Facebook Case Analysis

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I. Introduction

Facebook is a social networking website that allows you to connect and share memories with your family and friends online. Originally designed for college students, Facebook was created in 2004 by Mark Zuckerberg while he was enrolled at Harvard University. By 2006, anyone over the age of 13 with a valid email address could join Facebook. Although Facebook did face competition in its early stages from incumbents within the industry on a national as well as international level, it kept growing rapidly.

Based on the data provided and analysis done, I would like to bring to light some key concerns and suggest some recommendations for an Investment in the IPO.

II. Facebook Inc. – Business Model

Facebook primarily generated revenues by advertising. Advertising

accounted for 98%, 95% and 85% of Facebook’s revenues in 2009, 2010 and 2011 respectively. Since all user data is available to Facebook and is owned by the company, Advertisers on Facebook were provided with the opportunity of selecting target segments based on user data, expressed interests, social connections and other demographics. The remainders of Facebook’s revenues were generated through their payments business, which was exponentially growing since 2009; this unit generated $13 million, $106 million, $557 million in the years 2009, 2010 and 2011 respectively.

Facebook had quite a few competitive advantages; large user base, Business model built around data, ease and simplicity of use, mobile app for user engagement and an aggressive stance towards an inorganic growth strategy.

III. US IPO Market - Technology Industry

At the time of the Facebook IPO, the US economy was still recovering from the 2007-09 economic crises and the global economy including Europe and developing economies were in crisis or were faltering.

According to data in Exhibit 1, It can be observed that IPO fundraising (in dollar terms) in the first quarter of 2012 witnessed a 70.2% decrease Year-on-Year as compared to the first quarter of 2011. Also IPO fundraising (in # of IPO terms) activity in the first quarter of 2012 witnessed a 46.9% decrease Year-on-Year as compared to the first quarter of 2011.

Also, Exhibit 2, depicts the recent technology IPO’s in the US markets whose performance was being analyzed by Mr. McNeil’s Team, It is very evident that the stock price of the companies in the industry had witnessed a ‘pop’ on the first day of being traded. Companies such as Groupon and LinkedIn sold at a price above their initial price range. It was the overvalued intrinsic value of the stock that made the prices fall gradually. As far as the IPO for Zynga goes, even though their IPO price was within their price range, its

IV. Purpose of the Facebook IPO

Today, Facebook is the world's largest social network, with more than 1 billion users worldwide. The goal stated in the 2011 Facebook prospectus was that Facebook intended to connect all the 2 billion global Internet users.

In 2011, Facebook Inc. made the decision of going public after noticing the increasing popularity and presence of social media companies. Facebook decided to go for the IPO as it would allow existing shareholders and

investors to participate in the public markets and also allow Facebook to make use of the public equity markets for future fundraising. It was pre-determined that the proceeds from the IPO would be used for working capital and general corporate purposes.

V. Valuation of the Share

The intrinsic value of a company is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.1

In the case is given a Discounted Cash Flow (DCF) approach to evaluating the intrinsic value of the company and the shares. Exhibit 3 shows the analysis of the DCF keeping all the baseline assumptions in line with the analysis

performed by Prof. Aswath Damodaran. The only thing that has been taken into account is the additional number of shares, which may be floated into the public market post-IPO. This has led me to value the share at $32.47. This

price is below the price talk of $34 to $38 per share and may indicate the stock to be overvalued if all the stocks held by the stakeholders may be traded in the open market in the short to medium term.

Another method by which we may be able to determine the value of the stock by using Exhibit 4, which is given below, the extract from the consolidated balance sheet gives us the pro forma values for the pro forma for stock

options and pro forma for stock options+IPO. The difference between these 2 figures i.e. $11,998million and $5597million would give us $6,401million. Therefore, Value of Issue/No. of shares issued = 6,401/180 = $35.56 per share. This price is between the price range of the price talk of $34 to $38 which was updated by the underwriters as this estimation would value the stock at $35.56 .

