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Facebook's Sharp Drop in Q4 Growth Raises IPO Stakes


Facebook is a wonderful company, but at a $100 billion valuation, if you're bullish on the themes driving its growth, there are better places to put your money.

The key question investors have to ask themselves is if they want to pay this spring what Facebook might not be worth until 2014.

When thinking about Facebook's valuation, there are two ways to look at it. First, how does Facebook compare to its two closest publicly traded peers, LinkedIn (LNKD) and Zillow (Z) (I'll go into why I consider those its closest peers), and second, how does it compare to the business model it's trying to be when it grows up, Google (GOOG)?

Let's start with the second question. The great thing about Facebook and Google is the companies are similar enough that apples to apples comparisons seem appropriate. Both are large Internet platforms that attract hundreds of millions of users per month. Both generate the majority of their revenues through targeting ads. Both have high margins and business models fairly impervious to competition. So how do the two stack up at IPO time?

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Google went public in the summer of 2004, and we see that Facebook's 2011 revenues and profits exceeded Google's 2004 results. That being said, Google grew faster in 2004 than Facebook did in 2011, and it ended the year with a market cap just above $52 billion, barely half of what Facebook's looking to attain. Google continued to power ahead in 2005 and 2006, growing revenues over 90% and 70%, respectively, with margins expanding to nearly 30%. Because of its strong growth and margin expansion, Google finished 2006 with a market cap of over $140 billion.

If we think Google's valuation trajectory was fair, then the 2012 and 2013 margin and revenue growth estimates I entered in red are what Facebook probably needs to achieve in order to justify its $100 billion valuation – at the end of 2013. Note that Google even grew revenues another 56% in 2007, which investors took into account at the end of 2006 to arrive at that valuation.

So how are things looking for the House of Zuckerberg? A little soft, if Q4 is any indication. Facebook has two sources of revenue, advertising and payments. Advertising is traditional display advertisements. Payments are a relatively new development, sometimes more commonly known as Facebook Credits. To purchase items or virtual goods on platforms like Zynga (ZNGA) games, users must pay with Facebook Credits. Facebook typically takes around 30% of each dollar spent on those platforms. As the virtual goods industry has taken off, the payments revenue line item has increased from $0 in 2009 to over $550 million in 2011. This is fantastic, but as the following table shows, while payments revenue is growing over 100%/year, it represents less than 20% of total revenue and advertising revenue slowed significantly in Q4.

The drop in advertising revenue growth in Q4 is the biggest concern in thinking about Facebook's valuation. If it's just a one quarter hiccup, no biggie, and fortunately we'll likely see Facebook's Q1 earnings before the stock starts trading in Q2. However, if advertising growth really has slowed to the 40-50% range, payments revenue will have to continue growing over 100%/year if Facebook hopes to maintain a $100 billion valuation.

At the moment, when you strip out its net cash Google has a valuation of $145 billion. It earned almost $10 billion this year on almost $30 billion in net revenue. If Facebook is really fortunate, that's probably how its business will look around 2017. I don't see how Facebook at $100 billion is attractive relative to Google at $145 billion ex-cash.

Perhaps that's too apples and oranges for now, given that Google is relatively mature and Facebook is growing much faster. How about relative to LinkedIn and Zillow? First, why those two? While the tech and financial worlds see Facebook as a social networking company, I don't. I see it as a company that has connected millions of users who interact and produce valuable data footprints, which has attracted the attention of advertisers and others looking to take advantage of the data, behaviors, and intentions of users. Facebook, LinkedIn, and Zillow all do this in their own way, and all have built platforms that will be difficult to disrupt given their entrenched user bases, network effects, and their knowledge gained from the quantities of data already gathered.

As the table below shows, Facebook's growth is slowing, perhaps rapidly, while LinkedIn and Zillow growth has continued to accelerate over the past few years. Q4 estimates for LinkedIn and Zillow are in red, and with the conservative expectations post-IPO companies are given, look for both to post triple-digit increases yet again. Growth companies hit their profitability inflection point, when they move from operating at a loss to operating at a profit, at different times. And while Facebook hit its inflection point in late 2008, both LinkedIn and Zillow just hit theirs this year, and should see strong margin expansion over the next couple of years in addition to superior revenue growth. Both also stand to benefit more from the improving labor and housing markets than Facebook, which is more of a general platform to attract consumer eyeballs. Finally, while Facebook's margins are currently far superior to both LinkedIn and Zillow, on a price to sales basis Facebook at a $100 billion valuation would trade at 27 times 2011 sales versus 13.6 times LinkedIn's 2011 estimates and 12.5 times for Zillow.

The bottom line: Facebook is a wonderful company, but at a $100 billion valuation, if you're bullish on the themes driving its growth, there are better places to put your money.

Twitter: @conorsen
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Positions in GOOG, Z, LNKD

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