search, then it is possible that demand for search would decrease. In extremis, so much would transpire inside the Facebook walled garden that Facebook's search and discovery engine, which it will most certainly have and evolve as its property grows, would replace Google search for a growing number of queries18.
∑ Google seems to have had some success acquiring Google Plus users, which is not surprising given the emphasis it has placed on the product, even changing the design of its search home page and other properties to integrate Google Plus (or, as Google puts it, integrate all of its services). However, the reported engagement levels are still disappointing. For example, comScore reported that on average, Google Plus users spent only 5 minutes on site in December 2011, which is far below the average of 423 minutes (7 hours) that it reported Facebook users spent on site during the same period. And these numbers exclude mobile users, which we suspect would make the disparity greater.
∑ On the advertiser or revenue side, it is clear to us that Google will be a formidable competitor to Facebook. We have discussed AdSense as the incumbent platform in the Web, and pointed out that Facebook will have to deliver yields to advertisers that match or exceed AdSense to create a "social network." In addition, Google's display strategy, centered on the Ad Exchange, clearly is seeking to capture a large portion of the display advertising spend from both direct response and brand advertisers.
18 To be sure, we think this is a low likelihood scenario and that Google will continue to be the pre-eminent search engine in the Web for years to come, with limited impact from Facebook on its growth in search.
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As Google uses technology and the large amounts of user data it collects (we note the recent change in its privacy policies, a non-trivial step with clear regulatory risk) to improve the functionality, targeting, analytics, and ultimately ROI and yield associated with display impressions traded on its platform, it will raise the bar Facebook will have to clear to attract online advertising dollars to its platform. As we pointed out above, we think much will depend on whether or not "social advertising' will materially outperform traditional display meaningfully for a large portion of ad budgets.
∑ In large part because of the strong network effects associated with social and Facebook's platform approach, which gives it increased flexibility to adapt and evolve the user experience19, we think Google faces a material challenge in creating a social network that can compete with Facebook. However, given Google's resources and position in the Web, it clearly poses a material threat to Facebook going forward, which cannot be dismissed.
∑ Governance. Mark Zuckerberg controls and will continue to control the vast majority of votes directly or by proxy, even after a Facebook IPO. The structure of the board of directors and the rules associated with appointments could potentially limit the influence and leverage of external shareholders. Of course, we have seen a similar story before with Google where Larry Page, Sergei Brin and Eric Schmidt control the majority of the voting stock. Early signs (compare, e.g., the way Google allocated its IPO shares and the process currently under way with Facebook) suggest that Facebook will be more investor friendly than Google, but the risk remains: we would not be surprised if three or four years from now we hear Facebook investors discussing the levels of disclosure and guidance the company provides, as well as worrying about the process the company follows to take decisions relative to investing in uncertain long-term opportunities and managing near-term financial performance.
19 Despite having much of its code developed in PHP, which we suspect will create scalability and manageability problems going forward.
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Disclosure Appendix
Valuation Methodology
U.S. Internet
We value the stocks in our coverage based on our forecast of 2013 EPS and on the historical price-to-forward-earnings multiple relative to the S&P500's. We use our EPS earnings estimate to calculate theexpected earnings growth in 2013 and select the relative PFE multiple based on that growth rate and recent history. We benchmark the target price with the outcome of a long-term DCF model, which assumes terminal growth rate of 0%.
Risks
U.S. Internet
Sector risks:
- Global economic conditions: Consumer and advertising spend are the main drivers of revenue for allcompanies in our coverage, and deterioration of economic conditions could have a material negativeimpact on revenues and earnings of all companies in our coverage.
- Cyber-security: All companies in our coverage depend on the global Internet. Their data (includinguser-data), infrastructure, and services could be compromised either by malicious attackers or by an"act of God" that compromises major portions of their Internet infrastructure. This could have a majornegative impact on revenues and earnings of all companies in our coverage.
- Network neutrality: Companies in our coverage pay telecommunications service providers forterminating their traffic in accordance to local regulation and business practices, either directly orthrough third-parties (e.g., CDNs). They do not pay to ensure that their traffic is delivered to the enduser with a higher or lower priority than other traffic from the Internet. If fixed or mobiletelecommunications service providers were to charge Internet companies for the delivery of bitsbeyond the usual traffic termination charges, the revenues, earnings and stock prices of companies inour coverage could be negatively affected.
- Privacy: Privacy-related regulation or a major leak of consumer information leading to lower Internetusage could have negative impact on the future revenues, earnings and stock prices of all companies inour coverage.