VI. Key Concerns

There are a number of major concerns that an investor such as CXTechnology Fund must pay attention to before being exposed to unknown risks. Few of the concerns that are more important than others are as follows:

• Shareholding structure completely in favor of Mark Zuckerburg – Since

Mark Zuckerburg is entitled to 56% of the voting rights because of the class B shares, the decision making power in the organizational is too concentrated and a small mistake at the hands of Mr. Zuckerburg may deteriorate a lot of firm value.

• Sales revenue is forecasted to increase only marginally in the medium to

long term – The DCF model proposed by Prof. Aswath of NYU stern

assumes that sales growth will increase at a decreasing rate and increasing number of DAU’s and MAU’s are critical to sustain any substantial

growth.

• At the time, Facebook wasn’t able to advertise on platform on the mobile

devices, which was increasingly being adopted by users – this would hamper the sales revenue as the advertisers would be less inclined to use Facebook as a medium for reaching out to users who access their accounts using mobile devices.

• User engagement – This is one of the most important factors in keeping

the MAU’s and DAU’s high always, and only if these numbers are seen to be increasing and promising would advertisers pay Facebook for

advertisements. A roadmap must be in place to keep user engagement at satisfaction at an all time high.

• User data security and privacy – Facebook has taken a lot of heat in the

recent years and even years preceding the IPO in regard to the social values of the social media behemoth. Underage users and Social experiments on users are only some of the proven accusations on the company and such incidents would only erode shareholder value.

If a potential institutional investor does not pay attention to critical issues in the industry such as these before investing, it may lead to negative returns and also erode significant value from their portfolio.

VII. Recommendation

As the importance or social media rises in the day-to-day operations of corporations, it has encouraged a lot of companies to invest in social media. Also, the previous Tech IPO’s relating to the social media sub-category did perform very well indeed and also allowed short-term traders to make money on the first day of trading after a spike in the price.

The Facebook IPO has potential to deliver returns given their growth trajectory and aggressive growth model. Investors may view Facebook’s positive cash flows as a good signal in the future of the company.

CXTechnology Fund should make the investment on the first day of the IPO in Facebook in two phases at various price points. They should do so in order to sell part of the shares and capitalize on the initial spike in share value in intraday trades and secure some returns and the other part in order to stay invested in the company for the long term, as it seems to be a promising investment from the analysis.

VIII. Exhibits

Exhibit 1 Recent Technology IPOs

Company Ticker IPO date IPO price Gross Proceeds 1st Day Total Return

1st Week Total Return

1st Month Total Return LinkedIn LNKD 19-May-11 $45.00 $352.8 million 109.4% 91.9% 45.6% Groupon GRPN 3-Nov-11 $20.00 $621 million 43.0% 21.3% -5.3% Zynga ZYNG 16-Dec-11 $10.00 $1 billion -5.0% -6.1% -11.3%

Exhibit 2

Market Statistics on US IPOs

Quarter Number of deals %chg QoQ. Quarter Capital raised ($B) %chg QoQ.

Q1'04 339 Q1'04 29 Q2'04 385 14% Q2'04 33 14% Q3'04 339 -12% Q3'04 29 -12% Q4'04 457 35% Q4'04 39 34% Q1'05 327 -28% Q1'05 29 -26% Q2'05 409 25% Q2'05 39 34% Q3'05 364 -11% Q3'05 38 -3% Q4'05 452 24% Q4'05 74 95% Q1'06 360 -20% Q1'06 39 -47% Q2'06 473 31% Q2'06 66 69% Q3'06 355 -25% Q3'06 49 -26% Q4'06 608 71% Q4'06 112 129% Q1'07 395 -35% Q1'07 37 -67% Q2'07 574 45% Q2'07 95 157% Q3'07 442 -23% Q3'07 59 -38% Q4'07 603 36% Q4'07 105 78% Q1'08 253 -58% Q1'08 41 -61% Q2'08 274 8% Q2'08 39 -5% Q3'08 164 -40% Q3'08 13 -67% Q4'08 78 -52% Q4'08 2.0 -85% Q1'09 52 -33% Q1'09 1.4 -30% Q2'09 82 58% Q2'09 10 614% Q3'09 146 78% Q3'09 34 240% Q4'09 297 103% Q4'09 67 97% Q1'10 293 -1% Q1'10 54 -19% Q2'10 314 7% Q2'10 47 -13% Q3'10 302 -4% Q3'10 53 13% Q4'10 484 60% Q4'10 132 149% Q1'11 296 -39% Q1'11 47 -64% Q2'11 383 29% Q2'11 66 40% Q3'11 291 -24% Q3'11 29 -56% Q4'11 255 -12% Q4'11 29 0% Q1'12 157 -38% Q1'12 14 -52%

Exhibit 4

Discounted Cash Flow Analysis

2011 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E Termina l

 DCF Base

year

1 2 3 4 5 6 7 8 9 10 year

 Assumptions: 7.6% 7.6% 7.6% 7.6% 7.6% 0.0%

Revenue growth rate 40.0% 40.0% 40.0% 40.0% 40.0% 32.4% 24.8% 17.2% 9.6% 2.0% 2.0% EBIT (Operating) margin 45.7% 44.6% 43.5% 42.5% 41.4% 40.3% 39.3% 38.2% 37.1% 36.1% 35.0% 35.0% Tax rate 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 39.0% 38.0% 37.0% 36.0% 35.0% 35.0% Increase in CAPEX + WC as % of sales 67% 67% 67% 67% 67% 67% 67% 67% 67% 67% 100% Cost of capital 11.1% 11.1% 11.1% 11.1% 11.1% 10.5% 9.8% 9.2% 8.6% 8.0% 8.0% 67% 67% 67% 67% 67% 67% 67% 67% 67% 67% 100%  Free cash flow to firm ($ millions):

Revenues 3,711 5,195 7,274 10,18 3 14,256 19,959 26,425 32,979 38,65 1 42,36 2 43,20 9 44,073 EBIT 1,695 2,318 3,167 4,325 5,903 8,051 10,377 12,599 14,35 3 15,27 9 15,12 3 15,426 EBIT(1-tax) 1,017 1,391 1,900 2,595 3,542 4,830 6,330 7,811 9,042 9,778 9,830 10,027 Increase in CAPEX + WC 995 1,392 1,949 2,729 3,821 4,333 4,391 3,800 2,486 568 864 FCFF 396 508 646 813 1,010 1,997 3,420 5,242 7,292 9,262 9,162 Terminal value 152,707  Present value:

Cumulative discount factor 0.900 4 0.8107 0.729 9 0.6572 0.5917 0.5357 0.4877 0.446 5 0.411 1 0.380 6 0.3806 PV of FCFF and TV 357 412 471 534 598 1,070 1,668 2,341 2,998 3,526 58,128 Value of firm 72,101.2 - Debt 1,587.0 + Excess Cash 2,000.0 Value of equity 72,514.2

- Cost of equity options (after tax) 3,088.5 WACC Equity Debt Preferre d

Capital Value of common equity 69,425.7 Market values

$81,247.8 $1,587.0

$-$82,834.8 Post-IPO number of shares (millions) 2,138.1 Weights in WACC 98.08% 1.92% 0.00% 100.0% Estimated value /share $32.47 Cost of

Component

11.24% 2.37% 7.14% 11.07% Price talk $38.00

Price as % of value 117%

Exhibit 4

Extract from Consolidated Balance Sheets

Consolidated Balance Sheets: As of March 31, 2012

Pro forma for stock options

Pro forma for stock options +

IPO

Cash and marketable securities $3,910 $3,910 $10,311

Working capital 3,655 3,980 10,381

Property and equipment, net 1,855 1,855 1,855

Total assets 6,859 7,184 13,585

Total liabilities 1,587 1,587 1,587

IX. References

1. Intrinsic Value Definition | Investopedia. (2003, November 23). Retrieved July 3, 2015, from

http://www.investopedia.com/terms/i/intrinsicvalue.asp Mark, K., Compeau, D., Dunbar, C., & King, M. (2014).

Facebook, Inc: The Initial Public Offer (A). In (W12453 ed.). Ivey Publishing.