- Disruptive innovation or global competition: Companies in our coverage derive the majority of theirrevenues from Internet advertising (GOOG, YHOO), e-commerce and e-commerce related services(AMZN, EBAY), and the delivery of content over the Internet (NFLX). Because of relatively lowbarriers to entry, they face the risk of increased competition from a new entrant or from a establishedbusiness in an adjacent space (e.g., Google, Apple or Netflix selling books online); successful entry oreven its announcement could have a negative impact on future revenues, earnings and/or stock prices.
Google Inc
- Google is currently a party in multiple regulatory proceedings (including formal investigations by theUnited States Federal Trade Commission and by the European Union). Actions by these or otheragencies seeking to regulate Google's activities could have a negative impact on the company'srevenues, earnings, and/or its stock price.
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- Android phone manufacturers and Google are involved in a number of law suits related to intellectualproperty. Unfavorable outcomes related to these lawsuits could have a material impact on Google'sfuture ability to capture mobile search upside
- If Apple were to remove Google as the default browser on iOS-powered mobile devices, or charge alarge incremental amount to keep Google as the default search engine, it could have material negativeimpact on revenues, earnings and the stock price.
- If consumers' online behavior or preferences were to change significantly, it could have materialimpact on Google's advertising revenues and the company's performance.
- A negative reaction by other handset manufacturers who distribute the Android operating to theacquisition and integration of MMI could limit Google's upside in mobile online advertising, includingsearch.
- If Google were to pursue another large acquisition or invest a large amount of resources in ventures not directly connected or immediately adjacent to its businesses, financial and stock performance could suffer.
Yahoo! Inc
- Yahoo! could be acquired at a premium to current valuation. Conversely, if the Board of Directorsdecides it will not pursue a comprehensive or partial sale, the stock price may fall.
- Yahoo! may hire a new CEO, whose reception by the market and ability to steer the company in themedium term may have a material impact on the stock price.
- If our assumptions on the timing and degree of competition Yahoo! will face on search and displayprove wrong, the company's performance and stock price may differ materially from our forecast.
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SRO REQUIRED DISCLOSURES
∑ References to "Bernstein" relate to Sanford C. Bernstein & Co., LLC, Sanford C. Bernstein Limited, Sanford C. Bernstein (Hong Kong) Limited, and Sanford C. Bernstein (business registration number 53193989L), a unit of AllianceBernstein (Singapore) Ltd. which is a licensed entity under the Securities and Futures Act and registered with Company Registration No. 199703364C, collectively.
∑ Bernstein analysts are compensated based on aggregate contributions to the research franchise as measured by account penetration, productivity and proactivity of investment ideas. No analysts are compensated based on performance in, or contributions to, generating investment banking revenues.
∑ Bernstein rates stocks based on forecasts of relative performance for the next 6-12 months versus the S&P 500 for stocks listed on the U.S. and Canadian exchanges, versus the MSCI Pan Europe Index for stocks listed on the European exchanges (except for Russiancompanies), versus the MSCI Emerging Markets Index for Russian companies and stocks listed on emerging markets exchanges outside of the Asia Pacific region, and versus the MSCI Asia Pacific ex-Japan Index for stocks listed on the Asian (ex-Japan) exchanges - unless otherwise specified. We have three categories of ratings:
Outperform: Stock will outpace the market index by more than 15 pp in the year ahead.
Market-Perform: Stock will perform in line with the market index to within +/-15 pp in the year ahead.
Underperform: Stock will trail the performance of the market index by more than 15 pp in the year ahead.
Not Rated: The stock Rating, Target Price and estimates (if any) have been suspended temporarily.
∑ As of 04/11/2012, Bernstein's ratings were distributed as follows: Outperform - 40.7% (1.6% banking clients) ; Market-Perform - 49.2% (0.4% banking clients); Underperform - 10.2% (0.0% banking clients); Not Rated - 0.0% (0.0% banking clients). The numbers in parentheses represent the percentage of companies in each category to whom Bernstein provided investment banking services within the last twelve (12) months.
∑ Bernstein currently makes a market in the following companies GOOG / Google Inc, YHOO / Yahoo! Inc.
12-Month Rating History as of 04/10/2012
Ticker Rating Changes
GOOG O (IC) 11/04/11 O (DC) 01/04/10
YHOO M (IC) 11/04/11 O (DC) 01/04/10
Rating Guide: O - Outperform, M - Market-Perform, U - Underperform, N - Not Rated
Rating Actions: IC - Initiated Coverage, DC - Dropped Coverage, RC - Rating Change
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OTHER DISCLOSURES
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CERTIFICATIONS
∑ I/(we), Carlos Kirjner, Ph.D., Senior Analyst(s)/Analyst(s), certify that all of the views expressed in this publication accurately reflect my/(our) personal views about any and all of the subject securities or issuers and that no part of my/(our) compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views in this publication.
Approved By: CDK
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